Below is a link to Part III of a four-part continuing legal education seminar I recently gave on business structures, characteristics and choosing the right one for your business.
Please see: http://vimeo.com/44119419
Part IV will be made avaialble in the next blog post.
Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters
Showing posts with label LLC. Show all posts
Showing posts with label LLC. Show all posts
Monday, July 16, 2012
Thursday, July 5, 2012
Business Entities: Structures, Characteristics and Choosing the Right One for Your Business (Part I)
Below is a link to Part I of a four-part continuing legal education seminar I recently gave on business structures, characteristics and choosing the right one for your business.
Please see: https://vimeo.com/44118492
Parts II, III and IV will be made avaialble in the next several blog posts.
Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters
Please see: https://vimeo.com/44118492
Parts II, III and IV will be made avaialble in the next several blog posts.
Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters
Monday, March 5, 2012
Why the LLC is a Favorite for Start Ups (Part III)
This post is Part III of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities. While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business. What is it about the LLC that makes a preferred structure for start-ups? As explained in the first installment, there are three reasons the LLC has become so prevalent:
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of Part I of this discussion, and Part II focused on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners. This final installment examines the user friendly nature of the LLC, which imposes very few compliance requirements in order to maintain the entity.
Reason #3: The user friendly nature of the LLC.
For consumers, one trademark of good technology is whether it is user friendly. Similarly, the LLC has become a preferred choice of many entrepreneurs because it requires very little to form and then maintain the entity.
A. Formation. The formation of a limited liability company requires very little:
(i) In New York, the form for the Articles of Organization is available online at http://www.dos.ny.gov/corps/llccorp.html#artorg and can be filed by anyone (the "Organizer") without the need of a lawyer or a legal service. The Organizer forms an LLC by filing the Articles of Organization, pursuant to Section 203 of the Limited Liability Company Law, with the Department of State. Any person or entity may be an organizer and the the Organizer does not have to be a member of the LLC.
(ii) Operating Agreement. Pursuant to Section 417 of the New York Limited Liability Company Law (NYLLCL), an Operating Agreement must be entered into by the members. Part II of this series discussed the importance of the Operating Agreement, and the flexibility allowing the members to construct the rights and obligations as the members wish, subject only to express restrictions in the NYLLLCL or as otherwise prohibited by law. The limited liability company Operating Agreement is not filed with the State.
(iii) Publication Requirement. New York maintains an arcane requirement that LLC's publish a notice of the formation of the entity in two newspapers (as designated by the county clerk) for six consecutive weeks. See NYLLCL Section 206. The publication fees vary by county, but regardless are expensive and, quite frankly, an unjustifiable but legally required expense. Upon compliance with the publication requirement, the newspaper will provide an affidavit of publication to be filed with the State. With this ridiculous requirement comes the obvious question: What are the ramifications of failing to publish and can it be corrected? If you have not met the publication requirements, "the authority of such limited liability company to carry on, conduct or transact any business in [New York] shall be suspended." NYLLCL Section 203. However, some courts have held that if the LLC cures the failure after filing the action, the lawsuit can be maintained, and a suspended entity can cure the default. The other major concern is whether the members lose the protection of the LLC, and since the answer is uncertain the ambiguity means it is sensible to comply with the publication requirement.
(iv) Comparison with Corporation. Formation of a corporation is also relatively simple requiring only the filing of the Certificate of Incorporation using a pre-printed and form approved by the New York State Department, see http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf. Unlike the LLC, no publication requirement exists, which obviously saves a considerable expense over formation of the LLC. However, as publication is a one-time requirement, other factors (such as tax advantages) often mean entrepreneurs still prefer the LLC.
B. Tax Filings. Because an LLC does not have a tax status separate from its members, the LLC does not file an entity tax return. While the LLC must prepare an informational filing showing the profit and losses of the LLC's business, see IRS Form 1065, there is no separate determination of tax liability for the LLC and thus no separate tax calculation. The absence of a separate tax existence of the LLC is in contrast to the corporation, which is required to calculate the tax liability of the corporate entity and file a actual (rather than an informational return). Of course, the shareholders also will have an individual tax liability based on any distributions (dividends) received from the corporation. The tax returns of the corporation and the informational return of the LLC must be retained with the records of the entity.
