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Paste Description for Episode 1 - Incorporation

Notes on the podcast at http://cameronkeng.com/podcast-ep-1-incorporation/

Episode 1 - Incorporation
Thursday, December 30th, 2010 at 3:00:44am UTC 

  1. - EP 1 - Incorporation -
  2.  
  3. Hey guys, this is Cameron Keng and this is my podcast.  I'm going to keep this podcast to fifteen minutes, even though I said I was going to make it thirty, because I get sick of hearing my own voice.  I'm going to talk on corporations because that's something I keep seeing on Hacker News.  People ask me about this all the time and I have a real problem with the reasons I hear when they tell me why they want to do it.
  4.  
  5. - Don't Incorporate Unless You Have To -
  6.  
  7. Let me give you a scenario:  on HN, you have this startup with these two awesome developers.  Before they even make a dime, they run out and incorporate themselves.  Then they write this huge post letting everyone on HN know that it's easy to start a corporation without a lawyer or an accountant and that everyone should hurry up and do it.  Then I read the post and I think:  "You didn't pay an attorney, but you paid LegalZoom or incorporate.com at least $200, and then you paid another $200-$300 to the state to actually incorporate."
  8.  
  9. So they're out there telling everyone to pay $200 when they could get standard documents for free, I have a huge issue with that and that's the scenario I'm going to deal with today.  The first question I have for people who want to incorporate is:  "Do you have a good reason?" 
  10.  
  11. - Good Reasons to Incorporate -
  12.  
  13. Basically, there are only three good reasons to incorporate:
  14.  
  15. 1.  You have significant profits or net income.
  16. 2.  You have high liability.
  17. 3.  You're getting funding.
  18.  
  19. All of those are good reasons, but only if they're true.  The chance of a startup facing liability issues is pretty low, unless they're doing something like construction.  And even if you're getting funding, is it a sure thing?  Even then, it only matters when it's from a VC.  If it's just your mom or dad fronting you money, they don't care if you're incorporated or not.
  20.  
  21. The point you really need to worry about is:  do you have an immediate, real, tangible benefit from incorporating right now?  Because if you don't, hold off.  You're wasting money for no reason.  You're a developer, so let me put this into perspective.  You know Rackspace, right?  They have this cheap cloud service where you only pay for what you use that lets you save money if you don't get much traffic.  So if you're willing to save a few cents by using pay-as-you go services, why pay $500 or more for an unnecessary incorporation?
  22.  
  23. Let's return to our first reason for incorporating.  You need to have significant profits because, because otherwise there's no money to protect an there are all these other nightmare problems like tax returns that come along with incorporating.  What you need is a business model, not just a business plan.  People often confuse the two, but there's a difference.  When you set up a blog with great content and you set up AdWords and AdMob, that's a business plan.  Your business plan is content generation.  A business model is what you have when you are making a steady income.  So once you create an idea, you have a business plan and once you start making real money, you have a business model.  So you wait to incorporate until you have significant income, because that's the only time you have something to protect.  Until then, you don't have much to worry about because you don't have anything worth taking.
  24.  
  25. Now for reason two:  liability.  This is a huge issue when you're dealing with something like construction.  If you're doing something like a simple bank startup, then you have a lot of liability because it's a government regulated industry.  So in that case, you need to incorporate.  But if you're something like 37Signals, it doesn't matter.  Who's going to complain and sue you?  You're not going to face million dollar lawsuits over something like a lost email.  There's just not much liability there, so why waste time and money incorporating?
  26.  
  27. Now we go back to reason three:  funding.  Chances are, you're not going to get funding.  That's just how it is.  So it probably won't be an issue.  If you're getting money from anyone other than your family, then yeah, it's important.  But if you're getting money from family, they probably don't really care if you incorporate or not.  So unless you have good reasons, don't incorporate, because you're wasting time and money on something that's not important.
  28.  
  29. - What Kind of Corporation Should I Become? -
  30.  
  31. Now let's consider the alternative where you have a good reason to incorporate and you're absolutely positive that it's necessary.  What legal entity are you going to consider?  If you're going to be a large company and you have a lot of liability and VC funding, you're not going to have a choice.  They're going to tell you right away that you have to be a C-corp, because they require different stock classes.  Basically, what that means is they want to have special privileges.  They might want class-A stock, which could have two or three times the voting power of class-B, and you can only do that with a C-corp.  So if you're getting funding, you don't have to worry about this, because they'll tell you what they want to do
  32.  
  33. But if you're a bootstrapper or a lean startup, then you're going to have two real choices:  an LLC or an S-corp.  These both have the same benefits:  they both pay tax once.  They don't get taxed twice like a C-corp where they pay corporate tax, then they pay dividends to the shareholders like you, which you get taxed on.  Both an LLC and an S-corp are a pass-through, which means that there is no corporate tax.  You only pay tax on your 1040, so you're only taxed once.
  34.  
  35. When you talk to a lawyer or an accountant, they're going to tell you to always do an S-corp.  That's just professional opinion.  An LLC is really easy to incorporate and ridiculously flexible.  You can choose to be taxed as an incorporation or a partnership and once you create it, there's no more paperwork to do.  So why doesn't everyone do an LLC?  Money.
  36.  
