A remarkable number of upstart Internet businesses are Nevada corporations, often because the operators have been sucker-punched by one of these "instant Nevada corporation" companies, part of whose bait is Nevada's favorable tax structure. This is one of many examples of bad management: Entrepreneurs who are experts at computer technology, but who think they can cut corners by doing their own legal and accounting work. The advisability of this ranks right along with that of performing surgery on yourself or filling your own teeth.
So we have before us John Q. Entrepreneur, a computer promotions wiz who, hoping to march in the footsteps of Bill Gates, wants to start some variety of Internet service. Often what happens in situations like this is that Mr. Entrepreneur goes into business for himself, under his own name and, when the business begins generating income, becomes perplexed about what to do. Incorporate? Become a limited liability company? Or just keep it in his own name?
To begin with, regardless of what form of organization John decides to have, it is unlikely that he is going to operate a Web site called "John Q. Entrepreneur's Web Site". Instead, he has come up with a catchy name, perhaps "dynawidgets.com," a trade name, also known as a "d/b/a" or a fictitious "business name" or an "assumed name". Every state has a rule requiring that, if you operate a business in any name other than your own, you must file some form of documentation that publicly discloses as much. The form of disclosure varies from state to state, as does the nomenclature. However, there is a uniform reason for this requirement (and it is usually a criminal offense to fail to comply with it): To allow consumers a mechanism by which they can find out the identity of the person or entity with which they are doing business.
For example, suppose you go down the street to a fast-food Chinese restaurant called Chinese Delights, and the resulting purchase includes an egg roll, which gives you food poisoning. The food poisoning leaves you out of work for a month, so you decide to sue Chinese Delight for your anguish and lost wages.
But who is "Chinese Delight"? What person? Or what corporation? The way you should be able to answer this question is to go down to the County Clerk's office (or wherever your state's fictitious business name repository is located) and look up the fictitious business name "Chinese Delight". You might find, for example, that "Chinese Delight" is a fictitious business name registered by an individual named John Smith, or perhaps a corporation named Chinese Fast Food Restaurant Specialties, Inc. Either way, you now know who is legally responsible for poisoning your food, and you bring the lawsuit against either "John Smith d/b/a Chinese Delight" or "Chinese Fast Food Restaurant Specialties, Inc. d/b/a Chinese Delight". (For the record, this author is unaware of any restaurant named "Chinese Delight" or any corporation named "Chinese Fast Food Restaurant Specialties, Inc." and, if any such places or such a corporation is in existence, none has served any poisoned foods insofar as this author is aware.)
Similarly, when John Q. Entrepreneur decides that he wants to operate his business known as "dynawidgets.com," he will frequently identify himself as "John Q. Entrepreneur d/b/a dynawidgets.com". This confers no trademark rights or any other rights. It simply tells the World that "dynawidgets.com" is, in fact, a business owned by John Q. Entrepreneur. The next thing that John likely will do is register "dynawidgets.com" with InterNIC. This does nothing more than confer John's exclusive right to use that World Wide Web address.
The above example is a method of operating a business called a "sole proprietorship". From a tax standpoint, the business owner simply includes a "Schedule C" on his or her tax return, reflecting the business's income and expenses (including depreciation and all that other accounting gobbledygook). And if somebody finds a reason to sue dynawidgets.com - such as for overdue debts, defamation, copyright infringement, or whatever - the target of the suit is John Q. Entrepreneur. His entire personal fortune is at risk.
Now, suppose that John Q. Entrepreneur comes to the realization that he simply cannot do everything himself. John is a marketing-type guy - good with concepts, pitches and the like; but the HTML pages that he writes are really not very good. John's friend Tom Techhawk, on the other hand, can make a computer do anything but toast bread, and he writes the most magnificent HTML pages anyone has ever seen. And if they combine their talents on this dynawidgets.com project, there is much money to be made. Given that prospect, they agree that they will work together on dynawidgets.com, splitting the expenses 50-50 and splitting the profits 50-50.
