There are steps you can take as a business owner to limit your exposure and protect your personal assets. This article explains how to legally separate you and your business, thus protecting yourself from the risks of business ownership. By having an entity (corporation or LLC), there is a legal presumption that you are not liable for corporate debts.
If you start a business without forming an entity, then your legal status is “Sole Proprietor.” There is no legal separation between you and your business. The debts and obligations of your business are your personal debts and obligations.
If you do not create an entity but use a business name that is different from your legal name, you need to register a Fictitious Business Name (another article topic altogether). While you are legally required to do this as a sole proprietor, having a registered FBN does not create a separate legal entity, and you remain personally liable for the operations of your business.
Separate Legal Existence
When you create a corporation or LLC that entity has a legal existence that is separate from you personally. The entity is “born” as of the date the Articles of Incorporation (for corporations) or the Articles of Organization (for LLCs) are filed with the Secretary of State.
The general rule is that shareholders, officers and directors of corporations, and members and managers of LLCs, are not liable for the debts or obligations of the company. This is known as the Corporate Shield Doctrine; also known as “limited liability.”
In your contractual dealings with anyone, such as a client, vendor, supplier, contractor, etc., you would clearly designate the full name of your business entity (not your personal name) as the party/signatory to the contract. If you execute the contract on behalf of the entity and not yourself personally, the entity is the proper party to the lawsuit in the event of a dispute. If an adverse judgment is entered, it is against your entity, not you. Your personal assets are protected. If the entity needs to file bankruptcy, your personal credit is left intact (assuming you haven’t personally guaranteed any obligations).
Exceptions to the Rule
As with any general rule, exceptions exist to the Corporate Shield Doctrine. If you fail to pay your employees or commit other Labor Code violations, then you can be personally liable. If you engage in acts outside the scope of your corporate duties, or if you commit fraud, you cannot hide behind your corporation. If you personally guarantee a contract or sign in your personal capacity, then your corporation provides no protection. The most heavily litigated exception is the Alter Ego Doctrine, which is so detailed that it requires a separate article itself. To grossly oversimplify the doctrine, you need to run your company like an actual company; adhere to corporate formalities and maintain separate finances. I’ll dive deeper into that another time.
By creating a corporation or LLC for your business you create a legal separation between you and your company, and the legal presumption is that you are not liable for the obligations of your company. If you are in business, whether you are selling products or performing services, I strongly urge you to consider creating a legal entity to limit your liability and protect your assets.
Beware the Phantom LLC!
Have you ever referred to your business as an LLC, before getting around to forming the entity? Rational reasons could exist – maybe you intend to form the entity after making a few sales, but you wanted to lock down the domain first; or perhaps you believe including “, LLC” in your name makes you appear more established and professional. Either way, if you hold yourself out in business as being a limited liability company (or corporation), when you are in fact a sole proprietor, there can be devastating real-world consequences.
It is very simple to confirm the status of any corporation or LLC in California. Click here to check the status of any registered business in the state. Assuming you entered the name correctly, if someone is holding themselves out as being a corporate entity in California, and they do not appear on the Secretary of State database, then this person has a big problem. If you are contemplating doing business with any company, I strongly recommend looking them up before getting too involved.
Below are examples of faux LLCs I’ve encountered. Litigation battle stories incoming!
Non-existent llc on a purchase agreement
When I was a new lawyer fresh out of law school a client hired me to file suit on a failed real estate transaction in which he was the buyer. The buyer executed a purchase agreement in the name of his LLC, but the seller refused to perform. I drafted a complaint seeking a remedy called specific performance and attached the contract as an exhibit. I confirmed on the Secretary of State website that the LLC existed before filing suit.
The defense immediately served discovery asking the buyer to admit the LLC did not exist at the time of contracting, and that the contract contained a non-entity. This tipped me off that we had a major problem, and I looked up the entity again, this time comparing the date of the entity formation with the date on the contract.
Sure enough, the buyer created the entity months after the contract was formed, just before we filed suit. At the time the contract was formed, the buyer did not exist; it was a non-entity. You might think the member/owner of the LLC could just sue in its stead, but the contract contained a fictitious name, meaning the name was something other than the legal name of the buyer. The fictitious name was not registered with the county recorder, and contracts with non-registered fictitious names are voidable by the other party. The seller opted to void the contract. Had the seller communicated his intention we may have avoided litigation altogether, but that is a separate article.
