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Why incorporating my startup was my worst mistake (heyhamza.com)
192 points by chamza 2445 days ago | hide | past | web | favorite | 95 comments



Corporations are not particularly hard or expensive to start, maintain, or dissolve - but you need to be at a stage of life where a thousand dollars here or there is not a major burden. If you are not yet at that stage, that is a different story and there is no doubt that forming or dissolving an entity such as this will normally set you back a thousand or two on either side. In that case, you should tread cautiously unless you can raise some funds (even if it friends-and-family money) to be able to handle such costs without too much pain.

As a lawyer, I would have to say that you should do it by the book and dissolve the entity. I have, however, had a variety of clients over the years who left a Delaware corporation to die without dissolving it and they have not had trailing personal liabilities as a result of the accrued corporate franchise taxes (of course, it is a different matter if the corporation earned a net profit and has an obligation to file income taxes - in that case, failure to file can cause serious problems for the corporation and for its management).

The $89K tax bill is typical of any Delaware corporation that has large numbers of authorized shares, even with a low par value. This often proves a shock to unsuspecting founders who file a do-it-yourself entity without understanding the issues. However, in almost all cases involving an early stage startup, you can deal with this easily by using the alternative valuation method tied to value of assets in the company. Use of the alternative method usually reduces the franchise tax to a very low level. It is easy to find out how to use the alternative method (forms and instructions are available online through the Delaware Secretary of State).

It seems that you needed to set up the entity in order to try to manage the issues with your co-founder and so the choice to set up a corporation was not really a mistake. The choice to set it up in Delaware for a simple situation can be a mistake, in my judgment, but I am probably in the minority among startup lawyers on this issue in believing that a home-state incorporation in the interests of keeping things simple can be and often is the best choice for founders (see http://grellas.com/faq_business_startup_002.html). It is no disgrace for a Silicon Valley startup to incorporate in California, even for a public company (no less than Apple itself is a California corporation). Had you done a home-state incorporation, you would have avoided the hassles with the $89K tax bill, as most states besides Delaware states have a fixed, low amount that you pay every year as a minimum franchise tax (in California, $800).

Incorporation is definitely not for everyone. When and if to incorporate can be tricky questions. I also have outlined a few of the factors to guide that decision as well (http://grellas.com/faq_business_startup_007.html).

There are a good number of early-stage startups that really can't easily afford professional fees and so the answer is not to use a lawyer in all cases to incorporate. But, even if you can't afford a lawyer, it is always worth consulting with one for strategic advice on incorporating before you do so. Such a first consultation is dirt cheap in most cases, and sometimes free. The modest amount paid is well worth it just to be alerted to the main issues and pitfalls involved in setting up an entity. Thus, while it was probably not a mistake in itself to set up your corporation, it likely was a big mistake to do so without some guidance of this type (I had made this comment in connection with your original piece as well - http://news.ycombinator.com/item?id=1924719).

Sorry to hear about the business failure. I know the HN community often stresses what a valuable learning experience this can be but there is no denying that it is a very painful affair by any measure.


One caveat for those conducting business from California is that you have to pay the CA $800 franchise tax even if you incorporate in another state. This seems to be something people don't catch after filing it do-it-yourself Delaware co's/LLCs online. If you're running your startup from California, incorporating in Delaware technically exposes you to costs from both states.

The CA tax is waived in just a few cases. For example, some types of corporations (not LLCs) are exempt in the first year, and an LLC that is dissolved before the first year and meets other requirements may also be exempt.

Disclaimer: I am not a lawyer.

Reference: http://www.ftb.ca.gov/FORMS/misc/1063.pdf

(Also, we're lucky to have contributors like grellas in the HN community. Thanks.)


That's correct. California requires "foreign" corporations (any business entity incorporated in another jurisdiction) "doing business" in Califoria to register as a foreign corporation (or LLC) in California. This "franchise tax" is similar to the "franchise tax" paid by domestic corporations (incorporated in California), and is the greater of net income from California activities (all activities, for California-based companies) or $800.

The franchise tax for foreign corporations is heavily dependent on having a physical nexus to California, such as offices, employees, or equipment located within California borders. For example, registering as a Nevada company but headquartering in Santa Monica would result in the imposition of a franchise tax. While this situation is quite common, it usually has the nasty side effect of subjecting the business to nasty tax penalties for not paying franchise taxes they thought did not apply.

The franchise tax is waived for domestic S-Corporations in their first year of existence, unless they are profitable. LLCs are required to pay the franchise tax whether or not they dissolve in the first year unless they were never a going concern (i.o.w., they never actually did any business).


Another good example of a big, high revenue/high profit corporation that isn't a Delaware corporation is Microsoft. They are incorporated in Washington.

I believe that at least at one time (early '90s, when I got this information from my corporations professor in law school--maybe it is different now), Delaware was basically a rocket docket for complex corporation cases, such as shareholder lawsuits against large public companies. That was one of the attractions of them for large public companies, which might be worth adding to your FAQ. Who wants their cool merger delayed by many years over a suit from grumpy shareholders?


Microsoft does avoid paying taxes, but by using the Irish tax haven:

http://techrights.org/2009/05/02/microsoft-evading-tax-irela...

(I couldn't find the original, less biased account, but it's been well documented)


I believe Microsoft was a Delaware corporation for many years -- at least for several years that I worked there in the '90s. I don't know why they changed.