C. Management of the Entity. An LLC is not required to have more than one manager regardless of the number of members. In contrast, a corporation with three or more shareholders must have at least three directors. The requirement of three directors increases the cost of operations, creates additional administrative burdens, and affects the dynamics of managing an entity which is obviously much simpler in the case of an LLC managed by one manager.
D. Maintenance/Administrative Requirements.
(i) Annual Meetings. A corporation must hold an annual meeting of its Directors and of its shareholders. Contrast that with the LLC, which requires no annual meeting, unless the Operating Agreement provides otherwise. And, just because the corporation is only required to hold one annual meeting, significant business decisions should be handled by formal resolutions. Although not required, t is advisable for an LLC to document important resolutions thereby demonstrating that the members observe formalities in the event of an attempt by a third party to pierce the protection afforded the members by the LLC structure.
(ii) Minutes of Meetings. New York State also requires that corporations keep and maintain copies of all meeting minutes. Accordingly, proper Minutes of meetings need to be recorded by a designated person, which preferably is a Corporate Secretary elected annually. Not only are minutes required by law, they may be required by your bank or even parties to a transaction as proof of corporate approval. Additionally, shareholders have a right to review these records upon reasonable demand. If you have a corporation, the record book should contain at a minimum the Articles of Incorporation, by-laws, stock certificates, and copies of resolutions and minutes of corporate meetings. LLCs do not have a requirement to record minutes of meetings, although it is a good idea to do so from a record keeping standpoint and also to demonstrate adherence to corporate formalities.
(iii) Shareholder/Member Lists. Corporations must maintain a list of all of its shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof; LLC's are required to keep a list of its members (together with the contribution and percentage interest) and managers.
(iv) Organizational Documents. Both the corporation and LLC need to keep a copy of the organizational documents, i.e., the Articles of Organization and all amendments of the LLC and Certificate of Formation of the corporation. Further, a copy of the LLC's Operating Agreement or Corporation By Laws shall be kept with the entity records.
E. "But I Heard VCs don't like LLCs." It is often suggested that businesses looking to raise third party financing from VCs or Angels should not form an LLC as the structure will be an obstacle to attracting financing. While this may have been the case a few years ago, the prevalence of the LLC, tax advantage and the flexibility of the LLC as evidence by the ability to draft the Operating Agreement to fit the rights and obligations of the members has, for the most part, put this concern to rest. Importantly, if a future investor insists on a corporation, the LLC members have a right to convert the entity to a corporation. Be forewarned, however, that conversion of an LLC to a corporation gives rise to important tax considerations which should be discussed in advance with a tax professional.
The LLC has certain obvious advantages when compared to a corporation, but choosing the proper entity for your business can be driven by a number of factors, including those that are particular to the nature of your business or your tax situation. Therefore, it is important to consult a lawyer and often a tax advisor before proceeding with the formation of the business structure.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of Part I of this discussion, and Part II focused on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners. This final installment examines the user friendly nature of the LLC, which imposes very few compliance requirements in order to maintain the entity.
Reason #3: The user friendly nature of the LLC.
For consumers, one trademark of good technology is whether it is user friendly. Similarly, the LLC has become a preferred choice of many entrepreneurs because it requires very little to form and then maintain the entity.
A. Formation. The formation of a limited liability company requires very little:
(i) In New York, the form for the Articles of Organization is available online at http://www.dos.ny.gov/corps/llccorp.html#artorg and can be filed by anyone (the "Organizer") without the need of a lawyer or a legal service. The Organizer forms an LLC by filing the Articles of Organization, pursuant to Section 203 of the Limited Liability Company Law, with the Department of State. Any person or entity may be an organizer and the the Organizer does not have to be a member of the LLC.
