“Four Serpents were unleashed and the masses trembled. Each wyrm took a name that conjured dread: Incorporation, Tax, Contract and the progenitor of them all, Fear.”
To start a business, I must draw my sword and fight these dragons.
I am not a lawyer or a tax advisor. The following is not legal or tax advice. If you need legal or tax advice, you should engage the services of a qualified professional.
The Incorporation Dragon
The first dragon to defeat will be The Incorporation Dragon. Its sharp teeth threaten me with tax mistakes and lawsuits.
By default and automatically, when I start a company, it is a sole proprietorship. The entire company is owned by one person: me. I don't need to do anything, not even file a government form. Before I earn any money, I don't even have to mention my company on my personal income taxes ... unless I want to.
Without customers, partners, investors or workers, I can develop software for as long as I want (even years) without filing any forms, either for the company or myself. Once I start to try to sell or when I convince somebody to become a partner, investor or worker, I might consider changing from a sole proprietorship to another form:
- Sole proprietorship (default)
- Partnership
- LLC, an abbreviation for Limited Liability Company
- Corporation
Tax Deductions versus Legal Liability
Generally, when I choose the form of the company, I choose between having the company to be either the same as me or separate from me. I choose whether the company should legally be treated as me or as a separate artificial person from me.
If the company and me are legally the same, I can put company losses (few or no sales minus expenses) on my personal income tax return. I will likely pay less taxes, both personal and company, because my company losses can be deducted from my income from a regular job in the same way as I deduct my 401(k) contributions or my home mortgage deduction. Even if I am afraid to deduct my company losses, I may change my mind later and be able to file or pay a tax preparer to file amended returns in future years. If my company makes a profit, however, I will have to pay the taxes on my company's profit on my personal income tax returns which may higher than corporate taxes that I'd pay if I filed the corresponding corporate tax returns.
If the company and me are legally separate, I cannot put company losses on my personal income tax return. The company files its own separate tax return. However, the company can get its own credit and its own credit cards. Also, if a customer or investor sues the company, they aren't automatically suing me. They sue an artificial person who is separate from me. As an owner, I have limited liability for the actions of the company.
So:
- Sole proprietorship (same as me)
- Partnership (same as me)
- LLC (separate from me for legal purposes but same as me for tax purposes)
- Corporation (separate from me)
And:
- Sole proprietorship (tax deduction but no limited liability)
- Partnership (tax deduction but no limited liability)
- LLC (tax deduction and limited liability)
- Corporation (limited liability but no tax deduction)
How do I choose
While an LLC may seem generally better than a corporation, there are other considerations besides deducting company losses on my personal income taxes. How I expect the company to operate and how different people can become involved are more important considerations. The flexibility of corporate stock, which can't be issued by LLCs, is often a vital factor in the decision.
When I start developing the software for my new company, I start as a sole proprietorship. Since I do not a product to sell yet, the company has no sales. However, it still has expenses, including paying contractors and purchasing software. Since it is losing money, I want to deduct these losses on my federal and state personal income taxes. Also, since it has no customers or investors yet, the company is unlikely to be sued so I personally do not need the limited liability protection. I do not file any separate tax returns nor do I apply for any county or city licenses since I do not need to.
When the company is ready to start selling, I will choose between an LLC and a corporation. Both have limited liability protection which is why I limit my choice to them. If I expect the company to include only me and a few partners, possibly with many salaried workers who don't have any company ownership, then I will choose to create an LLC. If I expect the company to have a broad range of investors and stock-motivated workers and, thus, need corporate stock and a formal and flexible corporate structure, then I will choose to create a regular "C" corporation.
For those who may be wondering, I do not choose to create an "S" corporation (as an alternative to a regular "C" corporation). An "S" corporation automatically divides its profits and losses among shareholders. Instead of having that happen, I generally want to keep profits inside the corporation so the corporation can use them the next year. To avoid double-taxation on dividends, a "C" corporation can either award executive bonuses or temporarily convert to an "S" corporation and then convert back.
