3 Dumbest LLC Formation Mistakes

Whether you’re setting up an LLC on your own or having a professional handle it, there are several LLC formation mistakes to watch out for. Here’s what you need to know before you complete the paperwork.

I see a lot of dumb LLC formation mistakes. Maybe more than most people because I regularly teach a graduate tax class on LLC formation.

Some of the mistakes are made by entrepreneurs and investors trying to save money on accountants and attorney fees. And I guess that’s okay — albeit penny-wise and pound-foolish.

But you know what really irks me? Some of these mistakes — in fact, most of them — are made by attorneys and paralegal services. Professionals who should know better.

But enough whining. Without further fanfare, here are the three dumbest mistakes that I see people make again and again and again.

Mistake #1: Forgetting about Foreign LLC Registration Rules

Read those tempting advertisements for Delaware or Nevada limited liability companies? The advertisements sound pretty good, but most small businesses shouldn’t use out-of-state LLCs or for that matter out-of-state corporations.

Here’s why: If you’re doing in business in, say, New York, you’re not going to be able to avoid state taxes by forming your LLC in, say, Nevada. The tax and corporation laws in your state will require you to register your out-of-state (that is, “foreign”) LLC in the states where your business operates. Those same laws will require you to pay state income taxes in the states where you earn your income. 

A couple more quick points: Large businesses do like Delaware for a variety of reasons — mostly having to with how sophisticated the Delaware Court of Chancery is. But this applies to really big businesses that will litigate in Delaware — not small businesses.

Nevada does offer corporations a no-income-tax haven, but you need to set up a real business presence there with an office, employees, and property — the whole enchilada.

Mistake #2: Electing to be Treated as a C Corporation

An LLC is a chameleon for tax purposes, which is great. An LLC with a single owner can be treated as a sole proprietorship, a C corporation or an S corporation (assuming eligibility requirements are met). An LLC with multiple owners can be treated as a partnership, a C corporation or an S corporation (again, assuming eligibility requirements are met).

But just because you can do something doesn’t mean you should. And unless you’ve got expert tax advice from an attorney or certified public accountant, you shouldn’t make the election to be treated as a C corporation.

A C corporation is taxed on its profits. When those profits are distributed to shareholders, they are taxed again. By electing to be taxed as a C corporation, the LLC owners create an extra level of taxation.

Bummer.

Mistake #3: Electing to be Treated as an S Corporation Too Early

LLCs can also elect to be treated as S corporations, as noted in the preceding paragraphs. And once a business generates profits well in excess of the amounts paid to owners for salaries, an S corporation election saves the owners big money.

Sometimes tens of thousands of dollars per owner per year.

But you don’t want to elect S corporation status too early — especially if the LLC is owned and operated by a single owner.

By electing S corporation status, the LLC needs to file a corporate return and needs to begin doing payroll — even if the only employee is the owner — and may need to pay additional payroll taxes like the employer’s portion of Social Security and the federal unemployment tax.

Wait until your business is profitable before changing your LLC to an S corp. Your patience will pay off in two ways: simpler accounting and less expensive tax returns.

New York LLC formations expert and tax accountant Stephen L. Nelson, CPA, has written more than 150 books. Formerly an adjunct tax professor at Golden Gate University, Nelson is also the author of QuickBooks for Dummies.