(ii) Operating Agreement. Pursuant to Section 417 of the New York Limited Liability Company Law (NYLLCL), an Operating Agreement must be entered into by the members. Part II of this series discussed the importance of the Operating Agreement, and the flexibility allowing the members to construct the rights and obligations as the members wish, subject only to express restrictions in the NYLLLCL or as otherwise prohibited by law. The limited liability company Operating Agreement is not filed with the State.
(iii) Publication Requirement. New York maintains an arcane requirement that LLC's publish a notice of the formation of the entity in two newspapers (as designated by the county clerk) for six consecutive weeks. See NYLLCL Section 206. The publication fees vary by county, but regardless are expensive and, quite frankly, an unjustifiable but legally required expense. Upon compliance with the publication requirement, the newspaper will provide an affidavit of publication to be filed with the State. With this ridiculous requirement comes the obvious question: What are the ramifications of failing to publish and can it be corrected? If you have not met the publication requirements, "the authority of such limited liability company to carry on, conduct or transact any business in [New York] shall be suspended." NYLLCL Section 203. However, some courts have held that if the LLC cures the failure after filing the action, the lawsuit can be maintained, and a suspended entity can cure the default. The other major concern is whether the members lose the protection of the LLC, and since the answer is uncertain the ambiguity means it is sensible to comply with the publication requirement.
(iv) Comparison with Corporation. Formation of a corporation is also relatively simple requiring only the filing of the Certificate of Incorporation using a pre-printed and form approved by the New York State Department, see http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf. Unlike the LLC, no publication requirement exists, which obviously saves a considerable expense over formation of the LLC. However, as publication is a one-time requirement, other factors (such as tax advantages) often mean entrepreneurs still prefer the LLC.
B. Tax Filings. Because an LLC does not have a tax status separate from its members, the LLC does not file an entity tax return. While the LLC must prepare an informational filing showing the profit and losses of the LLC's business, see IRS Form 1065, there is no separate determination of tax liability for the LLC and thus no separate tax calculation. The absence of a separate tax existence of the LLC is in contrast to the corporation, which is required to calculate the tax liability of the corporate entity and file a actual (rather than an informational return). Of course, the shareholders also will have an individual tax liability based on any distributions (dividends) received from the corporation. The tax returns of the corporation and the informational return of the LLC must be retained with the records of the entity.
C. Management of the Entity. An LLC is not required to have more than one manager regardless of the number of members. In contrast, a corporation with three or more shareholders must have at least three directors. The requirement of three directors increases the cost of operations, creates additional administrative burdens, and affects the dynamics of managing an entity which is obviously much simpler in the case of an LLC managed by one manager.
D. Maintenance/Administrative Requirements.
(i) Annual Meetings. A corporation must hold an annual meeting of its Directors and of its shareholders. Contrast that with the LLC, which requires no annual meeting, unless the Operating Agreement provides otherwise. And, just because the corporation is only required to hold one annual meeting, significant business decisions should be handled by formal resolutions. Although not required, t is advisable for an LLC to document important resolutions thereby demonstrating that the members observe formalities in the event of an attempt by a third party to pierce the protection afforded the members by the LLC structure.
(ii) Minutes of Meetings. New York State also requires that corporations keep and maintain copies of all meeting minutes. Accordingly, proper Minutes of meetings need to be recorded by a designated person, which preferably is a Corporate Secretary elected annually. Not only are minutes required by law, they may be required by your bank or even parties to a transaction as proof of corporate approval. Additionally, shareholders have a right to review these records upon reasonable demand. If you have a corporation, the record book should contain at a minimum the Articles of Incorporation, by-laws, stock certificates, and copies of resolutions and minutes of corporate meetings. LLCs do not have a requirement to record minutes of meetings, although it is a good idea to do so from a record keeping standpoint and also to demonstrate adherence to corporate formalities.
(iii) Shareholder/Member Lists. Corporations must maintain a list of all of its shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof; LLC's are required to keep a list of its members (together with the contribution and percentage interest) and managers.
(iv) Organizational Documents. Both the corporation and LLC need to keep a copy of the organizational documents, i.e., the Articles of Organization and all amendments of the LLC and Certificate of Formation of the corporation. Further, a copy of the LLC's Operating Agreement or Corporation By Laws shall be kept with the entity records.
