Incorporated in the wrong jurisdiction? Now what?

Let’s say you are an entrepreneur who lives in Arizona, so you decide to incorporate your web-based business in Arizona. A few years later, your wife’s company transfers her to New York.  To operate your company in New York as a foreign (i.e., out-of-state) corporation, you would qualify to do business in that state. When that happens, your company becomes obligated to pay franchise taxes and file tax returns in both Arizona and New York. Ouch!

To continue your business venture without having to pay Arizona taxes and fulfill Arizona corporate compliance requirements, the traditional options are: (1) dissolve the Arizona company and form a new corporation, or (2) form a new corporation and merge your existing Arizona corporation into it.  Although many believe that it is possible to reincorporate the company as a “tax free reincorporation” under Internal Revenue Code Sec. 368(a)(1)(F), until now, there has been no simple transaction to do so.   See, RR96-29. The traditional options required forming new companies, resulting in a new tax ID number and bank accounts, and re-establishing (or at least massaging) vendor relationships.

On August 1, 2009, Delaware came to the rescue by broadly enabling existing entities to convert to Delaware entities (without a cumbersome merger).  The new law even permits the conversion of one entity type to another entity type (e.g., the conversion of an Arizona LLC to a Delaware corporation). See Section  265 and 266 of the Delaware General Corporation Law, DE Conversion Statute.

To convert your Arizona corporation to a Delaware corporation, you would simply file a Certificate of Conversion along with a Certificate of Incorporation.  The resulting Delaware corporation would then be qualified to do business in New York.

Delaware is a jurisdiction of choice for many reasons, including low annual fees and well founded corporate law. Small business owners are fans of Delaware for an altogether different reason – mobility.  See http://www.eminutesonline.com/delaware-jurisdiction-of-choice-for-mobile-generation/.  Let’s say your spouse can’t stand the New York winters and wants to move to Florida.  In that case, you would simply surrender the right to do business in New York and qualify the Delaware corporation to do business in Florida, a process which inexpensively maintains the continuity of your corporation.  For more on this topic, watch http://www.eminutesonline.com/what-is-the-benefit-of-incorporating-in-delaware-watch-video/.

Delaware: Homerun for Celebrities and Investors Concerned About Anonymity

Limited information collected by Delaware makes it an ideal jurisdiction for clients who are concerned about protecting their identity.  For celebrities or investors who prefer not to be publicly identified, forming a company in Delaware is a homerun.

When a California investor acquires property through a LLC and acts as the manager, the report that must be filed with the California Secretary of State (Statement of Information) identifies the investor (publicly) as the manager of the company.  The investor who forms a corporation or a second LLC to act as the manager is no better off, as the manager would be identified (publicly) on the Statement of Information for the second LLC.

Delaware, like most states, collects information when a company is formed and annually thereafter.  However, Delaware is unique in the limited amount of information requested.  First, when a new LLC is formed, the Certificate of Formation only identifies the name of the company, the resident agent, and the name of an authorized person who signs the form.  The authorized person is typically a lawyer who is handling the formation of the company.  Delaware LLCs must pay the $250 LLC tax on June 1.  When filed online and paid with a credit card, unlike most other jurisdictions, no member, manager, or address information is requested or confirmed; and no signature is required.  In short, the annual filing requirements for a Delaware LLC can be handled without a trace of the person handling the filing.

When our real estate investor in California wishes to protect his or her identity, the solution is to form a Delaware limited liability company to own the property, which is then qualified to do business in California. A second Delaware LLC is formed to act as the manager.  As Delaware does not collect information on the identity of its managers, there is no public record that identifies the real estate investor.

Over the years, there have been a lot of schemes designed to conjure up identity protection, but these schemes have been mostly hocus pocus.  Many clients have asked about using “nominees”, which are essentially hired guns who will act as a corporation’s officers or as the manager of the LLC.  However, these schemes are expensive, and wrought with risk associated with appointing a complete stranger as the CEO of your company.  Using Delaware for anonymity purposes carries none of these risks.  Delaware has a sophisticated judicial system, and is a preferred jurisdiction for the flexibility and mobility it provides to those who form businesses there.  See, http://www.eminutesonline.com/what-is-the-benefit-of-incorporating-in-delaware-watch-video/; http://www.eminutesonline.com/delaware-jurisdiction-of-choice-for-mobile-generation/.

