Sunday, March 14, 2010

Should I Form a California or Delaware Corporation?

I am often asked by my new entity clients if there is any benefit to establishing a Delaware corporation as opposed to a California corporation and the answer is always the same, "it depends" (classic attorney answer).  We often discuss Limited Liability Companies (LLCs) as well and look the the new companies unique situation before settling on an entity and where to establish it.  

No single factor is controlling in determining the form of business organization to select, but if the business is expected to expand rapidly (every start-ups dream), a corporation will usually be the bests alternative because of the availability of employee incentive stock plans; ease of accommodating outside investment and greater long-term liquidity alternatives for shareholders.  A corporation also minimizes potential personal liability if statutory formalities are followed.  The question remains, is there any benefit to establishing a Delaware corporation as opposed to a California one?

A.  Background

A corporation is created by filing articles of incorporation with the Secretary of State in the state of incorporation.  Corporate status is maintained by compliance with statutory formalities.  A corporation is owned by its shareholders, governed by its Board of Directors who are elected by the shareholders and managed by its officers who are elected by the Board.  A shareholder's involvement in managing a corporation is usually limited to voting on extraordinary matters.  In both California and Delaware, a corporation may have only one shareholder and one director.  A president/CEO, chief financial officer/treasurer and secretary are the officer positions generally filed in a startup and, in fact are required under California law.  All officer positions may be filled by one person.

B.  California vs. Delaware

The reasons for using a Delaware corporation at startup are the ease of filings with the Delaware Secretary of State in financings and other transactions, a slight prestige factor in being a Delaware corporation and avoiding substantial reincorporation expenses later, since many corporations which go public reincorporate in Delaware at the time of their IPO.  Delaware corporate law benefits are of the most value to public companies.  However, if the corporation's primary operations and at least 50% of its shareholders are located in California, many provisions of California corporate law may be applicable to a private Delaware corporation and such a company would pay franchise taxes in both California and Delaware.  These considerations may result in such a business choosing to incorporate in California instead of Delaware.  Another reason for keeping it simple and using a California corporation is the current non-existent IPO market which makes an acquisition a more likely exit for a start up.

There is more flexibility under Delaware law as to the required number of Board members.  When a California corporation has two shareholders, there must be at least two Board members.  When there are three or more shareholders, there must be at least three persons on the Board.  Under Delaware law, there may be one director without regard for the number of stockholders.  Most Boards stay lean and mean in number as long as possible to facilitate decision-making.  Since the Board is the governing body of the corporation, when there are multiple board members, a party owning the majority of the shares cans still be outvoted on the Board on important matters such as sales of additional stock and the election of officers.  Removing a director involves certain risks even when a founder has the votes to do so.  Thus, a founder's careful selection of an initial Board is essential.  You want board members whose judgment you trust (even if they disagree with you) and who can provide you with input you will not get from the management team.

A corporation is a separate entity for tax purposes.  Income taxed at the corporate level is taxed again at the shareholder level if any distribution is made in the form of a dividend.  The "S" corporation election limits taxation to the shareholder level but subjects all earnings to taxation whether or not distributed.  A corporation my be an "S corporation" and not subject to federal corporate tax if its shareholders unanimously elect S status for the corporation on an timely basis.  "S corporation" is a tax law label; it is not a special type of corporation under state corporate law.  Like a partnership, an S corporation is merely a conduit for profits and losses.  Income is passed through to the shareholders and is generally taxed only once.  Corporate level tax can apply in some circumstances to an S corporation that previously had been a "C" corporation for income tax purposes.  Losses are also passed through to offset each shareholder's income to the extent of his basis in his stock and any loans by the shareholder to the S corporation.  The undistributed earnings retained in the corporation as working capital are taxed to a shareholder.

The current maximum federal corporate tax rate is 35%.  The California corporate income tax rate is 8.84% and the Delaware corporate tax rate is 8.7% but Delaware income taxes do not apply if no business is done in Delaware and only the statutory office is there.  There is also a Delaware franchise tax on authorized capital which can be minimized at the outset by increases as the corporation has more assets.

If the business fails, the losses of the initial investment up to $1 million in the aggregate (at purchase price value) of common and preferred stock (so-called "Section 1244 stock") may be used under certain circumstances by shareholders to offset a corresponding amount of ordinary income in their federal income tax returns.  An individual may deduct, as an ordinary loss, a loss on Section 1244 stock of up to $50,000.00 in any on year ($100,000.00 on a joint return).

If statutory formalities are followed, individual shareholders have personal liability only to the extent of their investment, i.e., what they paid for their shares.  If the corporation is not properly organized and maintained, a court my "pierce the corporate veil" and impose liability on the shareholders.  Both California  and Delaware law permit corporations to limit the liability of their directors to shareholders under certain circumstances.  The company can raise additional capital by the sale of issuance of more shares of stock, typically preferred stock when an angel or venture capitalist is investing.  Though rare, the power of a court to look through the corporation for liability underscores the importance of following proper legal procedures in setting up and operating your business.

So should you form a California or a Delaware corporation? It depends.  This is a discussion you should have with a qualified business attorney and accountant.  There are a lot of online incorporators who will incorporate you in whatever state you want.  However, they cannot properly advise you on the proper entity and jurisdiction.  

If you have a business or are contemplating starting a business in California, please do not hesitate to contact Daniel J. Alexander II @ The Out-House General Counsel to discuss your options.  You can also connect to me via telephone at (951) 737-4040 ext. 2 or using the Google Voice Widget on the right hand column of this website.

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