Introduction

This chapter introduces you to the structures, procedures, and legal rules you need to know to form a profit-making corporation and keep it running.

To help you understand where a business corporation fits in the corporate landscape, we begin by briefly describing other types of corporations, including nonprofit, professional, and close corporations. Then we cover the basic legal paperwork and procedures that you must undertake to form and operate a business corporation, including the issuance of shares to your initial shareholders. This background information will help you follow the specific instructions we provide in the later chapters for preparing corporate articles, bylaws, and minutes, and making your first stock issuance. This chapter also helps you understand the specific corporate and securities rules contained in your state sheet in Appendix A and any corporate or securities statutes you may wish to browse in your state's Business Corporation Act tor Securities Act.

Understanding and paying corporate taxes is covered in the next chapter, Chapter 3.

Kinds of Corporations

State law classifies and regulates different types of corporations. This book shows you how to form a business corporation (a few states call it a "profit corporation"). Essentially, a business corporation is one that engages in any lawful business that is not specially regulated under state law (such as the insurance, banking, or trust business).

Before discussing the rules that apply to business corporations -- the type most readers of this book will want to form -- let's look at a few other types of corporations that are set up and operated under special state rules. You must follow unique procedures to form one of these types of corporations, which are not covered in this book.

Nonprofit Corporations

A nonprofit corporation (in some states called a not-for-profit corporation) is formed under a state's Nonprofit Corporation Act for nonprofit purposes. In other words, its primary purpose is not to make money for its founders, but to do good work -- for example, to establish child care centers, shelters for the homeless, community health care clinics, museums, hospitals, churches, schools, or performing arts groups. Most nonprofits are formed for purposes recognized as tax-exempt under federal and state income tax laws. This means that the nonprofit doesn't have to pay corporate income tax on its revenues, that it is eligible to receive tax-deductible contributions from the public, and that it qualifies to receive grant funds from other tax-exempt public and private agencies.

State law as well as federal tax-exemption requirements typically prohibit a nonprofit corporation from paying out profits to nonprofit members, except in the form of reasonable salaries to those who work for it. When a nonprofit dissolves, the members are normally not allowed to share in a distribution of the nonprofit's assets. Instead, any assets remaining after the nonprofit dissolves must be distributed to another tax-exempt organization. Special types of nonprofits may be recognized under state law that allow people to own, in one fashion or another, corporate assets, so they can receive a portion of these assets when the nonprofit dissolves. For example, a nonprofit homeowners' association or nonprofit trade group may give each member a proprietary interest in the assets of the nonprofit. But these special nonprofits do not enjoy the same benefits as a qualified tax-exempt nonprofit. They may be eligible for an income tax exemption, but they normally do not qualify to receive tax-deductible contributions or public or private grant funds.

Nonprofit corporations, like regular business corporations, have directors who manage the business of the corporation. The nonprofit corporation can also collect enrollment fees, dues, or similar amounts from members. Like regular corporations, a nonprofit corporation may sue or be sued; pay salaries; provide various types of employee fringe benefits; incur debts and obligations; acquire and hold property; and engage, generally, in any lawful activity not inconsistent with its nonprofit purposes and tax-exempt status. It also provides its directors and members with limited liability for the debts and liabilities of the corporation and continues perpetually unless steps are taken to dissolve it.

There are key differences between forming and operating a nonprofit and a regular business corporation:

• To form a nonprofit, in most states you must file special nonprofit articles of incorporation. These are normally available for downloading from your state corporate filing office website. (See your state sheet for contact information.)
• Nonprofit bylaws typically contain provisions similar to those of business corporations. However, nonprofits typically set up a number of special committees to handle nonprofit operations, and nonprofits routinely schedule more frequent meetings of directors than their commercial counterparts. Also, nonprofits replace shareholder provisions with member provisions, which specify the rules for membership meetings and the qualifications, responsibilities, and rights of members. Of course, nonprofit bylaws do not contain provisions relating payouts of profits (payment of dividends). The state Nonprofit Corporation Act typically follows or is in close proximity to the state Business Corporation Act in the corporate statutes. So you can usually use the citation to your state's Business Corporation Act to help you locate the Nonprofit Corporation Act. (A few states include nonprofit as well as business corporation statutes in a consolidated General Corporation Act.) See your state sheet in Appendix A for information about locating corporate laws.
• A critical part of forming and operating a nonprofit is obtaining a federal and state income tax exemption and making sure to operate the nonprofit in a way that meets the tax exemption requirements. The requirements for obtaining a state income tax exemption should be posted on your state tax agency website. (See the "State Tax Information" section of your state sheet in Appendix A.)

For more information about nonprofit corporations. For all the forms and instructions you need to organize a nonprofit corporation in your state, including step-by-step instructions on preparing nonprofit articles and bylaws and applying for and obtaining your federal 501(c)(3) nonprofit tax exemption, see How to Form a Nonprofit Corporation, by Anthony Mancuso (Nolo). (California readers should see Nolo's How to Form a Nonprofit Corporation in California, also by Anthony Mancuso.)

Professional Corporations

Most states have special requirements for forming a corporation whose owners will provide state-licensed professional services. The list of particular professions to which these rules apply varies from state to state, but typically lawyers, doctors, other health care professionals, accountants, engineers, and architects must follow these special rules when they incorporate. Other professionals ranging from acupuncturists to massage therapists may also be included.

How to find out whether you must form a professional corporation. If you plan to form a corporation to render professional services, check your state's corporate filing office website (see your state sheet) to see what professions must incorporate as professional corporations. If this information is not posted, send the office an email asking if your profession must incorporate as a professional corporation. If your profession is not on the state's professional corporation list, you can establish a regular business corporation -- the type this book shows you how to form.

If your profession is on the professional corporation list in your state, you must file special professional corporation articles of incorporation to form your corporation, not the standard articles for a business corporation discussed in this book. In many states, professional corporation articles are available for downloading from the corporate filing office website. (See your state sheet for contact information.)

In addition to the rules set out in this book that apply to business corporations, the following rules and requirements typically also apply to the formation and operation of professional corporations:

• The name of a professional corporation normally must include a special designator such as "Professional Corporation," "P.C.," or the like, and must meet any additional professional business name requirements imposed by the state licensing board that oversees the profession.
• In addition to professional corporation articles, you may be required to file a certification from the state licensing board showing that all shareholders hold current professional state licenses.
• Generally, the corporation must be formed to render only one professional service, but some professions are allowed to form a corporation to render more than one professional service in related fields. For example, a licensed surgeon may be allowed to incorporate a professional corporation together with a licensed orthopedist.
• The corporation must render professional services only through licensed members, managers, officers, agents, and employees.
• Each licensed professional must carry the amount of liability insurance specified under the rules that apply to the profession.
• Generally, licensed shareholder/employees of professional corporations remain personally liable for their own negligent or wrongful acts, or acts of those under the professional's direct supervision or control, when performing professional services on behalf of the corporation. The limited liability shield of the corporation does, however, normally protect professionals from personal liability for the negligent acts of other professionals in the incorporated professional practice. (And, as for other corporations, the liability shield protects professional shareholders from personal liability for the regular commercial debts and other business liabilities of the corporation.)

Flat corporate income tax rate for certain professionals. Whether you form a regular business corporation or a professional corporation to render professional services, an important IRS tax provision may apply to you. Specifically, Internal Revenue Code §§ 11(b)(2) and 448(d)(2) provide that professionals engaged in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting are subject to a flat 35% federal corporate income tax rate. This rate is applied to any taxable income left in the corporation -- that is, income not paid out as salary or fringe benefits to the professionals and other employees of the corporation -- at the end of the corporation's tax year. In other words, these professionals, unlike the owners of regular business corporations, do not enjoy the benefit of keeping taxable income in the corporation at the lower corporate income tax brackets of 15% to 25%. (See Chapter 3.) For this reason, professionals who expect to retain income in their corporation often prefer to organize themselves as an RLLP to obtain limited liability protection and avoid the flat 35% corporate tax. Income earned in an RLLP, as in a partnership, passes through the entity and is taxed at regular individual income tax rates of the owners, which may be lower than the flat 35% professional tax rate.

The Close Corporation

Many states have enacted laws, usually as part of their Business Corporation Act, that allow for the organization of a special type of business corporation, called a "close corporation" or "statutory close corporation." These laws permit corporations with a small number of shareholders -- usually no more than 35 -- to operate without a board of directors according to the terms of a specially prepared shareholders' agreement. In other words, the owners of a close corporation can dispense with normal corporate formalities and operate their corporation under a shareholders' agreement, similar to the way in which owners of a partnership operate their business under the terms of a partnership agreement.

Operating a close corporation under a shareholders' agreement can provide business owners with a great deal of flexibility. For example, the shareholders' agreement can dispense with the need for annual director or shareholder meetings, corporate officers, or even for the board of directors itself, allowing shareholders to manage and carry out the business of the corporation without having to put on their director or shareholder hats. And, as in a partnership, profits can be distributed without regard to capital contributions (stock ownership); thus a 10% shareholder could, for example, receive 25% of the profits (dividends). Special tax rules apply to this sort of special allocation of business profits; your tax adviser can fill you in on the details if you want to know more.

Despite the benefits of informality and flexibility, most incorporators don't want to form close corporations. Indeed, it is estimated that less than 2% of all business corporations are formed as close corporations. Why hasn't the close corporation business form caught on in the states that allow it? There are a number of reasons.

To begin with, most incorporators do not want to operate their corporation under informal or nonstandard close corporation shareholder agreement rules and procedures. In fact, many incorporators form a corporation to rely on the traditional corporation and tax statutes that apply to regular business corporations. (By doing so, they know what is expected of directors, officers, and shareholders -- for example, they can simply follow the rules set out in their state Business Corporation Act to call and hold meetings of directors and shareholders without having to design their own procedures.) Second, shares of stock in a close corporation normally contain built-in restrictions on transferability, and most incorporators do not want their shares to be restricted in this way. Third, it is costly and time-consuming to prepare a shareholders' agreement. It's much simpler and less expensive to adopt standard corporate bylaws.

For more information about close corporations. Your state corporate filing office website, listed in your state sheet in Appendix A, should tell you whether you can form a close corporation in your state and, if so, how to do it. Typically, you must add special provisions to your articles of incorporation to elect close corporation status, prepare and adopt a special shareholders' agreement that follows the requirements set out in your state's Business Corporation Act, and prepare special stock certificates that contain language that limits the transfer of the shares represented by the certificate.

The Business Corporation

This is the type of corporation that this book shows you how to form. In the remainder of this chapter we'll review the statutes (laws), required documents, state offices, and other features on the legal landscape you'll encounter on your way to forming your own business corporation.

Corporate Statutes

Each state has many laws that regulate the organization and operation of a business corporation. The portion that governs most areas of corporate operation is the state's Business Corporation Act (BCA). Your state sheet, contained in Appendix A, provides the specific BCA provisions for major areas of corporate organization and operation. This section simply provides a summary of how the state BCA and other business laws will affect your corporate life and tells you how to locate the laws if you need to look something up.

Business Corporation Act

Most of the laws that govern corporations are contained in your state's business corporation statutes, usually titled the "Business Corporation Act" (BCA) or "Business Corporation Law." The BCA spells out the essential rules for forming and operating a corporation. For example, the BCA explains the requirements for preparing and filing articles of incorporation to form the corporation, the rules for preparing and changing corporate bylaws, and the basic rights and responsibilities of corporate directors, officers, and shareholders. The BCA explains when and how directors and shareholders meet to approve corporate decisions, and how much leeway a corporation has in setting its own rules that vary from the BCA requirements. We cover BCA director, officer, and shareholder rules in more detail in the remaining sections of this chapter.

Other Laws

In addition to the Business Corporation Act, other state laws regulate special areas of corporate activity. These include the following.

