How to Form Your Own California Corporation
Anthony Mancuso, Attorney
February 2013, 15th Edition
Form a corporation in California with the book that's helped thousands of Californians incorporate!
Protect your business and save on attorney's fees by forming a California corporation on your own. How to Form Your Own California Corporation makes incorporating a straightforward task for any small business owner. This all-in-one guide contains the forms, tax rules, practical information, and step-by-step instructions you need to successfully incorporate a California business. Learn about:
- different types of California corporations and how they work
- filing articles of incorporation
- how to stay legal by keeping legally sound corporate records and minutes
- securities laws and exemptions
- corporate taxation
- preparing bylaws
- issuing stock
- obtaining licenses and permits
- perks for your employees
This edition is completely updated and revised to provide current regulations, tax requirements, contact information for relevant agencies, helpful resources, and the most up-to-date forms available.
Nolo has dozens of products created just for California residents. Check out Nolo's list of California products.
“An excellent book.”-San Francisco Chronicle
- Incorporation Forms
- Name Availability Inquiry Letter
- Name Reservation Request Form
- Articles of Incorporation
- Cover Letter for Filing Articles
- Incorporator’s Statement
- Notice and Meeting Forms
- Waiver of Notice and Consent to Holding of First Meeting of Board of Directors
- Minutes of First Meeting of the Board of Directors
- Shareholder Representation Letter
- Notice of Transaction Pursuant to Corporations Code Section 25102(f)
- Bill of Sale for Assets of a Business
- Receipt for Cash Payment
- Form for Cancellation of Indebtedness
- Bill of Sale for Items of Property
- Receipt for Services Rendered
- Share Register and Transfer Ledger (only as tear-out in book, not on download)
- Stock Certificates (only as tear-out in book, not on download)
Anthony Mancuso is a corporations and limited liability company expert. He graduated from Hastings College of Law in San Francisco, is a member of the California State Bar, writes books and software in the fields of corporate and LLC law, and studies advanced business taxation at Golden Gate University in San Francisco. He has also been a consultant for Silicon Valley EDA (Electronic Design Automation) companies, most recently working on a C++ open-source integrated circuit database project team. He is the author of several Nolo books on forming and operating corporations (both profit and nonprofit) and limited liability companies. His titles include Incorporate Your Business, How to Form a Nonprofit Corporation (national and California editions), Form Your Own Limited Liability Company, The Corporate Records Handbook, and LLC or Corporation? His books have shown over a quarter of a million businesses and organizations how to form a corporation or LLC. He also is a licensed helicopter pilot and has performed for years as a guitarist in many musical idioms.
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TABLE OF CONTENTS
Your Incorporation Companion 1
Choosing the Right Legal Structure for Your Business 3
The Different Ways of Doing Business 4
Comparing Business Entities at a Glance 25
How California Corporations Work 31
Types of California Corporations 32
Corporate Powers 36
Corporate People 37
How Many People May Organize the Corporation? 44
Selling Stock 47
Paying Dividends 48
Dissolving a Corporation 48
Piercing the Corporate Veil 49
Issuing and Selling Stock 51
Securities Laws and Exemptions 52
The Limited Offering Exemption 53
Federal Securities Act 63
Corporate Taxation 67
California Taxes 68
Federal Taxes 69
S Corporation Tax Status 73
Corporate Accounting Periods and Tax Years 77
Tax Concerns When Stock Is Sold 78
Tax Treatment When an Existing Business Is Incorporated 79
Tax Treatment of Employee Compensation and Benefits 85
Steps to Form Your Corporation 89
Step 1. Choose a Corporate Name 91
Step 2. Prepare Your Articles of Incorporation 98
Step 3. Set Up a Corporate Records Book (or Order a Corporate Kit) 104
Step 4. Prepare Your Bylaws 105
Step 5. Appoint Initial Corporate Directors 109
Step 6. Prepare Minutes of the First Meeting of the Board of Directors 111
Step 7. Prepare Shareholder Representation Letters 126
Step 8. Prepare and File Notice of Stock Transaction Form 133
Step 9. Issue Shares of Stock 140
After You Incorporate 155
Postincorporation Paperwork and Tasks 156
Tax Forms - Federal 162
Tax Forms - State 165
Licenses and Permits 168
Workers' Compensation Insurance 168
Private Insurance Coverage 169
Lawyers and Accountants 171
Accountants and Tax Advisers 173
Using the Interactive Forms 175
Editing RTFs 176
List of Forms 177
Contact Information and Incorporation Forms 179
Choosing the Right Legal Structure for Your Business
The Different Ways of Doing Business............................................................ 4
Sole Proprietorship..................................................................................... 4
The Limited Liability Company................................................................... 10
The Corporation........................................................................................ 14
Comparing Business Entities at a Glance....................................................... 25
To help you make sure that forming a California corporation is the best legal and tax choice for your business, this chapter compares the California corporation to other small business legal structures. Our discussion is based upon recent tax and legal rule changes, and—most significantly—the rise in use of the limited liability company. This relatively new business structure shares some of the traditional legal and tax qualities of the corporation, while at the same time offering some of the less formal attributes of a partnership. The corporation continues, however, to stand apart from all other business forms because of its built-in organizational structure and unique access to investment sources and capital markets. It also continues to uniquely answer to a need felt by many business owners for the formality of the corporate form, a quality not shared by the other business structures.
The Different Ways of Doing Business
There are several legal structures or forms you can use to operate a business, including a sole proprietorship, partnership, limited liability company, or corporation. Two of these structures have important variants: The partnership form has spawned the limited partnership and the registered limited liability partnership. And the corporation can be recognized, for tax purposes, as either the standard C corporation or an S corporation. In a standard C corporation, the corporation and its owners are treated as separate taxpaying entities, whereas in an S corporation, business income is passed through the corporate entity and the owners are taxed on their individual tax returns.
