Modern society has been structured around convenience thanks to a variety of technological advancements. With just a few taps on a smartphone, anyone can summon a vehicle while streaming music from a library containing millions of artists. The convenience afforded by many of the most popular apps and tech companies is undeniable. But not everyone selling ease and convenience will actually bring simplicity to your life.
Off-the-shelf tax programs have conditioned the public to accept the validity of the do-it-yourself approach to filing taxes. Sure, you can answer basic questions and file taxes in a manner that satisfies your legal obligations, but I’m concerned to see the DIY mentality spreading to entity formation. The industry of online entity formation is booming thanks to this mindset and the promise of “convenience” and “low prices.”
As an international tax advisor, I’ve advised countless clients on entity formation and reorganizations to ensure they are customized to their business needs. This requires determining which entity type is best for the intended purposes, selecting the best tax classification, evaluating potential liability issues, determining what ownership restrictions are needed, learning who will be the owners, determining who will hold which offices, deciding where the entity should be formed and much more.
I’ve yet to see anyone achieve their desired results by forming an entity online. Here are four big mistakes that are easy to make, and what you should know:
Choosing The Wrong Type Of Entity
The type of entity you choose will impact how you and your company are taxed. Online entity mills do a tremendous disservice to the public by intimating that a 500-word article on the various entity types provides a sufficient basis on which to make critically important decisions.
What happens if you choose the wrong structure and want to reclassify your entity years later? Break out your checkbook, as this will most likely be a taxable event. As well, keep in mind that your entity type will greatly impact your attractiveness to new partners and investors.
Giving Potential Litigants A Massive Advantage
At a minimum, forming an entity involves contract law, tax law, corporate law and intellectual property law. Would you feel comfortable delivering a lecture on these subjects in front of lawyers? If the answer is “no,” it would be unwise to file your own entity documents. If you are taken to court, then your arm-chair legal work will be attacked by trained professionals.
Most online entity mills don’t include operating agreements with their base package. Pay for an upgrade and you’ll be encouraged to use boilerplate templates. Courts apply a general principle dictating that ambiguities within a contract or document are to be interpreted against the drafting party. A lack of expertise or experience is not a valid defense.
Improperly Securing Your Ownership Interests
It’s very easy to make mistakes when formally establishing classes of stock, the privileges of each stock class and ownership interests. Mistakes can cost you money and even control over your company.
Causing Uncertainty About Intellectual Property Rights
Failing to properly determine intellectual property rights when the entity is formed can cause big problems down the road.
What intellectual property was created before the entity was formed? Is the contribution of intellectual property rewarded with stock? What happens to the intellectual property that is created for the enterprise? What happens to the intellectual property if the entity dissolves? What happens with respect to intellectual property when a principal partner leaves the venture? All of these questions must be properly addressed from the start.
There seem to be two reasons for people choosing the DIY approach: price and understandable ignorance. Most people have not studied the law in any great detail and are simply unaware of the pitfalls. The sales pitch and promotional materials used by entity mills give people a false sense of security. But once you’ve made a mistake, reversing course or pivoting to what you should have done originally can make matters worse.
That’s why it pays to hire help from the start. Here are four tips to find a suitable advisor or lawyer for your entity formation needs:
Find an experienced business advisor.
Your uncle might be a swell guy and a talented divorce lawyer, but he likely doesn’t have the skill set you need. Determine if an advisor has the necessary experience for your matter before hiring them by asking about their experience forming entities. Ask for case studies of companies and situations similar to yours, and what the end results were.
Ensure they are knowledgeable about tax.
Many tax professionals these days go to graduate school to earn an additional degree: LLM in tax for lawyers and MT for accountants. You can look for these additional credentials, though some advisors without them still have enough experience in business to form a company with tax efficiency. Look for an advisor with at least five years of experience.
Determine if they are willing to put in the time to understand your business.
Look for advisors who highlight their attentiveness in their promotional materials and offer customized solutions — this shows they are willing to offer personalized attention over generic solutions. I also recommend avoiding anyone who gives free consultations. If an advisor is getting clients by giving their time away for free, they likely don’t have time to focus on your needs. Remember, these people get paid for their time. If an advisor can give their time away, then not enough people want to pay for their advice. So, why would you?
Ignore the billboards.
Billboards are for ambulance chasers, not lawyers who you should entrust with your life’s work. Many urban centers have business and entrepreneur clubs. Get out and meet people. Consider attending industry conferences for tax/business professionals. I recommend filtering by price and selecting an advisor at the upper end of your budget.
As with most things in life, you get what you pay for. The same is true when you consider convenience versus quality.