Many businesses start out as a sole proprietorship or a partnership of individuals. This may be the best form for you to conduct your business. However many businesses choose to operate as a legal entity such as a corporation or limited liability company. There are economic and tax advantages to consider as well as questions of liability to creditors. Every case situation is a little different. Please feel free to call me to discuss these issues.
As you operate your business you are constantly making decisions. Many of these decisions have serious legal consequences. Put me on your team so that you can get in touch with me on an as-needed basis. I am generally available by phone or e mail to answer your questions.
You may need a contract or lease reviewed. I have had years of experience doing this type of work. I believe you will find my turnaround time is reasonable.
I am a firm believer in "preventative law". By this I mean taking legal steps to avoid legal problems before they occur. Choosing the correct legal form in which to do business (sole proprietorship, corporation, etc.) is an important factor for avoiding legal liability. Also you need to ensure that the contracts you sign are not going to cause legal disputes in the future. I make it my business to do what I can to keep your business out of trouble.
In the unfortunate event that you do wind up in litigation I can handle the case for you. I have years of experience at conducting lawsuits on behalf of my clients. I always try to obtain the best results possible at the minimum of expense to my clients.
MAYBE A SOLE PROPRIETORSHIP WILL WORK FOR YOUR BUSINESS.
Many business people decide they do not need an "entity". The simply conduct business as a sole proprietorship. If a sole proprietor wishes to conduct business under a name which is not his own name then he must file a Fictitious Business Name Statement with the county or counties in which he wishes to conduct business.
YOU MAY NEED TO FILE A FICTITIOUS BUSINESS STATEMENT
What happens if a business owner, say "John Smith" fails to file a Fictitious Business Statement but nevertheless operates under a name not his own such as "Acme Products"? Usually the business owner runs into a problem when he receives a check made payable to "Acme Products". His bank won’t take it because the business bank account has been opened in the name of "John Smith". The bank will tell John to go file a Fictitious Business Name Statement.
There are other reasons to file a Fictitious Business Name Statement. For example John Smith cannot sue under the business name unless he has filed a Fictitious Business Name Statement.
What is the procedure for filing a Fictitious Business Name Statement?
The first thing you should do is make sure that the name you are using is not going to infringe on anyone else’s name. A good way to start is to put the name into a search engine and see if any potential competitors are revealed. But this is just a start. There are more effective ways to check. I can help with that.
Once you settle on a name obtain the form from the county or counties in which the business will be conducted. For the County of San Diego I suggest you go to the following web site:
http://arcc.co.san_diego.ca.us/arcc/services/fbn_info.aspx
The procedures are described on that web site. Also you can down load the forms. The fee you pay to the County is $20.00 for the first business name and owner AND $4.00 for each additional business name OR owner name.
You also must publish the Fictitious Business Name Statement in a legal newspaper. This can be expensive so you should check around with various newspapers. For example, the last time I checked the San Diego Union Tribune was charging $260.00. But the Coast News was only charging $38.00. Whatever newspaper you chose, make sure it is a "Legal Newspaper". They will tell you if you ask them. Most newspapers are "Legal Newspapers."
YOU MAY WANT TO INCORPORATE
It costs money to incorporate. Why would you want to do so?
REDUCING OR ELIMINATING LIABILITY BY INCORPORATING
The traditional reason for a business to operate in the corporate form is to limit liability. There are basically 2 types of civil legal liability:
1. Liability for a broken promise known as "breach of contract".
2. Liability for alleged wrongful conduct which is not based on a broken promise. This is known as "tort" liability. The most common tort is "negligence".
If your business is incorporated you may be able to reduce your liability if you are sued for either breach of contract or for a tort.
CORPORATE PROTECTION FROM LIABILITY FOR BREACH OF CONTRACT
An example of how having your business incorporated might limit your liability for breach of contract is as follows: You wish to lease a space and you have your corporation sign the lease instead of you signing the lease. If you are sued for not paying your rent (this is a kind of breach of contract) you can take the position that only your corporation is liable - not you.