The Tax Dragon
With this first dragon dispatched, a second dragon, called Tax, appears. It breathes a terrible fire that threatens to consume all my money.
There are three different ways for me to be taxed: an income tax, a sales tax and a franchise tax.
An income tax is a tax on my company's profit, the sales minus the expenses.
A sales tax is a tax on my company's sales, a percentage of the sales price of each sale is taxed.
A franchise tax is a tax not based on income or sales. It is usually a flat fee plus an additional fee per employee or my company's assets.
Only governments can tax me. There are four government types: federal, state, county and city.
The U.S. federal government only has a yearly income tax. If I make no sales or even lose money, neither me nor my company pay income taxes on the company activities. If my company is a sole proprietorship and I don't make any sales, I don't even have to mention my company on my personal tax return (IRS Form 1040EZ, IRS Form 1040A or IRS Form 1040) and the company doesn't need to file any return. If my company is a corporation, I have to file an IRS Form 1120-A or IRS Form 1120, regardless of whether the company made a profit or took a loss. Federal corporate tax returns are due on March 15 each year.
The State of California government has a yearly income tax and a (usually) yearly sales tax. For a sole proprietorship, my company pays state income tax only if my company makes a profit, that is, company sales are greater than company expenses. If my company is a sole proprietorship and I don't make any sales, I don't even have to mention my company on my personal tax return (FTB Form 540A or FTB Form 540) and the company doesn't need to file any return. If my company is a corporation, I have to file an FTB Form 100 and the company pays at least $800; $800 is the minimum tax for all corporations operating in California. (California has an unusually high minimum tax.) California corporate tax returns are due on March 15 each year.
If my company sells physical items (downloading software doesn't count as a physical item), my company must collect sales tax from customers and pay the California State Board of Equalization (BOE). Sales tax varies by county; in Santa Clara county, it is 8.25%. If I sell physical items, my company will need to apply for a Seller's Permit. The permit is free. If I want to avoid paying sales taxes when I buy items that I will resell, I can create my own resale certificates or download a BOE-approved form. BOE tax returns will be due depending on a variety of factors but many, possibly most, are due January 31 on each year.
The County of Santa Clara government has a sales tax but it is collected by the California State Board of Equalization (see above). It also sells fictitious business name filings for $37.35. A fictitious business name, also known as a DBA or Doing Business As, allows my company to operate under a different name than its regular name. Sole proprietorships must have a name that includes the owner's full name. Corporations are incorporated with a corporate name that I select. If my company wants to advertise and accept purchases under a different name than its regular or corporate name, I must make a fictitious business name filing. If my company uses its regular name or its corporate name, it does not need a fictitious business name. Fictitious business name filings last for 5 years. The filing is due before I start advertising or accepting checks under the fictitious business name.
The City of San Jose government has a yearly franchise tax, also known as a business license or business tax. The business license costs $150 per year but can cost more, depending on how many employees and owners that I have. Other cities can have business taxes as low as $35 or even less. Any type of business that operates in the city must pay. The business tax is due each year around the time of the year that I first applied for the original business license.
The Contract Dragon
With two dragons slain, the third of the triplets, the Contract Dragon, wields its claws to shred my confidence that the company can legally protect itself.
To run a company, I need the following contracts:
- NDA, an abbreviation for Non-Disclosure Agreement
- Independent Contract Agreement for Consultant
- Copyright Assignment
An NDA is a secrecy agreement that allows me to discuss valuable company information with a prospective customer, partner, investor or worker. Not every person that I meet needs to sign an NDA. Sometimes I talk only in generalities and don't tell a person any company secrets. Other times, it may be worth the risk to get somebody's help by telling them company secrets, even if they refuse to sign an NDA.
An Independent Contract Agreement for Consultant is the agreement between me and some workers. Rather than taking on a permanent employee which requires me to abide by many employment laws, I will often contract with a worker temporarily to get a specific task accomplished.