Often, business owners start with the simplest legal form, the sole proprietorship, then move on to a more complicated business structure as their business grows. Other businesspeople pick the legal structure they like best from the start, and let their business grow into it. Either way, choosing the legal structure for your business is an important decision you must make when starting a business. The analysis that follows, which includes examples of businesses that might sensibly choose each type of business structure, should help you make a good decision.
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A sole proprietorship is the legal name for a one-owner business. It is the easiest business entity to establish. Just hang out your shingle or “Open for Business” sign, and you have established a sole proprietorship. Sure, there are other legal steps you may wish to take—such as registering a fictitious business name different from your own individual name by filing a “dba statement” with the county clerk—but these steps are not necessary to establish your business legally.
Personal liability for business debts, liabilities, and taxes. In this simplest form of small business legal structures, the owner, who usually runs the business, is personally liable for its debts, taxes, and other liabilities. Also, if the owner hires employees, he or she is personally responsible for claims made against these employees acting within the course and scope of their employment.
Simple tax treatment. All business profits (and losses) are reported on the owner’s personal income tax return each year (using Schedule C, Profit or Loss From Business, filed with the owner’s 1040 federal income tax return). And this remains true even if a portion of this money is invested back in the business—that is, even if the owner doesn’t pocket business profits for personal use.
Legal life same as owner’s. On the death of its owner, a sole proprietorship simply ends. The assets of the business normally pass under the terms of the deceased owner’s will or trust, or by intestate succession (under the state’s inheritance statutes) if there is no formal estate plan.
Don’t let business assets get stuck in probate. The court process necessary to probate a will can take more than a year. In the meantime, it may be difficult for the inheritors to operate or sell the business or its assets. Often, the best way to avoid having a probate court involved in business operations is for the owner to transfer the assets of the business into a living trust during his or her lifetime; this permits business assets to be transferred to inheritors promptly on the death of the business owner, free of probate. For detailed information on estate planning, including whether or not it makes sense to create a living trust, see Plan Your Estate, by Denis Clifford (Nolo).
Sole proprietorships in action. Many one-owner or spouse-owned businesses start small with very little advance planning or procedural red tape. Celia Wong is a good example—Celia is a graphic artist with a full-time salaried job for a local book publishing company. In her spare time she takes on extra work using her home computer to produce audio cassette and CD jacket cover art for musicians. These jobs are usually commissioned on a handshake or phone call. Without thinking much about it, Celia has started her own sole proprietorship business. Celia should include a Schedule C in her yearly federal 1040 individual tax return, showing the net profits (profits minus expenses) or losses of her sole proprietorship. Celia is responsible for paying income taxes on profits, plus self-employment (Social Security) taxes based on her sole proprietorship income (IRS Form SE is used to compute self-employment taxes; Celia attaches it to her 1040 income tax return).
If Celia has any business debts (she usually owes money on a charge account at a local art supply house), or a disgruntled client successfully sues her in small claims court for failing to deliver prepaid art work, Celia is personally liable to pay this money. In other words, she can’t simply fold up Wong Designs and walk away from her debts claiming that they are the legal responsibility of her business only.
Put some profits aside to buy business insurance. Once Celia begins to make enough money, she should consider taking out a commercial liability insurance policy to cover legal claims against her business. While insurance normally won’t protect you from business mistakes (like performing incomplete or late work or failing to pay bills), it can cover many risks including slip-and-fall lawsuits, damage to your or a client’s property, or fire, theft, and other casualties that might occur in a home-based business.
Businesses Co-Owned by Spouses
Spouses in all states who work together and share profits and losses in an unincorporated business can elect to be taxed as a “qualified joint venture.” This designation means they get treated as sole proprietors for tax purposes. To qualify, the couple must be the only owners of the unincorporated business and they must both “materially participate” in the business. The spouses must also file a joint Form 1040 with two separate Schedule Cs showing each spouse’s share of the profits. Each spouse includes a self-employment tax schedule (Schedule SE) to pay self-employment tax on their share of the profits. If the couple qualifies for this exception, each spouse gets Social Security credit for his or her share of earnings in the business.
What if a couple jointly own their business as an LLC? In this case, the spouses will normally be treated as partners and must file a partnership tax return for the LLC. However, if the couple lives in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), then they have the option of treating their business as a sole proprietorship. They do this by filing an IRS Form 1040 Schedule C for the business, listing one of the spouses as the owner. There is no requirement that both spouses materially participate in the business, so this election is easier than the qualified joint venture status described above.
Only the listed spouse pays income and self-employment taxes on the reported Schedule C net profits. This means only the listed Schedule C owner-spouse will receive Social Security account earning credits for the Form SE taxes paid with the 1040 return. For this reason, some eligible spouses will decide not to make this Schedule C filing and will continue to file a partnership tax return for their jointly owned spousal LLC. Also, the IRS treats the filing of a Schedule C for a jointly owned spousal LLC as the conversion of a partnership to a sole proprietorship, which can have tax consequences.
Finally, if one spouse manages the business and the other helps out as an employee or volunteer worker (but does not contribute to running the business), the managing spouse can claim ownership and treat the business as a sole proprietorship.
For more information on spousal businesses, see “Forming a Partnership” in IRS Publication 541 and “Husband and Wife Business” and other information on the IRS website at www.irs.gov. In all cases, be sure to check with your tax adviser before deciding on the best way to own, file, and pay taxes for, a spousal business.
Running the business as an informal sole proprietorship serves Celia’s needs for the present. Assuming her small business succeeds, she will eventually need to put it on a more formal footing by establishing a separate business checking account, possibly coming up with a fancier name and registering it as a dba with the county clerk. If she hires employees, she will need to obtain a federal Employer Identification Number (EIN) from the IRS. She may also feel ready to renovate her house to separate her office space from her living quarters (this can also help make the portion of the mortgage or rent paid for the office deductible as a business expense on her Schedule C).