If you didn’t pay the rent because your business has failed then you probably don’t care if your corporation is sued. But you may certainly care if you are sued personally.
The landlord may try to sue you personally anyway. He may tell the court that you have ignored corporate formalities such as keeping proper records or mixing your personal money with the corporation’s money. This is called "piercing the corporate veil". If you run the corporation properly, however, it is difficult for a creditor to "pierce the corporate veil." It is a good idea to have an attorney advising you how to set up and run the corporation to reduce the risk that a creditor can pierce the corporate veil and get to your personal assets.
CORPORATE PROTECTION FROM LIABILITY FOR TORT
Let’s say you send your employee out to pick up a package from the post office and, on the way to the post office, the employee negligently runs over a 35 year old orthopedic surgeon in a cross walk. Hopefully, you have good car insurance which covers you. But does your car insurance cover employees in the course and scope of employment? Maybe yes, maybe no. If the doctor would have been expected to have earned $200,000 for the next 30 years you might be held liable for $6,000,000 in lost earnings. Are your policy limits that high? Probably not.
If you were incorporated you would not have any personal liability (unless the estate of the deceased pierced the corporate veil.)
What if you, the business owner, commit the negligent act? For example, what if you were driving the car that killed the doctor? Or what if you are the surgeon yourself and you negligently cut off the patient’s wrong leg? Having a corporation will not help you in this situation if you yourself do the act. Therefore you should also have good liability insurance. Buying the right kind of insurance is a critical decision that every business owner must make. I can refer you to qualified insurance agent or broker.
REDUCING YOUR TAXES BY INCORPORATING
If you operate your small business as a corporation you will probably operate as an S corporation rather than a C corporation. The reason is that, in the case of a C corporation, the profits of the business are taxed one time at the corporate level and then a second time at the shareholder level when the profits are distributed as taxable dividends (double taxation). However, if you elect S status, there is no tax at the corporate level. The profits (and losses) of the S corporation are passed through to the shareholder(s).
When you operate as a sole proprietor, partnership, or LLC, you pay "self-employment taxes" on all the profits you earn from your business. Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% of net earnings up to $97,500 for social security (old age, survivors, and disability insurance) and 2.9% with no earnings limit for Medicare (hospital insurance).
Now, let’s assume you earn $90,000 in profits from your unincorporated business in a particular year. You’ll have to pay $13,770.00 ($90,000 x 15.3%) in self-employment taxes. And that’s on top of your State and Federal income taxes. Ouch!
Had you been an S corporation, you could have saved $6,886 in self-employment tax. How? As an employee of the S corporation, the shareholder/owner receives wages for his services. These wages must be reasonable. Additional profits are passed through to the shareholder/owner and are taxable for income tax purposes, but not for self-employment tax purposes.
For example, let’s use the same $90,000 in profits as above, but this time $45,000 is paid out as salary with the remaining $45,000 as profits. You, as an employee, would pay Medicare and Social Security payroll taxes on your salary ($45,000 x 7.65% = $3,443). The S corporation, as your employer, would pay the same amount of payroll tax on your behalf ($45,000 x 7.65% = $3,443) for a total of $6,886.
As an S corporation, the $45,000 in additional profits would pass to you free from self-employment tax – a tax savings of $6,886 ($45,000 x 15.3%)! (The half profit, half salary is just an example. Your tax advisor will give you the specific ratio that he or she deems correct for your situation.)
IS FORMING A COPORATION THE ONLY WAY TO LIMIT LIABILITY?
There are other types of business entities that business people use to avoid liability: LLCs, limited partnerships, trusts. As laws change from year to year the types entities popularly used go in and out of fashion. For example, in the 1970s and 1980 Limited Partnerships were popular. They are not so popular now. These days most business people either use a corporation (S type or C type) or an LLC.
