Choice of entity is always an early question encountered by entrepreneurs. Below is a summary of certain key differences between forming a limited laibility company vs a corporation: I. Formation An LLC is formed by filing Articles of Organization (LLC-1) with the California Secretary of State. The current filing fee is $70. The filing requires relatively little information with respect to the identity of the members (owners). However, the identity of the LLC members must be disclosed in the Statement of Information (LLC-12) which has to be filed within 90 days after filing of the original Articles of Organization if the LLC is a member-managed LLC. If the LLC is a manager-managed LLC, only the manager's identity needs to be disclosed in the LLC-12. The filing fee for the LLC-12 is $20. In contrast, forming a corporation requires filing of Articles of Incorporation with the Secretary of State, and payment of a $100 filing fee. The Articles of Incorporation can be more complicated than the Articles of Organization since they must meet statutory requirements in accordance with California Corporation Code (the "Code") Sections 200-202. An initial Statement of Information (Form SI-200C) is also a required filing within 90 days after the corporation files its Articles of Incorporation. A $25 filing fee is charged for the filing. Unlike with LLCs, the Statement of Information for corporation does not require the disclosure of the identity of shareholders, as it only requires the disclosure of the officers and directors. The annual filing obligation for the Statement of Information will be discussed later in this document. II. Organizational Matters Bylaws vs. Operating Agreement For a corporation, the governing document is the Bylaws. The Bylaws typically follow Code Section 212. In some instances, where permitted, the Bylaws' provisions may vary from the Code's statutory provisions. The Bylaws set forth rules governing voting, meeting, notices, election of officers and directors, share issuance, and other corporate governance issues. A counter-part of the Bylaws in a LLC is an operating agreement. It governs the relationships among the member(s) and the management of the LLC. Members' initial capital contribution will also be listed in the operating agreement. Furthermore, the operating agreement often incorporates cross-purchase provisions that in a corporation are typically found in a shareholders agreement Although neither the Bylaws nor the LLC Operating Agreement must be submitted to the Secretary of State, these two documents have to be prepared at the beginning of the formation process. Organizational Resolutions The organizational resolutions are standard resolutions setting forth the items that require approval by the board of directors of the corporation in order to get the corporation organized. The organizational resolutions usually include the appointment of the initial director(s). They also require the board to elect and ratify the appointment of corporate officers such as the chief executive officer, chief financial officer and secretary. The organizational resolutions also require the board to approve the initial capital structure of the corporation. An LLC usually does not need to have its members approve a document like the organizational resolutions during the formation stage because the operating agreement should have already covered most of the issues such as the appointment of the Manager (if it is manager-managed LLC) and the capital contribution information. Tax IDs, Double Taxation vs. Pass-through Taxation For federal income filing purpose, both the corporation and the LLC need to file a SS-4 Form with the Internal Revenue Services (IRS) to obtain their federal tax identification number (FEIN). The FEIN number may also be required for other purposes such as opening a bank account for the company. With respect to taxation, a corporation is subject to what is often referred to as "double taxation." The corporation is required to prepare a separate tax return and to pay tax based on its net income at specified corporate tax rates. Then, the remaining net income of the corporation, when distributed to the shareholders is taxed again at the individual level at the shareholders' tax rates on their personal tax filing. In contrast to a corporation, an LLC is by default treated as a conduit for tax purposes. It is often referred to as "pass-through" taxation. This means that, for federal tax purposes, all net income and net losses of the LLC pass through to the members of the LLC without being taxed separately at the LLC level. If the LLC only has a single member, it will still be afforded single-level, pass-through tax treatment but will be treated as a "sole proprietorship" for federal income tax purposes. III. Capitalization and Ownership Capitalization In return for a membership interest, the member of an LLC may contribute money, property, or a binding obligation to contribute any of these to the LLC in the future as provided in the Articles of Organization or Operating Agreement. A person can also receive an economic interest in the LLC but not necessary a membership interest in an LLC. Under certain circumstances, an LLC interest may be deemed a "security". The legal definition for "securities" is an investment in an enterprise with the expectation of profit from the efforts of other people. Interests in the LLC often are treated as securities because one can invest in the LLC to expect the return of the profit, but someone else is actually running the business of the enterprise as in the case of a manager-managed LLC. Some states including California expressly define LLC interests as securities. However, if the LLC is structured as a member-managed LLC, and all of the members