Chapter 10
Formation of a Corporation
Introduction
This chapter explains how a corporation is formed and considers how preincorporation and postincorporation document preparation affects the subsequent existence of the corporation and its business. Paralegals must have a basic understanding of the information presented in this chapter because document preparation, at least in the initial stages, is the domain of paralegals in the legal workplace.
Preparation of the articles of incorporation and corporate bylaws is crucial to the operation of the corporation and will affect all aspects of its existence and operation. In addition, the tax implications of electing the corporate form will have a long-term effect on the financial well-being of a business and must be carefully considered.
Therefore, in this section, you will have the opportunity to analyze and prepare corporate documents, including not only articles of incorporation but also requisite state filings.
Lecture Notes
Creating the Corporation
A corporation is a legal “person” that must be formed or born of statute.
¨ Preincorporation Considerations
Ø Corporate Name
A corporation’s name must contain the words “corporation,” “incorporated,” “company,” or a corresponding abbreviation.
Example: Creation Sensations, Inc.
Ø Similar Corporate Names
A corporation’s name must not be deceptively similar to another corporate name. This prevents consumer confusion and unfair competition.
Example: Shane intends to open a fast-food hamburger restaurant named McRonald’s in the downtown area. He has a large red sign with white letters and large golden arches made by a local sign company. When he files his articles of incorporation with the secretary of state, they are rejected, on the basis that his name is deceptively similar to another similar business.
¨ Preincorporation Document Preparation
Ø Articles of Incorporation: A Corporate Birth Certificate
A business does not become a corporation unless and until the secretary of state accepts the articles of incorporation, the founding document. The secretary of state will reject and return the articles if they are incomplete or incorrect.
Informational Filing
The articles of incorporation are an informational filing. That is, the articles provide the secretary of state basic information about the corporation, such as
name of corporation
purpose of corporation
capital structure of corporation
registered agent
initial board of directors
Note: It is generally best to provide only the required information in the articles, because they are difficult to amend and are a public record available for public inspection.
¨ Postincorporation Procedures
After a corporation is formed, it must be organized (e.g., directors elected, duties of directors identified, financial records established and maintained, etc.). Therefore, after a corporation is formed, bylaws (written procedures) are adopted and organizational meetings are held.
Bylaws
Corporate bylaws provide written guidelines for the management and operation of the corporation. The bylaws generally include
dates and places of shareholder and board of director’s meetings
voting of board of directors
duties of board of directors or officers
stock issuance and ownership
corporate finances (e.g., bank accounts)
Organizational Meetings
The incorporator (the person who created the corporation) or the board of directors hold a meeting to
elect directors (if none are designated in the articles of incorporation)
appoint corporate officers
approve articles of incorporation
adopt bylaws
ratify preincorporation transactions
¨ Defective Incorporation Doctrines
A validly formed corporation is known as a de jure corporation (“of law”).
But if a corporation does not comply with statutory requirements, then corporate structure may be set aside and shareholders may be personally liable for obligations of corporation.
A defective corporation, however, may be saved according to one of the following theories:
o De Facto Corporation (“of fact”)
A business that has not properly incorporated, but has attempted to, may still protect its owners from personal liability for the business debts and obligations if the owner has in good faith both
1. attempted to comply with statutory incorporation requirements
2. operated as a corporation (e.g., uses corporate name)
Good Faith Requirement
The rule only protects business owners who have acted in good faith and attempted to properly incorporate.
Rationale: If a business operates as a corporation and the public deals with the business believing it to be a corporation, then both parties’ expectations are that the owners are not personally liable for the debts and obligations of the business.
Example: Gloria files articles of incorporation for her business with the secretary of state. The articles fail to designate the company’s registered agent. The court will generally not set aside the corporate form based on such a technical omission.
Ø Corporation by Estoppel
A business owner who enters into a contract as a corporation, but has not substantially complied with the statutory requirements for incorporation, may still be protected from personal liability in a contract dispute.