LLCs, generally speaking, do not have the tax advantages discuss above that pertain to corporations.
So you might ask: If either an S Corporation or an LLC helps get you limited liability, but only an S Corporation gets you tax benefits, then why do so many businesses and investors use LLCs?
The answer is that an S Corporation might not work for your situation.
For example, if your business has more than one owner the profits must be paid to the owners in proportion to their ownership interests in the case of an S Corporation. The Internal Revenue Code allows for more flexibility in the allocation of profits in the case of an LLC. Two people might own a business equally but wish to share in the profits unequally. This is allowed for LLCs but not for Corporations (although you might be able to accomplish the same result by giving one of the shareholders bonuses or salary).
Also, if the business has too much passive income then you cannot use an S Corporation. Where the passive investment income exceeds 25% of the gross receipts for 3 consecutive taxable years then you lose the right to operate as an S Corporation. This is the reason you usually see investment operations such as real estate investment businesses operating as LLCs as opposed to S Corporations.
HOW EXACTLY DOES A CORPORATION OR LLC LIMIIT LIABILITY?
Corporations and LLCs accomplish the goal of limiting liability in the same way. A business person creates an "entity". This is the corporation or LLC. Then the entity conducts the business rather than the business person. That way if the business does something for which it gets sued (for example it fails to pay a debt) then the entity is liable not the business person.
But it doesn't always work that way. If the business person does not set up the entity correctly or does not run it properly then the creditor can pierce through the entity and sue the individual business owner personally. This is called piercing the corporate veil.
Sometimes a creditor of the business will require the business person to sign a personal guarantee prior to extending credit. This is very common in leases. Banks also very commonly require a personal guarantee from the borrower.
SO HOW DO I SET UP THE CORPORATION OR LLC SO AS TO STOP A CREDITOR FROM PIERCING THE CORPORATE VEIL?
I should say that, in law, there are rarely any guarantees or statements that can be made with 100% certainty. A business owner cannot be absolutely certain that doing business as a corporation or LLC but, by doing it right, he may be able to substantially reduce the risk.
LET’S START WITH CORPORATIONS
A corporation is legally formed when you file the articles of incorporation with the office of the California Secretary of State. If you go to their site http://www.ss.ca.gov/ you will find a great deal of useful information.
Currently the filing fee that you pay to the Secretary of State is $100.00. You can check to see if that's changed by going to this site: http://www.ss.ca.gov/business/bpd_forms.htm#be
A corporation must pay a minimum franchise tax every year. A franchise tax is a fax for the privilege of doing business in the State of California. This tax is collected by the Franchise Tax Board. They have a very helpful site at http://www.ftb.ca.gov/ The minimum Franchise Tax is $800.00 per year.
Here is how the Franchise Tax Board explains it:
"Minimum tax is the amount you must pay the first quarter of each accounting period whether the corporation is active, operates at a loss or does not do business. The current minimum tax is $800. For new corporations that qualify or incorporate with the Secretary of State after January 1, 2000, the tax is measured based on their income for the year and subject to estimate requirements. For subsequent years, the minimum tax $800."
To verify that the above information remains current check here: http://www.ftb.ca.gov/businesses/faq/712.html
Even though the corporation is technically formed as soon as you pay the $100.00 and file the articles of incorporation there are some other things you need to do to set it up properly.
You need to make some decisions: You need to determine things like who the officers and directors of the corporation will be, who will be the stockholders of the corporation and how much they will be paying to the corporation in exchange for their stock.
Once you make the various decisions on setting up the corporation you need to prepare minutes of the organizational meeting of the board of directors documenting these organizational decisions. You don't actually have to have a meeting if you do not wish but you have to properly document, in minutes, what decisions were made. You also have to prepare bylaws for the operation of the corporation.
