BUSINESS ORGANIZATIONS

There are many things to consider when forming a business entity. The business lawyers at Skeeters, Bennett, Wilson, & Pike, assist owners of businesses to select the correct entity for their company, to help them form that company, and to assist in the operation of the company. We provide the legal advice in forming business entities such as S and C corporations, general and limited partnerships, limited liability companies, and not for profit corporations. We also assist professionals in forming professional service corporations.

Without a business plan, a plan of operation, and an exit strategy, simply forming the business entity is not enough. We prepare and counsel our clients in asset purchase agreements, buy/sell agreements, partnership agreements, operating agreements for limited liability companies, and dissolution. We continue to represent our clients and give advice to both buyers and sellers when acquiring a business, merging with another business, or selling their business. In addition, we prepare and maintain corporate records so that the company is always in compliance with all state and federal laws. We advise businesses concerning non competition agreements as well as the enforcement of those agreements. Our attorneys represent shareholders, officers and directors in all aspects of corporate life.

BUSINESS LAW ENTITY BASICS

Selecting the Right Business Entity

SELECTING THE RIGHT BUSINESS ENTITY

Every business has some form of a business entity, even if it is by default. The type of business entity that is chosen will determine the amount of liability of the owners, the owners taxing structure, and the degree of control the owners have in the business entity.

Sole Proprietorship

A sole proprietorship is a business owned by one individual and is not a separate legal entity from that individual. The owner is not only the sole owner of the business law assets but is also directly and personally responsible for the debts and liabilities of the business. The sole proprietorship is the simplest of all business law forms and does not require the filing of any documents with the Secretary of State. But this business entity exposes the owner to unlimited personal liability. The profits and losses of the business are reflected on the individual owners’ personal tax return. The income earned by a sole proprietorship is treated as self-employment income subject to self-employment tax.

General Partnership

A general partnership is made up of two or more owners who join together to form a business. A partnership can also be called a joint venture. Each owner is called a partner and each partner is personally responsible for all of the partnership’s liabilities, and has full authority to bind the partnership as to third-party contracts. There is usually a partnership agreement, which outlines how profits and losses are to be shared, but some partnerships do not have partnership agreements. The partners are personally responsible for the partnership’s liabilities and obligations. A filing with the Secretary of State is not required with partnerships. A partnership for tax purposes is called a pass through entity and the partnership is required to file a federal information return which shows net income, net loss, capital gains, etc., which flows through to the individual partners to be reported on their personal tax returns.

Limited Partnerships

A limited partnership is similar to a general partnership except that limited partners are personally liable for the debts, obligations, and liabilities of the partnership only up to the amount of their investment. The general partner is liable for all such obligations. A limited partnership is composed of two or more individuals and at least one of the individuals is the general partner which controls the day-to-day operations of the partnership. The limited partners have no control over the day-to-day operations of the limited partnership. Limited partnerships for taxing purposes are similar to general partnerships in that they are pass through entities and only file an informational tax return and the limited partnership pays no taxes directly. Limited liability partnerships are rarely used due to the limited liability company statutes that have recently been enacted in most States.

Limited Liability Company (LLC)

An LLC is a separate legal entity, separate from its owners. The LLC owns its own assets and is responsible for its debts, liabilities, and obligations. The owners (members) are not personally liable for the obligations, liabilities, and debts of the LLC. An LLC can be managed by all of its members, or the members may choose a manager or managers to run the day-to-day operations of the LLC. An LLC is formed by filing Articles of Organization with the Secretary of State. An LLC can be taxed as either a corporation or a partnership depending on the election of the members. Most LLC's are taxed as partnerships. Therefore, most LLC’s are pass through tax entities. The LLC is a very popular business law structure because it provides limited liability for its members while allowing pass through taxation, eliminating double taxation.

Corporations

A corporation is also a separate legal entity, separate from its owners. The corporation owns its own assets and is responsible for its own debts and obligations. The owners of a corporation (shareholder/stockholder) are not personally liable for corporate debts and liabilities. Corporations are managed by a board of directors. The board of directors then elects officers to run the day-to-day operations of the corporation. Corporations are created by filing Articles of Incorporation with the Secretary of State’s Office. Corporations can be taxed as a separate legal entity (C-corporation ) or become a pass through taxable entity called an S-corporation. C-corporation income is taxed not only at the corporate level but once any income is distributed to the shareholders, the shareholders are also taxed for the dividends they receive. With an S-corporation, double taxation is eliminated and the S-corporation pays no corporate taxes itself but passes any income through to the individual shareholders who report that on their individual tax returns. For small corporations, an S-corporation is much more useful because it allows pass through taxation, eliminating double taxation, as well as limiting the shareholders liability. It is similar to an LLC in many respects. An LLC can own other entities but S-corporations are prohibited from owning any other business entities.

Before even the most promising business can put down roots and prosper, its owners must make the threshold decision about what kind of legal entity it will be. Different options are available, with each option having strengths and weaknesses. Legal requirements may vary by state depending on the business form chosen. Following are some general characteristics of the most prominent business entities. As the variety of choices indicates, competent legal advice is necessary to make the proper decision.

Sole Proprietorship

The greatest virtue of a sole proprietorship is its simplicity. From a legal standpoint, the business and its owner are the same. This allows the proprietor to avoid most of the formalities required for some other business law forms. For example, business income is reported on the proprietor’s personal tax return. One significant drawback is that a sole proprietor has personal responsibility for all business debts and court judgments.

