Choose a Business Entity

[ LiB ]

Choose a Business Entity

Figure 2.2. Finding the right fit will save you taxes and time.

Now that you have some idea how you will be splitting the pie, it's time to decide the flavor. The government authorizes different forms under which businesses can be organized and operated, with each form (or entity ) having its own rules regarding ownership, taxation , management, required documentation, and liability. The primary forms in the United States are

• The corporation

• Limited liability company ("LLC")

• Partnership

• Sole proprietorship

This section introduces the major distinctions and varieties of the corporation, LLC, and partnership, as well as finding the entity most suitable to your enterprise's needs. Fortunately, you can always reorganizeoften tax-freeas a different entity if those needs change.

NOTE

NOTE

Because sole proprietor ships are generally inap propriate for a develop ment company, they will not be covered here.

Figuring out the best kind of entity for your business will help your company:

1. Protect owner and employee personal assets from company liabilities.

2. Minimize taxes by using losses to offset gains, avoid corporate-level tax (i.e. "double taxation"), and pass the money into your pocket at long term capital gains ("LTCG") rates, which top out at 20 percent, instead of ordinary income ("OI") tax rates, which can climb to 38.6 percent.

3. Gain access to the financing sources you need by organizing in a financier-friendly form.

4. Create a clearly defined ownership pool that can be divided among founders, financiers, and employees .

5. Operate efficiently with third parties, such as suppliers, customers, and employees.

The biggest differences among the entities are the following:

Corporations are treated as separate legal entities, almost like a person, that are owned by other separate legal entities (shareholders). The major benefit of this is that anyone suing or collecting from a corporation can only collect from the corporation's assets (except in very limited circumstances, see "The Corporation: C-Corporations: Liability" section)so your company's creditors couldn't take your house if the company ends up unable to pay its bills. The major detriment of the separate entity theory is that every dollar you earn as a corporation will be taxed twice: the corporation pays tax on its income, and shareholders pay tax on money distributed to them as dividends or stock value appreciation . S-corporations, which avoid the double tax, are discussed in "The Corporation: S-Corporations" section.

Partnerships, LLCs, and S-corporations have the bonus of "pass-through" taxation, meaning that all income is passed tax-free through the entity to the owners , who then pay tax on the distributions. These entities have other drawbacksgreater exposure to company liabilities and onerous ownership restrictions, respectivelythat are discussed in depth later in this chapter.

NOTE

CAUTION

DOUBLE CAUTION: State law generally governs business organization and opera tion.These can vary significantly, so I can't urge you strongly enough to consult a local attorney. Understanding the vagaries of state law (and you may have to comply with the laws of more than one state) isn't easy, so don't go it alone.

The Corporation

There are two types of corporations, the C-corporation and the S-corporation , so named for the Internal Revenue Code subchapters governing each. The two share many of the same structures: the company is owned in units of equity called shares; shareholders control the company indirectly via an elected board of directors, who hire and fire the executives that run the company. The main difference is one of taxation; an S-corporation passes its profits (and losses) through to its shareholders, escaping the double taxation. Of course, as the IRS giveth, it also taketh away; S-corporation status is accompanied by some onerous restrictions that must be carefully weighed against the tax boon.

C-Corporations

C-corporations are most appropriate if your company:

• Is widely held (more than 75 shareholders). Other business entities limit ownership to 75 or fewer entities.

• Wants to offer inexpensive options to attract employees. C-corporations can issue different classes of stock with different privileges and prices, making it possible for employees to pay less for shares than outside investors.

• Plans to raise money from corporations or investment funds. Some business entities restrict ownership to natural persons, and others carry tax burdens for certain kinds of investors.

• Expects owner/investor turnover . Transferring ownership is simplest in a corporation, more complex in a partnership.

• Employs shareholders as salaried employees or service providers. Investor-employees can avoid the double-tax by taking profits as (reasonable) salary, which is deductible from corporate income.

Ownership and Restrictions

The C-corporation has almost no restrictions on who or what entities may own the business. The corporation is considered a separate legal being and may be owned by any number of shareholders, including only one. Foreign parties and other business entities may own the C-corporation. Because the corporation is wholly distinct from its owners and exists as a separate legal entity, it survives all changes in ownership, including the death or ouster of a founder.

Management

One of the virtues of both types of corporations is that management procedures are largely standardized by law. Certain variations are possible, but this standardization gives a level of comfort and transparency to investors.