E. "But I Heard VCs don't like LLCs." It is often suggested that businesses looking to raise third party financing from VCs or Angels should not form an LLC as the structure will be an obstacle to attracting financing. While this may have been the case a few years ago, the prevalence of the LLC, tax advantage and the flexibility of the LLC as evidence by the ability to draft the Operating Agreement to fit the rights and obligations of the members has, for the most part, put this concern to rest. Importantly, if a future investor insists on a corporation, the LLC members have a right to convert the entity to a corporation. Be forewarned, however, that conversion of an LLC to a corporation gives rise to important tax considerations which should be discussed in advance with a tax professional.
The LLC has certain obvious advantages when compared to a corporation, but choosing the proper entity for your business can be driven by a number of factors, including those that are particular to the nature of your business or your tax situation. Therefore, it is important to consult a lawyer and often a tax advisor before proceeding with the formation of the business structure.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Wednesday, February 22, 2012
Why the LLC is a Favorite for Start Ups (Part II)
This post is Part II of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities. While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business. Therefore, what is it about the LLC that makes a preferred structure for start-ups? As explained in the first installment, there are three reasons the LLC has become so prevalent:
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.
Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).
The document governing the rights and obligations of the members of an LLC is the Operating Agreement. The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.
A. Do you want the entity controlled by all the members or a manager? Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.
B. Do you want all the members to have the same rights? If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights. Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders. Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.
C. Do you want to restrict the transfer, pledge or sale of membership interests? Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests. Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.
D. What can be done if I have a dispute with my partner? The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).
E. What are other examples of what can be included in the Operating Agreement and what are the limitations? Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful). Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms.
F. But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation? The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays. The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors. If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation. Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.
In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors.
The final installment on this topic will discuss the operational simplicity and ease of use of the LLC.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.
Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).
The document governing the rights and obligations of the members of an LLC is the Operating Agreement. The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.
A. Do you want the entity controlled by all the members or a manager? Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.
B. Do you want all the members to have the same rights? If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights. Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders. Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.
C. Do you want to restrict the transfer, pledge or sale of membership interests? Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests. Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.
D. What can be done if I have a dispute with my partner? The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).
E. What are other examples of what can be included in the Operating Agreement and what are the limitations? Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful). Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms.
F. But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation? The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays. The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors. If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation. Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.
In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors.
The final installment on this topic will discuss the operational simplicity and ease of use of the LLC.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Thursday, February 16, 2012
Why the LLC is a Favorite for Start-Ups (Part I)
An unscientific survey of the most often asked question posted on the web by start-ups is: "What type of entity should I form for my new business?" In most cases, lawyers and entrepreneurs will suggest the limited liability company. While compared to a corporation, LLCs are a new form of business organization, but start-ups more often choose the LLC over a corporation. Therefore, what is it about the LLC that makes a preferred structure for start-ups? The answer: favorable tax structure, flexibility and ease of use. The next three posts will review:
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
Reason One: Why Start-Ups often Prefer an LLC over a Corporation: No Double Taxation.
As a quick primer on business entities, there essentially four types of entities most businesses consider utilizing: (a) a corporation, (b) a limited partnership, (c) an S Corp or (d) an LLC. As a simple explanation, a limited partnership is generally not as popular for start ups because it requires at least one partner have the status of a General Partner, meaning that partner has unlimited liability (which most entrepreneurs do not want to risk for obvious reasons). An S Corp is formed as corporation but is taxed like a partnership, and thus the business entity is not subject to a separate tax (discussed more fully below); however, there are restrictions on S Corps (including that they are limited to 100 shareholders, none of which can be foreigners, and there is no ability to create separate classes of shares), which may restrict the ability to bring in additional shareholders. Essentially, then, that leaves the corporation and the LLC as the popular choices for structuring a business.
(c) Non-resident Alien: Unlike an S Corp, a non-resident alien can be the member of an LLC, and therefore it is worth noting that non-resident alien LLC members do not have to pay self-employment tax.
