Formation Is Not a Panacea

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I have had many conversations with many different sorts of people who have all kinds of ideas about forming an organization for their project or enterprise. I know people who control half a dozen corporations or LLCs who aren’t doing anything in particular. I have met people who take very circuitous routes to avoid having any kind of organization even when it hurts them. As a result, I have become fairly cynical about formation and advise clients to form if one of two conditions is met: to limit liability and to manage outside investment. What type of organization they should form should depend on which condition they’re up against. There are other reasons people suggest, but they really don’t withstand scrutiny.


If you have a public-facing organization, you run the risk of someone getting hurt. If you place goods in the hands of consumers, you run the risk of your product hurting them. If you do independent consulting or contracting work for outside clients, there is a possibility of liability there, but that risk is small and could be contracted around if you have control of your contracts. The protection you get from incorporating will limit your personal liability to whatever you invest in the organization. Someone slips in your restaurant and breaks their arm? You should have insurance to cover this, but if the insurance coverage is problematic, you will never lose your retirement savings over it. I spoke with a client recently who explained that one of his competitors went down in flames because of employee lawsuits.

I have spoken with some tech entrepreneurs who think they don’t have anything to worry about with regards to liability. Maybe they write a few mobile games or write some other small web services, but cannot identify any situation where the amount it would cost them if they were hit with a complaint would be greater than the value of the organization. (SCO Linux disputes aside)

If your main concern for your project is to limit your liability, then a Limited Liability Company (LLC) is the right thing for you. But be sure to follow at least some of the formalities if you go this route, or the liability limitation won’t do you any good. I made a previous post there.

Many would put general debt liability in this category, but I am reluctant to add it. Banks are wise to people forming LLCs to avoid having to pay back loans. A mature organization may take on unsecured debt, but a new business will have the credit rating of a baby and formation will hurt more than it will help. Forming an organization to avoid debt is likely to have you personally guaranteeing the debt, which defeats the purpose of the exercise and usually lands you with worse terms than you would get if you entered into the debt agreement as a sole proprietor or partnership.

LLCs with groups of people become unwieldy fast, though. Although it is a good way to pool resources for a few people, this structure becomes unwieldy with more than a handful of investors. If some people are contributing a little and others a lot then you have real problems dividing the pie.


If you’re seeking an equity investment of any kind, you must have a corporation. S corporations are a good vehicle for managing that and function much like LLCs, but are limited to 100 investors who are US nationals. I don’t recommend this to everyone since corporate formalities are a non-trivial overhead. You can put off forming that organization until you are ready to solicit investment, although it could be problematic to make arrangements with suppliers and resellers if you change corporate identity and wish to maintain those agreements.

Reasons that aren’t good enough

I have been told by a number of people who should be very knowledgeable that I should form an organization for myself. Every time I looked into it seriously, I failed to see the promised upside. A few of the reasons I have heard include:

Tax breaks

Now, I am not a CPA or tax advisor, so I can’t speak to all the advantages or disadvantages of different organizational types. It’s my understanding that income from each type of organization is reportable as a different type of income.

If you form an organization in some of the tax havens, you can take advantage of tax breaks in those places. However, you get taxed for the money you yourself earn where you live. All of the organizations discussed here are pass-through organizations, so the organization wouldn’t have to pay any corporate taxes. Even if your organization is paying payroll taxes, those taxes are paid in your jurisdiction. If the organization you formed owns property, then that property could be taxed at a more favorable level… if that property is not real property outside the tax haven, but otherwise… there’s no value.

California AB5

I have spoken with a lot of people who are concerned about making the distinction between their work as a contractor and that of an employee. Yes, forming an organization can eliminate considering you for the pool of “potential employees” for that organization. It could help, but is not a great way to address the problem. It is better to be aware of all the factors that go into figuring out how to limit how the work you might do, or the manner in which you would complete your work would avoid satisfying them. See the state Department of Industrial Relations page on the subject for more information. I personally recommend against this because it is invariably to the independent contractor’s detriment if they are working like an employee and being paid like a contractor.