You will need to purchase a book to put all these papers in so that people who are concerned with the corporation's activities (such as shareholder and maybe the IRS) can easily find the documents. If you want you can use any loose leaf notebook but companies sell special books for this purpose. You will also need stock certificates. There are many companies that sell these products. I like to use Attorneys Corporation Service: http://www.attorneyscorpservice.com/
I believe it’s important for the corporation to look "legit" when people like the IRS or prospective lenders or investors wish to examine the corporate records. Having a good quality minute book, in addition to adhering to the various required formalities is essential.
The corporation is going to need to open up a bank account. You will need to bring a copy of the articles of incorporation to the bank. In addition, some banks require you to bring in minutes of the board of directors which authorize the corporation to open the account and which state who has the authority to sign checks.
Sometimes the name of the corporation is not the same as the name of the business. For example, you might have a business called Mel's Pizza. But when you tried to file the articles of incorporation the Secretary of State rejected your articles because there is already a corporation in California named Mel's Pizza, Inc.
In this case you will probably file the articles of incorporation under a different name, any name, say Thallium Pizza, Inc., then file a fictitious business name as "Mel's Pizza".
If this happens you need to bring in to the bank proof that you filed the fictious business name statement before they will let you open the bank account.
Another one of the early things you do when you set up a corporation is to issue stock. You need to decide how much money is going to be paid for the stock and by whom. Many business owners want to pay as little as possible. The payment you make to the corporation in exchange for the stock is considered a "capital contribution".
Your attorney will tell you that if you contribute too little to your corporation as capital then someone could accuse you of having a "thinly capitalized" corporation. If the corporation is thinly capitalized creditors may be able to pierce the corporate veil. There is no exact answer to the question of "How much is enough?" I sit down with my clients and discuss the issue in detail.
Your tax advisor will also have thoughts on the amount of your capital contribution. The amount of capital the shareholders have invested will have tax consequences.
You might ask: To whom do the shareholders pay the purchase price for the stock? The answer is that the shareholders deposit their personal funds into the corporation's bank account. The date of that deposit is the date of the stock issuance. That date appears on the stock certificates.
Shares of stock in a corporation are considered "securities". It is illegal to sell securities unless you obtain approval from the government or have an exemption from the approval process. The approval process, called "qualification" is lengthy and expensive. The governmental agency in California that is in charge of this process is the Department of Corporations. http://www.corp.ca.gov/index.htm
Most small businesses rely on the exemption set forth in Corporations Code Section 25102(f). This exemption from the approval process may be used if the stock will be sold to no more than 35 people, there is a preexisting relationship between the stockholders and the corporation, the purchasers are buying the stock for themselves and do not plan on reselling the stock at the time they purchase it, and the sale was not advertized.
You can find a complete of explanation these requirements at http://www.corp.ca.gov/pdf/25102fcpcs.pdf
In order to use the 25102(f) exemption you must file a notice with the Department of Corporations within 15 days of the day you make that deposit into the corporate account in exchange for the stock.
You are required to file the notice electronically (which is actually a really nice convenience). The link to the page which you must enter the data in order to electronically file the notice: http://www.corp.ca.gov/loen/loen.htm
Of course there are fees. But they are modest. If the purchase price of the stock is $25,000 or less it’s only $25.00.
Shortly after you file the articles of incorporation you or your attorney will receive a notice from the Secretary of State that you need to file a Statement of Information. (This used to be called Statement by Domestic Stock Corporation) You may file it electronically or by mail. The fee is $20.00. Here's a link to the page if you want to file it electronically: https://businessfilings.ss.ca.gov/
Shortly after incorporating you will need to get an Employer Identification Number or EIN from the IRS. This is sometimes called a "Tax ID Number." The IRS uses this number to identify taxpayers that are required to file various business tax returns. People that pay your corporation money will ask you for the EIN because they know that they must put that number on the 1099 forms that they file.
You obtain the EIN by filing Form SS-4 with the IRS.
The EIN can be obtained online from the IRS at the following site: http://www.irs.gov/businesses/small/article/0,,id=102767,00.html