If you’ve decided to form a legal entity to operate your new business, you’re already on the right track. However, if you set up your company improperly, you might miss the tax benefits and limited liability protection. Here, you’ll learn three common mistakes new business owners make when forming a legal entity (and how to prevent them).
1. Forming an entity in the wrong state
You may have heard that Delaware, Wyoming, and Nevada are good states to form an LLC or S-corporation. While these jurisdictions do have benefits, business owners must always get the state’s permission to operate where their company actually does business.
So, if you run a business that operates in California, you need to get the green light from the California Secretary of State.
The two ways to comply are:
- Form a California legal entity
- Form an out-of-state legal entity and qualify to do business in California
For more on this topic, check out my article on out-of-state LLCs. Also, just to be clear, owning rental properties in a state counts as “doing business’ in that state.
2. Forgetting to file IRS Form 2553 for an S-corporation
For many active businesses, including real estate flippers, S-corporations are often the best legal entity. If you’re not sure about whether an S-corporation is right for you, check out my article on choosing legal entities for real estate investors.
When you set up an S-corporation, you need the same documents as you would with a C-corporation:
- Articles of Incorporation (filed with the Secretary of State)
- Bylaws (internal governing documents)
However, to take advantage of pass-through taxation, you must also file IRS Form 2553 within 75 days of forming your corporation. If you forget, the IRS will tax your corporation as a C-corporation. Not good!
To convert an existing C-corporation to an S-corporation, you can file a Form 2553 within 75 days of the beginning of your business’s tax year.
3. Ignoring corporate formalities
After going through the process of forming a legal entity, some business owners shove the legal documents in a drawer to rest for eternity.
Bad idea.
Your job isn’t done once your formation documents are filed with the Secretary of State. Many states require corporations and LLCs to file periodic updates.
For example, California requires LLCs to file a Statement of Information within 90 days of registering with the California Secretary of state and every two years thereafter. Forget to file and the Secretary of State will put you in the doghouse, suspending your LLC’s good standing.
In addition to filing periodic reports with the government, you should always follow the rules in your business’s internal governing documents and properly approve major corporate decisions.
For example, if you have an S-corporation, your board of directors should either hold a meeting or sign a written consent before the corporation issues stock, enters into material agreements, or amends the corporation’s formation documents. Holding an annual meeting of the stockholders is a good idea too, even if it’s just you and the two other shareholders (and even if it lasts only 15 minutes).
Ignoring the rules in your corporation’s bylaws (or LLC’s operating agreement) can mean big trouble. If someone sues your corporation or LLC, a court might “pierce the corporate veil” and hold you personally liable for your business’s liabilities — this ruins the point of forming a legal entity in the first place. To guard yourself against veil piercing, be careful to follow corporate formalities.
Form your legal entity correctly (the first time)
Taking care to properly create your new business will help you avoid headaches and uncertainty down the road. Forming the right legal entity in the correct state, filing all required paperwork, and observing corporate formalities can help keep your new legal entity in the government’s good graces. If you have any questions about starting, growing, or protecting your business, feel free to reach out.