(d) Minimizing Self Employment Tax: There may be ways to minimize the self employment tax owed by LLC members, including
(i) if a member is a passive owner (i.e., not involved in management of the LLC), the distributions may be exempt from self employment tax, but the tax regulations are complicated and the exemption should be discussed with your tax advisor;
(ii) an owner who receives repayments of a loan and payments on lease from the LLC may be able to avoid self employment tax on such payments.
3. Start Up Expenses and Losses: When starting a business there is an expectation that the partners will have substantial start up expenses, and for most businesses it may be months or years before it shows a profit or can make distributions to its owners. For a corporation, the expenses/losses are deductions from income of the entity for determining the tax liability of the corporation. The LLC has the advantage that, as with the profits, the expenses/losses are similarly allocated to the members individually who thereby benefit from the ability to take these allocated deductions on their individual tax return.
Of course, before deciding the appropriate entity for your business, issues such as taxes and other aspects of the various types of entities should be discussed with your professional advisor. Your particular financial or tax situation may favor choosing one form of entity over another.
The next installment of this Article will discuss how the flexibility of the LLC has made it an attractive business structure for new businesses.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
Reason One: Why Start-Ups often Prefer an LLC over a Corporation: No Double Taxation.
As a quick primer on business entities, there essentially four types of entities most businesses consider utilizing: (a) a corporation, (b) a limited partnership, (c) an S Corp or (d) an LLC. As a simple explanation, a limited partnership is generally not as popular for start ups because it requires at least one partner have the status of a General Partner, meaning that partner has unlimited liability (which most entrepreneurs do not want to risk for obvious reasons). An S Corp is formed as corporation but is taxed like a partnership, and thus the business entity is not subject to a separate tax (discussed more fully below); however, there are restrictions on S Corps (including that they are limited to 100 shareholders, none of which can be foreigners, and there is no ability to create separate classes of shares), which may restrict the ability to bring in additional shareholders. Essentially, then, that leaves the corporation and the LLC as the popular choices for structuring a business.
1. Taxation of a Corporation: A corporation is taxed on any net income (profit) at the corporate entity level, and if there is a distribution to the shareholders (of net profit), each shareholder is then taxed on this distribution (a dividend). The result, is a double taxation:
(a) corporate level: 15% to as high as 35% depending on level of net income, and
(b) shareholder level 15% on the dividend distributions to shareholder.
The double taxation arises from the fact that the entity itself and the shareholders each have a separate taxable identity and each are required to file a tax return and pay taxes on net income (as to a corporation) or dividends/distributions (as to a shareholder). Of course, the corporation generally does not have to make a distribution to shareholders, but that may not be a satisfactory solution for a closely held company where the shareholders are expecting distributions of profits.
(b) shareholder level 15% on the dividend distributions to shareholder.
The double taxation arises from the fact that the entity itself and the shareholders each have a separate taxable identity and each are required to file a tax return and pay taxes on net income (as to a corporation) or dividends/distributions (as to a shareholder). Of course, the corporation generally does not have to make a distribution to shareholders, but that may not be a satisfactory solution for a closely held company where the shareholders are expecting distributions of profits.
2. Taxation of a Limited Liability Company: LLC’s provide all the protection of a corporation (thus unlike a partnership, the members of an LLC have limited personal liability for the LLC’s debts). But, in contrast to a corporation, an LLC is not classified for tax purposes as a separate entity, rather it is a “pass through”.
(a) Single-Member LLCs:
(i) Unless the member makes a different tax election, single member LLCs are classified as a disregarded entity. As such, the LLC entity is not subject to a tax separate from the member and all income or deductions of the LLC go on the owner's tax return. For LLCs that operate an active trade or business, this means the income and deductions are listed on "Schedule C Profit or Loss From Sole Proprietorship" of the sole member. If rental property is held through the LLC, then the owner would include income and deductions on the owner's "Schedule E Supplemental Income and Loss."
