Determining Your Company's Legal Structure

Overview

Congratulations! You have decided to start your own business. What do you need to do besides simply opening a bank account, ordering stationery, and getting a phone number?

First, you must decide your business's legal structure. You may have heard such terms as corporation, partnership, company and others, but may not be sure of their benefits or disadvantages. This article will explain the legal structure options available to you.

Before acting on this information, please remember that this article contains only general information that will apply to most situations. Although we cover the most important questions you face in choosing a business entity, the legal and market conditions affecting that choice are far too complex to cover completely here. In addition, each business has its own unique facts, and no general advice can properly account for them.

Finally, remember that laws constantly change. This is particularly true of tax law, one of the most important considerations in starting a small business. As a result, you should consult with your professional advisors — your accountant, insurance professional and business attorney — to decide what will be best for you.

Outline:

  1. Introduction: Types of Entities
  2. Considerations in Selection of an Entity
  3. Preserving Limited Liability
  4. Resources

I. Introduction: Types of Entities

Sole Proprietorship

A proprietorship is perhaps the simplest form of entity, but in many cases the riskiest — nothing more than you, individually, doing business (whether under a trade name or not) without additional filings. Some examples include a paper route, lemonade stand or self-employed consultant. This simplicity provides the proprietorship's greatest advantage: little paperwork or legal planning is required, taxes are reported on your personal return (but on a separate form), profits and losses come out of your own pocket and you, alone, make all the decisions.

Taxation of business revenue is consolidated with the personal return of the proprietor at individual tax rates. There is no separate taxation of business income or other business-related tax attributes. Additional excise or business-related taxes may be imposed in some local political jurisdictions.

If a proprietorship is so easy, why consider anything else? In fact, whether through conscious choice, failure to consider alternatives, or the "penny wise, pound foolishness" of refusing to spend funds for professional advice, many businesses begin as proprietorships by default. Unfortunately, there are many reasons why that could be a mistake.

You'll face unlimited personal liability. All personal and business assets are at risk for business liabilities, regardless whether used in the business or not. Business creditors can chase after your personal bank accounts, house and other assets (unless you protect them in another way, such as joint ownership with a spouse in many states). Even with "safe" businesses, many reasonable people will not expose their homes and savings to the whims of unreasonable creditors and unpredictable courts and juries in our litigious society.

Other drawbacks include:

1. You and your business may be ineligible for tax-free fringe benefits that are available to more formally organized businesses.

2. Your business is not a "going concern" apart from you that you can sell as an asset at death or retirement.

3. A fictitious name filing may be required if a "dba" ("doing business as") or trade name is used.

Consider the "one member LLC" as an alternative, if it is permitted in your state. The one member LLC provides the benefits of "proprietorship taxation" on your personal return, combined with protection of your personal, non-business assets (such as your home and bank accounts) from business creditors. Creditors can collect only the assets contributed to the business.

Partnerships

Despite the formal, legal name, a partnership operates like a proprietorship conducted by two or more people. For example, if a sibling or friend ever helped you with your lemonade stand or paper route, and you split the profits, you had a partnership. Partnerships come in two types: general partnerships, in which creditors can collect from all partners' personal assets (as well as the business assets), or limited partnerships, in which partners who agree not to participate in management limit their loss exposure to their investment in the business. Every limited partnership must have at least one personally liable general partner, although often the general partner can be a corporation or another limited partnership to control the risk.

As with proprietorships, the greatest benefit of a partnership is pass-through taxation. The entity does not pay tax itself, other than certain excise or franchise taxes. Instead, all tax attributes (income, losses, deductions, credits) can "pass through" to individual partners for use in their personal tax returns at individual tax rates.

The downside is that joint partners can still face personal liability. All personal assets of all general partners (including those not contributed to partnership), e.g., homes, bank accounts, are at risk.

General partnerships

You can have a formal, written partnership agreement or choose to be an "at will" partnership, with only an oral understanding. An "at will" partnership is simply two or more persons conducting business together under terms of an unwritten agreement (although the Uniform Partnership Act provides many "default terms" for the relationship) that any partner can terminate at any time, for any reason. A written partnership agreement specifies terms more precisely, including termination conditions, division of profit and loss, division of responsibilities for the conduct of business, etc.

