3 ENTITIES

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3 ENTITIES

A house divided against itself cannot stand.

—ABRAHAM LINCOLN (FROM MATTHEW 12:25)

To complete your business start-up and operations checklist as well as your business plan, you need to know what kind of body your business will wear. Why body? That’s what corporation means.

Incorporate—1398, “to put [something] into the body or substance of [something else],” from L.L. incorporatus, pp. of incorporare “unite into one body,” from L. in- “into” 1 corpus (gen. corporis) “body.” The legal sense first recorded in Rolls of Parliament, 1461.

—FROM THE ONLINE ETYMOLOGY DICTIONARY,
HTTP://WWW.ETYMONLINE.COM

Decisions, Decisions, Decisions

Once you get past all the setup and planning, your business will be a joy to run. You’ll love what you’re doing. Everything will fall right into place, and you soon won’t have to stop and make decisions each time you must make a move. So far, you’ve been doing drudge work, getting set up, but that will change. You have one more big decision to make. Then you’ll be ready to go forth and conquer the world. (Of course, that one big decision comes only after lots more little decisions.)

What Do You Want to Be When You Grow Up?

The official term for the form—or body—of your business is business entity. There are two ways to decide what kind of business entity you are: decide for today or decide for the long run. Those not making plans, by default, decide only for today. But you—you have great plans. You want a dynasty! You want a piece of that IPO (initial public offering) pie.

There’s no reason not to get it. TechCrunch.com claims venture capitalists (VCs) are flush with money, chasing too few good ideas. VCs are experiencing a funding hangover—seven venture capital firms have raised over $8 billion in early 2016. The money has to go somewhere.¹ Why not tap into that?

You can’t tap into VC money by being sloppy. To get it, you’ve got to start out with a corporation or limited liability company (LLC), and you must have the right accounting team. Your advisory team can help you find the right firm to lay the foundation.

Not everyone wants the stress of venture capital oversight. You might want the freedom to succeed or fail on your own strengths. That doesn’t mean you can’t have investors. You may—but you can keep them at a distance with smaller LLCs or limited partnerships composed of people you know. Before you decide, let’s see what your choices are.

First, understand that what is presented here is just an overview of your options. To fully list all your options would take volumes. Use this information as a starting point for a discussion with your advisory team. There’s just enough information here to help you frame intelligent questions.

Misplaced Generosity

Jerry, a new client, came to me one day to help him set up his brand-new business. After telling me a little bit about his new guitar lesson business, he proudly showed me the California LLC documents that Andrew, a friend of his, had paid for on his behalf. I cringed in horror.

His dear friend Andrew, though meaning well, had just obligated Jerry to a life of needless separate tax returns, an extra $800 annual fee to the California Franchise Tax Board, and a potential gross receipts tax. Plus Andrew had only loaned Jerry the money for the new LLC. Jerry also had to pay that back. All this, before Jerry even opened his doors. What a great friend!

Jerry and I sat down and outlined his business plan, determining his anticipated client base and potential income for the first three years, and then we outlined the expenses it would take to generate that income. In the end it was clear that with Jerry having a full-time job, this business would grow slowly but steadily. It would not earn enough income to make it worthwhile to incorporate, or set up any other entities, for at least the first three years. Perhaps, with some diligent marketing and referrals, Jerry would be in a position to quit his job and run the guitar business full-time in about five years. Not sooner.

Since a guitar business is not likely to cause expensive lawsuits, there was no reason not to operate as an uncomplicated sole proprietor.

We thanked Andrew for the LLC—and told him to either keep it or have his incorporator instantly revoke it before it started generating a mountain of paperwork for Jerry. Fortunately, the incorporator was able to revoke it quickly. But it did not return Andrew’s money. After all, the incorporator had done its job!

A Quick Overview of Entities

Presently, in the United States, there are only two basic types of entities—those that pay taxes and those that pass the taxes over to the owner’s personal tax return. Some entities swing either way. Once a small business decides what type of entity it is, it must stay with that decision. For some entities, like S corporations, there are exceptions, but they may only change once every five years. Here are three of the key issues you’ll need to understand before going deeper into the body of your business.

