Forming a Corporation or LLC

Are you forming (or have you formed) a corporation or limited liability company (LLC)?  Here are some of the key legal considerations we will discuss with you:

What are the reasons for forming a corporation or LLC?

A principal reason for the formation of a legal entity is to separate the assets and liabilities of the business from the assets and liabilities of the founders, allowing protection of the founder’s personal assets from the liabilities of the business. We regularly form legal entities for our clients, including corporations, limited liability companies (LLCs) and partnerships.

What kind of legal entity is best for you?

In the United States, the decision regarding type of entity generally involves a corporation versus an LLC or sometimes a limited partnership (LP).  Each form of entity provides liability protection for its owners (other than the general partner of an LP), but each operates very differently for governance and tax purposes.  Choice of entity depends on many factors, including type of business, method of financing, employee equity compensation needs and tax considerations.  See my article, Choice of Entity for a Startup Company.

Should your corporation or LLC elect Subchapter S status?

Upon formation, a corporation should always consider the tax election between Subchapter C and Subchapter S for federal and state income tax purposes.  Note that the differences between a C corporation and an S corporation relate to tax treatment and requirements (including restrictions on shareholders), not formation or corporate governance.  In some cases, an LLC may elect Subchapter S treatment for specific tax reasons.  We always advise clients to engage a certified public accountant for assistance with corporate and partnership tax and accounting issues.

Where should you form your corporation or LLC?

For all types of entity, the state of formation is an important issue.  For a business operating in California, the choice is usually between California and Delaware.  In general, a business operating in California will be subject to California taxes, even if formed in another state, such as Delaware or Nevada.  If the corporation is formed in Delaware or another state other than California, but operates in California, the out-of-state or “foreign” corporation must qualify to transact business in California by registering with the California Secretary of State.  Many California-based startup companies incorporate in Delaware but neglect to qualify in California, which can result in significant penalties.

How is ownership allocated among participants in a corporation or LLC?

We counsel regarding allocation of ownership among founders, employees, consultants and investors.  See Structuring Founder Relationships.  Many founders are confused by the difference between authorized shares and issued shares.  The number of authorized shares is simply a limit in the articles or certificate of incorporation on the number of shares that may be issued, a limit that should not be exceeded.  Only shares actually issued are used in the determination of ownership.

How is a corporation or LLC managed?

Corporations are managed by a board of directors which elects officers to run the business on a day-to-day basis.  We will explain to you the differences between directors and officers and what requirements must be satisfied and what procedures must be followed for corporate governance purposes.  An LLC may be managed by one or more members (owners) of the LLC, or by managers who need not be members.

How much capital is required to form a corporation or LLC?

The initial capitalization of a company is an important but often overlooked aspect of forming an entity and preserving the liability shield offered by a corporation or LLC.  A creditor may be able to “pierce the veil” of a corporation or LLC – and reach a founder’s personal assets – if the entity is formed with no or minimal assets.  We discuss with you how much needs to be invested at the outset and the importance of always separating business and personal finances in order to maintain the limitation of liability.  Liability insurance is also needed for many types of business.

Should you form your own entity or hire a lawyer?

If you’re not a lawyer and you form your own entity, the process will in almost all cases be incomplete and the documents will be substandard.  The defects will become apparent if you try to attract outside investment or have a dispute with an employee or commercial partner.  Online incorporation services are not law firms and are not licensed to provide legal advice.  You receive none of the protection that comes from hiring a licensed professional.  You have no attorney-client relationship with an online service.  There are simply too many critical decisions and it’s too easy to make expensive mistakes when starting a new company.   Engaging a qualified attorney is a small investment relative to the value and importance of the services and the overall cost of starting a new business.

Already form your own corporation or LLC?

If you have already formed your own entity in California or Delaware, we can review the basic formation documents (articles/certificate of incorporation and bylaws for a corporation or articles of organization/certificate of formation and operating agreement for an LLC) and briefly identify serious problems without charge.  You can then decide whether or not you should replace those documents (or change type of entity or state of formation) before proceeding.  Of course, no lawyer can take responsibility for the contents of documents that he or she did not prepare before the documents were adopted and/or filed.