The Dangers of Cutting Corners When Setting Up A Business Entity

May 20, 2021by Brian Walsh

Many business owners have no idea that the legal entity for their business is not setup up properly or is incomplete. Operating a business that is not properly formed can put the business and its stakeholders in legal jeopardy for a whole swath of hidden legal issues.

When forming a business, it may be tempting to cut corners to accelerate the process or save money. Maybe you were advised that it’s a simple process that you can easily do yourself. Perhaps you were told that you should just have your accountant, or a cheap online formation service do it for you. The problem is that you usually don’t know what you don’t know until it is too late.

There’s a lot at stake when starting a business. It pays to be diligent in the initial phases. Whether this is your first business or your tenth, it’s worth taking your time to secure the proper guidance to establish your company correctly, potentially avoiding time consuming and costly legal challenges later on down the road.

How It Happens3 Common Causes of
Improper Business Entity Formation

Many businesses end up either improperly formed or incomplete because either the right questions, relevant to the business, were not asked or some of the necessary steps needed to properly setup the company were simply missed.

1. You Setup The Company Yourself

There’s nothing wrong with doing the setup yourself. But you really need to have a good idea of what you’re trying to accomplish, and the steps needed to get there.

Getting information off the internet can help you to a certain extent. However, a lot of that information can be confusing, incomplete, or simply wrong. Moreover, most of what you do find is geared more towards a basic common setup more so than what you may need for your business and your specific situation.

There are a number of steps necessary to properly set up your company. Those steps will vary depending on location, the type of business, and the type of business entity being formed. Failing to take any of those steps or to carefully consider your situation could cause hidden legal issues down the road.

When you first started your business doing it yourself (DIY) may have been a viable option. If your business has grown in the interim there may be hidden legal issues you need to address.

With DIY business formation there is a knowledge gap. That knowledge gap could expose you to unnecessary legal liability and could prove to be expensive in the long run.

2. You Used An Online Service

The primary selling factors for online incorporation services is that they bridge that knowledge gap, are fast and less expensive than working with an attorney.

These services are not the cure-all they like to market themselves as and may not be appropriate for your business. In general, you are asked a series of generic questions about your business or are asked to fill out a one size fits all form. From the answers provided you are directed to a generic package of services to form the business entity.

There are a few flaws to this approach. First, it does not take into account your and your business’ specific circumstances. Second, you are generally expected to know what you need. Third, although you may think you are getting help to guide you through the process you really aren’t.

Once you compete the fill in the blank forms and pay the fee you are told you are done, and the paperwork is on its way to be registered with the state. You get a warm and fuzzy feeling of accomplishment and check entity setup off your to-do list.

It could be years before you discover that there is a problem with how your business is structured.

Depending on the circumstances, there are a lot of potential legal issues that could occur. The simple fact of the matter is that online formation services can’t give you legal advice. And, unless you have the formation and governing documentation reviewed you can’t confidently know if the entity was properly and completely setup.

3. Your Accountant Set It Up For You

Having your accountant set the business up is often a convenient choice. Moreover, some accountants see it as a value added service, they can provide their clients.

The problem is, accountants are accountants, not business lawyers. They understand the tax implications of a business structure, but they don’t know the legal implications. Nor do they know the legal requirements for setting up your business or the governing documents you may need for your circumstances.

The pitch generally focuses on lower cost, a streamlined process, and convenience but they usually only facilitate a few of the required tasks for proper formation. Taking this route could leave you with a partially formed entity with no, or incomplete governing documentation. Opening you and your business to both internal and external legal liability

When It's FoundCommon Ways Partial or Incomplete
Business Entity Formations are Discovered

Most business owners simply do not know that there’s a problem until they’re under pressure to produce the formation and governing documentation.
  1. The business gets sued: Both your lawyer and the opposing lawyer will want to see both the formation and the governing documentation.
  2. A lender requests the documentation: A lender is going to want to make sure they are dealing with a legitimate business. And that the person they are working with actually has the authority to enter into an agreement.
  3. You apply for government designation: If you are trying to get designated as a small business, minority owned or become a government contractor.
  4. Unresolvable conflict between founders, shareholders, partners: Conflict resolution processes are normally outlined in governing documents; like, owners agreements, shareholder agreements and operating agreements.

The IssuesThe Hidden Dangers of an
Incomplete Business Formation

There are a lot of potential issues that could crop up if company documentation is not in order. The following are just a few of the potential issue that could occur. They can be complicated, time consuming and expensive to resolve.

Risk Piercing The Corporate Veil: Piercing the corporate veil is the court’s decision to apply a company’s liabilities as personal liabilities, forcing the owner to face them as an individual. This happens when a business is improperly formed or maintained and cannot hold up in the eyes of the law.

Securities and Equities Issues: Ownership interest in a company is considered a security. Failure to properly file these securities and comply with state and federal regulations could open both the business and you personally to investor lawsuits.

Ownership and Control Issues: The company could start out with too few authorized shares. This becomes a problem when the company wants to offer equity interests, as they will now face additional fees to amend documentation and increase their share amount.

Increased Tax Liability: Business formation lawyers educate clients on the differences between LLCs, corporations, sole proprietorships, and partnerships and determine a path accordingly. There are a number of tax issues to consider when setting up the legal structure for your business. Depending on the situation, when done properly tax exposure can be reduced.

Disputes Between Shareholders: At issue here is not that a dispute occurs. There’s no getting around that. At issue is when the dispute cannot be properly resolved. Unless you’ve worked out a dispute resolution process in the company’s governing documents; such as, an operating agreements, owners agreement, shareholders agreement etc. – business operations could be severely disrupted, if not halted.

Difficulty Taking on Investors: There are any number of issues that occur that could make taking on investors a difficult prospect. Depending on the situation you may only have to file amended documentation. But, there are situations where, in order to take on investors, you will have to dissolve the company and then start a new one.

Trademark Infringement: This happens more often than you might think.  A lot of time and money will go into he branding of your new company. It would be a pretty expensive prospect for your new company to go to court over trademark issues or to have to redo all the branding for the company. Neither accountants nor online services do in depth trademark reviews.

Final ThoughtsDoes Your Business
Have Hidden Legal Issues?

If you formed the legal structure for your business yourself, leveraged an online service, or your accountant did it, then you likely have hidden legal issues that need to be addressed. You should consider having an attorney review your companies formation and governing documents. In some cases you may want to consider having a full legal audit done.

We can help you address those legal issues no matter what they might be.  Whether we simply need to complete the formation process, reconstruct missing records, or start from scratch we can help build a strong legal foundation for your business that can withstand scrutiny.

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