General Partnership

A partnership is a business run by two or more persons, but the “persons” can be individuals or business entities. In a general partnership, all partners are “general partners,” which essentially mean that their business fates are closely intertwined. Each general partner has unlimited personal liability for partnership debts, can incur obligations on behalf of the partnership, and acts as an agent for the other partners and the partnership. The partners usually share equally in managing the business and dividing the profits, but they may set their own terms for these and other matters in a written partnership agreement. Tax liability on partnership agreement. Tax liability on partnership income is “passed through” to the individual partners so that each partner pays taxes on his or her individual share of the profits.

Limited Partnership

In a limited partnership, there are general partners and limited partners. General partners run the business’s day-to-day operations and have personal liability for partnership obligations. Limited partners are usually passive investors in the business. They are not personally liable for partnership debts and the most they can lose is the amount invested in the partnership. A limited partnership allows money to be raised for the business from the limited partners, but the general partners do not have to share with them day-to-day decision making or comply with requirements for creating a corporation and issuing stock.

In contrast with a corporation, a partnership dissolves and is liquidated upon the death or withdrawal of a partner unless the partnership agreement provides otherwise. For example, the agreement may allow a buyout of a deceased or withdrawn partner, election of a new partner, and continuation of the business. As a general rule, a limited partnership continues on unaffected by the loss of a limited partner.

Corporation

A corporation is an entity that is separate from its owners, with its own legal rights and responsibilities. The owners (the corporation’s shareholders) are not personally liable for debts of the corporation. The shareholders elect a board of directors to supervise the corporation and the board appoints officers to manage day-to-day matters. The major drawback for the corporate model is having its income taxed twice: first on the corporation’s income and then on any dividends paid to the individual shareholders.

The S Corporation, a hybrid creature of the Tax Code, has some characteristics of corporations and some of partnerships. If specific tax rules are satisfied, income in an S corporation is taxed only when it is passed through to the owners. Also, the owners retain their insulation from personal liability for corporate debts.

Limited Liability Company

An increasingly popular form of business entity is the limited liability company (LLC), another hybrid combining some of the best traits of the other entities. The owners, called members, are not limited in number or type, as are shareholders in an S corporation. While LLC members generally have the kind of limited personal liability associated with the corporatins, they have flexibility to participate in the management of the business if the governing document called “articles of organization,” so provides. The earnings of an LLC are given the same advantageous passed-through treatment as are earnings of a sole proprietorship or partnership, thereby avoiding double taxation.

BUY-SELL AGREEMENTS FOR SMALL BUSINESSES

The transfer of ownership interests in a small business should take into account all of the considerations that make each business, and especially a family-owned business, unique. The vehicle for accomplishing the transfer is usually called a buy-sell agreement. Its name barely begins to describe the buy-sell agreement’s various purposes. With professional advice, the agreement can be tailored to meet the objectives of each small business, whether the business is in the form of a close corporation, partnership, limited liability company, or some other structure.

By creating a market for the ownership interest of a shareholder who has retired, become disabled, or died, a buy-sell agreement insures that such an interest can be converted into cash when cash is more important than having shares in the company. Since small businesses often pay out most or all of their profits in salaries, an equity interest in the business would be much less valuable if its owner was not assured of being able to sell that interest back to the business or to other shareholders.

Valuation of the Business

When a triggering event in a buy-sell agreement causes the interest of one owner of a business to be purchased by other owners, or by the business as an entity, a critical issue is placing a dollar value on that interest. It is difficult to set a market value for shares in closely held corporations, whose stock by its nature has little or no liquidity. An agreement can set the price for shares according to a predetermined formula, value as shown on the company’s books, an appraisal by a third party, or some other method. In any event, it is important that the provisions on the valuation and purchase price of shares in the company be kept current.

Orderly Transition of Ownership

A buy-sell agreement also may serve as an orderly method for maintaining control over the company despite a change in the composition of its owners. In a family-owned business, this may mean a clause in the agreement effectively keeping the business in the family by allowing remaining family members to buy the interest of a departing owner. For children who decide not to carry on in the business, cash, perhaps generated by life insurance on the senior owner, might be an alternative to inheriting part of the business.

A typical buy-sell agreement for a family business provides that, on the death or departure of one shareholder, the remaining shareholders have the right to purchase his or her shares. Those participating in the buyout usually acquire those shares in an amount commensurate with their holdings. An alternative could give the corporation itself the right to purchase the shares. However, this option may bring into play laws for the protection of creditors that limit the power of corporations to purchase their own shares. A hybrid approach sometimes used in buy-sell agreements allows the business to buy its own shares, only to the extent permitted by relevant statutes, but the remaining shareholders could then purchase any shares not acquired by the corporation.

Avoid Conflicting Terms

Since one of the triggers for application of a buy-sell agreement is a shareholder’s death, shareholders should avoid conflicts between the terms of the agreement and their estate plans. When the terms of an agreement and a will cannot easily be reconciled, the odds increase for litigation, rather than the smooth transition for which the agreement was designed. If a will predates the agreement, it may be necessary to draft a new will that is consistent with the agreement. A less complicated approach is to amend the will with a codicil providing that business interests are to be disposed of according to the buy-sell agreement.

Consistency between an estate plan and a buy-sell agreement is important not only as to disposition of shares, but also as to voting or management rights in the company. A shareholder should determine whether his estate or heirs should have such rights, and then be sure that the documents accurately reflect the shareholder’s wishes. Similarly, a shareholder should consider whether limits on his executor’s voting rights are desirable, so as to avoid the possibility that the executor will act to frustrate the shareholder’s intent.

One purpose of any contract is to avoid future disputes between the parties by establishing rights and duties for future contingencies. Aside from dealing with the substantive issues raised by transferred ownership, a buy-sell agreement also can head off conflict, or at least help solve it, by providing for a form of alternative dispute resolution or mediation.