Whether they know it or not, they now have a partnership. More specifically, what they have is a general partnership. What they might not know, however, is that in a general partnership, each partner is individually liable for all of the debts of the partnership. So, if dynawidgets.com turns out to be a bust, the creditors of dynawidgets.com can collect any money owing from whichever partner has the money to get. This is probably fine with Tom, since he just graduated from college and is scrambling around to find the money to pay off his student loans and get a new set of tires for his '72 Plymouth. John, on the other hand, is a veteran promoter, which has gotten him his 5000 square foot house, two Ferraris and a Lear jet. John is unconcerned about the prospect of pumping many thousands of dollars into dynawidgets.com to get it going, along with considerable effort and talent. John is very much concerned, however, about the specter of dynawidgets.com winding up in the dumper, profit-wise, and leaving him personally liable for hundreds of thousands of dollars in debts.
The answer to all of this, of course, is a corporation or some other form of limited liability entity, such as a limited liability company, a limited liability partnership, or whatever other entity the state legislature in question has made available.
A corporation is an artificial entity, created by the state. It nonetheless has the capacity to own property, pay taxes, enter into contracts, sue and be sued, own trademarks and copyrights, and be involved in almost any other business activity for which a natural person can be involved. Corporations can even be convicted of crimes. Limited liability companies, limited liability partnerships, and other similar entities are recent creations of state legislatures.
For purposes of this article, suffice to say that if you decide you should incorporate, and you probably should, the question of whether to have a corporation or limited liability company or limited liability partnership or whatever other entity is available in your state is one that can only be answered after a "sit down" with your lawyer and your CPA.
Corporations have several distinct advantages over partnerships and sole proprietorships, perhaps the most significant of which is limited liability. Another significant advantage is perpetual existence.
The limited liability aspect of corporations is tricky, especially where small businesses are involved. The most significant benefit, however, is that if dynawidgets.com, Inc. turns upside down, the creditors can get their receivables only from whatever assets there are in the corporation. Moreover, if dynawidgets.com, Inc. becomes a thriving business, with a good stream of income and a comparable stream of expenses, John Q. Entrepreneur does not have to worry about his personal fortune in the event that the stream of income is suddenly cut off. The worst that can happen to him is that he loses the investment that he has put into the company.
However, there are several exceptions to this. First, there is a concept called "alter ego," which can leave corporate owners liable for all of the corporate debts. This happens when, as often is the case with one-owner businesses, the business is ostensibly operated as a corporation, but the owner of the corporation commingles his personal assets and business with those of the corporation, fails to follow corporate formalities and generally fails to treat the corporation as the separate entity that it is.
Simply operating the corporation as it should be operated can prevent the problem of "alter ego." The corporation absolutely must have a separate bank account that is used only for corporate expenses. If you start writing corporate checks for your groceries, that increases the likelihood that a court would find that you are not operating the corporation as an independent entity. It is likewise important to follow all corporate formalities. Many small business owners do nothing more than form the corporation and then engage in only the corporate formalities required by the state corporation office (generally, this is the Secretary of State) and the bank. It is dangerous to ignore the other formalities associated with organizing and operating a corporation, such as creating an appropriate incorporating agreement, by-laws and having annual meetings (or a waiver of annual meetings), and so on. These activities are most often neglected in one-owner corporations or, in the states that allow them, one-owner limited liability companies. Another practical exception to the limited liability benefit of corporate existence is that creditors also know about corporations' limited liability status. So, if you go to the bank wanting to take out a loan to fund some endeavor that your corporation is planning, expect the bank to tell you that the shareholders are required to personally guarantee the loan. Banks are well aware of the concept that a one-owner corporation can easily be looted by its owner, leaving creditors high and dry. Other folks extending credit to your corporation likely will also require personal guarantees (landlords and attorneys, for example).
The final significant twist to corporate limited liability is tort liability, ranging from negligence in auto accidents to copyright infringement to sexual harassment to assault. If you, as president of dynawidgets.com, Inc., sign a lease for some office space on behalf of the corporation, you are not personally responsible for the rent (unless you personally guarantee the rent); only the corporation is responsible. On the other hand, if you are driving the company truck over to the computer store to pick up some hardware and, in the process, crash into a parked car, both the corporation that owns the truck and you are responsible. (A good reason, by the way, to have insurance against tort liability.)
By comparison, if Mr. Techhawk crashes the company truck into a parked car, the owner can sue Techhawk and the corporation, but not John Q. Entrepreneur. The same is true for any of the other torts enumerated above; only the corporation and the actual perpetrators are liable. Often, incidentally, corporations are required to indemnify and defend their employees who find themselves taken to court over employment activities, such as negligently crashing the company truck into a parked car.