Celia can do all of this and still keep her sole proprietorship legal status. Unless her business grows significantly or she takes on work that puts her at a much higher risk of being sued—and therefore being held personally liable for business debts—it makes sense for her to continue to operate her business as a sole proprietorship.
A great source of practical information on how to start and operate a small sole proprietorship is Small Time Operator, by Bernard Kamoroff (Bell Springs Press). Also, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo), a small business guide to taxes, which includes a full discussion of setting up and deducting the expenses of a home-based business.
A partnership is simply an enterprise in which two or more co-owners agree to share in the profits of a business activity. No written partnership agreement is necessary. If two people go into business together, and do not incorporate or form a limited liability company, they automatically establish a legal partnership. Partnerships are governed by each state’s partnership law. But since all states have adopted a version of the Uniform Partnership Act, laws are very similar throughout the United States. Mostly, these laws contain basic rules that provide for an equal division of profits and losses among partners and establish the partners’ legal relationship with one another. These rules are not mandatory in most cases, and you can (and should) spell out your own rules for dividing profits and losses and operating your partnership in a written partnership agreement. If you don’t prepare your own partnership agreement, all provisions of California’s partnership law apply to your partnership.
A general partnership has the following characteristics:
Each partner has personal liability. Like the owner of a sole proprietorship, each partner is personally liable for the debts and taxes of the partnership. In other words, if the partnership assets and insurance are insufficient to satisfy a creditor’s claim or legal judgment, the partners’ personal assets can be attached and sold to pay the debt.
The act or signature of each partner can bind the partnership. Each partner is an agent for the partnership and can individually hire employees, borrow money, sign contracts, and perform any act necessary to the operation of the business. All partners are personally liable for these debts and obligations. This rule makes it essential that the partners trust each other to act in the best interests of the partnership and each of the other partners.
Partners report and pay individual income taxes on profits. A partnership files a yearly IRS Form 1065, U.S. Partnership Return of Income, which includes a schedule showing the allocation of profits, losses, and other tax items to all partners (Schedule K). The partnership must mail individual schedules (Schedule K‑1s) to each partner at the end of each year, showing the items of income, loss, credits, and deductions allocated to each partner. When a partner files an individual income tax return, she reports her allocated share of partnership profits (taken from the partner’s Schedule K‑1), and pays individual income taxes on these profits. As with the sole proprietorship, partners owe tax on business profits even if they are plowed back into the business.
Partnerships Can Choose to Be Taxed as Corporations
Unincorporated co-owned businesses, including partnerships and limited liability companies (discussed below), can choose to be taxed as corporations by filing IRS Form 8832, Entity Classification Election. Most smaller partnerships will not wish to make this election, preferring instead to have profits divided among the partners and then taxed on their individual tax returns. But this is not always true. For example, some partnerships—especially those that want to reinvest profits in expanding the business—may prefer to keep profits in the business, and have them taxed to the business at the lower initial corporate tax rates. Your tax adviser can tell you if this tax strategy makes sense for your business. (See Chapter 7.)
Partnership dissolves when a partner leaves. Legally, when a partner ceases to be associated with carrying on the business of the partnership (when he or she withdraws or dies), the partnership is dissolved. However, a properly written partnership agreement provides in advance for these eventualities, and allows for the continuation of the partnership by permitting the remaining partners to buy out the interest of the departing or deceased partner. Of course, if one person in a two-partner business leaves or dies, the partnership is legally dissolved—you need at least two people to have a partnership.
Watch out for a partnership tax termination. A partnership terminates for tax purposes if 50% or more of the interest in the partnership’s capital and profits are sold or exchanged within a 12-month period. Under these circumstances, the partnership might continue legally under the terms of the partnership agreement, but would terminate for tax purposes. Upon the deemed termination of partnership, each partner could owe significant income taxes. (I.R.C. § 708(b).)
For a much more thorough look at the legal and tax characteristics of partnerships, and for a clause-by-clause approach to preparing a partnership agreement, see Form a Partnership, by Ralph Warner and Denis Clifford (Nolo).
Partnerships in action. George and Tamatha are good friends who have been working together in a rented warehouse space where they share a kiln used to make blown glass pieces. They recently collaborated on the design and production of a batch of hand-blown halogen light fixtures, which immediately become popular with local lighting vendors. Believing that they can streamline the production of these custom pieces, they plan to solicit and fill larger orders with retailers, and look into wholesale distribution. They shake hands on their new venture, which they name “Halo Light Sculptures.” Although they obtain a business license and file a dba statement with the county clerk showing that they are working together as “Halo Light Sculptures,” they don’t bother to write up a partnership agreement. Their only agreement is a verbal one to equally share in the work of making the glass pieces and splitting expenses and any profits that result.
California Limited Partnerships
Most smaller partnerships are general partnerships—this means that all owners agree to manage the partnership together, and each partner is personally liable for debts of the partnership. However, there are two other fairly common types of partnerships: limited partnerships and registered limited liability partnerships (RLLPs). Each of these is quite different from a general partnership.
The Limited Partnership. The limited partnership structure is used when one or more of the partners are passive investors (called “limited partners”) and another partner (called a “general partner”) runs the partnership. A certificate of limited partnership is filed with the secretary of state to form a limited partnership, and a filing fee must be paid. The advantage of a limited partnership is that, unlike a general partnership where all partners are personally liable for business debts and liabilities, a limited partner is allowed to invest in a partnership without the risk of incurring personal liability for the debts of the business. If the business fails, all that the limited partner can lose is his or her capital investment—the amount of money or the property paid for an interest in the business. However, in exchange for this big advantage, the limited partner normally is not allowed to participate in the management or control of the partnership. To do so means losing limited liability status and being held personally liable for partnership debts, claims, and other obligations.
Typically, a limited partnership has a number of limited partner investors and one general partner (there can be more, but there must be at least one) who is responsible for partnership management and is personally liable for its debts and other liabilities.
