- Reasons to Form
- Considerations When Forming
- Types of Entities in California
- California Secretary of State Fees
In addition to providing the full suite of IP services, we also provide business law services, such as forming business entities and assisting with the ongoing legal obligations associated with certain business entities, e.g. attending annual board of director meetings and filing required annual filings with the Secretary of State and other regulatory agencies.
I. Reasons to Form – Limited Liability
The main reason, by far, people consider forming a business entity is to limit liability exposure. Some types of business entities have what is known as “limited liability” while other business entities have “unlimited liability.” As a general rule, business entities which exist as a separate legal individual, a legal person so to speak, have limited liability for the investors/owners; while business entities which are not separate legal individuals have unlimited liability. For example, corporations, LLCs, and LLPs have limited liability for the investors/owners; while sole proprietorships and general partnerships have unlimited liability.
A very important note regarding so called “limited liability”
Even with the so called limited liability business entities, an individual is always liable for their own torts. So if you are an owner, a director, or an officer of a limited liability business entity and you commit a tort, you may be liable for the tort. Whether you may receive indemnification from the business entity is another question, but as a general rule you may be liable for your individual torts, even if committed while acting within the scope of the business entity. For example, consider you as a single shareholder owner, the single director, and the CEO of a corporation and while making a business related delivery you negligently cause a motor vehicle accident. Per the general rule, you will likely be personally liable for this tort.
So when we talk of limited liability, this generally means the investors/owners of the limited liability business entity are not liable for the debts of the business entity, e.g. for contracts gone bad. Also with some limited liability business entities, the investors/owners may not be personally liable for the torts committed by other investor/owners.
An IP example. Consider yourself an inventor who obtains a patent claiming their invention. Wisely you have assigned the patent rights to a business, a corporation or a LLC which you are the sole owner of. Now a potential infringer sues you and the business seeking a declaratory judgment that the patent is invalid. Because it is the business which owns the patent rights, you should be able to have yourself dismissed out of the suit.
In contrast consider unlimited liability. Assume you are one of two partners in a general partnership. Your other partner, without your knowledge, enters into a terrible business deal that goes sour, leaving the general partnership liable. However, the general partnership does not have sufficient assets to take care of this debt and so the creditor may seek your personal assets to secure payment of the debt. In some jurisdictions and depending on the facts, the creditor may even be able to reach your personal assets before exhausting your partner’s personal assets, but generally the entities assets must be exhausted first. (Whether you may obtain indemnification from your partner is another question entirely.)
The moral, “limited liability” certainly does offer some potentially very valuable liability protection, but limited liability is not “no liability,” it is not a perfect shield against all forms of liability. Whereas, “unlimited liability” can expose you personally to horrendous liability. If your business is profitable, it should be a limited liability entity.
Other Reasons to Form – Fundraising and Exit Strategy
Other reasons you might want to form a limited liability business entity is your potential investors may require that such an entity be in place before they will make a financial investment with you. Generally, this means an entity such as a corporation or a LLC.
From a transactional perspective, the corporation is the best entity for bringing on investors and raising capital, because changes in ownership are conveyed by the transfer of shares. Now of course, modernly and presently the LLC is very popular and depending upon your business, you may also be able to effectively fundraise with a LLC.
Additionally, your exit strategy from your business, if you have one, may also play into the type of business entity you form. Are you planning on being acquired by a larger entity? Are you planning on selling your ownership to one or more others? Just like with raising capital and bringing on investors, the corporation is ideally suited to transferring ownership upon your exit, because all you essentially need to do is transfer your shares to the acquiring entity.
With that said, any of the business entities that are available, one may be able find investors, raise capital, and have a successful exit strategy. But some of the business entities make such transactions potentially easier and less costly to facilitate; while others types of business entities are tougher to find investors, raise capital, and have a successful exit. For example, with LLPs and PCs the investors must also be an appropriate professional.
II. Considerations When Forming
The main considerations when contemplating forming a business entity are tax liability, what state to form in, and the type of entity to form.
Tax Liability
Generally, if the business entity is limited liability then it is a legally recognized individual, a legal person. And just like natural persons, legal persons like corporations and LLCs may also be taxable, both by the states they operate in and by the federal government (i.e. the IRS). This is commonly known as “double taxation.” In a double taxation scenario the income of the corporation is taxable and then when corporate derived income (e.g. dividends) is disbursed to investors, that income is also taxable. For most business owners then, double taxation is bad, undesirable and to be avoided. Double taxation is generally only viable for large publicly traded corporations, which may have thousands of investors which are generally disconnected and not involved in day to day management. But for smaller businesses choosing a business entity form that is not doubly taxed may be optimal.
