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As a practicing business attorney for 18 years, I have heard it all when it comes to incorporating a business. Many think that incorporating their business will help them cut the federal tax bill or avoid paying state income taxes completely. First-time entrepreneurs often have misconceptions about incorporation, usually resulting from an optimistic desire for lower taxes or third-hand advice from a friend or a friend's accountant. When small business owners fall prey to some of these myths, the consequences can range from higher taxes to misunderstanding their personal liability. To gain a better understanding of these myths, it's important that you understand some of these misconceptions surrounding incorporation.

 Incorporating can help with avoiding state taxes:Those starting a business in California might be jealous of neighbors in Nevada who don't have to pay state income taxes. Many entrepreneurs believe that they can incorporate in a low tax or no tax state and their business is not required to pay any income taxes. It sounds like a great strategy but it does not work. When it comes to state taxes, it does not matter where the business is incorporated. What generally matters is where the owner operates the enterprise. Those living and running a business in California still need to pay state taxes on the income earned in California even if the company is incorporated in Nevada. Moreover, Nevada requires an annual filing of the list of officers and directors of the corporation and requires a business license. These fees can add up very quickly and outweigh the benefit of paying no state taxes.

 Incorporating protects the owner from all personal liability:Incorporating is a critical step for separating an owner from the business, but it does not absolve the owner of all personal responsibility. As the proprietor of a business, the owner can still be held personally liable for the business in several situations. If a business proprietor signs a contract in the owner's personal name, personally guarantees a loan, does not keep up with corporate compliance paperwork, or commits a crime, the owner will be personally liable.

 It's better to wait until a product is ready for the marketplace:Many small business owners prefer to avoid legal paperwork until they absolutely have to deal with it. Some believe there is no need to incorporate until they start selling a product or service. This line of thinking is wrong on two counts: First, liability issues related to a business can arise long before products hit the marketplace; for example, an employee, independent contractor, or vendor might sue the owner for related reasons. The second reason to incorporate early is related to an owner selling the company, as it's more desirable to treat the sale proceeds as long-term capital gains than ordinary income. The stock in your company must be held for more than one year.

Make no mistake, it is critical to form a corporation for entrepreneurial activities to minimize personal liability. In some cases, these business legal entities can lower taxes, but incorporating should never be considered an easy way to avoid taxes.

Before I explain which legal entities exist and which one would be a good fit for you, it's important to understand what exactly is a startup.