Business Entity Formation
The legal formation of a new California corporation begins with the filing of Articles of Incorporation with the Secretary of State’s Office. Similarly, the formation of a new limited liability company (LLC) begins with the filing of Articles of Organization. As your business attorneys, we will handle the filing of your articles, but that is merely the first small step in incorporating a new business. While the filing of Articles commences the legal existence of either new business entity, it is not sufficient to simply file articles. Unlike the online document filers, only knowledgeable business attorneys can provide you with advice concerning your entity’s capital structure, contracts, corporate governance and ongoing legal support.
1. Legal advice on choice of entity;
2. Perfecting the organization of the corporation by establishing the first board of directors and documenting all necessary board resolutions in the initial Minutes;
3. Filing all appropriate claims of exemption under state and/or federal securities law filings, such as the Limited Offering Exemption provided under California Corporations Code Section 25102(f);
4. Legal advice on what constitutes valid consideration in exchange for stock, and legal advice on adequate capitalization for your business and the dangers of being deemed “thinly capitalized” in the event of a law suit;
5. Filing the corporation’s Statement of Information under Corporations Code Section 1502 with the Secretary of State; and
6. Documenting the capital structure of the corporation, creating stock certificates and issuing them to the founding shareholders.
A non-attorney cannot advise you about the which entity is right for you, and will never finalize and perfect the organization of your corporation. A new corporation must issue stock to shareholders, comply with securities laws, elect a board of directors, appoint officers to run the corporation, and take a series of other board actions to perfect its organization. If a new corporation is not perfected, and its owners fail to follow the formalities of corporate governance, the corporate entity may not be respected when its owners need it most — when they are counting on it to shield them from personal liability in a lawsuit. Courts can choose to disregard the existence of a corporation that is improperly formed and governed, treating the entity instead as merely the “alter ego” of its owners. This is the primary reason why the founders of a new business should not rely on a non-attorney incorporation service to incorporate their business. While such services can file generic Articles of Incorporation, they cannot legally provide legal advice as to which entity is the right entity (e.g., corporation, LLC, limited partnership, and so on) for a business. Nor can they follow through with the perfection of the corporation’s organization by adopting bylaws, electing a board, issuing stock to shareholders and complying with securities laws, appointing officers and providing ongoing legal advice to the new corporate entity. As San Jose business attorneys, we offer just such advice.
California Corporation and Limited Liability Company (LLC) Distinguished
Although they have been in existence now since 1994 in California, the LLC still seems to mystify some. We do not intend here to provide an exhaustive explanation of all of the differences between these two legal business entities, but rather to simply provide a general overview of the main factors that distinguish them.LLC Management / Ownership Structure Is Less Formal than a Corporation
LLCs are in many ways more akin to partnerships than to corporations. Under the default rules provided in the Beverly-Killea Limited Liability Company Act (California Corporations Code Sections 17000 et seq.), an LLC’s ownership structure, management structure, and the rights and duties of owners (“Members”) to each other closely resemble those of partners to each other. LLCs do not (again, by default) have the hierarchical, multi-tiered structure of a corporation (which always must have shareholders, officers (in particular, at a minimum a corporation must have a President/CEO, a Treasurer/CFO, and a Secretary), and a board of directors. LLCs are considerably more informal and malleable. LLC members may create a structure that mirrors a corporate management structure, but they do so by agreement, not because such a structure is mandated by statute.Unlike a corporation, the LLC as a business entity, is granted perhaps more flexibility in how Members may choose to structure their relations to each other and their business than any other type of business entity. Members may choose to actively manage the company or be solely passive investors. Unlike with other entities, Members of an LLC may structure the equity ownership such that the distributions of income or debt made to them differ from their strict percentage ownership of the company. Finally, LLCs do not have to strictly adhere to some of the formalities imposed upon corporations — for example, you do not have to have annual shareholder meetings to elect a board of directors as a corporation would. For these reasons, the LLC is more flexible than a corporation.
Despite its informality, an LLC still offers a shield from personal liability for its Members for the debts of the company, just like a corporation. Please note, however, that no business entity shields its investors or managers from all forms of liability (see related discussion of The managing Members of an LLC, like the directors and officers of a corporation may still be held liable individually for their individual civil wrongs, such as making a fraudulent misrepresentation. What you do get from a corporation or an LLC is a liability shield from the company’s contract debts — the ordinary debts that arise in the course of business. If the LLC fails, your personal assets are protected.
Default Income Tax Treatment of Corporations Versus LLCs
By default a California corporation (or a corporation formed in any US jurisdiction) is treated by the IRS as a separate entity that must report its own income and pay taxes on that income. Subsequent distributions of net profits to shareholders are then again taxable as income to the shareholders. This is frequently referred to as the “double burden” of corporation taxation. However, provided that the corporation meets certain qualifications (i.e., no more than 75 shareholders, only shareholders who are natural persons and not other entities, only shareholders who are permanent US residents, etc.), a corporation may elect to be an “S” corporation under Subchapter S of the Internal Revenue Code, which eliminates the corporate level of income taxation. By becoming an “S” corporation, the entity becomes treated as a “flow-through entity” for IRS tax purposes, meaning that the corporation’s income is not taxed; rather its net profits “flow through” to the shareholders, and only the shareholders get taxed on these profits in proportion to their percentage ownership of the corporation.An LLC, on the other hand, is treated as a “flow through” entity by the IRS by default. An LLC does not need to elect such treatment.