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Corporate Kit -- Deluxe Edition

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The AllBusiness.com Practical Guide to Incorporation



Overview
Where to Incorporate
Limited Liability
Corporate Formalities
The Advantages and Disadvantages of a Corporation
Costs


Overview

Defined

A corporation is defined as a legal entity or structure created under the authority of the laws of a state consisting of a person or group of persons who become shareholders. The entity’s existence is considered separate and distinct from that of its members. Like a real person, a corporation can enter into contracts; sue and be sued; pay taxes separately from its owners; and do the other things necessary to conduct business. Since a corporation is an entity in its own right, it is liable for its own debts and obligations. As a result, providing that corporate formalities are followed, the corporation’s owners (the shareholders) typically enjoy limited liability and are legally shielded from the corporation’s liabilities and debts.

Life of a Corporation

The existence of a corporation is not dependent upon who the owners or investors are at any one time. Once formed, a corporation continues to exist as a separate entity even when shareholders die or sell their shares.

A corporation continues to exist until the shareholders decide to dissolve it or merge it with another business.

State Law

Corporations are subject to the laws of the state of incorporation and to the laws of any other state in which the corporation conducts business. Corporations may thus be subject to the laws of more than one state. All states have corporation statutes that set forth the ground rules as to how corporations are formed and maintained.

Where to Incorporate?

The laws governing corporations vary from state-to-state. As a result, a common question prior to incorporation is “Where should I incorporate?” The simple answer for the great majority of companies is that you should incorporate in the state in which your corporation intends to conduct the majority of its business. If you intend to do business in only one state, you should incorporate in that state.

Other Considerations

If you feel you might be interested in incorporating in a state other than the one in which your corporation will conduct the majority of its business, you will want to consider the following issues:

  • What is the tax rate for the state(s) you are consideration for incorporation?
  • What are the comparative costs of incorporation in a particular state versus the costs of registering to do business as a foreign corporation in that state?
  • What are the corporate laws of the state with regard to the rights and responsibilities of corporate shareholders, officer, and directors?
  • What are the corporate laws of the state regarding the rights of creditors?

When corporation laws were first being enacted by the states, several states purposely enacted laws to attract businesses to incorporate in their states even though the corporations would do business in other states. The first states in this group were New Jersey, Delaware, Maine, Arizona, and a few others. Today, Delaware is the clear winner. Close to one-half of all corporations listed on the New York Stock Exchange are incorporated in Delaware even though most of those corporations have their principal places of business elsewhere.

If you incorporate in one state and end up conducting most of your business in a different state, you will have to qualify to do business in that other state, which will involve more fees and costs, more filing requirements, and more paperwork. If your business actually conducts business in more than one state, or if it is a large, publicly held corporation, it can be worth the additional cost and time to incorporate in one state but operate in another state or states.

A corporation doing business in a state other than its state of incorporation is considered a foreign corporation. See Chapter 11 for a discussion about corporations qualifying to do business in states other than the state of incorporation.

Delaware

According to the Delaware Secretary of State, there are several reasons that so many companies choose to incorporate in Delaware:

  • The Delaware General Corporation Law is one of the most advanced and flexible corporation statutes in the nation;
  • Delaware courts and, the Court of Chancery in particular, have over 200 years of legal precedent as makers of corporation law;
  • The state legislature takes its role seriously in keeping the corporation statute and other business laws current; and
  • The office of the Secretary of State operates like a business rather than a government bureaucracy with modern systems and a customer-oriented staff.

The Delaware Court of Chancery has an excellent reputation and is predominantly a business law court. Its judges have a great deal of experience with business disputes. Other states have created similar specialty courts, but none have achieved quite the reputation of the Delaware Court of Chancery.

Highlights of benefits to incorporating in Delaware include:

  • Low cost incorporation fees;
  • No state corporation income tax for Delaware corporations not operating in Delaware;
  • No name or address disclosure requirement for the initial board of directors;
  • One person may hold all corporate offices;
  • The corporation must have a registered agent in Delaware, but not a business office; and
  • Claims relating to the corporation will be heard by the Delaware Court of Chancery.