Although Delaware has been criticized as the “world’s most secret financial location” (http://www.guardian.co.uk/business/2009/nov/01/delaware-first-choice-tax-haven), and there is undoubtedly room for abuse, celebrities, public figures, successful investors, and others have a legitimate interest in safeguarding their personal information.

Converting to a California Corporation: Why Risk Getting Stung Twice?

Let’s say you’re an actor in New York who forms a New York corporation.  When the draw of California is no longer resistible, you pack up your car and go west!  What do you do with your New York Corporation?  To operate your company in California as a foreign (i.e., out-of-state) corporation, you would qualify to do business in California. When that happens, your company becomes obligated to pay franchise taxes and file tax returns in both New York and California (which happen to be two of the highest taxed states in the nation).  To continue to use your corporation without having to pay New York taxes and fulfill New York corporate compliance requirements, the knee-jerk solution would be to “convert” the corporation to a California corporation.  As explained in this article, the better choice might be to convert the corporation to a Delaware corporation.

The California Conversion Process is Straightforward

California allows foreign entities (see, Cal. Corp Code Sec. 1150 et seq. for corporations and Cal. Corp Code Section 17540.01 et seq. for LLCs)  to convert into California entities (as long as the state you are exiting also permits the conversion). Conversion effectively moves the entity from one jurisdiction to another, resulting in the same exact entity existing in an alternative home jurisdiction, while ending its existence in the original jurisdiction. Once the entity is converted to a California entity, it will retain the employer identification number that was originally assigned to it. Similarly, there is no need to assign royalties, intellectual property, or any other assets because the entity maintains a continual existence.

Under California law, to authorize the conversion, the converting entity must prepare and execute a Plan of Conversion. The Plan of Conversion essentially serves as a road map for the conversion. It includes the terms of the conversion, the manner of converting the shares of each of the shareholders of the converting corporation into securities or interests in the converted entity,  the provision providing for the governing documents for the converted entity to which  the holders of interests in the converted entity are to be bound (Bylaws for a corporation, Operating Agreement for LLCs,  etc.), any provisions  that are required by the jurisdiction in which converted entity was originally organized.  The Plan of Conversions must be approved by the Board of Directors and a majority of the outstanding shareholders, if it is a corporation or membership interest if it is a LLC.

Once the Plan of Conversion is approved, the converting entity must file the appropriate Certificate of Conversion or Statement of Conversion with the California Secretary of State, which will effectuate the change with the California Secretary of State. The converted entity must also notify the Secretary of State in the original jurisdiction of the change by filing the appropriate form.

But You Would Have To Be Nuts to Get Stung Twice

So, now you’re an actor with a California corporation; and you decide to move to Las Vegas.  You have to deal with the exact same problem all over again.  In other words, after moving to Nevada, you would still be obligated to pay California franchise tax and file a California tax return.

Instead of converting to a California corporation when you moved from New York, converting to a Delaware corporation and qualifying to do business in California would have given you the flexibility to pick up and move your corporation from state to state with relative ease.  To read how this works, see http://www.eminutesonline.com/incorporated-in-the-wrong-jurisdiction-now-what/.

Delaware is a jurisdiction of choice for many reasons, including low annual fees and well founded corporate law. Small business owners are fans of Delaware for an altogether different reason – mobility.  See http://www.eminutesonline.com/delaware-jurisdiction-of-choice-for-mobile-generation/.  Let’s say your spouse can’t stand the New York winters and wants to move to Florida.  In that case, you would simply surrender the right to do business in New York and qualify the Delaware Corporation to do business in Florida, a process which inexpensively maintains the continuity of your corporation.  For more on this topic, watch http://www.eminutesonline.com/what-is-the-benefit-of-incorporating-in-delaware-watch-video/.

How to Form a California Corporation: A Step-By-Step Guide

This article is a step-by-step guide to forming a California corporation.