I suppose in the end it comes down to how much stuff you can (or want) to hold in your head at the same time.

My limited company has cost about £50 in administration and set-up fees so far. But the cost of learning enough stuff not to get myself in trouble has probably been tens of hours of otherwise billable time, plus the ever present risk of doing something wrong.

The problem is that it can be hard to know what is actually difficult, and what is easy but just expensive because not many people know how to do it. It would be nice if somewhere there was a definitive guide to what is worth doing yourself for any given hourly rate.

E.g. if your time is worth £50/hr then doing your own company set up is worth it, but you should hand off pay roll taxes to a professional. If your time is worth £100 an hour, then you should do these three things to cut cost a little, then outsource the rest.


I'm at a loss to understand the headline of the original article.

There is an incredibly simple tax calculator at (http://www.corp.delaware.gov/frtaxcalc.shtml) that makes it obvious that there are two alternative methods of calculation with vastly different outcomes in terms of tax liability.

If you're going to bypass using a lawyer or tax advisor, you need to do your homework. Franchise tax for a C Corp with, say, 10MM shares at no par value and no assets should be about $150.


Excellent write up, George. Even before the "where" to incorporate question, people need to answer the "if," "when," and "why" questions (and some others).

In general, many/most "startups" don't need to incorporate until one of a handful of triggers fire, such incoming investment, upside valuation event on the horizon, tax reasons, launch to the public, especially if the project/site/app is risky in terms of liability, some others.

Like many other real options (the option to incorporate or not, then where, in this case), it's often better not to exercise them early (except for the special reasons that mean otherwise).


I wholeheartedly agree. Really good point! Wait to swing at that ball until it has almost hit the floor--wait, hold, wait, hold, and wait some more. And other than the fact that the article addresses incorporating in Delaware, why are we limiting this discussion to corporations as apposed to the myriad of other entity solutions? And shouldn't we be discussing how to formalize our relationships so that the formalities HELP us, not hinder us? So I would add "what kind of formalities do we need" and then "what kind of entity?" to your "other" questions as well. I don't know if you need a lawyer -- depends on the lawyer -- a lawyer who is willing and able to see into the dynamics of the group and has the wisdom to keep the agreements as loose as possible for as long as possible.


For non-US citizens/residents who are building startups focused on the US market, do you have any suggestions on where to incorporate (e.g. in the US, offshore, "home" country etc)? How much of the decision should be based on potential legal issues and how much on tax?


From a tax perspective, locating the US office in a tax free jurisdiction is most wise. These states would include Washington, Nevada, Wyoming, Texas, Florida, and (sort of) New Hampshire. Also, setting up a relationship between the foreign entity and the US entity to minimize US taxes (as Microsoft has done --see above) certainly helps. Finally some attention has to be paid to the tax effects on the US citizens (or green card holders) and the non citizens (or green card holders). Most foreign tax questions involve an expert in the US as well as in the foreign jurisdiction.

As for legal issues - contracts are handled internationally all the time with ease. But liability issues vary dramatically from state to state and even more from country to country.

For a start up, unless the nature of the business is very liability intense, I would focus on the tax issues. As this article has shown, tax can be really, really expensive.


Oh, come on guys, if you think these are troubles related to incorporating a business, you should really try to do it in Croatia.

For starters, all companies need to be registered at the Court of Commerce, and each new company needs to have a name approved by a judge. Second, you're legally bound to have a name either in Croatian, Latin or Ancient Greek (or presumably another "dead" language, if you can prove it); and even if you do, a judge has to OK it (a friend of mine has recently been through about 30 names and still hasn't been approved; the whole process of approving a name can take days).

Then you have to physically go (yourself, or your lawyer) to 3 or 4 offices to file various registration papers; all in all it can take a better part of the month to incorporate. And to top it all, even if your company does nothing, has no income or expenses, it has some monthly dues to the state from day one, simply because it exists.


Why don't you open in Bosnia or Montenegro? Both are very liberal and have western banks. I have used businesses + accounts in both as offshore vehicles.

You can get a business registration, bank account and merchant account with gateway in Montenegro for a few hundred dollars and in a couple of days.

Heck, with a few thousand dollars you can register your own bank in Montenegro.


Nik, if the solution is to open a company in another country, I'd rather do it in the UK, which is even more sophisticated than the ones you mention, and is only a couple hours' flight away. Actually, I did it already. ;)


It's not a competition though. This guy has been through a rough experience dealing with starting a company, and he has decided to share it with us.

Not to be rude, but I'm unsure exactly where your story fits into that.


It sounds like Franchise Tax associated with annual returns is payable by the corporation, not you personally.

From 8 Delaware Code §503: "All corporations accepting the provisions of the Constitution of this State and coming under Chapter 1 of this title, and all corporations which have heretofore filed or may hereafter file a certificate of incorporation under said chapter, shall pay ...". http://delcode.delaware.gov/title8/c005/index.shtml

It is 8 Delaware Code §277 (http://delcode.delaware.gov/title8/c001/sc10/index.shtml) which says that Franchise taxes have to be paid by the corporation before the Corporation can be dissolved.

It sounds like the corporation is behind on franchise tax, and so is therefore insolvent - it has liabilities exceeding the assets.

