|IncorporationIncorporation is an important issue to the new business, as well as any business. However, the subject is not the most important. Incorporation is probably the most misunderstood. The area of corporate organizations tends to be filled with myth. I would like to give an overview of incorporation that I hope to resolve the myths, and help you determine whether and when to incorporate, how to incorporate and where to incorporate.A “corporation” is the creation of a legal entity that exists separate from its owners. Early corporations were “joint stock companies” that were used by merchants to raise money to find new trade routes, bring spices and products to Europe from the Orient, and to undertake other risky ventures.
There were, and still are, two key purposes in forming a corporation: 1.) joint ownership; and 2.) limited liability. If you were a single merchant trying to find a better source for rare spices, you would have a tremendous investment. The odds of success were slim, but the payoff for success was massive. But, only a few people would have the wealth to single-handedly undertake the risk of losing that much of their money. Thus, the corporation allowed an owner to share ownership with other investors. Before the introduction of corporations, an investor could share ownership with others, but it would have taken the form of a partnership. A partnership is a form of organization where two or more people get together to share ownership of an enterprise. Partnerships can take any number of forms, and equity (ownership) can be divided up in any number of ways. However, partnership law had one major draw back: all partners were jointly and severally liable for the activities of the organization and for some of the activities of the other partners. Personal liability was a problem for any enterprise; but it was a particular problem when an investor faced liability for the activities of someone else. In other words, historically a merchant would be personally liable for the activities of his business, but if he knew his business and he ran his business, then he could control his risks to some extent. In modern days, the same is still true. A sole proprietor faces personal liability for the activities of the business, but at least the business owner is in control of those risks to some extent.
Now, in thinking of incorporation, we should always start with these two “needs” that incorporation addresses: diverse ownership and limited liability. Before you incorporate, you should focus on these questions, not only on whether to incorporate, but with regard to which type of entity to choose as your corporate form.
In looking at the first issue, we need to analyze whether you will have diversified ownership. Will you have partners? If you will not have partners, are there any investors? What role will your investor play? If you will not have investors, will you need investors down the road? Is your spouse a co-owner, or will you own the company (even though your spouse normally “owns” half of everything in the marriage under community property law)? If you are going to have co-owners, partners, shareholders, investors involved, there are a host of issues that need to be addressed. If you are not, then the matter is more basic. Let me address issue of limited liability before going into detail about diverse ownership.If you are the “sole” owner of your business, then you may not “need” to form a corporate entity at all. Remember the two questions: are there diverse owners? And, do I need limited liability? So, if you are the sole owner, then you do not “need” a corporate entity for the first problem; and the second problem (of liability) can be addressed with insurance, as discussed in Chapter 23. Now, if you are the sole owner, and you do not need limited liability, then you may not want to incur the expense and trouble of forming and maintaining a corporate entity.
In California, for example, a corporate entity costs about $200 in fees to form, but then if the entity is a “pass through” entity (discussed in Chapter X on taxes), then there is an additional fee of $800 per year, every year, known as the minimum corporate tax. If you operate a pool cleaning service that only makes $20,000 per year, then you would spend about 5% of your annual profit just to have a corporate entity. It may not make sense to form a corporate entity for many small businesses; particularly where there is a single owner-operator, and a small annual profit. The only issue to address if you are the sole owner, and you believe that you will always be the sole owner is the issue of limited liability, addressed later in this chapter.
If you are going to have diverse ownership, either now, or in the future, then you should evaluate the corporate issues carefully. The first issue to examine is “when” you will have diverse ownership. If you are going to operate as a sole proprietorship until you reach a certain benchmark, before you take investors or partner with others, then you may not need to create your organization until you reach that benchmark.
For example, if I practice law as a single-attorney practice, I very well might partner with another attorney down the road. If I am going to anticipate a future partnership, I can form a corporate entity now that allows me to add partners down the road. But, I can also wait until I find a potential partner to form an organization. Part of the decision might be what kind of partner I want to have later; part of the decision might be how I hope to operate organizationally down the road.
Here is what I mean. If I have a plan to grow a significant practice, and hire younger attorneys to work for me, and eventually grant them (or sell them) small partnership interests, then I should form an organization in advance that has this structure already “packaged” and allows me to control the future allocation of ownership. I might form a limited liability partnership or limited liability company (for professionals there are specific entities that each state authorizes to be formed known as “professional” entities). My LLC might only have me as an owner for many years; but as the sole owner, I could create a category of shares or “units” that I will issue in the future to my apprentices as they mature into independent attorneys. They would become “shareholders” or “unit holders” or “members” of my LLC, and in essence become “partners” in the organization. They would have the choice to accept the terms of my packaged partnership, or to not. This pre-planning would put me in the position of having a predictable way to allocate ownership in the future, even while I am still a solo-practice.
This same approach might not work, however, if the future partner is a peer. If, after five years of solo-practice, I wanted to partner with another attorney to join our mutual talents, and resources, then I would not have a very easy time selling my small shares of pre-packaged LLC units. My peer would negotiate for a “fair” allocation of ownership, and we would then form an entity that accomplishes our purposes. We very likely would form an LLC which is owned 50/50 by the two of us, or if there were more of us, in some other equitable way. My point is that with any business, your future expectations of ownership should guide your decisions about entity formation now.
If you are starting a web-design company, you have to evaluate the same issues. You need to try to predict whether and when you will diversify ownership, as well as how you expect the ownership to look. Do you want employees that earn their way into “partnership?” Do you want a peer that joins forces with you to create a larger firm? Do you want “silent” investors that buy stock and leave you alone? Do you want to raise capital immediately by selling stock in your company to family and friends? Every one of these questions has a different implication for your organizational choice.