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The Return of the Pre-Incorporation Agreement

On Behalf of | Apr 6, 2023 | Business Law

Happy New Year. This time next year, the corporate-law world will see a significant change.

The Corporate Transparency Act will take effect on January 1, 2024, requiring almost every U.S. entity to report its ownership to the IRS Financial Crimes Enforcement Network (FINCEN). CTA has very significant penalties. Fail to report, and you face up to 2 years in prison plus fines up to $10,000. If you form a LLC today, then you have a report due by Jan. 1, 2025. If you file articles after Jan. 1, 2024, then your report is due within 30 days of filing. (Read more about the CTA here.) This author believes that practitioners will eventually evolve their habits to avoid risk of unnecessary CTA penalties.

With this groundwork being laid, here is a New Year’s prediction for 2023: We will witness the return of the pre-incorporation agreement.

A pre-incorporation agreement is a contract among the prospective owners of an entity and sometimes a third party, concerning a conditional business transaction or the operation of the entity itself. If the condition is not satisfied, then the entity is not formed and the contract is void.

It’s true, the pre-incorporation agreement has seen better days. This author has been practicing corporate law for 12+ years and has formed hundreds of entities — but has drafted fewer than 5 pre-incorporation agreements (or pre-organization agreements, for LLCs). Why is that? Over the past few decades, forming an LLC has gotten very easy, cheap, and anonymous. In Ohio, it takes less than 10 minutes to complete the form set of articles of organization, with a $99 filing fee and very minimal public disclosure. Compare that to spending $500-$2,000 of legal fees on a pre-incorporation agreement that may never have significance. In killing off the pre-incorporation agreement, practitioners concluded, “We might as well just form the entity on the front end, establishing the liability shield as early as possible, and avoiding the cost of drafting a contract that might never go into effect.”

But the pre-incorporation agreement is poised for a comeback.

Here’s why: Unused entities are trip wires for CTA compliance. By implementing a pre-incorporation agreement, a businessperson can avoid the risks that will soon accompany owning an unused entity.

CTA has an exception for certain dormant entities, as long as the entity (1) is not engaged in active business, (2) is not owned by any foreign person, (3) holds no assets, and (4) has not in the past 12 months either had a change in ownership or a transfer of funds exceeding $1,000. That will capture many of the dormant entities, but not all of them. Furthermore, it’s unlikely that any entity formed in 2024 will be able to claim dormant status to avoid an initial filing.

Yes, pre-incorporation agreements are antiquated, but they may again become useful. No comment on whether next year’s prediction will pertain to corporate seals.

Attorney Michael R. Rasor is advising clients on CTA compliance and corporate formation issues. Reach him at [email protected].

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