Don't Start Off by Incorporating

One of the big ways to become a loser is to follow the traditional road of setting up a corporation before starting a new business. I and millions of others have taken this road, and let me tell you some, it's wrong.

I am not giving you legal advice on this, because the traditional legal advice is to incorporate to limit your liability. Actually, in many instances (such as fraud; guarantees of corporate obligations; liability for unpaid wages of the corporation, at least in New York; and liability for unpaid withholding taxes, federal, state and city; and association of your name with the corporation by the nation's credit reporting companies) this advice does not hold true. Incorporating doesn't avoid these and other unpleasantries.

The main reasons for urging people not to incorporate, when they start up a business, are strictly business considerations.

The first reason is that waiting for a corporation to be formed is a deterrent to moving forward with your planned business activities. You think that you have to incorporate first and, not knowing the law, do very little if anything to further the business while trying to find a lawyer, raise the money needed to pay the lawyer up front in advance of incorporation (because you have no regular lawyer willing to do the work on a billing basis), have various communications with the lawyer to make up your mind what features to have in your certificate of incorporation; and finally wait for the corporation to be formed and you to obtain evidence of such incorporation.

You wind up waiting perhaps a month or longer, which has a tendency to take the steam out of your intention to start up the specific business, so that you often wind up with an unused corporation on the shelf instead of a business doing any business.

The second reason for not incorporating is that there are more costs than you realize associated with the creation of a corporation or other type of business entity. First of all, there is the value of the time you have to spend in creating the corporation, as described in the first reason above. This has a certain economic value to you, which we'll say amounts to $1,000 in lost opportunities.

Then there is the cost of reserving the corporate name and then incorporating under the reserved name (the filing fees and taxes) plus the fees for the attorney and paralegal firm or corporation system which may prepare the various papers for use in incorporating, including the preparation of the certificate for reservation of the corporate name, the certificate of incorporate, the minute book, stock certificate book, seal, by-laws and various shareholder, director and incorporator's minutes. These fees in the aggregate can add up to $750 to $1,500 or more, depending on the complexity of the work, such as including various classes of stock and setting up some type of qualified plans under IRS rules.

But these initial fees are only the beginning. Every so often you will incur fees payable to accountants, tax preparation firms and lawyers for various services which your corporation will need from them to prepare and file various forms and reports, including the preparation of balance sheets and profit and loss statements for use in connection with annual tax returns (federal, state and perhaps city), for the preparation and filing of various payroll tax withholding forms and reports for the corporation, insurance reports, and whatever other reports various governmental agencies will require of your corporation, even if it is doing no business, merely because you have created an "entity" and have obtained a tax identification number from the I.R.S. showing to the world that your corporation is one more "legal entity" at which various private and governmental types can feed.

Of course, you must include all directors' and shareholders' meetings and the various minutes which you must maintain to prove that your corporation is really doing business as a corporation and that it is not just yourself doing business under a "sham corporation" or fictitious corporate entity. You have to spend time and money to give substance to a corporation to prevent yourself from being liable as the "alter ego" of the corporation.

The total cost per year for these services which otherwise would not be required if you merely did business as yourself, perhaps under an assumed name (i.e., d/b/a), could easily amount to $2,000 to $3,000 or more.

A third reason is that the use of a corporation is deceptive to the user, because he/she thinks that there is little cost and much protection from personal liability, but as we've seen above, this is not true.

A fourth reason: For lawyers, there is something else which should be considered. When you incorporate a business you are now forcing yourself in any lawsuit you may bring or in any lawsuit which may be brought against you, to hire a lawyer or law firm at market rates to represent your corporation.

The reason for this is that under the ABA Code of Professional Responsibility a lawyer is not permitted to represent a client (even if its his wholly owned corporation) if the lawyer is to be a witness in the matter. Since the lawyer presumably is going to be a witness in some respects in any significant matter involving the corporation, he/she will have to pay some outside lawyer or law firm to learn about the problem, to coordinate with the owner of the corporation, and to provide the needed representation at a cost which often can add up to $20,000 or more in relatively simple litigation, and make the litigation too costly to continue, which thereby creates liability for the corporation merely because it is a corporation.

This has happened to me several times, and it makes one sick to see the result, especially when the rule of law (the ABA Code provision) shouldn't have such effect.

But this is the rule when a lawyer is the owner of the corporation and therefore a witness for the corporation. In some states (such as New York) a corporation must be represented by a lawyer when it comes to court actions, whereas in other states, such as Pennsylvania, a corporation may be represented by an officer, director or significant shareholder. But even this latitude in states such as Pennsylvania doesn't overcome the ABA Code provision which says that a lawyer cannot be the lawyer for a client (even a wholly owned subsidiary) if the lawyer is going to be a witness.

In fact, this prohibition even extends to the costly part of the lawsuit, which is the pretrial phase, when most of the legal time is put in. During this period, there is no trial, and the prohibition seems most outrageous to be applied prior to trial, but it is, and you should be aware of it. Also, the prohibition applies to the posttrial and appellate phases, so that a lawyer with his own corporation has to hire some other lawyer, at a cost which can amount to $20,000 to $100,000 or more, and make it impossible for the corporation to have representation.

You must also realize that a lawyer who is sued directly, as an individual, does not have that prohibition. He/she is permitted to represent himself/herself whether as a defendant or plaintiff. Thus, a lawyer who does business as an individual (even though he/she uses an assumed name) is permitted to represent himself/herself in a court action and testify at the same time. The ABA Code of Professional Responsibility doesn't deprive a lawyer of that constitutional freedom, thank god.

When a major law firm is sued, the law firm often does represent itself, whether the firm is incorporated or not, and even though partners in the firm are to be witnesses at the trial. I'm not sure that there is a solid basis for permitting an incorporated law firm (or even a partnership) to represent itself (a corporation or partnership) and testify at the trial through one of its shareholder or member lawyers while denying this opportunity to an individual practitioner who happens to incorporate his business (and has no employees or other shareholders or directors). But this is how things work, and I thought you would like to know.

Finally, a fifth reason: But there is more. And this is the best reason not to incorporate. If the corporation should ever get behind in filing reports, tax returns, census forms, withholding tax returns, 1099's, or any of a large number of documents which various governmental agencies require to be filed by a corporation, you will encounter the brown envelope problem, a name which I have given to the situation where for the next 10 years you will be plagued by a never ending stream of brown or white envelopes from various government agencies demanding that you file something, or telling you that there are warrants outstanding for non-payment of fictitious amounts (such as $100,000) designed to make you take action, I guess; and demands for filing of additional responses; demands for payment of late fees, interest, penalties, additional taxes, and whatever else government revenuers can dream up to stifle small business.

My best business advice to you is keep it simple, and don't incorporate until later, if ever. Don't fall into the trap of premature incorporation. Give the business a chance to fail and avoid all the costs and hassle, and only if there is a business (after a year or two of development, or more) should you start thinking about the form of business entity which is best for your business.

Good luck!

Copyright © 1995 by Carl E. Person. Permission is given for non-commercial users to send a copy of the data processing file for this work by electronic means to a specific individual for his or her own use, and then only if the entire file is sent, including this copyright notice, but no permission is given for anyone to copy or transmit this file for or to any person for public viewing or downloading. It is intended by the author of this work that the work shall be made available in electronic form only through LawMall (tm).