As an alternative to double taxation, there may “pass-through” taxation business entity forms. For example, “S” type corporations have pass-through taxation and are not double taxed like the “C” corporation is. LLC’s may also be setup with “S” corporation pass-through taxation or taxed like a partnership which may have pass-through taxation.
State to Form in
The question of which state to form the business entity in and what type of business entity to form are closely related questions. This is so, because business entities are creatures of state law and thus any given business entity generally owes its existence to the state’s statutory and common laws. (Statutory law is law developed by legislatures and common law is law developed from the decisions of judges.) For example, the available types of business entities that may be formed in California may not be same as the available types of business entities that may be formed in Texas.
The most popular states to form a given business entity in are: the state(s) in which the business operates in, states with no income taxes, and Delaware.
Delaware…
For example, the majority of publicly traded corporations are Delaware corporations. Part of the reason behind Delaware’s popularity is historical. Delaware was an early adopter and the leading developer of corporate law, particularly when that business entity was still novel. Since then, Delaware has developed a significant body of both common law and statutory law, wherein such a body of law provides some degree of certainty to legal issues, which business owners crave.
As noted, the body of business and corporate law of Delaware largely protects publicly traded corporations and thus such laws may not be the best suited laws for start-ups and smaller non-publicly traded business entities.
States with No Income Tax – e.g. Nevada and Florida
Some also taut benefits of forming a business entity within a state that has no income tax, such as Nevada and Florida. As you may have guessed, those who taut this option are typically such states. Forming your business entity in a state with no income tax may actually cost you more money on an annual basis than if you had simply registered in your home state (assuming your home state is not a state with no income tax). For example, if your home state is California, but you formed your business entity in Nevada, you may not be saving yourself any money. While you may not owe any income tax to Nevada, you’ll still owe money to California. If your business entity is profitable you’ll owe California income tax. And if your business entity is not-profitable you still owe an annual registration fee to the California Secretary of State for registering your “foreign” business entity. In addition, by forming in Nevada, when your home state is California, you’ll incur a cost to maintain a Nevada address for mailing official and legal notices. Additionally, you may owe Nevada for a business license and an annual filing fee cost. Thus, unless your home state is a state with no income tax, we do not generally advocate forming within such a state.
Home State
Generally, we advocate forming your business entity in your home state. Which for most start-ups, means forming the business entity in the state in which you are domiciled in, i.e. the state of your primary residence.
For our business entity formation services, our services are limited to forming business entities within the State of California, since we are California licensed attorneys.
III. Types of Entities in California
Generally within California the following business entities may be formed:
1. Sole Proprietorship
2. General Partnership
3. Limited Partnership (LP)
4. Limited Liability Partnership (LLP)
5. Corporations (Inc., Co., Corp.), including non-profit
6. Limited Liability Company (LLC)
These six types of business entities may also be broken down into which entities have unlimited liability and which have limited liability.
You may also want to visit the California Secretary of State’s website for what business entities may be formed within California, see e.g. http://www.sos.ca.gov/business/be/starting-a-business-types.htm
Unlimited Liability – the Sole Proprietorship and the General Partnership
Both the sole proprietorship and the general partnership have unlimited liability wherein the owner’s may be personally liable. The owner’s personal assets may be at risk. Generally both types of entities are also not recognized as legally distinct persons and so are generally not double taxed.
The main distinguishing aspect between a sole proprietorship and a general partnership is simply the number of business owners. With a sole proprietorship there is only a single natural person owner. With a general partnership, there is at least two owners.
There is no formal requirement to form either a sole proprietorship or a general partnership. There is nothing that has to be filed with the California Secretary of State. Business checking accounts needs not be opened. As long as you are attempting to sell goods and/or services for a profit you may be a sole proprietorship.
For a general partnership to be formed, all that is needed is “an association of two or more persons (or entities) to carry on as co-owners of a business for profit.” California Corporations Code (CCC) section 16101 (9). You need not have any written partnership agreement. The case law is replete with individuals who were carrying on as co-owners of a business for a profit – i.e. were in fact a general partnership – and the owners had no idea they were in fact such a business entity with unlimited liability.
Limited Liability California Business Entities
In California, the corporation, the LLC and the LLP are the limited liability business entities. But first a note regarding LP’s, i.e. limited partnerships.
