Top Mistakes Made by New S-corps and LLCs

Start By Indy Editorial Team

On No Horizontal

Lindsey had a thriving independent photography business. A few years back, she incorporated her enterprise as a limited liability company (LLC), reckoning that a formal business structure would insulate her from personal liability for business debt and client lawsuits.

She wasn’t exactly wrong, but she did make one critical error — she never consulted an attorney about the limits of her company’s, well, limited liability. Soon enough, Lindsey cast aside her expense tracking app and started racking up personal charges on her business credit card, which not coincidentally had a great rewards program. She could afford these charges, but there was no way to justify them as business expenses.

The bill came due, literally and figuratively, when a client sued Lindsey for breach of contract. She expected her asset-light LLC to weather the lawsuit; at worst, she thought, she’d make a small short-term loan to replace business equipment sold to satisfy an adverse judgment. Lindsey didn’t realize that, in commingling personal and business funds and failing to keep adequate records, she’d invited her counterparty to pierce her LLC’s corporate veil — to hold her personally liable for the entity’s actions. The funds in her personal savings account, the car in her driveway, the gold jewelry she inherited from her grandmother, even her wedding ring: it was all on the line.

Don’t Be Like Lindsey — Avoid These Common Post-incorporation Mistakes

Lindsey isn’t the only Indy guilty of commingling personal and business funds. Fortunately, her rookie mistake is as easy to avoid as it is common.

Other post-incorporation mistakes are easy enough to avoid or correct, too. If you’re planning in the year future to incorporate a new LLC or elect to treat an existing single-member entity as a corporation for tax purposes, mind these pitfalls.

Incorporating in the Wrong State

The typical Indy maintains a physical business presence in just one state. Under normal circumstances, that jurisdiction is the most sensible place to incorporate their business entity. Incorporating in a state where you don’t do business adds to your compliance requirements and tax bill, writes legal expert Drake Forester, unless you’re based in a high-tax state (many California businesses incorporate in Nevada for this reason) or expect to be sued often (which is why big corporations often incorporate in Delaware).

Choosing an Impermissible Corporate Structure

Many states restrict incorporation for certain types of enterprises. For instance, California LLCs can’t perform professional services that require a license, such as law. Northwest Registered Agent has a handy guide for all 50 states; check with your state’s incorporation authority for more details.

Omitting a Proper Operating Agreement

Even if it’s not required by law in your state of incorporation, a properly drafted LLC operating agreement has key advantages, per legal author Edward A. Haman:

  • It supersedes state law, giving you more control over how your business operates
  • It strengthens your claim of limited liability
  • It reduces the risk of disputes with future partners, should your business grow

You can find free or cheap operating agreement templates at legal document centers like Rocket Lawyer and LegalZoom, but you’ll need a licensed attorney to create a custom agreement that fits your present needs and accommodates future professional goals.

Failure to Observe Local Licensing Requirements

Indies operating in federally regulated industries and various professional niches (law, accounting, hair styling) need state or federal business licenses in addition to active articles of incorporation. If you sell physical goods or taxable services, you’ll need a sales tax permit too. Refer to this SBA summary for more details.

Failure to Protect Essential Intellectual Property

No matter how insignificant your business seems, there’s little downside to copyrighting the intellectual property that sets it apart. At minimum, copyright your business name and logo, if you have one. If your business relies on unique processes or technologies that you’ve developed yourself, consider pursuing patent or trade secret protection.

Failure to Maintain Your Corporate Veil

Lindsey’s hypothetical misadventure is just one example of failure to maintain a wall between personal and business expenses. Doing any of the following increases your risk of being held personally liable for your business’s activities and obligations:

  • Using business funds to pay personal expenses, or vice versa (at minimum, you’ll want to maintain separate business and personal bank accounts)
  • Making personal loans (shareholder loans) out of business funds without proper documentation or accounting
  • Failure to maintain corporate records as required by state law, such as annual meeting minutes and annual reinstatement filings

Common S-corp Mistakes

These mistakes pertain to single-member LLCs that elect to be treated as corporations for tax purposes, a move known as S-corp election. For most Indies, the most significant downside risk of each is greater tax liability.

Missing the Annual S-corp Election Deadline

The annual S-corp election deadline is the 15th day of the third month of the entity’s tax year. If your tax year coincides with the calendar year, that’s March 15th. Missing the deadline means you forfeit any tax benefit from your S-corp election for the current tax year — not the end of the world, but not ideal.

For new business entities, the S-corp election deadline for the current tax year is 75 days from the date of incorporation. See IRS instructions for Form 2553.

Failure to Pay Yourself a “Reasonable” Salary

S-corporation owners avoid some self-employment tax liability (the employer’s share of Social Security and Medicare taxes, or about 7.5% of taxable income) by treating themselves as employees of the entity, even if they’re the sole owner. They need only pay self-employment tax on a “reasonable” salary, not total net income.

What constitutes a “reasonable” salary? IRS guidelines outline such factors as:

  • The time and effort required of the role
  • The role’s training requirements
  • Experience typically required for comparable roles
  • Prevailing salaries for comparable roles
  • Non-salary bonus payments

Setting Your “Reasonable” Salary Too High

The opposite mistake is quite common, too. As long as you can justify your salary as “reasonable” based on the factors enumerated above, there’s no reason to increase your self-employment tax burden by paying yourself what you’re actually worth.

Failure to Make Payroll Tax Payments

Once you’ve set a reasonable salary, you’ll need to actually, you know, pay yourself.

You can save some cash with a DIY approach to payroll. To do this, you’ll need to complete a W-4, set a payroll schedule, use the IRS withholding calculator to compute payroll taxes, and make scheduled (usually monthly) payroll tax payments throughout the year

If you’re worried about missing payroll tax deadlines or miscalculating your payroll tax obligations, use an automated payroll system that handles all this on your behalf. This costs more, but it virtually eliminates the risk of calculation errors. Fit Small Business has a head-to-head-to-head comparison of three top payroll processing services here.

Practice Makes Perfect

Everyone makes mistake, even proud owners of single-member LLCs and S-corps. Don’t worry so much about achieving perfection right out of the gate; it’s more important that you learn from, and avoid repeating, your missteps.

Fingers crossed, you won’t make any of these rookie business owners mistakes. If you do, here’s to hoping you’ll only make them once.

About The Author

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