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CSoli921

Forming LLC for Internet Company

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Background Story: I am going to form an LLC for an information product business. I have already tested my services under a sole proprietorship and was profitable. In the first year of operating my LLC, my main (or full) source of income will be from internet purchases of digital products which I create. In the next year or so, I am going to travel from NJ (current permanent residence) to CA for at least one year. After the first year, I am going to decide whether CA will be my long-term permanent residence.

Question: Which state do I form my LLC in, NJ or CA? Should I continue to operate as a sole proprietor until I establish a long-term permanent residence? Or should I form my LLC in a different state that has less tax requirements being that my company will be internet-based?

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Which state do I form my LLC in, NJ or CA?

 

Either flip a coin or consult with a local business attorney for advice.  In order to evaluate this intelligently, one would need a lot more information than you have provided or should provide in a public forum.  This is not the sort of thing about which you should pinch pennies.

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In order to intelligently answer this question, no more information is required. The answer to this first question was a guage to aqcuire a competent business attorney on a Law web site. If an attorney can answer this question, I will consider retaining their services.

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Actually, a lot more information about the business is indeed needed to know where you should organize the LLC, or even if using a LLC is at all beneficial. I think it will help to explain some the basics about LLCs and other limited liability entities. 

 

A sole proprietor of a business is personally liable for all debts that are incurred as a result of the business. In other words, he has unlimited liability for the debts of the business. Partners of a general partnership have unlimited liability for the debts of the business. A corporation, LLC, or other limited liability entity shields owners of a business from personal liability for the debts of the business that would occur simply because of being an owner. But the liability is not absolute.

 

First, the owners are, of course, liable for any debts that they personally guarantee. Most major creditors of a small corporation or LLC, including bank lenders, landlords, utility companies, any supplier that ships on credit, etc., will require personal guarantees from all (or at least the principal) owners prior to doing business with them. 

 

Second, you are always liable for your own negligence. Thus, let’s suppose that Alan and Bob own a LLC that operates a small store. Bob works the store himself and is the LLCs only employee. Alan never works there and is simply an investor in the LLC. Bob is negligent in failing to clean up a water spill that occurred in the store and took no steps to warn customers of the spill. Cindy slips in the water and is injured. Bob is personally liable for Cindy’s injuries because he was the one who was negligent and thus caused her injuries. The LLC, as Bob’s employer is also liable for Cindy’s injuries. Alan, however, would be protected from personal liability for Cindy’s injuries because he wasn’t the one who was negligent and he is protected by the LLC form of ownership from being liable just because he’s an owner.

 

Third, the law provides that owners or others may be liable for the debts of a business even though the business is operated by a limited liability entity. For example, some tax obligations (typically employment taxes and in some states sales taxes) of a limited liability may also become personal liabilities of the owners or other responsible persons in the company because the tax statutes expressly provide for that.  

 

Finally, owners may be liable for the debts of the business if they fail to sufficiently honor the separate existence of the entity. Very generally this means that the owners have blurred the distinction between themselves and the entity by doing things like having the company pay for personal expenses of the owner, the owners using the entity’s assets for personal use, and so forth. Several different doctrines, like piercing the corporate veil, alter ego, and nominee may be used by creditors of a limited liability entity to go after the owners personally in these sorts of circumstances.

 

Thus, it may be that your particular business might not even benefit all that much from the limited liability that a LLC or corporation offers. That’s going to depend a great deal on the details of your business.

 

As for taxation, understand that for most small businesses, organizing the entity in a state other than a state in which it conducts business won’t save it much, if anything, in tax. It might actually increase the taxes the business pays. A full discussion of tax issues is beyond the scope of this message board, but let me address a couple of points.

 

Federal taxation, of course, is the same regardless of where in the U.S. the business is organized or where in the U.S. it operates. So, the differences for a company that does not operate outside the U.S. will occur with state and local taxes. Note that for federal income tax, a LLC organized in the U.S. that has only one owner is by default disregarded and treated as a sole proprietorship of the owner. Thus, if you form a LLC for the business and do not elect to have it treated as a corporation, your federal income tax for the business will be handled just like it is now with your sole proprietorship.

 

Not all states follow the federal treatment of LLCs, but NJ and CA do. Thus, for NJ and CA income tax, your LLC would also be treated as a sole proprietorship unless you made the election with the IRS to treat the LLC as a corporation. 

 

For a sole proprietor or LLC treated as a sole proprietorship, the state in which you are a resident will tax you on all the income of the business no matter where it was earned. Every other state will tax you on the business income you derive from that state. Your home state will then give you a credit for the income tax you paid to those other states.

 

In short, in which of those two states you organize the LLC won’t affect the income taxes you pay if it’s treated as a sole proprietorship. What will matter is in what state you are resident. 

 

It is very important to note that even though California treats single member LLCs as sole proprietorships for income tax purposes, California imposes a separate tax on all LLCs that are organized in California, registered in CA, or that conduct business in CA. This tax is based on the gross receipts of the business and is a minimum of $800/year. Thus, while you are operating from CA you’d be subject to this tax no matter where the LLC is organized, and if the LLC is organized or registered in CA you’d be subject to this tax even if you no longer conduct any business there.

 

Which brings me to a another issue. Pretty much every state, including NJ and CA, require business entities like LLCs and corporations that are organized outside the state but that conduct any significant business activity in the state to register as a foreign (meaning out-of-state) entity. This is one reason why organizing in a state in which you do not conduct business can be more costly. You end up paying fees to organize it and then pay filing fees anyway in every state where your business operates, too. 

 

Taxation of corporations (including LLCs that elect to be treated as corporations) works differently. Usually for a new small business, a C-corporation (a federal tax term referring to any corporation that is not a S-corporation) is not the most tax efficient way to go. The owners get no benefit from any losses incurred and are subject to double taxation on corporate profits. S-corporations are taxed like partnerships, eliminating the double taxation, but there are still limits on use of losses by the owners that a sole proprietorship would not have. At the state level, corporations are taxed through a process known as formulary apportionment. The state establishes apportionment factors (e.g. sales, payroll, etc) and establishes a formula that determines how much of the corporation’s total worldwide income is attributable to that state. The corporation is then taxed at the corporate income tax rate based on that share of its income. Here again, where the corporation is organized doesn’t really affect how much income tax the corporation pays. Again, though, corporations organized or registered in CA will pay that extra tax that I described earlier that is based on gross receipts. Other states may likewise have some kind of franchise tax for being organized or registered there.

 

In some cases there may be a benefit to organizing as a S-corporation over being a sole proprietorship,  either to save federal tax or save state taxes. But that’s something that must be determined based on the particular facts of the business. Note that a LLC may elect to be treated as a S-corporation. 

 

You’ll need to decide if you even want or need to form a limited liability entity like a LLC or corporation. From there, you’d decide in what state to organize it. In most cases it’s best to simply organize it in one of the states in which you conduct business. You will also need to decide if you wish to elect C-corporation or S-corporation status for the entity. I strongly urge anyone going into business to discuss all these issues with a business attorney and a tax attorney so you can make the best decisions. If you do it yourself and mess it up, you can cost yourself a lot more money later on. 

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