1. Reserve the corporate name.  The first and most exciting task is to select a corporate name.  In California, if the name is available, it can be reserved for 60 days.  See, http://www.eminutesonline.com/are-there-any-restrictions-on-the-name-of-my-corporation-watch-video/.
2. Prepare and file the Articles of Incorporation.  The Articles of Incorporation is a simple document, typically a single page, that sets forth key organizational information regarding the company (e.g., name, number of authorized and issued shares, agent for service of process, provisions limiting the liability of officers and directors, etc.).  To learn about the optional provisions that can be set forth in the Articles, see http://www.eminutesonline.com/what-optional-provisions-may-be-included-in-the-articles-of-incorporation/.  The Articles are filed with the California Secretary of State.  See, http://www.eminutesonline.com/california-experiences-extreme-filing-delays/.
3. Prepare a IRS Form SS-4 and Obtain a Tax Identification Number.  To obtain a Federal Tax Identification Number, a IRS Form SS-4 must be completed.  Once signed, the FEIN can be obtained online on the IRS website.  See, http://www.eminutesonline.com/what-is-a-federal-employer-identification-number/
4. Prepare Bylaws.  The Bylaws, among other matters, provide the date and time of the annual meeting of the Shareholders. The requirement for Bylaws is governed by the Corporations Code of the jurisdiction of incorporation. Bylaws are the rules under which the Shareholders and Directors of the corporation agree to operate. In the event of a conflict between the Bylaws and the Articles of Incorporation, the Articles of Incorporation will govern, and, in the event of a conflict between the Articles of Incorporation and the General Corporation Law, the General Corporation Law will govern.  See, http://www.eminutesonline.com/what-are-bylaws/.
5. Minutes of the Organizational Meeting.  The Minutes of the Meeting of the Incorporator and the Board of Directors cover a wide range of topics, including adoption of the previously filed Articles of Incorporation, adoption of the Bylaws, election of Officers, approval of a form of Share Certificate, designation of an agent for service of process, the authorization for the filing of the Statement of Information, the designation of the corporation’s principal office and corporate bank account, authorization to file the Application for Employer Identification Number, for the issuance of shares, and if the corporation elects to be taxed under subchapter “S”, the authorization for filing of the Election by a Small Business Corporation (Form 2553) (Subchapter “S” corporation).
6. Issue the stock certificates and qualify the shares with the Department of Corporations.  Physical share certificates are next issued, evidencing each shareholder’s ownership of shares in the company.  Typically, a Notice of Transaction Pursuant to California Corporations Code Section 25102(f) is filed to exempt shares from qualification or registration.
7. Prepare and file IRS Form 2553 if a S-Corporation.  The Election by a Small Business Corporation (Form 2553) is the federal tax form by which the corporation elects to be taxed under Subchapter “S” of the Internal Revenue Code. There is a deadline within which the form must be submitted to the IRS. In addition, the spouses of married shareholders must, in most cases, be identified on the federal “S” election form. Some states require an additional filing to be treated as an “S” corporation under state law (e.g., see form CT-6 for New York).
8. Prepare and file the Initial Statement of Information.  Each corporation must file a Statement of Information within 90 days after the date of incorporation and annually thereafter. The Statement lists the Officers, Directors, Agent for Service of Process and the principal place of business for each domestic and foreign corporation qualified to do business in California. The failure to file the Statement of Information by the deadline will result in a penalty.
9. Prepare any applicable ancillary documents: Finally, additional documents should be drafted to reflect the business and corporate matters that are key to the operation of the corporation.  Examples include: medical expense reimbursement plans, employment agreements, promissory notes, shareholders agreements, and investors rights agreement.
10. Qualification to do Business.  Filing a registration to do business in a state other than the state where the company is formed “qualifies” a corporation to do business in the particular jurisdiction. If a corporation does substantial business in a jurisdiction where it is not qualified, it may be subject to fines and penalties and will not have the protection of that jurisdiction’s court system.