Securities act or blue sky law. This law contains each state's rules and procedures for offering, issuing, selling, and transferring shares of corporate stock and other securities within the state. The term "blue sky law" is derived from the sometimes underhanded, and often colorful, practices of corporate con artists who, in return for an investment in their latest get-rich-quick undertaking, would promise the "blue sky" to unsuspecting investors. The securities laws of each state attempt, through registration and disclosure requirements, to tone down the picture painted by stock promoters to a more realistic hue.

The "State Securities Information" section of your state sheet provides basic information on the securities laws and procedures that apply to issuing your initial shares to the founders of your corporation. This information includes the Web address of your state's securities law office, where you can usually find a link to your state's securities law. If the state securities office website does not provide this link, we give you the Web address where you can find your state's securities law online. If you do not have an Internet connection, call your state securities office; often it provides a free pamphlet that contains your state's securities act. (The telephone number for your state securities office is also listed in your state sheet.)

For more information on securities laws and procedures, see "Stock Issuance and the Securities Laws," below.

State Tax or Revenue Code. Most states impose corporate income or franchise taxes that are based on the amount of taxable income earned in the state by a corporation. Your corporation pays these taxes in addition to federal IRS income taxes. Each state's Tax or Revenue Code typically contains the state's income or franchise tax rules.

Tax statutes are even more off-putting than legal statutes. We think you'll get the most useful information directly from your state's tax publications, forms, and other instructions posted on your state's tax agency website. The "State Tax Information" section of your state sheet provides the website and other contact information for this office, along with information about the type and rate of any corporate income or franchise tax imposed by your state. If you don't have an Internet connection, call the state tax office telephone number listed in the "State Tax Information" section of your state sheet and ask for corporate publications and forms by mail.

Other state and local laws. Other state laws affect the operations of all businesses, whether or not they are incorporated. For example, state and local building codes, professional and occupation licensing, environmental laws, local ordinances, zoning laws, and other laws and regulations may apply to your business and its operations.

Laws that apply when forming a business. For an excellent resource on the various state laws and regulations that apply to forming all types of businesses, corporate and noncorporate, see The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo), available in both national and California editions.

Corporate Filing Offices

Each state has a corporate filing office where you file paperwork (and pay fees) to create or dissolve a corporation. Typically, this filing office handles all state business filings, including limited partnership and limited liability company (LLC) filings as well as business corporation and nonprofit corporate filings. Throughout this book, we refer to the office that accepts corporate filings as the corporate filing office. Typically, the official name of this office is the Corporations Division of the Secretary (or Department) of State. The main corporate filing office is located in each state's capitol city. Some states maintain branch offices in secondary cities as well.

The "Corporate Filing Office" section of your state sheet contains the name, address, telephone number, and website of your state's corporate filing office. Generally, the best way to obtain the latest corporate filing and fee information and the latest corporate filing forms is to visit your state's corporate filing office website. Most state corporate filing office websites provide corporate statutory forms such as Articles of Incorporation, Amendment of Articles, Change of Registered Agent, or Registered Office Address, and the like. (Your state sheet lists the corporate forms available on each site.) Many state websites also contain links to the state's corporate tax office and state employment, licensing, and other agencies.

For a faster response, contact the filing office via email. Corporate filing offices typically respond to email inquiries much faster than they respond to snail mail or telephone messages. (It's not uncommon to have to wait a day or more to get a telephone call through to a busy state filing office.)

In short, if your question is not answered on the filing office website, send the office an email inquiry. (You will find the email address on the state filing office website.)

Corporate Documents

The primary corporate legal documents are articles of incorporation, bylaws, stock certificates, and minutes of meetings. This section introduces you to each in turn.

Articles of Incorporation

The key corporate organizing document are the articles of incorporation. In some states, the articles go by a different name, such as the corporate charter or certificate of incorporation. A corporation comes into existence when its articles of incorporation are filed with the state corporate filing office. The filing of articles is the only legal filing necessary to create a corporate entity. However, you'll want to follow up after filing articles by preparing and adopting bylaws, holding a first meeting of directors, and issuing stock to your initial shareholders. These additional steps are necessary to make sure the legal organization of your corporation is complete.

The articles normally contain basic structural information, such as the name of the corporation, the names and addresses of its directors, its registered agent and registered office address, and the corporation's capital stock structure. The information that must be included is typically established by a section of the state Business Corporation Act titled "Contents of Articles of Incorporation." Standard state articles forms contain all required provisions. State articles statutes also normally list optional provisions that you can include in your articles, such as provisions to implement a complex stock structure with different classes or series of shares. (We discuss adding optional provisions to articles in Chapter 4.)

Example: The Equine Equity Investors Corporation adds an optional provision to its articles that sets up a multiclass stock structure consisting of Class A Voting shares and Class B Nonvoting shares. Another optional provision is added that requires a vote of two-thirds of each class of stock for the approval of amendments (changes) to the corporation's articles or bylaws.

Most corporate filing office websites provide a downloadable, ready-to-use articles of incorporation form that you can use to establish your business corporation. This book provides an articles form for use in Iowa and Nebraska, the only states that do not offer a standard articles form. For all states, we provide specific instructions in the "Articles Instructions" section of the state sheet to help you obtain and complete your articles so that they are acceptable for filing with the corporate filing office.

Bylaws

After articles of incorporation, a corporation's bylaws are its second-most important document. You do not file bylaws with the state. They are an internal document that contains rules for holding corporate meetings and carrying out other formalities according to state corporate laws. Bylaws typically specify how often the corporation must hold regular meetings of directors and shareholders, as well as the call, notice, quorum, and voting rules for these meetings. Also, bylaws usually contain the rules for setting up and delegating authority to special committees of the board of directors, the rights of directors and shareholders to inspect corporate records and books, the rights of directors and officers to insurance coverage or indemnification (reimbursement by the corporation for legal fees and judgments) in the event of lawsuits, plus a number of other standard legal provisions.

Many of the procedures set out in corporate bylaws are controlled by statutes in your state's Business Corporation Act. For example, most states require corporations to hold an annual meeting of shareholders to elect or reelect the board of directors to a one-year term of office. In your bylaws, you set the date of this annual meeting. Similarly, most states require written notice of shareholders' meetings to be delivered to each shareholder no less than ten nor more than 60 days prior to the date of the meeting. In your bylaws, you can specify the exact number of days required for providing notice of shareholders' meetings. If you do, your notice period must fall within this ten-to-60-day range.

This book provides fill-in-the-blank bylaws (both tear-outs and on CD-ROM) that you can use for your corporation. In Chapter 4, we explain how to use your state sheet information to complete your bylaws.

Stock Certificates

A new corporation issues stock to its founders and initial investors. Stock ownership is usually documented by stock certificates given to each shareholder. Today, many states do not require the actual completion and delivery of paper stock certificates to shareholders, but we think it continues to make sense to issue certificates. A stock certificate is tangible evidence of a person's ownership rights in your corporation, and most founders and investors expect to receive one after buying shares in a new corporation.

State law sets out the very basic content requirements for stock certificates. Normally, the minimum information necessary is the name of the corporation, the state where the corporation was formed, the name and number of shares issued to the shareholder, and the signature of two corporate officers. We provide ten tear-out stock certificates in Appendix C. We describe your state's stock certificate requirements in the "Share Issuance Rules" section of your state sheet. Blank certificates that comply with your state's requirements may be available in local stationery stores. If you want custom-printed certificates, a local legal printer will prepare your certificates for a higher cost. We provide specific information on how to issue the initial shares of your corporation in "Sale and Issuance of Stock," below.

Minutes of the First Directors Meeting

After filing articles and preparing bylaws, the initial board of directors meets to formally approve the bylaws, approve the issuance of stock to initial shareholders, appoint corporate officers, and handle other essential corporate start-up tasks. If the initial members of the board are not named in the articles, the incorporator -- the person who signed and filed your articles -- prepares a written "Incorporator Statement" in which the incorporator appoints the initial board members prior to its first meeting. Once the board has been named -- either in the filed articles or the incorporator statement -- the board of directors can hold its first meeting. The actions taken by the board at its first meeting should be documented by written minutes that are filed in the corporate records book.

Chapter 4 of this book shows you how to prepare an incorporator statement (if you need one) and minutes of your first board meeting. (This book contains forms you can use for both purposes.)

For help with corporate minutes. For simple forms that you can use to record subsequent board and shareholders meetings, together with more than 80 resolutions you can adopt to handle the approval of standard legal, business, and tax decisions reached at these meetings, see Nolo's The Corporate Records Handbook, by Anthony Mancuso.

Corporate Powers

Each state's Business Corporation Act gives business corporations carte blanche to engage in any lawful business activity. In legalese, "lawful" doesn't just mean noncriminal; it means not otherwise prohibited by law. Generally this means that a corporation can do anything that a natural person can do. However, in most states, it is not lawful for a regular business corporation to engage in the banking, trust, or insurance business. If you want to set up one of these special financial corporations, you will need to follow special procedures -- for example, obtain the written approval of your state's Banking or Insurance Commission, and prepare and file special articles of incorporation with the state.

Here's a partial list of things that a business corporation may do. These powers do not need to be listed in your articles and bylaws:

• Engage in any lawful business.
• Adopt, amend, and repeal bylaws.
• Qualify to do business in any other state, territory, dependency, or foreign country.
• Issue, purchase, redeem, receive, or otherwise acquire, own, hold, sell, lend, exchange, transfer, or otherwise dispose of, pledge, use, and otherwise deal in and with its own shares, bonds, and other securities.
• Assume obligations, enter into contracts, incur liabilities, borrow and lend money, or otherwise use its credit, and secure any of its obligations, contracts, or liabilities by mortgage, pledge, or other encumbrance of all or any part of its property, franchises, and income.
• Make donations for the public welfare or for community fund, hospital, charitable, educational, scientific, or civic or similar purposes. (Like individuals, business corporations are allowed to make charitable donations.)
• Establish and carry out pension, profit-sharing, stock-bonus, share-pension, share-option, savings, thrift, and other employee retirement, incentive, and benefit plans.
• Participate with others in any partnership, joint venture, or other association, transaction or arrangement of any kind, whether or not such participation involves the sharing or delegation of control with, or to, others.
• Adopt, use, and alter a corporate seal. (A corporate seal is simply a stamped or embossed design showing the name of the corporation and its state of formation.) Although state law does not require the use of a corporate seal, some corporations use the seal on formal corporate documents, such as stock certificates, to signify formal approval of the document by the corporation.

Your corporation can engage in more than one line of business. Although state BCAs don't specifically say so, it is clear that a business corporation can engage in as many lines of business as management sees fit. You do not need to set up a separate corporation for each line of business.

Corporate People

While a corporation is considered a legal "person," capable of making contracts, paying taxes, and otherwise enjoying the legal rights and responsibilities of a natural person, of course it needs real people to carry out its business. State BCAs classify corporate people in the following ways:

• incorporators
• directors
• officers, and
• shareholders.

As we explain below, state statutes -- and occasionally courts -- give each of these corporate people different rights and responsibilities.

Incorporators

Your incorporator is the person who signs your articles of incorporation and files them with state corporate filing office. The incorporator is not required to be an initial director, officer, or shareholder of the corporation -- nor must the incorporator be a resident of the state. The only legal requirement for incorporators is that, in many states, the incorporator must be at least 18 years old. (If your state imposes an age requirement for incorporators, we list it in the "Articles Instructions" section of your state sheet.)

Even though it is not required, we recommend that you pick one of your initial board members as your incorporator. This helps to ensure that the entire board of directors, which must pick up the reins of management immediately after the corporation is formed, is in the corporate formation loop right from the start. It also means that any correspondence between your new corporation and the state corporate filing office will reach at least one director.

Directors

Under each state's Business Corporation Act, directors are given the authority and responsibility for managing the corporation. Let's look at some of the common features of state law that apply to directors.

