By UpCounsel Corporate Attorney Scott Woodman

Knowledge is a good thing. It equips us with at least some of the resources necessary to make good decisions. But as the adage goes, “a little bit of knowledge can be a dangerous thing.”

Such is the case when it comes to starting a business and trying to figure out if you should operate it in your name or out of an entity, and, if an entity, where you should form that entity. These are two very important decisions in the planning of a business, both of which can have far reaching effects on the future of the business, and on whether that future will look like the future the business owner is envisioning at the outset.

It is challenging enough for the business owner to arm themselves with enough information, let alone knowledge, to make some initial decisions. After all, other issues loom large, such as how to actually provide the service or product to the consumer, and, even more importantly, how to make money from doing so. But a little bit of knowledge on a subject can and often does result in bad decision-making.

Entity Choice

Let’s just get it out there: there is a distinctly jazzed up view of limited liability companies. It is rare that I get clients coming to me asking for corporations anymore. People have heard so many great things about LLCs – they are easy to get started, flexible for multiple purposes, require little maintenance and formality, etc. No wonder these things are popular.

But as wonderful as some of these attributes are, it is important to understand when such attributes will add value to a business and when and how they can hurt a business. For instance, LLCs certainly do not require some of the initial multitude of documents that corporations require – bylaws, organizational minutes, etc. But if you want to get some real mileage out of the LLC via some of that great flexibility, then the LLC will need an operating agreement with teeth, and very well-groomed teeth at that. Flexibility comes at a cost.

And if you do not care about flexibility, but just want to avoid formality, that too can come at a cost. For instance, LLCs are generally either taxed as sole proprietorships or partnerships, so if you are planning to be actively involved in the business, you may lose some of the self-employment tax avoidance that, say, an S-corp may provide. Additionally, sometimes it is better for certain people to have to engage in the dreaded formalities every year because they need to understand and remember that the entity that they are creating is a separate legal entity, and not their personal banking mechanism.

Of course, you may be able to get your cake and eat it too, in the form off an LLC taxed as an S-corp. Hopefully you have considered the reduced basis bang for your buck an S-corp provides versus a partnership. That loss of value may be detrimental depending on the type of business you are going to operate.

Even if an LLC seems like a better choice than a corporation because of some of these attributes, will it fit the needs and desires of the business owner? Will there be investors, what states will the company operate in, and how many owners will the company have? These questions play into entity choice.

The bottom line is that, although lawyers are expensive, there is a reason for this. It is because we must look at a situation from many different angles. We must understand the needs and desires of our clients, the legal options available to them, and how those options stack up given the client’s needs and desires. This is not an easy process. But getting it right at the beginning is way too important not to make sure it is done right.

Delaware Versus Other States

Maybe even more popular than LLCs are Delaware LLCs. So many people have heard that Delaware is where it’s at for entity creation that they consider no other place. But just as with entity choice, understanding Delaware’s advantages as they relate to a business owner’s needs and desires is the important test.

Delaware certainly does have some big advantages over other jurisdictions, such as the following:

Attitude: Delaware is a pro-business state. Those of us in California can only dream of such a thing. Delaware prides itself on understanding the needs of businesses and catering to them as best they can. The citizens, and the power brokers who yield the power the citizenry provide them, understand that it is the business community that pays the bills and employs the people that allow the state to prosper. Making the necessary interaction with the government easier and not harder results in more prosperity for the citizens of the state, not less.

Secretary of State: Because of the attitude mentioned above, the Secretary of State’s office has been structured to be user-friendly. It has a great online mechanism. The agents work fast and therefore, filings are much faster in Delaware than in most states. The process, forms, etc. are also much easier to handle. And resolution of problems is so much faster, easier, and more efficient. Obvious errors on paperwork can be corrected via filing a Certificate of Correction. Try getting obvious errors fixed in California. Trust me, it isn’t so easy.

Court of Chancery: Another nice aspect about Delaware is that they have one court system that only hears business/corporate law matters. The judges are exceptionally well-versed in business law, and there are no backlogs from overrun courts. This setup limits litigation surprises.

Corporate Law: The caselaw developed from the Court of Chancery, as well as the statutory law developed by the legislature in concert with the corporate bar, is so well developed in Delaware that planning is made so much easier because, as stated above, surprises are limited. The business owner (or at least his or her counsel) knows what they are going to get. And planning is the lifeblood to a successful business, so a lack of surprises is one form of “lack” that is very desirous.

The Investment World: Because of the well-worn path of corporate and business law development, investors, such as investment bankers or venture capitalists, also prefer to invest in businesses established in Delaware. Potentially reduced director and officer personal liability (through indemnification provisions), is another strong reason why principals in new startups are eager to incorporate or organize in Delaware. Privacy, both for officer/directors and for shareholders or members, is also a benefit of Delaware, as the state does not require the same kids of disclosures that other states require.

The Takeaway

These attributes sound great, but are they of value? The answer to this question will depend on the business owners needs and desires. If the owner wants to operate an insurance agency in Los Angeles, as the sole owner of the company, how would any of these attributes be of any value? But to a fledgling tech startup soon to seek that exciting infusion of new VC money, these attributes can be mighty important both now and in the future.

What should be gleaned from the discussion on both issues (what type of entity and where to form it) is that reaching out to qualified counsel to assist in the planning and analysis, before these choices are made, can pay dividends at the beginning, middle, and end of a business life cycle. Qualified counsel has more than a little bit of knowledge; and that is a good thing, because danger is best left for other forays.

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About the author

Scott Woodman

Scott Woodman

I have practiced law in southern california for over 20 years. My primary areas of practice have been business, tax and estate planning. I have also occassionally practiced in the areas of litigation and bankruptcy. I have handled unlawful detainer actions for both landlord and tenant, and have represented businesses in business litigation and real estate agents in insurance defense matters.

I earned my Bachelor of Science at Oklahoma State University majoring in Finance and Accounting and minoring in Economics. I earned my law degree at Pepperdine University School of law and my LL.M. in Taxation at the University of San Diego School of Law.

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