(ii) Self-Employment Tax: As a single member LLC, the owner also must pay self employment tax consisting of FICA and Medicare at a rate of 13.3% for 2011 and 15.3% for 2012. While self employment tax is an additional burden that corporation shareholders don't pay, the single-member gets a deduction on their income of fifty percent of the self employment tax. However, often a shareholder in closely held/small companies will be paid a salary for services provided to the corporation. While the corporation will pay part of FICA and Medicare, there may ultimately no real savings as compared to the LLC because the owner is responsible for the taxes, whether it is paid through the business (as with a corporation), or directly by the owner (for a single member LLC). One common thought is to avoid any payroll tax in a corporation by not paying the sole shareholder a salary; however, this defeats the tax benefit gained from reducing the taxable net income of the corporation itself.
(b) Multiple Member LLC:
(i) An LLC with more than one member is by default classified as a partnership. Like single-member LLCs, co-owned LLCs do not pay taxes on business income. Instead, the income and deductions of the LLC are reported on a partnership return. However, the LLC still does not pay a separate entity tax. The limited liability company itself files an informational LLC tax return (Form 1065) and issues a K-1 to each member. Instead, the income and deductions are divided among the members based on the economic terms set forth in the Operating Agreement (or, if there is no operating agreement, in accordance with each membership percentage in the LLC). The members in turn receive a K-1 from the LLC, which shows the allocation of the member's share of the income and deductions of the LLC.
(ii) Self Employment Taxes. A member in a multi-member LLC also pays self-employment taxes. LLC taxes are paid by each member according to his/her share of the profits and losses. Like in a single-member LLC, each member files a Schedule C and calculates self-employment tax on Schedule SE.
(c) Non-resident Alien: Unlike an S Corp, a non-resident alien can be the member of an LLC, and therefore it is worth noting that non-resident alien LLC members do not have to pay self-employment tax.
(d) Minimizing Self Employment Tax: There may be ways to minimize the self employment tax owed by LLC members, including
(i) if a member is a passive owner (i.e., not involved in management of the LLC), the distributions may be exempt from self employment tax, but the tax regulations are complicated and the exemption should be discussed with your tax advisor;
(ii) an owner who receives repayments of a loan and payments on lease from the LLC may be able to avoid self employment tax on such payments.
3. Start Up Expenses and Losses: When starting a business there is an expectation that the partners will have substantial start up expenses, and for most businesses it may be months or years before it shows a profit or can make distributions to its owners. For a corporation, the expenses/losses are deductions from income of the entity for determining the tax liability of the corporation. The LLC has the advantage that, as with the profits, the expenses/losses are similarly allocated to the members individually who thereby benefit from the ability to take these allocated deductions on their individual tax return.
Of course, before deciding the appropriate entity for your business, issues such as taxes and other aspects of the various types of entities should be discussed with your professional advisor. Your particular financial or tax situation may favor choosing one form of entity over another.
The next installment of this Article will discuss how the flexibility of the LLC has made it an attractive business structure for new businesses.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Monday, November 7, 2011
Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)
Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.
Myth #8: "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."
If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role. All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off. So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business. In no uncertain terms, this is a serious mistake for a number of reasons, including the following:
1. If this is an LLC, do you have an Operating Agreement? If this is a corporation, do you have detailed by laws/shareholder agreement? If this is a partnership, do you have a partnership agreement? If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law. Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)? If not, you may be very surprised later if a dispute arises, at which point it will be too late.
2. What if the new partner fails to do what was promised, dies or becomes disabled? You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html). If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.
3. The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both). Can the partner do this? It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.
4. The new partner just signed a contract binding the entity, one which you would not have approved. In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity. Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity. (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html). Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.
5. You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners. If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees. While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.
6. The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property. In fact, the partner is filing patent claims and then plans on licensing the rights to third parties. You could have avoided any issue with an invention agreement agreement assigning the rights to the inventions and intellectual property to the business. (See http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).
7. You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island. You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs. You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example. It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.
While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity. If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious. There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners.
Disclaimer: The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship. There is no substitute for legal advice from an experienced business/corporate lawyer.
