Chapter 4: Establishing Your Corporate Structure

For most businesses, the ideal corporate structure is to incorporate in Nevada. Want to incorporate for $300? I tell you how.

There are numerous resources for deciding on which format—or structure—your new business should take. The starting-your-own-business dummy guides are good places to find supplemental data.

That said, I believe you should structure most product businesses—the kind we have been discussing—as Nevada C Corporations. Of course, you should and must consult your tax advisor and perform due diligence on this topic. I am not a practicing attorney and this is not tax or legal advice.

Quick Introduction to Corporate Structure

You can set up your business as a sole proprietorship or as some type of corporation. Sole proprietorships are good for home-based businesses. You can “write off” a fair number of expenses, run your business so that it shows a small loss on paper (hey—the Italians do it), and pass that loss directly to your own Form 1040. The paperwork required to have a sole proprietorship structure around your business is marginal.

The downside, of course, is a higher level of liability from your business activities. Consider what this legal liability means. For instance, if you ship someone a large playground set—which is damaged in shipping—what is the true extent of your legal liability? In reality, you can just ship another unit and reduce chance of litigation. From a tax standpoint, additionally, the “word on the street” is that sole proprietorships have a much higher chance of IRS audit.[1]

In contrast, many business owners like the prestige of having and saying they own their own “company.” You should be aware that regardless of a company’s profit or loss, that company will owe a minimum of $600-$800 in franchise taxes every year. In other words, even if your corporate entity loses $10,000, you will still owe $800 in taxes on Form 541. As a general rule, then, your business needs about $60,000 in revenue to break-even (covering the $800 in franchise taxes).

Why a C Corporation?

All corporations start as Cs, and the other options like S Corporations and Limited Liability Corporations are variations on the C theme. All are good choices—the difficulty is deciding which structure is best for your particular business.

The best way to describe “why C?” is that C has more benefits to our ends than the other competing formats. First, there is more legal precedent on the C Corporation than other formats. This is an advantage in that I would much rather have an attorney tell me: “You will lose this hearing because of X, Y, and Z” rather than the attorney saying, “There is no LLC case-law on the subject.” Case law and administrative rulings provide good evidence of how a court or agency would rule on an issue.

Second, in order for the benefits of the S corporate structure to be applied, business information is provided to the IRS. In other words, for you and your two partners to carry one third of the S-Corp loss to your personal tax returns, all of that information goes on each person’s return. This severely weakens our desire for privacy and protection (see note on Nevada below and the latest organizational strategies below). The number of partners/ members is limited in S Corporations and LLCs, whereas the C Corporations’ stock gives you scalable flexibility.

Third, the C Corporation is treated as a separate entity, and therefore is taxed differently and separately from you. Corporate tax rates are lower than individual tax rates, and of course corporations are entitled to many tax deductions that are not available to sole proprietorships or partnerships. This may include season tickets and more generous automobile and travel allowances.

Finally, a Corporation gives you something your sole proprietorship cannot: your money back if you file for bankruptcy. The magic happens in three places: first, when your attorney issues stock, make sure it is called “Section 1244” stock; second, in the appropriate location such as your first board of director meeting minutes and on the stock certificate, say the magic words “Section 1244” stock; and third, if your company loses money and closes, including bankruptcy, you file Federal Form 4797 “Sale of Business Property.” Your loss is counted as “Ordinary” and will have the accompanying favorable tax treatment. If your loss of investment is $90,000, you won’t get it all back, but it will make your Form 1040 look incredibly better! In the spirit of this book’s practicality, here is my non-legal, non-tax advice on what to say:

First, in your incorporation papers, say “I, [your name], hereby assign to [name of company] the assets described on Exhibit “A” attached hereto and incorporated herein at the values stated therein in exchange for 25,000 shares of common stock of [name of company].
Second, in your first “Minutes of the first meeting of the Board of Directors of [name of company],” note something like the following: “Section 1244 Stock. The Board of Directors have determined that in order to attract investment in the Corporation the Corporation shall be organized and managed so that it is a “small business corporation” as defined by Internal Revenue Code Section 1244(c)(1), as amended, and so that the shares issued by the Corporation are “Section 1244 stock” as defined in Internal Revenue Code Section 1244(c)(1), as amended. Compliance with this section will enable shareholders to treat the loss on the sale or exchange of their shares as an “ordinary loss” on their personal income tax returns. RESOLVED, that the proper officers of the Corporation are authorized to sell and issue common shares in an aggregate amount of money and other property (as a contribution to capital and as paid up in surplus), which together with the aggregate amount of common shares outstanding at the time of issuance does not exceed one mission dollars, and RESOLVED, that the sale and issuance of shares shall be conducted in compliance with Internal Revenue Code Section 1244, so that the Corporation and its shareholders may obtain the benefits of Internal Revenue Code Section 1244, and RESOLVED FURTHER, that the proper officers of the Corporation are directed to maintain such accounting records as are necessary so that any shareholder that experiences a loss on the transfer of common shares of the Corporation may determine whether they qualify for “ordinary loss” deduction treatment on their personal income tax returns.”

