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Corporations & LLCs

Reduce Your Personal Liability from Your Business

Here is a quick outline to help you avoid personal liability from your business. FIRST, FORM A CORPORATION OR LLC FOR YOUR BUSINESS In most cases, you should not run your business in your own name as a sole proprietor (or as a partnership). You should hide behind a corporation or LLC, and take the limited liability that comes with those entities. DON'T PUT PERSONAL ASSETS IN YOUR CORPORATION; OBSERVE FORMALITIES If you have a corporation or LLC, do not put personal assets in the entity. This increases the likelihood that a creditor will pierce the entity and get to you. Personal assets belong in trusts; business assets belong in corporations or LLCs. Also, hold regular board & shareholder meetings, make your annual filings and pay your franchise taxes. BE CAREFUL WITH CONTRACTS First, read everything you sign, because your company will be responsible for it later on. Second, when you sign a contract, make sure you sign on behalf of your company and not in your own name. Make sure your signature line clearly states the name of your company and your title with the company. This makes clear the capacity in which you sign so that no one can later argue that you signed personally. Third, in your contracts where applicable, try to have provisions that cap your damages at specific dollar amounts, and that exclude certain types of damages (e.g. consequentials). AVOID PERSONAL GUARANTEES Don’t sign personal guaranties. When you sign a guaranty, you become personally liable for your company’s debt. This ruins your safe exit from the business. True, some transactions require a guaranty, for example, bank loans. That said, you can negotiate away the guaranty in most other transactions, including leases and supplier contracts. If nothing else, put up a good fight against the guaranty. ALWAYS PAY THE GOVERNMENT The government writes the laws for its own benefit, not yours. Specifically, the law can hold officers in a company personally responsible for the company’s taxes notwithstanding the corporate shield. The worst examples of this are — Payroll and other withholding taxes. If you’re a control person in a company, be sure it is paying its payroll taxes to the IRS and CA EDD. The IRS and CA EDD go after a company’s control persons (e.g. CEO or CFO) personally to collect unpaid payroll taxes. The control person keeps the liability for life until paid – you cannot discharge the liability in bankruptcy. Word to the wise: Don’t get smart and convert your employees to contractors to avoid payroll taxes. If you misclassify your employees as contractors, the government will still treat them as employees and assess you for the payroll taxes you should’ve paid. This debt extends to all missed payroll taxes during the term of misclassification, perhaps years. That’s a big bill. Read Classifying a worker as employee or contractor. CA sales tax. California holds control persons liable for a company’s unpaid sales and use taxes. This liability attaches at dissolution, termination or abandonment of a corporation. Again, be sure your company pays its sales taxes. BUY INSURANCE Lastly, there is no substitute for liability and professional insurance. If you get sued, your insurance company pays to defend the case and pays the ultimate settlement. Your premiums are a small price to pay for this peace of mind. Please do not be cheap when buying insurance. Get a good broker, and be happy to pay a higher premium for a reputable insurance company that actually pays its claims.

Negotiate an Operating Agreement in California

In this article, I explain the basic negotiation points for an LLC Operating Agreement in California. I focus mainly on control and on exit (buy-sell). CONTROL Control starts with voting percentages, meaning, who has sufficient votes to control the LLC’s decision-making? If the LLC has a board, control means the number of votes on the board. The member with control likes simplicity. Since it already has control, it wants to end the discussion there. An Operating Agreement drafted by the controlling member frequently has a short section on management that states the percentages or votes (i.e. control) and nothing else. The members without control want complexity, that is, they want the Operating Agreement to have provisions that restrict the controlling member. Minority, non-controlling owners need to protect themselves from majority action. Protection usually comes in the form of veto votes, which give the minority a right to stop a particular action proposed by the majority. Consider these veto rights (and their rationales): Hiring, firing, replacing the manager or officers ⇒ Although the minority won’t run the operations of the business, they want some control over who will. Salaries & bonuses for management ⇒ Minority owners should prevent control persons from siphoning off substantial salaries and bonuses, leaving no profits for anyone else. Affiliate transactions ⇒ This veto vote guards against the manager entering into sweetheart deals with its affiliates thereby redirecting profits to itself. Distribution of profits ⇒ This veto vote helps minority members ensure some minimum distribution of profits to themselves. Transfer of ownership interests ⇒ If the majority wants to sell their ownership to a third party, the minority might want to reject that third party as their new partner. Issuing ownership interests to existing or new members ⇒ This veto vote guards against the unfair dilution of the minority owners, including when the majority sells ownership to themselves or friends at sweetheart prices. Selling the business or merging ⇒ The minority wants some level of control over its ultimate exit, including to prevent the majority from selling the business in a sweetheart deal that primarily benefits the majority. Amendments to the Operating Agreement ⇒ The minority doesn’t want the majority to unilaterally change the terms of the deal. EXIT, A.K.A. BUY-SELL Every Operating Agreement should have provisions for the buy-back of a member’s ownership. I call this the economic divorce; others call it buy-sell. If the business, for whatever reason, needs to remove a particular owner, the Operating Agreement gets you a divorce on terms that are fair to everyone. Triggers for Buy-Back. Traditional buy-sell involves what I call the 4 D’s & 2 B’s. The 4 D’s are death, disability, divorce and dispute, and the 2 B’s are bankruptcy and bad transfers. I talk about these buy-sell trigger events at length in the articles under the heading “Shareholder Relations; Buy-Sell” at right. Other buy-back triggers may include a litany of “for cause” events, and they essentially give the control persons a number of vague and open-ended reasons to remove an owner. Some LLCs just cut to the chase, without need for pretext, and permit the control group, at-will without-cause, to buyback a member’s ownership. This latter expulsion can be important to the continued, smooth operations of the business, but it’s clearly dangerous to the minority owners who are subject to removal. Buy-Back Price. The buy-back price is the crucial term for all buy-sell events. A high buy-out price gives the exiting owner a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process or accounting formula to fix a price. Next look at payment terms, because payment up-front in one lump sum is much better than payment by promissory note over a long period of time. Non-Competition Covenant. In California, it’s legal to apply a non-competition covenant to a minority owner who has been bought out. Most non-competition clauses are for a period from 1 to 3 years, and cover the region in which the business is active.