The Registered Limited Liability Partnership. The registered limited liability partnership (RLLP) is a special legal structure designed for persons who form a partnership in California to perform the licensed professional services of attorneys, accountants, or architects. (Architects can form a California RLLP until January 1, 2019.) An RLLP is formed by filing a registration of limited liability partnership form with the California Secretary of State.
The point of an RLLP is to relieve professional partners from personal liability for debts, contracts, and claims against the partnership, including claims against a nonparticipating partner for professional malpractice by another partner. However, a professional in an RLLP remains personally liable for his or her own professional malpractice.
Example: Martha and Veronica have a two-person accounting partnership, registered as an RLLP. Each has her own clients. If Martha loses a malpractice lawsuit, and Veronica did not participate in providing services to that client, Veronica should not be held personally liable for the judgment. If Martha’s malpractice insurance and partnership assets are not sufficient to pay the judgment, Martha’s personal assets, but not Veronica’s, are subject to seizure to satisfy the unrecovered judgment. If they had an accounting general partnership practice that was not registered as an RLLP, both Martha and Veronica could be held personally liable for either CPA’s individual malpractice.
Many professionals cannot form an LLC in California. They can obtain similar legal liability protection by forming a California professional corporation. Ask your state licensing board for additional information.
Why You Need a Written Partnership Agreement
Although it’s possible to start a partnership with a verbal agreement—or even with no stated agreement at all—there are drawbacks to taking this casual approach. The most obvious problem is that a verbal agreement can be remembered and interpreted differently by different partners. And having no stated agreement at all almost always means trouble. Also, if you don’t write out how you want your partnership to be operated, you lose a great deal of flexibility. Instead of being able to make your own rules in a number of key areas—for example, how partnership profits and losses are divided among the partners—California state partnership law will automatically come into play. These state-based rules may not be to your liking (for example, state law generally calls for an equal division of profits and losses regardless of partners’ capital contributions).
Another reason why you should prepare and sign a written partnership agreement is to avoid disputes over what happens when a partner wants to leave the business. Here are just a few of the difficult questions that can arise if a partner wants to leave the partnership:
If the remaining partners want to buy the departing partner out, how will the interest be valued?
If you agree on value, how will the departing partner be paid—in a lump sum or installments? If in installments, how big will the down payment be; how many years will it take for the balance to be paid; and how much interest will be charged?
What happens if none of the remaining partners wants to buy the departing partner’s interest? Will your partnership dissolve? If so, can some of the partners form a new partnership to continue the partnership business? Who gets to use the dissolved partnership’s name and client or customer list?
California law does not necessarily provide helpful answers to these questions, which means that if you don’t have a written partnership agreement, you may face a long legal battle with a partner who decides to call it quits. To avoid these and other problems, a basic partnership agreement should, at a minimum, spell out how much interest each partner has in the partnership, how profits and losses will be split up between or among the partners, and how any buyout or transfer of a partner’s interest will be valued and handled. The aftermath of the dissolution of the partnership also should be considered, and rules set out for a continuance of the partnership’s business by ex-partners if desired.
This type of informal arrangement can make sense for the very early days of a co-owned business, where the owners, like George and Tamatha, wish to split work, expenses, profits, and losses equally. However, for the reasons mentioned earlier, from the moment the business looks like it has long-term potential, the partners should prepare and sign a written partnership agreement. Furthermore, if either partner is worried about personal liability for business debts or the possibility of lawsuits by purchasers of the fixtures, then forming a limited liability company or a corporation probably would be a better business choice.
The Limited Liability Company
The limited liability company (LLC) has become popular with many small business owners, in part because it was custom-designed by state legislatures to overcome particular limitations of each of the other business forms, including the corporation. Essentially, the LLC is a legal ownership structure that allows owners to pay business taxes on their individual income tax returns like partners (or, for a one-person LLC, like a sole proprietorship), but also gives the owners the legal protection of personal limited liability for business debts and judgments as if they had formed a corporation. Or, put another way, with an LLC you can simultaneously achieve the twin goals of one-level taxation of business profits and limited personal liability for business debts.
Licensed professionals can’t form an LLC in California. Only businesses that render services under nonprofessional, occupational licenses can form an LLC in California. Professionals who must form a professional corporation if they incorporate (doctors, architects, lawyers, pharmacists, and so on) are the same group of professionals who can’t form an LLC in the state. There may be others, however, who fall into this group. If you provide any type of licensed service that might be considered a professional service, contact your state licensing board and ask if you are allowed to form an LLC in California before getting started on the process.
Here are some of the most important LLC characteristics:
Limited liability. The owners (members) of an LLC are not personally responsible for the LLC’s debts and other liabilities. Specifically, members are not personally liable for any debt, obligation, or liability of the LLC, whether that liability or obligation comes from a contract dispute, tort (injury to other persons or damage to their property), or any other type of claim. This type of sweeping personal legal liability protection is the same as that enjoyed by shareholders of a California corporation. In short, the LLC and the corporation offer the same level of limited personal liability protection.
Pass-through taxation. Federal tax law normally treats an LLC like a partnership, unless the LLC elects to be taxed as a corporation (by filing IRS Form 8832). The California Franchise Tax Board treats a California LLC for state income tax purposes as it is treated for federal income tax purposes. An LLC with an annual gross income of $250,000 or more must pay an additional annual fee, based upon a graduated fee schedule that is subject to adjustment from year to year.
If an LLC is treated as a partnership at the federal and state levels, it files a standard partnership tax return (IRS Form 1065, Schedules K and K-1) with the IRS (and Form 568 with the state). The LLC members (owners) pay taxes on their share of LLC profits on their individual federal and state income tax returns. An LLC that elects corporate tax treatment files federal and state corporate income tax returns.
Ownership requirements. You can form an LLC with only one owner (member). Members need not be residents of California, or even the United States for that matter. Other business entities, such as a corporation or another LLC, can be LLC owners.