Control is divided among three groups: shareholders , directors , and officers . Shareholders are the actual owners of the corporation. The board of directors is something like a council of elders , composed of people with admired business experience who may or may not be shareholders. The officers and executives of the corporation are employees of the corporation who run it on a day-to-day basis. The shareholders elect a board of directors. The board of directors is responsible for the high-level strategic management of the company and makes most of the major decisions, including hiring (and firing) of officers. The officers (for example, the CEO, president, and CTO) then manage day-to-day operations. Crucial decisions affecting the corporation, such as a sale of substantially all of the corporation's assets, are decided by shareholder vote.

State statutes mandate certain officer positions, generally a president, treasurer, and secretary. In most states, one person can hold all positions and is not subject to any ownership qualifications.

Figure 2.3. Corporate control is divided among share holders, the board of directors, and the officers.

Taxation

Ay, here's the rub. In exchange for all the flexibility and attractions of the C-corporation, the IRS exacts what is known as "double taxation." The corporation's profits are taxed once at the entity level, and then shareholders pay tax on whatever gain they receive.

The corporation must pay a federal tax on its profits of 15 to 34 percent. One common way to mitigate this bite is for shareholders who are also employees/service providers to distribute earnings to themselves in the form of legitimate salaries, which are deductible from corporate income. A closely held, owner-operated C-corporation can thereby gain many of the benefits of C-corporation status while minimizing the tax consequences.

Corporations distribute earnings in one of two ways: as dividends or as an appreciation in the value of the business, which usually translates into an increased share value. A corporation may decide to issue dividends if it has ready capital and profits in excess of its requirements for growth. While this confers the benefit of current income to shareholders, dividends are taxed at the shareholder's OI tax rate. If the corporation reinvests the money and the share price appreciates, the shareholder gains two tax benefits:

1. She pays no tax until the sale of the share.

2. Any appreciation in the share price will be taxed at the LTCG rate if the stock is held onto for more than one year, or at an even lower rate if the stock qualifies for the small business corporation exemption (see sidebar: "Small Business Corporation stock").

Figure 2.4. Tax planning is required to minimize double taxation of C-corporation profits.

Liability

With some exceptions, shareholders, directors, and officers are protected from the corporation's liabilities by what is known as "the corporate veil." If the company goes bankrupt, creditors cannot look past the corporation's assets to the owners for satisfaction of debts. If money damages are awarded to a party suing the corporation, that party cannot look to the owners for the award. Generally, shareholders can only be held liable for the debts of the corporation if a court finds that they used the corporation to intentionally perpetrate a fraud or injustice.

Seven Simple Liability Precautions

Normally, creditors of a corporation may only look to the assets of the corporation, not the shareholders, to satisfy debts.This is what is known as the "corporate veil." The corporate veil can be pierced (disregarded), however, where a court finds that shareholders used the corporation to fraudulent or unjust ends (the alter ego doctrine, where the shareholders use the corporation as their alter ego to perpetrate fraud).The court's goal is to prevent crooks from exploiting the corporate laws to escape personal liability.

To make it more unlikely that a court will find a reason to pierce your company's corporate veil, and to maintain good personal/corporate financial hygiene:

1. Be sure that the company is adequately capitalized and insured, taking into account the risks of the business. For game developers, this might include having a cash cushion against a publisher's delay in paying a milestone and a general liability insurance policy, as well as all state and federally mandated insurance.

2. Don't use corporate assets for personal reasons. In other words, don't take the corporate car on a kayaking trip to Baja (unless there is some legitimate business purpose for the trip, such as a company outing).

3. Don't commingle corporate and personal assets.This means keeping separate business and personal checking accounts; don't pay your personal bills from the company till, even if you reimburse the company.

4. Keep a separate set of books and records for the corporation and your own personal assets.

5. Avoid self-dealing and sweetheart deals. Keep your nose extra-clean when it comes to dealings between the corporation and any major shareholder or director by fully disclosing any potential conflicts of interest in written corporate records and getting approval from disinterested board members or an appropriate third party.

6. Be sure that all corporate actions requiring proper, papered authorization receive it from the board of directors or shareholder. This means obtaining, recording, and holding onto shareholder and board authorization. Conduct shareholders' meetings and board meetings regularly (at least once per year) and keep accurate minutes in corporate records.

7. All contracts for the corporation should be signed with the corporation's name above the signature line, and the name and title of the person signing below the signature line. This makes it apparent to the other parties to the contract that they are dealing with a corporation and not the person, and they should expect to have recourse only to the corporation's assets should something go amiss with the contract.