Taxation. Table 3.1 displays your tax-paying options. As you can see, corporations are the only businesses that must pay their own taxes. Table 3.2 supplies the tax rates. Income or losses from all other business forms are, or may be, passed on to you. You report them on your tax return and pay taxes at your highest tax bracket. These businesses are called “pass-through” entities.

TABLE 3.1 How Income Taxes Are Handled by the Entity

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TABLE 3.2 Tax Rates

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Unless you’re currently in the highest personal tax bracket, you’re better off not forming a corporation. Corporations are notorious for double taxation. Corporations pay tax. Then you pay tax on the dividends or wages they pay you. However, if you are in a high tax bracket, a corporation might be a great idea. You can run lots of employee benefits through the corporation to bring down profits. And the tax on the “qualified dividends” will be 0 percent to 20 percent, depending on your tax bracket. That might actually be a substantial savings when you are personally in a 25 percent or higher tax bracket.

Self-employment taxes. Chapter 11 goes into self-employment taxes in depth. For now, all you need to know is that they cost you 15.3 percent of your business profits, even if your overall taxable income is zero. Income from all the “You Pay” entities is subject to self-employment tax, except one—the S corporation.

Payroll. Working officers of corporations, S corporations, and LLCs filing as corporations are required to take a reasonable salary. With a $458 billion “tax gap”² looming over the country, the IRS has hired an army of auditors. The newly trained auditors are visiting corporate books, looking for unreasonably low wages. (We will explain “adequate compensation” in a moment.) They are looking for hobbies reported as businesses, incorrectly reported retirement deductions, unreported tips, and unreported eBay-type transactions, among other things. For all the other types of entities, wages are not permitted for the owners. Owners’ families may be paid, if appropriate, as Chapter 9 explains. Owners may be required to receive “guaranteed payments.”³ Those are not subject to payroll taxes at the business level. But they are subject to self-employment taxes. (Remember that 15.3 percent we mentioned above?)

It’s a real shame. Most working partners, even sole proprietors, would prefer to have a clear, definite payroll to deal with, rather than having to remember to make quarterly estimated payments.

Major Issues Related to Entities

Before outlining the pros and cons of the various entity options, let’s look at five major issues that are common to all of them. Rather than boring you by repeating them in each entity, let’s summarize them in advance. The issues include: What is an Invest- ment; Partnership Profits and Compensation; Adequate Compensation; The Liability Protection Myth; and Raising Money.

What Is an Investment?

An investment is money you receive from someone who will own shares of your business. In a partnership, this is called a partnership interest. In a corporation, this is called stock. In an LLC, this is called a membership unit or stock. When people make an investment, they expect to get a return on that investment. There are two types of returns. The first is the long-term expectation, which means that investors will make a healthy profit when they sell (or cash out) their partnership interests or stocks. The second is the periodic return during operations. Those periodic returns could be in the form of dividends (often quarterly or annually) when you have a corporation. For partnerships (or entities reporting as partnerships), the partners would get distributions (monthly, quarterly, or annually). It’s important to note that if the business should fail, the investors generally get little or nothing back—beyond a proportionate split of whatever assets might be left over after creditors are paid. The good news for the people who started the business is that once the business is defunct, they won’t owe the investors anything more. (If the “investment” had been a loan, on the other hand, the business owner or founder might still be on the hook to repay the loan after the business is closed or dissolved.)

Partnership Profits and Compensation

When it comes to any partnerships and LLCs (or other LL entities) the following considerations are important to understand:

Profits and losses may be split by formula, time devoted to the company, or other criteria, instead of only by ownership percentage. In fact, the Schedule K-1 (which transfers the partnership’s income, expenses, and credits to the partners) has three separate lines to show the way things are split:

1. Profit sharing

2. Loss sharing

3. Capital ownership

Partners (or members) working in the business must receive a “guaranteed payment” to cover the value of their services. This payment comes to the working partner(s) before any profits are split.

