1.  Extra Initial Filing Fees.

If you incorporate in Delaware you will not only have to pay the filing fees for the state in which you are transacting business, but also Delaware filing fees, which include $89 for the Delaware Certificate Of Incorporation and $50 for the Certificate of Good Standing, which you will need to register the corporation in most states, including California.

These filing fees are in addition to the filing fees you will then need to pay to register your corporation in the state in which your corporation is actually conducting business.  For example, to register your Delaware corporation to do business with the California Secretary of State’s Office you will also need to file a California Statement Of Designation Of Foreign Corporation, which has a $100 filing fee in addition to the Delaware filing fees.

2.  Annual Costs For A Registered Agent for Service of Process.

In addition to extra filing fees, if you incorporate in Delaware you will be required to have a registered agent for service of process.  The annual fees for this service vary, but companies such as Biz Filings and Legal Zoom charge $129 to $149 each year.

3. Extra Franchise Taxes.

If you incorporate in Delaware you will not only have to pay the annual franchise tax in the states in which you are “doing business,” but also in Delaware.

For example, if your company is headquartered in California, but you incorporated in Delaware, each year you will not only have to pay the $800 annual franchise tax in California, but also the annual franchise tax in Delaware.

4.  Extra Reporting Requirements.

If you incorporate in Delaware, you will have a second layer of reporting requirements.  For example, if you incorporate your company in Delaware, but are headquartered in California, you would have to comply with the reporting requirements in both states.

For these reasons, not every company should incorporate in Delaware.  Instead, you should make sure that the benefits of incorporating in Delaware outweigh  the extra expense and time of being incorporated there instead of whichever state your company is headquartered in.

If you incorporated your company in Delaware, what have you found to be some of the biggest advantages and disadvantages?

Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

1.  Approval Of The Board Of Directors.

A majority of the board of directors needs to pass a written resolution approving the dissolution of the corporation.  

2.  Approval Of The Shareholders.

If shares have been issued, a majority of the outstanding shares will also need to approve the company’s dissolution.

Startups often use equity to help attract and keep talented workers.  This article outlines the differences and similarities of stock options and restricted stock purchase agreements and why most early stage startups which issue stock shortly after formation select restricted stock when compensating their workers.

What are stock options?

Stock options give employees the right to buy a specific number of shares of the company at a specified price (the “strike price“) during a window of time.

What is restricted stock?

Restricted stock vests overtime, typically over a four year period. If the worker leaves the company before all of the stock has vested, the company has the right to repurchase the unvested stock back from the worker.

How are stock options and restricted stock similar?

Both stock options and restricted stock encourage loyalty to the company by incentivizing the worker to remain with the employer for at least a minimum period of time.

In addition, both provide an important tool to startups that may not have much cash to attract top talent.

Finally, both encourage the worker to increase the value of the company, which creates a unity of interest between the worker and the employer.

How are stock options and restricted stock different?

One key difference is restricted stock vests over time regardless of whether the value of the stock increases. In contrast, stock options do not automatically vest. Instead, stock options have an expiration date and the worker can only exercise their options during a specific window of time.

What are the benefits to stock options?

With stock options the worker is not out any money if the stock price does not rise because they can decide not to exercise the stock options.

That being said, for new startups the fair market value for restricted stock is often only the par value of the shares and so the purchase price is typically very minimal.

Why are restricted stock agreements often better than stock option plans for most early stage startups?

Each situation is unique, but most early stage startups use restricted stock rather than stock options for five reasons.

1.  No Need For a 409(a) Valuation.

The board of directors is required to determine the fair market value of stock for both restricted stock and stock options.

The key difference is for restricted stock it is the fair market value of the stock when it is purchased, which for very early stage startups is often the par value of the stock as the company shortly after formation does not yet have much value.

In contrast, under IRS Regulation 409(a) if the the valuation of stock options is done by a professional valuation company, the valuation is presumed to be correct and the burden is on the IRS to prove otherwise if there is ever an audit.