California Experiences Extreme Filing Delays

California is experiencing extreme delays in the time it takes to process Articles of Incorporation and Articles of Organization for new business entities. Historically, a filing would take about 7 to 10 business days to process. Presently, it is taking anywhere from 7 to 27 business days for the Secretary of State to process these filings, with wild fluctuations within that range. The delayed processing time is a direct result of budget constraints plaguing the State. To cope with a decrease in funds budgeted to the Secretary of State, the Fresno and San Francisco satellite offices have been closed, diverting all filings to the Sacramento office. The delays are not expected to improve, and worsened with the recent closing of the of the San Diego satellite office on April 2, 2010. Further, the Secretary of State has been experiencing some technical computer issues resulting in additional delays. While we have discouraged our clients from paying the additional filing fees for expedited filings in California due to the high cost, expedited filing may be the only option for our clients with time sensitive filings.

How Many Directors Are Required?

The answer turns on where you incorporate.  In most states, one director is required:  Delaware (one director required, see, http://delcode.delaware.gov/title8/c001/sc04/index.shtml),  Nevada (one director required, see, http://leg.state.nv.us/NRS/NRS-078.html#NRS078Sec115), New York (one director required, Bus Corp Law Sec. 702.  See, http://public.leginfo.state.ny.us/menugetf.cgi?COMMONQUERY=LAWS).  California, on the other hand, marches to the beat of its own drummer.  In California, the number of required directors depends on the number of shareholders. Under California law, a corporation is required by law to have at least three directors. However, the corporation may have one director if the corporation has only one shareholder; and the corporation must have at least two directors if the corporation has only two shareholders. See, http://www.eminutesonline.com/how-many-directors-are-required/

Did you think the majority rules in California? Think Again – Cumulative Voting is the law for all California corporations

Conventional wisdom dictates that the majority shareholder of a board of directors has the ability to elect the majority of the board. Board rooms across California assume this majority rules result without realizing that 1) cumulative voting changes the entire game; and 2) cumulative voting is the law for all corporations in California that are not publicly traded.

Cumulative Voting: The Basics

The number of votes available to a shareholder in a given election is equal to the number of shares owned by the shareholder multiplied by the number of positions up for vote.  Cumulative voting is a process of voting that allows a shareholder to cast all her votes toward a single nominee, or split her votes among several nominees in any proportion she chooses.  By contrast, under conventional voting, shareholders may not cast more than one vote per share to any single nominee. 

First, we will look at the results of an election under a conventional voting scheme.   Let us assume that two shareholders, Susan and Tom, are voting in an election for a three director board.   Susan, as the majority shareholder, holds 500 shares.  While she would have 1,500 votes total (3 X 500 shares), Susan would be limited to 500 votes per nominee.  Tom, as the minority shareholder, holds 300 shares.  While he would have 900 votes total (3 x 300 shares), Tom would be limited to 300 votes per nominee.   

Thus, the election would proceed as follows, with the director nominees listed across the top and the shareholder voters listed down the left-hand side:

Figure 1:  Results in a Conventional Voting Scheme

	John	Jim	Jane	Jordan	Jessica	Janis
Susan’s Vote			500		500	500
Tom’s Vote	300	300		300

 

The result is that Susan as the majority shareholder is able to elect Jane, Jessica and Janis on the Board of Directors, thereby controlling all positions on the Board.   Tom is completely shut out of the election because at most, he could only apply 300 votes toward each of his nominees, which will always be defeated by Susan’s 500 votes per nominee.  The majority, as represented by Susan, always wins in this scenario.

 Under a cumulative voting scheme, however, the minority shareholder position is strengthened.  Tom could “cumulate” all 900 of his votes toward one nominee, 450 each to two nominees, or allocate his votes in any combination of his preference.  The result is that Tom has a stronger chance of being able to elect at least one out of the three directors through cumulative voting:

 Figure 2:  Results in a Cumulative Voting Scheme

	John	Jim	Jane	Jordan	Jessica	Janis
Susan’s Vote			500		500	500
Tom’s Vote	900

 

In addition to providing Tom a better chance of obtaining representation on the board of directors, cumulative voting creates incentives for Susan and Tom to negotiate their votes for the most optimal outcome according to their strongest preferences.  For example, let us assume that while Susan does not prefer Jim to be on the board of directors over her slate of nominees, she is dead set against John’s candidacy.  Likewise, while Tom does not prefer Janis to be on the board of directors over his top three choices, he is absolutely against Jessica’s candidacy.  Susan and Tom can negotiate to vote their strong preferences (or negative preferences).  Thus, Susan and Tom’s most disliked nominees, John and Jessica respectively, do not make it onto the board as a result of a strategic allocation of votes:

 Figure 3:  Results of Negotiated Voting in a Cumulative Voting Scheme

	John	Jim	Jane	Jordan	Jessica	Janis
Susan’s Vote	NO!		750			750
Tom’s Vote		900			NO!