It makes sense for a large, publicly held corporation to incorporate in Delaware. It also may make sense to incorporate in Delaware if your corporation will conduct business in more than one state. It does not, however, generally make sense for a small, privately held corporation that will only conduct business in another state to incorporate in Delaware.

If you are a California business only doing business in California, there will be extra costs and paperwork to be a Delaware corporation, and you should most likely choose to be a California corporation. But again, if you are only doing business in one state such as California, it will generally make more sense to be a California corporation.

Nevada

Nevada is another state attempting to attract businesses to incorporate there by enacting corporate-friendly laws. Some of the benefits of incorporating in Nevada include:

  • Anonymity for stockholders by allowing stockholders to avoid having their names becoming part of the public record;
  • Stockholders, directors, and officers may be nonresidents of Nevada;
  • No state annual franchise tax;
  • No state corporate tax on profits; and
  • One person may hold all corporate officers.

But again, if you are only doing business in one state such as California, it will generally make more sense to be a California corporation.

Secretary of State

The Secretary of State is the official who is responsible for handling each state’s business filings. The office of the Secretary of State for each state is where you file the documents and paperwork, and pay fees to create, manage, and dissolve a corporation. The best way to obtain the most up-to-date filing and fee information regarding your corporation is to contact your state’s Secretary of State, first by visiting your state’s Secretary of State website. All states provide access to corporate filing information in this manner. Contact information for the Secretary of State for each state is set forth at the end of this book in Appendix D.

Do I Need to Hire an Attorney to Incorporate My Business?

There is no requirement that you hire an attorney to incorporate your business. However, if you decide to incorporate in a state other than the one in which your corporation has its principal place of business, it is a good idea to hire an attorney. At other places throughout this book we note when it would be advisable to hire an attorney. This suggestion is made when the corporation is dealing in any of the more complicated corporate issues, such as taxes or securities issues.

If you think you might need to hire a lawyer at any point in the incorporation process or before or after, Appendix B includes a list of “10 Questions to Ask Your Business Lawyer” to assist you in selecting an appropriate attorney.

How Do I Find A Corporate Attorney?

You might want to hire an attorney to incorporate your business, or to review your incorporation documents. You might want to hire an attorney if you will incorporate in one state and do business in another. You also might want to hire an attorney to advise you on complicated corporate legal issues.

There are many ways to find an attorney, including:

  • Looking in your local telephone directory;
  • Calling your local bar association;
  • Asking colleagues and friends for recommendations;
  • The Legal Center at www.AllBusiness.com; and
  • Search online for attorneys at www.lawyers.com; or perform a search with a search engine for attorneys including your state and area of law.

And be sure to check the website of the law firm or attorney you select to evaluate the background and experience of the attorney.

Ten Questions to Ask Your Business Lawyer

Once you decide to hire a business lawyer, you have to find one who has the right experience for your business needs. Following is a list of questions to ask, the answers to which will help you determine whether you have found the right business attorney:

  1. How long have you been practicing law?
  2. What is your area of specialty?
  3. Have you represented companies like mine?
  4. Who are the attorneys and paralegals at your firm that would work on my matters and what experience do they have?
  5. How do you charge legal fees and for what expenses will I be charged (e.g., faxing, word processing, copying, postage)?
  6. Do you have sample legal forms, agreements, and policies that I can use for my business?
  7. How many corporations have you incorporated?
  8. What experience do you have in handling employment matters?
  9. What experience do you have in dealing with tax matters?
  10. What kinds of advice do you give to businesses to lessen the likelihood of litigation?

Limited Liability

Defined

One of the key advantages to forming a corporation as your business entity is that if it is properly formed and operated, creditors should not be able to successfully sue the corporation’s shareholders for their personal assets. This is what is known as limited liability. If something goes wrong, the shareholders will have only risked what they invested in the corporation and not their personal assets.

