Articles Posted in Business Formation & Development

One of the most important decisions entrepreneurs face when starting a new business is how to organize the new venture.  Although the flexibility provided by a limited liability company (LLC) is enticing, California’s gross receipts tax is distasteful to many business owners.  Moreover, the rigidity and formality of the standard corporate structure can prove cumbersome for young businesses.  California’s statutory Close Corporate (meaning that the form of business entity was created and governed by statute) provides entrepreneurs a third option offering much of the same flexibility LLC’s provide while simultaneously avoiding California’s gross receipts tax.  Because the ultimate choice will vary from business to business, it’s important to consult with a San Diego business attorney and a tax professional such as a C.P.A. before moving forward.  

corporate-955464-m.jpgA close corporation is one in which the shares of the corporation are not freely traded and are held by a limited number of individuals.  Significantly, the shareholders of a close corporation can authorize the elimination of the board of directors and run the corporation themselves, actively managing and operating the company’s day-to-day affairs. Most states have statutes specifically limiting the number of shareholders (generally between 30 and 50),and requiring that certain transfer restrictions appear on the stock certificates.  California’s Corporation Code Sec. 158(a) requires that a close corporation’s Articles of Incorporation state, “This Corporation is a close corporation and that the number of shareholders shall not exceed 35.”  In order to properly establish the corporation as closely held, the shareholders must prepare a written agreement (shareholder’s agreement) outlining the method by which management decisions are to be made and determining what, if any, restrictions are applicable to the sale of the ownership shares.

Because the shareholders manage a close corporation, they owe greater fiduciary duties to each other, and the controlling shareholders owe minority owners the highest duty not to oppress them.  In the normal corporate structure, if a minority shareholder disagrees with the manner in which the company is conducting its business, typically his only recourse is to sell the stock (assuming the company’s officers or directors are not violating the law or the corporation’s bylaws).  In a close corporation, however, sale of the stock is generally not an option.  As such, the law allows minority shareholders to sue the majority shareholder(s) and seek court intervention in the management of the company

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A 2011 decision by a federal court highlighted the applicability of a legal theory known as the business judgment rule to corporate officers in California.  Codified at section 309 of the Corporations Code, the business judgment rule establishes a presumption that a corporate director, in the performance of his or her duties, acts on an informed basis, in good faith, and in the honest belief that his or her actions are in the best interest of the corporation.

man-on-a-bridge-3-1427249-m.jpgIn Federal Deposit Insurance Corp. v. Perry (C.D. CA December 13, 2011) (Case No. CV 11-5561 ODW), the U.S. District Court for the Central District of California held that the business judgment rule is inapplicable to decisions made by corporate officers (as opposed to “directors”) on behalf of the corporation.  In Perry, the Federal Deposit Insurance Commission (“FDIC”) sued the defendant, Matthew Perry, in his capacity as CEO of Indymac Bank, alleging that Perry breached his fiduciary duties by negligently allowing the bank to generate over $10 billion in risky residential loans.

Due to the volatility of the secondary market in which the loans were slated to be sold, Indymac was forced to absorb the loans into its own investment portfolio, resulting in losses of more than $600 million.  In July of 2008, Indymac Bank closed and the FDIC was appointed as receiver.  Perry moved to dismiss FDIC’s complaint, claiming it had failed to allege facts upon which it could state a claim for recovery.  Specifically, Perry contended that the business judgment rule protected him from liability stemming from decisions he made as a corporate officer of the bank.  FDIC countered that the business judgment rule does not apply to corporate officers in California.

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A security is a financial instrument or a tradable asset of some type.  The Federal Securities Act defines a “security” as a laundry list of items which can be boiled down into three broad categories:

  • Debt securities (banknotes or bonds).
  • Equity securities (stocks or interests in partnerships or limited liability companies (LLCs)).
  • Derivative securities (futures or options).

man-made-world-4-167269-m.jpgFor the purposes of this discussion, the focus will be on whether ownership in a corporation or limited liability company constitutes a security, thereby requiring compliance with U.S. securities laws in its sale or purchase.  Usually, an offering of securities must be registered under the Securities Act of 1933, unless it falls under an exemption.  The standard as to whether stock is a security in any given circumstance was set forth nearly forty years ago in the U.S. Supreme Court cases of United Housing Foundation v. Forman, 421 U.S. 837 (1975) and Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).