Director Qualifications

State law does not impose residency or stock ownership requirements on directors. Your directors can come from any state and need not be shareholders. The only director requirement in some states is an age requirement -- in these states, directors usually must be at least 18 years old.

The directors meet and make decisions collectively as the board of directors. In all states, the board may consist of one or more individuals. Many state BCAs specifically say that a director must be a natural (real) person, as opposed to another corporation or limited liability company (LLC). Even if your state's BCA doesn't say this, it is understood in all states that only real people may be elected as board members.

The "Director and Officer Rules" section of your state sheet lists any director requirements found in your state's BCA.

Director Meetings

In most states, directors must meet at least once each year. One reason for this requirement is that most state BCAs specify that directors must be elected (or reelected) for a one-year term at an annual meeting of shareholders. (See "Shareholders," below.) Once the board is voted in or continued in office at the annual shareholders' meeting, the newly elected or reelected board holds its annual meeting. At this meeting, board members accept their election to the board, then transact any business planned for the meeting.

The date, time, and place of the annual directors' meeting is normally specified in the bylaws. State BCAs usually allow the annual meeting to be held without having to give each director prior written notice of the meeting, but we think it's a good idea to provide written notice of all meetings, including annual board meetings. Directors, particularly newly elected ones, may not note or remember the annual director meeting date specified in the bylaws. Of course, boards often meet more frequently than once per year, particularly in larger corporations with multimember boards. (See "When Do Directors Meet?" below.)

Additional meetings are called special meetings. State law typically requires that directors receive written notice of the date, place, and purpose of all special meetings of directors.

The "Director Meeting Rules" section of your state sheet in Appendix A lists your state's specific requirements for annual and special directors' meetings, including calling and giving notice of meetings, as well as setting a quorum and voting rights. This language indicates whether or not you can vary the statutory rules. (If you can, the language will say "except as otherwise provided in the articles or bylaws," which means that you are permitted to specify your own rule in your articles or bylaws.)

Director Voting

Under state law, board members are given one vote each when making board decisions at directors' meetings. The BCA in most states normally sets the quorum requirement for board meetings -- that is, the number of directors who must be present to hold a board meeting -- at a majority of the full board. However, in most states, your bylaws can change this default rule and specify a greater- or less-than majority quorum rule for directors' meetings. State law also typically provides a majority-voting rule for the approval of board decisions at a meeting. This means that the board approves decisions at a meeting by the "yes" vote of at least a majority of the directors present at the meeting. Again, this majority rule is usually a default state rule; you are normally allowed to specify a different director approval rule in your bylaws.

Example: Tie-Dyed RetroFitters, Inc., is a retro clothing store owned and managed by its four founders. The corporate bylaws establish a four-person board, with a quorum for board meetings specified as a majority of the authorized number of directors. Therefore, to hold a directors' meeting, three of the four directors must attend. A majority of those present at a meeting must approve a decision -- remember, at a minimum, a quorum must be present. If all four board members attend a meeting, three directors must approve a decision proposed at the meeting. If a minimum quorum of three attends, then two of the three must approve a deision proposed at the meeting.

Some states set a minimum quorum requirement for directors. In many states, your bylaws cannot establish a quorum of directors that is less than one-third the number of the full board. We tell you if your state imposes this sort of minimum quorum rule for directors in the "Director and Officer Rules" section of your state sheet in Appendix A.

In addition to approving decisions at meetings, directors can also take action by written consent. Under state BCAs, this written voting procedure is allowed for all types of director action -- that is, any type of action that directors can approve by voting in person at a real meeting. This means that the directors can individually or collectively date and sign a form that says they approve a particular item of business, without the need to hold a face-to-face meeting. State BCAs normally require the signature of all directors on a written consent form of this sort -- obtaining the signed consent of a simple majority of directors is not sufficient under most state statutes. Look in your state BCA for a section with the title "Directors' Action by Written Consent" or "Directors' Action Without a Meeting" to see how many directors must sign a written consent form in your state.

Board Committees

In smaller corporations, the owners who also run the corporation as officers or other supervisory personnel make up the full board of directors. In larger corporations, the board may include individuals who are not involved with day-to-day corporate operations. These outside directors, who may be representatives of venture capital groups or financial institutions that have provided capital or financing to the corporation, rely heavily on reports of board committees to get the information necessary to make good decisions. For example, the compensation committee of a larger corporation may report regularly to the board to propose the granting of salary increases, bonuses, and stock options to deserving corporate employees. Similarly, a special finance committee may be established by the board to review corporate performance in one or more lines of its business.

State BCAs recognize the need for these committees to help the board get its work done. Here is a typical statute:

In performing the duties of a director, a director shall be entitled to rely on information, opinions reports, or statements, including financial statements, prepared or presented by a committee of the board, as to matters within its designated authority, which committee the director believes to merit confidence.

The above statute is typical in that it allows directors to rely on committees if the director is satisfied that a committee report merits confidence. State BCAs also allow a board to delegate its managerial authority to special types of committees, called executive committees of the board. These are committees made up of two or more board members, and often other corporate personnel such as officers, that take responsibility for one or more areas of board decision making. Larger corporations may set up one or more committees of this sort to handle ongoing areas of corporate management. The full board may meet less frequently to review overall corporate policy, while the committees of the board meet regularly to handle their assigned areas of responsibility.

State law limits the types of authority that can be delegated to an executive committee of the board. Typically, an executive committee cannot, without full board concurrence, amend the articles or bylaws, approve a corporate dividend, or take other specified major corporate actions. Here is a typical BCA statute covering executive committees:

Executive Committees of the Board: The board may, by resolution adopted by a majority of the authorized number of directors, designate one or more committees, each consisting of two or more directors, to serve at the pleasure of the board. Any such committee, to the extent provided in the resolution of the board or in the bylaws, shall have all the authority of the board except with respect to: 1) the approval of any action which also requires the approval of shareholders; 2) the filling of vacancies on the board; 3) the fixing of compensation of directors for serving on the board or any committee of the board; 4) a distribution by the corporation [typically, this is defined elsewhere in the Act as a dividend or other payment out of the profits and earnings of the corporation to shareholders]; and 5) the establishment of other committees of the board or appointment of members to these other committees.

Despite the restrictions, executive committees are permitted to handle a variety of corporate decision-making matters, including hiring and payroll decisions, corporate projects and operations, and a variety of management and overview tasks that would otherwise be handled by the full board.

Directors' Duties

Directors are required under state BCA statutes to exercise care in making management decisions and act in the best interests of the corporation. If a court decides that a director has violated these duties, the director may be held personally liable for any resulting financial loss to the corporation or its shareholders.

Duty of Care

The first and foremost duty owed by a director to a corporation is the statutory "duty of care." Here is a typical state BCA statute that defines, in general terms, a director's duty of care:

A director must act in good faith, in a manner the director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar conditions.

This is a very broad standard. Courts interpret it to mean that a director is allowed to make mistakes that lead to financial loss for the corporation and its shareholders without fear of personal legal liability, as long as the director had good reason for making the decisions. And, as discussed in "Board Committees," above, one good reason may be that the director relied on the apparently reliable reports of a board committee.

The duty of care Is normally easy to fulfill. The standard for the directors' duty of care is fairly lenient. A director has to be negligent (careless), almost to the point of flagrant inattention or fraudulent disregard of the financial implications of board decisions, to violate the statutory standards. And in small corporations, even if the standard is violated, personal liability problems are rare. This is because the people who have legal standing to seek damages for a director's violation of the duty of care are those whose have been harmed financially by a director's bad decision making -- namely, its shareholders. In a closely held corporation where all board members also are the corporation's only shareholders, it is unlikely that one director will sue another. But it's not unheard of, particularly if one or more directors officially disagreed with a corporate decision they felt was too risky and wrongheaded -- and the value of their shares was diminished significantly because of it. But even if the disgruntled director-shareholders do bring suit against the other directors on behalf of the corporation, they will win only if they can convince a court that the directors had little or no business reason for their decision or that they made it simply to further their own personal financial interests, not those of the corporation.

In larger corporations with shareholders who are not members of the board of directors, chances increase that a disgruntled shareholder who has no voice in management may decide that the directors acted wrongly and should be held accountable for a major loss of share value. Even so, shareholder suits that seek to impose personal liability on a director are infrequent. They most often arise when a corporation is on the auction block -- that is, when it is being sold or merged with another corporation. For example, courts have held the board personally liable to the shareholders for agreeing to a sale favored by a leading board member if the board did not adequately investigate the current market value of the corporation and seek counteroffers to the proposed sale.

How to avoid trouble. As a director, a court is more likely to find you in violation of your duty of care if you do not bother to attend and participate in board meetings, obtain information about the likely financial consequences of a board decision, or check alternative courses of action before going forward with an action that can affect share value. In other words, don't miss board meetings or simply attend and rubber-stamp proposals brought up by other board members for consideration, particularly if the decision involves a major commitment of corporate funds or resources. Another way of saying all of this is that it's okay for you to approve board decisions that put corporate capital or share values at risk as long as you are reasonably aware of the nature of these risks and decide they are worth taking to achieve a valid corporate business objective.

Many state BCAs underline the importance of a director's paying full attention to corporate decision making, rather than merely sitting back and letting others muscle their pet projects past the board. Under many BCAs, a director present at a meeting during which an action is approved is legally considered to have approved all decisions reached at the meeting unless the director speaks up and votes "no" to the decision or specifically requests that his or her dissent or abstention be entered in the minutes (or hands the chairperson a written abstention to the proposal).

Here's a typical statute that stresses the importance of taking an active stance as a director:

A director who is present at a meeting of the board of directors when corporate action is taken is deemed to have assented to all action taken at the meeting unless:

(a) The director objects at the beginning of the meeting, or promptly upon his or her arrival, to holding the meeting or transacting business at the meeting and does not thereafter vote for or assent to any action taken at the meeting;

(b) The director contemporaneously requests that his or her dissent or abstention as to any specific action taken be entered in the minutes of the meeting; or

(c) The director causes written notice of his or her dissent or abstention as to any specific action to be received by the presiding officer of the meeting before adjournment of the meeting or by the corporation promptly after adjournment of the meeting.

Example: A trustee in bankruptcy sued to recover from the estate of a corporate director a large sum paid as "loans" to the director's sons, who also sat on the board of a successful banking and insurance business. The court agreed that even though the director had not personally received the funds, she should not have deferred to the decisions of her sons without making her own inquiries. She had a duty to question any payouts made by the corporation, to examine financial statements, and to learn the requirements of corporate and insurance law that limited the making of the excessive insider loans. The court held the director's estate liable for payback of the loans, saying that "ornamental" or so-called "dummy" directors have the same responsibility to actively and attentively protect corporate assets as all active board members. Francis v. New Jersey Bank, 87 N.J. 15, 432 A.2d 814 (1981).

Some state statutes provide extra protection from shareholder suits. In recognition of the increased willingness of shareholders and their attorneys to sue directors -- particularly when share values fall following action by the board -- many state legislatures have added special director immunity provisions to their BCAs to help directors avoid personal liability when shareholders launch legal challenges to corporate management. This additional help comes in the form of special BCA provisions that let a corporation place language in its articles that limits or eliminates all personal liability of the board to the corporation or shareholders except in a few special cases. Typically, immunity cannot be provided where the board has acted unlawfully or where it can be shown the director purposefully acted against the best interests of the corporation or otherwise in flagrant disregard of the director's statutory duty of care.

