C
OMPLEXITY IN
B
USINESS
F
ORMATION
Craig H. Wendland
May 24, 2013
Often, individuals hoping to begin business in California reach the conclusion that they should form a separate business entity. This decision may be based on a variety of reasons, including prestige, increased sales, liability concerns, and/or tax implications. Unfortunately, individuals are often met with a bewildering array of choices that often ends in frustration. Does it need to be so complex?
The quick answer is: Yes and No… but mostly No.
While there are many different choices for business formation, many can be ruled out by the individual almost immediately. The formation itself can be relatively inexpensive and fairly pain free.
The complexity comes in how detailed and complex you would like the company run, the stock structure you would prefer, and the tax implications of your choice. While it’s likely that your small business is trying to limit costs, the choice of entity form IS a critical step. If you are going to spend some money on your new business, this is an area you should not skimp. A brief tax consultation for your particular locale is a critical step and attorney advice may be a necessity depending on the
complexity of your business. This article is limited to for-profit business formation in California, but will have a brief discussion of Delaware and Nevada incorporation concerns. It is intended for small businesses, and is in “laymen” terminology. It is for information purposes only, and is not intended as legal advice.
Initial Considerations
Clients often ask for advice on which state they should incorporate. Many times this is based on misleading or erroneous online advice about avoiding state fees, and state or federal taxation. The small business owner should be aware that regardless of state there are annual and tax franchise fees, as well as federal taxes and employee expenses to consider. Many of the expenses and requirements differ from state to state.
In California, for example, almost all corporate forms must pay a minimum annual corporate tax of $800. If you don’t do business in California, it might be a better idea to incorporate somewhere else, as this is a fairly high minimum tax. However, if a business chooses to incorporate outside of California, they must still register with California prior to “transacting intrastate business.” (California Corporations Code §§ 2105, 15909.02, 16959 or 17451). Ergo, if you are going to be doing your business in California it is unlikely that you will avoid many state fees by incorporating elsewhere. Beware solicitors who advertise that you can pay “no taxes” on your business by incorporating elsewhere… generally, this is simply a gimmick hoping to lure your business.
A second initial consideration is the business name. Prior to formation, a business name search should be completed to confirm that the name is available. A similar check for conflicting trademarks, internet domains and out-of-state business names may be wise prior to finalizing the business name choice. It is important that you should consider your name choice that is not misleading. Use your common sense. For example, avoid calling your new bakery, “Laurie’s Law Office,” or stating that it is a government agency or police department.
You can hire someone to do a name search for you, but the easiest (and cheapest) way is to go to yourlocal county clerk and using their computers to search for fictitious business names that conflict with your choice. Online access may be difficult to obtain, but check your secretary of state to see if this is available. Generally you may also reserve a name via mail to the Secretary of State.
You can search the USPTO’sTrademark Electronic Search System (TESS) to check for trademark conflicts. There are many internet service providers who will check to see if your choice of domain is available. E.g.godaddy.com,Network Solutions,whois.net, etc.
Business Entity Choices
Once your choice of name is set, you must settle on a form for your business. These are discussed in greater detail below, but a listing of the common formations is in order. In California, the major forms a business may choose are:
to register as an individual or business Doing Business As “DBA” or with a Fictitious Business Name “FBN”;
to file as a General Partnership, a Limited Partnership or a Limited Liability Partnership; to incorporate as a C-Corporation, a Close Corporation, Professional Corporation, or use the S-Corporation election;
to create a Limited Liability Company “LLC”; or to create a Non-Profit or “Benefit” Corporation. FBN/DBA
A Fictitious Business Name (“FBN” or “dba”) registration is simply a “pass through” name… it’s just a registration with the state so that if there is a conflict with someone in the future, there is a contact listed for your fictitious name. It does not reduce business liability or taxation for the individual with the FBN.
A business owner who will do business in California must file a FBN with the state within forty days of starting business if: (1) the business is a sole proprietorship doing business under a name not containing the owner’s full surname, (e.g. John Doe opening a business known as Doe Cleaners); (2) if the business is a Partnership; or (3) if it is a corporation doing business under a name other than its legal
name.
OK. How do I set up my name? To list your name you must: (1) Register it with the California by filling out a form available from your local County Clerk; (2) Publish the name in an approved
publication (once a week for four weeks in California); and (3) Periodically renew the name, (every five years in California). You should be provided with a list of approved periodicals when you register the name.
I. General Partnership, Limited Partnerships, Limited Liability Partnerships
A business owner may form a partnership with at least one other individual. The partnership may be a General Partnership, a Limited Partnership or a Limited Liability Partnership.