Applicable only to contract disputes
Rationale: If a party enters into a contract with a company it believes to be a corporation, it does not expect the owners to be personally liable for the debts and obligations of the business. Therefore, the court may protect the parties’ expectations.
No tort application—a tort victim can still recover against the owner(s).
Example: The driver from Jason’s Florist, Inc., hits and injures a pedestrian while en route to making a delivery. Jason has made no attempt to incorporate his business; he simply uses the abbreviation Inc. to make his business appear more professional. The pedestrian sues Jason’s Florist, as well as Jason, for her damages. Jason may be held personally liable for the pedestrian’s damages.
¨ Taxation Considerations
Ø Federal Income Taxation
Corporations suffer double taxation.
taxation level 1: corporation taxed as “person”
taxation level 2: shareholders are taxed on dividends
Exception: Corporations that qualify (have fewer than 75 shareholders, domestic ownership, etc.) may elect to be taxed as S corporations. S corporations receive pass-through taxation: the IRS passes through the S corporation and taxes the individual shareholders on the corporate profits.
Ø State Income Taxation
Prorated State Taxing
Each state in which the corporation transacts business may tax the corporation on moneys earned in the taxing state.
Rationale: protects corporations from paying multiple state income tax on the same profits.
Answers to Study Questions in Review
1. How does a corporation notify the public of its corporate status?
The name of the corporation must indicate its corporate status. Thus the name of a corporation must include the word “corporation,” “incorporated,” “company,” “limited,” or a corresponding abbreviation.
2. Once a business files its articles of incorporation with the secretary of state, does its corporate existence begin?
No. The articles of incorporation must also be accepted by the secretary of state. If the articles are incomplete, incorrect, or otherwise insufficient (e.g., the corporate name is deceptively similar to another corporate name), the secretary will reject the articles.
3. What is the purpose of the corporation’s organizational meeting?
At the organizational meeting, directors are elected (if none were appointed in the corporation’s articles of incorporation), corporate officers are appointed, the corporation’s articles of incorporation are approved, the corporate bylaws are adopted, all preincorporation transactions of the organizers are ratified, and all other organizational matters are addressed.
4. Distinguish between a de jure corporation and a de facto corporation.
A de jure corporation has substantially complied with the statutory requirements of the state for formation of a corporation; it is, therefore, a corporation “of law.” A de facto corporation, however, has not met all of the statutory prerequisites to incorporation. It is a defective corporation that will be viewed by the state as a corporation “in fact” because it has in good faith attempted to satisfy the statutory incorporation procedures.
5. Will the owners (shareholders) of a corporation be held personally liable for the debts and obligations of the corporation if the business has not properly complied with the state’s statutory requirements for formation of a corporation?
Yes, if the business cannot qualify under a defective incorporation doctrine (i.e., it cannot qualify as a de facto incorporation or corporation by estoppel)
6. What unincorporated business entity most closely resembles a corporation?
A limited liability company
7. What is an S corporation?
An S corporation is a small corporation that has qualified for and elected special tax treatment that allows it to be taxed as a partnership (only once).
8. What are the qualifications necessary for a corporation to seek an S election?
The corporation must be domestic, not have more than 75 shareholders (married shareholders count as one shareholder), have only natural persons or their estates as shareholders, have only shareholders who are U.S. citizens or resident aliens, and have only one class of stock.
9. Distinguish between the manner in which a partnership is taxed and the manner in which a corporation is taxed.
Partnerships receive pass-through taxation; that is, the business profits pass through the partnership (so that the business itself is not taxed), and the individual partners declare their respective share of the partnership’s income as their personal income. Corporations are taxed twice. The corporation is taxed on its profits; if the profits are distributed as dividends to its shareholders, the dividends are taxed as the personal income of the shareholders.
10. Flint, Inc., conducts 75 percent of its business in California, 15 percent in Idaho, and 10 percent in Washington. Which state can tax the company on its profits?
Each state in which the corporation does business may tax the corporation on the business activity that the corporation transacts in its state.