If a state's BCA contains a provision of this sort, you'll likely find it in the section that specifies the optional provisions that may be included in your Articles of Incorporation. Here's a typical provision, extracted from California's "Articles of Incorporation -- Optional Provisions" statute (California General Corporation Law, § 204(a)(10)):

The Articles of Incorporation may set forth provisions eliminating or limiting the personal liability of a director for monetary damages in an action brought by or for or in the right of the corporation for breach of a director's duties to the corporation and its shareholders, provided, however, that such a provision may not eliminate or limit the liability of directors (1) for acts or omissions that involve intentional misconduct or a knowing violation of law, (2) for acts or omissions that a director believes to be contrary to the best interests of the corporation or its shareholders or that involve the absence of good faith on the part of the director, (3) for any transaction for which the director derived an improper personal benefit, (4) for acts or omissions that show a reckless disregard for the director's duty to the corporation or its shareholders in circumstances in which the director was aware, or should have been aware, in the ordinary course of performing a director's duties, of a risk of serious injury to the corporation or its shareholders, or (5) for acts or omissions that constitute an unexcused pattern of inattention that amounts to an abdication of the director's duty to the corporation or its shareholders.

Again, it is probably unnecessary for a small business corporation where all shareholders will serve on the board of directors to adopt this type of provision. However, if you are worried about shareholder suits against your board -- perhaps because you plan to have outside shareholders who may question risky policies the board must implement to achieve success in a competitive market -- you may wish to look at your state BCA for this sort of director immunity provision. Adding this type of provision to your articles also makes sense if you want to reassure outsiders who serve on your board that they have the maximum legal protection possible. If you find an immunity statute in your state BCA, you can add the required language to your articles. A lawyer familiar with your state's BCA can help you get the job done right. (See Chapter 6.)

Duty of Loyalty

In addition to a director's statutory duty of care, state courts also say that a director has a duty of loyalty to the corporation. This duty of loyalty means a director must give the corporation a right of first refusal as to business opportunities the director becomes aware of while serving the corporation. If the corporation fails to take advantage of the opportunity after the board member discloses it, or if the corporation clearly would not be interested in it, the director can pursue it.

The duty of loyalty is simply a matter of fair dealing and common sense. No one wants a board member to take personal commercial advantage of an opportunity that arises within the corporate context unless the corporation itself is given first shot at it. If a board member violates the duty of loyalty, he or she can be held personally liable for the value of the commercial opportunity lost by the corporation.

Example: A corporate director, who also works as an officer, is researching sites for new corporate headquarters when he discovers land being offered at a ridiculously low price. He buys the land for himself to launch his own sideline business without first reporting back to the full board and letting it decide whether to make an offer on the property. A court finds the director personally liable to the corporation for the value of the bargain the director appropriated for himself -- that is, the difference between the bargain sales price and the higher prevailing market price the corporation ended up paying.

The duty of loyalty issue rarely presents a problem in a small corporation context where all directors are actively involved in the destiny of the corporation on a full-time basis; they don't have outside business interests that conflict with their corporation. But in larger corporations with outside board members who have separate commercial interests, conflicts may more easily arise. For example, a board member with an outside business may discover a business opportunity that presents itself at a board meeting or as part of the reports or information the director reviews. This opportunity may provide a possible advantage to the director's outside business, as well as the corporation's. In this situation, board members can't blithely go ahead and use the opportunity for their outside business without first telling the board that they are interested in doing so and seeking the board's permission.

Conflicts of Interest

If you browse your state BCA, you'll probably find a law under the "Directors" heading that deals with board approval of transactions in which a director has a financial interest -- for example, approval by the board of a lease of commercial real estate owned by a director. The title of this section may be "Directors' Conflict of Interests," "Board Approval of Self-Interested Transaction," or a similar title.

Throughout the states, these conflict of interest statutes share common provisions and features. In most states, the statute says that the full board is allowed to approve corporate business decisions that financially benefit one or more directors, as long as certain formalities are carried out. Typically, one way to approve such transactions is by the affirmative votes of a sufficient number of disinterested directors (those who will not benefit from the deal) after disclosure of the personal benefit to the interested director. The number of required votes is usually defined by statute as a majority of the full board without counting the vote of the interested director. (Most states allow you to count the interested director for purposes of obtaining a quorum for the meeting, but not to approve the deal.) Of course, in a small corporation it may not be possible to find a sufficient number of disinterested directors. For example, if two members of a three-person board financially benefit from a deal, the vote of the remaining one director will not constitute a majority of the full board.

Most states also allow the shareholders to approve a transaction that benefits a director. After full disclosure of the benefit to the director is made at a shareholders' meeting, a majority of shareholders must approve the transaction, not counting the votes of any shareholders who may benefit from the transaction. Again, in a small corporation, it may be difficult to obtain a sufficient number of disinterested shareholder votes, since the benefited directors may own most of the corporation's shares. Fortunately, most state statutes provide a third way to validate the decision. This alternative simply requires that the deal be fair to the corporation at the time it was approved by the board, even if it was approved in part by directors (or shareholders) who stand to benefit financially from the transaction.

Here are some points to keep in mind when considering rules relating to conflicts of interest:

• These rules normally come into play only if a board decision is later challenged in court by a disgruntled shareholder who sues the benefited director on behalf of the corporation. Typically, the suit will demand the benefited director pay back the amount of the undeserved benefit to the corporation -- plus interest, legal fees, court costs, and possibly punitive damages. If your small corporation does not have outside shareholders, you do not need to worry about shareholder suits, provided all your director-shareholders agree to the decision.
• If your deal is fair to the corporation -- that is, if the benefit that accrues to a director is the same financial benefit that would accrue to anyone doing business with the corporation in a similar deal -- it should withstand challenge, regardless of how it was approved. Another way of saying this is that a director, just like any other person or company, is entitled to do business with your corporation as long as the deal is fair and commercially reasonable. In fact, executives from other businesses, such as bank managers, investment advisers, and CEOs from other companies, sit on the boards of promising small corporations, not just to give expert advice and guidance but to help facilitate business between their corporations. Again, as long as the corporation doesn't put together sweetheart deals that favor these outside board interests at the expense of the corporation and its shareholders, the deals should be considered fair.

Director Approval of Shareholder Distributions

State BCAs impose limits on the payout of corporate profits and earnings to shareholders and other corporate insiders. Typically, these payouts are made in the form of dividends to shareholders. In small, closely held corporations, dividends are rarely paid, since they are subject to double taxation (even though under current federal tax rules, dividends are subject to low individual tax rates -- generally 15%).

However, other types of distributions that are subject to these BCA restrictions can occur -- for example, the buyback of shares by a director/shareholder or the payback of a shareholder loan made by a corporate insider. If the board approves a shareholder distribution in violation of state BCA requirements, each director can be held personally liable for the amount not allowed under the state's BCA.

State requirements for shareholder distributions vary. Most apply what is called a solvency test, which requires that the corporation be able to meet its expected financial obligations after the distribution -- that is, be able to pay its bills as they become due after the payout of funds to shareholders. Some states also add an assets test, which requires that corporate assets exceed liabilities by a specified amount or ratio. In states that use a par value scheme in the corporate statutes, additional limitations are placed on paying out funds from the corporation's stated capital account. (This is the financial account that holds all par value amounts paid in by shareholders; see "Par Value States," below.)

To find your state's shareholder distribution requirements, browse your state BCA's Shareholder section, looking for a statute with the title "Dividends," "Distributions to Shareholders," or "Payments From Stated Capital."

It doesn't pay to bankrupt your own corporation. As a matter of practice, any payment approved by the board -- whether to shareholders or to other corporate insiders, such as directors or officers -- is likely to be subject to legal attack if it leaves a corporation insolvent. The reason: This type of overspending is likely to be challenged later on as a violation of the director's duty of care to the corporation. Court cases in this area show that even shareholders in small corporations can personally recover money from directors who approve a generous payout to corporate insiders -- for example, a buyback of the founder's shares or repayment of a founder loan -- when it leaves the corporation without sufficient funds to stay in business. And even though general corporate creditors don't normally have legal standing to sue directors for breach of their statutory duty of care to the corporation, in extreme cases state courts have found ways to let creditors recover money from directors personally. For example, when directors close down their corporation by raiding its remaining cash reserves to buy back their shares without first paying off creditors, state courts have required the directors to personally pay the creditors.

Personal Liability to Outsiders

So far, we've focused on a director's personal liability to insiders -- that is, to corporate shareholders -- for causing financial harm to a corporation by:

• breaching the duty of care or loyalty to the corporation
• entering into a preferential personal business deal with the corporation without full disclosure and approval by the other board members or shareholders, or
• approving an unlawful distribution of corporate funds.

But what about a director's liability to outsiders, such as banks, vendors, or suppliers? As you already know, the basic limited liability rule is that board members are not personally liable for corporate debts and liabilities owed to or claimed by outsiders. This means that if an outsider successfully sues a corporation for unpaid bills or for failure to pay or perform under a corporate contract, the directors are immune from personal liability arising from the dispute. However, as is almost always true in law, there are a few exceptions to this standard rule:

• Personally signed loans and contracts. In the early phase of corporate operations, a bank may ask corporate founders to cosign a corporate loan and personally guarantee repayment if the corporation defaults. It may also ask the founders to pledge their own personal assets -- such as home equity -- as security for the cosigned loan. If a director signs a bank loan or any other type of corporate contract in the director's own name, that director will be personally liable in the event of a default under the loan or contract -- and any personal assets pledged as security are subject to seizure and liquidation.
• Unpaid taxes. If the corporation fails to pay corporate income or payroll taxes, the IRS and state tax agency can seek to hold any "responsible person," including a board member, personally liable for taxes plus interest and penalties. (See "Appointing an Executive Committee to Handle Employee Compensation," above.)
• Personal liability statutes. State and federal law may hold corporate directors personally liable for violations of special statutes -- for example, repeated or flagrant violations of environmental or toxic cleanup laws, or intentional violations of securities statutes. As a director, your best defense against this sort of personal liability is to stay informed of any special legal rules that apply to your corporation, and to vote "no" if a board decision may give rise to a legal penalty.
• Personal injuries. Directors are personally liable for injuries and other damage they personally inflict on others. The legal way of saying this is that directors are personally liable for their own legal torts. In other words, if you, as a corporate director, hold a press conference and unlawfully libel and cause harm to a competitor's business, don't expect the shield of corporate limited liability to protect you. You are personally liable for any damage you cause to other people, other companies, and their property.
• Corporate raiding. As mentioned in "Director Approval of Shareholder Distributions," above, if you raid your corporate cookie jar -- by approving an overly generous buy-out of your shares or some other self-interested business deal that leaves your corporation unable to pay its bills -- you may face a creditor lawsuit. In some states, a court will make you return the money to your corporation so the creditors can get paid -- plus order you to pay lawsuit-related costs and attorney's fees.

Director Indemnification and Insurance

As we've said, the directors of smaller, closely held corporations normally do not need to lose sleep worrying over whether they have met their statutory duty of care to their corporation. That's because corporate management and shareholders are normally the same people or, at the very least, are in close touch. Since directors and shareholders have the same information, even if corporate resources are used to implement risky corporate strategies that have lackluster financial results, shareholder lawsuits rarely follow.

But as a business grows and outside shareholders invest in the corporation's future, shareholder disputes can more easily arise. Outside shareholders are usually not aware of the nuances of board decisions. Even regular shareholder mailings and meetings may not be enough to educate shareholders about the wisdom of aggressive decisions made by the board to keep the corporation competitive. If the corporation loses money, one or more shareholders may file suit, seeking personal judgments from corporate directors for a failure to exercise their statutory duty of due care.

Fortunately, the laws of all states contain indemnification and insurance provisions that help a corporation protect its board members from having to pay money out of their own pockets, even if a shareholder suit succeeds or is settled on terms favorable to the shareholder. These statutes also help with other costs that must be paid even if the directors win, such as lawyers' fees and court costs (deposition costs and filing fees). Here's a brief rundown of how they work.

Indemnification

State BCAs contain indemnification statutes that cover some out-of-pocket lawsuit and settlement amounts a director may be asked to personally pay. "Indemnification" means that someone else promises to pay money to cover certain costs. BCA indemnification statutes specify the circumstances under which a corporation can agree to directly pay or reimburse a director for amounts that the director must pay because of an act -- or failure to act -- as a director.