A General Partnership is the most common form of partnership. It is simply an agreement between parties, and does not require official documentation to be filed with the state. An official written agreement is advisable. A Statement of Partnership Authority (GP-1) may be filed with the Secretary of State to register the general partnership. The owners are all personally liable for any legal actions and debts the company may face. A general partnership is not taxed by the IRS, but is “passed through” to the individual. In practice, income is divided per partner agreement and reported to the IRS at the end of the year on a Schedule K-1 for taxation at the individual level, post deductions. (Individuals may still be required to comply with estimated tax returns, and should speak with a CPA.) Owners may deduct business expenses from income generated to the partnership at the “Partnership” level, or after division at the “Partner” level.
A Limited Partnership adds a level of security to a general partnership. There must be one or more General Partners in a Limited Partnership. As in a general partnership, General Partners are considered agents of the partnership and manage the business. Limited Partners are segregated from the general liability, have no management authority and are not personally responsible for partnership liabilities outside of their investment in the partnership. A Limited Partnership must clearly disclose that it is a LP during business dealings. The Limited Partnership is required to pay an annual $800 tax to California.
In California, a Limited Liability Partnership is a form of partnership in which ALL partners receive limited liability. They are particularly popular with professional services partnerships. In California, this is limited to public accountancy, law, or architecture. Notably, malpractice liability protection is
restricted. As with other partnerships, an LLP provides “pass through” income/taxation. The LLP’s primary distinction from a Limited Partnership is that all partners are provided liability protection, and all partners may be involved in business management. The primary distinction between a GP and an LLP is limited liability, and that LLP owners are “equal” in terms of management and distributions, according to their ownership share of the partnership. There is an $800 annual tax for an LLP.
II. Corporations:
C-Corporations “C-Corps” are the general corporate form for established businesses in California. They exist as a separate entity from the individual owners, who share ownership of the corporation through company stock. The primary benefit of C-Corp formation is the protection of personal assets from corporate liability, a separate entity structured so that you can accept money from investors, multiple owners/ownership via the issuance of stock, the deduction of business expenses, a reduced personal audit risk from the IRS, and the use of “Corp.,” “Corporation,” “inc.,” etc. in the corporate name to increase credibility with consumers. C-Corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level, (e.g. In California net income tax at 8.84%, minimum of $800).
A second general form of the corporation is called a closely held corporation (“Close Corp”). This form is provided in California for corporations held by a small number (<35 in California) of closely involved business owners (e.g. a family owned business). It provides for excellent liability protection, and is similar to a Corp for tax ramifications. This form avoids some of the strict formalities of a
C-Corp, but this cannot make a public offering of its stock. The election of Close Corp status must be unanimous and stated in the articles. As ongoing formalities are lax, shareholder agreements are often complex and should be drafted by experienced counsel. Often, shares of the Close Corps are restricted for sale to outsiders, which can severely affect marketability and share price.
The S-Corporation “S-Corp” can be thought of as a hybrid between a partnership and C-Corp. It is considered a separate legal entity via the state. An S-Corp is actually a C-Corp that has made a specific tax election, based under Chapter 1, Subchapter “S” of the Internal Revenue Code. This tax election provides for pass through taxation like a partnership, rather than a separate taxation level as a C-Corp uses. It is generally elected by small/startup businesses with a smaller number of owners, which seek to simplify the tax ramifications of corporate ownership. Similar to the C-Corp, this form provides for limited liability protection, stock ownership and investment through the sale of shares and the use of corporate identifiers in the name to gain consumer credibility. S-Corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no federal income tax is normally paid at the corporate level unless retained in the S Corp. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners. The pass through is at the federal level. S-Corps still pay an annual franchise tax of 1.5% of net income in the state of California, (minimum $800). They may issue only one form of stock, have limited stock holders and no more than 25% of their income may originate from passive sources.
Professional Corporations are similar to C-Corps, and applies to certain sets of professionals, including attorneys, physicians, engineers, accountants and architects. It provides the same liability shield of a C-Corp, although malpractice liability in California may be limited. A Professional
Corporation’s stockholders are generally not personally liable for the malpractice of other stockowners. They are also required to adhere to certain restrictions imposed by their profession, and additional code under the California Business and Professions Code.