If the corporation simply doesn't pay the franchise taxes for a year, the charter will be repealed (see 8 Del C. § 511, http://delcode.delaware.gov/title8/c005/index.shtml). Expect to lose all assets owned by the corporation, including any code.

IANAL, but I suggest you get advice from a lawyer or accountant about this.


Expect to lose all assets owned by the corporation, including any code.

How does this process work?


You really should update your original "How I Incorporated My Startup" article http://heyhamza.com/33994010 to admit you got in over your head. It really changes the whole lesson of the first article. I see you've added disclaimers, but you need to also link back to the potential $89,000 mistake.


Incorrect: Your worst mistake was not talking to a lawyer and an account before doing your incorporation. The value of these professionals isn't their ability to file paperwork but to give you advice that's customized to your situation. Too many geeks think they can reverse engineer what goes into passing the bar or getting a CPA, but the reality is that the smart ones really know enough to know what they don't know...


Consulting a lawyer/accountant would have set someone back even before they started. I asked for the price to consult a lawyer before and it cost around $2500 just to have a chat regardless of the outcome. There is an unwritten guideline "do first, ask for forgiveness later" among people trying to blaze new trails. (NOTE: felons need not apply =) ).


"do first, ask for forgiveness later" applies to software design, but it doesn't apply to the IRS. Firstly you could have spoken to a personal accountant for next to nothing, and there is such a glut of lawyers out there that it's easy to get one for much less. As with any other pros pick these helpers via recommendation from other that have had good results.

PS I say this as someone who did a DIY incorporation and had to un-do it at a later date when it didn't make sense...


I think "do first, ask for forgiveness later" may apply generally to any institution/community where the authority are people who wants the institution to function in the spirit it was setup rather than based solely on the rules that were implemented to govern it. If the IRS was run in that spirit, then such abnormal cases can be dealt with by 'taxing' the person for IRS wasting resources to deal with it but not the rather astronomical figure of tens of thousands of dollars.


There are some law firms that defer all legal fees until a startup raises money; that way, you can get the legal advice until you have some money in the bank to afford paying their hourly rate.


How do they deal with the "call-girl effect" (perceived value of services rendered declines rapidly after the fact)?


Worst mistake I ever made was consulting with a lawyer in setting up a business. Nearly everything he said and advised was completely wrong, and he came highly recommended.

Never accept the word of a lawyer on anything.


Could you expand a little on what happened in your particular circumstances? The advice "Never accept the word of a lawyer on anything" seems a little controversial, to say the least.


To support his point, I registered a startup in Cyprus a while ago, we made it clear to the lawyer that we had very little money and we needed it as cheaply as possible, but he still had us register for trademark, VAT, and who-knows-what other bells and whistles we never needed. It cost us a few thousand dollars more than if we had to do it ourselves (it was about $50 and filling out two forms to do it ourselves).

When it came to dissolving the company, the lawyer quoted us $3000 to dissolve. Not trusting anyone by that point, I called the companies house and they said that, to dissolve the company, all we had to do is fill out a form at their offices, we did it and we didn't even have to pay a cent.

Many lawyers will give you advice that leads to them getting paid more rather than benefitting you.


Getting advice from the clerk behind the counter is a big mistake. Filing the form may be all that's required from their end, but that may not be all that's required by law.

It sounds like you failed to communicate effectively with your lawyer to get the advice you needed. And that's what it is: advice. You can choose to accept or reject the advice since you are the one who is taking the actions.


On what grounds would I choose to reject it? I'm paying him to give me advice because he's the one who knows how these things work, if I knew what to do I wouldn't need him.

By that logic, in the end it all comes down on the GP's "never accept the word of a lawyer on anything".


If it is that blatant then follow up with the relevant professional association that licenses lawyers wherever you are - if there was misconduct then you may well be due some money in recompense.


The hard part, though, is getting a good lawyer and accountant. I've worked with bad ones and good ones, and you can't always tell the difference from the outset.

Many times, I've found that lawyers' and accountants' opinions on critical issues are diametrically opposed. Clearly, someone was wrong in those instances. As expensive as it is, I'm now leaning towards the idea that one should always get two independent opinions, just as a sanity check.

I also strongly recommend double-checking everything yourself. You're still getting professional advice, of course. But sometimes it's good to practice what's derisively called "playing lawyer" and do some legal reading.

A good lawyer or accountant will not mind you asking questions like: "The corporation code says X; could this be applied to me to mean Y?" If your professional does get offended by those questions, I'd consider it a red flag. You're paying by the hour, right? It's no skin off their nose if you want to chat.


[deleted]


"Regardless of if I talked to a professional, I'd actually have to pay the same amount to dissolve this entity."

Really? There is a reason companies like G.E. (http://online.wsj.com/article/SB1000142405274870453020457623...) legally pay essentially no federal taxes. Because there are sophisticated lawyers and accountants (a.k.a. professionals) who figure out how to shift the law to their advantage.

For example, there may be laws in place that allow you to write-off of the dissolution of your business against your personal income taxes. Or perhaps there is a way to file a grievance with the state to prevent having to pay the dissolution fees, based on some statute pertaining to small companies. However, you won't ever know, because you don't want to talk to a professional.

Recognize that you're in this situation in the first place because you didn't want to talk to a professional. Now, as the situation has escalated, you still don't want to talk to a professional. This does not bode well for your future business dealings.