I realized the case had no merit and we had to cut our losses and dismiss. I learned to always and immediately confirm the legal status of any company within whom I deal, whether it’s my client or the other side. This lesson stuck with me throughout my career.
You should never execute a contract on behalf of a non-existent entity because you’ll lack standing to sue if you should ever become a plaintiff.
non-existent llc on a lease
The next scenario is the converse of the first. Now I represented the defendants. The case involved a commercial lease where the tenant executed the lease as an LLC, and the parties went to litigation.
The complaint named both the LLC and the individual members as defendants. My first instinct was to complain that the landlord improperly sued the individuals, as members of an LLC are generally not liable for company debts. However, I recalled the lesson from the early real estate case, so I checked my client’s status on the Secretary of State website.
I learned my client signed a commercial lease on behalf of a non-entity. The principals of the company erroneously thought they had formed the LLC. They claim to have paid a lawyer to file papers with the state to create the entity, but somehow it never happened.
I wanted to assert that the individual members were subject to dismissal, but they were in fact personally liable for the company’s debts because there was no company! I had plenty of substantive grounds to defend the case, but their personal assets were exposed because they contracted in the name of a non-entity.
Even worse, the owners were operating under a fictitious name, which was not registered with the county. This means if a client refused to pay them for their work, they would have been barred as a matter of law from being a plaintiff!
The landlord dismissed the case after I served discovery that went to the heart of the dispute, so my clients dodged a bullet.
I represented a client, an actual LLC, who was being sued on a bogus fraudulent transfer case. The plaintiff corporation contended a third party owed it money, and that the third party conspired with my client to frustrate collection, fraudulently transferring assets to my client.
The allegations were meritless, but I immediately looked up the plaintiff corporation on the Secretary of State website. The plaintiff entity was never formed. The lawsuit alleged the plaintiff got a judgment in another case, and he was seeking to hold my client liable for the judgment. Nobody in the prior case noticed the plaintiff was a non-entity, and that the judgment was invalid! Compounding the problem, the plaintiff lacked standing to sue in the second case.
I had to bring a motion to change venue before asserting the standing defense, and the motion was granted. Before the case was transferred I notified counsel, as a professional courtesy and in an effort to save my client on defense fees, of my intention to bring a motion to dismiss on the standing issue. Counsel realized his blunder and could not deny his client was a non-entity. He therefore responded that his client was just a fictitious business name (even though the complaint alleged it was a corporation), and that the “true” plaintiff was an individual named Jose.
Counsel presented a fictitious business name certificate to me, but FBN certificates expire after five years. I notified counsel of this defect, and he quietly dismissed the case. I was in his shoes when I was a new lawyer, so I can’t be too judgmental, but this guy had been practicing law much longer than me.
fake llcs on social media
I have seen several people promoting business pages on Facebook with names ending with “LLC”. Curiosity sometimes causes me to casually look them up, and on multiple occasions I have found these “LLCs” to not exist at all. As I said at the beginning of the article, rational reasons could exist but my perspective is these people are holding themselves out as something they are not.
Be very cautious about transacting business with someone willing to cut corners and be disingenuous. I personally believe these people know better, but they lack the resources or know-how to form their own entity, so they take the shortcut and slap "LLC" or "Inc." at the end of their name, hoping nobody notices. These are not the traits of someone with whom I would transact business.
But Tom, what if they just formed the entity outside California? Great question! I have written in the past about the wisdom of forming out of state entities (click here), but here’s the real problem: if you are doing business in California and formed a foreign entity (meaning out of state), you still have to register the entity in California. You have to file papers and pay fees, just like any other California entity.
In closing, if you are contemplating a business transaction with someone holding themselves out as an LLC or corporation, take a moment to check their legal status. Use this link right here. Send me a note if you'd like me to check it for you (no charge!), and let me know if you have any questions.
Real scenario: a business owner called me to inquire about registering his Nevada LLC to conduct business in California. He lived and operated in California, yet he formed the LLC in Nevada because that state does not have income tax. He formed the entity using an online service - not an attorney - and had no idea what to do next. He didn't have legal advice when he created the entity, he just paid an online service to create the entity.