Your particular business or situation may lead you to conclude that you should incorporate as an LLC or S Corporation (or not at all). That’s fine. The following advice applies to all corporate structures.

Why Form in Nevada

The reasons for using Nevada are many, and these reasons range from simple to complex.

First, it is believed that at least half of new Nevada incorporations are by individuals from other states.[2] Second, Nevada has no income tax, no tax on corporate shares, no franchise tax, and so on. As noted earlier, even Nevada corporation still have to pay federal franchise taxes. Third, Nevada is apparently the only U.S. state that does not share information with the IRS. Despite tightening of requirements in May 2007 to cut down on money-laundering and criminal activity, the key benefits remain. The net result of these benefits is no taxes and higher privacy for you.

One person in Nevada can hold corporate positions, so the same person can be treasurer and secretary, for instance. The corporate officers (i.e., treasurer) can live anywhere in the world. You can have board meetings in Hawaii, for instance. You can incorporate with the assistance of an incorporation service and never set foot in the state.

If your business starts to become successful, then you can take further steps to “bullet-proof” your corporation’s legality. See chapter 15 and seek the services of incorporation services.[3]

How to Incorporate for $300

When the first edition of Maui CEO was published, there were only five Nevada-based companies that could assist you with incorporation.[4] Now they are coming out of the woodwork. My recommendation is to use Inc Paradise (http://www.incparadise.com/). At time of writing, Inc Paradise will incorporate you in Nevada for $283. This fee includes everything, including filing fee, stamped articles, name availability check, and resident agent for a year (required). Also, for $168[5] this company will also give you a 90-120 minute consultation on selecting the right structure.

The Inc Paradise Web site also provides links and information on setting up a local bank account (if required), mail forwarding, getting a free Employer Identification Number (EIN) and local phone numbers. Inc Paradise can be reached at the URL above or at 1.888.284.3821. As an alternative, investigate Biz Filings at www.bizfilings.com. I have not used their services, but they do spend money to have a booth at eBay Live, so that is promising.

If you need fancier things, like having a live operator answer the Nevada phone number with your business name, then you should also consider Laughlin Associates. Laughlin is well-respected and provides incorporation services in all 50 states. See www.laughlininternational.com or call 1.800.648.0966.

The Latest Strategy

Many accountants and merchant bankers[6] will tell you not to incorporate out of state, because you can never get around the “nexus” of being in another state. This may be true, depending on the type of business you establish. However, within the context of businesses contemplated by this book, articulate to your advisers the “virtual” nature of the majority of your activities. You are targeting 48 States, not a local community.

If you are still worried, here’s the latest tax reduction strategy: set up a C Corporation in one state and an S Corporation in Nevada.

Let’s say you “live” in Nevada, either physically or through an incorporation services’ “residence” program. You also lease warehouse space in California, and therefore feel a nexus requirement to California.

First, you set up a C Corporation in California. Any activity which appears to be California-based is directed to and through this company. This company is named, has a website, and so on. The C Corporation structure provides a few extra barriers between you and the corporate organization.

Second, you set up a Nevada S Corporation. This is named XYZ Corp., or something that can in no way be easily connected to the California C Corporation.

Now, let’s assume the California C Corporation makes $200,000. They set up a consulting agreement with the Nevada S Corporation for $200,000 of periodic payments. In this manner, the $200,000 of profits is drained from California to Nevada. In California, you have $0 net profit and pay no income taxes. Once the $200,000 is in Nevada, which has no income tax, you have saved yourself 9%-10%. Then, pay yourself a small salary (say, $50,000) or take distributions as permitted by the Corporation, and use the rest to pay against corporate bills.

Obviously, this type of dual-state structure requires that both corporate entities pay the minimum franchise taxes, which means the break-even is around $120,000 of gross income.

Again, I am not encouraging you to do anything blatantly illegal. As you focus on your low-cost value proposition, no cow is sacred, meaning every way to reduce costs must be considered.

For now, we move from Nevada to China.

[1] According to some collateral from one of the incorporation services, “Sole proprietorships…are the highest audited business structures…[and] corporations have a less than 2% chance of being audited by the IRS.” Incorporate In Tax Free Nevada, Laughlin International, Inc. of Carson City, NV, pg 2.

[2] Incorporate In Tax Free Nevada, Laughlin International, Inc. of Carson City, NV, pg 3.

[3] See http://123-inc.com/, http://www.companiesinc.com/, or http://www.nevadaincorporation.org/

[4] I have no affiliation with, and have received no compensation from, any service.

[5] http://www.incparadise.com/asset-protection/

[6] A merchant banker is a fancy word for someone who helps $5M-$20M businesses get non-traditional funding outside of venture capital.