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Formation of a Corporation


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									                            Chapter 10
                     Formation of a Corporation

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

              Corporate Name

                      A corporation’s name must contain the words “corporation,”
               “incorporated,” “company,” or a corresponding abbreviation.

                       Example: Creation Sensations, Inc.

              Similar Corporate Names

               A corporation’s name must not be deceptively similar to another corporate name.
               This prevents consumer confusion and unfair competition.

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                      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

     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.

               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

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               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

              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.

              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.

____________________________________________________________Formation of a Corporation                            3
                      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
              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.

              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.

____________________________________________________________Formation of a Corporation                         4
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.

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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.

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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?

____________________________________________________________Formation of a Corporation                 7
       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.

____________________________________________________________Formation of a Corporation               8
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


   Cc:          Hal and Jan Steven

____________________________________________________________Formation of a Corporation               9
               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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