• This guaranteed payment is subject to self-employment taxes.

• This prevents the working partner from reducing his or her share of profits and self-employment taxes by spreading the income—especially to family member owners, or others.

When it comes to the profit-sharing percentage, all partners will pay taxes on their share of the income whether the partnership or entity distributes any cash to them or not. Watch out! The partnership often doesn’t file its Form 1065 until late in the year (by September 15th). So you may need to hold off filing your own tax return until you get your K-1. That may be the first time you learn how much income you must report. And, if the partnership didn’t give you a distribution of your share of the profits, you might be caught short. So definitely stay in touch with the managing partners early in the year to get the numbers—and perhaps some cash to cover the taxes. Note: This same issue also applies to S corporations (and all pass-through entities).

When there are multiple owners, it’s always wise to get “key person” insurance policies. These are insurance policies you take out on the life of each owner with the partnership as the beneficiary.

• When one of the owners dies, the policy pays the family of the deceased in order to buy out their interest in the business.

• This allows the survivor(s) to own and operate the business without suddenly becoming partners with the deceased’s spouse or children.

Adequate Compensation

Adequate compensation is a universal theme in all entities—especially those that provide tax advantages. So just how much is adequate? You would think that this is purely subjective, since the IRS never actually defines an amount in so many words. The IRS touches upon some of its considerations when it talks about S corporation compensation and health insurance benefits.⁴ Do you want something a little more definitive? Here are two resources you can use to pull reports about compensation in your own industry. The IRS has been known to accept these reports during business audits. There is a fee for each report. But if it will help you win an audit, the modest fees are certainly worth it.

• http://www.rcreports.com

• http://www.reasonablecompensation.com/

Liability Protection Myth

Many people form corporations (C and S) and other entities specifically to limit their liability—but please understand that you don’t really get personal liability protection at all. That’s a major misunderstanding. Although you might be protected from the debts of the entity, you are not protected from lawsuits. Think about this. You are working in your business entity (especially if you are the one doing the primary work). You do something wrong. The customer or client sues. Who will they sue? Naturally, they will sue your business. But if you are the one who caused the problem, damage, loss, or harm, they will also name you in the lawsuit. Your corporation or limited liability entity gives you no protection at all. On the other hand, suppose one of your employees is responsible for the harm or damage. Are you protected? Nope. You’ve heard the old saying “The buck stops here.” Ultimately, you are responsible for everything your employees do. Of course, you could always defend yourself in court and win. But at what cost? The monetary cost and time and stress invested in litigation is enormous. Even when you win, it could deplete your savings—and destroy your health.

So if it’s primarily liability protection you want, skip the entity altogether. Instead, get a solid liability insurance policy—and read it! Consider adding an umbrella policy to protect more of your assets if the liability policy can’t go high enough to protect your life’s savings (home, retirement accounts, investments, children’s college funds, and so on).

Raising Money

These days, there are some creative ways you can raise money to start your business or to fund specific projects. By now, you’ve certainly heard about “crowdfunding.” There are several major websites that can help you raise money, like Kick Starter.com, IndieGoGo.com, GoFundMe.com, and others. The money you raise can be handled one of two ways—as income to your business, or as investments in your business.

When you raise money by offering shares in your business, you are raising capital. Those people who buy in are investors. In order to sell shares or micro-shares in your company, you will most likely need to be a corporation. CrowdExpert.com has a directory of the top investment crowdfunding sites—http://crowdexpert.com/investment-crowdfunding-platform-directory/. Fundraising costs are low because these small capital offerings are generally not required to be filed with the SEC (Securities and Exchange Commission). However, it’s well worth reading the SEC’s interesting and detailed bulletin for investors using crowdfunding—http://iTaxMama.com/SEC_Crowdfund. Investors still need to meet certain qualifications, but they are not as stringent as those for publicly traded investments or venture capital investments. This can be a good avenue to get investors—especially if you only want to sell a small part of your business to raise operating, development, or research funds. Before doing this, do your research thoroughly.