I inhaled deeply and hoped he wouldn't shoot the messenger. I informed him of the procedure and cost for registering his Nevada LLC in California, which he is required to do, and considering the cost of maintaining one entity in two states, he could form a new entity in California for less. Given the cost and extra paperwork, it made no financial sense to operate his Nevada LLC in California. He still has to pay state income tax to California, and he only created more work and expense for himself.
I gave him a quote with the option of: 1) forming a new California LLC; or 2) registering his Nevada LLC in California. I advised him that the legal cost of each option was roughly the same, but the ongoing/future cost of the second option was twice as high. The prospective client said he would "figure it out," and he never called back. The poor guy wasted money and made his business structure unnecessarily complicated. Sometimes my job requires me to tell people what they don't want to hear.
If you are operating your business in California and considering incorporating in one of the seven states that do not have income tax (Texas, Florida, Nevada, Alaska, Washington, South Dakota, or Wyoming), it can be tempting to form your company out of state then operate in California. By forming your business entity in a non-income tax state, you don't have to pay state income tax, even if you live in California, right? Not only is this assumption wrong, but forming the entity out of state, then operating in California will double your expenses and paperwork.
entity formation in general
Creating a legal entity is relatively simple. You complete a form and pay a fee to the secretary of state of your chosen state, then file the annual statement (called a Statement of Information in California). You have to do more than that to properly maintain the entity (a separate topic for a future article), but that is literally all you have to do to create a legal entity that has a separate legal existence from you personally.
You must designate a person or company in the state of incorporation as your agent for service of process. This is the only person authorized to accept service of legal process, such as a summons or subpoena.
Every year you must file an annual statement, called a Statement of Information in California, and pay a $25 fee (due bi-annually for LLCs). California's Franchise Tax Board also charges $800 a year for the privilege of operating a business entity in California - regardless of whether the entity was formed outside California. You will get a penalty and interest hit if you pay the fee late, and the state will suspend your business if you fail to pay at all.
This process is generally the same across the states, subject to variations in nomenclature.
registering a foreign entity
Suppose you live and work in California, but have already created an entity in another state. Regardless of whether you have a foreign LLC or corporation, you need to register the entity in California before it can do business here. If you are transacting "intrastate business" in California (a fluid and undefined term), then you must register with the California Secretary of State before transacting business. It's a safe bet to assume that if you are an LLC or S-Corporation, and you live and work in California, but formed a Nevada LLC, you need to register the LLC in California.
Here's what to do. You must submit a form and pay a fee to the Secretary of State of your state of incorporation, and request what is generally called a Certificate of Good Standing. Again, nomenclature varies among the states.
Once the Certificate of Good Standing arrives, you file an Application to Register a Foreign LLC with the California Secretary of State, along with a $70 filing fee. Upon approval, you have to file and pay for the annual Statement of Information (due within 90 days), and you must pay the annual $800 FTB tax.
These annual fees are in addition to the fees you must pay to the state of incorporation. You also must appoint an agent for service of process in California, in addition to an agent in the state of incorporation.
In summary, by registering your foreign company to conduct business in California, you have annual filings and fees in two states.
but what about no income tax?
Wasn't the whole point of incorporating in a foreign state to avoid paying state income tax? Unless you are personally domiciled in that zero income tax state, the answer is No!
Consider this - LLCs and S-Corps have pass through taxation, so the profits and losses are allocated to the tax returns of the individual members/shareholders. The entities themselves don't file tax returns. If you are domiciled in California, then you pay income tax to California. Your Nevada LLC doesn't absolve you of tax liability to California.
If you formed a Nevada LLC to avoid state income taxes, but you are domiciled in California, then you are going to pay income tax, and the entire purpose for incorporating out of state was frustrated.
Even worse, you will have to register your business in California (if you are transacting business here), and that entails fees and paperwork to both states. You also must submit annual filings and fees to both states, and appoint a registered agent in both states.
In closing, if you're considering forming your LLC or S-Corp. out of state to avoid income tax, and you are domiciled in California, I hope this article gives you pause. Go speak with your tax professional to corroborate your tax savings theory. If you have already formed the entity out of state and are domiciled in California, you might consider dissolving the foreign entity and forming a new entity in your home state.
Being in business is hard enough, and you shouldn't complicate your life with unnecessary paperwork and fees.
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