Should You Incorporate Your Business

If you are a sole proprietor, you probably ask yourself, should I form an entity for my business? What are the costs and benefits of forming an entity versus remaining a sole proprietor? Answering these questions is not easy. The answer is different for every business depending on its circumstances and needs. The answer depends on a balancing of many different and conflicting factors. Most of us suffer information overload not long after starting this analysis – all of the factors start swimming around in our minds and we don’t know what to think. This article gives you a quick roadmap in deciding whether or not to form an entity. The first and foremost consideration is whether you need limited liability. Next you ask, are the costs of forming and maintaining an entity worth the limited liability protection? Then you determine whether you will be taking on a partner. Then you delve into the tax advantages and disadvantages of forming a corporation. Last, you weigh the factors against one another and make a decision. Limited Liability. Limited liability is the primary factor in deciding whether or not to incorporate. A sole proprietor is personally liable for all debts and liabilities of the business. On the other hand, a shareholder of a corporation (or member of an LLC) is not personally liable for the corporation’s debts (except payroll taxes and for the shareholder’s own negligence and the negligence of employees under the shareholder’s supervision). Costs. You want the benefits of limited liability. Now you need to ask yourself, is it worth the price? Limited liability costs money – entities pay franchise taxes and require higher legal and accounting costs for their organization and maintenance. In fact, if you want to reduce the analysis to the absolute bare minimum, answer this question: For you, is limited liability worth the costs of having an entity? Partners. If you want a partner, you probably will need to form a corporation or LLC. Although two or more sole proprietors can work together as a partnership, this is not your best choice. Partnerships are risky because each partner is liable for the acts of each other partner in carrying out the partnership’s business. Tax Factors. In my experience, the tax analysis will cause most of your confusion. Worse, in the end you may find that the various and sundry tax advantages and disadvantages seem to cancel one another out. For this reason, for the most part, tax should not be a major factor in deciding whether to incorporate (although tax still is a big factor in choosing between entities). Tax Advantages of Incorporation. There are few remaining tax benefits for incorporation. Moreover, what few tax benefits there are work only for “C” corporations (not for “S” corporations, partnerships or most LLCs). In brief, forming a “C” corporation helps with fringe benefits (most notably health insurance) and life insurance. Forming an entity does not do much good for your retirement plans. In two limited areas, forming a “C” corporation can provide some benefit. First, if the applicable corporate tax rate is lower than your personal tax rate, then incorporating can shift income to the lower corporate rate. Second, you can defer income tax by selecting a fiscal year. The bottom line here is to talk with your accountant. If not structured properly, you run the risk of incurring the dreaded double tax and the 35% flat tax for personal service corporations. Tax Disadvantages of Incorporation. As I mentioned above, entities must pay a franchise tax. California imposes an $800 minimum franchise tax on corporations and LLCs (except that corporations are exempt from the minimum tax in their first year of existence). Also, being a sole proprietor has these additional tax benefits: (i) a sole proprietor can never be taxed as a personal service corporation; and (ii) a sole proprietor can avoid FUTA, California unemployment taxes and workers compensation premiums (but not the self-employment tax, i.e. the social security tax). This article only gives a short roadmap of the issues involved in deciding whether or not to incorporate. There is a lot more to this topic than introduced here. So, before you do anything, get competent legal and accounting help.

