Bizadvisor.com   Legal Services    About Mary Hanson   Business Articles The Business Advisor STEPS IN INCORPORATION: What needs to be done to properly set up a corporation. by Mary Hanson

If a corporation is not properly set up, the worst problem that can arise is that the corporation will provide no protection from personal liability, and the shareholders may be held personally liable for obligations that should have been solely corporate obligations.

A number of other problems can arise from the failure to establish and maintain the corporate structure, ranging from surprise tax liabilities to disputes among shareholders.

Here is a checklist of the steps and issues involved in properly setting up a corporation:

1.  Consider whether incorporation is appropriate, and what other forms of business might be considered. Consider whether this is the appropriate time to incorporate. A California corporation can be formed in less than 2 weeks, so there is no need to rush. The pros and cons should be carefully considered before forming a new entity, which is also a taxpayer.

2.  Make sure the correct state is chosen. A corporation formed in another state must qualify to do business in California if it will "do business" here.

3. Check to make sure the name you plan to use as the corporate name does not infringe the name or trademark of another business. The Secretary of State does not check anything except conflicting names already on its list as a corporation in California. It is your responsibility to make sure your name does not infringe on the rights of other businesses.

4.  To form a California corporation, the Articles of Incorporation are filed with the Secretary of State for the State of California. This begins the corporation's existence, but does not provide any other structure.

5.  After Articles of Incorporation are filed, the corporation must be completed with the adoption of Bylaws, the naming of the Board of Directors, the issuance of stock, and other steps discussed below.

6.  Have the Incorporator who signed the Articles of Incorporation execute an "Election of Directors," so that the naming of the initial Board of Directors is documented.

7. Have the initial Board of Directors meet and take the actions necessary to complete the organization of the corporation. At this organizational meeting of the Board of Directors the Board adopts the Bylaws, authorizes the issuance of stock and the opening of the corporate bank account, and elects the officers of the corporation. At this meeting other forms may be executed for filing, such as the form for election of S corporation status, the Notice of Transaction to be filed with the Department of Corporations to comply with state securities laws, and the Statement by Domestic Stock Corporation.

8.  The Bylaws are mostly provisions from the California Corporations Code, setting out the rules on voting, calling meetings, and other structural issues. The Bylaws state the number of Directors on the corporation's Board of Directors. Make certain that this is correct, so that you don't need to amend the Bylaws, and, more importantly, so that your Board of Directors is correctly established.

9.  Make certain that stock is issued in exchange for assets or cash. Don't issue stock that has not been paid for in cash or assets. Have stock certificates prepared to document the ownership of the shareholders. In order to offer, sell, or issue stock, you must comply with securities laws. For most small businesses, exemptions from registration of the stock are available for shareholders who are founders of the business and friends or family members of those founders. In order to use the most common exemption, a form must be filed with the California Department of Corporations.

Records must be maintained to show that the exemptions used for the issuance of stock were appropriate for each particular issuance and the particular shareholders.

If you are raising funds from individuals who are not family members or long-term friends or business associates, it is important to comply with securities laws. The easy exemptions may not be available, and a "disclosure document" providing detailed information on the proposed "investment" is necessary.

10.  Prepare minutes of the organizational meeting, evidencing the actions taken by the Board of Directors. Have these minutes signed by the Secretary of the corporation. If the Board wishes to take actions without meeting together, have a "Consent to Action Without Meeting" signed by ALL the Directors.

11.  After Articles of Incorporation are filed, you have 90 days to submit a form called the Statement by Domestic Stock Corporation to the Secretary of State. This is the primary public information on your corporation. On this form you will report the address, type of business, the names of officers and directors, and the agent for service of process for the corporation. This form must be filed every year.

12. If S corporation status is desired, you must file form 2553 with the IRS. This form should be filed within 75 days of the filing of the Articles of Incorporation. The filing of this form, with the signatures of all the corporation's shareholders, makes the corporation an S corporation, provided that the S corporation status is accepted by the IRS.

13. If stock is issued in exchange for assets contributed to the corporation (as is often the case in the incorporation of an ongoing business), make certain that a list of contributed assets is completed and checked with the business's accountant. Make certain that the initial corporate records are properly set up and that the assets included in the books of the corporation are documented as being transferred to the corporation in exchange for stock.

