Articles Posted in Corporations

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In Parts I and II of this Article I talked about how important a complete and properly formed business entity is for estate planning and liability protection. There are also many other potential impacts of not having your corporation or LLC documentation in order. Here are just a few:

IRS Problems: Just over five years ago I got a call from a licensed contractor in Campbell who was being audited by the IRS and needed to present his corporate minute book to the auditor in five days time. His company had not done minutes of the shareholders or the board of directors for the previous six years. It took us much more time to go back and recreate the corporate minutes and ended up costing my client at least twice what it would have if we had prepared the minutes each year when the information was fresh. However, it was necessary to document certain shareholder loans which would not have been upheld by the IRS if they weren’t properly authorized by the corporation.

Securities: Many new business owners do not understand that an ownership interest in a corporation or a manager-managed limited liability company is considered a security and may require federal and/or state securities filings. Failure to make these required filings may result in shareholders having rescission rights whereby they can demand their investment back from the company, and any person controlling the entity could have personal liability to return those funds.

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Filing your Articles of Incorporation or Articles of Organization with the Secretary of State is only the first step in creating your corporation or LLC. Unfortunately, most online business formation services take your money and don’t do much more than that for you. And many do-it-yourselfers don’t perform the required tasks unless they are somehow notified that additional filings or documents are needed to complete the formation of their entity. Even some business owners that have an attorney form their company correctly initially often fail to keep up the required formalities. The problem with stopping at filing your Articles, or even your initial formation documents, is that if you do not treat the corporation or LLC properly, then the courts can do what is called “piercing the corporate veil” and look through the company to the business owners for liabilities of the business.

Some of the basic formalities required in order for the courts to maintain the liability shield of a corporation include:

• Holding annual meetings of the shareholders and the board of directors.
• Maintaining the corporate minute book, including organizational minutes, corporate resolutions authorizing or ratifying major decisions, and minutes of annual shareholders and board meetings.

• Issuing and canceling stock certificates as appropriate and maintaining an accurate stock ledger.

For both corporations and limited liability companies, requirements include:

• Having bylaws for a corporation or an operating agreement for an LLC.
• Not commingling funds with personal funds or funds of another entity, including maintaining separate bank accounts, paying company expenses out of the company only, and not running individual expenses through the company.
• Making required Secretary of State filings.
• Filing federal and state business tax returns.
• Making required federal and state securities filings

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I recently met with a new client from San Jose whose father was dying. My client’s father owned a small business and was a director and officer of that company. There were two immediate issues for us to deal with. First, the corporate minute book was a mess and we needed to clean up the stock certificates and minutes of the board and shareholder meetings quickly to make sure they actually said what my client’s dad intended. Second, we needed to re-title several assets that were supposed to be in the corporation but were not currently titled that way, including some real property in Campbell.

Why is the minute book important? In this case, the share certificates were inconsistent and did not agree with the Articles of Incorporation or the stock ledger. This could result in a shareholder dispute as to ownership of the company and voting control. Also, there were no minutes for the last five years. Without minutes of the shareholders and the board of directors, the corporation was risking its liability shield. [See Part II of this Article for more about Liability Protection.]

Why is the title of the assets important? Assets owned by the corporation should be in the name of the corporation and not held personally by a shareholder. In this case, assets were in dad’s name but he had always treated them as owned by the corporation. So, if dad died and left the corporation to his son, he was intending those assets go with it. But, those key assets of the company would not be included in an inheritance that leaves the corporation to the son and the other assets to other beneficiaries. In addition, property that is not titled in the name of the corporation might not carry the liability protection of the corporation in case of a lawsuit. [See Part II for more about Liability Protection.]

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Any large business transaction, particularly a merger or acquisition, requires a well-coordinated team for success. Assembling your team early on makes a large difference between success and failure, whether you are in San Jose, California or Sydney, Australia.

The most critical advisors are your attorney and your accountant. If you are a business owner and you don’t have an attorney or an accountant advising your company, you need to get one now. Although either professional can “parachute in” to assist your company in the event of a sale, their advice to you will be much more efficient and effective if they have direct and long term experience with your company. Failing to have ongoing advice in legal, tax, and financial matters will likely result in the need for remedial work and higher expense in closing a business sale.

Finding a suitable attorney will likely be your first task in assembling your business team. As with any advisor, you should use your referral network to find a professional that is appropriate to your business. You should only choose someone who you believe can act as a trusted, strategic advisor in planning, growing, and selling your business, rather than someone who can merely produce documents. An attorney who you allow to attend your board and/or shareholder meetings and generally become familiar with your business will be able to advise you on building the proper foundation for an ultimate sale of your business. He or she will also be able to tailor their advice to the realities of your business and your own risk preferences.

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Whether your business is located in Silicon Valley or somewhere else, whenever you hire someone, that worker is either an independent contractor or an employee. Using the correct classification is crucial because federal and state governments are targeting businesses with incorrectly classified employees to collect substantial employment taxes and penalties. In addition, workers may sue for employee benefits they claim they should have been eligible for.

How do you determine the proper classification?

The IRS and the state governments have different tests. The IRS tells you to consider behavioral control (do you have the right to control what will be done and how?), financial control (is the worker offering their services to others and incurring their own costs?), and relationship of the parties (more than just the title of any employment contract). California boils it down to one question: Does the employer have the right to direct and control the manner and means in which the worker carries out the job? If the answer to that is not clear, there are ten secondary factors to consider.

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In Part 1 of this entry, I discussed problems that some of my Silicon Valley clients have had with improper choice of entity – either because the tax consequences weren’t considered, or because restrictions in the California Corporations Code or Business and Professions Code were not taken into account. Here are two more expensive mistakes that business owners make when they try to form their own corporation or LLC online.

1. Not doing the required securities filings.

Online sites may not tell you that if you fail to file California and/or Federal securities filings you could be in violation of securities laws resulting in tremendous personal liability to return funds to your investors, despite the liability shield the entity is supposed to provide. Sometimes by the time I get involved it is too late to fix this, but sometimes we can do a late filing and get some, if not all, of the protection it provides. Corporations, as well as some LLCs and partnerships, are securities and must be treated accordingly.

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I was in Los Gatos getting my hair cut this weekend and my hairdresser said something very interesting – he said that his best clients are the ones who try to do their hair themselves (especially their color) and then come to him to fix the mess they made. He said they are so grateful when he fixes the problem they created that they become clients for life. I am not the type of person to try to do my hair myself – too much risk for me. However, it struck a chord with me because it seems more and more I spend my time working with clients who have formed their own corporation or limited liability company through forms found on the internet, and then come to me to fix some problem they caused.

What is wrong with forming your own corporation or LLC online? Nothing, if you know what you are doing. However, most people who are starting a new business and need an entity do not specialize in forming companies. Here are two of the four most common (and costly) mistakes I have helped my Silicon Valley clients fix:

1. Picking the wrong type of entity — with disastrous tax consequences.

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