Answers to Case Studies in Review
1. Larry, Joe, and Curly own an excavating business together. Because of their potential liability for errors (hitting a gas line) or omissions (failing to locate electrical or other service lines before a dig), they want to incorporate to protect their personal assets. They ask Joe’s girlfriend, a paralegal student, how they should go about forming a corporation. She tells them that all they have to do is add the designation “Inc.” after their name. Larry, Joe, and Curly therefore call their company Big Hole, Inc. No documents are filed with the secretary of state or prepared for the corporation.
Big Hole, Inc., contracts with a local home builder to excavate the foundation for a new home in downtown Dallas. The parties’ contract recites that the excavators will have all service lines located prior to beginning excavation work. Curly is responsible for scheduling the location; however, his wife has a baby the week before the work is to begin and he forgets to have the lines located. During the excavation, Larry hits a main power line that supplies power to over one million Dallas residents. The cost for the repairs is $500,000.00; Big Hole, Inc., does not have the insurance or funds to pay for the repairs. The power company’s attorney learns that Big Hole, Inc. is not even a registered corporation with the secretary of state. Therefore, the attorney files suit against Larry, Curly, and Joe personally. Can the power company sue Larry, Joe, and Curly personally to cover the repairs?
Yes. Corporations provide shareholders protection from personal liability for the contractual debts and other obligations of the corporation. Thus the personal assets of the shareholders generally cannot be attached to satisfy the obligations of the corporation. However, Big Hole was not properly incorporated and it cannot qualify for protection under a defective incorporation doctrine (de facto corporation or corporation by estoppel). To qualify as a de facto corporation, the owners had to attempt in good faith to comply with the state’s incorporation laws. Other than adding the designation “Inc.” to the company’s name, there was not substantial compliance. Further, the doctrine of corporation by estoppel will not be extended in this case, because the loss to the power company did not occur incident to a contractual relationship between the power company and Big Hole.
2. Beehive Honey, Inc., a California corporation, is owned by the Arthur brothers of Sacramento, California. Each of the three brothers has an equal interest in the business (e.g., the same class of stock). The brothers have asked your supervising attorney to help them find a way to reduce the tax liability. What ideas would you offer your supervising attorney?
The brothers should apply for qualification as an S corporation. They are a small domestic corporation with only one class of stock. They could clearly qualify and receive the benefits of partnership (pass-through) taxation.
3. Explain the tax structure that would result from your ideas in Case Study 2, supra. (Hint: you need to know the answer to Case Study 2 to answer this question).
If Beehive Honey qualified as an S corporation, the corporation would not be taxed on its business income. Rather, the shareholders would declare the corporate dividends as their personal income.
Project Applications
1. Your supervising attorney has given you the following task:
TO: File
FROM: MEB
DATE: June 9, 1999
RE: Incorporation of Book Club 2000
Book Club 2000 is a publisher of children’s books, headquartered in Dallas, Texas. The company is owned by a husband and wife team, Jan and Hal Steven; the business is run out of their garage. They want to incorporate their business, but they are very concerned about the tax consequences of incorporating. They intend to be the only shareholders of the corporation and hold equal interests. Hal will be the president of the corporation (and the agent for service of process), and Jan will be the vice president. Their daughter, Tracy Steven, will be the secretary. Their accountant and banker will be Ron Bill of Texas Security Bank, 111 NW Blvd., Dallas, Texas, 78626.
I have explained to them the benefits of a subchapter S election. Prepare the documents necessary to incorporate their business and complete the necessary tax forms for the subchapter S election.
Cc: Hal and Jan Steven
459 Forkline Rd.
Dallas, Texas 78626
2. After you have prepared the documents requested in Project Application 1, supra, your supervising attorney tells you that the Stevens want their company to be a Delaware corporation because a friend told them that Delaware is “corporate friendly.” Prepare the documents necessary for Book Club 2000 to be a Delaware corporation. (Hint: Obtain the filing requirements and forms from the Delaware secretary of state).
3. Prepare corporate bylaws for Book Club 2000 as a Delaware corporation.
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______Formation of a Corporation