Legal Compliance Checklist for a Start-Up Business

Forming a business can feel overwhelming. You worry about all the things you know, and you worry about all the things you don’t know. I write this checklist to fill in the great unknown. This checklist gives you a bird’s eye view of legal compliance for your start-up business. Let’s start at the beginning – incorporation. Form a Corporation or LLC. Your basic choices are a C corporation, S corporation, or an LLC. Get an attorney to help you choose among the entities, and in which state to incorporate. Also see my article Should You Incorporate Your Business? Shareholders / Buy-Sell Agreement. If your business has more than one owner, seriously consider getting a shareholders / buy-sell agreement to govern your relationship with your partner. These agreements save you a lot of money if partner relations go bad. A buy-sell agreement resolves disputes between the partners, including exit provisions if the partners can’t work together anymore. I call this the partners’ economic divorce. For more info, see the article regarding Buy-Sell Agreements. Get a Federal Employer Identification Number (EIN). You can call the IRS for your EIN or get it from the IRS’ website. Bank Accounts. Once you have your company’s articles of incorporation plus EIN, you can open bank accounts. Choose a Location. First decide on a general location, then check local zoning requirements to be sure you can operate your business there. Visit your local planning / permits department for this and other local requirements for your chosen location. Real Property Lease. One of the most important contracts you’ll sign is the lease for your company’s offices. The lease will bind you for years to come, and you’ll have to continue paying rent even if the business doesn’t perform well. This is another area where you need a lawyer. Trademarks. Does anyone else have prior rights to use your business name? Search the internet to see if anyone is using your name in your industry and in your geographic scope. Your geographic scope relates to how far you look for customers. A local retail store might have a local geographic scope, but an internet business can have a worldwide scope. If your internet searches come up clean, consider getting a trademark on your name. If your searches show problems, talk to a lawyer about what to do next. Patents / IP. If your business depends on patents or other intellectual property, talk with an attorney about protecting your IP. Fictitious Business Name. If your company uses a fictitious name (that is, a dba or some name other than the company’s legal name), you must register the name in your county. Business Licenses. There are many types of state and local licenses that could apply to your business. For example, you’ll need health and sanitation licenses if you have a restaurant. Call the CA Department of Commerce, Office of Small Business, for information about the state licenses that might apply to you. Seller’s Permit. If you sell merchandise, get a seller’s permit from the California State Board of Equalization. Employer Filings and Withholdings. If you have employees, file form DE-1 with California EDD. This starts the never-ending process of employment law compliance. Hire a payroll company to handle your employee wage withholdings. Don’t misclassify your employees as contractors — read Should you classify a worker as employee or contractor. Workers Compensation and Other Insurance. Once you have employees, get an insurance broker for workers compensation insurance. Workers comp is required by law. And now that you have an insurance broker, look into property and liability insurance to cover risks associated with your operations (note that the landlord in your lease might require this insurance). That’s it for this bird’s eye view of the start-up of your business. I hope this checklist has been helpful to you. Finally, read Reduce your personal liability from your business to learn how to protect your personal assets from business risks.

Corporate Structure Levels of legal Control Over a Business (Medical Practice as an Example)

LEVELS OF LEGAL CONTROL Level #1: Shareholders / Partners The shareholders elect the directors. The shareholders should meet at least once a year to do so. By controlling the composition of the board of directors, the shareholders can control the corporation. In most other respects, however, the shareholders (in their capacity as shareholders) have no control over the corporation, with exception for a handful of required votes on dissolution and the like. *** In a partnership, the partners are akin to the shareholders. The partners as a group elect the managing committee. Level #2: Board of Directors / Managing Committee The board of directors controls over matters of general operating policy. These include, for example, the hiring and firing of officers, setting compensation, declaring bonuses, issuing stock, corporate borrowing and other big decisions. The board should not micro-manage the practice. Directors set the corporation’s policies, and they should leave to the officers the implementation of those policies. *** A partnership might have a managing committee, which is akin to a board of directors. Level #3: Officers / Managing Partner The officers run the business. In CA, the corporation must have at least the following officers: president/CEO, corporate secretary and treasurer/CFO. One person can serve simultaneously in all 3 positions. The officers oversee the rest of the practice’s employees. *** A partnership might have a managing partner, who is akin to the CEO, CFO and corporate secretary all rolled into one. Level #4: Employees The rank-and-file employees do the day-to-day work. Practice administrators usually are at this level. CEO / MANAGING PARTNER Many practices have a managing partner, who is akin to the CEO, CFO and corporate secretary all rolled into one. In many practices, the doctors don’t want to be bothered with management. Instead they prefer to focus on their individual practices. If that’s the case, the practice should provide special compensation to the managing partner, otherwise no one will do the job. It’s no fun managing other doctors. POWER If no one wants to be bothered with management, the managing partner by default has great power. Sometimes the other doctors don’t pay attention to management. Over time, management can carve out little fiefdoms for itself. For example, a managing partner can be the sole signer on bank accounts, the sole contact for accountants, bookkeepers and lawyers, the sole person to whom employees report, and more. If the managing partner leaves for any reason, or if the practice develops a split between warring factions, it will take time and effort for the other partners to pick up the pieces and keep the practice running. We all know the quote “power corrupts; absolute power corrupts absolutely.” I think it more accurate to say that power deludes. It’s good to put boundaries around the exercise of power, to keep it realistic, transparent, and within the bounds of common sense. The board or managing committee should actively and regularly examine the management of the practice. The CEO / managing partner should regularly report to the board or other shareholders or partners, including the delivery of quarterly financial statements. Oversight is the best way to keep things under control. In some practices, the doctors might choose to have the corporate documents set forth in detail the limits on the powers and duties of the CEO / managing partner. For example, the CEO might have the unilateral right to incur expenses only up to $5,000, or enter into contracts with a maximum term of 1 year. To exceed those limits, the CEO would need the approval of the board of directors. In many cases, it’s good to rotate the position of CEO every couple of years.

