Chapter 21: Starting a Business: LLC's and other Options

Close Corporation

A corporation with a small number of shareholders whose stock is not publicly traded and whose shareholders play an active role in management- it is entitled to special treatment under state law.

Terminating a Partnership

A partner always has the power to leave a partnership but may not have the right. In other words, a partner can always dissociate, but if she has violated the partnership agreement, she will have to pay damages for any harm that her departure cause A partnership at will, means that any of the partners can leave at any time, for any reason, without owing damages. A dissociation is a fork in the road: The partnership can either buy out the departing partner(s) and continue in business or wind up the business and terminate the partnership. If the partnership chooses to terminate the business, it must

Transfer of Ownership

A partner cannot sell his share of the organization without the permission of the other partners. He can only transfer the value of his partnership interest, not the interest itself. He cannot, for example, transfer the right to participate in firm management or vote on firm matters.

Franchises

All franchisors must comply with the Federal Trade Commission's (FTC) Franchise Rule. In addition, some states also impose their own requirements. Under FTC rules, a franchisor must deliver to a potential purchaser a Franchise Disclosure Document (FDD) at least 14 calendar days before any contract is signed or money is paid.

Sole proprieorship

An incorporated business owned by one person Ease of formation. If an individual runs a business without taking any formal steps to create an organization, she automatically has a sole proprietorship. Generally, there is no need to hire a lawyer or register with the state, so costs are low. Taxes. A sole proprietorship is a flow-through tax entity, which means that, although Linda must pay personal income tax on any profit she earns, the business itself does not pay income taxes. The business is not even required to file a separate tax return

Flow through Tax entity

An organization that does not pay income tax on its profits but passes them through to its owners who pay the tax at their individual rates

Partnership

An unincorporated association of two or more co-owners who operate a business for profit Partnerships are flow-through entities: The partnership itself does not pay income tax, instead the profits pass through to the partners, who report it on their personal return Each partner is personally liable for the debts of the enterprise whether or not she caused them. Thus, a partner is liable for any injury that another partner or an employee causes while on partnership business as well as for any contract signed on behalf of the partnership Very few businesses deliberately choose to be a partnership. They are more likely to drift into it unknowingly, because a partnership is easy to form. In fact, nothing is required in the way of forms or filings or agreements. Ideally, a partnership should have a written agreement, but it is perfectly legal without one. Financing a partnership may be difficult because the firm cannot sell shares as a corporation does. The capital needs of the partnership must be provided by contributions from partners or by borrowing. Unless the partnership agrees otherwise, partners share both profits and losses equally, and each partner has an equal right to manage the business. In a large partnership, with hundreds of partners, too

S Corporation

Congress created S corporations (aka "S corps") to encourage entrepreneurship by offering tax breaks. The name "S corporation" comes from the provision of the Internal Revenue Code that created this form of organization. Shareholders of S corps have both the limited liability of a corporation and the tax status of a flow-through entity. Thus, all of an S corp's profits (and losses) pass through to the shareholders, who pay tax at their individual rates.

Three Steps to Termination

Dissolution. A partnership dissolves anytime the business cannot continue, such as when (1) a partner leaves, and the remaining partners cannot agree unanimously to continue on, (2) the partners decide to end the partnership, or (3) the partnership business becomes illegal. Winding Up. During the winding-up process, all debts of the partnership are paid, and the remaining proceeds are distributed to the partners. Termination. Termination happens automatically once the winding up is finished. The partnership is not req

Piercing the Company Veil

Fail to observe formalities. Members must treat the LLC like a separate organization. Thus, if an LLC enters into an agreement (particularly with a member), a legitimate contract needs to be drafted and sign Commingle assets. This trap is the most dangerous. An LLC and its members must keep their assets separate. If courts cannot tell who owns what, they are likely to grant creditors access to the assets of both the organization and its members. Fail to provide adequate capital In extreme cases, if an LLC is established without enough capital to run its business, then a court may look to the members' assets. One LLC had capital of only about $20,000 but proceeded to borrow millions of dollars from one of the members. That ratio looked wrong. Commit fraud Courts are unwilling to protect fraudsters who try to use an LLC as a shield against liability.

LLC Qualities

Flexibility Unlike S corporations, LLCs can have members that are corporations, partnerships, or nonresident aliens. LLCs can also have different classes of stock. Transferability of Interests As a general rule, unless the operating agreement provides otherwise, existing members of an LLC cannot transfer their ownership rights, nor can the LLC admit a new member without the unanimous permission of the other members. Duration It used to be that LLCs automatically dissolved upon the withdrawal of a member Going Public Once an LLC goes public, it loses its favorable tax status and is taxed as a corporation, not a partnership. Thus, there is no advantage to using the LLC form of organization for a publicly traded company. And there are some disadvantages: Unlike corporations, publicly traded LLCs do not enjoy a well-established set of statutory and case law that is relatively consistent across the many states. For this reason, privately held companies that begin as LLCs often change to corporations when they go public Piercing the Company Veil Limited liability is one of the great advantages of an LLC. However, if members abuse their rights, a court may remove their limited liability.

