The most common legal and tax mistakes when establishing limited liability companies (s.r.o.) and joint stock companies (a.s.)

Starting a new company is an exciting step on the road to business success. Whether you are planning to establish your first limited liability company or are a seasoned company expanding your structure with another joint-stock company, it is easy to overlook some important legal and tax aspects in the initial euphoria. Unfortunately, mistakes made when setting up a company can prove very costly later on, whether in the form of legal disputes between partners or unexpected tax assessments and fines.

Author of the article: ARROWS (JUDr. Kateřina Müllerová, office@arws.cz, +420 245 007 740)

As a lawyer specializing in corporate law, I often meet clients who only later discover that they overlooked something when establishing their company. In this article, I will therefore highlight the most common mistakes in the legal and tax areas when establishing limited liability companies (s.r.o.) and joint-stock companies (a.s.). At the same time, I will offer practical advice on how to avoid these mistakes and show you examples from practice of the consequences of underestimating them. The aim is to enable you to avoid unnecessary risks and embark on your new business venture with confidence, ideally knowing that you have an experienced advisor at your side.

Main legal mistakes when establishing a company

Incorrectly drafted founding documents (articles of association or statutes)

One of the most common mistakes is using a universal template for the founding agreement or statutes without adapting it to the specific situation of your company. The articles of association for a limited liability company (or the statutes for a joint-stock company) represent the basic "rules of the game" – they govern the relationships between shareholders, shares, voting rights, the decision-making process of the executive or board of directors, and much more. Errors in the articles of association may include, for example, the omission of a right of first refusal when transferring shares, unclear definition of the powers of the managing directors, or inappropriately set rules for the distribution of profits.

Such shortcomings may not become apparent immediately, but in crisis situations (such as a dispute between shareholders or the entry of an investor) they can result in long and costly disputes. For example, if the articles of association do not address the procedure in the event of a deadlock between two 50% shareholders, this can paralyze the company's decision-making process. The solution is always to have the founding documents tailored to your needs – an experienced lawyer will discuss your specific requirements with you and cover all important scenarios that may arise during the life of the company in the agreement.

Inappropriate choice of statutory bodies (managing directors and members of bodies)

The second common problem is the selection of unsuitable persons to manage the company. The managing director of a limited liability company or a member of the board of directors or supervisory board of a joint-stock company should not only be trustworthy, but also competent and able to perform their duties. You will make a mistake if you appoint, for example, a family member or acquaintance as an executive purely out of loyalty, even though they do not have the necessary experience. Similarly, it is risky to give the position to someone who does not understand their legal obligations, as statutory bodies bear legal responsibility for the management of the company and must act with due diligence.

Another omission is often failing to check for legal obstacles to future managing directors. Czech legislation stipulates that a person who, for example, has gone through bankruptcy or has been banned from performing certain activities by a court cannot be a managing director or member of a body. If you appoint such a person, the court will not enter them in the commercial register and the entire process will be delayed. In addition, it is necessary to clarify in advance how the executives will act (independently, each with full or limited authority, or jointly, two or more) and to clearly stipulate this in the articles of association. A poor choice or unclear definition of the powers of the company's management can lead to chaos in management and, in the worst case, to financial damage or legal liability towards partners or third parties.

Underestimating trade and license requirements

In order for a company to legally commence its activities, it is not enough to simply be entered in the commercial register. It is also necessary to have all business licenses properly taken care of. A very common mistake, especially among start-up entrepreneurs, is that when filling in the subject of business in the founding documents, they do not correctly list all trades or omit that some activities are not among the free trades and require proof of professional competence. For example, the operation of skilled trades (such as construction or hospitality) requires that you personally or your responsible representative have the appropriate education or experience and obtain a trade license for the given field.

If a company does not have such legal qualifications and nevertheless commences operations, it exposes itself to the risk of fines and a ban on operations by the trade licensing office. Another example is when an entrepreneur fails to obtain a special license or permit (e.g., a license for road transport or a license from the Czech National Bank for certain financial services) and only realizes this after investing time and money in starting the business. It is therefore essential to check all the requirements for your line of business at the outset and ensure that the company meets the conditions for obtaining the relevant authorizations. A lawyer or specialist advisor will help you identify what documents and qualifications are needed so that your company can operate completely legally from day one.

Risk structure of ownership and capital

Another area where mistakes are often made is in setting up ownership shares and company capital. Formally, it is possible to establish a limited liability company with a capital of as little as CZK 1, but too low a registered capital can send an undesirable signal to business partners and investors about your creditworthiness. I also encounter situations where partners do not think through the ratio of their shares and the rules for decision-making. For example, two partners with 50/50 shares often leave decision-making to the principle of unanimity, which may seem fair at first, but at the slightest disagreement, it completely paralyzes the company.