Operating a California Corporation

The purpose of this Memorandum is to discuss certain procedures and operations relevant to a newly-formed California corporation. The summaries below are not a complete analysis of the areas discussed, rather they are provided to give a basic understanding of the legal requirements which California corporation should follow. Because this discussion is general in nature, it should not be relied upon as complete information regarding any of the matters discussed, but rather, should be used as a general guide. Please feel free to contact me if you have any questions. CORPORATE FORMALITIES It is difficult to overstate the importance of maintaining the formal integrity of the corporation. It is a legal entity independent of its shareholders, officers and directors, and should always be treated as such. To ensure that the benefits offered by the corporate form are maintained, not the least of which, of course, is the protection of shareholders against the imposition of personal liability for obligations incurred by the corporation, the corporation should scrupulously observe the corporate formalities discussed below. The holding of regular shareholders’ and directors’ meetings is an important aspect of maintaining the corporation. All contracts entered into by the corporation, including employment contracts, buy-sell agreements, loans, leases and purchase contracts should be made in the name and on behalf of the corporation. In addition, all important transactions concerning the corporation’s business should be approved by the board of directors, and that approval should be reflected in the minutes of board meetings. The following formalities should be observed in connection with the ongoing operations of the corporation. Shareholder Action. Under California law, shareholder meetings or action by written consent should be held or taken at least once a year. Unless otherwise provided in the articles of incorporation, the presence in person or by proxy of persons entitled to vote a majority of the voting shares of a corporation constitutes a quorum. In addition, shareholder action may be taken by written consent of the shareholders without a meeting if the consent process satisfies statutory requirements. The principal order of business to come before the shareholders at their annual meeting is the election of the board of directors. In addition, certain fundamental changes in the corporation’s form of operation require the consent or approval of the shareholders. Such changes include amendment of the articles of incorporation, sale of all or substantially all of the corporation’s assets, merger or consolidation of the corporation with or into any other corporation, and the winding up and dissolution of the corporation. Director Actions. Although day-to-day management of the corporation is generally delegated to its officers, matters of general operating policy should be considered and authorized by the board of directors. There is no statutory requirement with respect to how frequently the board of directors should meet; as a matter of sound practice, however, regular board meetings should be held at least annually. In addition, a specially convened meeting of the board may be called if action is required before the next regular board meeting. Meetings may be held by a quorum of the directors in person or by conference telephone, as long as all members can hear one another. In lieu of a meeting, action by the board may also be taken by the unanimous written consent of the directors. Matters for which board approval should be obtained include the following: - Election of officers, setting of salaries of senior officers, and declaration of bonuses (at least annually, typically at a meeting of the board of directors immediately following the annual shareholder meeting); - Appointment of board committees; - Opening of corporate bank accounts and the designation and change of corporate officers authorized to act as signatories; - Corporate borrowing and the concomitant giving of security; - Consummation of contracts for the acquisition, disposition or lease of significant assets or services, or for the rendition of services outside the corporation’s ordinary course of business; - Policy decisions with respect to the construction of significant assets or other projects which may require accumulation of surplus reserves and the use of available cash; - Adoption of pension, profit-sharing, bonus and other employee benefit plans; - Declaration of dividends or redemption of shares; - Amendment of the bylaws; - Review of financial statements; - Appointment of auditors; - Any action which requires the consent or approval of the shareholders, including those shareholder actions described above; and - The issuance and sale by the corporation of additional shares which are authorized by the articles of incorporation or the grant of options to purchase such additional shares. Distinction Between Officers and Directors. Directors control the corporation’s policies, while officers are charged with the implementation of those policies. A director may not delegate his or her authority. Thus, for example, a director may not give his or her proxy to vote at a meeting of the board of directors. An officer, on the other hand, may generally delegate responsibility and authority. Under California law, the corporation must have a president, a secretary and a chief financial officer (treasurer), all of whom are chosen by the board of directors. Any two or more offices may be held by the same person. The general scope of the duties of each officer is outlined in the bylaws. The officers of a corporation serve at the pleasure of the board of directors. Even though an officer may have an employment contract which grants certain rights to compensation, he or she may be removed from office by action of the board, subject to any such continuing rights to compensation. Termination of an officer as an officer or employee nevertheless raises serious issues of labor law which should be considered on a case-by-case basis. A director or officer may resign at any time. Acceptance of the resignation is not necessary. A resignation is effective upon its delivery to the corporation, unless stated to be effective at a future date. In the case of a resigning director, the remaining directors may (unless the articles of incorporation or bylaws otherwise provide) appoint a new director to fill a vacancy. The shareholders may at any time fill a vacancy, amend the relevant corporate documents or expand the board, or take action to remove a director which is consistent with relevant corporate documents and corporate law. DIRECTORS' AND OFFICERS' RESPONSIBILITIES Both directors and officers should be mindful of the following important duties and responsibilities: Payment of salaries to employees. Officers responsible for the payment of salaries must see that the corporation pays those salaries. Failure to do so may result in criminal penalties under the California Labor Code. Many banks offer a “payroll service” to their customers; you may wish to consider such a service for your corporation when the number of employees so warrants. Payroll taxes. All payroll taxes (including income tax withholdings) must be promptly paid by the corporation. Failure to pay may result in the imposition of civil or criminal liability on officers and directors. We recommend that all payroll tax matters be handled with care and with the guidance of an accountant where appropriate. Loans to directors. If the corporation loans money to its directors, any other directors approving such loans may be held personally liable for any amounts which are not repaid, unless the loans were approved in advance by a vote of the shareholders. Duty to inspect. A director has the absolute right to inspect all corporate books, records, documents and property. In fact, a failure to exercise such rights might subject a director to liability for negligence in the event the corporation (or its creditors) suffers a loss by reason of the director’s failure to exercise due diligence in such matters. Fiduciary duty. Officers and directors have a fiduciary duty to the corporation and its