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Business Formation & Choice of Entity
You can operate your business as a sole proprietorship, as a corporation,
as a limited liability company, as a general partnership, or as a limited
partnership. General partnerships may be oral. The main advantages of
operating as a fictitious entity - corporation, limited liability company,
limited partnership - are the credibility and prestige in having such
an entity and, most importantly, the limited liability. Normally, you
cannot be made to pay personally the liabilities of a fictitious entity
in which you have invested.
The main reasons to operate as a sole proprietorship or general partnership
are ease of formation and tax benefits. Such entities do not have to pay
income taxes, although they may have to file informational returns. You
have to pay income taxes though on your share of any profits. Thus, if
your business has only a small exposure to liability or the exposure can
be covered with insurance, you may well choose not to form a fictitious
entity.
In choosing which of the three types of fictitious entities - corporation,
limited liability company, limited partnership - to form, the main consideration
is the differences in the way the three are taxed under the Internal Revenue
Code. A corporation can often elect to be taxed as a sub-chapter S corporation
(rather than a sub-chapter C corporation) giving it the tax status of
a partnership. Often, however, you may want to be taxed as a C corporation
since the corporation could then deduct certain expenses and benefits
that a S corporation cannot. These tax considerations bring us to an important
point. The regulatory environment is such that we highly recommend
you consult with an accountant when establishing a business. In addition
to helping plan your tax liability, an accountant can help you set up
your financial books and accounts.
Other considerations in choosing a business entity include: whether an
interest in the business can be easily transferred; whether the business
has continuity of existence beyond the life or participation of a particular
member; whether the entity lends itself to centralization of management;
the number of equity investors and whether they participate; the extent
financing is sought through a complex structure of different classes of
stock, etc.; whether the entity is conducive to estate planning considerations.
You also need to choose the state in which you will form your fictitious
entity. With the adoption of simplified corporate filing procedures in
all states, it generally is best to form the entity in the state in which
you will be operating primarily. If later you decide to take your business
public through an initial public offering (IPO), then you can reincorporate
in Delaware as part of the IPO process. (Delaware is still often the most
advantageous place for a publicly traded company to be established since
Delaware offers the most sophisticated corporation law and its law is
protective of management.) You also must register to do business in every
state in which you are "doing business." Consult with legal
counsel when determining whether you are "doing business" in
a particular state.
Often you will have to obtain state-issued business licenses and permits
as well. These may include an occupancy permit and a permit to operate
a particular type of business.
No matter what type of entity you choose, if there is more than one investor
of either money or labor, then some agreement needs to be made governing
the relationship of the investors. If a corporation, this is normally
the stockholders agreement. If a limited liability company, this is normally
the operating agreement. If a partnership, this is normally the partnership
agreement. If you do not have the money to draw up such an agreement,
then the state law has default provisions that will govern the relationship.
Therefore, it is possible to save money at the time of startup by skipping
such an agreement; however, it is not recommended. Many problems could
arise from the lack of such an agreement. The following is a checklist
of the major considerations to include in an investor agreement.
INVESTOR AGREEMENT CHECKLIST
1. Control of the Corporation/Limited Liability Company/Partnership
The following actions will require what percentage of the investors to
approve?
A. The default percentage is 80%. This should be increased or decreased
according to the number of investors, the percentage of shares each
holds or
will hold.
a) amendment of the Corporation's Articles of Incorporation or Bylaws/the
LLC Operating Agreement/the partnership agreement;
b) approval of a merger or consolidation;
c) sale of all or substantially all of the assets of the business;
c) dissolution of the business entity;
d) authorization to issue additional shares of the Corporation's capital
stock or admit additional members to an LLC or additional partners
to a partnership;
e) distribution of profits;
f) any loans to officers, directors, managers, partners or employees
of the Corporation/LLC/Partnership or guarantees of their financial
obligations in excess of one thousand ($1,000.00) dollars per annum;
g) transactions involving a conflict of interest, directly or indirectly,
between the Corporation/LLC/Partnership and any officer, director,
managers, partners or employee of the business;
h) approval of pension plans, retirement plans or other employee benefits;
i) approval of the Corporation's/LLC's/Partnerships's Annual Value.
B. The following matters shall be effected by the vote of holders of
fifty-one (51%) percent of the issued and outstanding stocks or 51%
of the LLC member shares or partnership interest:
a) increase or decrease the number of directors or managers;
b) approval of the Corporation's/LLC's/Partnership's annual budget,
including but not limited to:
1) salaries of officers, managers, partners or bonuses in excess
of any compensation set forth in any applicable employment agreement;
2) individual capital expenditures over ten thousand ($10,000) dollars,
including capital leases and the acquisition of real estate.
c) removal of officers, managers.
d) No inter vivos transfers of stock or interest allowed. (In other
words, no one can sell their stock or interest unless 51% agree.)
2. Shareholders/Members/Partners can use stock as collateral with 80%
consent of others.
3. Right of first refusal granted. This means that if a shareholder/member/partner
finds a buyer of his interest, the business has the right to buy him out
at the same price the shareholder/member/partner found a buyer at.
4. Option to purchase stock or interest of terminated employees: applies
to termination with or without "just cause"?
5. Option to purchase stock or interest of terminated employees:
2. If employee owns less than 20% & terminated with cause or quits,
then the business has option to purchase.
3. If employee owns less than 20% & terminated without cause or
disabled etc., then the business must purchase.
4. If employee owns in excess of 20% & terminated with cause, then
employee has option to sell to the business.
5. If employee owns in excess of 20% & terminated without cause
or disabled etc., then the business must purchase.
- The purchase price of the stock or interest shall be:
1. If employee owns less than 20% & voluntarily or for just cause
terminated before 5 years, then book value.
2. Same but after 5 years & without just cause, disability etc.,
then higher of book value or annual value & insurance proceeds.
3. Same but termination with or without cause & owning in excess
of 20%, then higher of book value or annual value & insurance
proceeds.
4. When a CPA determines the annual value of the stock or interest,
ratification thereof will be by majority of directors/managers &
80% of stock?
5. The business shall purchase insurance on lives of all owners?
6. Mandatory arbitration of all disputes and in what jurisdiction
- DC, Virginia, Maryland.?
7. 80% vote required to terminate this agreement?
Business
Financing
Limited
Liability Company
Corporation
Partnership
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