Limited Partnerships (LPs)
A LP has at least one general partner and at least one limited partner. The general partner generally has unlimited liability and the limited partner generally has limited liability. Traditionally, the limited partner must be a “silent partner” i.e. essentially a financial partner and not an active management partner. If the limited partner engages in active management, they may become a general partner with unlimited liability. This is known as the “control rule.” CCC section 15903.03. In California LPs are creatures of statute, not common law, and do require a filing with the Secretary of State to be formed. However, a partnership agreement need not be in writing.
Corporations (Inc., Co., Corp.)
Corporations are limited liability business entities and are legally separate and distinct persons, apart from their owners. Ownership in a corporation is conveyed by owning at least one share in the corporation. Corporations are relatively old as far as business entities go, which is beneficial because in all jurisdictions there is a significant body of both case law and statutory law to draw from, which provides some certainty with legal issues related to corporations.
Corporations are unique in that ownership and management need not be vested in the same entities. For example, owners are shareholders, entities which own shares. Whereas management is done by a board of directors. Shareholders elect directors to the board. The board makes the management decisions of the corporation. The board may hire special employees of the corporation, known as officers, such as a President, CEO, CFO, Secretary, etc. The shareholders, directors, and officers may all be different. In smaller corporations, the shareholders, the directors, and the officer may be the same entities. In fact in California one may form a single shareholder corporation, wherein that single shareholder is also a single director and a single officer.
Advantages of the corporate form of business include:
Limited liability;
Ease of ownership transfer, by transferring shares – facilitates fundraising and exit strategy;
Significant body of case law and statutory law; and
May have perpetual existence.
As a potential disadvantage, because of the extensive history of corporations, corporations may be rather formal business entities, where it may be important to observe corporate formalities to continue to receive the benefit of limited liability. This may entail holding formal annual shareholder meetings, annual board of directors meetings, documented by formal meeting minutes, filing annual reports with appropriate regulatory bodies. When there may only be a handful or less of shareholders, adhering to such corporate formalities may seem like a burden. To alleviate this disadvantage, most jurisdictions, including California recognize what is called a “close corp.” wherein adhering to corporate formalities may be somewhat relaxed. However, even in a close corp. a shareholder/director/officer should not mix personal assets and corporate assets, as this may permit a creditor/claimant to “pierce the corporate veil” and obtain personal assets of the shareholder/director/officer. Even with a close corp. the shareholder/director/officer should respect the separateness of the corporate identity in order to continue to receive the limited liability offered by the corporate form of business.
In addition to setting up a “close corp.,” one may also decide how the corporation is to be taxed, i.e. whether the corporation will be a subchapter “S” corporation with pass-through taxation or a “C” corporation with double taxation – per the IRS code. While pass-through taxation is generally preferred for most smaller business entities, forming a type “S” corporation does have some limitations. For example, there is a cap on the maximum number of shareholders you may have, which is currently 100. The shareholders must be natural person, and U.S. citizens or resident aliens. And you may only have one class of stock. Note, it is actually technically correct to form the California corporation and then to elect subchapter “S” status for that formed California corporation by filing form 2553 with the IRS.
Additionally, if your corporation is for certain professionals, you may establish a “professional corporation” which is distinguished by the “PC” suffix in the corporate name. For example, professional corporations may be formed for accounting, dental, law, and medical corporations. But, some corporations, such as engineering firms and real estate companies may not be considered professional corporations per the applicable section of the CCC. See e.g. CCC section 13400 et seq.
In California, a corporation is only properly formed when the Secretary of State acknowledges your proper filing of an “Articles of Incorporation.” Such a properly formed corporation is known as a de jure corporation.
Thus to form a corporation in California the “incorporator” or his agent (i.e. attorney) must file a statutorily proper Articles of Incorporation. There is some specific information that must be addressed in the Articles of Incorporation in order for the Secretary of State to sign off on them.
For example, per CCC section 202 the bare bones minimum statutorily acceptable Articles of Incorporation must address:
1. Appropriate naming requirements of your proposed corporation. Your proposed corporate name cannot be confusingly similar to another business entity already registered with the Secretary of State. And your corporate name should end with one these suffixes: “Limited,” “Ltd.,” “Inc.,” “Corp.,” or “Co.”
2. You must include a “Purpose Clause.” Usually your purpose clause should be general in nature. If you do use a narrow purpose clause you could potentially create future ultra vires issues if you stray beyond your narrow purpose.
3. You must include a name and address of your “Agent for Service,” i.e. a person whom is authorized to receive official correspondence, such as summons, subpoenas, and the like. This person must be a natural person, i.e. a real living human and not a corporate entity.
4. You must state the number of shares which are authorized and the number of classes for the shares. However, you need not disclose your actual capital structure or your initial capitalization.