However, if the company does not use a professional valuation company, if there is ever an audit the company and not the IRS has the burden of proving the valuation is correct. As a result, companies typically hire an outside valuation firm to do the valuation of stock options. The thousands of dollars it costs to have 409(a) valuations completed, could instead be spent on other things for the company, such as software programming or marketing.

After a company has gained value the valuation of grants of restricted stock is no longer par value, but for an early stage start it is much easier, and less expensive, to properly determine the value of restricted stock than it is stock options.

2.  Stock Options Could Become Worthless.

Also, a stock option could become worthless.  For example, a stock option grant with a strike price of $10 has no value if the fair market value of the stock is later determined to be $8.  In contrast, if restricted stock is granted when the stock is trading at $10 and is later worth $8, the stock is still worth $8 and has only lost 20% of its value.

3.  Restricted Stock Might Better Motivate Workers.

In addition, some workers might be better motivated with restricted stock than with stock options because workers will get shares of the stock regardless of whether its value increases.  In contrast, stock options are worthless if the value of the stock goes down or if the worker fails to exercise the stock option.

Restricted stock, therefore, might better motivate some workers to think and act like owners of the company, take a personal interest in the company and be more focused on meeting the company’s objectives because they will obtain shares regardless of whether the stock price goes up or down.

In contrast, stock options might do less to instill a sense of ownership because the worker could invest years in the company only to find that the value of the stock has decreased and so there is no value in the stock options. Because the value of the stock may not increase, the worker might not have the same amount of loyalty to the company than if they had been granted restricted stock.

4.  Immediately Start The Clock Running For The Lower Capital-Gains Rate.

If the worker makes an 83(b) election, the income from the restricted stock grant will be recognized at the time of the stock ”transfer” - its purchase date – rather than when the stock vests. The reason this is important is if an 83(b) election is made the long term capital gains holding period also begins on the purchase date of the restricted stock rather than when the stock vests.

5.  Workers’ May More Be More Likely To Focus On The Long Term Value Of The Company.

Finally, a worker with stock options might be more likely to be motivated to increase the short term stock price so they can exercise their stock options even if this comes at the detriment to the longer term growth of the company.

For all of these reasons, most early stage startups which issue stock shortly after formation use restricted stock instead of stock options as they often provide a superior method of compensating and motivating workers.

Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend  and Ronak Patel expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this article.

If you do not elect to have your California professional corporation taxed as an S corporation, the default is for it to be taxed as a C corporation.

As a C corporation, your professional corporation would pay federal taxes on its profits and you would also pay individual taxes if you receive salary, bonuses, or dividends from the corporation.

By electing to be taxed as an S corporation, your professional corporation would instead be a pass-through tax entity, like an LLC or a partnership.  Electing to be taxed as an S corporation may also allow you to pass losses from the business to your personal income tax return, where you can use it to offset income that you may have from other sources.

Finally, if the corporation pays you a “reasonable salary,” you may not be required to pay self-employment taxes on any additional corporate profits that are paid to you as dividends as a shareholder in addition to your reasonable salary.

You should consult with your CPA or tax professional to make sure being taxed as an S corporation is the best fit for your professional corporation, but for most California professional corporations electing to being taxed as an S corporation rather than a C corporation provides the most tax savings.

Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Professions that are required to be professional corporations include many of those that must have a state license, such as dentists, certified public accountants, doctors, lawyers, optometrists, psychiatrists, and psychologists.

Professional corporations have more restrictions than traditional corporations.  For example, with a few limited exceptions, officers, directors and shareholders of a professional corporation must be licensed to conduct the professional activity.

In addition to specified rules governing professional corporations in the California Business and Professions Code, a professional corporation is also subject to the regulations of the applicable governmental agency overseeing the profession in which the professional corporation is engaged.

