Do-it-yourself incorporation services abound on the internet, and with their low price they are enticing to aspiring business owners, especially in the start-up phase when the owners are trying to save as much money as possible. In the end, though, they can cost your company a lot more in both time and money if you don’t know what you are doing, as one business owner recently found out.
This business owner’s situation serves to highlight what types of problems can arise, and the associated risk, when proceeding with the incorporation of your company without being fully informed about the legal and tax consequences of what is written, or not written, in the organizational documents.
In this case, the aspiring business owner bought the standard incorporation package from an incorporation service without first talking to legal and accounting professionals. He thought it was a matter of simply filling out some forms since it was just going to be him as the shareholder, director and CEO. The problem was the forms that were filed ended up containing several critical mistakes, some the fault of the owner, some the fault of the incorporation service, creating undesirable legal and tax consequences.
Specifically, for the incorporation filing alone, there were three errors with serious legal and tax consequences: The first was S corporation status was elected instead of C corporation status on the federal tax identification number form. The choice between the two has dramatic tax implications. The company owner did not understand the difference between the two types of corporations and did not know why S corporation was noted on the form (once he understood the difference, it turned out he wanted to be a C corporation).
The second major error was the description of the company’s business activities in its incorporation document. The document gave a precise description of the type of business to be conducted by the company. This precise description, down the road, however, could have caused problems because in this particular state of incorporation a company can only engage in the type of business identified in its incorporation documents. Conducting any other type of business is not allowed. For example, if a company says in its incorporation filings that it will be a toy manufacturer and it later decides it also wants to get into newspaper publishing, it cannot without changing its incorporation documents. And, to amend the incorporation documents could have been difficult depending on the number of shareholders because in this particular state of incorporation, such a change would have required the shareholders’ approval.
To avoid this problem, the company would have wanted to describe its activities using terms as broad as possible. For example, in this particular state it is permitted to use language saying the company’s purpose is to engage in any lawful act or activity. This language would have allowed the company to branch out into any type of business as it saw fit (assuming the company meets any other state and federal requirements such as licenses, permits etc.).
The third error was the most alarming; the incorporation was filed in the wrong state! Because of that error, the company had to go through a time-consuming dissolution procedure in State A and incorporate again in State B.
As to the dissolution, additional errors were made on those documents as well, but before filing the paperwork the frustrated owner finally sought legal help. We reviewed the documents and discovered the person named as the authorizing signatory was a director who had been replaced months earlier by another. This person, while still involved with the business, had no authority whatsoever in the company and could not authorize its dissolution. In addition, the proper corporate officers were not named. Fortunately, we were able to correct the dissolution forms before they were filed as well as ensure the formation documents for the actual desired state of incorporation were correct.
As this business owner’s situation shows, there is a risk involved with the do-it-yourself incorporation services. The risk, though, can be minimized by talking to your accountant, your attorney and other professionals relevant to your business before deciding how to proceed.