 

Cumulative Voting:  It’s the law!

In California, cumulative voting is a statutory right for shareholders of non-publicly traded corporations.  By default, cumulative voting is available to shareholder elections of directors and it need not be specified in the articles or bylaws.  Further, cumulative voting cannot be denied in the articles or bylaws as a matter of public policy (Corp. Code §708(a)).   Only publicly traded corporations may opt out of the requirement (Corp. Code §301.5(a)).

The rationale behind cumulative voting is that the process translates into more proportional representation of the shareholders on the board of directors, giving minority shareholders the opportunity to exert influence on management  through the election of directors who support their interests and priorities. 

No Opt-Out Provision

You might think about incorporating in a different state to avoid the cumulative voting requreiment altogether.  Think again.  California law prohibits an out of state corporation from opting out of cumulative voting by amending its articles or bylaws.  (Corp. Code §708(a)).   Cumulative voting even applies to certain foreign corporations if more than half of their shareholders live in California and they do most of their business here.  (see Wilson v. Louisiana-Pacific Resources, Inc. 138 CA3d 216 (1982); Corp. Code Section 2115).  For an explanation of what constitutes a “pseudo-foreign” corporation, see http://www.eminutesonline.com/what-is-a-pseudo-foreign-corporation/.

What Is a Pseudo Foreign Corporation?

Generally, a corporation is subject to the laws of the state in which the corporation was formed. Consequently, incorporating in Delaware, for example, is a common practice as businesses “shop” for the most favorable state corporate law advantages.

Straight forward, right?  Think again. 

If branded a “pseudo foreign” corporation, California will apply California law to the company, regardless of where the corporation is formed.

Two Tests Must be Satisfied

California applies two tests for foreign, non-public, corporations that if met, would subject a foreign corporation to California law as a pseudo foreign corporation (see Corp Code §2115(b)):

1)       The “Tax-Factor” Test: Is the proportion of the corporation’s property, payroll, and sales in California compared to the company’s total property, payroll, and sales more than 50 percent during its latest full income year?  (see Corp Code §2115(a)(1)). 

2)       The “Shareholder Residence” Test: Is the corporation’s outstanding voting securities held of record by persons having California addresses more than 50 percent?  (see Corp Code §2115(a)(2)).

If both tests are met (i.e., more than half of the shareholders live in California and most of the company’s business is conducted in California), California will consider the corporation a “pseudo foreign” corporation and will treat it, for certain purposes of fundamental importance to California, as if it had incorporated in California in the first place. 

This means that the corporation would be subject to a “menu” of key California laws that are rooted in public policy concerns, including among others (See Corp C §2115(b)):

• annual election of directors (Section 301)
• removal of directors without cause (Section 303)
• directors’ standard of care (Section 309)
• indemnification of directors, officers, and others (Section 317)
• shareholder’s right to cumulate votes at any election of directors (Section 708, subdivisions (a), (b), and (c))

Basically, California is trying to exert its public policies (most designed to protect minority shareholders) on corporations that are doing business in California even if the corporation has attempted to avoid California law by incorporating elsewhere.  If you want to shop around for the best corporate law and do business in California, beware that California law may trump the law of the home state of a corporation.  To learn more about the one reason that corporations are nonetheless well served to incorporate in Delaware – mobility, watch “What is the benefit of incorporating in Delaware”, http://www.eminutesonline.com/what-is-the-benefit-of-incorporating-in-delaware-watch-video/, or read “Delaware: Jurisdiction of Choice for a Mobile Generation”, http://www.eminutesonline.com/delaware-jurisdiction-of-choice-for-mobile-generation/.