actively participate in the management of the LLC, then the LLC interests may not be securities. There is little guidance as to what constitutes active engagement in management, so it can be risky to assume that LLC interests, even in a member-managed LLC, are not securities unless the facts are abundantly clear (i.e., a three-member LLC in which all three members are equal partners who regularly participate in decision making regarding the business). Otherwise, LLC interests should be considered as securities, and all the normal steps to comply with applicable federal and state securities law should be taken. As for a corporation, someone must give something of value (typically, cash or assets) to purchase the stock and to become a shareholder. A future obligation to contribute property or services is not proper consideration; however, Code Section 409(a)(1) does permit shares to be issued in exchange for a promissory note provided the note is adequately secured by collateral other than the shares themselves or pursuant to an employee stock purchase or option plan. A corporation can vary shareholder rights by issuing different classes or series of stock. Stock is a security and its issuance is subject to securities laws under state "Blue Sky" laws and also federal law. In California, a corporation needs to file a Notice of Transaction with the California Commissioner of Corporations when issuing shares in a limited offering pursuant to a securities exemption under Code 25102(f). Economic Allocations Unlike a corporation, an LLC cand esignate special arrangements for economic allocations. Through use of classes of preferred stock, a corporation may be able to approximate the variety of economic allocations that can be accomplished in an LLC, but it requires far more effort and documentation to do so. Allocation of Profits and Losses Dividends may only paid in proportion to the stock ownership within each class. Code Sections 500 and 501 limit distributions to shareholders. Unless the distribution is made from retained earnings, the corporation must satisfy certain solvency test based on its assets and liabilities. Nor may a corporation make a distribution to shareholders if the corporation is unable to meet its liabilities as they mature. LLC profits and losses are allocated and distributed among the members as provided in the operating agreement. In the absence of such an operating agreement provision, profits and losses are allocated in proportion to each members' capital contribution. In the absence of an agreement to the contrary in the operating agreement, distributions of money or property representing a return of capital are made in proportion to contributions and other distributions are made in proportion to the allocation of profits. Transferability of Interests An LLC member can freely transfer his or her rights to share in the LLC's profits and losses and distributions (known as economic interests). However, a member cannot cause a new person to become a substituted member (with voting and inspection) by virtue of a transfer unless provided in the operating agreement or by consent of majority interests of the members. In contrast, absent an agreement among the shareholders providing otherwise, shares of a corporation's stock are freely transferrable. In smaller or closely held corporation, however, shareholders typically enter into a buy-sell agreement specifying, in advance, the events triggering a buy-out, the method for determining the purchase price for the stock and the payment terms. IV. Operations and Formalities Management Structure Except in the case of a statutory close corporation, management and control of a corporation is vested in the board of directors, elected by the shareholders. The directors generally establish the policies and make major decisions, but day-to-day dealings with third parties are delegated to the corporation's officers and employees. For a small corporation, the same person many be shareholder, director and officer. An LLC is known for its flexible management structure. Management of an LLC may be centralized with the appointment of one ore more designated managers and managers need not be members. Alternatively, management may be vested in all of LLC's members. Unless the Articles of Organization or operating agreement provides otherwise, each member has the right to vote in proportion to his or her interest in the LLC's current profit. Corporate Formalities Corporations are subject to certain basic statutory requirements and formalities that cannot be waived or modified; such formalities are not mandatory in the LLC context. As an example, corporations must hold an annual meeting of shareholders and an annual meeting of directors (or take action by written consent in lieu thereof), and the board of directors are expected to make decisions, take action and keep records of such actions for activity that is outside the ordinary course of the corporation's business. Below are few examples of the actions which require the board's approval: (a) To select and remove corporate officers and to award their respective compensation' (b) To authorize the issuance of shares of stock of the corporation; (c) To authorize or amend the corporation's stock option plan;
(d) To borrow money and incur indebtedness for the purpose of the corporation, and to cause to be executed and delivered, in the corporate name, promissory notes, bonds, debentures, deeds of trust, mortgages, pledges, hypothecations, or other evidences of debt and securities the corporation; and
(e) To authorize the merger and acquisition of the corporation, including but not limited to the sale of the substantial asset of the corporation or the purchase of the substantial asset of another corporation.