Management flexibility. LLCs are normally managed by all the owners (members)—this is known as member-management. But state law also allows for management by one or more specially appointed managers (who may be members or nonmembers). Not surprisingly, this arrangement is known as manager-management. In other words, an LLC can appoint one or more of its members, one of its CEOs, or even a person contracted from outside the LLC, to manage its affairs. This setup makes sense if one person wishes to assume full-time control of the LLC while the other owners act as passive investors in the enterprise.
Formation requirements. Like a corporation, LLCs require paperwork to get going. Articles of organization must be filed with the California Secretary of State. And if the LLC is to maintain a business presence in another state, such as a branch office, it also must file registration or qualification papers with the other state’s secretary of state or department of state. California’s LLC formation fee is $70. California LLCs, like California corporations and limited partnerships, must pay an annual minimum $800 tax to the Franchise Tax Board. There is an additional LLC annual fee, with a tiered rate structure, for LLCs with annual gross incomes of $250,000 or more. The additional fee may be anywhere from $900 to $11,790.
Add in the cost of goods sold when computing annual gross income. A California LLC engaged in an active trade or business must include its cost of goods sold. (Typically, the cost of goods sold is subtracted from gross income.) This means that even unprofitable LLCs can be subject to the annual LLC fee. Ask your tax advisor for more information.
Like a partnership, an LLC should prepare an operating agreement to spell out how the LLC will be owned, how profits and losses will be divided, how departing or deceased members will be bought out, and other essential ownership details. However, preparation of an LLC operating agreement is not legally required. If it is not prepared, the default provisions of California’s LLC Act will apply to the operation of the LLC. Because LLC owners will want to control exactly how profits and losses are apportioned among the members rather than following the default rules set out in the LLC Act, preparing an LLC operating agreement is a practical necessity.
The Series LLC—A Rising Star on the Business Entity Horizon
A new type of LLC is taking shape under state LLC laws: the series LLC. States are still in the process of developing their series LLC statutes and it will take time for them to coordinate the laws, fees, and tax treatments. Once this happens, however, and the courts settle some of the legal nuances of series LLCs, the series LLC may indeed become the next big new thing in business entity formations.
Although not yet allowed under California law, several states including Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah, and Wisconsin have adopted a series LLC formation statute.
The main characteristic and advantage of the series LLC is that it allows you to set up one or more series of assets within a single LLC. The business and assets of each series can be managed and operated separately—for example, each series can have separate owners and managers, a separate operating agreement that specifies a separate division of profits and losses associated with the series, and other separate formation and operation characteristics. And, under some state statutes, there is also a separation of legal liability between each series within an LLC. Before you jump on the series LLC bandwagon, however, there are certain things you should keep in mind. For one, a state that does not have a series LLC statute may not respect the characteristics of a series LLC formed in another state. And, because these entities are so new, there are other uncertainties. For example, it is not clear that a federal bankruptcy court will respect the separateness of each series within an LLC.
Finally, forming a series LLC may seem like a good way to avoid paying a lot of formation and annual fees for multiple LLC entities. However, some states may not be willing to forgo these filing fees so easily. In California, for example, the Franchise Tax Board assesses an $800 franchise tax payment, plus an annual added gross receipts fee of up to $12,000 per year, on each LLC formed or operated within the state. It has stated that it will treat each series in many out-of-state LLCs as separate LLCs. (See FTB Form 568 and FTB Publication 689 for further information on California’s treatment of out-of-state series LLCs, available at the FTB’s website at www.ftb.ca.gov.)
See Nolo’s Form Your LLC Online to create your LLC online, or see Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo). This book contains instructions on how to form a California LLC, prepare an operating agreement (member- and manager-managed agreements are included), and handle all other LLC formation formalities.
LLCs in action. Under the name “Aunt Jessica’s Floral Arrangements,” Barry and Sam jointly own and run a flower shop that specializes in unique flower arrangements (the name stems from the fact that Barry used to work for his aunt Jessica, who taught him the ropes of floral bouquet design). Lately, business has been particularly rosy, and the two men plan to sign a long-term contract with a flower importer to supply them with larger quantities of seasonal flowers. Once they receive the additional flowers, they will be able to create more floral pieces and wholesale them to a wider market. Both men are aware that they will encounter more risks as their business grows. Accordingly, they decide to protect their personal assets from business risks by converting their partnership to an LLC. They could accomplish the same result by incorporating, but they prefer the simplicity of paying taxes on their business income on their individual income tax returns (rather than reporting profits and paying business taxes on a separate corporate income tax return). They also realize that they can convert their LLC to a corporation later to obtain the advantage of lower corporate tax rates on money kept in the flower business or, even more simply, make an IRS election to have their LLC taxed as a corporation without changing its legal structure.
Do-Good LLCs and Corporations—The Latest in LLC Entities
A number of states allow for the formation of hybrid entities (LLCs and/or corporations) that can exist to make a profit and do good. For example, some states authorize the formation of a “low-profit LLC” (also called an “L3C”) that can be formed for an educational or charitable purpose but also can make a profit. States initially created this special type of hybrid entity to allow foundations to more easily distribute funds to a qualified social-purpose organization, although the IRS has not yet formally approved L3Cs for this purpose. L3Cs are not allowed in California at present.
Closer to home, California allows the formation of “flexible purpose corporations” and “benefit corporations,” which can be formed to do good works as well as to make money. The advantage of these new California entities is that they can allow the principals to spend time and money trying to do good without having to worry about stakeholders being upset (and suing them) for not spending all their time trying to turn a profit.All of the above hybrid entities are sometimes loosely referred to as “B corporations.” However, this term really refers to a certification that a socially responsive corporation, LLC, or other entity can seek, not to a separate type of corporation or other distinct legal entity (see www.bcorporation.net for more information).
Now let’s look at the basic attributes of the corporation, the type of business organization this book shows you how to organize.
A corporation is a statutory creature, created and regulated by state law. In short, if you want the privilege—as the courts call it—of turning your business enterprise into a California corporation, you must follow the requirements of the California Corporations Code.