While professional corporations do not provide liability protection for malpractice, you could have limited liability protection for claims not based on malpractice, such as a slip and fall accidents.

In addition, by forming a professional corporation you may be able to deduct payments for benefit plans, such as disability or health plans or group term insurance.

Finally, you should speak with your CPA or other tax professional about whether there is the potential to have tax savings by forming a professional corporation and then electing to have it taxed as an S corporation.

Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

1.  The Corporate Law Expertise Of The Delaware Court of Chancery.

Delaware has a highly respected court that focuses on corporate issues – the Court of Chancery.  Because of this specialization, the Court of Chancery has a great deal of expertise and familiarity in resolving complex corporate disputes.

No corporation wants to be involved in litigation, but if you are it is reassuring to know the dispute will be resolved by a very knowledgeable judge who is sophisticated in resolving corporate law matters.

2.  The Extensive Precedent of Delaware Corporate Case Law.

Corporate case law in Delaware is much more extensive than in other states due to the high volume of corporate cases.

More case law means increased predictability of the likely judicial resolution of a business law dispute. If there have been several similar cases to the one facing your corporation there is less uncertainty about the judicial outcome, which can be key when strategically deciding whether to settle a dispute or invest the time and capital to litigate.

3.  The Flexibility Of Delaware Corporate Statutes.

The Delaware corporate statutes provide a great deal of flexibility in the organization of a corporation and the rights and duties of board members and shareholders.  For example, Delaware allows one person to be the only director, shareholder and officer of a Delaware corporation, whereas some other states require at least three people to fill the officer and director positions.

Although many of Delaware statutes have been mimicked in other states, the extensive case law mentioned above is an enormous asset when determining how a Delaware statute is likely to be interpreted.

4. Corporate Attorneys Are Familiar With Delaware Law.

Most corporate attorneys are familiar with Delaware business law.  This can lead to your attorney more efficiently and cost effectively assisting you if your company is incorporated in Delaware than if it is incorporated in a less popular state.

5.  Angel and VC Investors Prefer To Invest In Delaware Corporations.

Angel investors and venture capitalists tend to prefer to invest in companies incorporated as a C Corp in Delaware.  Therefore, if you are serious about receiving investments from these types of investors, you may want to incorporate in Delaware.

 6. Investment Bankers Prefer Delaware Corporations.

Many investment bankers insist on a company being incorporated in Delaware before they take it public. Thus, if a goal is to eventually have an initial public offering (IPO), you may want to incorporate in Delaware rather than later having to convert the company to a Delaware corporation.

7. You Send A Message That It Is A National Company And You Understand the Preferences of Investors.

If you incorporate in Delaware, you send a message – “This is a national company.”  From a marketing perspective, this could be important for your customers and investors.  You also send a signal to investors that you understand their preferences and are serious about receiving investments.

8.  There Are Greater Privacy Protections in Delaware Than Some Other States.

Delaware does not require officer or director names to be disclosed on formation documents.  This provides a layer of anonymity that is not available in some states.

9.  Quality Customer Service and Quick Turn Around Times.

The Delaware Secretary of State’s Office has made it a priority to provide expedited filings. In fact, you can have your filings guaranteed to be processed in less than an hour.

In contrast, California has a 24 hour processing option, but it is not guaranteed to be completed within 24 hours and the rush processing fee is significantly more expensive than in Delaware.  This can be critical if you need to close a deal very quickly.

10.  Can Be Less Expensive To Relocate The Corporation.

The annual franchise tax in Delaware can vary depending on a variety of factors, but it can be as low as $125 per year with reporting fees.  In contrast, in California the annual franchise tax is $800.

If you incorporate in California and later move the corporation to a different state, you still have to pay the $800 annual franchise tax each year, but if you incorporate in Delaware and later move the annual franchise of your “home state” where you initially incorporated could be as low as $125.

What Are The Drawbacks to Incorporating in Delaware?