There are law firms that do work for free for start-ups. I'm guessing one of your friends from high school or college is a lawyer at one of these firms. Reach out to the people you know, and figure out how to leverage your connections to get some professional advice. Remaining ignorant is not the solution to this problem.


GE is incorporated in New York not Delaware. GE pays NY state franchise taxes not Delaware.

Overall, GE paid $2.7 billion in income tax in 2010 and over $1 billion in payroll, state and local sales and property taxes.


Ok, but what's your point? On $19 Billion in profit, they paid no federal income tax. I made substantially less than $19B last year, and I paid both state and federal income tax.

Also, if you read the article I posted on G.E., it talks about how you can write off up to $10,000 in start-up costs on your taxes. I think this may be for the company, not the individual, so maybe that doesn't help in a dissolution. However, my overall point was simply that professionals know about all these loopholes, regular Joe start-up guy does not. So go see someone who knows what they're talking about.


It's a shame these things aren't more straightforward. This is a somewhat detached and subjective view of the US but it seems to me that US regulations are designed to nickel and dime you at every turn. If you incorporate here in the UK, don't trade, and dissolve, you owe diddly squat and any taxes you do pay are reasonably simple and well known.

I'm far from a defender of the UK in most cases - especially tax rates - but as a business person in the UK, I at least don't feel like the government or regulations are out to trick me and that I need an expert or a lawyer by my side for every decision I make.


It's mostly due to delware (other states are very different). The state of Delaware uses its lenient coporation laws as a way to make a ton of revenues for the state. These laws attract most corporations (for foreigners some of these laws are very useful) in the US and franchise taxes for a state the size of Delaware are incredibly important.

Like I said other states have very different laws but most people will tell you that with all the bad delaware is still not decent choice to incorporate.


In fact, Delaware makes so much from these taxes that it doesn't even have a sales tax. Other taxes for Delaware residents are also very low compared to its neighboring states.


Are you sure about this? That the UK is a more straightforward place to incorporate than the US? I'm dubious.

* First, there's not much evidence that the person we're talking about really owes a dime to Delaware. He set up a C-Corp (!), which apparently owes some corporate tax, but that doesn't make him personally liable. So, despite choosing the most complicated conceivable way to incorporate in the US, he can probably still just walk away.

* Second, does the UK have an LLC or S-Corporation equivalent? That is to say: is there a structure you can use to get pass-through taxation (business proceeds taxed once, as income) instead of corporate taxation, and have a shareholder structure that allows you to grant equity to employees? Because that is exactly the structure most pre-VC and bootstrapped startups want.

* Third, the US doesn't have the UK's system of rules requiring qualified directors; for instance, a bankruptcy in the US can't prevent you from being a principal in a company.

* Fourth, isn't it more expensive to incorporate in the UK than it is in the US? It costs under $100 to get a liability shield to do business under in the US. What's the equivalent UK cost?

* Fifth, and finally, aren't the laws in the US simply more business-friendly than in the UK? UK employees need to be given reasonable notice or compensation prior to termination; the UK is also not an "at-will" employment regime, making it harder to fire and thus harder to hire employees.

The UK is, from what I've read, the best of the business regulatory regimes in Europe, and the rules don't look onerous; they only look marginally more annoying than those of Delaware. However, I think that by looking at the weird choice made by one blogger (a full-on C-Corp), you might have gotten a distorted idea of what the regs in the US actually are.


I should note that I am not a lawyer or an expert on this stuff ;-)

Second, does the UK have an LLC or S-Corporation equivalent? That is to say: is there a structure you can use to get pass-through taxation (business proceeds taxed once, as income) instead of corporate taxation, and have a shareholder structure that allows you to grant equity to employees? Because that is exactly the structure most pre-VC and bootstrapped startups want.

A LLP - http://en.wikipedia.org/wiki/Limited_liability_partnership - provides pass-through and though it's called a "partnership" is actually a true corporate body. They are not very common as they were only created a few years ago and are not like US LLPs.

The standard "private limited company" represents nearly all of the corporations I encounter. These attract double taxation but this is not particularly onerous. Bear in mind that there are no "state" income taxes in the UK. There's one system, one set of rules, so on a £150k profit, the company would pay 20% corporation tax, and then the remainder split however many ways would attract personal dividend tax from each person. Thanks to a tax credit you get (to help counteract the corporation tax) the basic rate of dividend tax is effectively 0% (then you pay higher bands based on the dividend added to your normal income).

It's not exactly 1 + 1 = 2 territory, but it's a single system that any business owner or small-time bookkeeper can look up and feel confident about doing the calculations for.

Third, the US doesn't have the UK's system of rules requiring qualified directors; for instance, a bankruptcy in the US can't prevent you from being a principal in a company.

Yes, but this is an issue of personal bankruptcy which only lasts for 12 months (and potentially less). It's now common to take out an IVA (Individual Voluntary Arrangement) to avoid bankruptcy. Flipping it around, the UK doesn't have the US's system of "accredited investors" meaning that investment opportunities are open to more people ;-)

Fourth, isn't it more expensive to incorporate in the UK than it is in the US? It costs under $100 to get a liability shield to do business under in the US. What's the equivalent UK cost?

£20 ($32) - http://www.companieshouse.gov.uk/infoAndGuide/companyRegistr...