If you browse your state's BCA, you'll find a corporate indemnification statute, titled "Indemnification," "Indemnification of Directors and Officers," or a similar title. These statutes tend to contain very similar provisions from state to state. Here's a summary of the provisions you're likely to find in your state's BCA:

• If director wins. Generally, if a director wins a lawsuit, corporations may indemnify -- pay the director -- legal costs incurred by the director, such as attorneys' fees and court costs. In many statutes, the corporation must pay these costs if the director succeeds in court.
• If director loses or settles. If a director loses a lawsuit or agrees to a settlement, the BCA normally allows the corporation to indemnify the director for legal judgments, settlements, attorneys' fees, and other costs if the director acted in good faith and in the best interests of the corporation. Typically, this determination must be made by a majority of the nonindemnified directors, by a majority of shareholders (not counting shares owned by the indemnified director), or by a court.
• Limits on indemnity. If the director loses a lawsuit or settles a controversy involving (1) the director's breach of the duty of care or loyalty; (2) the receipt of an improper personal benefit by the director; or (3) the payment of unlawful distributions to shareholders, the statutes normally prohibit any indemnification. These prohibitions make sense. In each of these situations, the director has unlawfully caused financial harm to the corporation. If the director pays the corporation for its loss and then the corporation reimburses the director for this payment, the corporation has won nothing at all -- it is left in a losing position, and the director is off the hook financially. Here's another way of saying this: A corporation cannot indemnify a director for unauthorized financial harm the director causes to the corporation; the director has to personally pay these amounts.

This is a very general summary. If indemnification is important to you, make a point to look at your BCA indemnification statute. Each state's law is different, and even small differences in wording can make a huge financial difference to your corporation and its directors if they are sued.

Insurance

Most state BCAs specifically allow a corporation to purchase insurance to pay for directors' personal lawsuit and settlement costs, including judgments, settlements, legal fees, and court costs. State statutes normally place no limit on what these policies may cover. Typically, they can cover all kinds of losses, whether or not the losses are eligible for indemnification under the state's BCA.

Commercial insurance companies call director and officer liability policies "D & O liability policies." As with any insurance policy, premium payments vary according to the deductible amount and total liability ceiling selected for the policy. Depending on the policy, insurance companies may make payouts to reimburse a corporation for indemnification it has paid a director, to advance or reimburse legal costs, or to cover settlements or judgments. And, because insurance can cover amounts that can't be indemnified under state law -- such as personal liability for a director's breach of duty to the corporation -- payouts also can go right to the directors to cover legal costs, settlements, and judgments not indemnified by their corporation.

Of course, D & O policies contain exclusions from coverage -- most won't pay if a director knowingly violates the law or commits fraud.

Officers

State BCAs specify the officer positions that a corporation must fill. These are known as the corporation's statutory officers and usually include a president, vice president, secretary, and treasurer. You list the names and addresses of your statutory officers in the annual filing you must make each year with your state corporate filing office. (This filing is a formality, and the fee to file your annual statement is normally small.) Most states allow one person to hold all the required corporate officer positions. We list the required statutory officer positions and related state law provisions applicable to officers in the "Director and Officer Rules" section of your state sheet in Appendix A.

State law normally does not impose specific requirements on what statutory officers must do, except to say that one officer -- typically the corporate secretary -- must be appointed to keep corporate records, including meeting minutes. Often, the boards of small business corporations fill the statutory officer positions as a formality to comply with state requirements, while the people who supervise and run the corporation day to day are given titles other than those required by law.

Example: DD Huge and Max MC form their own rap music publishing and artist representation company, Phat & Phunky Pheatures, Inc. To meet the statutory requirements, DD is appointed as the president and Max as the treasurer of the corporation. No salaries are paid for filling these statutory officer positions. DD is paid a corporate salary for acting as the Chief Rap Rep and Max is paid a salary as Caliph of Phinances. People are paid for what they do; not for their title.

In practice, the title given the top corporate officer is usually Chief Executive Officer (CEO) and the top finance officer is usually called the Chief Financial Officer (CFO). (A COO is a Chief Operating Officer.) Even the title vice president is outdated. Most corporations instead refer to second-tier corporate officers as associates, managers, or directors of a particular corporate department -- such as marketing associate, sales director, publicity manager, or director of online operations -- rather than using a vice president title.

The statutory officer position of secretary normally has no real-life counterpart in the everyday world of the corporation. In other words, the position of corporate secretary is one created to accommodate state BCA legal requirements, not the entrepreneurial needs of the corporation. However, the person appointed as secretary does have real work to do. As mentioned above, the secretary must keep the legal records of the corporation, preparing minutes of board and shareholder meetings. And banks and other financial institutions often require the signature or certification of the corporate secretary to attest that the board has approved items of business, such as a formal board resolution to approve a bank loan or line of credit. The secretary also normally handles all requests from the board or shareholders for copies of corporate legal documents -- such as corporate articles, bylaws, or minutes of meetings, or records of stock ownership in the corporation. Common practice is to delegate many of the duties of corporate secretary to another salaried officer -- commonly the chief corporate financial or administrative officer.

Whatever you call corporate officers -- and whatever tasks you delegate to them -- keep the following points in mind:

• Officers can bind the corporation legally to a contract or other business relationship unless the party they do business with knows the officer does not have authority to transact the particular business -- an exception that rarely occurs.
• Officers, like all corporate employees, are generally not personally liable for their acts while working for the corporation. However, like other employees (as well as directors), they are personally liable for any harm (personal injuries or torts) they cause to another person. (The corporation can be liable, too, if it was negligent in hiring the officer.)

Officers should sign contracts in their corporate capacity. No matter what their title, officers should sign contracts and transact business in the name of the corporation, showing the officer's title next to their signature. If the officer signs a contract without affixing a title after or under the signature, and the corporation defaults on the deal, the officer may be held personally liable for any loss caused by the corporation's default if the other party can show it was reasonable to believe the officer was transacting business on the officer's own behalf.

Shareholders

Shareholders invest in a corporation and elect its board of directors. They are not personally liable for corporate debts or other obligations. A shareholder's basic financial rights in the corporation are:

• participation in corporate dividends, and
• a stake in corporate assets (the shareholders' equity as shown on the corporate balance sheet).

In practice, shareholders of small corporations normally do not receive dividends. Rather, they wait until the corporation's overall value increases, then sell their shares. In a small, closely held corporation, the only market for these shares is another shareholder or the corporation itself. If the corporation has a good chance for success, the shareholder waits until the corporation is sold to another business that cashes out the existing shareholders or converts their shares to marketable shares in the acquiring business. And, of course, the corporation may go public and create a market for its own shares.

State BCAs contain various provisions that regulate and define shareholder responsibilities and rights. In this section, we look at the most common shareholder meeting provisions and stock issuance rules.

Annual Shareholder Meetings

Most state BCAs require shareholders to meet annually to elect (or reelect) the board of directors to a one-year term. Even in a small corporation, shareholders must receive written notice of annual meetings. Typically, this notice must be mailed or delivered within ten to 60 days before the meeting.

At a shareholder's meeting, a quorum must be present before the meeting begins. Most state BCAs require the presence, in person or by written proxy, of at least a majority of all the voting shares. The corporate secretary is normally required to bring an alphabetically ordered list of current voting shareholders and their share interests to the meeting, and to have it available for inspection by anyone who wants to see it.

Once a quorum is counted and the annual meeting begins, the names of directors are placed in nomination by those present, and the shareholder votes are taken. The standard voting rule is that each share gets one vote, and the nominees to the board who receive the highest number of votes (up to the number of directors to be elected) are designated as directors for the next one-year term.

In addition to standard voting practices, most states allow shareholders to use special cumulative voting procedures to elect directors. Under cumulative voting rules, a shareholder gets a number of votes to cast in an election that equals the number of shares owned multiplied by the number of directors to be elected. This total number of votes can be cumulated and voted for just one director, or split up and voted for more than one nominee.

Cumulative voting procedures vary from state to state. Some statutes say that shareholders can use cumulative voting unless it is prohibited in the articles. Some say that the articles must specifically authorize cumulative voting before it can be used. Even if cumulative voting is authorized by state law or the articles, the normal rule is that a shareholder must specifically request to use it at a shareholder's meeting to elect directors. If so, then all shareholders must cumulatively vote their shares for the election of directors.

We list your state's requirements for annual and special shareholder meetings in the "Shareholder Meeting Rules" section your state sheet. To read the full BCA provisions, see the "Shareholders" or "Shareholders' Meetings" section of your state's BCA. For cumulative voting provisions, look for a section called "Cumulative Voting" or "Election of Directors" under the "Shareholders" heading. Also look in the "Articles of Incorporation -- Required Provisions" section of the BCA to see whether you must place provisions to authorize or prohibit cumulative voting in your articles.

Special Shareholder Meetings

The board calls special shareholder meetings during the year whenever it needs shareholder approval for an important item of corporate business. In most states, the board must ask shareholders to approve:

• amendments (changes) to the corporation's articles
• the sale of substantially all corporate assets
• the merger of the corporation with another business, or
• other structural changes that affect existing shareholders.

For example, the board may wish to attract investment capital by creating a new class of preferred shares of stock that provide a liquidation preference to investors -- that is, that guarantee the preferred shareholder a return of two times the purchase price of their shares when they are sold back to the corporation or when it liquidates or is merged. (Regular shares do not contain this sort of preference.) State BCAs normally require the approval of at least a majority of all the existing shares of the corporation to create a new class of shares that has preferences not enjoyed by the existing shareholders.

The shareholders themselves can decide to call a special meeting of shareholders to exercise authority granted under the state BCA -- for example, to fill a vacancy on the board or replace a director, to amend the articles or bylaws, or even to vote to dissolve the corporation. State law normally sets a low ownership threshold for calling shareholders' meeting -- typically, 10% or less of the corporation's shares.

A standard state corporate law requirement is that only the business described in the notice of a special shareholder's meeting can be approved at a special shareholder's meeting. If new business comes up during the meeting, another special shareholders' meeting must be called and held to take care of it. Again, we list your state's BCA rules for the calling of shareholder meetings in the "Shareholder Meeting Rules" section of your state sheet.

Capitalization of the Corporation

A corporation needs people and money to get started. The money or dollar value of assets used to set up a corporation is called its capital, and the process of obtaining these start-up funds and property is called capitalizing the corporation. Most states have no minimum capitalization requirements. The District of Columbia is the exception. There a corporation must have at least $1,000 in capital before it begins doing business. (Capitalization requirements are explained in the "Articles Instructions" section of the state sheets in Appendix A.)

While it may be tempting to start a business on a shoestring and earn as you learn, the idea of starting a corporation with little money or assets is usually impractical. Business corporations are in business to make money, and you normally need at least a reasonable amount of cash and assets to begin corporate operations. To give your corporation the best chance of succeeding, we recommend that you fund your corporation with enough money and other assets to begin doing business and to cover short-range expenses, taxes, and debts. Of course, if your business will be based in your home, or otherwise get off to a low-key start, your initial investment or capitalization can be appropriately modest. In short, the important thing is not the amount you contribute, but that your start-up capital is large enough to meet initial business needs.

There are various ways to capitalize a new corporation. Here are the most common:

• Incorporating an existing business. The existing owners transfer the assets of an unincorporated business to the corporation in exchange for shares. Each owner of the previous business (who now becomes a corporate shareholder) receives a percentage of stock ownership equal to their ownership percentage in the prior business. This book provides a bill of sale form that unincorporated business owners can use to document the transfer of the assets from their unincorporated business to a new corporation in return for shares. (See "Prepare Receipts for Your Shareholders," in Chapter 4, Step 7, for the form and for a discussion of legal and tax issues that may arise when you incorporate an existing business.)
• Incorporating a new business. The founders pay cash and transfer property to the corporation in exchange for shares. If state law allows, some founders receive shares in return for a promise to provide services to the corporation or by promising to pay for the shares later. We discuss the specifics of stock issuance in "Sale and Issuance of Stock," below.
• Personal loans. Whether incorporating a new or existing business, some owners may decide to make a personal loan to the corporation in addition to buying shares. The corporation normally repays these loan funds within a few years, often with the corporation making interest-only payments during the loan term and paying off the principal at the end of the loan period.