1. Annual Costs For A Registered Agent for Service of Process.

If you incorporate in Delaware, you will be required to have a registered agent for service of process.  The annual fees for this service vary, but companies such as Biz Filings and Legal Zoom charge $129 to $149 each year.

2. Extra Franchise Taxes.

If you incorporate in Delaware you will not only have to pay the annual franchise tax in the states in which you are “doing business,” but also in Delaware.

For example, if your company is headquartered in California, but you incorporated in Delaware, each year you will not only have to pay the $800 annual franchise tax in California, but also the annual franchise tax in Delaware.

3.  Extra Reporting Requirements.

If you incorporate in Delaware, you will have a second layer of reporting requirements.  For example, if you incorporate your company in Delaware, but are headquartered in California, you would have to comply with the reporting requirements in both states.

If the benefits of incorporating in Delaware described above are not important to your company, you may want to avoid the extra expense and time of being incorporated in Delaware.

If you incorporated your company in Delaware, what have you found to be some of the biggest advantages and disadvantages?

1.  Only Authorize 5,000 Shares of Stock.

By March 1st of each year you will have to file an annual report and pay a franchise tax in Delaware.  The tax is calculated based on the authorized shares for the company by using either the Authorized Shares Method or the Assumed Par Value Capital Method, whichever is less expensive.

The Authorized Shares Method is based on the number of authorized shares and is calculated as follows:

     (i) If the company is authorized to issue 5,000 shares or less the annual franchise tax is $75;

     (ii) If the company is authorized to issue 5,001 to 10,000 shares the annual franchise tax is $150; and

     (iii) for each additional 10,000 authorized shares the annual franchise tax is increased by an additional $75.  The maximum annual tax under the Authorized Shares Method is $180,000.

You may, therefore, decide to authorize the company to only issue 5,000 shares so you pay the minimum amount of Delaware franchise tax each year ($75).

2.  Authorize Millions of Shares.

The second school of thought is to authorize millions of shares, typically 10,000,000 shares.

The rationale is individuals who receive 1,000,000 shares feel like they are receiving something of greater value and may be more motivated than individuals who receive 500 shares, even if the shares represent the same percentage of ownership in the company.

In addition, having more shares provides more flexibility in allocating shares on vesting schedules.

The drawback is in Delaware having more than 5,000 authorized shares results in a higher annual franchise tax.

If you authorize millions of shares, you will most likely calculate the Delaware annual franchise tax using the Assumed Par Value Capital Method.  The calculations under this method can be complicated, but the Delaware Secretary of State’s Office provides a good explanation and  examples of how to determine the tax here.

If you have any questions regarding how many shares you should authorize for your Delaware corporation, please contact me at Doug@BendLawOffice.com.

Who should be concerned about Section 83 of the Internal Revenue Code?

Section 83 should be of particular concern to founders and employees who receive stock that is subject to vesting.  Two examples are when a founder or an employee sign a restricted stock purchase agreement or if they agree to a stock option plan that allows them to exercise their options prior to vesting, but subject to a restrictive stock agreement.  However, these are just two examples – you should consult your tax and legal counsel to determine whether your particular circumstances raise a potential Section 83 issue before signing a stock purchase agreement.

What is Section 83 and what happens if you do not file an 83(b) election?

Under Section 83, if you purchase stock that is subject to vesting and do not file an 83(b) election, you will pay income tax on the difference between the price paid for the stock and the stock’s fair market value when it vests, even if you do not sell the stock at that time.  In addition, the holding period for determining whether the income from the sale of the shares qualify for long term capital gains treatment does not begin until the shares have vested.

How is the income from stock taxed if you make an 83(b) election?

In contrast, if you make an 83(b) election, the income from the stock is recognized at the time of the stock ”transfer” - its purchase date – rather than when the stock vests. The long term capital gains holding period also begins on the purchase date of the stock.

Why is it important when the income from your stock is recognized?

