6 Mistakes to Avoid When Setting Up Your Corporation or LLC

According to Freelancers Union, there are approximately 42 million Americans who make their living independently — roughly 30% of the workforce. And somewhere along the way, small business providers, contractors, and freelancers need to grapple with selecting a business structure.

Forming an LLC or corporation can be a relatively quick and easy process. However, the truth is that most small business owners aren't experts in either tax or business law. There are some easily avoidable mistakes that can have a significant impact on their business. Here are six of the top mistakes we see.

1. Selecting the Wrong Business Entity

The LLC (Limited Liability Company), S Corporation and C Corporation are the three most common types of business structures in the U.S. These structures have some distinctive features, so picking the right option is important.

• An LLC is great for small businesses that want liability protection, but also want minimal formality and paperwork.
• The S Corporation is a pass-through entity for federal taxes (like the LLC) and is great for small businesses that can qualify.
• Lastly, the C Corporation files its own tax report and isn't appropriate for most freelancers, unless you plan to seek funding from a VC or your tax adviser specifically advises you.

Here are some examples of common mistakes made when choosing a business structure:

• A freelance graphic designer forms a C Corporation and finds herself paying a significant portion of her income due to double taxation.
• Two partners form an S Corporation for their SEO consulting business and soon realize they must share in the income in direct proportion to their ownership (at least when it comes to tax reporting), even though they've actually arranged to allocate the profits 75%-25% this year. They should have formed an LLC instead where they can have more flexibility in dividing the profits.

The point is, there are many minor but significant mistakes that founders can make when starting a company. It is tempting to use a generic form that you can obtain on the internet, or even from a governmental agency. The better strategy is to at least spend an hour with competent attorneys to discuss your plans.

2. Incorporating in the Wrong State

Delaware and Nevada are hot states for incorporation. Delaware offers some of the most developed, flexible, and pro-business statutes in the country, and Nevada has become a popular choice due to its low filing fees and the lack of state corporate income, franchise, and personal income taxes. However, these benefits are more advantageous to larger companies. If your business has less than five shareholders, incorporate in the state where your business has a physical presence. Otherwise, you'll be dealing with too many hassles and fees for operating out-of-state, including difficulty opening a business bank account, appointing a mandatory registered agent, and fees for operating as a 'foreign entity' in your own state.

3. Neglecting Necessary Business Licenses

A corporation or LLC is not the same as a business license. Most businesses are required to get some form of local, state, or federal license. This can be true for a freelance writer working from home, so you should check with your local city hall or county office to see what kind of license you may need. Most business licenses are inexpensive to obtain and are much cheaper than having to pay costly fines for operating without a license.

4. Staying in Compliance

Your job isn't over once your applications are in and your LLC or Corporation is formed. You must keep your business entity in compliance. If a plaintiff shows that you have not maintained your LLC/corporation, your "corporate shield" can be pierced, making your personal assets vulnerable. This means you must:

• Keep your personal funds separate from those of the business (no commingling).
• Use your business title when signing business documents so that no one can argue that you were signing in your personal capacity.
• Register your company's "Doing Business As" (DBA) name.
• Send in your Annual Statement/Annual Report at the time required by your state of incorporation.
• File for foreign qualification if you're operating in any state(s) other than your state of incorporation.
• Keep the state up-to-date with any key changes to your business with an "Articles of Amendment."

5. Not Completing the Formation

Today, it doesn't take much effort to legally form an entity. But often that's where the effort stops. When forming an LLC, for example, the company is formed by filing Articles of Organization. That creates the legal entity. There is another important step, and that is to draft and sign an Operating Agreement for the company.

The operating agreement outlines the structure of the company, including financial and working relationships. With some limited exceptions, the operating agreement governs all of the following:

• Relations among the members as members and between the members and the limited liability company
• The rights and duties under this chapter of a person in the capacity of manager
• The activities and affairs of the company and the conduct of those activities and affairs
• The means and conditions of amending the agreement

The operating agreement may contain any provision that is not contrary to law. In Arizona, even if the operating agreement conflicts with a provision of the Arizona Limited Liability Company Act, the provision of the operating agreement governs, subject to certain restraints.

Among other things, the operating agreement details each member's percentage of ownership, addresses how the profits and losses will be divided, and outlines each member's responsibilities.

An important reason to formalize your operating agreement is to protect the members of the LLC. An operating agreement is often considered "Exhibit A" by the courts with respect to limiting the personal liability of the members. Without an operating agreement, a court might assume that the LLC is actually either a partnership or a sole proprietorship.

If you ever need to prove it, a formal operating agreement will lend credibility to your LLC's separate existence. For example, some banks require an operating agreement before allowing an LLC to open a company bank account.

This next point can't be emphasized enough. Good operating agreements are detailed! They outline each member's responsibilities and describe the inner workings of the business. As a general rule, the operating agreement should attempt to leave very few questions unanswered. That way members will know what they should expect during their involvement.

One of the issues that can arise when forming an LLC by oneself or creating it online is that the operating agreement gets forgotten or, if one is created, it is simply too generic. If you buy an operating agreement online, 9 times out of 10 it contains boilerplate provisions that are destined to create problems down the road. Each member should receive a copy of the operating agreement so if questions do arise, one can easily check to see if the answer is already there.

The operating agreement must be signed by every member of the LLC for it to be enforced. Amending an operating agreement usually requires the unanimous consent of all of the members. If there is already a disagreement among the members it is unlikely that you will find the votes needed to amend your LLC's operating agreement.

This may surprise you, but the operating agreement can be oral or sometimes even implied. Consequently, there will almost always be some agreement among the members about their relationship. But this implies that there will almost certainly be some disagreement as well. This may result in litigation. The best practice will always be to formalize the operating agreement in writing and to include as much detail as reasonably possible.

The operating agreement should include decisions about the contributions that the members must provide. Also, the operating agreement should include terms regarding the expulsion or suspension of existing members.

Here's an example of something that is often neglected. What happens to a member's ownership interest if that member dies? As a valuable property item, the member's spouse or estate now owns the membership interest in your LLC. He or she may want to step in and become part of the LLC. If that's agreeable with you, great. Often it is not. You can address this scenario in your operating agreement.

6. Not Forming a Business Entity

The biggest mistake is assuming your business is too small to worry about forming an LLC or Corporation. In today's uber-litigious society, it's wise to separate your personal and business finances. By staying as a sole proprietorship, you're putting all your personal assets at risk. So, even if you're putting in 80-hour weeks to drum up a new business, take some time to incorporate or form an LLC. You'll be able to scale your business far more smoothly and securely for years to come.