Basic Business Structures – Part 1: The Corporation

Over the next couple of weeks, I’ll be going into more detail regarding the most common types of business structures — the corporation, the partnership, and the limited liability company. My intent is to give a very brief overview of the most prominent legal features, pros, and cons of these business organizations, so that when the time comes for you to start organize your own business, you will be a bit more knowledgeable when you sit down to speak with you attorney!

 

Here in Part 1, I will discuss the basic corporation — of course, there are other flavors of corporations, such as the professional corporation or the non-profit corporation, that I will discuss in more detail in future articles. Indeed, there are sometimes differences between a corporation that is a Fortune 500 company (commonly known as a publicly held corporation), and a corporation that is a small business with a few owners (known as a closely-held corporation or close corporation). Where there might be differences between the two, I will try to point them out in this article.

Corporations are possibly the most formalistic of any business organization, because the law requires that they be structured and run in certain ways. The law requires that a for-profit corporation be managed by a board of directors, and requires a minimum number of people to serve on the board (depending on the number of shareholders), and requires that the corporation have a set of bylaws that dictates the rules by which the board manages the corporation. (Terminology note: I’ve seen entrepreneurs ask attorneys to draw up “bylaws” for their partnership or LLC — partnerships and LLCs have partnership or operating agreements, corporations have bylaws; it’s best always be clear with what you ask your lawyer for, otherwise you may end up with something like an LLC holding company with a corporate subsidiary!) Corporations are required to have, at the very least, annual meetings of the board of directors and annual meetings of the stockholders (if any) where the board makes management decisions and stands for election by the stockholders. This contrasts with other types of business organizations, which are generally not required to have a written operating agreement and can be relatively informally run by some or all of the owners.

Ownership interests are held by stockholders/shareholders. At the most basic level, stock is the most liquid business interest and can technically be freely bought and sold; however, it is possible to restrict the sale of stock in one way or another by adding restrictions to the legend on the stock certificate. Of course, practically speaking, stock in start-up corporations is almost completely illiquid, as one would be hard-pressed to find someone to invest in a new, unproven business.

Ownership interest in a corporation does not automatically grant management interest; although the stockholders of a start-up corporation are often the directors, the law does recognize a distinction between the two. Difficulties may arise with start-ups where owners are also directors — directors sometimes have fiduciary duties to the corporation that may be opposed and superior to duties to the shareholders; director/shareholders acting in their own interest against the interest of the corporation can run into serious trouble with the business’ creditors. While management power can be delegated to corporate officers, it may not be reserved to the stockholders. Stockholders generally are limited to electing directors and ratifying major strategic decisions of the board, such as mergers, acquisitions, or dissolutions.

The ownership and management interests of a corporation can be structured to free up most of the equity to sell to investors, while keeping management in the hands of the founders; for example, a corporation may have stock owned by the founders that only owns a relatively small percentage of the equity while having electoral control of the board of directors, in addition to stock sold to investors that owns a majority of the equity, but does not have majority control of the board — of course, such a structure must be drafted carefully to avoid any fiduciary duties that the founders may have as both directors and stockholders.

Corporations have the option to be taxed under two subchapters of the Internal Revenue Code: Subchapter C and Subchapter S. Under the default classification of Subchapter C, corporate income is taxed both at the corporate level, and then again when profits are paid to shareholders in the form of distributions/dividends. The advantage to this form is that the tax liability remains with the corporation so long as dividends are not paid. Under Subchapter S classification, the profits and losses of the corporation, as well as the tax liability flow directly to the shareholders, thereby avoiding the double-taxation problem of Subchapter C classification; however, Subchapter S classification has several restrictions, including a limit of one class of stock, having no more than 75 shareholders who are either individuals (excluding non-resident aliens or spouses of non-resident aliens who have an interest in the U.S. citizen’s stock) or estates, certain types of trusts, or tax-exempt pension plans or other organizations, and not being an ineligible business such as a financial institution or insurance company.

Choosing Subchapter C taxation may be preferable for start-ups where the owners intend to reinvest all of the profits and not take dividends and have the tax liability remain with the business; Subchapter S allows owners to claim the corporation’s profits and losses and receive dividends without having the income taxed at the corporate level. However, entrepreneurs with corporations should take care in their selection, as a corporation can only make one selection in a 60 month period.

 

The above is a rather cursory overview of some of the major legal aspects of corporations; if you have any questions or would like a further explanation of an issue covered above, please go to our Contact page to send us your questions, or set up an initial consultation if you are interested in setting up a corporation. Thanks for reading!

How “limited” is “limited liability”?

One of the primary benefits of incorporation or formation of a limited liability partnership or company is the feature of limited liability — the liabilities of the business are the business’ alone, and the scope of owners’ exposure is limited to whatever capital they have invested in the business, keeping their personal assets safe. But in practice, how limited is the limited liability shield of corporations and unincorporated business organizations?

