A Simple (and Expensive) Mistake Corporation Owners Make

Even though most of my clients today form LLCs, there are still some cases where nothing but a corporation will do. It’s still a great structure for foreign-based owners, and if you’re looking at going public, it’s your only real choice.

But there’s a mistake a I see a lot of Corporation owners make with their initial set-up, which winds up costing them hundreds of dollars down the road. It’s called ‘undercapitalizing’ a Corporation, and here’s how it works.

When you create a Corporation, in most states you have to create a framework for its shares. That means determining three things: (1) how many total shares your Corporation can issue, (2) the types of shares your Corporation can issue, and (3) the authorized value of those shares. Today, we’re talking about the total number of shares your Corporation can issue.

The total shares is also called ‘authorized capital.’ Essentially it’s an upper limit on the number of shares your Corporation could ever issue. In the case of a public company, or a company that is being formed with the intention of going public, this amount can be pretty high – 75 to 100 million shares is a pretty standard amount. Public companies need lots of extra shares, as selling them off to new or existing investors is one of the primary ways they can raise money.

In the case of a small company, you don’t need so many shares. But the reverse mistake I see is people setting up their Corporations with too few shares instead. This can lead to a situation where you’re stuck, and you may not be able to grow when you need it most.

For example, let’s say you set up a small Corporation, with 200 authorized shares. You issue 100 shares to yourself and 100 to your business partner, so you can be 50-50 owners. All is well until you want to bring on an investor, who wants some shares in the Corporation. Because you issued everything to yourself and your partner, there’s nothing left to give your new investor.

Now you have two options: give up some of your shares, or go back and spend the money to amend your Articles of Incorporation, creating a larger authorized capital amount, so you have something to sell to your investor.

With Option 1, you are selling part of your ownership to the new investor. There are some serious consequences to this!

  • If you sell an investor half of your shares, you’re going to reduce, or dilute, your ownership in the Corporation. If you’re a 50% owner, and sell 25% of your shares, you are now a 25% owner!
  • If you sell an investor your shares, you’ll have a tax hit. Selling those shares is going to be a taxable event on your personal bottom line, because you’ll have to declare a capital gain equal to the amount the investor is bringing into the Corporation.
  • If you gift those shares to your new investor instead, you’ll be reducing your lifetime gifting allowance. That can impact your estate planning and how you move your assets to your heirs.

Your only real choice is Option 2 – going back and amending your Articles of Incorporation to create a larger pool of shares. But this can be expensive. You’ll be paying a filing fee to the state and, depending on how many shares you need to add, and at what value, you could increase your maintenance fees. Plus, you need at least a majority of shareholders to approve the change. If you can’t get that, you’re dead in the water.

Our Solution

There are 2 easy ways to fix this problem. First, when you incorporate, set a reasonable authorized capital amount, and give yourself enough shares to grow. We usually suggest a minimum of 5,000 shares for companies that intend to stay small and not have many shareholders.

Second, don’t issue all of your authorized shares at the beginning. This is a huge mistake I see people make all the time! When it comes to calculating your ownership in a Corporation, the only shares that count are the shares that are issued.

So in our example, you and your partner could each have 10 shares and you would still be the 50-50 owners of your Corporation. The other 180 shares don’t count for ownership purposes. They’re insubstantial – they don’t become tangible until you issue them. Now, if you wanted to issue your investor shares, they would come from this pool. Of course, your percentage of ownership would change – if you issued him 10 shares, all 3 of you would have 10 shares, making you all 33.33% owners. However, because the shares came from your Corporation’s pool of shares, and not from your personal shareholdings, there would be no tax consequence to you or your partner.

There are many variables when you’re structuring a business. That’s why it’s hard to go through a quick-service website. Unless you talk to someone who’s got some knowledge and experience on both the tax and the legal side, it’s hard to know what you don’t know. And that can leave you vulnerable.

Got questions? Contact us! We’re here for you.

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