A fictitious name filing can be made if a trade name is used.

Limited Partnerships

To obtain limited liability for the passive investor, or limited partners, a Certificate of Limited Partnership should be filed with the Secretary of State in your state.

A separate Agreement of Limited Partnership specifies all relevant terms of organization (management, distribution of cash, rights on liquidation, control and voting, etc.).

Limited partners are liable only to the extent of their capital contribution for their limited partnership interests. Limited liability is contingent upon total lack of involvement in business or management of enterprise.

IRS "check the box" regulations in effect since December 1996 now allow you to choose between pass-through taxation described above, or corporate tax described below, without regard to the complex tests under the old law (requiring flunking Internal Revenue Code ¤7701 tests for continuity of life, centralized management, limited liability and free transferability of ownership interests). Some states may still apply the old partnership taxation test for state purposes, however, until legislative adoption of the federal check the box rules in those states.

Limited partnerships require one or more personally liable general partners. A general partner may be a corporation with limited (but more than nominal) assets.

Having additional persons in the business — "partners" — does add concerns. For example, any partner can create an obligation of the partnership. In other words, your partner can sign a contract that you disagree with, but your business will still be obligated to pay for it. In addition, each partner is "jointly and severally liable" for all business debts. In other words, even if you had nothing to do with a particular liability, the creditor can collect it from the business, the responsible partner or you, the innocent partner, at the creditor's choice. Although partners can try to recover losses from the wrongdoing partner, third parties can collect from the partners with the most assets or the easiest ones to reach, regardless of fault.

When choosing an entity for a business that will be the owners' primary source of income and employee benefits, however, partnerships (and limited liability companies, discussed below) present a potential disadvantage. In most cases, many highly desirable employee benefits — health care, group insurance — may be taxed more highly than in a comparable corporation due to "self-employment" taxes. Professional tax and financial planning can solve this problem, particularly in smaller businesses where the ability to provide tax-advantaged benefits may be a major consideration for the owners.

Do not confuse the traditional general and limited partnerships with a new type of entity that has existed in some states (but not all) only since the early 1990s, the limited liability partnership, or LLP. Formed primarily to protect professional firms historically organized as general partnerships, LLPs limit partners' personal liability for wrongdoing of other partners and, in some cases, for business liabilities generally. Protection varies greatly from state to state. LLPs allow existing partnerships to add some limited liability without renegotiating existing arrangements, as may be required to incorporate or form a limited liability company (discussed below). In addition, LLPs must often carry specified minimum insurance levels. Because the benefits and disadvantages of LLPs can vary so greatly from state to state, you should consult your professional advisors before selecting this type of an entity.

Corporations

Corporations, the most common form of organization for large businesses in the United States, require complex legal paperwork, in exchange for a major benefit for large and small firms and their owners. Creditors of a corporation cannot collect from the personal assets of the owners, the "shareholders." Instead, creditors are generally left with only the corporate assets, if any remain.

Liability is limited to assets that are owned by the corporation, with no personal liability of shareholders, officers, directors or employees, except in certain regulatory areas or as a result of the failure to maintain corporate form (also known as "piercing the corporate veil").

Corporate profits are taxed twice — once in the hands of the corporation and again upon distribution to shareholders as dividends. Tax planning concerning corporate expenses can mitigate double taxation.

Unlike the lemonade stand and paper route examples, corporations do not come into existence haphazardly. A formal document, the "Articles" or "Certificate" of incorporation, must be filed in the state capital. After filing, the investors elect a board of directors to govern the business and adopt bylaws to establish rules. The board then picks officers — a president, secretary and treasurer — to run the day-to-day aspects of the business. Corporations doing business in more than one state must comply with registration requirements in each location.

Corporation Tax Considerations

A dollar of corporate profit is generally taxed twice. The corporation pays a separate tax on its income, before any profits are distributed to the investors/shareholders. The investors then pay personal income tax on the remaining profits in their hands.

