Formation of Corporations, Limited Liability Companies and Partnerships

We regularly form legal entities for our clients, including corporations, limited liability companies (LLCs) and partnerships. 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 start by counseling regarding choice of entity, typically corporation versus limited liability company (LLC) or limited partnership (LP). Each form of entity provides liability protection, but each operates differently for governance and tax purposes. Choice of entity depends on many factors, including type of business, method of financing, and employee equity compensation needs. See my brief article, Choice of Entity for a Startup Company.

For corporations, we discuss the tax election between Subchapter C or Subchapter S for federal and state income tax purposes. Note that the difference between a C corporation and an S corporation relates to tax treatment and requirements (including restrictions on shareholders), not formation or governance. We always advise clients to engage a certified public accountant for assistance with corporate tax and accounting issues.

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 or Delaware. In general, a business operating in California will be subject to California taxes, even if formed in Nevada. If the corporation is formed in Delaware or another state (other than California), but operates in California, the “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.

We counsel regarding allocation of ownership among founders, employees, consultants and investors. 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. See Structuring Founder Relationships.

Corporations are managed by a board of directors which elects officers to run the business on a day-to-day basis. We 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.

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 assets. We discuss 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.