SP disadvantages

Liability. As the owner of the business, Linda is responsible for all of its debts. If ExSciTe cannot pay its suppliers or if a student is injured by an exploding cabbage, Linda is personally liable. Limited capital. The owner of a sole proprietorship has limited options for financing her business. Debt is generally her only source of working capital because she has no stock or memberships to sell. For this reason, sole proprietorships work best for small businesses without large capital needs.

LLC

Limited Liabilities Company An LLC offers the limited liability of a corporation and the tax status of a flow-through entity. As such, it is an extremely useful form of organization often favored by entrepreneurs because it offers the best of both worlds—limited liability and lower tax Members are not personally liable for the debts of the company. They risk only their investment, as if they were shareholders of a corporation.

LLP

Limited Liabilities Partnership Offers the limited liability of a corporation and the tax status of a flow-through organization. Partners are not liable for the debts of the partnership, but, naturally, they are liable for their own misdeeds. To form an LLP, the partners must file a statement of qualification with state officials. LLPs must also file annual reports.

Advantages of a Corporation

Limited Liability. If a business flops, its shareholders lose their investment in the company but not their other assets. A corporation protects managers and investors from personal liability for the debts of the corporation and the actions of others, but not against liability for their own negligence (or other torts and crimes). Transferability of Interests. As we will see, partnership interests are not transferable without the permission of the other partners, whereas corporate stock can be bought and sold easily. Duration. When a sole proprietor dies, legally so does the business. But corporations have perpetual existence: They can continue without their found

Disadvantages of a Corporation

Logistics. Corporations require substantial expense and effort to create and operate. The cost of establishing a corporation includes legal and filing fees, not to mention the cost of the annual filings and taxes that states require. Corporations must also hold meetings for both shareholders and directors. Minutes of these meetings must be kept indefinitely in the company minute book. Taxes. As we have seen, a sole proprietorship is a flow-through entity that does not pay taxes itself; all taxes are paid directly by the owner. Shortly, we will look at other flow- through entities, such as partnerships and limited liability companies (LLCs) where, again, all taxes are paid directly by the owners, and none by the business itself. In contrast, a corporation is a taxable entity, which means it must pay income taxes on its profits and also file a tax return. Shareholders must then pay tax on any dividends from the corporation. Thus, with a flow-through organization, a dollar is taxed only once before it ends up in the owner's bank account, but twice before it is deposited by a shareholder.

Formation of LLC

Members are not personally liable for the debts of the company. They risk only their investment, as if they were shareholders of a corporation.

General Partner

One of the owners of a general partnership

Professional Corporations

Professional corporations (PCs) are mostly a legacy form of organization—few businesses would now elect to be a PC. PCs offer the limited liability of a regular corporation. If a member of a PC commits malpractice, the corporation's assets are at risk, but not the personal assets of the innocent members. PCs are a separate taxable entity not a flow-through organization. Therefore, the tax issues can be complicated and are a major reason why most professional groups now choose to be an LLC or an LL

Features of Close Corporation

Protection of minority shareholders Shares not public, shareholders would vote/veto and couldn't just opt out, so they are accepted as a shareholder Transfer restrictions Share holders work closely together; must agree on actions Flexibility Can operate without board of directors, bylaws, or annual shareholder meetings Dispute Resolution Can agree ahead of time to dissolve the company; if stalemate shareholders can ask judge to dissolve if other holders are acting oppressively

FDD Must provide information on...

The history of the franchisor and its key executives Litigation with franchisees Bankruptcy filings by the company and its officers and directors; Costs to buy and operate a franchise; Restrictions, if any, on suppliers, products, and customers; Territory—any limitations (in either the real or virtual worlds) on where the franchisee can sell or any restrictions on other franchisees selling in the same territory; Business continuity—the circumstances under which the franchisor can terminate the franchisee and the franchisee's rights to renew or sell the franchise; Required advertising expenses; A list of current franchisees and those that have left in the prior three years (a significant number of departures may be a bad sign

S Corporation Restrictions

There can be only one class of stock. There can be no more than 100 shareholders. Shareholders must be individuals, estates, charities, pension funds, or trusts, not partnerships or corporations. Shareholders must be citizens or residents of the United States, not nonresident aliens. All shareholders must agree that the company should be an S corporation.

Social Enterprises

These organizations pledge to behave in a socially responsible manner Almost half the states now offer charters to some type of socially conscious organization, collectively referred to as social enterprises. The most common forms of these organizations are benefit corporations and low-profit limited liability companies (L3Cs).

To become a Social Enterprise

Two-thirds of shareholders (or in some states more) must approve. The company must agree to measure its social benefit using a standard set by an objective third party. On its website, the company must assess and report regularly on its societal and environmental impact.