MEMORANDUM
FOR
A NEWLY INCORPORATED BUSINESS
This memorandum summarizes briefly certain information for the shareholders, officers and directors of a newly incorporated business. The decision to operate a business in the corporate form involves an understanding of the benefits and the pitfalls of a corporate legal structure. Because laws and circumstances change, please call upon us to clarify or expand upon these matters. You may also want to consult the accountant for the Corporation about some of the issues.
Corporate Formalities
Powers and Duties of Directors and Officers
Issuance of Shares
Transactions with Directors and Officers
Biennial Filing with the Secretary of State
Unfair Competition and Trademark Registration
Corporate Qualification or Name Registration
Fictitious Names
Selection of Accounting Period and Method
S Corporation Election
Employer Identification Number
Estimated Tax Installments
Income and Franchise Tax Returns
Federal and California Withholding Rules
California Sales and Use Taxes
Workers' Compensation
Casualty and Public Liability Insurance
Labor and Employment Laws/Employment Manual
State and Local Business Licenses
Buy-Sell Agreement/Estate Planning Documents
A corporation is a separate legal and taxpaying entity. To maintain this
separate status, and the related benefits, certain
formalities are needed.
One of the chief benefits of conducting business in
the corporate form is that shareholders usually are not
liable for corporate debts and liabilities. Under
the"alter ego doctrine", the benefit of this
limited liability may be lost if there is evidence that
the shareholders have ignored the Corporation as a
separate entity.
When considering whether the Corporation is the alter
ego of its shareholders, a court will consider a number
of factors, including,
The presence of one or more of these factors will increase the likelihood that the shareholders will be held personally liable for debts of the Corporation.
Accordingly, meetings of the shareholders should be held regularly, and not less frequently than annually. At shareholder meetings, such matters as election of directors, fundamental changes in corporate organization and capitalization and transactions between the Corporation and its directors and officers should be considered and approved or disapproved. A shareholder unable to attend a meeting may act by proxy.
The Board of Directors should also meet regularly to consider and approve or disapprove all other important transactions and policy matters (such as, stock issuances, nonroutine contracts, election of officers, salaries of officers and other managers, other employee benefits and policies, litigation policies and so on).
In lieu of meetings, action by shareholders and the Board of Directors usually may be taken by written consent. The Secretary or legal counsel should maintain a minute book containing corporate documents such as articles of incorporation, bylaws and minutes and consents documenting action by directors and shareholders. A list of shareholders should be maintained, and any transfer of stock should be recorded in the stock record book.
Additionally, the corporate name should be used on all contracts, employment agreements, buy-sell agreements, retirement plans, trust agreements, loans, leases, purchase contracts, invoices, bank accounts, corporate brokerage and investment accounts, stationery, note pads, professional cards, door and building signs, telephone listings, insurance policies, business licenses and credit cards involving corporate business.
As you know, the directors control corporate policy and the officers are responsible for putting that policy into effect. It is important that the directors and officers understand the distinction between their respective powers and duties, such as:
The issuance of initial shares of stock and the later issuance of additional shares in the Corporation is often a complex matter involving analysis of federal and state securities laws and regulations. Before any officer or director offers to issue shares or accepts funds from anyone who desires to become an investor in the Corporation or in any project of the Corporation, counsel to the Corporation should be consulted.
Both the federal and state securities laws contain exemptions from onerous registration requirements if certain conditions are met. Even if an exemption from registration is available, the anti-fraud rules continue to apply and full disclosure of corporate operations and financial condition is prudent. Consultation with counsel for the Corporation is encouraged to avoid the pitfalls and potential civil and criminal liabilities resulting from the improper issuance of shares.
A majority of disinterested directors and disinterested shareholders should approve all material transactions between the Corporation and any one or more of its directors or officers, or any entity in which any director or officer has an interest. The general rule is that transactions between a director or officer and the Corporation should be as beneficial to the Corporation as if the transaction was being entered into by the Corporation and a party having no interest in or control over the Corporation.
Similarly, loans by the Corporation to directors or officers, or by directors or officers to the Corporation, must be approved by the majority of disinterested directors. All loans should be documented by a promissory note and repaid according to the terms of the note. If the Corporation lends money to any director or officer, the other directors may be personally liable if the loan is not repaid.
Every other year the Corporation must file an information statement with the Secretary of State containing the names and addresses of the Corporation and its officers, directors and agent for service of process. A newly organized corporation must file this Statement within ninety days after the date of its incorporation. Thereafter, the Corporation must file the statement biennially by the end of the calendar month of the anniversary date of incorporation and at any time when the agent for service of process, or such agent's address, is changed. There is a $20.00 filing fee.