Keep loan transactions reasonable. If shareholders will lend money to the corporation, it's best not to overdo it. Some tax advisers think it's dicey to have a debt-to-equity ratio of more than 3-1, while some are more aggressive and balk if the ratio gets close to 10-1. Ask your tax adviser for specific advice. During a subsequent corporate tax audit, the IRS may become suspicious of a corporation with a high ratio of debt to equity or with very loose shareholder loan arrangements. The IRS may treat shareholder loans as contributions of capital if (1) all or most shareholders contribute very little equity capital to buy shares, and lend money to their corporation in relative amounts that reflect their share ownership percentages; and/or (2) the loans are not backed up with written promissory notes, or don't contain a commercially reasonable rate of interest. This means that the corporation cannot deduct interest payments it makes under the loans and that all payouts made by the corporation -- both interest and principal repayments -- will be taxed to the shareholder as a taxable dividend.

For promissory notes and other corporate forms. Nolo's The Corporate Records Handbook, by Anthony Mancuso, provides several types of shareholder and corporate promissory note forms on CD-ROM with instructions, plus many useful corporate minute forms and resolutions for approving and implementing standard items of ongoing corporate business.

Sale and Issuance of Stock

Under state law, several things must happen before your corporation can issue stock to its shareholders:

• Your articles must authorize the number and type of shares you wish to issue.
• Your corporation must actually receive cash or property in exchange for the stock to be received by your corporation -- or written shareholder promises to provide services or pay cash if your state allows it.
• Your board must approve the value of non-cash payments for stock. ("Your Minutes of First Meeting of Directors," covered in Chapter 5, let you do this.)
• You must meet the requirements of state and federal securities laws.

How Many Shares Should You Authorize?

Since many states charge an incorporation fee based on the number of shares authorized in the articles of incorporation, many small business incorporators sensibly authorize the maximum number of shares they can for the smallest incorporation fee. In some states, more shares that have a nominal or "par" value can be issued than shares without par value to obtain the smallest filing fee, so this also is a consideration. (For a full explanation of the par value concept, see "Par Value," below.)

In the "Articles Instructions" section of your state sheet, we tell you whether your state charges an incorporation fee based on the number of shares authorized in your articles. We also tell you how many shares you can authorize (with or without par value) for the minimum fee.

In states where your incorporation fee is not based on the number or type of shares authorized in your articles, you can authorize as many shares as you wish, including shares for later issuance to shareholders. In all cases, keep the following points in mind:

• The shares authorized in your articles place an upper limit on the number and type of shares you can sell to your shareholders. If you want to issue more shares than the number authorized in your articles or wish issue a new type not mentioned in your articles, you must amend the articles and file the amendment with the state corporate filing office prior to issuing the new shares.
• The actual number of shares you authorize in your articles and later issue to your shareholders is arbitrary. It is the relative stock ownership percentages that have real meaning to shareholders when it comes time to pay dividends, buy back shares, or sell your corporation.

Example: Bob and Charlie form their own corporation and contribute equal amounts of cash to buy its initial shares. Each should get one-half of the shares issued by the corporation, so that each ends up with half of the total shareholder voting power, each participates equally in any payouts of corporate profits, and each receives equal net sales proceeds when the corporation is sold. To accomplish this, the corporation could issue Bob and Charlie each one share, one million shares, or any number in between, as long as each gets the same number of shares.

• You set the value of your shares when you form a corporation. You can choose whatever price you wish, as long as it is set the same for all of your initial shareholders. If you set a low share price, you issue more shares to each shareholder than you would if you set a higher share price.

Example: Let's say Bob and Charlie from the previous example each paid $10,000 into the corporation to buy its initial shares. If you set a share price of $10,000 per share, each is issued one share. If you set a share price of one cent per share, each receives one million shares (1,000,000 x $.01 = $10,000).

In some states, the maximum number of shares that can be authorized in the articles for the smallest fee is small -- perhaps just 100 shares. But this isn't a problem, for the reasons set out above. If you have ten shareholders and issue each five shares (for a total of 50 shares), each gets a one-tenth ownership interest in the corporation, even though each holds only ten shares. And you have 50 shares left to issue to future shareholders.

Par Value States

We tell you if your state uses the concept of par value in the state sheets in Appendix A. Par value is a nominal dollar amount given to corporate shares -- it is not their real value, just a stated value that has legal significance under the laws of the some states. These par value states employ the concept of par value to regulate both the issuance of corporate shares and how the corporation uses the funds it receives for their issuance, as explained below. In par value states, shares of stock are authorized in the articles with either:

• a statement of their designated monetary par value, such as "100,000 shares with a par value of $1.00 per share," or
• a statement that the shares are without par value, such as "100 shares without par value" (these are referred to as "no-par" shares in some states).

Despite its continued use in some state BCAs, par value is not given much weight in the commercial marketplace. Instead, under modern financial reporting procedures, the value of shares is a floating figure, based on a corporation's current net asset value -- that is, the amount by which corporate assets exceed corporate liabilities (also called "stockholders' equity"). In other words, it's outdated to assign a fixed or par value to shares.

There are a number of legal and financial consequences to consider if you are incorporating in a par value state. Here are the main ones:

Shares within each class must have the same par value or must all be designated "without par value." We assume your corporation will authorize just one class of stock -- called common stock -- in which each share has the same voting, dividend, and liquidation rights.

The incorporation fee in many par value states is based on the total par value of the shares authorized in the articles; if you authorize shares without par value, the shares are nevertheless assigned an assumed par value per share for purposes of computing the incorporation fee. (If you are incorporating in a par value state, we tell you in the "Articles Instructions" section of your state sheet whether it makes sense to authorize par value shares to obtain the lowest incorporation fee.)

Par value shares must be sold to shareholders for at least their par value. In most cases, as explained below, par value amounts are set at a low, nominal amount, so typically par value shares are sold for more -- usually much more -- than their stated par value. In par value states, there is no lower limit on the price for which you can sell shares without par value.

The corporation's stated capital account must reflect the amount received by a corporation for the sale of par value shares, as well as the total amount received by the corporation for the sale of shares without par value. The stated capital account is a standard account used in corporate financial accounting. Any amount received by the corporation for par value shares in excess of par value is reflected in the paid-in surplus financial account -- another standard account. Note that the board is allowed to allocate a portion -- even most, but not all -- of the amounts paid for shares without par value to this paid-in surplus account, rather than having it all sit in the stated capital account. (This allocation, typically, must be made within 60 days of the sale of shares without par value.)

By the way, there is another capital account: the earned surplus account. It contains the corporation's retained earnings, and it is from this account that the corporation may pay dividends to shareholders. We summarize these allocation rules and some of the important par value rules that apply to your shares in the "Stock Issuance Rules" in your state sheet.

Find an accountant who has experience with small corporations. At first encounter, some of this accounting information may appear daunting. Fortunately, the terms are often more complicated than the underlying concepts. If you don't have experience in this area, find an experienced small business accountant who does. A good accountant will make sure your financial record-keeping system is properly designed to accommodate the par value rules in your state.

In par value states, the BCA restricts any transfers of funds or allocations made on the books from the stated capital account to other accounts. The historical legal premise here is that the stated capital account is meant to serve as a cushion for creditors, and its balance cannot normally be lowered except in special, technical situations described in the state's BCA. This is true, even though the protection that a stated capital account is supposed to provide creditors is outmoded. Today, corporate creditors look at the entire financial picture of the corporation, not simply its stated capital account, to decide the corporation's creditworthiness. Besides, corporations sidestep many of the par value restrictions by (1) placing a nominal par value on shares so that the lion's share of the funds received for par value shares is reflected in the paid-in surplus account, not the restricted stated capital account, or (2) issuing shares without par value, then making sure the board allocates most of the funds received for these shares to the paid-in surplus account.

Payments for Shares

In all states, a corporation may sell shares for cash and both tangible and intangible property, such as equipment, machinery, computers, patent rights, copyrights, or trademarks. A corporation can also issue stock in return for the cancellation of a debt owed by the corporation to the shareholder. Normally, this occurs when a corporation issues shares as a payback for money owed to a shareholder who helped start the corporation.

Issuing stock certificates. The issuance of stock signifies the formal acceptance of payment for the shares and recording of a shareholder's interest in the corporate records. Technically, you do not have to issue paper stock certificates under most states' laws (recording the transaction on the corporate books is enough). But following tradition, most incorporators do issue certificates. For more information, see "Payments for Shares," above.

Stock Issuance and Taxes

Let's look at the basic tax treatment of the most common stock issuance scenarios: stock for cash, stock for services, and stock for property. This is a general guide. For more technical information, consult your tax adviser -- and check the small business tax information on the IRS Small Business and Self-Employed Web page at www.irs.gov/businesses/small/index.html.

State tax law normally follows federal law. The very basic tax rules discussed here come from the federal Internal Revenue Code. Fortunately, state tax rules normally follow these federal rules.

Stock for Cash

The issuance of stock for cash is normally not taxed. The tax consequences of the investment are usually deferred until shareholders sell their shares. At that time, buyers report on their individual income tax return any gain or loss on the sale, paying capital gains tax on any gain. (The capital gains rates are usually lower than the individual income tax rate that would otherwise apply to income earned by the individual if the shares are held for at least one year.)

Stock for Services

The issuance of stock for services is normally taxable. The person who provides the services must pay income tax on the value of the stock received -- just as if the corporation paid the person for performing work or promising to perform work for the corporation.

Stock for Property

The issuance of stock for property is normally taxable -- the person transferring the property pays taxes on the difference between the value of the shares and the person's income tax basis in the property. The person's basis in the property is normally the amount paid for it, less depreciation and other adjustments to the basis that were or could have been claimed by the person on his or her individual income tax return.

Fortunately, there is one big exception to the rule that the issuance of shares in return for property is taxable. Specifically, Section 351 of the Internal Revenue Code says that a property transfer in exchange for shares is tax-free -- just as if you bought corporate shares with cash -- if all the shareholders buying shares with cash and property at the same time end up with at least an 80% ownership stake in the corporation. There are two basic ways to use Section 351 to qualify under this tax-free property exchange rule:

• You transfer property to your corporation for shares. If you, together with the other shareholders of your new corporation who pay cash and/or property for their shares, will own at least 80% of your corporation's voting shares, each of you qualifies for tax-free treatment for your exchange of shares for property (the cash transfers are already tax-free).
• You and your co-owners incorporate an existing business. If you and the other co-owners of the unincorporated business will own at least 80% of the voting shares of the new corporation, your transfer of business assets in return for shares will be tax-free under Section 351.

In addition, there are many rules under IRC 351 that cover special situations -- such as the purchase of shares by someone who contributes both services and property. We discuss the special IRC 351 rules that apply when incorporating an existing business in "Tax Treatment When Incorporating an Existing Business" in Chapter 3. Again, your tax adviser and the IRS small business website (www.irs.gov/businesses/small/index.html) can help you further understand these technical tax rules.

Stock Issuance and the Securities Laws

A share of stock in your corporation is classified as a security under state and federal securities laws. These laws regulate the offer and sale of stock by small and large corporations alike. Federal securities law is contained in the federal Securities Act. We discuss its basic application to the sale of your initial stock to the founders of your corporation in "Federal Securities Laws," below. First, let's look at how your state regulates the sale of initial shares in your corporation.

State Securities Law

Each state enacts and enforces its own securities law. This law applies to the offer and sale of stock within the state. If you offer or sell shares outside your state, the securities law of the outside state applies to your out-of-state transactions.