Documents Required

A corporation requires certain documents to be prepared and filed with the company state's secretary of state as well as the IRS. After the initial filings, there are sundry ongoing requirements to operating a corporation, such as conducting board meetings, taking minutes of those board meetings and approving them, and so forth. Your attorney can review these with you and set up a system to make it easier for you to remain compliant. Furthermore, there are certain agreements like the shareholders' agreement (see heading "Shareholders' Agreement," this section) that are not mandated by law but are highly recommended for proper functioning of the corporation.

NOTE

CAUTION

Consulting an attorney early in this process will save you money and heartache in the long run. She will help you figure out the capital structure, ownership distribution, and equity incentive plan best fit ting your needs, as well as help you develop tax-efficient strategies.

Certificate of Incorporation/Articles of Incorporation

The Certificate of Incorporation (COI) must be filed with the secretary of state of the state in which you will be incorporating (not necessarily the same as your principal place of business) to inform the government of your company's vital stats. Requirements for this document vary from state to state, but most require:

• Name.

• Business Purpose. For most states, this can be as general as "engaging in any lawful activity for which corporations can be organized in the state."

• Authorized Capital. This is the number of shares that the corporation can issue, their par value (usually $.01), and classes of stock, if more than one. Since it is common to issue preferred stock to later investors (see discussion below) you may want to authorize "blank-check" preferred stock (if your state allows it) to avoid the expense of amending the articles. Blank-check preferred stock states that preferred stock is authorized and shall have the rights, preferences, and privileges that the board sets in board resolutions .

• Agent's name and address. Service of process sent to this address will be deemed received, so rather than using the address of an individual associated with the corporation, hire one of the companies that provides this service inexpensively. The worst-case scenario would be that process is served on an agent no longer associated with the company and a default judgment is entered against your company.

• Indemnification. Indemnification is protection (usually reimbursement and legal defense) the corporation gives certain individuals against liabilities arising from their activities on behalf of the corporation. Here is where you specify the indemnifications that the corporation will furnish its officers, directors, employees, and agents .

The following provisions may or may not be permitted in your state of organization; if permitted and you desire their use, include them in your certificate:

• Supermajority requirements. More than a simple majority is required for shareholder or director actions. State the threshold percentage.

• Cumulative voting (see the "Where to Incorporate " section that follows ).

• Preemptive rights. Right of an investor to buy enough of any future rounds of financing to maintain his or her current percentage (also known as the "kiss of death").

Bylaws

Bylaws set out the nuts and bolts of a corporation's administrative functions. The bylaws establish, among other things:

• Where the corporation will be located.

• When, where, and how stockholders ' meetings will occur.

• How stock certificates will be issued, paid for, and transferred.

• How many directors the corporation will have, what powers they will have, how they will be elected, and how and when they will meet.

• Officer positions of the corporation, how they will be elected, what their powers will be.

Action by Incorporator

This is a simple, vital step that must be completed to effect incorporation. It can be done as soon as the COI is filed with the secretary of state. It is a short document in which whomever is named as the incorporator on the original COI (frequently your attorney's assistant) adopts the bylaws, appoints the first directors, and then resigns.

At its first meeting, the board of directors should appoint officers, authorize the issuance of stock to the founders, establish a bank account, and authorize payment of expenses. At the same meeting, or soon thereafter, the board should do the following:

• Adopt a standard non-disclosure agreement and other proprietary information forms for all employees and consultants .

• Draft an employee stock/option purchase plan (if applicable ).

• Adopt a restricted stock purchase agreement imposing vesting and a right of first refusal on employee stock/option grants.

• Set a fiscal year.

• Agree on tax status (C or S).

If your board is far-flung, your state may allow what is known as an "action by unanimous written consent ," which allows actions to be taken if all directors sign a document approving same.

Shareholders' Agreement

The shareholders' agreement establishes rules of ownership, most of which have to do with transferring ownership. Some individual clauses are covered in this chapter in the section "Owners' Agreements." A sample shareholders' agreement can be found at the end of this chapter.

Employment Agreements

If any of the founders or shareholders will be employed by the company, an employment agreement setting out the terms of their relationship with the company should be negotiated, signed, and referenced in the shareholders' agreement.

Small Business Corporation Stock

The IRS has created tax incentives for investment in new small businesses under sections 1202, 1244, and 1045 of the Internal Revenue Code.These sections allow for up to three major tax savings to investors in a qualifying small business ("QSB"):

• A 50 percent exclusion of any gain realized by the investor upon the sale of the stock (Section 1202 of the Code);

• Deferral of the gain realized by the investor if the investor "rolls over" such gains by purchasing additional QSB stock (Section 1045 of the Code); and

• If the investor loses money on the investment, re-characterization of any capital losses as ordinary losses (Section 1244 of the Code).