The fact of the matter is, limited liability shields, especially for new small businesses, may not provide all the protection you think it does. As a new small, start-up business with no proven track record of customers or cash flow, many persons or organizations that the new business will deal with may likely require the owners to personally guarantee the liability of the business. Once an owner personally guarantees a business’s liability, in the event that the business cannot satisfy those liabilities, the obligee may pursue the guarantor to satisfy the liability.

While many smaller liabilities, such as supplies, utilities, or a corporate credit card may be kept solely in the business’ name, owners of start-up businesses may be required by commercial landlords to guarantee leases for office or retail space, or required by banks to act as sureties for commercial loans. Third parties a start-up business owner will deal with may likely only accept the business as the sole liability holder, if at all, once the business has established itself as viable, with good cash flow and/or sufficient assets.

In addition, a limited liability shield does not shelter owners from liability they personally incur, in particular tort liability, even if such liability is incurred in the course of business operations. For example, an owner getting into an car accident in a company-owned car, driving on company business, is nonetheless personally liable for the damages and injuries he or she caused. And because owners of start-up businesses are generally directly involved in the day-to-day management of their businesses, including hiring and supervising of employees, even if tort liability is accumulated by employees, owners may nonetheless be liable under negligent employment/entrustment theories.

Furthermore, owners of small businesses must be careful not to undertake actions that can jeopardize the limited liability shield in a process known as “piercing the corporate veil”. Business organizations are considered, to one extent or another, entities separate from their owners — corporations especially are considered to have legal “personhood”. In the event that owners fail to recognize corporate formalities by, for example, not holding organizational meetings required by law or co-mingling personal and business funds, a plaintiff in a civil suit may ask the court to “pierce the corporate veil” and subject the personal assets of some or all of the owners to satisfy a judgment. Although courts have mostly applied the “piercing the corporate veil” doctrine to corporations, the general consensus among lawyers is that a court would also apply the same doctrine to unincorporated business organizations, with a legal standard reflecting the more informal management structure of many unincorporated business organizations.

Practically speaking, there are many kinds of liability that business owners cannot be protected from by limited liability shields, but can be mitigated against. Personal liability for commercial leases or loans can be minimized by careful planning and negotiation; personal tort liability can be minimized by a good insurance policy. And of course, owners should be careful to remember to treat their businesses as separate legal entities to avoid the risk of a court “piercing the corporate veil” in a civil suit.

The question then becomes — it is worth the time and expense to set up a limited liability business organization? Limited liability is relatively easy to obtain — corporations and limited liability companies automatically have limited liability shields, and is easy for partnerships that are eligible for limited liability to obtain it. Unless business considerations exist that dictate the selection of a business for not automatically endowed with limited liability, such as a general partnership, or ineligible for limited liability, such as a limited partnership (in Massachusetts; in some other jurisdictions limited partnerships are eligible for limited liability), there is no reason why start-up business owners shouldn’t take advantage of any protection that a limited liability shield can afford. Those owners should, of course, remain cognizant of the practical limitations of the limited liability shield.

Come on, do I *really* need a lawyer?

Short answer: probably yes. And I’ll tell you why.

I am a member of a listserv of solo and small firm practitioners. Recently there was a thread discussing the impact services like LegalZoom and other do-it-yourself legal forms are having on the legal industry. Members of the listserv shared their stories of clients who would come in and ask why they should hire a lawyer to write a will, draft a contract, or form a company, instead of saving money by doing it themselves through LegalZoom or similar services or buying a do-it-yourself form from Staples. Others members of the listserv offered reasons why most, if not all, people need a lawyer to handle their legal issues rather than saving money by doing it themselves.

Looking at it one way, lawyers are basically throwing in the will, the contract, or the incorporation papers for free (especially if they offer those services at a flat fee). What the client is really paying for is the lawyer’s time, knowledge, and advice, a real live person the client can sit down with, who will figure out what the client’s needs really are and then tailor the will, the contract, or the company’s by-laws to exactly what the client needs. Does the client really need just a simple will, or does the client need something more complex to ensure that all the client’s assets and interests are well-protected? Does the client really need to form a corporation or LLC, or will a sole proprietorship or joint venture do? A lawyer will make sure that the client’s documents comply with local law, including both statutes and case law interpreting those statutes, and will contact the client to notify him or her about changes in the law that may invalidate provisions of a legal documents and can amend those documents to bring them into compliance with the law.

More basic is the concept that if you buy a $79 legal document, you are likely only going to get a $79 legal document. Do you really want to spend only $79 on something that will govern your business, something that you may intend to become your livelihood? In addition, what exactly does LegalZoom provide for $79 over the do-it-yourself incorporation package one can purchase for $10 at Staples? Not much, really — LegalZoom offers attorney review for additional fees, but the main point of using LegalZoom, the legal document forms themselves, can be found at office supply stores for a fraction of the price LegalZoom charges.