Overview

The securities acts in each state are quite different, but they share the following five features:

• voluntary compliance
• disclosure requirements
• registration of nonexempt issues of stock
• agency approval of nonexempt issues of stock, and
• penalties for noncompliance.

Voluntary compliance. State securities agencies do not automatically track private sales of shares by corporations. You are expected to learn the rules and voluntarily comply with state law to protect your corporation and its investors.

Disclosure requirements. The basic rule for sales of stock in each state can be summarized simply: disclose, disclose, disclose. To comply with state law, you have a duty to disclose to investors all material financial and business information concerning the sale of shares. (This is called material disclosure; see "What Does ‘Material Disclosure' Mean?" below.) If you don't follow this rule, an investor can sue your corporation -- and in some cases, your founders personally -- to get their money back. And in some situations, investors may be able to collect punitive damages to punish dishonest sellers of stock for their underhanded business practices. So, the best way to comply with this basic disclosure rule is to honestly, and in advance of any stock sales, discuss the risks inherent in purchasing stock in your corporation, and to provide full financial disclosure to potential investors. Doing this will minimize your chances of being sued later by a disgruntled investor -- or, if you do get sued, of losing. In short, if you can show a court that an investor knew the risks of investing in your corporation before buying your corporation's shares, the investor, not your corporation or you, should have to assume any financial losses that result from the investment.

Registration. All states implement a securities registration system, which requires corporations that sell shares -- called issuers under the securities laws -- to file registration materials with the state prior to a sale of stock, unless the stock issuance is exempt from the registration requirements. Fortunately for new corporations, state securities laws contain exemptions that excuse you from registering your corporation's initial stock issuance. The idea behind these exemptions is to allow small corporations to obtain modest amounts of capital from well-informed insiders without having to bother with full-blown registration paperwork and fees. Most states provide more than one exemption that may apply to your new corporation. We discuss the most common exemptions in "State Securities Law Exemptions," below.

Agency approval of nonexempt issues of stock. If your stock issuance is not exempt, you must wait for your registration application to be approved by the state securities agency. If it is, your corporation receives a permit from the state to issue its shares. Most states implement a disclosure registration system that requires the issuer to file paperwork with the state containing all the financial, legal, and business details of the stock sale, as well as the risks associated with the investment. Potential buyers of the stock normally must receive a copy of these disclosures in a prospectus provided by the issuer before the sale. You will probably need to hire a lawyer and an accountant to help you prepare both your registration application and your stock prospectus.

Other states implement what is called a "merit" system of registration. In these states, you must provide the state and potential investors with all necessary registration information, just as in a disclosure state. Then, you must satisfy the state securities agency that your sale of stock is fair. Essentially, they scrutinize your registration application, then ask questions. To assure fairness, the office may impose restrictions on the securities offering -- for example, it may set a share price or limit the people to whom you may sell shares. The securities agency may place a limit on the sales price for shares, the number and types of shares you may sell, the types of people who may buy your shares, and how much each can invest.

Penalties for noncompliance. If you are required to register your stock issuance and you fail to do so, your corporation and you, personally, can be required to pay noncompliance penalties to the state. In extreme cases, you may face criminal charges authorized under state securities laws; but these are rarely brought to bear unless you really rip off your investors -- for example, by depositing their funds in your personal account instead of letting the money work to get your corporation off the ground.

To read your state's Securities Act and Regulations. In the "State Securities Information" section of your state sheet in Appendix A, we provide contact information, including a website, for your state's securities office. Securities office websites often contain a direct link to the state's Securities Act and Regulations. (If your state agency's website does not post or link to these statutes, we tell you how to find them elsewhere online.) Many securities office websites also provide general information on how to qualify for exemptions to registration requirements.

Further, most states encourage you to call the state securities office to learn more about available state securities exemptions -- they want incorporators to know the rules and how to meet them. You do not need to be a lawyer to call the securities office. In fact, you'll probably find the securities staff more helpful if you aren't an attorney. Many state securities offices have a stated policy of wanting to help business entrepreneurs tackle the technicalities of the securities laws in order to encourage new business formations in their state. Below, we discuss strategies that will help you use your state securities office website information in a sensible way.

Determining Your Securities Law Comfort Level

Before we describe the types of securities act exemptions you are likely to learn about on your state's securities office website, it's important to place this information in the context of forming a small corporation. Once you see the big picture, you can narrow your focus to the details of your state's specific exemption requirements. To do this, we recommend that you assess your securities law comfort level. This means asking yourself two questions:

How eager are you to learn the legal and technical requirements of securities act exemptions? If the whole idea of learning about securities law exemption requirements is unappealing or too technical for your tastes, it makes sense to pay a business lawyer to help you learn the rules.

Are your investors sophisticated businesspeople who are involved in running the corporation? If you're forming a small corporation with a close-knit group of business-savvy people who know each other well and will work together to manage and run the corporation, no one stands in a superior position to any of the others. You all know the risks of the enterprise, and each of you will stay equally informed as you try to make it a success. If things go badly, it is unlikely that one investor will sue the others for damages under the securities laws.

However, if any of your founders are unsophisticated or if you sell shares to outside investors who will not actively manage and run the corporation, the securities laws take on added significance. After all, the laws are designed precisely to protect people who pay money to others with the expectation of making a profit from the business activities of those who get the money. In other words, if your corporation fails, an unsophisticated or outside investor is more likely to ask a lawyer to sue to recover their investment from your corporation and its managers -- and that lawyer will, no doubt, look to see if the founders were in full compliance with the securities statutes when they asked for and received the investor's funds. If they weren't, the disgruntled investor may succeed in obtaining a court judgment for full repayment with interest to their clients plus attorney's fees, court costs, and perhaps punitive damages -- without having to show that their clients were treated unfairly.

Example 1: Barry and Beth incorporate their existing co-owned partnership to insulate themselves from personal liability, take advantage of corporate income tax splitting (see Chapter 4), and set up a stock option plan to motivate their employees. Each will receive one-half of the new corporation's shares in return for a transfer of their one-half interest in the partnership's assets to their new corporation. They both have a very high securities law comfort level: (1) after checking the securities laws, they know an exemption is available for the issuance of their initial shares, and (2) each knows what to expect from the other, and the risks associated with their existing business. Neither is very worried about their investment of partnership assets in the new corporation -- both understand that they will have to continue working hard to continue making a profit. With full disclosure of all business prospects and risks, neither is likely to sue the other over securities laws issues.

Example 2: After establishing that the securities law provides an applicable exemption, Beth asks her parents if they'd like to invest in Beth and Barry's reorganized business by buying shares in the new corporation. Her parents are fairly familiar with the business, accustomed to receiving a blow-by-blow description of its ups and downs from their daughter in her phone calls home. They say they'd be happy to invest a little to help give Beth's business a corporate facelift. Beth's securities law comfort level is high -- she believes her parents, who are reasonably experienced investors, understand the pros and cons of investing in her corporation. But Barry is more cautious. Knowing that Beth's parents may not fully appreciate the difficulties of making money in his and Beth's line of work, he insists on making a full disclosure of all material facts relating to their investment in a formal way. This consists of giving Beth's parents copies of current and past financial statements prepared for the partnership and a proposed business plan for the corporation's first year of operation. In addition, he insists on sitting down with both of them to explain the risks of their investment to them.

Example 3: Beth and Barry decide to use their incorporation as a means to obtain additional capital from unrelated outside investors. They plan on calling a number of their friends and acquaintances to see if any are interested in investing in their new company. This time, since they will be dealing with outside investors who won't know the business intimately, Beth's and Barry's security law comfort level is fairly low. Barry and Beth hire their own business lawyer to help them obtain a securities exemption for their stock issuance. They have browsed the securities laws and know they probably qualify for an exemption, but they want to make sure they dot all the i's and cross all the t's before selling any shares to outsiders. In addition, they recommend in writing that each investor have his or her own personal lawyer review the transaction.

As you consider your own situation, you may find that your comfort level is high. And that's fine. After reviewing your exemption choices, you'll probably go right ahead and issue your shares. But if the rules that apply to your situation look complex or your comfort level is lower than you'd like for other reasons, ask a business lawyer for help. (See Chapter 6.)

State Securities Law Exemptions

State securities laws contain different types of exemptions:

• Exempt issuer transactions. These exemptions apply to your corporation's initial sale of shares. Your corporation is the issuer.
• Exempt nonissuer transactions. These apply to sales of shares owned by your shareholders. You need not be concerned about these exemptions now, but your shareholders may want to rely on a nonissuer exemption later when deciding to sell their shares.
• Exempt securities. These exemptions apply to special types of securities, whether sold by an issuer or shareholder. State law often exempts securities of banks and other financial institutions, pension plans, stock option shares, and the like. In most cases, these security exemptions do not apply to the average business corporation wishing to sell initial shares to its investors.
• Broker or dealer exemptions. States not only regulate the sale of securities, but also the people and businesses who sell them. State securities law requires those who sell shares to meet licensing requirements and register as brokers, dealers, and salespeople. Fortunately, since your corporation does not expect to engage in the regular sale of securities as a business, it should qualify for an exemption from registration as a broker, dealer, or salesperson. But to be absolutely sure your state's broker-dealer rules do not apply to your initial issuance of shares, make a quick call to your state's securities office.

The remainder of this section discusses state exemptions from security transactions for issuers. This is the category of state law that helps most smaller corporations offer and sell their initial shares without having to obtain a registration permit from the state securities agency.

Your state's securities act may contain one or more of the following common exemptions in a section on exempt issuer transactions.

Incorporation exemption. Many states provide a straightforward exemption from registration for the initial issuance of shares to ten or fewer shareholders by a newly formed corporation. If your state offers this exemption, it is normally self-executing. This means that you don't have to file a form or pay a fee to take advantage of the exemption.

Small offering exemption. Many states allow a corporation, whether new or existing, to issue shares to a relatively small number of individuals without registration -- typically ten to 35 -- within a 12-month period. Some small offering exemptions require that: (1) you can't issue shares to more than ten in-state people within a 12-month period; and (2) the total number of in- and out-of-state shareholders during the 12-month period, counting all new and existing shareholders, cannot exceed 35. Pay particular attention to how the small offering exemption is worded. It can make a difference in how you count your shareholders. For example, you may not have to include certain shareholders in your count.

Limited offering exemption. Many states allow you to make a limited offering to 35 or fewer investors. Typically, you must offer and sell your shares privately, without advertisement. And you can't pay anyone a commission -- a percentage of the stock sale proceeds -- for helping to sell the shares. A limit may be placed on the total amount of money the corporation receives for the shares, and a time frame may be specified -- for example, you must count all sales made within a 12-month period. Some states require you to file a notice and pay a fee to rely on the state-limited offering exemption.

Most states make this exemption easier to use by saying you do not need to count "accredited investors" against the investor limit. (Spouses and relatives who share the same residence with an accredited investor normally do not need to be counted, either.) Accredited investor is a term borrowed from the federal Regulation D securities rules (see "Federal Securities Laws," below). Such investors often include corporate principals such as directors and executive officers, and sophisticated investors who meet specific net worth or annual income standards. Under most limited offering exemptions, you can sell shares to as many accredited investors as you like, as long as you meet the other exemption requirements.

Regulation D filings. Many states automatically exempt your issuance if you comply with one of the federal Regulation D stock issuance rules (see "Federal Securities Laws," below). Typically, you must file a copy of Form D, originally filed with the federal Securities and Exchange Commission, with the state, and pay a state filing fee.

Summing Up

Although state securities laws are highly technical, most states provide exemptions that small corporations can use easily, efficiently, and safely to offer their initial shares privately to founders and a limited group of family and/or sophisticated investors, without much red tape or fee expense. The "State Securities Information" section of your state sheet summarizes the most notable exemptions found in your state and shows you how to learn more by browsing your state's securities office website and state securities act.