shareholders. Because of the special duty of loyalty imposed by this relationship, neither officers nor directors may directly compete with the corporation, nor may they take for themselves business opportunities which are in the corporation’s current or reasonably anticipated line of business. Annual report to shareholders. California law requires that the accounting books and records, and the minutes of proceedings of shareholders and board of directors meetings, be open for inspection by any shareholder, director, or holder of a voting trust certificate. Further, corporations are required to send an annual report to shareholders not later than 120 days after the close of the fiscal year. The annual report must contain a balance sheet, an income statement of changes in financial position for the fiscal year, and also must be accompanied by a report thereon by the corporation’s independent accountants or, if there is no such report, by a declaration by an authorized officer of the corporation that the statements were prepared without an audit. This requirement can be waived in the bylaws by corporations with fewer than one hundred shareholders. Since your corporation falls into this category, I have waived this requirement in your bylaws. Corporations with one hundred or more shareholders that are not subject to federal securities reporting requirements also must comply with additional disclosure requirements. These include describing any significant transactions between the corporation and any director, officer, or ten percent or greater shareholder. Compensation of directors and officers. A director is not ordinarily entitled to compensation for services rendered as a director unless such compensation is provided for by bylaw or corporate resolution. The directors have the power to fix the salaries of officers. In most instances it would be prudent to submit elaborate compensation plans to the shareholders and the directors for their approval or ratification. Other duties. A director must be concerned with other sources of liability, including the improper declaration of dividends or repurchase of corporate shares, fraudulent entries in corporate books or reports, and failure to supervise properly the operations of the corporation. Compliance with applicable state and federal securities laws is an area of particular importance for directors, as securities liability is often asserted against directors. EVERYDAY MATTERS AS A CORPORATE ENTITY To further ensure that there is no confusion on the part of outsiders dealing with the new corporation, the following steps should be taken: All letterheads, bills, invoices, and other business forms used by the corporation should reflect its full legal name as well as its current address and telephone number. The telephone numbers of the corporation should be listed under its name with the telephone company and in all telephone and trade directories. The corporation’s full legal name or fictitious business name should appear on all signs in its building. Business cards should indicate both the corporation’s name and the employee’s name. Any existing contracts or leases should be transferred to the corporate name, if permitted. Future contracts or leases should be executed in the corporation’s name, with the signature blocks clearly identifying the signing party as an officer signing on behalf of the corporation. Accounting. It is the responsibility of the corporation’s officers and directors to make certain that customary accounting practices and auditing procedures are observed by the organization in a proper and timely fashion. A corporation is also generally required to pay various state and federal taxes as well as to withhold or pay various employment taxes with respect to its employees. Accordingly, the corporation should have an accountant who should be kept currently informed regarding all of the corporation’s business activities. If you do not yet have an accountant I will be happy to recommend one. Stock Issuance. As a general rule, the corporation must obtain a permit from the California Commission of Corporations before issuing stock. Exemptions from the permit requirement are available for certain transactions. Failure to comply with applicable securities laws can result in rescission of the issuance and may result in damages to the corporation. Federal securities laws are also applicable. I strongly recommend that the corporation seek the advice of counsel before any issuance of additional stock. Annual Reports. A form entitled “Statement by Domestic Stock Corporation” must be filed with the California Secretary of State annually. The form requires the disclosure of the names and addresses of the directors and principal officers, the address of the corporation’s principal office, the name and address of its agent for service of process, and the number of authorized directors. I have prepared and filed the initial annual report. After the first year, the Secretary of State will mail the form to the corporation each year, approximately three months prior to the due date (the month in which the articles of incorporation were filed). If you do not receive this form prior to the month in which it is due, you should contact the Secretary of State’s office and request that it be sent to you. Failure to receive the form is not an excuse for late filing. Failure to make a timely filing of this statement will result in a $250 penalty. In addition, failure to file this statement for two consecutive years can result in suspension of corporate rights, powers and privileges. I do not file annual statements after the first year. That responsibility is yours, but I would appreciate a copy of your annual filings for my records. Separate Corporate Tax. A corporation is treated as a separate taxpayer for state and federal tax purposes. As a result, a corporation is subject to a federal and state income tax on its income. A corporation’s shareholders are generally not subject to tax on corporate income until it is paid to them in the form of dividends. All corporations must satisfy certain tax reporting requirements such as the filing of state and federal income tax returns. The U.S. tax system is the most complex in the world. Tax planning especially with regard to large transactions or reorganizations of your business may considerably reduce the corporation’s tax. I recommend that you contact me and your accountant well in advance of any major transactions. S Corporation Election. Certain closely held corporations can elect S corporation treatment for tax purposes. An S corporation’s profits or losses are generally treated as the profits and losses of its shareholders. As a result, an electing S corporation is not subject to a tax on its income. In order to qualify for S treatment in the corporation’s first taxable year, the election must be made within two and a half months after the date of incorporation and requires the consent of the corporation’s shareholders. Election of Tax Year. A new corporation may elect to be taxed using either a calendar tax year or a fiscal tax year; however, a personal service corporation and an S corporation usually must use a calendar tax year. The period chosen must be the same as that used by the corporation to compute its book income. To adopt a taxable period, a new corporation simply files its initial federal and state income tax returns on the basis of the taxable period selected. A subsequent change in the accounting period generally requires advance consent of the IRS or the California Franchise Tax Board (FTB). Accounting Methods for Tax Purposes. Generally a corporation must use the accrual method of accounting for income tax purposes. However, S corporations and certain qualifying personal service corporations may elect the cash method of accounting by filing their initial tax returns in accordance with the cash method of accounting. Once an accounting method has been elected, approval of a subsequent change to another method must be obtained from the IRS or the FTB. California Income Tax (Franchise Tax). A California tax on income, called a franchise tax, is imposed for the privilege of doing business in California. A corporation