To qualify for a 50 percent reduction in the capital gains tax due upon sale of your QSB stock, the stock must meet all of the following criteria:

1. The corporation must be a domestic "C" corporation.

2. The stock must have been issued after August 11, 1993.

3. The stockholder must have received the stock as an original issue.

4. The aggregate gross assets of the corporation must not have exceeded $50,000,000 at the time of and immediately after the issuance of the stock.

5. At least 80 percent of the assets, by value, of the corporation must have been used in active trade or business.

S-Corporations

S-corporations are most appropriate for businesses that:

• Are closely held . An S-corporation can have no more than 75 shareholders.

• Will not have any corporate or international investors .

• Will generate initial losses that shareholders can use against their taxable income .

• Plan to distribute most profits immediately to shareholders . A company that reinvests most of its profits can minimize its corporate-level income tax. If the shareholders intention is to take profits out of the company as cash instead of reinvesting them to grow the company, then they will prefer a pass-through entity that does not have a corporate level income tax.

• Will not offer preferentially priced options to attract employees . An S-corporation can have only one class of stock, meaning that employees will have to pay the same price for shares as outside investors.

• Will not be able to distribute a significant amount of corporate income to shareholders by means of salary . Salaries are deductible from corporate income, creating a way for shareholders to avoid the corporate-level tax. If this option is not available, the presence or absence of corporate-level income tax becomes a major issue.

Figure 2.5. Pass-through entities may offer tax advantages to company owners.

Ownership Restrictions

S-corporations can have no more than 75 shareholders, all of whom must be individuals (though there are some allowances for tax-exempt trusts and estates) living in the United States. Developers who plan to raise money must consider this limitation carefully, since corporations (e.g. publishers) and foreigners form a large part of their investor audience.

NOTE

TIP

S-corporations are easily converted into C-corporations as needed, for instance in a situation where a for eign entity or corporation wishes to buy the S-corporation.

Another limitation is the S-corporation's ability to issue only one class of stock, which complicates the matter of incentive equity. (See the "Ownership of a Corporation" section in this chapter). Many developers do not find this a serious burden and opt to use other means to create employee incentives, such as profit-sharing plans, royalty participation pools, and bonus plans, see the Sharing the Wealth sidebar in Chapter 4, "Staffing Up." To avoid employees' owing tax on their receipt of shares, they must pay the same price as the investors.

Management

The S-corporation has management procedures that are largely standardized by law.

Control is divided among three groups: shareholders , directors , and officers . Shareholders are the actual owners of the corporation. The board of directors is something like a council of elders, composed of people with admired business experience who may or may not be shareholders. The officers and executives of the corporation are employees of the corporation who run it on a day-to-day basis. The shareholders elect a board of directors. The board of directors is responsible for the high-level strategic management of the company and makes most of the major decisions, including hiring (and firing) of officers. The officers (for example, the CEO, president, CTO) then manage day-to-day operations. Crucial decisions affecting the corporation, such as a sale of substantially all of the corporation's assets, are decided by shareholder vote.

State statutes mandate certain officer positions, generally a president, treasurer, and secretary. In most states, one person can hold all positions and is not subject to any ownership qualifications.

Taxation

The S-corporation entity does not owe federal tax on its profits. All profits and losses flow through to its shareholders, who then owe income tax (or receive deductions) on those distributions at the shareholder's ordinary income tax rate.

NOTE

NOTE

Owner-employees of an S-corporation may be eligi ble for reductions in their self-employment tax.

Many investor/founders like the S-corporation as an initial choice because they can deduct some or all of the losses generated by the company from income they generate through other avenues. There are many restrictions on this practice, and it requires the counsel of a solid tax planner to accomplish effectively.

Unlike the other pass-through entities (LLC and partnership), owners of an S-corporation may not decide amongst themselves how to allocate profits and losses; all profits and losses must be allocated by share ownership. Differential allocation is desirable in circumstances where, for instance, an S-corp will be generating tax losses for the first few years , and a large stakeholder (say, a founder) will not have enough income to use all of the loss, whereas a minority shareholder (say, an angel investor) will. Under the IRS rules regulating S-corporations, the minority shareholder will only be able to declare that portion of the corporation's loss corresponding to his or her ownership percentage in the company.