You can also raise money from potential customers, fans, and friends who will not own a piece of your business at all. They will be wooed by promises of e-books, special benefits, samples of your products, or other enticements. When you raise money this way, the funds you generate will be income. One outstanding example of using KickStarter to raise money for a project is the Veronica Mars movie. This project raised over $5 million! (See http://iTaxMama.com/Kick_V_Mars.)

Entities, in All Their Glory

So how do you decide? This section discusses all the major business formats with a brief explanation of how they work. Read the pros and cons carefully. There is no one perfect entity.

Although one of the most common questions to TaxMama is “Should I incorporate?” there is no pat answer. Your ideal business entity will depend on what you want out of your business.

Each entity type may have some advantages that are important to you. But there may be some other feature that makes it impossible for you to use. This will help you narrow down your decision.

Sole Proprietorships

This is just you, in business alone. You file your business tax return as a part of your personal tax return. (Some people call this a “DBA business.”) Use the long version of Form 1040 and either Schedule C or Schedule C-EZ. If you’re in business with your spouse, you’re really a partnership, aren’t you? The IRS thinks so and prefers that you report your income that way on Form 1065, U.S. Return of Partnership Income.

Pros

• It costs nothing to set up—unless you register a fictitious name, and then it’s about $50 to $100 every few years.

• You have complete autonomy in business operations and decisions.

• You aren’t required to keep a balanced set of books—but do it anyway.

• You aren’t required to have a separate bank account—but you should.

Cons

• Your profits are subject to self-employment taxes.

• Your business gets no tax benefit for medical expenses and insurance, without the complication and expense of a special plan—and hiring your spouse, as described in Chapters 9 and 10.

• Without any structure, owners often get mentally lazy and don’t think of their operation as a real business—so they rarely make long-term plans or grow the way they should.

• You are personally liable for everything that happens—and all the business debts. All of your assets, including your home and your savings, are at risk if you’re sued.

• There is no continuity of life for the business. When you die, the business does, too.

General Partnerships

Two or more people in business together are considered a general partnership (GP), if they don’t set up any other formal structure. Income is reported on Form 1065, with Schedule K-1s issued to partners.

Pros

• General partnerships are inexpensive to set up. You may even write your own agreement. That’s not a great idea, but it is a good starting point from which your attorney may prepare your partnership agreement. Even if there is no agreement, if two or more people are working together, you’re automatically a partnership in the eyes of the IRS.

• General partnerships pay no taxes.

• Losses are fully deductible on personal returns, unless they are real estate losses; those face passive loss limits, which are described in Chapter 6.

• Certain partnerships can get out of filing a tax return altogether. The partnership may file an election (which is a formal announcement to the IRS) that the partners chose to report the transactions on their personal tax returns. You may do this with investment clubs, certain real estate rentals, or groups of people simply sharing expenses but not in business together.

Cons

• All the partners must be consulted for decision making.

• If loans are required, all partners must provide their tax returns and financial statements. Many refuse because they don’t really want their partners to know how rich—or poor—they are.

• Profits are generally subject to self-employment taxes.

• All partners are personally liable for everything that happens. All their assets, including homes and savings, are at risk if sued.

• All partners are liable for the acts of other partners and employees, too.

• There can be continuity-of-life issues. This means if your partner dies, either the partnership is over or you’re saddled with an heir (spouse or child) who’s in a position to make business decisions. This usually results in conflict. Avoid this by using the key person insurance policies described above.

Limited Partnerships

Limited partnerships (LPs) are coming back into vogue. In a limited partnership, the limited partners put their money in and get complete protection from any liability or lawsuit of the business. However, limited partners don’t get to participate in the decision making. There must always be at least one general partner who takes on the liability for the whole company.

Pros

• LPs are less complicated than corporations, LLCs, or LLPs.