Fifth, and finally, aren't the laws in the US simply more business-friendly than in the UK? UK employees need to be given reasonable notice or compensation prior to termination; the UK is also not an "at-will" employment regime, making it harder to fire and thus harder to hire employees.

Yeah, there is some of this. However, a British company doesn't have any pressure to sort out health benefits and the legal costs are a lot lower (and the risk of getting sued for this and that seems to be somewhat lower based on the US and UK companies I know). So it's swings and roundabouts, as we say.

While "at will" employment is not (legally) done in the UK, it's not a particularly onerous system for businesses as long as they are careful. The notice period for an employee who's been with you for under 2 years is only a week, for example. For someone under a month, there's no notice period. As long as you aren't sloppy or outright discriminatory, you shouldn't be getting hauled in front of an employment tribunal.

you might have gotten a distorted idea of what the regs in the US actually are.

I did say it was subjective ;-) But I think a lot of it comes from the way in which the US has a plethora of particularly local laws. England, on the other hand, is more equivalent to a state and the laws across England are generally one and the same. Scotland has its own legal system but no-one in England would think to incorporate there (or in France, Germany, or wherever) in the way Americans incorporate across states.

Perhaps if people stuck to their own local states and were aware of their local laws, the situation would not be any more complex than in the UK. The interconnectivity of the US, however, means people do a lot of things across borders and seem to need expert help for everything.


I'm going through this exact same issue right now. I created a C-Corp in DE naively thinking that thats what everyone did and I expected to pay no more than the minimum ($75 or so) in franchise taxes at the beginning. Apparently, since the state needed more revenue, they passed a law that dramatically increased the minimum to $400. I was shocked when i realized this and called the state repeatedly to make sure that there wasn't a mistake. I paid $400 back in Feb and I'll pay another $400 soon so that I can dissolve the C-corp. I now have an LLC in Texas (my home state) which more than satisfies my needs, for now.

Talk about an expensive mistake.


As am I, I know exactly what you're going through. Have you thought about filing the dissolution as a 'Before Business Begins' dissolution (form 274)? We actually never got to the point of publicly releasing our project (and did not have a single cent of revenue), so I was looking at that type of dissolution to avoid this year's $350 minimum tax.

I have still not found what they define as "Beginning Business" in their legal statutes, but I'm assuming a company that never released a product and made no money would fit that definition. Of course, IANAL.


I'd never heard of that form, but I'll look into it.


Yeah, check section 274 here: http://delcode.delaware.gov/title8/c001/sc10/index.shtml

The various dissolution forms are here: http://www.corp.delaware.gov/disso09.shtml


It seems that all dissolution forms have this requirement:

"Before the Certificate can be filed, all applicable Annual Franchise Tax Reports must be filed. Please contact the Franchise Tax Section prior to submitting the document for filing to determine the Annual Reports due. Please make your check payable to “Delaware Secretary of State”"


You'll still have to pay $50 for the tax report to be filed (for each year), but there's no tax liability for the company if you file before business begins or before issuing shares.

You just can't file the reports online, you'll need to talk to a representative of the Franchise Tax Board and they'll email or fax you the company's Annual Franchise Tax Report.


Can I ask why you created a C-Corp in the first place?


Can't speak for CoachRufus87, but I did because my business partner was not a US citizen and we planned on taking on funding.


Naivety


I don't think incorporation was the mistake here, but rather incorporating with no help and without knowing what you're really doing is. I recently incorporated using harvard business services, for $300 I had everything taken care of for me and had all the paperwork in 2 days, well worth the money.


Totally agree. It would be unfortunate if anyone takes away from this that incorporating is a bad idea. What is a bad idea is incorporating with no idea of what you're doing. I disagree that this is a story of dissolution. It is a story of having incorporated with no understanding of the consequences, and finding out too late that he should have sought legal advice to begin with.

There is a lot of talk online about Delaware being the best state for incorporation. This is true if you are seeking outside financing, and most angels/VC's want to see a Delaware C Corp prior to investing. However, if you are going to raise investment, you need to have a lawyer anyway. So at the point you take investment, your lawyer can handle doing an incorporation in Delaware. No one should be filing for C-corporation status by themselves, with no background in the legal requirements.

In the meantime, if you are a startup who wants to put out a product for public use, or need to bring aboard paying customers of any kind, you should probably have an LLC. These are relatively cheap to create (and dissolve) and you can generally find law firms who will do pro bono work for startups in filing the appropriate paperwork (I have found several). Even LLCs require operating agreements and other paperwork before they are considered true legal entities. Any decent law firm does this all the time, and has the appropriate documents on file. Doing this yourself is again asking for trouble. For example, if you do business on behalf of your LLC as the "CEO", "President", or "General Manager", and have not specified that title in an operating agreement, you may be at risk of having the veil pierced (http://en.wikipedia.org/wiki/Piercing_the_corporate_veil), because you are transacting business on behalf of the company in a role that does not legally exist.

In most states, if you have an owner run LLC, your official title is "Member". However, most people don't want to represent their company as "Member", as this sounds weird, and is not a commonly used term. So in practice, you call yourself something else, like General Manager. If your operating agreement says that you can run the company under the title of "General Manager", or anything else you want to call yourself, then you are totally cool. If not, then you will be in trouble if a customer ever takes you to court.