Normally, a specially printed form will be sent to the Corporation by the Secretary of State in time to comply with the annual filing requirement. However, failure to receive the form from the Secretary of State does not relieve the Corporation either from the obligation to make this filing on time or from the possible assessment of a $250.00 penalty.
Trademark and service mark protection is derived from the use of symbolic words or a mark referring to the source of a product or service. The remedies available against an infringer can be increased through registration of trademarks and service marks with the U.S. Trademark Office, as well as with many states. If certain words, or a trademark or service mark used by the Corporation, have become valuable or are likely to become valuable, the officers should consult with counsel regarding the appropriate means for protecting the Corporation's rights. Similarly, if the Corporation's business conduct potentially infringes the rights of others, counsel should be consulted to assess means for minimizing exposure.
After the Corporation establishes its rights with respect to certain words or a trademark or service mark, an injunction may be sought against a business that subsequently begins using the words or mark so as to cause confusion, whether or not intentional, as to the source of the goods or services. Similarly, the Corporation can be enjoined from using words or a mark which are likely to be confused with words or a mark used by another business.
Many other practices may also constitute unfair competition, for example, theft of trade secrets and customer lists, bribery of employees of a competitor, misappropriation of valuable business data, disparagement of competitors or their products and other acts which fall below generally accepted levels of business conduct.
The laws of most states require qualification of foreign corporations doing intrastate business in those states. Under most state laws, an added benefit of such qualification is that no other corporation (foreign or domestic) may adopt the same name in that state. In some states qualification also protects the corporate name from use by other forms of business entities which may attempt to file fictitious business name statements (dba's) subsequent to the qualification.
A few states, including California, also have statutes which permit foreign corporations which are not doing business in those states to register their names for the sole purpose of preventing subsequent adoption of those names by others. These filings are quite simple and the expense is nominal. Also, these filing are renewable periodically.
Some corporations use fictitious business names (doing business as - dba's). Compliance with fictitious business name statutes will generally protect the fictitious business name from any subsequent use of the same name in the same jurisdiction by other persons or entities. Fictitious business name statements either are filed with a state authority and have state-wide effect or are filed on a county-by-county basis and are effective only within those counties where filings are made. If the Corporation is to use a fictitious business name, we recommend that a fictitious business name filing be made in each jurisdiction where the Corporation will maintain an office or conduct substantial business. The filings are simple, and the filing fees and publication costs are generally nominal.
In its initial federal and state income tax returns, a new taxpayer may elect to be taxed on a calendar or a fiscal year basis, if it consistently computes its income on the same basis in keeping its books. Even though the Board of Directors may adopt a fiscal year when the Corporation is first organized, the fiscal year may be changed by action of the Board of Directors at any time prior to filing the Corporation's first federal income tax return. After the first return has been filed, prior approval from the Internal Revenue Service ("IRS") and California Franchise Tax Board ("FTB") is often required for any such change in the fiscal year used.
In its first federal income tax return and first California franchise tax return, the Corporation will usually select either the cash or the accrual method of accounting. No prior approval of the initial choice of method is required, but a change of accounting method always requires the prior consent of the IRS and the FTB.
Under certain conditions a corporation and its shareholders may elect to have the Corporation treated as a "small business" corporation for the purpose of federal income taxes. This election permits the taxable income of a corporation making the election to be taxed to the shareholders, rather than the corporation. Later distribution of dividends to the shareholders out of the corporation's previously taxed income is tax-free.
There are numerous requirements which must be satisfied to qualify a corporation and its shareholders to make an election to be taxed in this fashion. The officers of the Corporation should consult with the Corporation's counsel or accountant to determine whether the Corporation is eligible to make such an election and to consider the consequences, advantages or disadvantages of making the election. California has adopted comparable provisions of flow through corporate taxation, but imposes a modest tax at the corporate level.
Every new business including a new corporation must obtain an Employer Identification Number from the Internal Revenue Service. The number must be used on all federal tax returns and related documents. The Corporation's accountant or counsel can assist in filing Form SS-4 to obtain this number.
Most active corporations are required to pay installments of estimated federal income tax. The first installment is due on the fifteenth day of the fourth month of the Corporation's taxable year. Each payment must be deposited with an authorized commercial bank depository or a Federal Reserve Bank.
The California franchise tax is imposed in advance for the privilege of doing business in California. The minimum tax is $800 per year, whether the Corporation is active or inactive. The franchise tax for the first taxable year historically has been paid at the time of incorporation, although California has been reducing this requirement in order to be more "business friendly." The Corporation must estimate its income for the first year and during the first year pay its estimated tax for the privilege of doing business in the following year. Thereafter, the tax is measured by the preceding year's net income from California sources (the "income year"). Estimated franchise tax is payable in installments. The first installment of estimated tax is due on the fifteenth day of the fourth month of the first income year (in addition to the $200 already paid). Filing requirements are described in the "Guide for Filing Franchise Tax Returns by Commencing Corporations," which should be sent to the Corporation by the Franchise Tax Board following its incorporation.