What sets the corporation apart from all other types of businesses is that it is a legal entity separate from any of the people who own, control, manage, or operate it. The state corporation and federal and state tax laws view the corporation as a legal person—it can enter into contracts, incur debts, and pay taxes separately from its owners.
Limited Personal Liability
Like the owners (members) of an LLC, the owners (shareholders) of a corporation are not personally liable for the corporation’s business debts, claims, or other liabilities. This means that a person who invests in a corporation (a shareholder) normally only stands to lose the amount of money or the value of the property which he or she has paid for its stock. As a result, if the corporation does not succeed and cannot pay its debts or other financial obligations, creditors cannot seize or sell the corporate investor’s home, car, or other personal assets.
Example: Rackafrax Dry Cleaners, Inc., a California corporation, has several bad years in a row. When it finally files for bankruptcy it owes $50,000 to a number of suppliers and $80,000 as a result of a lawsuit for uninsured losses stemming from a fire. Stock in Rackafrax is owned by Harry Rack, Edith Frax, and John Quincy Taft. Their personal assets cannot be taken to pay the money Rackafrax owes.
During hard economic times, the limited liability protection you receive with a corporation can be crucial. It provides a layer of protection between the owners of the business and the business itself. If the business starts to fall behind in paying its bills, the only resource creditors have is against the business itself. Often this means the creditors will be motivated to work with the owners so that the business can continue and pay its bills. And, if the business does fail, the owners won’t be held personally for its debts.
If you are running an unincorporated business, such as a sole proprietorship or partnership, consider converting to a corporation (or LLC). This could help you and your business survive downturns in the economy. After you incorporate, send a written notice to each creditor informing them that your business is now a corporation and that any future invoices, bills, and other statements should be made out in the name of the corporation. Be sure and re-sign any outstanding obligations in the name of your corporation and have the creditor acknowledge the new instrument. Also, ask them to send you any paperwork necessary to change your current accounts over to the name of your corporation. (See Chapter 6 for instructions on preparing a notice to creditors.)
Exceptions to the Rule of Personal Limited Liability Protection
In some situations, corporate directors, officers, and shareholders of a corporation can be held responsible for debts owed by their corporation. Here are a few of the most common exceptions to the rule of limited personal liability (these exceptions also apply to other limited liability business structures, such as the LLC):
Personal guarantees. When a bank or other lender makes a loan to a small corporation, particularly a newly formed one, it often requires that the people who own the corporation agree to repay it from their personal assets should the corporation default on the loan. Shareholders may even have to pledge equity in a house or other personal assets as security for repayment of the debt. Of course, shareholders can just say no—but if they do, their corporation may not qualify for the loan.
Federal and state taxes. If a corporation fails to pay income, payroll, or other taxes, the IRS and the California Franchise Tax Board are likely to attempt to recover the unpaid taxes from responsible employees—a category that often includes the principal directors, officers, and shareholders of a small corporation.
Unlawful or unauthorized transactions. If you use the corporation as a device to defraud third parties, or if you deliberately make a decision (or fail to make one) that results in physical harm to others or their property (such as failing to maintain premises or a work site properly, manufacturing unsafe products, or causing environmental pollution), a court may pierce the corporate veil and hold the shareholders of a small corporation individually liable for damages (monetary losses) caused to others.
Fortunately, most of the problem areas where you might be held personally liable for corporate obligations can be avoided by following a few commonsense rules (rules you’ll probably adhere to anyway). First, don’t do anything that is dishonest or illegal. Second, make sure your corporation does the same, by having it obtain necessary permits, licenses, or clearances for its business operations. Third, pay employee wages and withhold and pay corporate income and payroll taxes on time. Fourth, don’t personally obligate yourself to repay corporate debts or obligations unless you fully understand and accept the consequences.
When Your Creditors Can Go After Your LLC Interest
The LLC’s limited liability shield protects the personal assets of LLC owners from lawsuits that arise from LLC business operations and claims, with a few exceptions. However, this protection doesn’t always work the other way—that is, an LLC owner’s interest in LLC assets is not necessarily protected from creditors seeking to satisfy personal debts or lawsuit judgments against the owner.
In most states, including California, a personal creditor of an LLC owner can seize the owner’s interest in the LLC. Because an interest in an LLC is the personal property of each LLC owner, personal creditors are typically allowed to obtain a “charging order” against the owner’s interest in a business, such as a partnership interest, an LLC interest, or stock in a corporation. Essentially, a charging order is a lien against the owner’s business interest, which allows the creditor to receive profit payments that would otherwise go to the owner.
Example: Sam defaults on a personal bank loan unrelated to his LLC business, and the bank obtains a charging order against Sam’s LLC membership interest. This order allows the bank to be paid any profits that would otherwise be distributed to Sam under the terms of the LLC’s operating agreement.
A charging order may not do a creditor much good if an LLC does not regularly distribute profits to members. In that case, the creditor may be able to ask a state court to foreclose on (become the owner of) the LLCs member’s interest. If state law allows this (California Corporations Code Section 17302 does) and the court agrees, the creditor can become the new legal owner of the owner’s LLC interest. However, under most state laws, including California’s, a creditor who forecloses on an LLC interest does not become a full voting member of the LLC. Instead, the foreclosing creditor becomes a “transferee” or “assignee” who is entitled to all economic rights associated with the interest, such as a share of the profits paid out on the interest and the value of the interest when the business is sold or liquidated. Typically, an assignee or transferee cannot manage or vote in the LLC, nor assume other membership rights granted to full members under the LLC operating agreement. Again, if the LLC does not pay out profits regularly and there is little chance of the business being sold or liquidated, these economic rights might not mean much to a creditor.