Types of corporations for tax purposes:

C corporations impose taxation at both corporate and shareholder levels.

S corporations and shareholders that elect subchapter pass-through taxation (like partnerships) under ¬§¬§1361 et seq. of Internal Revenue Code, pay only one tax if qualifying conditions have been met (including 75 or fewer shareholders, prohibitions on certain types of trust or entity shareholders, prohibition on stock variations — other than voting/nonvoting classes, limits on types of income and non-citizen shareholders).

This double tax can be avoided through skillful tax planning, particularly in smaller corporations.

EXAMPLE: Assume $100 net income before taxes.

spacer C Corporation Bottom Bracket S Corporation S Corporation (35%) C Corporation (15%) w/Tax Planning
Net Income $100 $100 $100 $100
Corporate Taxes @ 35%/15% (35) (15) 0 0
Corporate Purchase of Deductible Benefits not Taxable to Recipients 0 0 0 (30)
Net Income After Corporate Taxes 65 85 100 70
Personal Income Tax @ 40% (state and federal) (26) (34) (40) (28)
Net Dollars To Investor/Shareholder 39 51 60 42
Total Tax Paid on $100 of Profit 61 49 40 28
 Plus $30 of tax-free benefits, for a total of 72

Beginning in 1997, Congress greatly liberalized eligibility for S elections, but not all states recognize S elections, generally, or the new rules. Check your state's position to avoid the costs of keeping separate books for federal and state purposes.

An S corporation (or other pass-through tax entity) can provide great tax savings on the sale or liquidation of a business with appreciated assets, particularly in the most common form of sale of privately held firms, an asset sale.

Special corporate tax elections are particularly useful to entrepreneurial or start-up businesses.

Section 1244 stock provides ordinary loss treatment, rather than capital loss, if the stock is originally issued under ¤1244 of the Internal Revenue code but later becomes worthless.

Section 1202 gives shareholders of C corporations only an exclusion of 50 percent of gain on stock held more than five years.

Each state permits different types of corporations, depending upon the business conducted; all states distinguish "for profit" or "business" corporations from nonprofit corporations. Small businesses often are referred to as "closely held" corporations. This can mean either a generic term for corporations with a small number of shareholders or a "statutory-close corporation," which is incorporated under a special chapter of the state corporate code and provides partnership-like rules of internal corporate organization without further action by shareholders.

Foreign corporations are organized in one state but may do business in one or more states. Depending on the level of out-of-state business, it may be necessary to register and pay both franchise and income taxes ("qualify to do business") in each state, or risk becoming ineligible to sue in the foreign state's courts. Although many large corporations incorporate in Delaware or Nevada to save taxes or take advantage of management-friendly courts, most small businesses can avoid unnecessary fees and taxes by incorporating in the state in which business is conducted.

Some types of businesses may only be conducted through special purpose corporations (e.g., banks, savings and loan institutions, insurance companies, professional practices, cooperatives, credit unions). You must consult your own Secretary of State's office or, in some cases, federal regulators for guidance.

Warning:

Unfortunately, both corporate tax law and corporate procedures can be very complex. Although in most cases standard forms will suffice when getting started, the variation can be so great from deal to deal that professional advice should be considered.

Limited Liability Company (LLC)

Since the early 1990s, small — and not so small — businesses have had another choice when starting a business: the limited liability company, or LLC. A hybrid of state liability law and federal tax law, an LLC — a partnership in the eyes of the IRS — pays no tax itself (an LLC's profits are taxed only once, in the "members'" personal returns, as in a partnership), but shields members' personal assets from business creditors as in a corporation. LLCs have become tremendously popular since 1997, when the IRS check the box regulations slashed LLC organizational costs by eliminating complex provisions designed to insure partnership taxation. As a result, the LLC's combination of tax simplicity and liability protection have made it the "entity of choice" for the new small business:

LLCs are now available in all states.

LLCs offer the same type of pass-through taxation as partnerships, since the LLC is considered a partnership by the IRS.