incorporated or qualified to do business in California is subject to a minimum franchise tax of $800. You are responsible for the payment of your corporation’s franchise tax. Estimated Franchise Tax Payments. Installment payments of the corporation’s franchise tax must be paid during the first year. The first installment generally is due within 3-1/2 months of the commencement of the fiscal year and is at least the minimum yearly tax of $800. The initial $800 payment made at the time of incorporation does not satisfy this requirement. Larger payments may be required depending on the corporation’s income. You should consult your accountant regarding the computation and timing of installment payments. Federal Income and Franchise Tax Returns. Annual federal income and California franchise tax returns are due on or before the 15th day of the third month following the close of the corporation’s taxable year. Employer Identification Number. A new business must obtain an employer identification number from the IRS. Application is made on IRS Form SS-4. I have instructed you how to obtain the number from the IRS. FEDERAL AND CALIFORNIA EMPLOYMENT TAXES If the corporation has or will have employees, it will be liable for certain federal and state taxes. As indicated above, many companies use a payroll service to handle these matters. These obligations are briefly described as follows: FEDERAL TAX REQUIREMENTS Wage Withholding. Employers are responsible for withholding federal income tax from the taxable wages which they pay to their employees and depositing those funds with the IRS. You will need to obtain from each employee a properly executed Employee Withholding Allowance Certificate (IRS Form W-4). Before January 31, following the close of each calendar year, you must provide each employee with an Annual Wage and Tax Statement (IRS Form W-2). Social Security Taxes (FICA). Both the employer and employee share responsibility for funding the social security system. In addition to paying its share for each of its employees, an employer must withhold each employee’s share of social security tax from wages paid to the employee and transmit those amounts to the IRS. Federal Unemployment Tax (FUTA). Nearly all employers are subject to this tax. Return and Deposit of Taxes. With some exceptions, employers subject to either income tax withholding or social security taxes must file a quarterly return on federal Form 841 and must deposit the income tax withheld and the FICA taxes with an authorized commercial bank depository or a Federal Reserve Bank or branch. CALIFORNIA TAX REQUIREMENTS Wage Withholding. In addition to withholding federal income tax, a California employer is generally obligated to withhold California state income tax from the taxable wages which it pays to its employees and deposit those funds with the state. California Unemployment Insurance Tax. A California employer generally must pay unemployment insurance tax if it pays taxable wages and generally must register with the Employment Development Department within 15 days after becoming subject to this tax. California Disability Insurance. California employees (but not employers) are generally subject to disability insurance tax. California employers are obligated to collect this tax by withholding the tax from wages paid to employees. However, the employer has the alternative of establishing a state-approved private disability insurance coverage plan. If this option is chosen, employees may be required to make contributions directly to this plan in lieu of the tax payment. City Payroll Tax. An employer who has employees in certain cities (e.g. San Francisco) may be obligated to pay a city payroll tax. California Sales Tax. If the corporation sells tangible personal property at retail in California, it will be subject to the California sales tax, unless the property sold is specifically exempt. The tax may be passed on to the purchaser, but the corporation must collect the tax and transmit it to the state. The corporation selling tangible personal property must file sales tax returns with respect to taxable sales which it makes and pay or prepay the taxes collected on a monthly, quarterly or annual basis, depending upon the amounts involved. If the corporation will be selling tangible personal property, you should promptly consult the corporation’s accountant regarding the dates on which these returns must be filed and the taxes which the corporation must pay. Seller’s Permit. All parties engaged in the business of selling tangible personal property in California must obtain a seller’s permit from the California State Board of Equalization. This permit is usually required even though the business itself sells such property at wholesale (so that sales tax would not apply). A separate permit must be obtained for each place of business and conspicuously displayed at each location. A business having a seller’s permit is able to purchase tangible personal property for resale without having to pay sales tax to the seller, provided it gives the seller a signed resale certificate in the form prescribed by the State Board of Equalization certifying that it is purchasing the property for resale. County Real Property Taxes. The corporation must also pay real property taxes on items of real property it owns. These taxes are paid to the county assessor of the county in which the property is located. You should consult with the corporation’s accountant regarding the payment of property taxes and the necessity of filing property tax statements. Other Taxes. Depending on the nature of your business, there may be special taxes imposed by federal, state, or local governments, such as those on alcohol, tobacco, gross receipts, and real estate transactions. Workers’ Compensation. California employers are subject to the state’s workers’ compensation laws and may be penalized for noncompliance. This law imposes liability upon employers for industrial accidents, even if the accident did not result from any negligence of the employer. The purpose of this law is to provide a fund for payment of expenses incurred in connection with job related injuries and to compensate the heirs of employees killed in such accidents. The corporation should obtain sufficient workers’ compensation liability insurance from an authorized insurer or obtain a certificate of consent to self insure from the Department of Industrial Relations. Workers’ compensation insurance is just one of the many types of insurance which a corporation should carry. We suggest that you consult with a qualified broker regarding the overall insurance needs of the corporation (see item 20 below). OTHER EMPLOYMENT REQUIREMENTS Employee Benefits. In addition to regular salary or wages, the corporation may wish to provide other forms of current or deferred compensation for its employees. Some of these types of compensation, such as bonuses or payments for sick leave and vacations made out of the general assets of the corporation, are payroll practices regulated primarily by California laws. Other forms of current compensation, such as health, disability or life insurance coverage for employees and their dependents, are welfare benefit plans regulated primarily by federal laws. Most types of deferred compensation programs, such as pension or profit plans, are also subject to federal laws. Even for a small business, complying with federal employee benefit laws may be a complex and expensive matter. Moreover, failure to comply with these laws may result in civil or criminal prosecution. In light of the foregoing, we recommend that you contact me to discuss any programs of current or deferred compensation you may be considering for some or all of the employees of the corporation. Notices. Employers are required to post, in a conspicuous location, a number of notices regarding employees’ rights. There is a master notice covering most of the required notices available from the California Chamber of Commerce. Labor and Employment Law. There are many federal and state laws governing the hiring, firing, compensation and other terms and conditions of employment and, consequently, much overlap exists between these federal and state labor laws. As with