Can you post some cases or background regarding piercing the corporate veil for an LLC based on "transacting business on behalf of the company in a role that does not legally exist"? Who is to say what does or doesn't exit? Based on this logic, a large LLC or LLP would be required to have its whole hierarchy listed in the operating agreement.


That's the point of the operating agreement. It says what does and does not exist.

To quote from Nolo.com (http://www.nolo.com/legal-encyclopedia/llc-operating-agreeme...) :

"The main reason to make an operating agreement is to help ensure that courts will respect your limited personal liability. This is particularly key in a one-person LLC where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Having a formal written operating agreement will lend credibility to your LLC's separate existence."

The operating agreement usually specifies that the member can operate all aspects of the business, including hiring, firing, etc. So authority flows from the member in terms of other people's titles, and it is not necessary to specify lower level employee's title in the operating agreement. It is, however, necessary to specify the relationship of each owner in an LLC to the business if they will be transacting business on behalf of the company. This ensures that the veil between personal and company property remains intact.


Bad news: there aren't any landmark cases. The area is so new that most states haven't even had this issue come up in court yet.

However, I can tell you that the general consensus is that LLCs borrow from corporate law where piercing the veil is concerned.

Veil-piercing isn't about "transacting business on behalf of the company in a role that doesn't legally exist." That's an indemnity issue (the LLC is trying to shuffle blame from itself to an employee). Veil-piercing is about going after the owners of a company on the grounds that the company is really just an extension of the owners' will and bank accounts.

Key factors for veil-piercing (for an LLC): - Owners use the LLC funds for personal expenses without reimbursing the LLC. - Zero/below-market loans from the LLC to the owners. - LLC business decisions made to benefit the owners rather than the business. - Undercapitalization (LLC not have enough money to pay its bills/expenses/liabilities without the owners covering some of these expenses).

There are more, but those are the big ones. The piggy-bank, low-interest-loan, and undercapitalization factors are usually the most important.


"Veil-piercing isn't about "transacting business on behalf of the company in a role that doesn't legally exist." That's an indemnity issue (the LLC is trying to shuffle blame from itself to an employee)."

No... you are confusing the issue.

By way of example, let's say that I am running a member (owner) managed LLC. My official title under state law is "Member". But I sign all my documents with customers and suppliers as "CEO". Then, the company goes broke, and owes money to its suppliers. The suppliers could argue that I did not represent the company in good faith, because I was not the CEO of the company. That position doesn't exist. So they might want to come after me personally instead. Depending on the laws of your state, the court may agree that you did not represent the company in good faith, and allow your suppliers to pierce the veil and come after your personal assets.

The only way to shift blame to an employee would be in cases of fraud or gross negligence, and even then, your company would probably still be liable. What I am discussing is only really relevant in cases where the owner and manager are one and the same (as in the case of the original poster's situation). This doesn't apply to employees who may sign on behalf of the company for routine transactions, but don't have any controlling interest in the company. However, as a manager, it is best to make sure that anyone with signatory authority in your company is given such authority in the operating agreement. However, there is no such thing as piercing the veil with regards to an employee of a company who does not have a substantial ownership stake. They will always come after the owners of the company if it seems that the company is a sham to protect personal assets. The more loosely you operate your company without specific legal agreements (ie operating agreement), the more likely someone will be able to prove that the company is a sham.


>> Veil-piercing isn't about "transacting business on behalf of the company in a role that doesn't legally exist."

That's what I thought, because it doesn't make sense. But I wanted to give him a chance to defend his statement.


His entire post is about dissolution, not incorporation.

Read the post.


I read both this article and his previous of where he created a company with 10,000,000 shares initially. This is why it cost him so much to dissolve the company. If he knew what he was doing he would have created far less shares, like 1500 total.


I've learned that 10,000,000 shares is fine if you have a low par-value per stock. I believe this many stocks are especially good if you're looking for outside investors/board members.

But actually, don't listen to me, I'm the one whose in this ridiculous mess.


How stupid this was is dependent on the specifics, which we don't really have. Were you on the brink of raising a round of capital? Or did you just incorporate in anticipation of raising a round later?

A C-corporation in Delaware is considered the best entity for raising outside investment. The State of Delaware knows this, and charges hefty fees for maintaining a C-Corporation, and apparently for dissolving one. So it makes very little sense to incorporate in Delaware unless you will be raising an outside round of capital, because the costs of maintaining the C-Corporation itself are very high for a start-up with no money. Recognize that a "do-it-yourself attitude" is awesome for developing start-ups. It is perhaps one of the worst attitudes to take in terms of corporate entity formation and maintenance. Documents on file with a law firm with appropriate date and timestamps are virtually bulletproof in court. This is one of the many reasons law firms exist. Documents pulled out of your filing cabinet, to which only you have been privy until the time they end up in court, are a bad, bad idea. Bootstrapping your legal documents or anything else having to do with your corporate entity is a flat out terrible idea, unless you basically do this for a living (in some cases, there are startups who create LLC's daily, in which case you presumably know all of this already).


I made a similar mistake myself, forming an LLC in Massachusetts. I did IT consulting for the SoHo and home market. It was around $550/year to keep the LLC in business ($500 plus filing fees), ~$50 to register with the town you're based for four years, and something like $250 to dissolve the LLC with the state. Every state has different fees; some are quite high, and others very low, pending on the type of business created.