• LPs don’t pay federal taxes.

• They provide complete liability protection for all limited partners.

• Raising money from partners is easy. You don’t have lots of general partners to answer to, or get approval from.

• Getting loans is easier with LPs than with GPs. Only the entity’s and the general partner’s financial reports need to be produced for the lenders.

• Profits and losses may be split by formula, instead of only by ownership percentage—just like general partnerships. Some partners may want losses—others may not be able to use them at all.

• A benefit for the general partner in the LP is that partnership agreements may have buyout clauses or prohibitions against selling the partnership interest without the general partner’s approval. This makes it possible for the general partner to raise the money for business, then buy out the partners after a reasonable return on investment is achieved for the limited partner investors.

• Limited partners’ earnings are not subject to self-employment taxes.

• Although there must be a general partner, the general partner could be an LLC or other limited liability entity. That way the general partner can avoid personal liability for the LP’s debts and lawsuits.

Cons

• LPs are more expensive to set up than GPs. You must get an attorney involved—whether it’s yours or one recommended by the people investing with you. Make sure all understandings and expectations are defined. If you don’t understand something—ask!

• Limited partners have no control over decisions. They could lose their investment if the general partner is inept or crooked. They won’t know in enough time to do anything about it, since the general partner often doesn’t keep them informed.

• Some states charge minimum annual taxes. (California’s fee is $800 annually.)

• For the limited partners, partnership agreements may have buyout clauses or prohibitions against selling the partnership interest without the general partner’s approval. This can make it impossible for the limited partners to get their money out of the investment if they need it or no longer trust the general partner. So evaluate these investments carefully.

• Limited partners’ income or losses are considered passive. Loss deductions are limited to passive income from other sources.

• General partners are fully liable if the company is sued.

Limited Liability Partnerships

Limited liability partnerships (LLPs) are usually reserved for professional groups, such as attorneys, accountants, architects, and others with special licenses—or really good political lobbyists.

Pros

• LLPs don’t pay federal taxes.

• They provide complete liability protection for all limited partners.

• They provide liability protection from the acts of other partners.

• No general partner is needed.

• Profits may be split by formula, time devoted to the company, or other criteria, instead of only by ownership percentage—and the same way that general partnerships may split profits on the K-1.

• There is continuity protection, so that even if a partner dies, the company continues. Do set up buy-sell agreements and key person insurance policies in case of death or disagreement.

Cons

• They are expensive to set up. All partners have a say in the issues. And being professionals, they are all experts—so they do tend to put in their two cents’ worth. All this “cooperation” pushes up attorney fees. It can also hamper change and growth—or enhance it!

• Some states, such as California ($800), charge minimum annual taxes.

• Rules are different in each state.

• Profits are subject to self-employment taxes.

• Since the partners are all professionals, generally working for the LLP, guaranteed payments are mandatory.

Limited Liability Companies

Limited liability companies (LLCs) are an interesting creation. You’ll see why when you read all the features in the “Pros” section that follows. LLCs are one of the most popular business forms with attorneys, since the attorneys can set them up easily using boilerplate forms. LLCs solve the problem of general partner liability. All partners, including managing partners, have liability protection from the debts of the business.

Pros

• Multiple-owner LLCs get to choose whether to report their business as a partnership, a corporation, or an S corporation.

• One-person LLCs may report either as an S or C corporation or on a personal Schedule C.

• LLCs may have multiple classes of ownership—this allows companies to give nonvoting shares to consultants and employees. Those members can share in profits but not decisions. Sharing profits with employees is a good way to attract workers without losing voting control.

• LLCs are permitted to issue shares that may not be sold. Again, this is perfect for consultants and employees. If they leave, you may buy them out at a prearranged price or formula, whether they like it or not.

• LLCs filing as a partnership don’t pay federal taxes.

• They provide complete liability protection for all members from the LLC’s debts.

• No general partner, with liability exposure, is needed.