Quick example: Founder A owns 65 percent of the stock and earns $30,000 in income. Founder B owns 20 percent of the stock, but also works at another company and earns $400,000. The company generates losses of $100,000 in its first year. Founder A has a $65,000 loss that he can deduct from his income, but because he only has $30,000 in income, $35,000 goes unused. Founder B has a $20,000 loss that she applies against her $400,000 income, but she sure could use that extra $35,000 loss to deduct against her salary. Alas, she can't;

NOTE

CAUTION

There are many assumptions and qualifications in this exampleit should not be used as a blanket application of the tax law.

S-corporations do not allow for differential loss allocation.

Two more limitations on using the S-corporation's losses:

• A passive shareholder (one who does not work for the company) cannot deduct the losses from most income. The losses are considered capital losses and are only useful against the investor's capital gains.

• Deductions are limited to the shareholder's basis in his stock. An easy way to think of basis is as your total cost paid for the stock. So if you have only paid $10 for your stock, you can only use $10 worth of deductions.

A potentially graver consequence of S-corporation taxation is that shareholders must declare their share of corporate profits whether or not said profits have been distributed . Thus, a cash squeeze could arise for an investor if the corporation retains profits but the shareholder must pay taxes on the profit.

Quick Example: Use the numbers from the example above, but change the $100,000 loss into a $100,000 gain. If the corporation stockpiles all of the profit, Shareholder A will feel the pinch of owing income tax on both his $30,000 salary and his $65,000 share of the profits, even though he has not received any of that money.

Liability

With some exceptions, shareholders, directors, and officers are protected from lawsuits and personal liability arising from their actions in connection with the company by what is known as "the corporate veil." If the company goes bankrupt, creditors cannot look past the corporation's assets to the owners for satisfaction of debts. If money damages are awarded to a party suing the corporation, that party cannot look to the owners for the award. Generally, shareholders, directors, and officers can only be held liable for the debts of the corporation if a court finds that they used the corporation to intentionally perpetrate a fraud or injustice. See Sidebar: Seven Simple Liability Precautions in this chapter for tips on how to keep your veil intact.

Figure 2.6. Fraudulent conduct may result in officer and/or shareholder liability.

Documents Required

A corporation requires certain documents to be prepared and filed with the company state's secretary of state, as well as the IRS. After the initial filings, there are sundry ongoing requirements to operating a corporation, such as conducting board meetings, taking minutes of those board meetings and approving them, and so forth. Your attorney can review these with you and set up a system to make it easier for you to remain compliant. Furthermore, there are certain agreements like the shareholders' agreement (see heading "Shareholders' Agreement," this section) that are not mandated by law but are highly recommended for proper functioning of the corporation.

NOTE

CAUTION

Consulting an attorney early in this process will save you money and heartache in the long run. She will help you figure out the capital structure, ownership distribution, and equity incentive plan best fit ting your needs, as well as help you develop tax-efficient strategies.

You will need to obtain the following documents to set up an S-corporation.

Certificate of Incorporation/Articles of Incorporation

The Certificate of Incorporation must be filed with the secretary of state of the state in which you will be incorporating (not necessarily the same as your principal place of business) to inform the government of your company's vital statistics. Requirements for this document vary from state to state, but most require:

• Name.

• Business Purpose. For most states, this can be as general as "engaging in any lawful activity for which corporations can be organized in the state."

• Authorized Capital. This is the number of shares that the corporation can issue, their par value (usually $.01), and classes of stock, if more than one. Because it is common to issue preferred stock to later investors (see discussion below) you may want to authorize "blank-check" preferred stock (if your state allows it) to avoid the expense of amending the articles. Blank-check preferred stock states that preferred stock is authorized and shall have the rights, preferences, and privileges that the board sets in board resolutions.

• Agent's name and address. Service of process sent to this address will be deemed received, so rather than using the address of an individual associated with the corporation, hire one of the companies that provides this service inexpensively. The worst-case scenario would be that process is served on an agent no longer associated with the company and a default judgment is entered against your company.

• Indemnification. Indemnification is protection (usually reimbursement and legal defense) the corporation gives certain individuals against liabilities arising from their activities on behalf of the corporation. Here is where you specify the indemnifications that the corporation will furnish its officers, directors, employees, and agents.

The following provisions may or may not be permitted in your state of organization; if permitted and you desire their use, include them in your certificate:

• Supermajority requirements. More than a simple majority is required for shareholder or director actions. State the threshold percentage.

• Cumulative voting (See "Where to Incorporate" section).

