An Incomplete or Improperly Formed Corporation or Limited Liability Company Can Hurt Your Silicon Valley Business in Several Ways, Part III: IRS Problems, Securities Problems, Shareholder Disputes
In Parts I and II of this Article I talked about how important a complete and properly formed business entity is for estate planning and liability protection. There are also many other potential impacts of not having your corporation or LLC documentation in order. Here are just a few:
IRS Problems: Just over five years ago I got a call from a licensed contractor in Campbell who was being audited by the IRS and needed to present his corporate minute book to the auditor in five days time. His company had not done minutes of the shareholders or the board of directors for the previous six years. It took us much more time to go back and recreate the corporate minutes and ended up costing my client at least twice what it would have if we had prepared the minutes each year when the information was fresh. However, it was necessary to document certain shareholder loans which would not have been upheld by the IRS if they weren't properly authorized by the corporation.
Securities: Many new business owners do not understand that an ownership interest in a corporation or a manager-managed limited liability company is considered a security and may require federal and/or state securities filings. Failure to make these required filings may result in shareholders having rescission rights whereby they can demand their investment back from the company, and any person controlling the entity could have personal liability to return those funds.
Debt v. Equity, Ownership and Control: I have worked with a Santa Clara consulting company for many years. Over the years the corporation went from being wholly owned by family to being owned by third parties as well. Unfortunately, it has been very hard for the family shareholders to adjust from the casual way they used to run the corporation. For years they added capital to the corporation without taking additional shares and without making it clear whether the additional capital was debt or equity. Now that third parties are involved, it is necessary to document every dollar that is put into the corporation and to determine whether that capital contribution results in additional shares which could impact control.
Shareholder Disputes: Every so often I get a call from small business owners asking me what their rights are to continue the business without their partner's consent. Usually I tell them that the answer lies in their ownership interests, their control of the board of directors, and their rights under their partner or shareholder buy-sell agreement. Failing to complete the entity formation means they are subject to the default rules of the California Corporations Code, which could be a lot different than what they intended, and may result in the termination of the business. I hate to see goodwill wasted like this. See Part IV of this Article for how a buy-sell agreement can help avoid this situation.