• There is no requirement for keeping minutes, thus reducing paperwork. But only a fool doesn’t maintain detailed records of all key business decisions, compensation changes, reimbursement policies, and employee or member benefits.

• Profits may be split by formula, time devoted to the company, or other criteria, instead of only by ownership percentage—just like general partnerships.

• Even if a member dies, the company continues. Remember to set up buy-sell agreements and key person insurance policies in case of death or disagreement, as described above.

• The manager running the LLC does not need to be an owner.

Cons

• They are expensive to set up properly.

• They are rarely set up correctly—with elections not being made about the business structure in a timely fashion. This ends up causing complications with the IRS.

• Some states charge minimum annual taxes. For instance, in addition to California’s minimum annual $800 fee, California also charges a gross revenue tax—which is due even if the LLC ends up with a net loss.⁵

• Rules are different in each state.⁶

• Profits are subject to self-employment taxes if the LLC files a Schedule C or a partnership return.

Corporations

Corporations (corps) are still the most common large business format used in the United States. Most publicly traded companies are corporations. Some, on the smaller stock exchanges, may be LLCs.

Pros

• All shareholders, including officers, have liability protection from corporate debt.

• Corps may have multiple classes of stockholders. Generally, preferred shareholders get a guaranteed rate of return, but they have no voting power. This allows companies to give preferred shares to consultants and employees. Those members get an assured stream of income but stay out of management decisions.

• Corporate dividends to shareholders have a preferred tax rate of 0 percent to 20 percent if the stock is held long enough.

• Corporations receiving dividends from other corporations they own may be able to exclude 70 to 80 percent of those dividends. (Or 100 percent for certain small business investment companies.)

• No general partner, with liability exposure, is needed.

• Shares are theoretically easy to sell, though in small corporations the stock may have restrictions—or no market.

• Even if a member dies, the company continues. Remember to set up buy-sell agreements and key person insurance policies in case of death or disagreement.

• Shareholders owning qualified small business stock (QSBS) for more than five years may exclude up to 100 percent of the capital gains on the sale (IRC Sec. 1202).⁷ Setting up your corporation to issue QSBS is a terrific strategy—especially since the PATH Act of 2015 also permanently removed the alternative minimum taxes that were formerly charged on the untaxed income.

• Shareholders of QSBS may deduct up to $50,000 ($100,000 for couples) on losses in the year of the loss, instead of having the losses limited to $3,000 in excess of capital gains.

• You may have unlimited shareholders.

• Anyone anywhere on the planet may own your corporate stock, subject to any Homeland Security restrictions.

Cons

• Corporations are expensive to set up properly.

• Some states, such as California ($800), charge minimum annual taxes, even when you have a loss.

• Profits are subject to double taxation. The corporation pays tax, and the shareholders pay tax on dividends issued from those already-taxed profits.

• The IRS may impose taxes for constructive dividends if you draw too much money.

• The corporation may be subject to an accumulated earnings tax if you draw too little money.

• The IRS may decide your wages are too high or too low and penalize you accordingly.

• If the corporation’s income comes primarily from the services of shareholders, you may be subject to a flat tax of 35 percent as a personal service corporation.

• Undistributed income of personal holding companies may get hit with personal holding taxes.

S Corporations

S corporations (S corps) have all the protections of corporations, but most of the tax filing advantages of partnerships.

Pros

• All shareholders, including officers, have liability protection.

• S corporations don’t need to keep detailed minute books, like a C corporation—though it would be wise to do so.

• No general partner, with liability exposure, is needed.

• Even if a member dies, the company continues. Remember to set up buy-sell agreements and key person insurance policies in case of death or disagreement.

• You may choose to switch to a C corporation format or back, once every five years, as long as you file Form 2553 by the fifteenth day of the third month of your fiscal year. But don’t make a habit of switching. You pick up extra taxes and lose certain benefits in the process each time.

Cons

• Corporations are expensive to set up properly.