5. Singed by the incorporator. Usually, we have the client, you, sign off on the prepared articles.
Additionally, per CCC section 204 here are some optional provisions one might want to include within the articles: if the corporation is a “close corp.,” whether voting is cumulative, and whether there are any preemptive rights.
In addition to filing a proper Articles of Incorporation, there are at least two other documents one generally creates when forming a corporation: bylaws and shareholder agreements. Both bylaws and shareholder agreements need not be filed with the Secretary of State.
Once the Articles of Incorporation have been successfully filed, a first organizational meeting should be held, wherein director(s) are elected and bylaws are adopted. Such a formal organizational meeting should be documented in meeting minutes. And then a “Statement of Information” must be filed with the Secretary of State within 90 days of filing the Articles of Incorporation.
Limited Liability Corporations (LLCs)
In many respects LLCs are a hybrid of the corporate form of business and general partnerships. Like corporations, LLC’s have limited liability and are legally separate and distinct persons, apart from their owners. Like corporations, LLCs may elect subchapter “S” pass-through taxation status with the IRS, if the limitations are met. And like corporations, a single member LLC may be formed, i.e. similar to a single shareholder corporation.
Advantages of the LLC form of business include:
Limited liability;
Flexible management structure;
Possibility of pass-through taxation (e.g. by electing subchapter “S” status or because is a single-member LLC); and
Less adherence to formalities associated with other business entities, such as the formalities associated with the corporate form.
Unlike corporate ownership, wherein the owner is a shareholder owning at least one share, ownership in a LLC is via membership, which is more akin to ownership in a general partnership. But the management structure of a LLC may be setup to mimic the management structure of corporations, this is known as “manager-managed” and must be affirmatively elected in the Articles of Organization, wherein the default LLC management structure is “member-managed” which is more akin to a general partnership management structure.
Unlike corporations, LLCs are a relatively new business entity. This means there is less of a body of well established law to draw from as there is with corporate law. In fact when new LLC legal issues pop up, the courts often look to whether a similar issue is settled law with respect to corporate law and/or with respect to general partnership law as a source of guidance.
Also because LLCs are relatively new business entities and because they are creatures of state law, LLC law currently varies much more from state to state, than corporate law from state to state. For example, in California, LLCs are for general types of business; but, LLCs are not permitted for professional businesses, such as lawfirms. But in other states, e.g. in New York, a lawfirm may be a LLC. Thus if your business has operations in several states, forming a LLC may not be the best choice sense each state looks upon LLCs differently and choosing the LLC as your business form may create some confusion.
To form, instead of filing Articles of Incorporation as one would do with a corporation, with LLCs one files “Articles of Organization” with the Secretary of State. California also does require an Operating Agreement, which is akin to bylaws in a corporation. But the Operating Agreement may be written or oral.
Limited Liability Partnerships (LLPs)
Lastly we have the limited liability partnership, the LLP. In California the LLP is only for architects, accountants, and attorneys. The vast majority of California LLPs are lawfirms. To form, one must file a form LLP-1, “Application to Register a Limited Liability Partnership (LLP)” with the Secretary of State. The filing fee is at least $70.
A Note on Foreign Entities
Also, other business entities, “foreign entities,” that may have been validly formed in other States (and sometimes other nations) may be recognized by California. If such foreign entities are operating in California, especially if such foreign entities maintain an office in California, the California Secretary of State may require the foreign entity to register and pay an annual fee. And the foreign entity may also owe California income taxes.
IV. California Secretary of State Fees (other governmental fees may be applicable)
The California State fees associated with forming various business entities, as well as ongoing fees, do change from time to time, so the current fees may be checked at the California Secretary of State’s website:
http://www.sos.ca.gov/business/be/forms.htm#gp
As of July, 2014, the main business entity formation fees are as follows:
For Corporations
$100 to file Articles of Incorporation for most types of for profit corporations, i.e. general, close, and PC. Plus $25 to file a “Statement of Information,” which must be filed within 90 days of filing your Articles of Incorporation, and thereafter annually.
For Non-Profit Corporations
$30 to file Articles of Incorporation for various non-profit corporations. Plus $20 to file the “Statement of Information,” which must be filed within 90 days of filing your Articles of Incorporation, and thereafter annually.
For LLCs
$70 for filing Articles of Organization. Plus $20 for Statement of Information, initially filed within 90 days of filing Articles of Organization and the every other year thereafter.
For LLPs
$70 initial filing fee (for filing Application to Register a Limited Liability Partnership (LLP)).
For LPs
$70 for initial filing fee (for filing Certificate of Limited Partnership (LP))
Our Legal Fees … for our business entity formation pricing click here.