  37. An LLC is great, but all that money is going to be self-employment income and you pay tax on that.  Self-employment tax is basically FICA and Medicare, and that adds up to 15.3%.  Many businesses are low-margin and that can kill you right there.  You need to save every penny you can.
  38.  
  39. That's where the S-corp comes.  But many people get set up as one and then they don't take advantage of it, because they don't understand it.  An S-corp is a corporation, so whenever you give money to your shareholders, in theory, it's a dividend.  A dividend is not self-employment income, it's investment income, so it's exempt from self-employment tax.
  40.  
  41. That means that if you pay yourself a reasonable wage, anything you pay yourself over that will be exempt from self-employment tax.  That means you're saving a lot of money.  If you have $80,000 that's investment income instead of self-employment income, 15.3% of that is $12,240, so we're looking at a big chunk of change.  That's why you're going to pick the S-corp instead of an LLC:  because it saves money.
  42.  
  43. - Where Should I Incorporate? -
  44.  
  45. After you know what legal entity you need, the next issue is where to incorporate.  Everyone usually heads straight to Delaware and I have a problem with this, because they're just following the crowd, they don't have a good reason for choosing them.
  46.  
  47. There are three main reasons why people often choose Delaware:
  48.  
  49. 1.  They have a Chancery Court.
  50.  
  51. The Chancery Court is a judicial body dedicated to business disputes and found only in Delaware.  This is important because they're experts in business disputes and there's a lot of case law out there.  That means that if you get sued, someone else has probably been sued for the same reason, so you can see how that case turned out.  This means you know where you stand during litigation, and that's important for business.
  52.  
  53. 2.  Low Taxes
  54.  
  55. Delaware is one of the few states with no sales tax and they have very low income tax rates.
  56.  
  57. 3.  Majority Interest Rules
  58.  
  59. What does this mean?  If you have majority interest, that is, you own 51% or more of the company, they're really on your side.  You have a lot of options to do whatever you think is best.  This is important, because without this kind of rule, you have to ask the minority shareholders for permission to do every little thing.  And that's really cumbersome for startups and companies that need more flexibility.
  60.  
  61. Nevada & South Dakota are fairly similar.  They're easy to incorporate in and they have low taxes.  But why are you going to incorporate in another state if you live in New York?  If you do that, you're going to have to file taxes in both states and you're going to need an accountant for that.  And if you make a mistake, both states could end up auditing you.  So you can end up doubling your problems by incorporating in a state you don't live in.  In other words, you have to be careful of choosing another state to incorporate in unless you have a very good reason, by which I mean that you have at least ten million dollars in net assets and a big future ahead, like Twitter.
  62.  
  63. A lot of people don't have a business background and they always hear about people incorporating in Delaware, so they just follow the crowd, rather than looking at their own situation, and that's a really poor decision.  It's really important that you do what makes the most sense for your business specifically.  Nine out of ten times, I'm going to tell people to incorporate in the state they live in, because that makes things simple.
  64.  
  65. - Incorporating Yourself -
  66.  
  67. Now that you've examined your situation, know that you really do need to incorporate and have decided where and how to incorporate, you need to go out there and do it.  It's really simple and you can do this part yourself, instead of paying someone.  All states have standard documents, which makes things easy for you.  You can go to the State of New York's website and download standard documents that they will always accept, so long as you fill them in with the right information and they're pretty much going to be perfect the way they are.  So you can just download the forms, fill them out, and you're done and you didn't have to pay LegalZoom or a lawyer several hundred dollars.  Now, you do want to check the state's incorporation fees.  The state will charge you a few hundred dollars, but you can't get out of paying that.
  68.  
  69. One problem with the state fees is that you have to pay them, even if you're losing money.  With the bad economy, many states lowered their fees, but other states that didn't have a fee, like Pennsylvania, have added a fee, especially for LLCs.  And, of course, you still have to pay taxes on top of that.  California and New York have some of the highest fees.  They've recently lowered them, but watch out for them.
  70.  
  71. - Parting Thoughts -
  72.  
  73. In the end, you'll probably need an accountant.  I've seen lots of them work and I don't have any good things to say.  My advice would be that you should trust them, but when they tell you that you have to do something, make them find the rule that says so.  One other common pitfall is that, in addition to your annual corporate returns, you have to file a lot of other paperwork:  employer returns, 941s, W-2s, etc.  And that's a cost you need to remember to budget for.
  74.  
  75. Lastly, but importantly, in order to keep your corporate liability protection, you need to remember to respect the legal formalities.  Don't play games by mixing your personal finances with the corporate finances, or try to treat the corporate accounts like they're personal accounts.  Otherwise, people who sue you can pierce the corporate veil and hold you personally liable.  So if you commingle personal and corporate funds and the corporation goes into debt, you, personally, can end up responsible for paying the debt.
  76.  
  77. Let me know how I did, I'm going to be doing this a lot.  I think I'm going to interview someone who went through this recently so we can get some perspective on that.  I really appreciate any comments, reviews or ideas you can give me because I'm new to this and I want some feedback.  Thanks a lot.  Bye.

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