IRS check the box regulations have simplified tax status.

Single member LLCs can elect to be taxed as a proprietorship or a corporation (while still preserving limited liability), and multi-member LLCs can elect to be taxed as a partnership or a corporation without regard to the complex "flunking" tests previously used.

Some states (primarily Florida, Pennsylvania and Texas) impose different tax rules that do not mirror partnership tax treatment. Since these rules are changing rapidly but make the LLC less useful, check your own state's current laws.

Personal liability of LLC members is limited to assets contributed to the entity, as in a corporation. The limited liability company protects personal assets against all third-party creditors.

LLC requirements include a limited liability company certificate to be filed with the secretary of state and an internal organization agreement (called an Operating Agreement). Because LLC laws provide much more flexibility than comparable corporate laws, greater care must be given to drafting an Operating Agreement that does not create unintended consequences.

Converting an existing business to LLC status may have substantial tax costs, because it may be deemed a dissolution and reformation.

In addition, members may be unwilling to re-negotiate terms of their relationship to draft an Operating Agreement. The LLP provides some liability limitation without either of these problems.

An LLC may be managed by its members, with each having an equal vote as in a general partnership (or a vote as designated in the Operating Agreement), or by a managing member or members, as designated in the certificate of organization or in the Operating Agreement.

Foreign and Multistate LLCs/LLPs

Inconsistent laws and taxation make use of multi-state LLCs complex, since states still regulate internal operation differently. Many prominent states — such as Pennsylvania, Florida and Texas — impose corporate level state taxes on LLCs.

Professional requirements may prevent out-of-state practice.

LLC vs. S Corporation (after tax law amendments effective 1/1/97)

S structure limits have been loosened, such as by raising the number of shareholders, and allowing corporate families of S corporations, called "qualified Subchapter S subsidiaries" or "QSSSs".

The S corporation's "one class" of stock rule can be avoided by partnership-like allocations in the LLC Operating Agreement.

Check the box rules reduce concerns about centralized management and participation in an LLC.

Nuisance corporate taxes (alternative minimum tax, accumulated earnings tax, personal holding company tax) can be avoided with an LLC.

Use of partnership taxation allows small businesses to avoid many complexities of corporate and Subchapter S accounting.

Although many states had permitted one member LLCs before 1997, that had little practical effect since a one member LLC could not qualify as a partnership for tax purposes — by definition, a partnership must have two partners. The check the box rules now allow one member LLCs to elect taxation as a sole proprietorship while preserving the limited liability of an LLC. (Note that adverse tax consequences may arise if a two-member LLC — taxed as a partnership rather than a proprietorship — loses one member and suffers a "partnership termination," even though the entity continues for state law and liability purposes.)

It is important to compare overall tax consequences between an LLC and an S corporation for such matters as payroll and self-employment taxes. These often overlooked levies may determine the final tax differences between and LLC and an S or C corporation. For many small businesses, with little or no profit after deductions for perks for the proprietor/owner, pass-through taxation may be less important than liability limitation and deductibility of benefits.

Despite the attractions of the LLC, many uncertainties remain because it still is a new form of organization:

Risk of a change in tax treatment of LLCs if IRS determines that LLCs have caused too great a revenue loss.

Promoters seeking investment in LLCs face a lack of credibility due to widespread use of LLCs in securities fraud.

Unsettled issues concerning extraterritorial application of domestic LLC legislation, for example, will my personal assets be protected if I am sued in a different state than where my LLC is organized? Many people were concerned about this risk in the early years of LLC use, but the "full faith and credit clause" of the U.S. Constitution would have required foreign courts to respect your home state's liability shield.

Unless properly planned, conversion of existing entities to LLC status may result in unnecessary tax costs and re-negotiation of organizational documents.

Business Trusts

Some states authorize particular types of trusts to conduct business activities, with some liability protection for business managers. These entities are rarely used except in those few locations (particularly Illinois and Massachusetts). Again, the new check the box rules should eliminate uncertainty about tax treatment of business trusts.