Often the purchase price and the fair market value of stock on its purchase date are the same.  Thus, if you make an 83(b) election, you may not have any income to recognize from the stock purchase and may only have to pay capital gains tax when the stock is sold.

However, if you do not make an 83(b) election, you may have substantial income tax liability when the stock vests if the stock increases in value, even if you do not sell it.

You, therefore, may want to file an 83(b) election, particularly if you believe the stock is likely to increase in value.  By doing so, the income from the stock will be recognized before it increases in value.  As an added bonus, by filing the 83(b) you will also start the one year holding period for long term capital gains treatment from the date you purchase the shares.

What is an example of how stock subject to vesting is treated under Section 83?

You and a friend start a company and purchase stock at the par value of $.0001 per share that is subject to a one year cliff and a four year vesting period.  Your friend promptly files an 83(b) election, but you forget to do so.  At the end of the one year cliff the stock is worth $1.00 per share.  Because you did not timely file an 83(b) election, you would recognize $0.99 per share as income, even if you do not sell the stock.  As the remaining stock vests, you would also recognize income equal to the difference between the fair market value of the stock and the $.0001 per share price at which you purchased it.

In contrast, because your friend promptly made an 83(b) election, they would not recognize any income as the stock vests because the 83(b) election accelerated the recognition of the income from the stock transfer to the purchase date.

What are the drawbacks to making an 83(b) election?

If you do not pay fair market value for the stock and make an 83(b) election, you could possibly pay income tax on stock that does not provide you with any benefit.

For example, you join a company in June of 2011 that was started in May of 2010.  You purchase 1,000 shares of restricted stock at the par value of $.0001 per share.

However, the company has been running for over a year and the fair market value of the shares is no longer par value, but is instead $1.00 per share.

If you file an 83(b) election, you would pay income tax on the difference between the fair market value of the stock and what you paid for your shares.  In this example, you would pay income tax on $990.90.

If the company  later dissolves and the stock is worthless, you would not receive any benefit from the income tax you paid.  In addition, if you later forfeit the stock, perhaps by leaving the company, you will not be allowed a deduction for the income tax you paid on the stock at the time you made the 83(b) election.

However, if the purchase price and the fair market value of stock are the same and you make an 83(b) election, you would not have any income to recognize from the stock purchase and may only have to pay capital gains tax when the stock is sold.

How much time do you have to make an 83(b) election?

You must file an 83(b) election no later than 30 days after the stock has been transferred.   The stock has been transferred on the purchase date of the stock, which is when you assume ownership of the stock.  The postmark date is the date of the filing.

How do you make an 83(b) filing?

The 83(b) election must include:

1. Your name, address, and tax identification number.
2. A description of the property for which you are making the election.  For example, “25 shares of common stock in X company.”
3. The date on which the property was transferred and the tax year for which you are making the election.
4. The nature of any restrictions on the stock.  For example, “Stock must be forfeited if employment terminates before June 1, 2015.”
5. The fair market value at the time of the transfer (ignoring restrictions except those that will never lapse) for which you are making the election.
6. Any amount you paid for the stock.
7. A statement that you have provided the required copies of the election, such as: “I have provided copies of this election as required in the regulation.”

The IRS does not provide a form 83(b) election, but you can find a sample 83(b) election form here.  It is strongly recommended that if you decide to make an 83(b ) election, you send it via certified mail.

What else must you do to properly file an 83(b) election?

You should make two copies of the 83(b) election:

1. Attach a copy of the 83(b) election to your tax return for the year the stock was transferred; and
2. Provide a copy of the election to the company from which you received the stock.

If your employer transferred the stock to someone besides yourself, you must also provide a copy of the 83(b) election to that person as well.

Do you have any 83(b) tips or advice?  If so, please provide them in the comments below.

If you have any questions regarding 83(b) elections or any other business legal issue, please contact me at Doug@BendLawOffice.com.