Exceptions

Shareholders’ personal assets are generally protected from creditors of the corporation. There are, however, certain circumstances in which limited liability will not protect those assets and a shareholder may be held personally liable, including possibly when:

  • There is a disregard of corporate formalities;
  • The shareholder personally injures someone;
  • The shareholder personally guarantees a bank loan or business debt on which the corporation defaults;
  • The shareholder neglects to deposit taxes withheld from employees’ wages;
  • Personal and corporate assets are commingled;
  • The corporation in inadequately capitalized; and
  • Corporate assets and liabilities are manipulated by the shareholder(s).

Piercing the Corporate Veil

Despite the general rule that a corporation’s creditors may not sue the corporation’s shareholders for their personal assets (known as limited liability for the shareholders) there are specific circumstances that permit creditors to pierce the corporate veil and satisfy corporate obligations by proceeding against assets of shareholders. Piercing the corporate veil is the exception to the rule, and although it is not often used, it is used in cases of fraud or other wrongdoing. It is used in circumstances where it would be unfair to permit a shareholder to “hide” behind a false or flimsy corporate veil.

While these cases are few and far between and usually involve very bad facts, you should keep always keep in mind that incorporation of a business does not afford a complete shield against liability for the corporate shareholders. The corporation should be treated as a separate entity, corporate formalities should be followed, and the shareholders, officers, and directors should act in a fair and reasonable manner in accordance with applicable corporate law.

Corporate Formalities

A corporation should follow proper corporate formalities in order to comply with applicable laws and to maintain its corporate existence. Any failure to follow these formalities might result in the loss of corporate status; loss of limited liability, leaving the owner and shareholders personally responsible for corporate debts; and potential loss of corporate tax benefits.

Corporate formalities fall into the following general categories:

  • Shareholder and director meetings (annual and special);
  • Signing documents as a corporation;
  • Corporate record keeping (financial and corporate documents);
  • State annual filings (corporate report, franchise tax, federal and state corporate tax);
  • Bank accounts (separate corporate bank accounts); and
  • Financial statements (income and cash flow).

A huge part of following proper corporate formalities is about creating and maintaining good records. The types of records you can be expected to keep for your corporation include the following:

  • Accounting and bookkeeping records;
  • Bank records;
  • Contracts;
  • Corporate records;
  • Correspondence;
  • Employee records;
  • Business forms;
  • Intellectual property records;
  • Marketing and advertising records;
  • Permits and licenses;
  • Stock records; and
  • Tax records.

Corporate formalities are discussed in detail in Chapter 8.

Advantages and Disadvantages of Forming A Corporation

Advantages

  • Limited Liability. One of the key reasons for forming a corporation is the limited liability protection provided to its owners. Because a corporation is considered a separate legal entity, the shareholders have limited liability for the corporation’s debts. The personal assets of shareholders are not at risk for satisfying corporate debts or liabilities.
  • Corporate Tax Treatment. Since a corporation is a separate legal entity, it pays taxes separate and apart from its owners (at least in the typical C corporation). Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. The corporation pays taxes, at the corporate rate, on any profits.
  • Attractive Investment. The built-in stock structure of a corporation makes it attractive to investors.
  • Capital Incentive. The stock structure also allows corporations to attract key and talented employees by offering an ownership interest in the form of stock options or stock.
  • Owner/Employee. A business owner who works in his or her own business may become an employee and thus be eligible for reimbursement or deduction of many types of expenses, including health and life insurance.
  • Operational Structure. Corporations have a set management structure. Shareholders are the owners of a corporation, who elect a Board of Directors, which then elects the officers. Other than the election of directors, shareholders do not typically participate in the operations of the corporation. The Board of Directors is responsible for the management of and exercising the rights and responsibilities of a corporation. The Board sets corporate policy and the strategy for the corporation. The Board elects officers, usually a CEO, vice president, treasurer and secretary, to follow the policies set by the Board and manage the corporation on a day-to-day basis. In a small corporation, the lines between the shareholders, Board of Directors, and officers tends to blur because the same people may be serving in all capacities.
  • Perpetual Existence. A corporation continues to exist until the shareholders decide to dissolve it or merge with another business.
  • Freely Transferable Shares. Shares of corporations are usually freely transferable because as a separate entity, the existence of a corporation is not dependent upon who the owners or investors are at any one time. A corporation continues to exist as a separate entity and is not terminated or dissolved even when shareholders dies or sell their shares. Shares of corporations are freely transferable unless shareholders have “buy-sell” agreements limiting when and to whom shares may be sold or transferred. Also, securities laws may restrict the transferability of shares.

