Forming a California LLC: Mistakes to Avoid by Stephen Nelson

Are you an investor or entrepreneur setting up a limited liability company for a California venture? Your decision probably makes good sense. An LLC reduces your legal risks and (usually) minimizes income and payroll tax expenses. But be careful! You want to avoid three common incorporation boo-boos:

Mistake #1: Ignoring the Franchise Tax

Limited liability companies deliver big benefits in terms of minimizing legal and business risks and in terms of grinding down your business taxes.

By owning a business or investment indirectly through an LLC, you create a barrier between your personal finances and those of the business--and you won't be liable for the business's debts solely because of your ownership.

Furthermore, if you own a business or investment through an LLC, you get some amazing tax accounting flexibility--including the option to have your limited liability company treated for tax purposes as just about whatever you want: a sole proprietorship (if there's one individual owner), a partnership, an S corporation, and so forth.

Unfortunately, the state of California (rather uniquely among states) reduces the attractiveness of the LLC option. The state levies an annual LLC tax on limited liability companies. At a minimum, this tax equals $800, but the hit goes up based on the business's income rises.

The $800 annual franchise tax is pretty significant for some small (especially part-time) businesses. Verify, therefore, that limited liability company formation is even economically justified.

Most small-scale ventures and sideline businesses really can't afford paying $800 or more for the advantages a limited liability company serves up.

Mistake #2: Forgetting About Understaffed State Government Offices

Another mistake related to incorporating in California concerns the absurd processing times required by the Secretary of State. Unfortunately, long delays screw around with your business start-up activities--and need to be recognized in your planning.

In mid-to-late 2010, for example, the California Secretary of State says that processing the articles of organization for a limited liability company requires roughly sixty days. That's actually pretty brutal: If you want to operate your business as an LLC, you'll going to have to wait almost two months just to get the business or investment entity setup.

Mistake #3: Using a Nevada Corporation or LLC

One other mistake you won't want to make is using a Nevada corporation or Nevada LLC.

With the massive hassle-factor of incorporating California limited liability corporation, you might wonder whether you can just go next-door to Nevada.

Another state's fees and taxes are almost always going to be lower than California's. And many states quickly process business formation documents because they realize that doing so benefits everybody.

But practically speaking, you can't simply "opt" for incorporating in another state. If you're operating your business or making an investment in California, you either need to use a California LLC or corporation... or if you've initially setup up a corporation in another state (like Nevada) you'll need to register your Nevada entity as a foreign corporation or foreign LLC operating in California.

Registering a "foreign LLC" or "foreign corporation" in California, however, puts you right back at square one: Registration of the foreign corporation takes months and triggers the annual franchise fees and taxes.