Delaware Wrinkle & its Consequences

California courts have upheld Corp. Code Section 2115.  See., e.g., Wilson v Louisiana-Pacific Resources, Inc. (1982) 138 CA3d 216.  (Court upheld constitutionality of Corp C §2115 and imposed cumulative voting for directors on pseudo foreign Utah corporation).   However, the Delaware Supreme Court has repudiated the statute provision in VantagePoint Venture Partners 1996 v. Examen, Inc.,  871 A.2d 1108 (Del. 2005) (“VantagePoint”).  The court in VantagePoint affirmed the Delaware Court of Chancery ruling, relying on conflicts of law principles and the Commerce Clause of the U.S. Constitution to dismiss Section 2115 of the California corporate code.  The issue of which state law applies to a pseudo foreign corporation in California may ultimately turn on who wins the race to the courthouse in forum shopping.  In the meantime, the opposing opinions regarding Section 2115 from the California and Delaware courts will continue to leave uncertainty for foreign corporations with meaningful business in California.

Hey Director: Think Twice Before Dissolving

One word of advice for a corporate director who sits on a board of a faltering corporation that is considering dissolving before the end of the year: resign. And do so long before the vote to dissolve. That’s because directors of California corporations may have personal liability following the dissolution.

California law imposes personal liability on shareholders of dissolved corporations for four years following the corporate dissolution.  See, http://www.eminutesonline.com/zombie-corporations-in-california-personal-liability-lives-on-for-four-years-after-corporate-dissolution/.  But the liability of the shareholders is limited to the amount the shareholder actually received at the time of the dissolution.  

Unlike shareholders, even directors who receive nothing whatsoever at the time of dissolution are personally liable (jointly and severally with the corporation) if they approve the distribution of assets to shareholders without first satisfying the liabilities of the corporation that are known at the time of dissolution. See, California Corporations Code Section 316(a)(2).   California law provides that the director is personally liable up to the amount of the illegal distribution (or if the illegal distribution consists of property, the fair market value of that property at the time of the illegal distribution) plus any accrued interest  from the date of the distribution, together with all reasonably incurred costs of appraisal or other valuation, if any, of that property or loss suffered by the corporation as a result of the improper distribution. See, California Corporations Code Section 316(C). 

The moral of the story: be very careful if you are a director of a corporation considering dissolution, especially when the corporation intends to dissolve without providing for all of its debts.

What You Need to Know About Incorporating in California at the End of the Year

Entrepreneurs who are planning to incorporate at the end of the year are usually focused on positioning the new business to kick off the year with a big bang! Rather than form the new business on the first business day of the year (January 4, 2010), California entrepreneurs can file their Articles before year end, so long as they do not actually do business in 2009.

Year End Tax Waiver Gives Incorporating Entrepreneurs Head Start on 2010 Plans

California Rev & Tax Code Section 23114 gives entrepreneurs a head start on their business plans for the new year by enabling them to file their Articles before year end without being obligated to file a tax return for the current tax year.  To satisfy the rule, a new corporation must meet both of the following requirements:

1. The tax year is 15 days or less;  and
2. The corporation did no business during the 15 days.

The date stamped on the Articles of Incorporation by the California Secretary of State (SOS) is the date that determines when the corporation is formed for purposes of the rule.   The California SOS passes this date to the FTB to use as a the corporation’s date of incorporation.    In our firm, to avoid confusion, we will file “year-end” Articles on December 18, 2009.

California Gives Tax Freebie for New Business Startups

There’s more good news.  In California, a corporation’s first year’s minimum franchise tax ($800) is waived (See, California Rev & Tax Code Sec. 23153(f).  See, http://www.ftb.ca.gov/law/Technical_Advice_Memorandums/2002/20020138.pdf

Between now and year end, entrepreneurs who are getting their corporations formed for start ups that might not actually start up until 2010 are well served to consider whether a little patience can save a few bucks.  Instead of filing the Articles now, unless the business requires it, preparing all of the documents and holding off on the actual filing until December 18, 2009, can result in considerable savings.

Next Page »