However, a LLC is not required to hold meetings or retain such records. For some businesses, the informality of the LLC can be an attractive alternative to the formalistic requirement of a corporation. The LLC Act expressly provides that failure to meet certain of the formalities required of a corporation (e.g., holding annual shareholder meeting and director meetings) is not a factor to be considered in a "piercing the veil" dispute. Nevertheless, certain fundamental changes in the form of operations of the LLC require the consent or approval of the members. Such actions include:
(a) Amendment of the articles of organization of the LLC;
(b) Sale or disposition of all or substantially all the assets of the LLC;
(c) To borrow money and incur indebtedness for the purposes of the LLC;
(d) To authorize the merger and acquisition of the company including but not limited to the sale of the substantial asset of the LLC or purchase of the substantial asset of another company.
Annual Filing of the Statement of Information
A domestic stock corporation shall file a statement of information (SI-200 C or SI-200 NC if no changes) with the California Secretary of State, within 90 days after filing its original Articles of Incorporation, and annually thereafter during the applicable filing period. The applicable filing period for a corporation is the calendar month during which its original Articles of Incorporation were filed and the immediately preceding five calendar months. For example, if a corporation filed its original Articles of Incorporation on January 1, 2009, then its applicable filing period will be from August 1 to January 1 of each year.
For an LLC, the statute requires the LLC to file the statement of information (Form LLC-12 or LLC –12 R if no change) with the secretary of state, within 90 days of filing its original Articles of Organization, and biennially thereafter during the applicable filing period. The applicable filing period for an LLC is the calendar month during which its original Articles of Organization was filed and the immediately preceding five calendar months. Using the above example, if the LLC's originally filed its Articles of Organization on January 1, 2009, then its applicable filing period will be between August 1 and January 1 of every other year. Failure to file the statement of information by the due date will result in the assessment of a $250 penalty.
California Franchise Tax
A corporation which is incorporated in or qualified to do business in California must pay the minimum franchise tax during the first quarter of each accounting period whether the corporation is active, operates at a loss or does not do business. The current minimum tax is $800. An LLC is also subject to the same minimum franchise tax rule. A corporation or an LLC is not subject to the annual tax if it did not conduct any business in California during the taxable year, or the taxable year was 15 days or less. The annual tax is due on the 15th day of the 4th after the beginning of the taxable year.
V. Dissolution
Dissolving a corporation in California requires multiple steps before and after the dissolution. First, a Certificate of Dissolution needs to be filed with California Secretary of State. Upon this filing, the Corporation's dissolution will be conditional and it will not become final until the issuance of a tax clearance certificate by the California Franchise Tax Board. There is no fee charged for the filing of the Certificate of Dissolution. Both shareholders' written consent and the board's written consent are required to authorize the dissolution process in accordance with California law and the Plan of Complete Liquidation and Dissolution of the corporation. A plan of liquidation with conveyance and assignment is required to allow the transfer of all residual corporate assets to its existing shareholders. During the dissolution process, the corporation needs to send a Notice to all its creditors and claimants if any after the dissolution process commences. The corporation also needs to file an IRS Form 966 within 30 days of the approval of the dissolution. Furthermore, a corporation must file a request for Tax Clearance (Form 3555) with the California Secretary of State together with the Certificate of Dissolution to obtain tax clearance. The corporation must receive tax clearance from the California Franchise Tax Board for the dissolution to be final. Generally, tax clearance can be obtained by either filing a final tax return and paying all taxes due (if any) or by having another person assume the corporation’s tax liability. It can take several weeks to obtain tax clearance.
To dissolve an LLC in California, one needs to file a Certificate of Cancellation with the Secretary of State after the dissolution process is completed. There is no fee charged for the filing of the Certificate of Cancellation. All members need to approve and sign the resolutions which authorizes the commencement of the dissolution process. The resolutions set forth the standard dissolution plan, which is to pay or adequately provide for all debts of the company, if any, and then distribute any remaining assets pro rata to the members. The members also need to sign the assumption of debts and liabilities document which will let the members assume all the debts and obligations of the LLC. Finally, the members need to execute a conveyance and assignment form which authorizes the transfer of all residual assets of the LLC to the members.
Darlene D. Chiang, Esq. is the author of this post and may be contacted at dchiang@lpslaw.com Ms. Chiang counsels business clients and financial institutions on corporate and regulatory matters.