14. Obtain a Federal ID Number (the "EIN" or "Employer ID Number") from the IRS for the corporation and open a corporate bank account. The corporation is a taxpayer and must file tax returns and maintain evidence that it is operating as an entity separate from its owners.

15. Make sure the shareholders who are to be compensated by the corporation as employees are included in the corporate payroll. Business owners who incorporate their business can no longer just take a draw or use business funds for personal purposes.

16.  Establish a plan to hold regular meetings. The legal requirement is for at least an annual meeting of the shareholders. Plan to hold the annual meeting of shareholders once a year, as required, at which the shareholders elect the Directors. In addition, since the Board of Directors is the real authority behind the corporation, plan to show at least the Board's yearly meeting, and in addition, formally record other actions taken by the Board throughout the year. Maintain formal minutes of these meetings in your corporate record book.

If you have a number of shareholders or directors who do not get together on a regular basis, plan to send formal meeting notices in order to comply with the requirements of the California Corporations Law.

If you have already incorporated, the following is a helpful checklist to see if your corporate records are accurate and complete:

p Check the number of Directors stated in the Bylaws. Compare this to the Statement by Domestic Stock Corporation and Minutes. Are they consistent and correct? Are there any vacancies on the Board (fewer named directors than the number stated in the Bylaws)? Are there more (or fewer) Directors than the Bylaws authorize? To increase (or decrease) the number of Directors, you must amend your Bylaws.

p Check your most recent Statement by Domestic Stock Corporation. Is the address correct and current? Are the reported directors and officers the same as those in the corporate minutes? If the Statement filed is not correct, obtain a blank one from the Secretary of State and file the correct information. The form is an annual form. Make sure any changes of address are filed so that the Secretary of State will send your forms to the correct address. This can now be done on-line with the California Secretary of State.

p Have you kept a copy of each filed Statement by Domestic Stock Corporation for each year?

p Check the authorized number of shares in the Articles of Incorporation and on the stock certificates. If the number is exceeded, some stock issued will be invalid. If so, you must amend your Articles of Incorporation and reissue stock.

p Check the issuance of stock. Do the minutes authorizing issuance and the stock ledger make clear how many shares are outstanding and who holds those shares? Is the consideration (money or assets) paid for the stock stated? Have certificates been made out showing the correct number of shares held by each shareholder?

p Check the securities law notices (e.g., the Notice of Transaction filed form showing the total consideration for each issuance of stock). Is there one for every time stock was issued? Are you sure it was filed with the Department of Corporations?

p Has there been an annual meeting of shareholders at least once a year? Do your formal records show the annual election of Directors by the shareholders? Do your records show that either all shareholders were present at the annual meeting or that all steps were taken to comply with legal requirements for meeting notices, quorum, and voting as stated in your Bylaws, or as provided in the Corporations Code?

p Do you show meetings of the Board of Directors, at least once a year? Do you have evidence of other meetings of the Board of Directors throughout the year?

p Are there promissory notes to evidence personal loans made to the corporation?

p Have your meetings or actions taken by the Board of Directors been done through valid meetings and majority vote? If you have several Directors, make sure your meeting records show compliance with legal requirements for meeting notices, quorum, and voting as stated in your Bylaws, or as provided in the Corporations Code.

p If your Bylaws or Articles of Incorporation have ever been amended, do you have certified copies of those amendments kept with the Bylaws or Articles of Incorporation?

p Do you have copies of the S corporation acceptance from the IRS?

These lists should help clarify the steps and the records that establish the validity of a corporation. There is a big difference between "filing Articles of Incorporation" and "setting up a corporation."

 PUBLISHER'S NOTE

In addition to completing the "required" steps, business owners and managers should at the time of incorporation address other important business issues. Ideally, a shareholder agreement restricting transfer of stock will be executed at the same time that stock is issued. The shareholder agreement should also provide for the buyout of stock in the event of death, disability, divorce, and termination of a shareholder's employment. The agreement should include other important issues, such as protection of proprietary information and a covenant not to compete in the event of the buyout of a shareholder.

While addressing the issue of proprietary information in the shareholder agreement, it is appropriate to make certain the company has a complete plan for identification and protection of all confidential information.