Disclaimer: This article is intended to provide information for your general education.  It is not intended to be used and should not be used for the purpose of avoiding federal income tax penalties.  Although the article discusses general legal and tax issues, it does not constitute legal advice.  You should not act or refrain from acting on the basis of any information in this article.  Instead you should seek the advice of tax or legal counsel who can discuss the facts and circumstances of your particular business or personal needs.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

1.  The Bylaws are the Company’s Legal Backbone.

A company’s bylaws provide the legal framework for how it operates, including the number of people who may serve on the board of directors, how to call a board of directors meeting, and the officer positions for the company.

2.  What if Your Company Does Not Have Bylaws?

If your company does not have bylaws in place, the laws of California will control how the company is run.  It is much better for the owners to determine how it would like to have the company operate than to rely on the state’s statutes.

It is similar to an individual not having a will or trust.  If they die, the state’s statutes determine how the individual’s assets are distributed.  Instead, the individual should thoughtfully think through how they would like their assets distributed and to set up the legal mechanism to enforce their plan.

Similarly, it is much better for business owners to strategically think through how they would like their company to operate than to rely on the state’s statutes, which might not always be the best fit for the company.

3.  Bylaws Provide Owners With Piece of Mind.

Every company eventually runs into challenges.  It is better to consider some of the potential turning points in your company and provide in the bylaws how you would like for the outcomes of these situations to be determined than to wait to make these tough decisions when interested parties and passions may create the perfect storm for litigation.

For example, what will happen if there is a legal dispute between the owners?  Do you want the company to be tied up in the expense and distraction of litigation or would you prefer arbitration?  What happens if one of the owners dies?  What if one of the owners wants out of the company?

The bylaws present an opportunity to calmly and objectively reflect on these issues before they occur.  It is wiser to answer these types of questions ahead of time and determine what might be the best solutions for your company than to rely on the default rules in the state’s statutes or to try to resolve them when clear heads are less likely to prevail.

 4.  Bylaws Help Protect Your Company’s Limited Liability Protection.

One of the primary reasons to form a corporate entity is to possibly have personal limited liability from the potential business debts and judgments against your company.

If a company does not have bylaws and is sued, a plaintiff could try to “pierce the corporate veil” by claiming the company should not be provided with the shield of limited liability protection because its owners did not follow corporate formalities.

In determining whether to pierce the corporate veil, the court would evaluate a number of factors to determine whether your company is legitimate, including whether you have the proper corporate documents and records.  By not having bylaws, a business owner is risking not being provided limited liability protection if it is sued.

5.  Bylaws Help Avert Misunderstandings Among Owners.

Communication and clear expectations are key to any successful relationship, including the relationship between business owners.  Bylaws clearly lay out how the company will be run, which can be crucial in preventing misunderstandings over how the owners expect the company to be managed.

6.  You May Need Bylaws To Set Up A Bank Account and to get Loans and Insurance.

Finally, if you would like to open a business account or apply for loans most banks will require you to provide a copy of your bylaws.  In addition, insurance companies may require you to provide a copy of your company’s bylaws before providing certain types of polices.

As a business owner it is often tempting to cut corners to lower costs. A strategically thought out set of bylaws should not be one of these cut corners.   Instead, bylaws should be recognized for what they are – one of the wisest investments a business owner can make to ensure the long-term effectiveness of their company.

If you have any questions regarding bylaws or any other business legal issue, please contact me at Doug@BendLawOffice.com.

Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.

A business owner does not need a physical location to incorporate in Delaware, but they do need to have a registered agent for service of process.

MyCorporation ($120), BizFilings ($129), Legal Zoom ($159) and a number of other companies provide a registered agent for service of process in Delaware.

However, you will also need to register your business in each state you are doing business.  Most states have a very low registration threshold because they not only want to know which businesses are operating in the state, but to also maximize revenue from franchise and other business taxes.

If you have any questions regarding incorporating in Delaware or any other business legal issue, please contact me at Doug@BendLawOffice.com.

Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.