It’s possible that people attracted to LegalZoom deep down recognize that they *do* need help with their legal issues, but are reticent, or in some cases legitimately unable, to pay for a lawyer. They believe, or want to believe, that LegalZoom can provide the help they need. For an entrepreneur, forming a small business will likely be the most important legal action he or she will ever take. It is obviously critical that forming a business be done correctly and address all of the needs of the founding owners.Where the issues are simple, an entrepreneur with a good understanding of business law may be able to make informed decisions and complete the organization process without the help of an attorney. But where the issues are complex, particularly where there are multiple owners who will act as managers and employees in a small business, retaining an attorney to sit down with you, review the facts of your situation, and provide advice tailored to it may be invaluable, especially if your business hits difficult times — having properly completed and tailored legal documents can avoid the expense of a messy situation that a small business may not be able to afford.

The consensus on the listserv was some people are just convinced that LegalZoom is all they need and that they can handle their legal issues themselves, and that no amount of persuasion otherwise would get them to acknowledge that they may need the help of an attorney to resolve their legal issues. For my part, as an attorney in private practice I do want as much business as I can get, and I do want to make a good living, but I’m not out to gouge my clients. I understand that starting a business can be a costly venture, and that some entrepreneurs believe they simply do not have the funds available to hire an attorney. However, I genuinely want to help entrepreneurs, and I genuinely believe that people with legal issues need to speak to an attorney to figure out what exactly they need to do. If cost is a concern, then I encourage entrepreneurs to speak to several attorneys to find one that provides the level of service the entrepreneur is comfortable with while understanding the financial concerns of the entrepreneur.

Again, I welcome questions, comments, or criticisms by leaving a comment on the article, or by going to the Contact Us page and sending us an email. Thanks for reading!

P.S.: There will be no blog article on Saturday. I hope everyone enjoy their Thanksgiving weekend; be safe going to and from wherever you will celebrate, and enjoy the food and the company of your family and friends. See you all next week!

I want to start a business, now what? (legally speaking)

So you (and your team, if you have one) have decided to start a business. You’ve got an idea, you probably have a business plan, have some start-up capital (or have a plan to obtain capital), you may even have customers already lined up. You’ve handled the business issues, and now you’re wondering what else you might need to do to get started with your business? Have you considered the legal aspects of your business?

First and foremost, have you considered legally organizing your business (e.g.: incorporation, or formation of a partnership or limited liability company)? Some of the considerations that go into the decision to legally organize your business include liability protection, management structures, and tax considerations. If your business may incur liability, especially tort liability, forming a corporation, LLP, or LLC may be highly desirable. Otherwise, your personal assets and the personal assets of everyone who may be deemed an owner of the company could be reached to satisfy the liabilities of the company. Of course, liability shields are not perfect, especially for small businesses where owners are often also managers and employees — as a small business owners are often asked to personally guarantee debts and other liabilities of the business, and owners who are managers/employees of the business are of course personally liable for any tortious conduct they perform (and could also be liable for tortious conduct of employees under negligent entrustment/employment theories!)

Because, starting out, business owners are often managers/employees of their businesses, when there are two or more owners it is necessary to have a comprehensive agreement that describes the rights, responsibilities, and authority of each owner in regards to each other and to the business. Not only is it preferable to have the operating structure and procedures spelled out while the business is running, but it is also critical to have everyone’s rights and responsibilities written down if and when things get tough for the business.

There are other legal issues that all businesses face. Does your business need office or commercial space? A commercial loan? Are you negotiating contracts with suppliers and/or larger-scale customers? The party on the other side probably has a legal professional reviewing the terms of the deal, at the very least. Commercial space leases, commercial loans, and vendor/buyer contracts may represent significant and long-term liabilities for your business; it is important to consult with a legal professional on any deal your business does, so as to at least understand the terms of the agreement, such as the extent of warranties in a vendor agreement or the nature and terms of a “go-dark” provision, for example, so as not to be surprised by any costly terms that can represent a significant financial burden to a new or small business.

Before starting up a business, it may be necessary to consult with an attorney to discuss the legal issues of starting up a business. Retaining an attorney to handle your incorporation/business organization and the legal aspects of your business deals can free you and your team up to focus on strategic planning, designing, marketing, and actually selling your products or services to your customers. Of course, not all new businesses have the capital initially to spend on legal services; a good attorney should be able to help you decide whether or not retaining an attorney is within your business’ budget or necessary. Very small businesses with a single owner who is the sole employee may not need to create a legal business organization, or may be organized simply enough that a well-informed entrepreneur may be able do it himself or herself. Even if you decide not to retain an attorney to handle your start-up needs, it doesn’t hurt to make contact with one for future reference.

Thanks for reading, and if you have any questions or topics you would like to see covered in future blog articles, don’t hesitate to leave a comment or head over to the Contact Us page to send us an email!

Welcome to the First Venture Legal blog!

Hello and welcome to the First Venture Legal blog!  Here I will be posting about topics, issues, and news items important to the small business start-up community. Articles will be posted every Wednesday and Saturday. Although the first posts will be more general in nature, they will set the stage for more specific blog articles to come. So check back every Wednesday and Saturday for new articles, or follow us on Twitter at @1stventurelegal where I will announce the posting of new blog articles. Feel free to add feedback in the comments, or contact me with suggestions for topics you’d like to see written about — go to the Contact Us to drop us an email!