Issues with Capitalizing Your New Corporation

Once you register a corporation in your state, you must go ahead and capitalize it. This raises a host of questions regarding the best way to do it and potential risks of getting it wrong.

First things first. Any discussion of capitalization needs a disclaimer. Every state sets forth its own rules on capitalization and you should look to your state of incorporation regarding them. These rules may cover issues such as minimum cash contributions that must be made, debt to equity ratios and so on.

Capitalization is simply the funding of the corporate entity. This is typically done through the sale of shares. If a corporation has 100,000 shares, it might sell 20,000 of these shares to three shareholders. The question, of course, is for how much money? There is no easy answer and there are issues to consider.

Capitalizing a corporation is really a tax issue. There are advantages to loaning money to a corporation instead of directly capitalizing it. The primary advantage is the repayment of the loans from shareholders is tax deductible to the corporation and places the shareholders in a stronger position compared to other creditors should the corporation run into problems down the line.

Given the above, one might be tempted to capitalize the corporation at the minimum amount allowed by your state, often $1,000 or so, and then just have the shareholders loan the remainder of the start up money to the corporation. This, however, can lead to problems as well.

The first problem is inadequate capitalization is one of the biggest factors in setting aside corporate protection under the theory of alter ego. If you form a corporation and start turning multimillion dollar deals, a $1,000 capitalization is not going to make a court very happy. As a result, it is vital that you evaluate your capitalization in relation to the dollar value the corporation will be dealing with in contracts. You do not want to lose the protection against personal liability provided by the corporate entity.

The second problem is the IRS. Yes, the IRS is always a problem, but there is a specific reason here. The IRS does not like to see "thin" capitalization of corporate entities. Why? Well, the payments on a loan are deductible to the corporation. If those payments are reclassified as dividend payments, which the IRS will often do, the interest deduction for the corporation is disallowed. Making matters worse, the loan repayments to shareholders will be reclassified as dividend payments and additional taxes will be due from the time of the first payment on the loans. The amendment of tax returns and payments of penalties and interest will be required.

When you form a corporation, a careful evaluation of the capitalization requirements of the entity needs to be considered. If it is handled incorrectly, it can come back to haunt you. Unfortunately, there is no bright line regarding the amount, so getting professional help is often wise.

Richard A. Chapo provides professional California incorporation services through SanDiegoBusinessLawFirm.com.