In summary, businesses wishing to incorporate will form as either a C-Corp or S-Corp, depending on size and participation. There are two major distinctions between the C-Corp and S-Corp. The first is the Corp pass through taxation. The second is that C-Corps have no restrictions on ownership, while Corps may have no more than 100 shareholders, and shareholders must be US citizens/residents. S-Corps cannot be owned by C-S-Corps, S-S-Corps, LLCs, partnerships or many trusts. S-S-Corps can have only one class of stock (disregarding voting rights), while C-Corps can have multiple classes. C-Corps therefore provide a little more flexibility when starting a business if you plan to grow quickly via investors, expand the ownership or sell your corporation.
While referring a client to qualified tax professional, there are several advantages and disadvantages of the election between an S-Corp and C-Corp form:
Advantages to electing S-Corp status include several major federal income tax advantages:
1. Single Level Tax. Much of the corporate profits and losses are passed through to the shareholders (owners) of the corporation thus eliminating the potential for the "double taxation" faced by C-Corps;
2. Net Losses Can Be Deducted On Personal Income Tax Returns. While the losses of a C- Corp can only offset the corporation's earnings, the net operating losses of a S-Corp
can be passed through to the individual shareholders and deducted on their individual tax returns in the year the loss occurs;
3. Minimization of SelfEmployment Tax and FICA. (SS/Medicare). With an S -Corp, the shareholders can minimize both self-employment and FICA taxes by creating a balance between a reasonable salary and dividends. Dividends (the corporate profits distributed to the shareholders) are not subject to either self-employment tax or FICA. There are various disadvantages to electing S-Corp status compared to C-Corp status:
1. Stock Sale Exclusion. A C-Corp may exclude up to 50% of the gain on the sale of "qualified small business stock;"
2. Tax Free Fringe Benefits. The shareholders of a C-Corp may avail themselves of tax-free fringe benefits such as health and accident insurance, while the S–Corp is
prohibited from deducting the costs of such fringe benefits provided to shareholder-employees who own more than 2% of the outstanding shares;
3. Shareholder Limitations. The C-Corp can have more than 100 shareholders, while an S-Corp must have less than 100 shareholders; the C - Corp can be owned by other corporations, non-resident aliens, LLCs, and other S-Corps, while an S-Corp can only be owned by individuals, estates, and certain qualified trusts;
4. IRS Scrutiny. The shareholder-employees of a C-Corp are scrutinized less by the IRS, while those same shareholder-employees of an S-Corp are scrutinized to ensure they receive a "reasonable salary" before any non-wage distributions (dividends) may be made to them; and
5. Corporate Losses. Unlike a C-Corp that can deduct and carry forward all losses, an S-Corp shareholder may not deduct corporate losses that exceed his or her "basis" in the corporate stock, which equals the amount of the shareholder's investment in the
corporation plus or minus a few adjustments.
In a choice between the S-Corp and C-Corp, the C-Corp is often the better choice when: (1) One or more of the shareholders are not U.S. citizens, or are resident aliens; (2) the corporation envisions having more than 100 shareholders; (3) the corporation requires, or can benefit from, different classes of stock (for venture capital, for example); (4) the corporation is a publicly traded company; or (5) the corporation earnings are such that a qualified CPA has determined that the C-Corp offers beneficial tax treatment.
III. Limited Liability Companies;
Similar to an S-Corp, a California Limited Liability Company “LLC” can be thought of as a hybrid between a C-Corp and a partnership. It is well suited for formation by a single owner (“member”). Like a partnership, it allows pass through taxation to avoid the double taxation of a C-Corp. Like a C-Corp, it allows for limited liability, a variety of ownership (foreign or domestic) and flexible stock classes. Overall, it is more heavily taxed than an S-Corp, except for various real properties losses. An LLC requires a detailed LLC operating agreement, the “articles of organization,” to be filed. This may increase the complexity of initial formation. However, LLCs do not issue stock and are not required to hold annual meetings or keep written minutes, which a corporation must do in order to preserve the
liability shield for its owners. Compared to an S-Corp, LLCs allow more flexibility in how profits and losses are distributed to members.
Notably, a California LLC is required to pay the minimum $800 California state franchise tax and is taxed at the general corporate tax rate in California (8.84%), which is higher than the California S-Corp (1.5%) for income.
For California income tax purposes, an LLC with more than one member will be classified as a partnership, and an LLC with a single individual member will be treated as a sole proprietorship, unless the LLC chooses to be classified as a corporation for income tax purposes. To be taxed as a corporation, the LLC must file an election.
Both the LLC and the S-Corp offer personal limited liability protection and pass-through tax treatment. Between the two, the use of an LLC is generally recommended only when one of the following exist: (1) when the owners have disparate interests in the company (e.g., one owner has 70% and the other 30%), and the two owners agree that they will not have an equal say in the operations of the business; (2) where the owners will have an equal interest in the business, but not an equal right to profits and losses; or where (3) the purpose of the entity is to hold or own investment property.
