California S Corporation: Dangerous Formation Mistakes

January 10, 2023

California S corporations offer great benefits like limited liability protection and tax savings. Unfortunately, many S corporation owners often miss critical steps during the incorporation process which can lead to “piercing the corporate veil” and invalidation of the corporation in case of a lawsuit or audit and the results could simply be catastrophic. 

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Common California S Corporation Formation Mistakes

Here are some of the more common mistakes and omissions made by business owners when forming their S corporations:

Lack of Bylaws

Bylaws are the rules and regulations of the California S corporation that governs its internal affairs. Bylaws typically cover things like board of director duties and responsibilities, and meeting and voting procedures. Preparation of bylaws is an often overlooked step.

Lack of Organizational Minutes

Organizational minutes are a written record of the proceedings and decisions of the S corporation shareholders and directors and can be used as proof of corporation decision-making in case of legal disputes. Yet another overlooked step.

Not Issuing Stock    

Corporation stock represents proof of S corporation ownership and entitles the shareholder (owner of the stock) to a share of corporate profits, voting rights and the right to receive dividends. Many fail to issue stock after filing Articles of Incorporation with the California Secretary of State. This is a crucial step since share issuance is an integral part of owning an S corporation.

Not Preparing a Stock Ledger

A stock ledger shows the history of all the California  S corporation shareholders. It shows the shareholder names, number of shares held, type of shares held and any ownership changes. It is very important to ensure that you have a ledger keeping track of all the S corporation owners and when there are any changes.

Not Appointing Directors

Directors are elected by the California S corporation shareholders and are responsible for making the corporation’s major decisions and policies. Directors elect officers. Again, many people file Articles of Incorporation then fail to formally elect directors.

Not Appointing Officers

Officers are individuals who are allowed to make decisions on the S corporation’s behalf and responsible for the day-to-day management of the S corporation. Officers are elected by the board of directors and typically are responsible for implementing the policies and strategies dictated by the directors. Appointing officers is another commonly overlooked task when forming a California S corporation.

Not Appointing a Qualified Registered Agent for the CA S Corp

A registered agent (also known as an agent of service of process) is an individual that is available from 9-5 daily at a California physical address. Failure of the agent to be physically present at the address provided can lead to what’s known as a “default judgement” in case of lawsuit. Many people who form S corporations fail to indicate a physical address or a person that is available from 9-5 daily at a physical address. Instead, they either indicate an address where nobody is during business hours. Others use mailbox addresses. Making an error here can be catastrophic in case of a lawsuit.

Not Executing a Buy-Sell Agreement

An S corporation buy-sell agreement (also known as a shareholder agreement) is a contract governing how and when shares can be transferred and sold and what happens when certain circumstances occur (e.g., shareholder death and disability). If your S corporation has more than one shareholder, failure to have a buy-sell agreement can be catastrophic.

Not Obtaining an EIN for the CA S Corp

An Employer Identification Number (EIN), also known as a Taxpayer Identification Number (Tax ID Number) is a nine-digit number assigned by the IRS to identify the S corporation. The EIN identifies the S corporation for tax purposes and is used for banking, obtaining licenses and filing taxes. An EIN should be obtained immediately after forming the S corporation.

Not Filing IRS Form 2553 Timely or Properly

IRS Form 2553, also known as the “Election by a Small Business Corporation” or “S corporation election” is the official IRS form that must be filed to switch the corporation from an S corporation to a C corporation. This avoids “double taxation,” allows the corporation to be treated as a pass-through entity and income tax to be paid on the shareholder (owner) level only. The S corporation election must be filed within 75 days of incorporation. S corporation filings are often laden with mistakes which can cause IRS rejections. Others completely fail to file the S corporation election and end up being taxed as a C corporation (which subjects them to double taxation).

Not Filing a California Statement of Information

The California Statement of Information is a mandated California Secretary of State form required to be filed within 90 days of incorporation and on an annual basis. It must include the name of the California S corporation’s officers, directors, and agent of service of process (registered agent). Failure to file results in assessment of a $250 penalty and corporation suspension.

Not Filing a Limited Offering Exemption Notice Timely or Properly

The California Limited Offering Exemption Notice (LOEN) is a filing that must be submitted to the California Department of Financial Protection & Innovation (DFPI) within 15 days off issuance of the S corporation’s stock. Failure to file can result in penalties being assessed.

Not Preparing for the CTA

The Corporate Transparency Act (CTA) is a new federal law going into effect on January 1, 2024. California S corporation owners should take the law into account now rather than waiting until the law goes into effect. Civil and criminal penalties apply to the CTA so this law must be taken seriously.

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