Potential problems for one-owner LLCs: Even though the California Corporations Code says that foreclosing on an LLC member’s interest is the sole remedy available to the creditor of an LLC owner, in exceptional cases (such as fraud by an LLC member), state and federal bankruptcy courts may figure out a way to allow a person who buys a foreclosed interest in a single-member LLC to become a full member of that LLC with voting rights. After all, with a single-member LLC, there are no other members’ rights to protect from the creditor. If this happened, the creditor might be in a position to force the sale of the LLC. We won’t discuss how this might happen—this area of law is complex and fast moving. If you are worried about the effects of a charging order against your LLC, please consult a knowledgeable California business lawyer to learn about the latest rules and court decisions in this area.
Corporate Tax Treatment
Let’s now look at a few of the most important tax characteristics of the corporation. We’ll start with the dual level of taxation built into the corporate business structure.
Dual Taxation and Income Splitting
The corporation is a taxpayer, with its own income tax rates and tax returns separate from the tax rates and tax returns of its owners. This separate layer of taxation allows corporate profits to be kept in the business and taxed at the initial corporate tax rates, which are generally lower than the marginal (top) tax rates of the corporation’s owners. The result of this type of business income splitting between the corporation and its owners can result in an overall tax savings for the owners (compared to pass-through taxation of all business profits to the owners, which is the standard tax treatment of sole proprietorships, partnerships, and LLCs).
Example: Jeff and Sally own and work for their own two-person corporation, Hair Looms, Inc., a mail order synthetic wig supply business that is starting to enjoy popularity with overseas purchasers. To keep pace with the surge in orders, they need to expand by reinvesting a portion of their profits back in the business. Since Hair Looms is incorporated, only the portion of the profits paid to Jeff and Sally as salary is reported and taxed to them on their individual tax returns—let’s assume their marginal (top) tax rate is over 30%. By contrast, the first $50,000 in profits left in the business for expansion is reported on Hair Looms’ corporate income tax return and taxed at the lowest corporate tax rate of only 15%. The next $25,000 is taxed at 25%.
Corporate tax rates max out at 34% for most corporations. Even though corporate tax rates can go up to 39%, all corporate net income below $10 million is subject to an effective flat tax rate of 34%. (See Chapter 4.)
How Small Corporations Avoid Double Taxation of Corporate Profits
What about the old bugaboo of corporate double taxation? Most people have heard that corporate income is taxed twice: once at the corporate level and again when it is paid out to shareholders in the form of dividends. In theory, the Internal Revenue Code says that most corporations are treated this way (except S corporations, whose profits automatically pass to shareholders each year—see below). In practice, however, double taxation seldom occurs in the context of the small business corporation. The reason is simple: Employee-owners don’t pay themselves dividends, which are taxed at the corporate rate when earned and at the shareholder level when paid to them. Instead, the shareholders, who usually work for their corporation, pay themselves salaries and bonuses, which are deducted from the profits of the corporate business as ordinary and necessary business expenses. The result is that profits paid out in salary and other forms of employee compensation to the owner-employees of a small corporation are taxed only once, at the individual level. In other words, as long as you work for your corporation, even in a part-time or consulting capacity, you can pay out business profits to yourself as reasonable compensation. Your corporation won’t have to pay taxes on these profits.
Furthermore, because most individuals now pay a 15% tax rate on dividends, the double tax associated with dividends is not as severe as it once was. And, dividends are not subject to Social Security tax, so business owners may realize a small tax savings by choosing to have part of their corporate salaries paid out to them as dividends.
LLCs and partnerships can elect corporate tax treatment. Dual taxation and income splitting are no longer unique to corporations. Partnerships and LLCs can elect to be taxed as corporations if they wish to keep money in the business and have it taxed at corporate rates. (See “Partnerships Can Choose to Be Taxed as Corporations,” above.)
Corporations Can Elect Pass-Through Taxation of Profits
Just as partnerships and LLCs have the ability to request corporate tax treatment, corporations can change their tax treatment to the type of pass-through taxation that normally applies to partnerships and LLCs. A corporation accomplishes this by making an S corporation tax election with the IRS.
When just starting out, form an LLC instead. An LLC, like an S corporation, gives its owners pass-through taxation of business profits plus limited personal liability for business debts. It also is more flexible than an S corporation for technical reasons (see “LLCs and Partnerships Have Technical Tax Advantages Over S Corporations,” below). Therefore, it usually makes more sense to form an LLC when you are just starting to organize your business.
If you are already doing business as a corporation, switching over to S corporation tax status—by making an S corporation tax election—makes sense if you wish to keep your corporation intact but want pass-through treatment of profits and losses to save tax dollars. This might be true, for example, for a corporation that no longer wishes to keep profits in the business, but can’t pay all of them out to shareholders as salaries (if some shareholders don’t work for the corporation or if the payout of all profits as salaries would render them excessive and subject to IRS attack, for example). It also may be true if a corporation begins to lose money and the owners want to deduct these losses on their individual income tax returns to offset other income (a number of technical hurdles must be overcome for this pass-through of losses in an S corporation to work—see “LLCs and Partnerships Have Technical Tax Advantages Over S Corporations,” below, for more information).
LLCs and Partnerships Have Technical Tax Advantages Over S Corporations
LLC owners and partners can split profits disproportionately to their ownership interests in the business (these are called special allocations of profits and losses under the tax code); S corporation shareholders can’t. Also, the amount of corporate losses that may be passed through to S corporation shareholders is limited to the total of each shareholder’s basis in his or her stock, plus amounts loaned personally by each shareholder to the corporation. (The basis is the amount paid for stock plus and minus adjustments during the life of the corporation.) Losses allocated to a shareholder that exceed these limits can be carried forward and deducted in future tax years if the shareholder then qualifies to deduct the losses. In contrast, LLC owners and partners may be able to personally deduct more business losses on their tax returns in a given year than S corporation shareholders. The reason is that both LLC members and partners get to count their pro rata share of all money borrowed by the business, not just loans personally made by the member or partner, in computing how much of any loss allocated to them by the business they can deduct in a given year on their individual income tax returns. Ask your tax advisor for more information.