Generic Terms: Companies, Joint Ventures and Strategic Partnerships

Finally, before discussing the factors affecting the choice of entity, let's clear up any confusion about several often misused terms: "company," "joint venture" and "strategic partnership." None of these is a particular type of entity for a business. Instead, both are colloquial terms that could apply to most of the business entities described above.

"Company," while often used in the legal name of a corporation and in the title "limited liability company," can be used with a corporation, partnership or LLC — the term is not limited to any one type of entity. In fact, even a sole proprietor can adopt a fictitious name using the word "company." (Of course, the same rule applies to the abbreviation "Co.") In contrast, terms such as "Corporation," "Corp.," "Ltd.," "LLP" or "LLC" all indicate a specific type of entity listed above.

A joint venture commonly describes an undertaking by two persons or firms, which is typically limited to one project. A joint venture may be structured, legally, in any of the forms listed above. Typically, joint ventures between business firms have been partnerships to avoid unnecessary taxes or overhead costs. Today, however, the simplicity and additional layer of protection offered by the LLC make it an attractive choice for "one shot" combinations. Consider carefully who will run the joint venture, what each party's obligations will be, who will own any product generated, and how the venture will end.

Many entrepreneurs look for "strategic partnerships." Again, this term must be distinguished from the formal legal relationship created by a partnership, described above. Instead, this more general use refers to a mutually beneficial joint arrangement with a low level of degree of formality. Typically, strategic partnerships are created by contracts, specifying how the two firms will cooperate in particular business relationships. Those relationships may, in some cases, involve formation of a particular entity to accomplish a common business purpose but need not always do so. For example, strategic partners may simply be preferred providers or vendors. Strategic partners should consider whether they share the same goals and how much they are willing to share and/or cooperate with the other short of a formal combination.

Back to Outline

II. Considerations in Selection of an Entity

The following factors should be considered in choosing which entity is appropriate for any business. Generally, the first two — limitation of personal liability and tax planning — will control the decision, but in particular circumstances other criteria may be most relevant. There is rarely a single "right" or "wrong" answer but rather a weighing and balancing of the benefits and disadvantages of different entities to achieve the desired goals listed below.

Elimination of Personal Liability of Owners of Business

Generally, a business owner will choose an entity that offers limited liability protection. Nonetheless, liability protection may not always be the deciding factor. Some businesses have no real liability exposure or exposures which can be limited by reasonably priced liability insurance. The business or its owners may not have meaningful assets at risk, either because all is invested in the business or through "asset protection techniques" (e.g., joint ownership with a spouse, special types of trusts, offshore ownership, etc.). Consider the following factors:

Pass-through personal liability cannot always be avoided, even with an LLC or a corporation. Several types of liabilities are routinely applied against business owners and managers personally, regardless of the form of entity chosen. Examples include:

Funds withheld for sales and income tax are considered held in trust for the government rather than business property.

Using these funds before they must be paid over at the end of the month (a common form of small business financing) may lead to criminal liability for those with control over the cash as well as a personal obligation to repay the taxes with interest and penalties.

Fines and jail sentences have routinely been imposed on business managers who could have required the business to comply with environmental laws.

Managers often are personally responsible for compliance with regulatory laws such as worker safety rules (OSHA) and the Americans with Disabilities Act (ADA).

ERISA fiduciaries are jointly and severally liable for failure to make plan contributions (including in multi-employer pension plans).

State law statutes make certain managers personally liable for unpaid wages.

Landlords and lenders regularly demand personal guarantees from owners, particularly small businesses without established reputations.

Fraudulent conveyance and bankruptcy laws allow creditors of an entity to reclaim assets distributed to its owners before all outside creditors have been paid.

"Promoters" — those who organize a new business — are absolutely liable for actions taken on behalf of a new entity, whether a corporation or an LLC, prior to its formation by a filing in the state capital. For example, the owner may be in a rush to sign a lease before the proper corporate papers have been filed. Although the entity can assume the liability and indemnify the promoter, the third party creditor can always try to collect from the promoter.