Disclaimer: The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship. There is no substitute for legal advice from an experienced business/corporate lawyer.
Wednesday, October 12, 2011
Shareholder Agreements: Define BuyOut Terms
In a prior posting, I noted the importance of setting forth clear terms for buying out another member (LLC) or shareholder (corporation). For example, the buyout terms/shotgun clause can be set forth in the Operating Agreement of an LLC (or a separate agreement between certain members) or in a shareholder agreeement of a corporation. The dispute between father and son of Amercian Chopper fame illustrates the need to clearly delineate the terms of any option. (Paul Teutul v. Paul M. Teutel, 2010 NY Slip Op 09248 (2nd Dept. Dec 14, 2010))
The father and son had an agreement that included an option for the Paul, Sr. to purchase the shares of Paul, Jr. "for fair market value, as determined by a procedure to be agreed to by the parties as soon as practicable." Paul, Sr. sought to exercise the buyout option, which Paul, Jr. opposed enforcement of the option. The Appellate Court ruled that while the reference in the clause to "the term of 'fair market value' in and of itself may be 'sufficiently precise' ... the plaintiff and the appellant went further and expressly agreed to later agree on a procedure for determining the shares' fair market value." Significantly, the Court, quoting prior precedent, stated that for a closely held corporation (i.e.small prviately-held business) where ownership is held by a small group of shareholders and shares are not easily sold, the fair market value of the stock "'involves a certain degree of inexact valuation and subjectivity, making the procedure by which fair market value is determined of particular importance.'"
The Court reasoned that, as opposed to cases cited by Paul, Sr. where the parties had agreed on an (albeit flawed) procedure for determining fair market value of the stock, the clause here was simply an agreement "to later agree on a procedure for determining fair market value," and thus was not binding.
THE LESSON: The valuation of the stock/membership interests does not have to be determined at the time of drafting the option (buyout clause), but there must be clear terms as to the procedure for valuing the stock. One alternative is to identify a 3rd party, like a CPA, as the person who will determine valuation and perhaps agree to share the expenses of the valuation.
Monday, October 3, 2011
The S Corp: Pros and Cons
Your are about to start a business, and you heard that an SCorp is a business structure used by many small businesses. However, you are not certain if it is the right structure for your business. Below is a simple list of the Pros and Cons of an SCorp:
PROS:
1. Provides the protection afforded shareholders of a corporation: An S Corp is actually formed as a corporation and is governed by the state corporate law statute (in New York: The Business Corporation Law). To become an S Corp, the owner makes an election to be taxed in accordance with Subchapter S of the Internal Revenue Code.
2. S Corps avoid Double Taxation: A corporation is taxed at the corporate level/entity level on its profits and then shareholders are taxed on any distributions (dividends) received from the corporation -- resulting in double taxation. An S Corp election means that there is no entity level/corporation tax, and instead shareholders are only taxed on the distributions thereby avoiding double taxation.
The ability to avoid double taxation is what makes the S Corp a popular choice for small businesses.
CONS:
1. Ownership restrictions: Limited to 100 shareholders, all of whom must be individuals, and none of which can be foreigners (i.e., shareholders must be US citizens or residents).
2. In contrast to the Limited Liability Company, there are more corporate formalities that must be observed (thereby increasing the cost of the maintenance as compared to an LLC).
3. Can only have one class of stock: so less flexible than a regular corporation ("C" Corp) or an LLC if want to vary the rights of shareholders; and
4. Unlike a "C" Corp and an LLC, profits and losses must allocated to shareholders based on their share in the business.
IMPORTANT: Like a "C" Corp, FICA is imposed only with respect to employee wages and not on distributions to shareholders. However, the IRS and state tax authorities see as a red flag an attempt to categorize wages as a distribution to shareholder where the shareholder-employees has not been deemed to have been reasonably compensated (paid wages) for the services performed withing the company. Simply stated, a shareholder-employee cannot try to reduce FICA obligations by shifting what should be wages to a distribution on shares.
The above does not constitute legal advice, and therefore if you are starting a business, make sure you discuss the proper structure with an attorney and an accountant.
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