Common Mistakes to Avoid When Choosing and Registering a Business Entity

Oversights, errors, and a lack of follow-through during the business entity selection and registration process can have dire consequences for entrepreneurs. With extra costs, legal issues, and stunted growth potential among the possible side effects, it’s important that business owners know what pitfalls to watch out for and how to avoid them. Below are some of the most common mistakes new entrepreneurs make when forming their new business. 

1. Choosing an Entity Type Without Considering a Tax Strategy

New business owners are often drawn to the Limited Liability Company (LLC) structure for its relative ease of formation and ongoing compliance requirements. However, the LLC isn’t an ideal entity for every business.

Before choosing to form an LLC, it’s critical to understand these aspects of the entity:

• Self-employment tax exposure – With LLC default tax treatment, all profit and loss pass through to the LLC members’ individual tax returns. Those individuals must pay 15.3% in Social Security and Medicare taxes on their percentage of the LLC’s taxable income.
• Eligibility for S Corporation tax savings – Not all LLCs may choose the S Corporation election. Some eligibility restrictions exist. For instance, an LLC cannot be taxed as an S Corporation if it has more than 100 members.
• Payroll vs. distribution strategies – When an LLC has chosen the S Corporation election, it’s critical that the company pays its working members a reasonable wage or salary. Remaining profits are paid as distributions to the members, and those distributions are not subject to payroll taxes (including Social Security and Medicare). If the IRS determines the LLC is paying its members inappropriately low wages or salaries in an effort to “game the system” and pay less in Social Security and Medicare taxes, an audit might be inevitable.

Some ways business owners can help ensure their entity choice aligns with a sound tax strategy include:

• Ask an accountant or tax professional for side-by-side (LLC vs. S Corporation vs. C Corporation) tax projections so that you can compare estimated outcomes for each entity option.
• Research what is appropriate as “reasonable compensation” for owner/employees in an LLC that’s taxed as an S Corporation, so wages/salaries vs. distributions are not disproportionate. Consider the type of work the owner/employee does for the company; the experience, education, and skills they have; and the compensation range typically paid for similar work within your industry and geographic area.
• Consult a financial professional for guidance on aligning your entity choice with your 3–5-year growth plan.
• Ask a tax professional about when a future IRS Form 8832 or 2553 election may be advisable to optimize your tax outcomes.

2. Failing to Understand Personal Liability Exposure

Forming an LLC or a Corporation certainly helps protect business owners from personal liability, but know that, in certain scenarios, that protection could be deemed null and void.

Situations when the corporate veil of protection might be pierced and put business owners’ personal assets at risk include:

• Personally guaranteeing leases or loans for the company
• Co-mingling of business and personal funds
• Failing to document company roles, responsibilities, and operating procedures in a governance document (i.e, LLC operating agreement, corporate bylaws)
• Ignoring insurance gaps
• Falling behind on ongoing compliance task deadlines (e.g., annual reports, tax returns, etc.)

Below are suggestions for safeguarding personal liability protection:

• Ask an attorney about what can put you at risk of piercing the corporate veil – e.g., loss of business owner’s personal liability protection, suspension of business operations, administrative dissolution, etc.
• Maintain separate business and personal bank accounts and accounting records to avoid co-mingling assets.
• Draft an operating agreement for your LLC or bylaws for your Corporation (and have a legal professional review them).
• Talk with an insurance advisor for guidance on which policies will provide the essential protection you need.

3. Registering in the Wrong State

Some entrepreneurs mistakenly believe it is most cost-effective and easiest to form a business entity in a state considered “business-friendly” (such as Delaware, Wyoming, or Nevada). In some scenarios, that might be the case. But if someone registers their business as a domestic entity in one of those states and has a physical location in and primarily conducts business from another state, they must file for foreign qualification in that other state. For instance, if a business’s three owners (shareholders) form a domestic C Corporation in Delaware but the company has its main office in New York, where its shareholders live and work, they will need to file to have their Corporation foreign qualified in New York. Only through foreign qualification may the Delaware C Corporation conduct business legally in New York.

So any tax savings or legal advantages an entrepreneur hopes to achieve by registering in a business-friendly state may be overshadowed by the additional costs of registering and complying in two states rather than just one.

To determine which state will be most advantageous as your state of formation (domicile state):

• Discuss with an attorney or other qualified advisor the circumstances under which foreign qualification will be required.
• Assess if the anticipated cost savings (from a tax or legal standpoint) of forming your entity in an alternate state will offset the additional registration and ongoing compliance costs of foreign qualification.

4. Missing Payroll and Tax Registrations After Formation

Filing formation documentation with the state establishes your legal entity, but your company might also need to complete various employment and tax-related registrations and tasks, such as:

• Establishing state payroll tax accounts
• Registering with the Department of Labor
• Applying for sales tax permits
• Setting up withholding accounts
• Registering for state corporate income tax

Letting these tasks slip through the cracks could result in IRS and state penalties, payroll issues, and legal action. Avoid those problems by:

• Using a post-formation compliance checklist to make sure you don’t miss any required steps. Talk with your accountant and attorney for guidance.
• Using a payroll platform, like Gusto, Patriot Payroll, Eddy, QuickBooks Online Payroll, Paychex, Justworks Payroll, ADP, or another SaaS payroll solution, that satisfies your needs.
• Outsourcing registrations to an online filings specialist to ensure they’re completed accurately and on time.

5. Not Aligning Entity Type With Your Funding and Exit Strategy

Entrepreneurs who don’t think through how their entity choice will impact their ability to grow and options when exiting their business may find it difficult to achieve their short- and long-term goals.

A few things to consider:

• Venture capitalists are usually more likely to invest in Corporations than in LLCs.
• S Corporations have ownership eligibility restrictions and limit the number of allowed shareholders, which can affect funding potential.
• Forming one entity type and then converting to another (e.g., changing from an LLC to a Corporation) might be considered a taxable event depending on the state’s approach to entity conversions.

Assess your situation and work through the following questions as you consult a financial professional who can offer input and direction:

• “Am I planning to raise capital?”
• Where do I intend to secure funding—angel investors, private equity, or an acquisition?
• “How long do I envision operating the business?”
• “What do I want to happen to the business after I’m no longer involved?”

6. Skipping Ongoing Compliance After Formation

Failing to track due dates and complete ongoing compliance responsibilities (such as those listed below) can result in fines, interest, penalties, legal complications, and more.

• Annual reports
• Franchise tax filings
• Sales tax reporting and remittance
• Maintenance of accurate payroll records
• Registered agent contract renewal
• Business license and permit renewals

Just a few of the potential consequences include loss of good standing with the state, frozen bank accounts, and administrative dissolution.

Nobody needs those hassles, so:

• Use a compliance monitoring tool to track your upcoming filing deadlines.
• Engage an accountant, attorney, or other business advisor who offers ongoing entity management services.

Keep Learning About Business Formation and Compliance

• Business Structure Wizard
• Starting a Business Checklist
• Tax Saving Features of Corporations, S Corporations, and LLCs
• What Is a Corporate Veil and Why Do You Need One
• 8 Payroll Mistakes That Can Hurt Your Small Business
• Small Business Annual Compliance Checklist

Note: If you’re an accountant, business coach, tax advisor, or other consulting professional, consider participating in our CorpNet Partner Program. It enables you to build a reliable recurring revenue stream and amplify your value by helping your business clients keep up with their ongoing compliance filings.