Q: When people come to you with documents that they self-prepared at an online incorporation services site, what are the risks?
A: First you run into the very basic issue of choosing the wrong entity or setting it up in the wrong state, which are very expensive mistakes to make and can be very complex to remedy.
There’s the issue of Corporation versus an LLC versus a partnership.
Then there is the issue of California versus Delaware and often another frequent state that people consider is Nevada.
The reason Nevada comes up so often is that businesses in California very often are under the impression that if they incorporate in Nevada, they do not owe California taxes. This is an incorrect impression. If you are doing business in California, you will owe California taxes regardless of the state in which you are incorporated.
More specifically, the kinds of mistakes that people make when obtaining forms from online services related to, for instance, the capital structure of the entity.
In the formation documents for a Corporation, you have to specify the number of authorized shares, and you very often have to specify something known as the par value of the common stock of the corporation. I consistently see inappropriate numbers used for authorized common stock and par value in either self-drafted documents or documents obtained from an online service. Very often, people do not authorize enough shares. And very often, people assign too high a par value to the stock. They will assign a par value of a dollar, or ten cents, or a penny, where typically you want to be no greater than a fraction of a penny per share.
This has implications in the future and also can have potential tax implications. That’s one of the mistakes I see: A bad initial capital structure – too few shares, too high a par value. Part of that is a frequent misconception between the concept of authorized shares and issued shares.
Let’s say you authorized ten thousand shares of a common stock, there’s a belief that until you’ve actually issued all those ten thousand shares, you haven’t fully issued the ownership of the company. So, if someone receives a thousand shares out of ten thousand share authorized, they think they only own ten percent of the company. But if a company only issues a thousand shares out of the ten thousand, then whoever receives that thousand shares, owns one hundred percent of the company.
It’s a misconception that a great many founders, when they are dealing with a corporation make or have; They think that the authorized number is the same as the ownership of the company; it’s important to understand that distinction.