State Incorporation Boo-boos

If you're an entrepreneur thinking about starting a small business, you've probably researched already the costs and benefits of incorporation. But you probably also need to look into one key issue--the possible state incorporation mistakes you don't want to make. Fortunately, with just a wee bit of preparation, you can sidestep the biggest blunders.

Mistake #1 to Avoid: Unnecessarily Incorporating Your Small Business

Incorporating your business venture does reduce your business risks and may minimize taxes. But the benefits don't accrue automatically nor is all situations. Accordingly, verify that you will enjoy benefits.

If you will personally be required to guarantee the new corporation's debts and if you personally provide all of the services, for example, a small business corporation may offer you little in the way of liability protection. Personal guarantees and personal tort liability (for your own actions) may "trump" the corporation's protective power.

Furthermore, until the operation generates meaningful income, incorporating probably won't save you taxes. Corporations typically cost more in accounting and legal fees. And corporations often don't save significant tax until income or payroll taxes are painful.

Mistake #2: Ignoring the LLC Alternative

Some entrepreneurs and small business owners automatically default to "corporation" when they think about setting up a new business. But that's too bad. Businesses and investment ventures can also be operated as limited liability companies, or LLCs. And the LLC option provides some clear advantages over a traditional corporation.

For one thing, an LLC often means simpler accounting and tax return preparation. A one owner LLC, for example, is disregarded as a separate taxpayer, meaning its income and deductions just get thrown onto the owner's regular tax return.

Example: A single member (one owner) LLC owned by a corporation just reports its business income and deductions on the "parent" corporation's 1120 or 1120S tax return.

Another advantage of the limited liability company? An LLC typically requires much less red tape and rigmarole to operate and govern than a corporation does. You can consider an LLC the equivalent of "lite" salad dressing or "lite" beer.

Mistake #3: Forgetting the S Election

Forgetting about the Subchapter S election, which allows the corporation to sidestep paying federal income taxes on the business profits, is another big incorporation boo-boo.

By default, corporate profits are subject to income taxes when earned by the business and then again when distributed to shareholders as dividends. This double-shot taxation disappears, however, if the shareholders elect "Subchapter S" status.

Tip: Stockholders must make the "Subchapter S" election before or at the very start of the first year they want to escape corporate double-taxation.

Note: The precise deadline for making an S election is by the seventy-fifth day of the tax accounting year (often March 15th), but early S elections can also be made up to twelve months before the effective date.


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Stephen L. Nelson is a Seattle CPA and the best-selling author of Quicken 2010 for Dummies as well as the do-it-yourself incorporation ebooks, Florida Incorporation and Georgia Incorporation