• Preemptive rights. Right of an investor to buy enough of any future rounds of financing to maintain his or her current percentage (also known as the "kiss of death").

Bylaws

Bylaws set out the nuts and bolts of a corporation's administrative functions. The bylaws establish, among other things:

• Where the corporation will be located.

• When, where, and how stockholders' meetings will occur.

• How stock certificates will be issued, paid for, and transferred.

• How many directors the corporation will have, what powers they will have, how they will be elected, and how and when they will meet.

• Officer positions of the corporation, how they will be elected, and what their powers will be.

A sample of corporate bylaws is included at the end of this chapter.

Action by Incorporator

This is a simple, vital step that must be completed to effect incorporation. It can be done as soon as the COI is filed with the secretary of state. It is a short document in which whomever is named as the incorporator on the original certificate of incorporation (frequently your attorney's assistant) adopts the bylaws, appoints the first directors, and then resigns.

At its first meeting, the board of directors should do the following: Appoint officers

Authorize the issuance of stock to the founders

Establish a bank account

Authorize payment of expenses.

At the same meeting, or soon thereafter, the board should:

Adopt a standard non-disclosure agreement and other proprietary information forms for all employees and consultants

Draft an employee stock/option purchase plan (if applicable)

Adopt a restricted stock purchase agreement imposing vesting and a right of first refusal on employee stock/option grants

Set a fiscal year

Agree on tax status (C or S)

If your board is far-flung, your state may allow what is known as an "action by unanimous written consent," which allows actions to be taken if all directors sign a document approving same.

Shareholders' Agreement

The shareholders' agreement establishes rules of ownership, most of which have to do with conditions of transferring ownership. Some individual clauses are covered in this chapter in the section "Owners' Agreements." A sample shareholders' agreement can be found at the end of this chapter.

IRS Election

S-corporation status is elected by filing form 2553 with the IRS, along with written consent of all shareholders, before the fifteenth day of the third month of the taxable year of the corporation for which S status is desired. A corporation must meet all of the requirements over the course of the entire year; otherwise , the election is deemed ineffective until the next year.

Where to Incorporate

You may have noticed that far more companies are incorporated in Delaware than appear to "reside" there. This is largely due to Delaware's well-established body of corporate law that strongly favors the corporation and gives management more power and discretion than the laws of some other states. If you elect to organize in Delaware, you will probably also have to file as a foreign company in the state of your company's principal place of business. The downside to incorporating in Delaware is that your company will have to comply with tax and regulatory requirements of both states and will incur additional expenses in filing and maintenance expenses such as employing a local Delaware agent .

An agent is a person legally authorized to act on behalf of your company. This kind of agent acts as your company's local presence for official communications. The state in which you incorporate needs to have a person within its borders through whom it can give your company official, binding communication, such as service of process.

Figure 2.7. IRS form 2553.

Points on which state laws vary:

• Types of consideration (payment) that can be used to buy stock

• Enforceability of voting agreements (agreements that essentially allow certain shareholders to elect a certain number of board seats)

• Ability of fewer than all shareholders to act by written consent

• Ability to stagger director elections (rather than having all directors up for election at once)

• Indemnification of officers and directors

• Validity of " poison pill" (anti-takeover) measures

• Shareholder appraisal rights (discussed in Chapter Three)

If your corporation is privately held (that is, not publicly traded) and it meets the 50/50 test (more than 50 percent of the shares are owned by California residents and more than 50 percent of the business is conducted in California), you will be subject to California corporate governance laws, which have a few quirks worth noting:

• California corporations may pay dividends or buy back shares only to the extent of the corporation's accumulated earnings.

• Privately held corporations must allow cumulative voting. Under cumulative voting, every shareholder receives that number of votes equal to the number of shares owned multiplied by the number of directors to be elected. This can give minority shareholders power to elect directors. Example: DevCo has 100 outstanding shares of voting stock Shareholder A owns 20 percent, Shareholder B owns 80 percent, and five board members are up for election. Shareholder A will have 20 votes to distribute as she sees fit over the nominees for the five board slots, Shareholder B has 80 to do likewise. Shareholder A can therefore be guaranteed one director of her choosing on the board if she places all 200 votes with one nominee.

• Staggering of board elections is prohibited ; all directors must be elected annually, creating more potential for radical change.

Figure 2.8. Cumulative voting can prevent tyranny by the majority.

Limited Liability Company

A limited liability company (LLC) is most appropriate for those companies that:

• Will not need to issue incentive equity to attract employees.

• Do not plan to raise money from an investment fund.