I did it mainly to limit liability, among other reasons. However a little while after forming, I spoke to a lawyer and he said that it basically doesn't limit you from being sued personally. You "can" attempt to deflect personal lawsuits with the LCC (easiest if you keep its finances/files/bank-account separated from your personal stuff, which I did), but it's no guarantee.

He basically advised me that forming the LLC was a waist of money in my situation, and I would have been better off simply as a sole-proprietor (e.g. DBA - doing-business-as). From the IRS's perspective, I was treated as a sole-proprietor for tax purposes (they don't recognize LLC's for single individuals). Of course by then, it was too late to easily dissolve the LLC and "switch" it to a DBA, so it was money wasted.

What annoyed me the most is the same problem Hamza had in the article. You have to pay money to dissolve a business! Really? REALLY?!? Obviously the business failed, or is being abandoned, because it didn't make enough money. Charging a "death tax" on a business seems pretty harsh. I understand if there's a filing fee of $20 or $30, but anything higher than that is ridiculous. Delaware wanting $1,600 from Hamza is downright insane. Perhaps there's more work involved dissolving a C-Corp than an LLC, but still, $1,600 is ridiculous.

Charging a business death-tax reduces seed capital needed to form a new business. Second, it reflects badly on the state, reducing the likelihood of incorporating in it again. Lastly, why not ignore paying the fee altogether, declare bankruptcy, and waste the time/money of the court system dealing with it all? I'm not sure about the legal implementations of that, but it might be a valid option if the C-Corp has no assets left. AFAIK you cannot ask shareholders to pay for it since they're legally shielded from the debts of a C-Corp.


What your lawyer meant was that its very easy to "pierce the veil" of the business entity (your LLC) to go after the owner when the business is owned and operated by a single person. In such instances, it is very difficult to show that the business has a separate identity from the owner. This is especially true for consulting, where the consultant is the business.

On the other hand, it is very difficult to pierce the veil of a business entity with more than one owner (unless the second owner is a spouse or family member of the first).


The ease with which one can "pierce the veil" varies dramatically from state to state. Another reason to be careful about your choice of location for corporate headquarters, employment, "significant contacts," and so forth.

In the meantime, how about IRS code that allows an inventor who owns his invention personally to take capital gains treatment on the sale of that invention contrasted with ownership by an LLC (even single person LLC) or other entity which subjects the owner at sale to normal income taxes at (usually) a much greater rate? I can imagine many convincing reasons for the entity to own the code. But why do that unless you have to? I would tend to want to own the code personally. More flexibility.


Someone never learned what "limited liability" means.

The whole point of a corporation is that you aren't personally liable for its debts! You just paid $400 for no reason!


the company is bankrupt and can't pay its taxes. File ch11. I don't know why you think you have to pay this, it isn't money you owe (the whole point of setting up the business, isn't it?)


This is a good object lesson in why you shouldn't take legal advice from someone posting on the web. The dude was wrong once, and perhaps twice if you are correct. Not to argue with your point, I just want to avoid playing armchair lawyer.


I had a Delaware C corp go bust and my advice from a highly-paid startup lawyer was to file bankruptcy and let it go.

It was eventually struck off the registry and I never heard anything again, and have even registered other corps since.

The only time you wouldn't is if you have taken an investment and want to provide a tax writeoff to investors, or if there are assets to divide. Then it needs to be disolved properly.

(Edit: to add here, if you have been negligent or criminal the creditors will usually be granted a court order to chase up debt with the directors personally. This is rare. In this case you have franchise fees that were run up in the course of doing business. The one thing to learn here that should have been in the original article is that Delaware's main source of revenue is franchise tax, which is calculated on the number of shares issues, so keep that number very low (ie. 3 founders = 3 shares). That is a pretty big thing to miss, IMO.)


This is the poster child for using http://foundrs.com : virtually incorporate with your co-founders, see how far it goes, when it gets serious convert into a real corporation.

Benefits: no corporate taxes, no accountant to pay. Vesting is automatic (4 years, monthly, just like founder stocks in a Silicon Valley startup). And it's legally binding (thank you copyright law, for once you were useful).


Stock is treated as taxable compensation once/as it vests, whether or not the entity is incorporated. Even worse, because the entity is not incorporated, the IRS could treat the stock as a partnership interest. Partnership tax accounting is a goddamn nightmare.

You could find yourself on the hook for thousands of back taxes plus fines if your "virtual corporation" is successful. And that doesn't even include potential state tax liabilities or self-employment taxes.


Has anyone stopped to consider what the real risk of being sued (and losing) is for your average startup website?

Is incorporation premature optimization?


Simple incorporation is really quite low cost, and very quick. CA is the worst I know of, with its $800 minimum franchise tax.

I just (re) incorporated in Oregon. I think it cost $150 (was $50 until 2009), and took about two days. IMO it's well worth it for legal protection from losing personal assets.


What are you paying your accountant each year? Is there a minimum corporate tax in Oregon? In MA I think it is 400 minimum a year.


I don't have an accountant. I'll get one once I'm making money so consistently that it's not worth my time to do it myself. :-)

The minimum corporate tax in OR is $150. In 2009, they raised it from $50, and (I think) increased the tax rates across the board. The biggest change is that they now tax on gross receipts which means you can't deduct expenses.


IANAL and this is probably bad advice, but...

You can let the company fall into bad standing.