A Copyright Assignment is useful for me to obtain software from somebody else. If the person created the software while not under contract, I can still get the rights to the software by signing one of these.
If I am running a corporation, I will want the following documents:
- Articles of Incorporation
- Bylaws
- Minutes of Organizational Meeting of Board of Directors
- Minutes of Special Meeting of Board of Directors
- Minutes of Annual Meeting of Board of Directors
- Waiver of Notice
- Promissory Note
- Affidavit of Mailing of Notice of Annual Meeting of Shareholders
- Minutes of Annual Meeting of Shareholders
- Annual Report to Shareholders
- Notice of Annual Meeting of Shareholders
- Agenda
- Voting Slips
An Articles of Incorporation is like the Declaration of Independence for my corporation. Usually, the state where I am incorporating will provide a fill-in-the-blank sample that I can follow. These are usually a page or two.
The Bylaws is like the Constitution of my corporation. It sets out rules on how my corporation will work. I will write these entirely myself but they mostly dictated by my preferences, not by laws. It is long: twenty or thirty pages.
A Minutes of Organizational Meeting of Board of Directors is a record of the first official corporate meeting. Typically, the Board will approve the Bylaws, elect corporate officers, adopt a corporate seal, issue stock and approve various expenses. These minutes are usually five pages or so.
A Minutes of Special Meeting of Board of Directors is a record of a special, often impromptu, corporate meeting to officially approve a corporate action. These are usually only one page, recording one specific corporate action.
A Minutes of Annual Meeting of Board of Directors is a record of the annual meeting. Typically, it is just one or two actions, such as an election of corporate officers and indemnification of those officers. It is usually only one page.
A Waiver of Notice is a document signed by various people to declare that they agree that they do not need official notice of a corporate meeting. It avoids the cost and time with mailing official meeting notifications. Most Board of Director meetings include this notice which all Board members sign. It is only one page.
A Promissory Note is a loan document, often between my corporation and a shareholder (myself). I agree to loan money to the corporation and the corporation agrees to pay it back with interest. It is usually one or two pages.
An Affidavit of Mailing of Notice of Annual Meeting of Shareholders is a declaration by the corporate secretary that the annual meeting notices were mailed correctly. It is often required by the Bylaws. It is usually only one page.
An Annual Report to Shareholders is a simple report on the performance of the company over the past year. Some reported data might be: current assets and liabilities and income and expenses for the past year. It is usually one to three pages long.
A Notice of Annual Meeting of Shareholders is a simple letter that is mailed to all shareholders who do not waive it to inform them of the annual meeting. It may also announce who is nominated for the Board of Directors. It is less than one page long.
An Agenda is a list of topics for a meeting. Only annual meetings need agendas, though it is harmless for other meetings to have them. It is less than one page long.
Voting Slips are for secret balloting to elect directors to the Board during the Annual Meeting of Shareholders. They are usually slips of paper with a few pre-printed lines and blanks to fill in the number of shares to vote for a particular candidate.
The Fear Dragon
The final dragon, Fear, is the granddaddy of them all and it paralyzes me with its gaze.
Doing my own incorporation, doing my own corporate taxes and writing my own legal documents is scary.
Yes, I can hire professionals to help me do them all. I can hire a lawyer or use one of the many Internet incorporators to help me with the Incorporation Dragon. For the Tax Dragon, I can hire an accountant, a tax preparer and/or a tax lawyer. And, for the Contract Dragon, I can work with a lawyer to help me write contracts.
But the Internet contains a wealth of information and examples, if I want to do all these things myself. In addition, there are books on all these topics from very reputable legal publishers, such as Nolo. I can collect all the knowledge and materials that I need to confidently run my company by myself, if I prefer to invest my sweat and time, rather than my money, to conquer all these uncertainties.
The Fear Dragon is destroyed by movement. If I stop being paralyzed, by either paying someone or doing it myself, the dragon is harmless. Lurking on the sidelines gives it its power.
“And thus the four terrible wyrms fled and the Eagle of Hope settled upon the World.”
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