In Forman, the stock at issue was that of a non-profit corporation that allowed its holders to rent a dwelling within a housing cooperative.  The Court concluded that this stock was not a security because it did not have any of the traditional indicia of investment stock, specifically: (1) the right to receive dividends; (2) transferability; (3) voting rights; and (4) the capacity to appreciate in value.

In Landreth, the holders of stock in a corporation sold 100% of it to the buyers, thus giving control over the corporation to the purchasers.  Nevertheless, the Supreme Court applied the Forman test, ultimately deciding that, unless the sale of stock involves selling shares where there is no investment motive, the stock must be considered a security.

The holdings of Forman and Landreth and provisions of the Securities Act are of particular importance to owners of close corporations and limited liability companies that want to sell or transfer their interests while avoiding being subject to securities laws.  The sale or transfer of stock in close corporations are automatically exempt from securities law when the following requirements are met:

  • The transfer or sale is limited to ten or less people who are organizers of the company or who invested through direct solicitation.
  • The transfer or sale did not involve any use of the mails, telephones or the internet.
  • The transfer or sale was limited to one state.

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Continued from “The Commercial Lease and Your New San Diego Business“.

Perhaps one of the most important aspects of starting a new business is the hiring of employees.  Employees are often both the face and backbone of any company and their hiring comes with a host of legal obligations, liabilities, and expenses.  Some estimates place the cost of finding, interviewing, hiring, and training a new employee at nearly $4,000.  In addition to each employee’s salary, employers need to add approximately 18% to employment costs for withholdings, payroll
taxes, worker’s compensation, and compliance with labor laws and this is exclusive of employee

Employees8.jpgThe first step in successfully completing the hiring process is to determine whether your company is, in fact, in need of an employee or employees.  For new businesses, knowledge and experience in the company’s industry helps to guide the decision.  If you are opening a retail clothing outlet in a busy shopping mall, you will almost certainly have to hire employees.  The decision for existing businesses is more complex.  Although every business is different, there are several key warning signs: missing deadlines; making mistakes due to excessive workload; or being so overwhelmed with miscellaneous tasks that it becomes difficult to focus on key aspects of the business.  Whether starting a new business or considering the hiring of employees for the first time, it’s important that the business has the resources to follow through. 

Once a business has decided that employees are necessary to its continued growth and success, there are a series of important steps that the business needs to take to ensure it complies with local, state and federal laws. 

Obtain an Employer Identification Number

Employer identification numbers (EIN) are tax identification numbers issued by the Internal Revenue Service (“IRS”) which are necessary to report taxes and submit other tax documentation.  An EIN number can be obtained at the IRS website by completing a short application process.
Establish A System To Withhold And Record Employment Taxes
The IRScrequires that all employers withhold employment taxes and keep records of such withholdings for at least four years.  Further, employers must submit W-4s (forms that state how much will be withheld from each employee’s paycheck) to the IRS and report annually how much they’ve paid in wages and withheld in taxes on their W-2s. In addition to being necessary for compliance with IRS and state tax regulations, the maintenance of tax records allows a company to monitor its growth, track expenses, and prepare tax returns.  For many small businesses, outsourcing payroll is an cost effective way of complying with employment and tax laws.

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Sweat equity” allows individuals with little or no capital to obtain ownership in a business, usually a partnership or California Limited Liability Company (“LLC”), by trading labor for equity. It allows individuals with financial capital to partner with others who have expertise in a particular field for the purpose of starting a business together.

169849_tax.jpgIt is important however for individuals wishing to engage in a sweat equity arrangement to be cognizant of the tax implications associated with the transaction. Essentially, the sweat equity partner is earning money that she then exchanges for an ownership interest in the company. Because the IRS taxes income and defines income as both cash and non-cash compensation, a sweat equity partner’s compensation, in the form of ownership in the company, is subject to taxation. Sweat equity is subject to income and payroll taxes when: (1) it is issued in connection with the performance of services; and (2) the person receiving the equity pays less than the fair market value for the equity obtained.