Does the firm's form of organization allow it to hold the owners and managers harmless against personal liabilities and advance expenses to them (such as legal fees) before a claim is resolved?

Employee liability is different than owner liability; since employees are not liable for actions taken on behalf of any entity within the scope of their duties, proper authorization protects employees against personal liability.

Additional Tax Planning Considerations

Double taxation can be avoided on profits, even in "non-pass-through entities, through salary payments, rent, bonuses, benefits, etc.; see table at Section I(c)(3). Although entrepreneurs may be unhappy with zero income for the year, that may be an excellent result if double taxation can be avoided by payment of salaries and other tax-deductible benefits to the owners.

Will profits be reinvested or distributed to owners? If reinvested, pass-through taxation may be less desirable and the owners will increase their wealth through appreciation of their equity.

Plan for potentially unfavorable tax consequences at termination of business (tax on distribution of assets from entity, recapture taxes on accelerated depreciation previously taken, death taxes).

The tax code imposes many limits on owners' use of pass-through losses (e.g., basis limitations, passive loss limitations, capital loss limitations, availability of loss carry forwards, "at risk" regulations, "substantial economic effect" regulations, state limits on use of consolidated returns that allow offsets of profitable and losing operations in corporate families). If planning for pass-through taxation of a loss company (common in the first years of start-up firms), be sure that you will be able to take advantage of the losses in your personal return.

Control Issues

Who will make decisions on behalf of the business — one person, or a group? How far can any one person commit the business to contracts or liabilities? Different rules apply for corporations, which have well established standards, and LLCs and partnerships, in which any partner or member can generally sign a contract. Consider the following issues when reviewing your organizational documents:

Do you want centralized management by one or a few leaders, or will you have multiple decision makers?

Restrictions on limited partner participation in decision making in limited partnerships are required to preserve limited liability of limited partners.

Use managing partners and executive committees to expedite day-to-day decisions without requiring assembly of full board or all partners.

Investigate how flexible a control structure is permitted under state organizational law. Often, you can tailor your management to your desires, even if they are different than standard control structures.

Financing Requirements; Continuity of Business

Corporations, LLCs and limited partnerships exist separately and apart from their owners and can continue in legal existence regardless of the death, disability or retirement of the owners. Proprietorships and, to a certain degree, general partnerships do not have that protection. In addition, investors often find well established entities such as corporations, limited partnerships and, to a growing degree, LLCs more attractive, particularly if the business can continue without one or two key owners. Because of these differences, raising capital can be easier if the choice of entity eliminates "continuity risks" for investors. Common investor concerns include:

Regulatory Requirements

Many state regulatory boards severely limit the types of entities for professional practices. For example, when New York State first permitted certified professional accountants to practice through limited liability partnerships, several Big Six accounting firms immediately converted from partnerships to LLPs.

Out-of-Pocket Costs Dictated by Choice of Entity

Particularly for the smallest businesses, consider carefully the out-of-pocket costs that will be incurred in your state.

Consider the costs of establishing an entity.

Don't forget about Secretary of State filing fees.

Publication fees for incorporation or fictitious names will be higher in metropolitan areas.

Will you incur costs to transfer property to your entity, e.g. state realty transfer tax, or special S corporation taxes if you dispose of appreciated assets within ten years after converting from a C corporation?

Initial legal fees for preparation of organizational documents, if any, may be more expensive for LLCs until forms are developed and tested.

You must pay commercial registered agent fees if you need an "official," reliable address other than your own or are organized in a state different than where your business is actually located.

Keep in mind the ongoing costs of entity maintenance.

Some entities must pay minimum taxes each year to their home state for the "privilege" of existence (often called a franchise tax).

Budget for professional fees you will incur each year to maintain the entity (annual corporate update or annual meeting, periodic accounting expenses).

Except for proprietorships, you will pay separate bank fees for separate accounts for the business and yourself, individually.

Budget for the costs of revised stationery, signs, business cards, form contracts, etc., to highlight entity status to potential creditors.