Disadvantages

  • Fees. It costs money to incorporate. At a minimum, there will typically be four types of fees, including: a fee to file the articles of incorporation with the secretary of state; a first year franchise tax prepayment; fees for various governmental filings; and attorney fees.
  • Formalities. The proper corporate formalities of organizing and running a corporation must be followed in order to receive the benefits of being a corporation.
  • Paperwork. A huge aspect of the corporate formalities that must be followed consists of paperwork. Reports and tax returns must be compiled and filed in a timely fashion; business bank accounts and records must be maintained and kept separate from personal accounts and assets; records must be kept of corporate actions, including meetings of shareholders and Board of Directors; and licenses must be maintained.
  • Disclosure of Names of Corporate Officers and Directors. Most states do not require that names of shareholders be a matter of public record; however, many states require that the names and addresses of corporate officers and directors be listed on one or more documents filed with the Secretary of State.
  • Dissolution. Since corporations have a perpetual existence, states provide a mechanism for dissolving a corporation and liquidating its assets. Dissolution does not happen automatically. A corporation can be dissolved voluntarily or involuntarily. A corporation’s officers and directors are charged with responsibility for dissolving the corporation, including gathering corporate assets, paying creditors and outstanding claims, and distributing remaining assets to shareholders.
  • Tax Consequences. C corporations have potential double tax consequences—once when the company makes its profit, and a second time when dividends are paid to shareholders. S corporations can mitigate this tax issue. See Chapter 6.

As you can see, there are many advantages and disadvantages of forming a corporation, and you should be aware of all of them in order to make an informed decision as to whether forming a corporation meets your business needs.

A chart summarizing the key differences between various types of business entities is included in Appendix A. The chart compares C corporations, S corporations, sole proprietorships, general partnerships, limited partnerships, and LLCs.

Costs

There are typically four types of costs for forming a simple corporation:

  • Fling fees with the Secretary of State;
  • First year franchise tax payment;
  • Various governmental filings; and
  • Attorney fees.
Ranges for Incorporation Costs

Activity Fees
Filing fees with the Secretary of State $45-$300
First year franchise tax prepayment $800-$1,000
Various governmental filings $50-$200
Attorney fees $500-$5,000

Filing Fees

Each state requires a fee to be included along with the incorporation papers. The filing fee may be set, may be based on the number of shares authorized, or be a combination of both. The highest filing fee of $300 is charged by Texas, with Alaska coming in at a close second at $250. Most filing fees range from $75-$125. See Chapter 3 for a discussion about Articles of Incorporation.

Franchise Tax Payment

A franchise tax is the fee paid for the privilege of doing business in a state. Not all states charge a franchise tax as an incentive for businesses. Nevada does not charge an annual franchise tax payment.

Government Filings

Two factors will determine the types of governmental filings for your corporation: the type of business; and the state of incorporation. See Chapters 7, 8, and 11 for discussions of the types of filings required for corporations.

Attorney Fees

Attorney fees is the cost that can vary the most when you incorporate and will depend on several factors: whether you are incorporating a simple corporation; whether you incorporate in the state in which your corporation conducts the majority of its business; whether the corporation can qualify for exemptions from federal and state securities laws; and, whether your corporation is involved in a heavily-regulated type of business.