Sweat equity is not immediately taxable if it is subject to a substantial risk of forfeiture. Sweat equity is subject to a substantial risk of forfeiture when the partner’s ownership in the equity is conditioned on future performance of services (e.g. the partner must work for the LLC for five years before her interest vests) or is contingent on the occurrence of a condition related to the transfer (e.g. the partner must attain a certain rank in the company). When the sweat equity is no longer subject to the substantial risk of forfeiture, it is considered vested and therefore subject to taxation.

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One of the most important decisions a person wishing to start a business will face is how to organize the new venture, i.e. whether as a corporation or a limited liability company (“LLC”).  If the decision is to form an LLC, there are a number of steps that need to be taken to organize the new company.  To properly form an LLC in California, each of the following steps must be taken.
1246726_business_phone_.jpgChoose An Available Name For The LLC
In California, the name of an LLC must end with the words “Limited Liability Company” or the abbreviation “LLC” or “L.L.C.” and the words “Limited” and “Company” are allowed to be abbreviated to “Ltd.” and “Co.”  The LLC’s name may not contain the terms “bank,” “trust,” “trustee,” “incorporated,” “inc.,” “corporation,” “corp.,” “insurer,” “insurance company,” or any words indicating that the LLC is in the business of insurance.  Finally, the name cannot be the same as, or deceptively similar to, that of any other California LLC or foreign LLC registered to do business in California.
The California Secretary of State maintains a database of current business names that may be checked to see if the name that has been chosen is available.  If a name is available, it can be reserved for up to sixty days by filing a reservation request with the office of the California Secretary of State.

File Articles Organization With The California Secretary Of State
An LLC is formally created when the Articles of Organization, Form LLC-1, are filed with the office of the California Secretary of State.  There is a $70 filing fee for Form LLC-1, which may be filed online at the Secretary of State’s website or by mail.
The Articles of Organization must include: the name of the LLC, the purpose of the LLC, the duration of the LLC, the organizer’s name and address, the name and address of the registered agent, and the whether the LLC will be member or manager managed.

Appoint A Registered Agent
California requires all LLC’s to appoint an individual to act as the registered agent for the company.  The agent is an individual or corporation that agrees to accept service of process (service of legal papers) on the LLC’s behalf.  If the designated agent is an individual, he or she must reside in California and the address must be recorded in the Articles of Organization. The agent may be affiliated with the LLC.  If the designated agent is a corporation, it must have filed a Certificate to Register as a Corporate Agent that places it on a list of companies that are permitted to act as agents.

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It is said that only two things in life are certain, death and taxes.  While everyone is required to pay local, state, and federal income taxes, business owners are generally subject to an additional burden – the self-employment tax (more commonly known as social security and Medicare taxes).  

911375_paper_work.jpgSelf-employed individuals are generally taxed at a rate of 15.3%.  This rate approximates the combined contributions of a regular employee and employer under the Federal Insurance Contributions Act (FICA), and is divided into two parts: 12.4% for social security on the first $113,700 and 2.9% for Medicare.  Usually, this self-employment tax is assessed on 92.35% of the self-employed  individuals’ income.

There are, however, various ways in which business owners can reduce the amount of self-employment tax they are required to pay.

One of the most important decisions individuals wishing to start a business face is how to organize the new venture under the laws of the state in which it is located.  Two of the most common ways to organize a business is as a corporation or a limited liability company (“LLC”), each of which has distinct benefits and disadvantages.  For the purposes of this article, it’s important to distinguish between the C-Corporation and the S-Corporation.  The C-Corporation is subject to double taxation (a tax on corporate profits and a second tax on dividends to shareholders as income).  Like LLCs, the S-Corporation is taxed as a pass through entity (the company’s profits are passed on to the owners as income – a single tax).  The distinction is important because businesses looking for pass through taxation opt between the S-Corporation and the LLC.  This article does not address the more complicated tax picture associated with C-Corporations.  

Credit crunch 4.jpgIn California, the decision whether to form an S-Corporation or an LLC is often guided by the expected impact the state’s tax scheme will have on the business.  Under California law, both S-Corporations and LLCs are required to pay an annual minimum franchise tax of $800.  LLC’s, however, are also subject to an additional tax burden known as the gross receipts tax.