But the quickest way to find out whether your initial stock sale qualifies for a state securities exemption is to email or call the securities office and ask them if they have an exemption that applies in your circumstances. Just tell them what you plan to do -- how many shareholders you'll have and what their connection is to your corporation -- and they may be able to give you the green light over the phone or send you a form to file to get the job done. If your state office isn't helpful -- most are, but there are exceptions -- you may wish to dig into the information provided on your state website, or hand the task over to a lawyer. And again, let your comfort level be your guide. It is one of the best indicators of how much to do yourself, and how much you may decide to pass along to a lawyer to do for you.

Federal Securities Laws

Federal securities laws apply to the issuance of corporate shares in all states. The reason the feds have a say in your stock issuance is that, one way or another, you will use the telephone, the mail, the Internet, or some other form of interstate commerce to carry out offers and sales of shares. This means that you can't ignore the federal rules when issuing corporate shares.

Federal securities law regulations parallel the state model discussed just above. You must register your initial offering of stock with the federal Securities and Exchange Commission (SEC) unless you qualify for an exemption. Failure to register, if you're required to do so, can result in financial penalties under the act and liability for your corporation and its founders. A disgruntled shareholder can seek rescission of the stock sale and collect interest on the money plus, perhaps, punitive damages. As discussed in the previous section, your best approach is to know your shareholders, make full disclosure to your investors, and pay close attention to your comfort level.

There are several federal exemptions available. Most small corporations that are eligible for a state exemption from securities registration should qualify under at least one of them. We present the most commonly used federal exemptions in the remainder of this section, in their normal order of applicability and usefulness. The first two do not require you to file any forms or pay fees, so look to them first. The third choice -- the Regulation D exemption scheme -- requires the filing of a form (but no fees). You probably will find that the initial sale of your new corporation's stock qualifies under more than one of the exemptions listed below. You should pick the one that's most convenient for you to use.

For more federal exemption information. The SEC website has a small business information page with links to helpful information on each of the federal exemption rules covered here, plus information on streamlined small business registration procedures if you decide someday to make a public offering of shares to obtain higher levels of capital. Go to www.sec.gov/info/smallbus/shtml.

Intrastate Exemption

Section 3(a)(11) of the Securities and Exchange Act contains the intrastate offering exemption for a sale of any share "which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within . . . such State or Territory." It is available for issuances of shares by a corporation to shareholders who reside in the state where the corporation was formed and where it carries out most of its business. This exemption is self-executing -- meaning that there is no form to file or fee to pay, and no limit is placed on the number of shareholders or the amount of money they can pay for their shares.

The intrastate exemption comes in handy for most newly formed, locally based corporations that simply issue their shares privately to a local group of shareholders. If your company owns out-of-state assets or does a substantial amount of business out of state, it may not qualify for the exemption. Federal Rule 147 (see "Intrastate Offering Regulations," below) provides a "safe harbor" set of rules for meeting the generally expressed requirements of the exemption. That is, it shows one way to be sure you are making a qualified intrastate issuance of shares. In part, it says that your corporation should qualify for the intrastate exemption if your corporation:

• has at least 80% of its assets, and earns 80% of its revenue, in your state
• has its principal office in your state
• makes offers and sales only to people who reside in your state, and
• intends to use 80% of the proceeds for business operations in your state.

You can make reliance on the intrastate offering exemption safer by getting each shareholder to sign a statement affirming that they are a resident of your corporation's state of formation and agreeing not to sell the shares to an out-of-state resident for a period of at least nine months after the initial issuance of the shares by your corporation.

You also make reliance safer if you place language on the face of your stock certificates -- this language is called a legend -- that says the shares have not been registered with the SEC and that they are subject to restrictions on resale. You also should place a notation in your corporation's stock records that the corporation should not transfer any stock certificates within nine months to out-of-state shareholders.

To download Rule 147. Rule 147 is not currently posted on the SEC website (www.sec.gov), but it may be available soon. In the meantime, you can download it from the Center for Corporate Law's website at www.law.uc.edu/CCL/33ActRls/rule147.html.

[Rule 147] omitted for online sample chapter.

Private Offering Exemption

Another exemption available under the Securities and Exchange Act is the private offering exemption. (It's actually called the nonpublic offering exemption, but we prefer to characterize it positively.) It is a one-line exemption contained in Section 4(2) of the Act for "transactions by an issuer not involving any public offering." It is a very generally stated exemption. Mostly, it applies to the private issuance of shares by a corporation to a small number of people closely connected with the business of the corporation. These individuals buy shares understanding the risk of their investment and knowing there is no market for the shares -- that is, they do not expect to sell the shares to another person. This is another self-executing exemption -- there are no forms to file or fees to pay.

The courts have discussed the basic elements that should be present when relying on this exemption (a leading case is SEC v. Ralston Purina Co., 346 U.S. 119 (1953)):

• The purchasers are able to fend for themselves due to their previous financial or business experience, because of their relationship to the issuer (the corporation, or its directors or officers), and/or because they have significant personal net worth.
• The transaction is truly a nonpublic offering involving no general advertising or solicitation.
• The shares are purchased by the shareholders for their own account and not for resale to others.
• The people to whom shares are offered are limited in number.
• The people to whom shares are offered have access to or are given information relevant to the stock transaction in order to evaluate the pros and cons of the investment -- for example, financial statements, a business plan, and information about risks.

In order to better understand the factors that should, and should not, be present when relying on the private offering exemption, the SEC issued Release No. 33-4552. This document contains several statements and examples regarding the private offering exemption. (See the text of the release itself, below.) For the most part, the release restates the factors listed above. It does provide additional guidance, however, to make reliance on the private offering exemption more certain. The guidelines are "safe harbor" rules, meant to show you a safe way to issue shares in a qualified private offering. You do not have to follow them, but we suggest you do to increase your chances of qualifying for the exemption.

Here are a few of these additional points (we've paraphrased and lowered the legal content a notch or two to make the material more digestible):

• The sale of stock to promoters who take the initiative in founding or organizing the business falls within the exemption. Sales of shares to people who will constitute the executive level of the corporation -- for example, directors and principal executive officers, such as the president, vice president, and chief financial officer -- also qualify. However, if stock is sold to uninformed friends, neighbors, and associates with no connection to the inner workings of corporate management, the stock sale doesn't qualify.
• If you go out and ask everyone who will listen to buy shares in your new corporation, you are making a public, not a private, offering, and you do not qualify for this exemption. This is true even if you end up selling shares only to insiders.
• Size matters. If you sell a significant dollar amount of shares -- even if you sell them to insiders, privately -- you are making a nonqualified public offering. The release doesn't provide numbers, just this general admonition not to get greedy.
• Don't sell shares to day traders or other high rollers. Selling shares to people with a penchant for stock flipping -- buying it one day, selling it the next -- will taint your private offering and make it look more like a public sale of stock.
• Your corporation should make an effort to control resales of stock issued under the exemption. The release suggests getting each shareholder to sign a statement that says the shareholder is buying the shares for investment, not for resale. Another suggestion is to place language on each issued stock certificate (called a legend) that says the shares have not been registered under the federal securities laws, have been purchased for investment, and can't be resold by the shareholder unless the resale transaction itself is registered under the federal securities laws or is exempt from these laws. Note that these procedural steps are offered in the release as suggestions. You don't have to follow them, but doing so helps your stock sale look even more like a private offering.

[Release No. 33-4552.] omitted for online sample chapter.

To download Release 33-4552. Release 33-4552 can be downloaded from the Securities and Exchange Commission's website at www.sec.gov/rules/final/33-4552.htm.

Regulation D Exemption Rules

Regulation D of the federal securities laws was enacted to make the sale of stock under the federal exemption rules more certain and to help smaller companies raise private capital. Regulation D contains three rules -- 504, 505, and 506 -- each of which is a separate exemption for the issuances of shares. The three rules have similarities, and each requires the filing of federal Form D with the SEC. There is no filing fee.

The amount of money your corporation may receive for shares, the number of purchasers, and the types of people to whom you can sell shares under each of the Regulation D rules vary. Each of the rules places importance on whether your shareholders are accredited investors. This term includes the directors and executive officers of the corporation, and people with either a $1 million net worth or an annual income of at least $200,000. If you limit sales to accredited investors, you may be able to advertise the availability of your shares, issue shares to more individuals, or have less stringent disclosure requirements. Following is a brief summary of the rules.

Rule 504

Rule 504 exempts offerings up to $1 million worth of shares in a 12-month period. In some cases, you can use Rule 504 to publicly advertise and sell your shares, depending on whether you registered your stock issuance with the state securities agency, delivered a disclosure document to your shareholders under your state's rules, or sell only to accredited investors. Many companies use Rule 504 together with their state's SCOR process (see the sidebar under "State Securities Law Exemptions," above) to raise $1 million in capital in a limited public offering.

Rule 505

Rule 505 exempts private offerings up to $5 million. Generally there must be no more than 35 nonaccredited investors, no general advertising is permitted, and specific financial and business information must be disclosed to any nonaccredited investors included in the offering. Shareholders receive restricted stock: They must agree not to sell their shares for at least one year without registering the sale. And the stock certificates should contain language stating that the shares are unregistered and that they may not be resold, unless the resale is registered or exempt from registration under the securities laws.

Rule 506

Rule 506 contains an exemption for the private issuance of shares. Most smaller, closely held corporations turn to Regulation D to obtain their exemption for a private offering of shares if they are not comfortable issuing their shares informally (without a filing with the SEC) under the private offering exemption discussed above.

Unlike Rules 504 and 505, there is no limit on the amount of money you can raise under this rule, though advertising is prohibited. As with Rule 505, you can sell shares to an unlimited number of accredited investors, and to no more than 35 unaccredited people. However, all nonaccredited investors must be sophisticated. This means that they, or their lawyer or other adviser who they designate to represent them, must have enough knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. The corporation must provide specific financial and business disclosures to all nonaccredited investors. You must also give each purchaser the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information that the corporation possesses, or can acquire without unreasonable effort or expense, that is necessary to verify the accuracy of information already furnished to the prospective shareholders. Stock issued under this rule is restricted. A legend on the stock certificates should say that future resales must be registered or exempt from registration under the securities law.

Doing a Regulation D filing under any of the Regulation D exemption rules requires work and technical expertise. You'll probably need the help of a lawyer who knows the federal securities rules to pick the best rule to use, meet its requirements, and prepare Form D. Lawyers typically charge $3,000 or so to help you with this task.

Strategies for Dealing With the Federal Securities Rules

Please review our discussion of assessing your state securities law comfort level, above. It applies here as well. Then consider these suggestions for approaching the federal exemptions and your initial stock issuance:

• Start by determining whether you clearly fall within the intrastate or private offering exemption. Probably 80% or more of small corporations issue shares in their state to their founders and easily qualify for both.
• If you are fairly sure you qualify for one of the two basic exemptions, but you want to raise your comfort level a little, review Rule 147 and Release 33-4552. Each explains ways to make reliance on each exemption more certain. For example, after reading Rule 147, you may decide to have all shareholders sign a statement that they reside in your state and that they agree not to sell shares to an out-of-state shareholder for nine months. Similarly, Release 33-4552 may motivate you to place a legend on your share certificates indicating that the shares are being purchased for investment and not for resale, and cannot be resold without registration or a determination that an exemption is available.
• If you are not sure whether you qualify for one of the two basic federal exemptions or if you want to use Rule 147 or Release 33-4552 but need help, see a lawyer.
• If you decide that you'd just feel a whole lot better following the specific exemption guidelines of one of the Regulation D rules, see a lawyer to select and meet the requirements of the appropriate rule (most likely Rule 506) and file Form D with the SEC.

Again, let common sense and good business judgment guide you. Whatever you decide, one other point bears repeating: Remember to disclose, disclose, disclose all material information to all investors in your new corporation. Finally, we recommend you ask an experienced lawyer to review your proposed stock issuance to ensure compliance with federal and state securities laws.