Experienced business attorney Jessica Zubiate-Beauchamp outlines the differences between business entities and their requisite considerations in this article, in addition to sharing her own experiences of working with clients and the obstacles they have faced in forming their businesses.
What are the key legal considerations to be taken into account during business formation? How do these differ between partnerships, corporations and limited liability companies?
The key legal considerations to take into account during business formation are (1) choosing the appropriate type of legal entity for the type of business being formed, (2) understanding and following required formalities to protect against personal liability of the members, partners or shareholders, and (3) ensuring you have thorough, well-drafted formation documents that are tailored specifically to your business, legal and tax needs.
The number one reason why most of my clients seek to form a business entity is to ensure there is sufficient protection against them being sued as individuals. Every type of entity has specific ‘formalities’ or procedures that must be followed by the forming members, officers, partners or directors. For example, a new limited liability company or corporation must properly notice and convene annual member or shareholders’ meetings and record the minutes of the meetings. These formalities are to ensure there is a corporate shield for the individuals running the company to avoid personal liability for the costs or debts of the company.
The specific formalities that must be followed and the types of documents and tax elections that must be made, although similar, do have some key differences between entities. Indeed, there are distinct tax differences between partnerships, LLCs, S-Corps and C-Corps that must be considered when trying to form a business.
The number one reason why most of my clients seek to form a business entity is to ensure there is sufficient protection against them being sued as individuals.
For example, an S-Corp has very specific criteria that must be met and elections to be made to qualify and remain an S-Corp, in addition to being a ‘pass-through’ tax entity where the profits are passed through to the shareholders and taxed individually. On the other hand, a C-corp, which is more common, is not a pass-through entity and the corporation is taxed on its profits typically at a higher rate. Additionally, certain types of limited liability partnerships are only available to certain categories of licensed professionals, including attorneys.
Related to the above, what potential legal pitfalls exist for business owners during formation?
In my experience, the most common legal pitfalls that exist are failure to understand the required formalities when forming the business and attempting to form the business by using general forms that are not state-specific. As to following required formality, it is extremely common for clients to bring me a binder for their corporation that looks great on the outside, but is blank inside – no minutes, no operating agreement and no share ledger or log. There is no written record of who owns shares and when those shares were acquired. Failure to keep records exposes business owners to potential personal liability for corporate debts and damages.
In addition, there are many small and medium-sized businesses that form corporations online and believe there is nothing more to do once they have become a recognised entity on the Secretary of State website. For example, the California corporations code requires that there must be documents filed, shares registered, taxpayer identification numbers obtained, shareholders meeting held, minutes written and approved and recorded, and an actual transfer of shares to shareholders. It is not sufficient with any business entity to merely ‘form and forget’.
It is also very risky when forming a business to do so without an operating agreement or corporate by-laws that provide the rules and guidelines for the business’s operations and governance. Any business in California should have a valid operating agreement, corporate by-laws or shareholder agreement that is specifically tailored to their business entity and which specifically addresses items such as (a) the number of shareholders, directors, or officers, (b) the voting rights and ownership rights of shareholders, and (c) procedures in place upon the death, incapacity, removal, resignation of officers or directors, or (d) how to deal with owner misconduct.
Failure to keep records exposes business owners to potential personal liability for corporate debts and damages.
Absent a governing agreement of the appropriate type, the business can be forced to deal with the draconian California Corporations Code at a time when the company may already be going through difficulties. The California Corporations Code is a baseline guide to governing a business and outlines the bare minimum. An operating agreement, partnership agreement or corporate by-laws (depending on the type of business you form) are recognised by the Corporations Code as the guiding and driving force of a corporation that can provide for so much more than the code and help to keep the business out of different types of litigation.
How can an experienced business law attorney help business owners to identify these risks and plan to avoid them?
An experienced business law attorney can help business owners determine the right type of entity for their needs and explain in laymen’s terms what the Corporations Code requires to properly form and maintain a business entity. A business law attorney will also have the knowledge and experience to anticipate legal and tax problem areas for the client and their business in order to prepare a complete and specific governing agreement that addresses procedures for governance of the business, ownership rights and electing officers and directors.
Two of the most common issues I see with my business clients pertain to an owner, member or partner that has begun competing with the company and/or is injuring the company to his or her own benefit, or an owner or member that has passed away unexpectedly and without a plan. A well-drafted operating agreement or corporate by-laws will give guidance to the owners on what they are authorised to do in difficult situations such as these.
Can you share any developing trends that you are witnessing in the business law landscape, especially relating to business formation?
With an increase in targeted internet marketing and search engines that can provide a barrage of information in an instant, I have personally seen an influx in clients trying to take shortcuts and form and operate business entities only by searching the internet and pulling up forms that may or may not be applicable. My clients have come in with forms from different states, forms that do not apply or with forms from a friend, bookkeeper or even their realtor in an attempt to form a business entity, but without having the requisite knowledge and information to do so.
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For example, I knew a gentleman who utilised the services of a company whose owners portrayed themselves as business formation experts online, had a flashy and impressive website and lots of fake reviews. In the end, they charged this gentleman money and, due to the incompetence of the company, committed a serious filing error which legally linked my client to a defunct corporation that had pending debts and liens. This man now has exposure to serious liability for a corporation he has never owned, all as a result of the error that the company he initially paid to form his corporation refuses to fix. To add injury to insult, there is no real point to sue the company for relief because it is involved in three current lawsuits already and has a host of judgments against it.
I have seen so many hardworking people find themselves in difficult and precarious financial, tax and legal positions because they utilised internet forms or internet companies to form a business without the tools for proper formation maintenance of a business in California. I highly recommend utilising the services of an experienced business law attorney to provide state-specific, accurate guidance and assistance to set the business entity on the right path to maximize benefits, limit personal liability, and minimize negative tax consequences.
Jessica Zubiate-Beauchamp, Partner
333 East Foothill Boulevard, San Dimas, CA 91773, USA
Tel: +1 909-305-5544
Fax: +1 909-305-5564
Jessica Zubiate-Beauchamp is the Managing Partner of Zubiate Beauchamp, LLP, which she joined in 2011. Jessica participates in all stages of civil litigation across a variety of areas of law, including trusts and estates, trade secrets, contracts, unfair business practices, business formation and litigation, and real estate, as well as contributing her knowledge on copyright.. Jessica is currently a member of the California Lawyers Association and the Eastern Bar Association. She is proud to provide pro bono legal business services to local non-profit organisations that promote music and arts education.
Zubiate Beauchamp LLP is a general civil law practice that serves a broad range of clients in California across Los Angeles County, the Inland Empire, Orange County and Riverside County. The firm specializes in transactional and litigation matters, with a particular focus on business law, real estate, , willsand probate, trust administration, employment and contract law.