• Are considering organizing as a partnership or S-corporation.

• Will not qualify for the QSBC capital gains reduction.

The limited liability company is a relatively recent, very popular addition to the roster of corporate entities. It combines the most desirable qualities of the limited partnership and S-corporation while eliminating some of those entities' more obvious drawbacks. Unlike the limited partnership, the LLC does not require any one person to bear ultimate liability for the company's debts. Unlike the S-corporation, it may issue more than one class of ownership interest, may have more than 75 shareholders, any of whom may be non-U.S. residents or entities, and may freely allocate profits and losses among members for tax benefits.

Ownership Restrictions

The owners of an LLC are called "members," each owning a "membership interest." Unlike partnerships and S-corporations, corporate investors are allowed to own membership interests in an LLC. While investment funds are free to invest in LLCs, most will not because of unfavorable tax consequences to their tax-exempt investors (for example, pension funds).

Management

Most LLCs will appoint one or more "managing members," who will actively manage the company's business. Because there are not many statutorily required management structures or documents, there is much latitude in how an LLC is managed. This confers the benefit of hand-tool-ing the operating rules to suit the members, but also creates the need for a well-drafted custom operating agreement. Some of the key clauses to include in the operating agreement are discussed in the "Ownership Agreements" section in this chapter.

NOTE

NOTE

Venture and investment funds will generally not invest in an LLC due to tax implica tions for their investors.

Taxation

The LLC is a pass-through entity. Corporate investors may be attracted to the form because LLCs allow for custom allocation of profits and losses to members. An LLC can also be incorporated, sometimes tax-free, at any time, making it a sound initial-stage entity form. A frequent strategy is for a company to organize as an LLC initially if it expects to generate losses. After those losses have been allocated to early investors, the company can incorporate if necessary.

Liability

Figure 2.9. Limited liability pro tects a company's own ers from the debts of the company.

Members have no personal liability for the LLC's obligations, butas with corporate directors they remain liable for errors and omissions committed while acting in connection with the business.

Documents Required

• Certificate of formation. The certificate of formation (also referred to as "articles of organization" in California) is a short document, similar to the articles of incorporation filed for a corporation, filed with the secretary of state that sets forth the basic information of the business: name, address, agent for service of process, term, and governance (that is, will the LLC be governed by the members or by managers appointed by the members).

• Operating Agreement. As mentioned above, taking advantage of the LLC's flexibility requires careful documentation of relations between the members and the company. Boilerplate documents are strongly discouraged. See the "Ownership Agreements" section in this chapter for a discussion of these contracts.

Partnership

A partnership is most appropriate for businesses:

• Whose founders desire to allocate profits and tax losses as they desire.

• With at least one founder willing to accept liability for the business' debts. Partnerships require at least one partner to be a general partner personally liable for the debts of the partnership.

• That do not expect to raise funds from foreigners or investment funds. Partners must be persons, and partnership income carries tax burdens on foreigners that can be avoided by using a corporation.

Figure 2.10. Flexible profit and loss allocation is an attractive feature of the partnership.

Ownership Restrictions

A partnership must be owned by two or more persons, which includes individuals, partnerships, corporations, and other associations. While foreigners are not prohibited from becoming partners in a United States partnership, the partnership entity is unattractive to them because they will owe U.S. tax on any income generated from their partnership activity (no such tax is due on a foreign entity's profits from a U.S. corporation).

Partnerships do not tolerate owner turnover very well. Adding more partners is not difficult, but the partnership legally dissolves on the death or withdrawal of a general partner (see the "Partnership: Liability" section in this chapter, on the distinction between general and limited partners). Most partnerships contain a clause providing an alternative to liquidation, generally a buyout of the departing partner, followed by the election of a new general partner if necessary.

Management

A partnership creates an agent relationship between each partner and the partnership, meaning that every partner has the authority to act on behalf of the partnership. Any partnerlimited or generalcan obligate the partnership if that partner is acting with the scope of the partnership's business. A rogue partner could obligate you to a bad business deal, but probably not to a lease on a Ferrari. The potential for chaos and liability makes the selection of partners and the drafting of the partnership agreement particularly important. Some would draw a parallel to marriage , but we do not consider ourselves authorities on that topic.

Limited partners generally cannot participate in control of the partnership; otherwise, they risk being treated as general partners for liability purposes (see the "Partnership: Liability" section that follows).

Taxation

A partnership, like an S-corporation or an LLC, is a flow-through tax entity.

