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Legal News, Business:  March 5, 2013

Common Mistakes With “Do It Yourself” Formed Legal Entities

By Ron Chauvel 1 comments

When it comes to small business entity formation, many persons are “doing it themselves” through various internet sites that claim to provide everything you need to form your own entity without incurring much if any legal expense.  Sounds attractive?


In our practice, we often come across such entities that have been formed by clients without any real legal expertise or consideration.  There follows several issues that these “do it yourself’ entities often present.


First, in many cases these entities are not perfected or completely formed.  For instance, to form a corporation it is necessary to do more than just file Articles of Incorporation with the Secretary of State.  A primary reason to incorporate is to limit individual liability for corporate debts and obligations.  If the corporate entity is not perfected, or completely and properly formed, the corporate shield against such liabilities may be pierced by creditors.  Of course, the “do it your selfer’ will not know that his entity is impotent until too late.


To properly incorporate, there must, among other things, be Bylaws, Shareholders and Directors Minutes, capital infusion, issuance of stock, and required filings with the Franchise Tax Board, Internal Revenue Service, Secretary of State and Corporations Commissioner.  If there are multiple shareholders, there should be a Shareholders or Buy-Sell Agreement.  Similar documents must also be prepared and filed for a limited liability company, and such entities must have a well thought out Operating Agreement to govern their management and business conduct.


Second, we often come across corporations or limited liability companies formed in other states without good reason.  Many persons are led to believe that filing an entity in Nevada will somehow result in tax savings.  Others form entities in Delaware thinking that there are benefits associated with Delaware law.  While there may be good reason to form in another state,  more often than not this is not the case.  If your enterprise is formed in another state but does business in California, then it must qualify itself in California.  The qualification process costs about the same as incorporating in California.  If your enterprise does business in California it must pay taxes in California on California source income.  So, forming an entity in another state that will do business in California will many times result in increased costs, taxes and administrative burdens.


No doubt, many that form entities elsewhere do not qualify their business in California or pay income on California source income.  This is fine until they are caught or a legal action is filed and then the costs of noncompliance can dwarf the savings achieved by organizing out of state.


Third, serious consideration should be given to the type of entity you form.  Will it be a corporation, limited liability company, partnership or limited partnership?  There are tax and legal reasons for selecting each of these entities, and the selection will vary depending on the type of business and future goals. Selection of an inappropriate entity can have drastic consequences.  In some cases, the entity may be converted to a more appropriate form of entity, but the cost of conversion will exceed the cost saved by “doing it yourself”. A tax accountant and an attorney should be consulted before selecting the type of entity to be formed. Otherwise, there may be serious tax or legal consequences down the road.


In sum, our experience indicates that the “do it yourself” approach results in cost savings up front, but will almost always result in increased costs and anxiety down the road if the entity succeeds and grows.  The “do it yourself’ approach can result in an improperly formed entity where the creators are subjected to individual liability for entity obligations.   Likewise, severe results may occur where the correct form of entity is not selected.   Of course, if the entity fails or flies under the radar then the up-front cost savings endure.  We believe most persons that form small businesses plan on growing and being in business for the long run, and these persons are well advised to consult professionals to assist in the formation process.  

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Thanks for the great post. I came across some websites 3 years ago when I needed a LLC. Some of them said "form your own LLC online in just 10 minutes". I think any serious business person wouldn't go with such services. Using an attorney to get things done right is absolutely necessary. Hope more people can see this post and understand why.