The other big advantage of a corporation is perpetual existence. This is of particular significance in businesses such as Internet sites because of their intensive acquisition of intellectual property (i.e., copyrights and trademarks). If you try to sell a business, which you operate as a sole proprietorship, for example, the transaction will require the transfer of all of the company's copyrights and trademarks. If the business is a corporation, on the other hand, the former owner can simply sell the stock of the corporation to the new owner, and nothing more need be done but a few corporate formalities. Worse yet, if you're operating your business as a sole proprietorship and you die (this will happen to you one day, you know), the efforts of your heirs either to keep the business afloat or to sell it will be a major headache, which translates into expensive legal fees.
There is, of course, a down side to selling a business simply by selling the stock in a corporation. If anyone buys a business using the mechanism of simply acquiring the corporate stock from its former owners, the buyer likely will require some assurance that there are no "minefields" in the corporation, such as hidden tax liabilities, incurred-but-not-reported employee grievances (e.g., racial discrimination, sexual harassment, etc.) or other such time bombs. Also, selling the stock in a corporation is selling a security, which has special legal implications, particularly for the seller. Another disadvantage of the corporate form is that corporations, like everyone and everything else, are liable for taxes. The particular problem is state and federal corporate income tax. If a corporation makes a profit, it is required to pay taxes; then when the profits are distributed via stock dividends, the shareholder again must pay taxes, albeit on the same profit on which the corporation was already taxed. There are two ways to avoid this "double taxation" problem. If a corporation has one or two owners who comparably share in the day-to-day operation of the business, the corporation can simply pay salaries and bonuses to the owner(s) to the extent that the corporation makes no profit and/or pay end-of-the-year bonuses until the corporation is out of money and, thus, makes no profit. Another way of avoiding corporate taxes is something called a "Subchapter-S" corporation. This means that the corporation is taxed the same way as a proprietorship or a partnership, such that the profits all flow through to the owners. However, Subchapter-S corporations are limited in a number of ways, such as a maximum of 35 shareholders, all of which must be human beings (i.e., a corporation can not own stock in a Subchapter-S corporation). Generally, limited liability companies, limited liability partnerships and others of these new-fangled entities combine the limited liability benefits of a corporation with the tax benefits of a Subchapter-S corporation, but without the Subchapter-S restrictions.
Deciding upon the place of incorporation of a small business is easy. Almost always, you should incorporate in the state in which you are physically located. If you live in California but incorporate in Nevada, that will not insulate you from California's corporate and personal taxes. If the "nerve center" of the corporation indeed is in Nevada, then incorporate in Nevada. But if you are operating a business in Los Angeles and you live in Los Angeles and you are collecting money in Los Angeles, it is unlikely that you can legally benefit by incorporating in Nevada. It is less expensive to incorporate in California than it is to incorporate in Nevada and then register to become qualified to do business in California.
If you learned anything from this, hopefully you have learned that it is important to have a sit-down with your lawyer and your CPA over the question of what form of business entity is best for you. Sole proprietorship? Partnership? Limited liability company? "C" corporation? Subchapter-S corporation? If your business already is operating, the sooner you have this sit-down, the better. If you decide to have a corporation or corporate-type entity, the sooner you have your sit-down, the fewer the cumbersome transfers of domain names, copyrights, trademarks, and other things you will be faced with. Once you have a corporation, limited liability company, or whatever, treat it with respect. Have the meetings; file the documents; keep a separate bank account; and keep the corporation's life separate from your personal life.
(Clyde DeWitt is a partner in the Los Angeles, California law firm of Weston, Garrou & DeWitt. He can be reached through AVN Online's offices, at his office at 12121 Wilshire Boulevard, Suite 900 Los Angeles, CA 90025 or over the Internet at [email protected]. Readers are considered a valuable source of court decisions, legal gossip and information from around the country, all of which is received with interest. Books, pro and con, are encouraged to be submitted for review, but they will not be returned. This column does not constitute legal advice but, rather, serves to inform readers of legal news, developments in cases and editorial comment about legal developments and trends. Readers who believe anything reported in this column might impact them should contact their personal attorneys.)