Probably the most attractive feature of the partnership is that losses and profits are freely allocable among partners. Unlike the S-corporation, in which profits and losses must be allocated by ownership, partners can gain tax advantages by agreeing to different arrangements. A situation where this may be desired is one in which a partner providing services wishes to give her share of a year's losses to a partner who donated cash. The best part is that profits can be allocated differently from losses. These arrangements can include preferred return systems, and may change over time.

There are limits to the utility of this flexibility. Passive losses (losses incurred by a partner who does not actively participate in the business) are not deductible from most forms of income. Since limited partners are generally assumed to be passive, limited partners will only be able to use the partnership losses against capital gains they may have incurred that year. Furthermore, a partner cannot claim a deduction greater than the amount of the partner's basis in his interest.

Liability

There are two forms of partnerships: general, and limited liability. In a general partnership, all partners have unlimited liability for the partnership's debts. In a limited liability partnership, there must be at least one general partner who accepts personal liability for the partnership's debts; all limited partners (none of whom may actively participate in the management of the partnership) are liable only to the extent of their contribution to the partnership. The general partner must take extra care when selecting partners, as every partner is a legal agent of the partnership and may transact business and create obligations on its behalf (see the preceding "Management" section).

The partnership is interesting because it is treated as a separate legal entity for some purposes, and not for others. A partnership can sue and be sued, and it may own property. However, the creditor of a partner would sue the partner's interest, not the partnership as a whole.

Documents Required

For a general partnership, no documents are required, merely a meeting of minds and intention to form a partnership. A limited partnership must file a certificate with the secretary of state and have a written partnership agreement.

All partnerships should have a written partnership agreement covering certain basic terms and eventualities, discussed in the following "Ownership Agreements" section.

Unlike corporate documents, which are reasonably standardized, the ownership, management, and profit-sharing relations among partners vary significantly, requiring carefully tailored agreements. Individualization equals attorney time, but it is usually necessary, as boilerplate forms are not likely to adequately reflect the partners' intent.

Added to the many dangers of engaging in business without a document clearly establishing ownership, intent, and eventualities is the application of state partnership laws in the absence of a written agreement. This can create undesirable outcomes due to provisions of law that may contradict the original intent of the parties (and, frequently, generally accepted notions of fairness). Partnership law is nowhere near as comprehensive as corporate law, meaning that partners will have a less established body of law to guide them in case of disputes.

Other Considerations

The following issues pertain to all businesses regardless of entity type:

Licenses

If you plan to do business or maintain an office outside your state of organization, it may be necessary to register as a foreign entity with the secretary of state for each state in which you will be conducting business. Furthermore, check with local counsel to understand any tax obligations you may incur, such as income or sales taxes. If you will have employees in states other than that which you are organized, your company may be subject to withholding worker's compensation, and other labor regulations.

Insurance

Unfortunately, insurance has become very expensive in the last couple of years, leading some companies to "self-insure." "Self- insuring " should always be used in quotation marks because it is a somewhat ironic term: it refers to the practice of putting money into a reserve/rainy day fund rather than paying premiums to a third-party insurer. Of course, the risk is that if disaster strikes when there is not enough money in the reserve, there is no coverage. Even with the limited liability afforded by many corporate entities, insurance is a good idea because

1. It protects the individuals working for the company against errors and omissions for which they would otherwise be personally liable.

2. Insurance can be the difference between a company's survival and its failure in case of fire, unexpected departures of owners who need to be bought out, or other devastating occurrences.

Don't expect investors to put money into a company with no limits to its exposure. Ask around for the name of a good insurance agent who works with other companies in the industry, and spend a bit of time with him explaining how your business operates. You should consider the following coverage:

• General liability/product liability

• Fire and casualty

• Worker's compensation

• Errors and omissions coverage for officers/directors/management

• Business interruption

• Disability and life insurance for key personnel

• Insurance to fund a buyout in the event of death or disability of an owner

Name

Once you choose a name for your organization, you will first want to check its availability for business use with the secretary of state for each state in which you will be operating. Then, and only then, should you pursue trademarking the name. You can do a cursory check at the United States Patent and Trademark Office's website: www.uspto.gov, but you should ask your attorney to do a proper trademark search and registration as soon as possible. Few things are more irritating than having to change your company's name after the stationery, business cards, website, and a bit of brand equity have been established. A U.S. trademark only protects use of your mark in the U.S., so consult with your attorney to decide if you should pursue international registration (see Chapter 5, "A Primer on Intellectual Property and Licensing," for a discussion of global IP protection issues).

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