most other regulations, a California employer is expected to comply with the more stringent standard where regulations overlap. It is therefore strongly recommended that you seek legal counsel when you are uncertain as to whether the state or federal laws apply to a particular employment matter. Wage and Hour. The California Department of Industrial Relations, through its Division of Labor Standards Enforcement, enforces state laws governing payment of wages, the establishment of the minimum wage, hours of work and overtime and conditions of employment. The federal Fair Labor Standards Act, enforced through the Wage and Hour Division of the U.S. Department of Labor, also regulates these areas. One of the areas in which California law is more stringent than federal regulations is in the payment of overtime. California law requires that overtime be paid to non-exempt employees for every hour worked over eight in a day or over forty in a week, while federal law only requires payment of overtime for every hour worked over forty in a week. A California employer must therefore comply with state law in the payment of overtime. Discrimination. California’s Department of Fair Employment and Housing prohibits unlawful practices in the hiring, employing and discharging of all persons to protect them against discrimination with respect to race, religious creed, disability, color, sexual orientation, familial status, marital status, national origin, ancestry, sex, age, and medical condition. Title VII of the Federal Civil Rights Act of 1964, the Federal Age Discrimination Employment Act of 1967, the Equal Pay Act of 1963 and the Americans with Disabilities Act also regulate fair practices in employment. Health and Safety. The health and safety of California workers is generally regulated by the Division of Occupational Safety and Health of the California Department of Industrial Relations and the Occupational Safety and Health Administration of the U.S. Department of Labor. Both these agencies have established health and safety standards to be followed by all employers, and require the correction of all conditions created by an employer which threaten the health and safety of its workers. Union Activities. The National Labor Relations Act (NLRA) protects employees’ rights to organize and to bargain collectively with their employers through representatives of their choosing. These rights include forming or joining a union; assisting a union to organize employees; striking to secure better working conditions; and, with or without the presence of a union, engaging in concerted activity related to wages, hours and working conditions. Specific rules apply to an employer’s rights and obligations in this area, and it is therefore recommended that an employer seek legal counsel for advice in the event of any union or other concerted activity by employees. Wrongful Discharge. During the 1980’s, the doctrine of “at-will” employment has been severely eroded by California case law, impairing the ability of employers to discharge employees “at-will.” As a result, wrongful discharge lawsuits are very common. Written or verbal statements made to employees, personnel policy manuals and company rules may be interpreted as creating a contract between the employer and employee precluding the employer from firing an employee except for “just cause.” Employers in California should therefore be aware of the legal ramifications of statements made to employees about terms and conditions of employment and should, in most cases, obtain legal advice in regard to potential employee terminations. AND STILL MORE Insurance. The corporation should consult a qualified insurance broker to determine which types of insurance policies should be purchased. It is generally advisable to obtain fire and extended peril insurance on all property which the corporation owns. A comprehensive public liability insurance policy is also advisable (and may from time to time be required for various purposes). Product liability insurance is also advisable for many businesses, as are other specialized types of insurance which may be applicable to your business. State and Local Business Licenses. State and local licensing is required for a wide variety of business and professions that may be conducted in the corporate form. Some cities in California require certain businesses to obtain a license and pay a tax for the privilege of doing business in that city. Local business tax authorities will provide information on business license requirements. Local Taxes. A few cities, including Los Angeles and San Francisco, impose a tax on the gross receipts of various businesses. Detailed information is available from local tax authorities. Fictitious Business Name. Trade Names. Trademarks and Trade Secrets. As you do business as a corporation, you will be using your corporate name as your trade name. You may also adopt an abbreviation of your corporate name, much as Pan American World Airways, Inc. does business as PAN AM or may adopt an entirely different name as your trade name. Should you adopt a trade name different from your corporate name, you should inform me so that I may assist you in preparing, filing and publishing a fictitious business name statement where this would be advisable. Trade names (or corporate names) also frequently function as trademarks or service marks. “PAN AM”, for example, is a service mark for airline passenger services. Besides being International Business Machines, Inc.’s trade name, “IBM” also functions as a trademark which distinguishes IBM’s products from others’. Trademark and service mark rights belong to the first person to use a mark. Therefore, it is advisable to determine the availability of a particular mark or trade name before you spend money establishing it. To prevent interference in the future from another with superior rights to a mark or name, I recommend that you consult me before adopting a trade name or trademark. Note that merely having a name registered as a California corporation will not give you federal trademark rights to it; it merely means that there is no other California corporation with the same name. If a creative process is involved in the production of the corporation’s products, a patent and suitable contractual arrangements may be appropriate to protect and preserve company ownership. Trade secrets may be protected by plant security and by requiring employees to sign agreements guaranteeing the safekeeping of trade secrets and confidential information. Intellectual or literary property may qualify for copyright protection. Securities. The issuance of securities by the corporation is subject to both federal and state securities laws. Although the federal and state definitions of a security are not identical, such definitions are quite broad and include stocks, options, warrants, evidences of indebtedness, investment contracts, and interests in a stock or profit-sharing plan. Officers and directors may be held personally liable for criminal and civil violation of securities laws. Thus, whenever a corporation considers offering, issuing, or selling securities, it must be cognizant of applicable federal and state laws. The corporation also should be aware of “private placement” and “limited offering” exemptions from these plans. Because of the complexity and high risks involved, I recommend that you contact me to assist the corporation with any securities-related transaction – for example, additional investments in the corporation by existing or new investors – before any phase of the transaction is undertaken. Termination and Dissolution of Corporation. Neither the corporation nor its employee-benefit plans (if subsequently established) should be terminated or dissolved without consultation with an accountant and with counsel. A corporation is not dissolved by reason of the death or disqualification of the sole remaining shareholder-director. Dissolution is accomplished only as provided by the California Corporations Code. In a similar vein, no pension or profit-sharing plan or other compensation arrangement you may establish should be terminated or altered without careful review and study by the advisers of the corporation.