In joint-stock companies, it is necessary to decide whether to choose a dual management model (board of directors + supervisory board) or a monistic model (administrative board with one statutory director). The wrong choice or misunderstanding of these structures can lead to non-compliance with the law or complications in the management of the company. It is also important to consider whether and how to regulate restrictions on the transferability of shares, minority shareholder rights, etc. in the articles of association if you do not want an undesirable investor to enter your company. Omissions in the area of ownership structure can result in differing expectations among shareholders, disputes over control of the company, or even future difficulties in selling the company or bringing in an investor. Here, too, the rule is: plan everything carefully and enshrine it in contracts right from the start, rather than making complicated adjustments later.

Main tax mistakes when setting up a company

Failure to address the tax implications of initial contributions

The tax aspects of setting up a company are often underestimated, which can backfire, especially when contributing assets to the share capital. Many entrepreneurs believe that transferring assets (e.g., machinery, vehicles, or real estate) to a newly established limited liability company is a purely internal matter with no tax implications. However, if the contributor (founder) transfers assets to the company that have significantly changed in value (typically real estate purchased cheaply years ago, the price of which has now increased many times over), this may have an impact on their income tax. Under certain circumstances, this difference in value must be taxed, even if you receive a share in the company instead of money.

Contributions whose market value is unclear can be similarly tricky – the law requires an expert valuation of non-monetary contributions to the registered capital, and a poor estimate or undervaluation of assets can cause problems during subsequent audits (for example, the tax office may examine whether the valuation corresponded to reality). Strict regulation of non-monetary contributions is a matter of course for joint-stock companies, but even in the case of limited liability companies, founders should be cautious and seek advice. Unresolved tax aspects of contributions can lead to unexpected tax liabilities or, in the worst case, to disputes with the tax office. The solution is to consult a tax advisor or lawyer about the planned contributions at the time of incorporation, who will assess how to carry out the transaction in a tax-optimized manner – sometimes it may be more advantageous, for example, to sell the assets to the company at market price or use another transfer mechanism rather than contributing them to the capital.

Errors in registering for VAT and other taxes

Another common mistake is failing to register for the relevant taxes on time. A newly established company is required to register for corporate income tax within 15 days of its establishment. Most entrepreneurs are aware of this, but they often forget about VAT (value added tax). If you know from the outset that your company will be carrying out large volumes of transactions, it may be advisable to voluntarily register for VAT right at the start so that you can claim VAT deductions on your initial investments. Conversely, underestimating your turnover and exceeding the registration threshold of CZK 2 million (the current limit for mandatory VAT registration) without registering in time may result in additional VAT and penalties.

Similarly, you need to consider other tax obligations: if you employ people, you must also register as an employer and pay advance payments for personal income tax, social security, and health insurance for your employees. For company vehicles, there is a road tax, which is also often forgotten. And if your new company was formed by spinning off part of another company, you will also need to address issues surrounding VAT on the transfer of part of a business (under certain conditions, this may be a transfer to which VAT does not apply, but formalities must be complied with). In any case, failure to register for taxes on time or to comply with reporting obligations can result in unpleasant penalties. It is therefore good practice to consult with experts on this administrative aspect when setting up a company – they will often provide you with a checklist of mandatory registrations and help you to complete everything correctly and on time.

Underestimating long-term tax impacts and benefits

Strategic tax planning should not be postponed until the company has grown. Even when setting up a company, decisions can be made that will affect future tax efficiency. A common mistake, for example, is not separating personal finances from business finances – entrepreneurs invest money or assets in the company spontaneously without documentation and then struggle to figure out what is a loan, what is a deposit, and how it is taxed. This may expose them to the risk that the tax office will reclassify certain transactions (e.g., "hidden" deposits or loans may have tax implications if they are not properly covered by a contract).

More experienced companies sometimes fail to consider the use of tax relief or optimization when setting up a new entity. For example, when establishing a new research and development company, it is possible to plan the use of deductible items for research and development (so-called R&D deduction) from the outset. Or, when expanding abroad, it is advisable to seek advice on how to avoid double taxation and take advantage of international double taxation treaties, or whether to establish a subsidiary in another country for strategic reasons. Although these issues go beyond the actual act of setting up a company, it is precisely at the start that it is time to think about them. If you don't, you may end up paying higher taxes than necessary or face costly restructuring in the future. By working with a tax advisor, you can set everything up at the very beginning so that you legally minimize your future tax burden and avoid problems.

Real-life stories: what problems can arise

Example 1: Underestimated preparation by a new entrepreneur – Mr. Dvořák decided to establish his first limited liability company in the construction services industry. To save money, he had a notary prepare a so-called "100-euro model articles of association" containing only the mandatory requirements. He stated "construction and renovation" as the subject of his business, but he did not realize that for a craft trade such as bricklaying, he needed a responsible representative with a vocational certificate in the field. The Trade Licensing Office suspended his trade registration and requested that he supplement his qualifications, which meant a delay in starting his business by several weeks. In the meantime, Mr. Dvořák almost lost his first job.