The gross receipts tax requires LLC’s to pay an additional fee, in addition to the minimum franchise tax, calculated based on the company’s gross revenues.  An LLC’s gross receipts tax is calculated based on the following scale:

$0 to $249,999 Gross Revenue = $0
$250,000 to $499,999 Gross Revenue = $900
$500,000 to $999,999 Gross Revenue =$2,500
$1,000,000 to $4,999,999 Gross Revenue = $6,000
$5,000,000+ Gross Revenue = $11,790

In California, S Corporations are taxed at a rate of 1.5% tax of net income earned, whereas LLC’s are taxed based on gross receipts pursuant to the above scale.  This means that depending on the amount of gross receipts and profit a business generates, the company will benefit differently by operating as a S-Corporation or an LLC.

Maybe you’ve formed a business partnership with high hopes, only to later realize that it just isn’t working out. Circumstances change and people move on. You might want out, your partner might want out, or maybe you both want out. Whatever the reason and whatever your goal, you have options.

1017221_business_silhouette.jpgDissolving the Partnership
If partners voluntarily agree to dissolve a partnership, the partners can collect the partnership assets, inventory them, and sell them to pay off creditors. They then divide any surplus between themselves. In addition, a statement of dissolution needs to be filed with the California Secretary of State. This isn’t a very difficult process, but it is a good idea to consult with a San Diego partnership attorney for guidance. A partnership attorney will ensure that the statement of dissolution is filed properly and that the partnership is wound down efficiently. The attorney will also draft a dissolution agreement.  A dissolution agreement is a contract that spells out the terms of the dissolution in the event of a future dispute between the partners.

A voluntary dissolution agreed to by all partners can become a little tricky, but it is the best possible outcome when it comes to dissolving a partnership. The results can be disastrous in cases where one partner disagrees about the terms of the dissolution or refuses to cooperate in dissolving the partnership, In such cases, partners are left with few options. They can opt for mediation, but this option is not likely where an unwilling partner buries his head in the sand and refuses to participate. In such cases, the unwilling partner would often rather see the business go under than to see any surviving partners succeed on their own.

If an informal resolution cannot be reached, partners may be left with no choice but to sue each other. This option is costly, time consuming and emotionally taxing for most people. In such cases, a judge will ultimately determine how the partnership assets will be divided. Only then will the partnership finally be dissolved. It typically takes more than a year, sometimes more than two years to fully litigate a partnership dispute. Obviously, drawn out litigation is not good for business, and often the underlying goodwill that goes along with the partnership’s assets does not survive the process.

When considering whether or not to dissolve a partnership, it’s important to understand every aspect of the partnership’s business before moving forward. Are there contracts or commercial leases involved? Will the partnership remain liable to customers or suppliers? Does insurance adequately protect the partners from future lawsuits stemming from the partnership business? Does the partnership own trademarks, copyrights or patents? Is there goodwill that can be sold along with the partnership assets and will that goodwill survive dissolution. Working with an experienced partnership attorney is the best way to ensure that all of the partnership’s interests are protected.

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It is common for entrepreneurs to get excited about new business ventures.  They often move forward with forming a formal business entity such as a California Limited Liability Company (“LLC”) believing that all of the elements of success are in place.  They hire a San Diego business lawyer to set up their LLC and file Articles of Organization with the California Secretary of State.  Sometimes, however, unanticipated changes or barriers stop the fledgling business in its tracks (partners back out, expected funding falls through or needed capital  equipment becomes unavailable).  Suddenly, the organizers of the LLC find themselves faced with the task of dissolving the company and aren’t sure what steps to take.  Some will simply ignore the situation assuming that no steps are necessary given that the company hasn’t conducted any business – no income is generated so no taxes are due.  This may or may not be true depending on the circumstances.  California LLCs are subject to a minimum franchise tax of $800.00.  This is true whether or not the LLC generates revenue.  Presently, it does not appear that the California Franchise Tax Board is interested in pursuing individuals for an LLC’s taxes so the organizers are not held personally liable in most cases.  Nonetheless, it makes sense to formally cancel or dissolve an LLC to ensure that any taxes due are paid and no outstanding obligations or liabilities come back to haunt organizers.  

1270512_boardwalk_paseo_entablado_3.jpgNewly formed LLCs may formally cancel the LLC and avoid California’s minimum franchise tax if the following requirements are met:

1.    A Form LLC-4/8 Certificate of Cancellation is filed within 12 months from the date the Articles of Organization were filed with the California Secretary of State;

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