Cumulative Voting Explained

Under CA Corporations Code §708, CA requires cumulative voting for the election of directors. To invoke cumulative voting, one or more shareholders must give notice prior to the meeting of the intention to vote cumulatively. Any candidate for whom shares are to be voted cumulatively must have been placed in nomination prior to the voting. Cumulative voting means that each shareholder may give one candidate a number of votes equal to the number of directors to be elected multiplied by the number of votes to which the shareholder’s shares are entitled. The equation is: [number of open director seats X number of shares = number of votes that may be cast by the shareholder]. The shareholder may also distribute the shareholder’s votes on the same principle among as many candidates as he sees fit. In any election of directors, the candidates receiving the highest number of affirmative votes are elected. Example: 3 directors are up for election, for 2 board seats. Assume the following cap table: Shareholder A: 100 shares Shareholder B: 100 shares Shareholder C: 75 shares Shareholder D: 50 shares 325 shares outstanding. The shareholders each have the following votes to split up among the candidates: Shareholder A: 200 shares Shareholder B: 200 shares Shareholder C: 150 shares Shareholder D: 100 shares 650 shares outstanding. Removal of Directors. Under CA Corporations Code §303, a majority of the outstanding voting shares may remove any or all directors; except that unless the entire board is removed, a director cannot be removed if the votes cast against that director’s removal or not consenting in writing would be sufficient to elect him by application of cumulative voting. Example: 2 directors are to be removed. Remember the equation: [number of open director seats X number of shares = number of votes that may be cast by the shareholder]. Shareholders A, C and D are in favor of the removal of both directors, and they will split their 450 votes – 225 for the removal of Director 1, and 225 for the removal of Director 2. Shareholder B is against the removal of Director 1. Shareholder B can cast his 200 votes against the removal of Director 1, but his votes still would be insufficient. Some split of the vote from Shareholders A, C and D would be required for Shareholder B to obtain the addition votes needed to block the removal of Director 1. For example, if Shareholder D joins B, then they would have a combined 300 votes to block the removal of Director 1. This would leave Shareholders A and C with only 350 votes to split between Directors 1 and 2. Shareholders B and D would be successful in blocking the removal of Director 1. If only one director is to be removed, then the calculus becomes easier. In this case, each shareholder can only vote his number of shares, and simple percentage ownership rules. For example, Shareholders A and C can cast 350 votes in favor of the removal of the one director. Shareholders B and D can only cast 300 votes, and would lose.

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