Special Considerations for Multiple Entities

If you use multiple entities — for different locations or different lines of business — several additional planning opportunities may be available.

Consolidated tax returns (if permitted in your state) will allow you to offset gains and losses; some states prohibit consolidation on state tax returns, but consolidation is generally permitted on federal returns.

Multiple entities allow you to shield profitable businesses from the risks of other businesses while consolidating for tax purposes.

Be sure to document inter-company transactions to avoid attacks on the validity of each entity.

If you sell goods or services within your corporate family, consult experienced tax counsel to be sure the IRS will respect the prices you charge (particularly if the effect is to shift profits to states or countries with lower tax rates).

Take advantage of the Internal Revenue Code's "group" provisions that allow you to file only one return for related entities (e.g. common paymasters, affiliated groups).

Back to Outline

III.. Preserving Limited Liability

Avoiding "Veil Piercing" Claims

Be sure that you always conduct business through and in the name of your entity rather than in your own name (unless you are a sole proprietor). Failure to follow the rules for the entity allows creditors to try to deny you liability protection because you did not really conduct business as an entity.

Always have the entity adopt resolutions to authorize action, even if there is only a "ratification" after the fact.

Use the proper form of entity signature by always signing documents in representative capacity as an agent of your entity: "XYZ LLC, by John Q. Smith, Managing Member."

Use proper signs, advertisements and business cards showing an entity rather than an individual (e.g., "John Smith, President, ABC, Inc." rather than "John Smith, Owner/Proprietor").

Use proper fictitious name filings.

Avoid commingling your business and personal funds in the same bank account.

Pay business and personal bills from separate accounts.

Maintain separate personal and business bank accounts.

Prepare notes and other documentation of all loans between the business and its owners.

Your entity must have a minimum capitalization reasonably adequate for the business to be conducted. Insurance counts.

Don't sign contracts or make commitments for the business until you have filed the correct papers to organize it, since you will be personally liable. The liability shield of the corporation or LLC does not exist until the entity exists through a filing in the state capital.

Exceptions:

Malpractice liability of professionals cannot be limited.

Pass-through liabilities (trust fund taxes, environmental/OSHA/ADA/ERISA regulatory liabilities, unpaid wages) cannot be limited.

Preserving Harmony: The Buy-Sell agreement among members or shareholders

Although beyond the scope of this module on choosing the correct entity, those forming a new business should at the same time enter into (or include in the bylaws, partnership agreement or operating agreement) an agreement restricting transfer and ownership of the shares or membership interests in the entity to avoid future disputes when one desires to transfer interest or must do so due to death or creditor claims. Common provisions in such agreements (also called "shareholder agreements," "buy-sell agreements", or "purchase and sale" agreements) include the following:

(1) Restrictions on voluntary and involuntary stock transfers.

(2) Mandatory deemed sale offers.

(3) Mandatory and permissive buy-outs and "shoot-out" clauses (i.e., one party sets a price and the other can choose to buy or sell at that price).

(4) Mandatory control provisions to regulate day-to-day management and decision making for extraordinary events (such as a sale of the business, merger, etc.).

(5) Escrow agent to hold transferred shares pending full payment.

Stanley P. Jaskiewicz is an attorney with the Philadelphia law firm of Spector, Gadon & Rosen. A member of the firm's business law department, he assists businesses on a wide range of legal matters, including contract law, secured lending, negotiated acquisitions, intellectual property and regulatory issues.

Back to Outline

IV. Resources

Books

Glenn B. Davis, revised by Barbara Bryniarski, "Choice of Entity -- Legal Considerations of Selection," Bureau of National Affairs/Corporate Practice Series Portfolio, CPS 50-3rd

William Streng, "Choice of Entity" (Bureau of National Affairs, Tax Management Portfolio, No. 700)

Elliott Manning, "Choosing the Business Entity" (Little, Brown & Co., Tax Practice Series)

Fred Steingold, "The Legal Guide for Starting and Running a Small Business" (Nolo Press, 1997)

Back to Outline

Copyright © 2013 Virtual Advisor, Inc.