When he finally registered the company and started working, it turned out that he and his partner had 50/50 shares and the partnership agreement did not specify what to do in case of a disagreement. The first disagreements were not long in coming—the partners could not agree on an investment in new equipment, and the company found itself at a standstill. In addition, Mr. Dvořák neglected to register for VAT, and when they exceeded the legal limit for sales within six months, the tax office retroactively assessed VAT and penalties. Lesson learned? If Mr. Dvořák had worked with a lawyer and tax advisor from the outset, he would have known about the need for professional qualifications, the partnership agreement would have been better drafted (e.g., resolving deadlock situations), and he would have been notified of his tax obligations in a timely manner. In the end, he turned to us to help remedy the situation – to amend the partnership agreement, set up a decision-making process, and resolve the additional VAT registration. However, it cost him much more time, energy, and money than if he had not underestimated these steps at the outset.

Example 2: An experienced company, a new entity, and unexpected complications – ABC, LLC, a company that had been successfully operating in e-commerce for ten years, decided to expand and establish a joint-stock company for a new division focused on fintech. The management believed that establishing a joint-stock company would be similar to establishing a limited liability company. However, they overlooked the fact that the articles of association of a joint-stock company must be more detailed – they did not clearly regulate the issuance of shares and restrictions on their transferability. When they wanted to invite an investor to join the joint-stock company, they encountered the problem that the articles of association did not allow new shares to be easily issued without the preemptive rights of existing shareholders, which complicated the entire transaction.

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An even bigger problem arose in the area of taxation: the parent company ABC contributed part of its business to the new joint-stock company as a non-monetary contribution. Everything was in order from an accounting perspective, but they underestimated the tax implications of the valuation. The tax office subsequently investigated whether the valuation of the contributed part of the business corresponded to market reality, and the audit process kept the company busy for several months. In addition, it turned out that some transactions between the limited liability company and the new joint-stock company should have been set up as normal business relationships with usual prices – by not formally addressing this, they risked additional income tax due to so-called transfer prices. ABC's management ultimately admitted that the "we can handle it ourselves" approach and the articles of association with only the basic legal requirements were not ideal. After consulting with our office, we helped revise the articles of association to suit their intentions and set up safe rules for valuation and trading between related companies with the accounting firm. The ABC story shows that even experienced management can encounter new pitfalls when entering uncharted waters without the proper professional support.

Recommendations for flawless company formation

To prevent your newly established company from becoming another case like the ones mentioned above, here are a few recommendations and best practices:

• Have your founding documents tailored to your needs – Avoid universal founding documents with only the mandatory requirements from a notary. Every business has its own specifics, and the articles of association or statutes should reflect them. Investing in precisely drafted documents right from the start will save you a lot of trouble in the future.

• Check your future executives and set clear management rules – Only select people for statutory positions who meet the legal requirements and whom you trust both professionally and personally. Clarify how they will make decisions in the company (independently, jointly) and include everything in the founding documents. This will prevent internal conflicts and dysfunctional management.

• Check trade license and permit requirements – Before submitting your application for registration in the commercial register, check what specific trades you need to register or whether you need a special license. If you do not have the necessary qualifications, find a responsible representative or another way to meet the requirements. Do not start doing business without the necessary authorizations.

• Consider the tax implications from the outset – Are you planning to invest assets or finances in the company? Talk to our tax expert about the best course of action. Clarify when to register for VAT and other taxes and take advantage of optimization options (e.g., VAT deductions on investments, choice of an appropriate accounting period). Setting things up correctly from the start can save you a lot of money and hassle.

• Plan with a view to the future – Imagine where you want your business to be in a few years. Are you planning to take on an investor, expand abroad, or hand over the company to your children? Such plans should be reflected in the structure of the new company. The wording of the articles of association/statutes, types of shares, the structure of the governing bodies, and the tax strategy can be adapted accordingly. What is easy to arrange now may be difficult or expensive to change later.

• Don't hesitate to seek expert help – Consulting a law firm or tax advisor is not an unnecessary expense, but a form of prevention. An experienced lawyer will point out risks that you may not have thought of yourself and suggest solutions. They can handle communication with the authorities on your behalf, prepare all the necessary documents, and ensure that the company formation process runs smoothly, while you can focus on your business plan.

Conclusion: Avoid mistakes and start your business with confidence

Starting a company is a major milestone, so it pays to do everything right from the start. The mistakes described above can happen to anyone – they can affect both newcomers and experienced entrepreneurs. The good news, however, is that these missteps can be prevented. The key is to not underestimate the importance of preparation and not be afraid to seek legal advice.

As lawyers with many years of experience in commercial law, we are ready to help you. If you are unsure about what you need to keep in mind when establishing a limited liability company or joint-stock company, contact our law firm. Together, we will review your plans, point out potential pitfalls, and ensure that the entire process runs smoothly and in accordance with the law and your business goals. Do not hesitate to contact us for a non-binding consultation – you will often save not only time and money, but above all, you will ensure a smooth start to your business without unnecessary risks.