Misconceptions, Schemes & Scams
This article covers two areas: misconceptions that people have that cause them to choose the wrong entity type, tax classification or formation state, and outrageous claims or tax avoidance schemes devised by online incorporation services and others.
Instant Business Credit
There is no shortage of hucksters in the business world looking to induce you to buy their goods based on false or misleading claims. This is not a rampant problem in the incorporation service business, but it is not uncommon either.
One claim that’s been around for some time promises to get you “instant business credit” regardless of your personal credit. It’s a claim that sounds too good to be true, but people just can’t seem to resist it. After all, in these difficult economic times, it’s not easy for someone with good credit and a solid business with a good track record to obtain credit. If you’re starting a business and need capital, or have a business but your personal credit is poor, you may feel you’ve got nothing to lose.
Fortunately, the Internet provides some assistance in learning from the mistakes of others. Before risking your money on this claim, click here to read stories posted by others who acted on the claim of “instant business credit.” Learn from the mistakes of others rather than making your own.
Avoiding Taxes Using a Nevada Corporation
If you thought the idea of getting instant business credit of $50,000 or more sounded intriguing, this one’s even better. After all, with business credit you’re actually supposed to pay back what you borrow. This scheme is intended to avoid the payment of business taxes altogether.
The companion article “Choosing Your Formation” State discusses the misconception about forming a corporation in Nevada to run a business that is located in another state (and conducts little if any business in Nevada) in order to avoid paying business taxes in the state where business in actually conducted. This article discusses a variation on that theme promoted primarily by some Nevada incorporation services.
This scheme instructs the business owner to form a corporation in his home state. Let’s say that’s California. Then the business owner forms another corporation in Nevada. The ownership is the same in both corporations. All the business in conducted through the California corporation where the principal business is located. All sales are generated in California or based on services provided in, or products sold or shipped from, California.
At the end of the corporation’s tax year, the business owner has the Nevada corporation send an invoice to the California corporation for “consulting services” or similar description. The invoice amount happens to be approximately the same amount as the taxable profits of the California corporation, which then pays the invoice and effectively “zeroes” out any California profit by treating the invoice as a legitimate and deductible business expense. Just like that the business owner has avoided California business income taxes and shifted his profits to the Nevada corporation bank account where the income isn’t taxed.
Instinct probably tells us that this doesn’t pass the smell test and, as usual, our instincts are correct. California and many other states require combined reporting on tax returns. California calls it a unitary tax. It applies when two or more companies are under common ownership. The business income from the unitary (or combined) business operations of these companies must be apportioned between (in our example) California and Nevada. However, since no real activity took place in Nevada, there is no legitimate basis for excluding the Nevada income from the California corporate tax return. In short, the California business owner should legally be reporting all income in California and paying California taxes on all profits, effectively negating the impact of the bogus consulting fee payment to the Nevada corporation.
When companies legitimately conduct business in several states, they are permitted to apportion the taxable income to the state where the sales or services were performed. This avoids the unfairness of paying tax twice on the same income. As always, the burden falls on the taxpayer if audited to support the apportionment percentages claimed for each state. In our example, the taxpayer would have no basis for claiming any apportionment in Nevada.
Other Schemes: Offshore Corporations, “Bearer” Stock Certificates and Other So-Called Asset Protection Devices
Offshore Corporations and Accounts
A widespread practice used to avoid U.S. income taxes is the establishment of an offshore corporation. One variation has the offshore corporation bill the U.S. corporation to produce a deductible business expense thereby shifting taxable income offshore to avoid taxation. Another variation has online companies set up offshore bank accounts and has their online payment portal service deposit credit card charges of customers directly into the offshore accounts.
The U.S. taxpayer then accesses these funds in several ways. A common method is simply to have a credit card tied to the offshore account so that purchases on the card in the U.S. are paid from the offshore account. Another method has the taxpayer purchase goods for his business using funds in the offshore account.
Click here to read a typical case prosecuted by the Department of Justice involving the fraudulent use of offshore bank accounts.
“Bearer” Stock Certificates
Until recently, Nevada has been the domestic resource for what are known as “bearer” stock certificates. These are stock certificates issued by a corporation that do not list the owner’s name. Instead, they state that the owner of the stock is whoever holds the certificate at the time ownership is questioned or determined.
Promoters of this “asset-protection” device use bearer certificates like a hot potato. Whenever the true owner (read “taxpayer”) must sign any document listing the owner of a corporation, the bearer certificate is handed to another person (who then is technically the owner of the shares) and the other person signs the document as the owner of the shares. As soon as the document is sent off, the certificate is returned to the taxpayer who is now restored as owner of the shares. Clever, huh? Not so much. The Department of Justice successfully prosecuted a person who aggressively promoted this scheme as part of his asset-protection system through seminars, a book, and training he sold to others to on how to market this system to the public.
Click here to read the complaint filed by the Department of Justice that led to the prosecution and incarceration of this individual.
There will always be people inducing you to believe they’re offering something that no one else can provide. When these claims sound too good to be true, conduct your due diligence before parting with your money. Carefully read the fine print disclaimers on a company’s website, check out a company on one of the recognized online sources for reporting scams, unsupported claims, or simply bad experiences with a company, and avoid becoming the next victim.
Incorporating Always Protects Your Personal Assets
It is common for people to think that forming a corporation or LLC to operate a business provides an absolute shield against any personal liability for debts and obligations of the business. While personal liability protection is extensive and will not be at risk unless there are exceptional circumstances, the phrase “limited liability protection” is not unintentional.
There is one factor common to all limited liability entities (LLEs) that will universally allow the protection of an LLE to be disregarded by a court and the owners to be held personally liable: the negligence or willful misconduct of an owner. The simple reason is that there is a strong public policy in favor of an individual being personally responsible for damages or injuries caused by his or her misconduct and this policy outweighs the limited liability protection that otherwise applies in an LLE.
The most common examples of this principle being applied are with professional corporations where the primary purpose is the delivery of a personal service for medical, legal, accounting, architectural or similar professional services where one often associates the term “malpractice.” Even though a professional delivers personal services through a corporation or other LLE form, he or she will still be personally responsible for any damages caused by his or her wrongful or negligent actions or inactions.
This principle applies equally to a regular business corporation or other LLE where the conduct may involve driving a truck, repairing equipment, or other activity where personal services are involved and cause, or are a substantial contributing factor in causing, damage or injuries to others or their property.
A more egregious factor that commonly causes the limited liability protection of an LLE to be disregarded is the use of an LLE to perpetuate a fraud, or where it would be unjust to allow an owner to hide behind the shield of a LLE. For example, if a person formed a corporation but never followed any required corporate formalities such as issuing stock, keeping minutes, etc., never capitalized the corporation with cash or other assets or had any insurance for risks involved in operating the business, a court would be likely to “pierce the corporate veil” and hold the shareholder(s) personally liable. The LLE would be considered a “sham” intended essentially to shield the owners from their conduct and not intended to function as a viable separate entity.