• Attorneys and corporate setup paralegals rarely file the S corporation election. You must remember to file it yourself or have your tax pro do it for you. If you don’t do it on time, you might lose the privilege of the S corporation status.

• When shareholders are added, all shareholders should sign the S corporation election, Form 2553, all over again. Companies often overlook this.

• Shares are not easy to sell because there is no public market. Generally, it’s wise to place restrictions on the stock to keep outsiders from owning your business.

• There are restrictions on the employee benefits of shareholders who own more than 2 percent of the business.

• When it comes to health insurance for the 2 percent or more shareholders, there are special rules—a total pain. See Internal Revenue Bulletin 2008-2.⁸

• Some states, such as California ($800), charge minimum annual taxes, even when you have losses.

• The IRS may decide your wages are too low and penalize you accordingly.

• S corps may only have one class of stockholders. Profits and losses are allocated solely by ownership percentage.

• S corp stock is not eligible for the qualified small business stock benefits (QSBS).

• Nonresident aliens may not own S corp stock.

• You may have no more than 100 shareholders.

Whew! That’s a lot of data. How can you decide what your company will be? Photocopy these last pages. Draw a line through all the things that are unacceptable to you. Highlight the items you like. This will give you a visual feel for which entities will and won’t work for you. To help you out, look at Tables 3.3 and 3.4, which give you a visual view of all the entities. Table 3.3 provides a side-by-side comparison of the primary tax considerations of all the entities. Table 3.4 provides a side-by-side comparison of the primary non-tax considerations of all the entities.

TABLE 3.3 Summary of Tax Considerations for C- and S-Corporations, Partnerships, and Family Trusts

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TABLE 3.4 Summary of Nontax Considerations for C- and S-Corporations, Partnerships, and Family Trusts

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A Brief Word About Nevada, Delaware, and Wyoming Corporations

You’ve probably heard many radio ads tempting you with the virtues of the Nevada or Delaware or Wyoming corporations. The ads encourage you to set up your corporation in Nevada or Delaware or Wyoming. They promise to fix your credit, get you loans without your guarantee, and help you do other things you could never do as a small business. Sure, there are good things about them—privacy, for one. The corporate registrars of Nevada, Delaware, and Wyoming won’t reveal your identity, only the identity of your agent for service. If you’re hiding out from creditors or a former spouse, this may be a way to tuck away your assets.

None of these states have corporate, LLC, or partnership income taxes. They don’t even require state tax returns. All you have to do is fill in an annual report about the current officers and agent for service—and pay the state a franchise fee.

What’s bad about using them? If you’re not living in one of those states, you’ll have to register your corporation to do business in your own state, too. Often, that will require you to reveal who you are. It will mean filing and paying your state’s taxes. It will mean extra forms and registrations. Basically, you are duplicating all the work and fees, giving up the privacy you hoped to get by filing out of state, and on top of that, you won’t save a dime in taxes.

What if you follow the advice of those aggressively pushing the Nevada and Delaware corporations and you don’t register in your home state? If someone doesn’t want to honor any of your contracts, he or she doesn’t have to and you have no standing in your state. Someone who figures out your company is not registered to do business in your state can walk away from your bills, and you can’t sue. Your own state, when it catches you, will charge you taxes, penalties, and interest for all the years you didn’t file tax returns locally. Try getting the courts to hear your case.⁹ You won’t have any luck.

If you feel you must set one up, because you think “Someday I’m going to leave my state. Besides, nothing really happens in my state. It all happens on the Internet,” it will cost you. To legitimately have all your transactions take place in Nevada, Delaware, or Wyoming, you’ll need a local address in that state. All your mail must be delivered to that state and then forwarded to you. Not only does this cost you money, but it adds about a week of time to each of your orders or banking notices. You must have either a phone number in that state or a toll-free number. After all, you don’t want your state to see you using a phone number in your own state if you are trying to avoid paying state and local taxes, right? Even local customers in your hometown must use that out-of-state phone number. Your bank account must be in that state. You must pay an agent for service. How much extra can you expect to pay so that you can avoid taxes in your own state? Here are some annual numbers:

If you set up an out-of-state corporation or LLC to save the annual $800 minimum fee in California (one of the more expensive states), you’ve just outsmarted yourself. You’ve spent $675 more than the taxes would have been or much more than $1,000 in excess of the costs to operate openly in your own state. Plus, who knows how many extra banking fees and insufficient fund fees you incurred because you learned about a bounced check too late to cover it in time! If you’re in a less expensive state, as far as corporations go, seeing how high the costs can run may make you think twice—the inconveniences generally outweigh the benefits.

The Real Benefit of Incorporating in Places Like Nevada, Etc.

Sometimes you team up with partners, friends, or business associates who will work with you actively in a business. Your associates are all in different states. Set up the main entity in Wyoming, Nevada, or Delaware—or even Florida, another tax-free state. Then register as a foreign corporation in each state where your business associates live and operate. Remember to register in the state where your fulfillment takes place (storage and shipping of inventory), if that takes place in yet another state.

Another good reason? You are at a point where you want to establish a solid business. You know that you will be moving to a different state within the next two to five years. You’re not sure where you will be moving. You can protect your company’s name, trademark, identity, and presence by establishing the master incorporation (LLC, etc.) in a neutral state. By setting up your business in neutral territory, you can move anywhere in the country without having to close your business and reincorporate elsewhere.

What About Nonprofits?

If you want to get attention and raise money quickly, a nonprofit organization is a great structure. The right cause will open lots of corporate doors and treasuries. Radio and television stations are required to run public service spots, so advertising can be free. The big drawback to being a nonprofit is that you can get voted out if you don’t structure your organization properly. You don’t actually “own” the “company.” So don’t set up your business as a nonprofit entity unless you’re prepared to do it right. Otherwise, the IRS will come down on you like a ton of bricks.

You can start out with a nonprofit entity to establish yourself, your image, and your credibility. Use that as a jumping-off point to create a parallel business, funneling part of your profits to your nonprofit. Just be careful not to use your nonprofit to give your own business advantages and benefits. Self-dealing can void your exempt status.

Set up things properly, and you will be helping yourself and doing good at the same time. Simply take a decent compensation as director of your nonprofit and make a remarkable improvement in the world around you. That’s what Fred Jordan did. His Fred Jordan Mission started by feeding and sheltering Los Angeles’s skid row homeless. Today it helps people as far away as Africa and Hong Kong. Or take actress Carmen Zapata of the Bilingual Foundation of the Arts, which promotes cross-cultural understanding by bringing the Latino experience and culture, through the medium of bilingual theater, to English-speaking and Spanish-speaking audiences. And there’s Rose Martin, whose Peace Neighborhood Center in Ann Arbor, Michigan, raises millions each year to help local people in need—and shares the wealth with other organizations in need.

The organization doesn’t have to be a charity. It doesn’t have to be depressing. You can start something that’s fun or that’s for people in specific professions or that gathers people with similar interests—like bowling, surfing, scrapbooking, video games, movies, eating, anything your imagination can dream up. Imagine devising a way to get paid for doing something you love!

Don’t you admire people who can bring their passion to their work and create a win-win situation for all concerned? That could be you—and your family.

Entities We’re Not Discussing

This book doesn’t cover the use of trusts or cooperatives as a business format. There are advantages to all those forms, too, along with pitfalls. If you’re feeling really aggressive, consider chatting with your advisory team about those alternatives.

All the Highlights in One Place

Let’s summarize what you need to know about entities. First of all, avoid Nevada, Delaware, and Wyoming corporations, unless you’re located in Nevada, Delaware, or Wyoming—or you run a business across several states. Don’t start a business thinking you can hide income offshore.¹¹ Cut taxes, but don’t make that your only consideration. Factor in long-term issues, such as health, retirement, and your family’s and staff’s needs.

The following overview lays out reporting requirements for each type of entity discussed in this chapter.