Ergo, due to the negative tax aspects/potentially higher formation costs, the use of an S-Corp over an LLC is usually recommended unless (1) the corporate purpose is to hold real estate; or (2) the co-owners want a non-traditional operating structure, or profit/loss distribution system.
IV. Forms and Formalities:
To properly organize a corporation, the corporation typically must file its Articles of Incorporation, adopt and prepare by-laws, properly capitalize the corporation, issue stock to the shareholders, prepare and file a Statement of Information with the Secretary of State, prepare and file the appropriate Notice with the California Commissioner of Corporations, elect the directors, have the directors appoint officers, file and publish a fictitious business name statement, register employees and begin to pay taxes.
Once properly formed, the corporation must continue to file its annual Statement of Information in a timely manner and properly notice, hold and document the annual shareholder and director meeting and special meetings of the Board of Directors to affirm certain corporate acts. Even a corporation owned by a single shareholder with a single director must properly notice, hold and document these meetings. Failure to complete these formalities, or failure to separate personal and corporate finances, may result in penalties including the loss of limited liability. This loss, known as “piercing the corporate veil,” results in personal liability to owners for corporate obligations.
The California Secretary of State provides the minimum filing form documents for a charge. Drafting services for more formal versions of these documents are common (e.g. Parasec). Statutory
requirements are detailed in the California Corporations Code, and the Business and Professions Code. For General Stock Corporations, see Sections 200–202 et seq.; for Close Corporations, Sections 158 and 200–202 et seq.; and for Professional Corporations, Sections 200–202 et seq. and 13400 et seq. Section 13401.5 lists valid PC professions in California.
1. Choose a business name for the corporation and check for availability.
Avoid misleading or deceptively similar names. A Close Corp name must contain the word "corporation," "incorporated" or "limited" or an abbreviation of one of those words. A Professional Corporation name must comply with the business and professions code for that profession. A Limited Liability Company and a limited Partnership may not include the words "bank," "trust," "trustee," "incorporated," "inc.," "corporation," or "corp." A Limited Liability Company must end with the phrase "Limited Liability Company” or the abbreviation "LLC" or "L.L.C." A Limited Partnership must state “Limited Partnership” or “LP.”
2. Appoint a director or directors for the corporation.
Corporations are required to have three or more directors unless (1) shares have not been issued, then the number can be one or two, (2) the corporation has one shareholder, then the number can be one or two, or (3) the corporation has two shareholders, then the number can be two.
3. Prepare and file articles of incorporation with the Secretary of State.
Articles of Incorporation must be filed with the state and the necessary filing fees paid. $100 filing fee. If you do not wish to have an attorney prepare your articles, the minimum statutory requirements for General Stock corporations (C-Corps/S-Corp) are met by Form ARTS-GS.
Authorized shares and par value must be listed in the Articles of Incorporation. California allows no par value, (California Financial Code §5620).
Corporations must list the name and address of a registered agent with a physical address (no post office boxes) in California.
4. Upon incorporation, C-Corporations are also required to adopt bylaws, hold an initial meeting of directors and shareholders, and issue shares of stock to owners, (Cal. Corp. Code §416 for certificate rules.) Certain documents are required to be held at the principal place of business, (Cal. Corp. Code §1500, 1600-01). To retain the corporate form, shareholders must continue the corporate formalities written into the bylaws.
5. California requires corporations and LLCs to file a Statement of Information shortly after the incorporation is complete (90 days/$25 filing fee). Thereafter, California requires corporations to file a Statement of Information annually during the first six-month period ending on the last day of the anniversary month of the incorporation. An annual report must be sent out within 120 days of the close of the fiscal year, unless there are fewer than 100 shareholders and the bylaws waive the requirement, (Cal. Corp. Code §1501.)
6. The Corporation should register for taxes (via an EIN, registration for employer taxes in California/FICA, inform the IRS and California of employees, set up workers’
compensation insurance) and obtain proper business licensing for the profession.
7. To make the S-Corp election, designate "S" status with IRS via Form 2553 within 2 months and 15 days of filing your articles of incorporation with California. There is no additional paperwork that you need to file with California.
8. Pay applicable FTB fees. (e.g. LLCs are required to pay their first year’s Franchise Tax Bill of $800 within 75 days, although some other entity forms are exempt.)