The only other way an existing corporation can get the limited liability protection and pass-through tax treatment of the S corporation is to dissolve, then reorganize as an LLC. This can be costly from a legal and tax perspective and a lot more trouble than simply electing S corporation tax status.
U.S. corporations with 100 or fewer shareholders who are U.S. citizens or residents can elect federal S corporation tax treatment by filing IRS Form 2553. Once an S corporation election is made with the IRS, the corporation is automatically treated as a California S corporation. It can opt out of S corporation treatment by filing FTB Form 3560 with the California Franchise Tax Board. An S corporation has all its profits, losses, credits, and deductions passed through to its shareholders, who report these items on their individual tax returns. In effect, this allows the corporation to sidestep federal corporate income taxes on business profits, passing the profits (and the taxes that go with them) along to the shareholders. Each S corporation shareholder is allocated a portion of the corporation’s profits and losses according to her percentage of stock ownership in the corporation (a 50% shareholder reports and pays individual income taxes on 50% of the corporation’s annual profits, for example).
These profits are allocated to the shareholders whether the profits are actually paid to them or kept in the corporation.
Example: Fred’s Furniture and Appliance was incorporated during a period of fast business growth, when Fred brought in two relatives as investors and moved his business to a larger storefront in an upscale neighborhood. He chose the corporate form to limit his and the investors’ personal liability and to accommodate his investors by issuing them shares in his business. With the business growing fast, the investors wanted to see some return of profits. Fred elects S corporation tax treatment. Net profits of the business pass through to the S shareholders directly and are taxed on their individual income tax returns. This meets the investors’ needs and avoids the double tax that would have been paid if profits were distributed to the investors as dividends. This also helps Fred, since he can keep his corporate salary reasonably low and still get money out of his corporation. Also, S corporation profits allocated to shareholders, unlike salaries, are not subject to self-employment taxes. (See Chapter 4.) This means Fred ends up with more after-tax money in his pocket.
Tax Consequences of Corporate Dissolution
You should consider an additional tax aspect of forming a corporation before deciding to incorporate—the tax consequences of ending the corporation when it is dissolved or sold. The general rule is that when a corporation is sold or dissolved, both the corporation and its shareholders have to pay tax on appreciated corporate assets. However, there are ways to minimize this double tax, if you plan in advance. The primary strategy is to arrange for a sale of stock (not assets) when the corporation is sold. (Best of all is a tax-free sale of stock/assets as part of a tax-free reorganization that is a merger with an acquiring corporation.) Check with your tax adviser on the eventual tax ramifications of dissolving your corporation right from the start. One of the most important preincorporation services your tax adviser can provide is to make sure that the future dissolution or sale of your corporation will not result in an unexpectedly hefty tax bill for your corporation and its owners.
Does It Make Sense to Incorporate Out of State?
You have no doubt heard about the possibility of incorporating in another state, most likely Delaware, where initial and ongoing fees are lower and regulations may be less restrictive than in California. Does this make sense? For large, publicly held corporations looking for the most lenient statutes and courts to help them fend off corporate raiders, perhaps yes. But for a small, privately held corporation pursuing an active California business, our answer is generally no—it is usually a very poor idea to incorporate out of state.
The big reason is that you probably will have to qualify to do business in California even if you don’t incorporate here, and this process takes about as much time and costs as much money as filing incorporation papers in California in the first place. You’ll also need to appoint a corporate agent to receive official corporate notices in the state where you incorporate—another expensive pain in the neck.
Incorporating in another state with a lower corporate income tax isn’t likely to save you any money. If your business makes money from operations in California, even if it is incorporated in another state, you still must pay California taxes on this income.
Example: Best Greeting Card, Inc., plans to open a Jenner, California, facility to design and market holiday greeting cards throughout the country. If it incorporates in Delaware, it must qualify to do business in California and pay California corporate income tax on its California operations. It also must hire a registered agent to act on its behalf in Delaware. It decides to incorporate in California instead.
Unless you plan to open up a business with offices and operations in more than one state and, therefore, have a real reason to shop for the best corporate domiciles, you generally should incorporate in your home state—California. To see how aggressively California interprets “doing business in California,” see the examples under this heading in FTB Publication 3556, available on the Franchise Tax Board’s website at www.ftb.gov. For an even more telling example of the risks you take forming an out-of–state corporation to engage in business in California, see FTB Publication 689, Don’t Gamble With Your Taxes: Incorporating in Nevada, also available on the FTB website
Owners Who Work in the Business Are Treated as Employees
A potential benefit of the corporate structure is that business owners who also work in the business become employees. This means that you, in your role as an employee, become eligible for tax-deductible corporate fringe benefits, some of which you would not qualify for as a sole proprietor, partner, or an LLC member.
For example, Henry incorporates his California sole proprietorship, “Big Sur Shoes, Inc.” He now works as a full-time corporate employee and is entitled to tax-deductible corporate perks, such as reimbursement for medical expenses and $50,000 worth of group term life insurance paid for by his business. If he gave himself these perks in his unincorporated business, his business could deduct them as ordinary and necessary business expenses, but he would have to report them as income and pay income taxes on them. Corporation employees also receive special tax benefits if they are issued qualified incentive stock options, restricted stock, and other forms of equity-sharing participation interests unique to corporations. (See Chapter 4 for more on corporate fringe and equity benefits.)
Built-In Organizational Structure
Perhaps the most unique benefit of forming a corporation is the ability to divide management, executive decision making, and ownership into separate areas of corporate activity. This separation is achieved automatically because of the separate legal roles which reside in the corporate form: the roles of directors (managers), executives (officers), and owners (shareholders). Unlike partnerships and LLCs, the corporate structure comes ready-made with a built-in separation of these three roles, each with its own legal authority, rules, and ability to participate in corporate income and profits.
Example 1: Myra, Danielle, and Rocco