The first federal income tax return must be filed on or before the fifteenth day of the third month following the close of the first taxable year. If the actual tax exceeds the estimated tax payments, the Corporation must pay the entire balance when the income tax return is filed; it can no longer be paid in two installments. Income tax payments, like estimated tax payments, must be deposited in a Federal Reserve Bank or an authorized commercial bank depository.
The first California income tax return is due on or before the fifteenth day of the third month following the close of the first taxable year. California law requires that the entire balance of tax due must be paid at the time such return is filed, less any advance payments made under the estimated tax procedure.
IRS Circular E, Employer's Tax Guide (Publication 15), which may be obtained from the Internal Revenue Service, provides employers with a summary of their responsibilities for withholding, depositing, paying and reporting federal income, social security (FICA) and unemployment (FUTA) taxes.
Most California employers are also required to withhold state income tax from taxable wages paid to employees. In addition, employers are subject to the state unemployment and disability insurance provisions. Further information is provided in the Employer's Tax Guide (DE 44), which may be obtained from the Department of Benefit Payments of the California Health and Welfare Agency.
With certain exceptions, tangible personal property sold within California in a retail sale is subject to California sales tax. The sales tax is imposed on the retailer, but may be passed on to the consumer as an additional cost of purchased items. Generally, the California use tax is imposed on transactions occurring outside the state in which property is purchased and delivered for use or other consumption within the state. In addition, if in its business the Corporation uses or consumes items formerly held in inventory, it is required to pay the use tax since no sales tax was paid on items of inventory purchased for resale.
In California, all persons engaged in the business of selling tangible personal property must obtain a sales tax permit from the Board of Equalization, even if the business itself sells only at wholesale. A business owning a permit can purchase tangible personal property for resale without paying sales tax, provided it gives the seller a resale certificate certifying that resale will occur.
Permit holders must file a sales and use tax return and pay or prepay the taxes collected on a monthly or quarterly basis, depending on the amounts involved. A separate permit must be obtained for each place of business and must be displayed conspicuously at the location for which it is issued.
Usually, new businesses are required to post a bond or other security acceptable to the Board of Equalization to ensure the payment of sales and use taxes. The amount of the bond or security depends on the amount of taxable sales the business is expected to make.
Most California employers are subject to the State's workers' compensation laws. These laws impose liability on the employer for industrial accidents, regardless of the employer's negligence, and provide a schedule of benefits to be paid for injuries or to the heirs of an employee killed in such an accident. The Corporation should obtain sufficient workers' compensation liability insurance from an authorized insurer or obtain from the Director of Industrial Relations a certificate of consent to self-insure. Insurance coverage may be obtained through the local office of the State Compensation Insurance Fund or may be placed with the privately licensed workers' compensation carrier.
Generally, it is advisable to obtain fire and extended peril insurance on all property for which the Corporation is responsible or which it owns. Particularly if the Corporation's premises are open to the general public, it is advisable (and may be required) that the Corporation purchase a comprehensive public liability insurance policy. Such a policy should insure the Corporation against liability imposed by law for the operation of its business and property. Product liability insurance is also available for most businesses. Other types of insurance also may be desirable for the Corporation's business, e.g., plate glass insurance, business interruption insurance, use and occupancy insurance, directors' and officers' liability insurance, or employment practice liability insurance.
Employers are generally required to comply with a variety of federal and state laws dealing with the employment relationship, such as laws concerning equal employment opportunity, minimum wages, overtime pay, safety and rest periods. In addition, employers should be cognizant of liability for wrongful discharge, sexual harassment and unlawful discrimination.
A properly prepared employment manual will address all areas relating to employment. These areas include vacations, sick days, overtime pay, sexual harassment, pregnancy leave and many other issues. A properly prepared employment manual can help avoid or minimize an employee's claim for wrongful termination, as well as other potential claims.
Many trades, occupations and businesses are specifically regulated by the State of California and the city or county where business is conducted. The local rules should be checked to determine any requirements applicable to the Corporation.
Every business with more than one (1) owner needs a properly prepared buy-sell agreement to provide for the purchase of the interest of a shareholder who is selling their interest in the business. There are many situations which could cause such a buy-out. These events are specified in the agreement. The properly prepared agreement will provide for a smooth and orderly transition upon the death or disability of an owner.
Each owner of a business should have his or her estate plan in order. The estate plan will protect the family of the owner, and will also help with the smooth and orderly transition of the business upon the death or disability of an owner.
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This memorandum has sought to summarize certain aspects of operating a business in the corporate form. Naturally, each business will have its own unique problems, and specific questions should be addressed to counsel. We encourage you to call us for legal advice in connection with the successful operation of your business.