I have heard of the various risks with doing that, and I've never understood how those risks go away with dissolution.

If the company is shutdown and not making money, then failure to file annual reports and tax returns is irrelevant because you will have no income to be taxed or fined against. You would have annual state filing fees that would go unpaid, but you would never be personally liable for them. And I can't imagine how you would be personally liable for the actions or inactions of a corporation that conducted no business.


I've thought about this and asked around. I was told that if I did not pay my tax returns and annual reports, the State of Delaware can go after me personally. I'd rather not risk that, and there is a monthly fee that gathers up if I don't pay the annual reports on time; which is what happened this time around.


Have you spoken to an attorney about this? They may be the best people who can advise you in this situation. Look around your area some lawyers offer free consults.


IANAL either ... but directors of companies do have legal responsibilities, and is it possible that the authorities could choose to purse the directors for failing to fulfil those responsibilities.

In the UK at least I believe you can be prevented from holding directorships in other companies, which may mess things up for you personally in the future even without a financial impact.

Not sure what happens if all the directors in a company resign?!


It cost me about $1000 recently to dissolve a Delaware Corporation.


This article should be entitled, "Why failing to hire an attorney was my worst mistake." It's easy to think that some googling and reading statutes will get you where you need to be, but there are very real pitfalls and tax traps out there that attorneys are far better equipped to help you avoid.

If you're not serious enough about your new business to pay for professional advice - you're not serious enough to start it.


It is odd that you have conflated seriousness with access to capital.


I don't think incorporating was a mistake, I incorporated a c-corp last year and read that getting 5K shares was the maximum while remaining at a minimum franchise tax. From my understanding, the initial amount of shares is not a big deal as this can be changed later (emitting new shares, blah blah blah).

I created the corp as an experiment and will see how it goes.


Consider it cost of learning. OTOH, you could have went to a lawyer who may have or may have not already known of the franchise increase. You would have paid an amount in the same ballpark as your c-corp taxes for this consultation.


Wow. Incorporating in Australia is a breeze by comparison. AFAIK, a four page form and ~$400. With an annual fee of $212.


1) This is why we tell our clients, right on our online order form that increasing shares will increase the cost. If they still insist on increasing the # of shares, we'll call and explain to them that you can file a low # of shares now and file "Articles of Amendment" to change it to a higher # later when you are better capitalized. Besides, most VC's are going to amend your original articles of incorporation anyway to create multiple classes of stock, etc. so it's really not worth it to authorize too many shares.

Finally, I've posted this link to our site before: http://www.mynewcompany.com/annual-report.htm

Bookmark it, and then you can check a) when and if you have an annual fee due for your company/state and b) what the filing fee is.


I've been here with several things in life. While winging it has been the source of some "winning" in my life, it has also been the source of many losses.

I'm more of a creative mind/sales guy. I'm an okay web designer, with very minimal programming skills. I tried to develop a tech driven start up and handle everything on my own including the programming. I worked so long & hard trying to take care of things I wasn't skilled enough to do that I was too exhausted to maximize on my talents.

So, I would say focusing on your strengths is a key to success. Marcus Buckingham has nice insights on strengths. Check him out.

-Cheers


I'm surprised that nobody is horrified by how deceiving this is. Its definitly a way for delaware to make money. May be it's just the way law is, you can't use your own judgement on if something is fair or not.

Bringing it back to a computer metaphor would be : Of course you should have done backup, everybody knows that ! You now need to pay 89000$ whether or not you need your data on that drive. You should have consulted an enginineer before buying a computer of course !

See... small mistake, disproportionous response.

At least think that you did nothing wrong, it's just that the law is unfair.


Regarding the amount owed, from my lawyer when I did this two years ago: Please note that there are two methods to determine the tax – the authorized share method and the assumed par value capital method (both methods are detailed on the website).  DO NOT sure the authorized share method as this will calculate a tax balance of over $75,000.00.   Do use the assumed par value capital method as this will calculate the balance at roughly the $75.00-125.00 range.


When someone sues you, you'll better understand why having a corp, LLC, etc. is important.


Unless he signed and recorded something saying otherwise he is not personally responsible for the debt of anyone else, including the Corp, and the state is trying to levy a tax on ignorance.


for a corp with no assets, i would've refused to pay and not bothered with the annual reports. after a number of years that stuff just goes off the books.

you might get some nasty letters. yawn.


I hope you filed Form 1120 also


Why did he have to pay?


state law


Nice law.


To anyone thinking about incorporating: unless you have a very good reason for doing so -- by which I mean solid legal and accounting advice, and money to pay associated costs -- do not bother incorporating outside your home state.

As others have said, DE has a great, business-optimized court system. But if you don't live in DE, you're instantly at a huge legal disadvantage if anything comes up. Meanwhile, you'll be stuck paying:

* annual corporate filing fees (WY), minimum franchise taxes (DE), licensing fees (NV), income taxes (many states), etc. in the state in which you've incorporated.

* foreign corporation fees/taxes and income taxes in your state of residence.

* foreign corporation fees/taxes and income taxes in any other state where you do conduct significant business beyond sales.

* registered agent fees in the state in which you've incorporated.

* possibly mail forwarding fees, depending on what you're trying to do.

(I incorporated in Wyoming last year, then realized how dumb that was, dissolved the corporation, and re-incorporated in my home state this year)




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