Similar to Form ARTS-GS, the state provides minimal statutory paperwork for filing a Close Corp which includes the minimal mandatory language in Form ARTS–CL, minimal statutory paperwork for filing an LLC (Form LLC–1), a Limited Partnership, (Form LP–1), and the permissive form for filing a General Partnership (Form GP–1). Once a general partnership has been formed, the state provides an Application to Register a Limited Liability Partnership (Form LLP–1) if the partnership wishes to form an LLP.
V. Out Of State Licensing
Occasionally, individuals will inquire about out of state incorporation, particularly Delaware or Nevada. For small business, these inquiries are generally spurred by misconceptions regarding tax or privacy benefits. For larger corporations, these inquiries are generally spurred by friendlier out of state corporate law.
If the corporation was formed out of state and will be “transacting intrastate business,” the corporation is required to register with California. California Corporations Code §§ 191, 15901.02(ai) and 17001(ap) define "transacting intrastate business" as entering into repeated and successive
transactions of its business in this state, other than interstate or foreign commerce. As a rule of thumb, if the business has a physical location in California and is doing business in California, generally it is required to register.
To register, corporations must submit a Statement and Designation by Foreign Corporation (Form S&DC-S/N) and provide a Statement of Good Standing from the jurisdiction in which the corporation was formed. Within 90 days, the corporation must file a Statement of Information. The corporation will still be required to pay any applicable franchise tax or income tax for the state, as discussed above. For a foreign professional law or accountant corporation use Form S&DC-PC, and Form S&DC–INS for foreign insurer corporations.
Similarly, Limited Liability Companies must register via an Application to Register (Form LLC-5), Limited Partnerships must file an Application for Registration (Form LP-5) and Limited Liability
Partnerships must file an Application to Register a Limited Liability Partnership (LLP-1). All must include a valid certificate of good standing.
VI. Out Of State Taxation
Smaller businesses should be warned that they are unlikely to benefit from a cost, complexity or tax perspective by incorporation out of state. For example, although Delaware and Nevada have no income tax and little or no filing requirement if no business is done in-state, they both still impose their own franchise tax. In Delaware, this can be as low as $75, but is based on a calculation depending on its authorized shares and corporate value. In Nevada, a fee based business license is required ($200) as well as an annual report which has a fee based on the authorized stock. Foreign corporations must also maintain a registered agent for their business. Thus, the corporation ends up paying to administrate out of state, but then must register and pay applicable taxes in California. Failure to register incurs the same penalties as any unregistered California business: Beyond the obvious tax fraud, the business cannot
avail itself of California courts, there may be implications to corporate limited liability, and corporate contractual agreements may be voidable by the other party.
VII. Out Of State Governance
Out of state incorporation may be attractive to established or venture capital corporations seeking a haven from shareholder friendly corporate governance law. Delaware, for example, is well known as a “corporation friendly” state. Benefits of incorporation in Delaware instead of California include:
1. A bigger body of law that has been well litigated;
2. Intra-corporate disputes (e.g. between shareholders/management) are resolved under “friendlier” Delaware law no matter the state;
3. Body of law is pro-management vs. derivative suits;
4. Body of law is pro-majority stock holders vs. minority holders;
5. Has historically offered excellent franchise tax rules and no/low corporate income tax;
6. To prevent costly reincorporation after growth, if the corporation later desires to reincorporate in Delaware;
7. Slightly more flexible and simpler incorporation rules in Delaware (e.g. Delaware has slightly more flexible rules on the number of directors at incorporation);
8. Prestige factor of a Delaware corporation.
Many of these benefits are similar in Nevada. Until recently, Nevada corporations also enjoyed stronger privacy regulations, although these have recently been eroded.
These benefits warrant legitimate consideration, but new business owners should be cautious. Costs often outweigh the benefits. Notably, any corporation which must register with California will lose any privacy benefit provided to foreign corporations. Moreover, many of the corporate governance benefits may be stripped in California if the corporation is doing most or all of its business in California. Under California Corp. Code § 2115(b), a corporation is deemed a “pseudo” foreign corporation based on an examination of the payroll, property, sales and ownership of outstanding voting shares with relation to California. If the corporation is deemed a “pseudo” foreign corporation, California corporate law supersedes the law of the jurisdiction in which the corporation is incorporated in many important areas.
Ultimately, if you are a small business owner doing most of your business in California, or with a physical presence in California, it is likely that you should incorporate in California. This will keep governance issues to minimum and reduce tax complications. Medium or larger business entities may consider moving out-of-state. There is a great deal of information published on this issue, and some additional research may be warranted. A visit with your local tax professional should be considered a necessity.
By: Craig H. Wendland, Esq.
Senior Associate, The Frost Firm
