Legal Issues in Forming a New Business
Forming a successful business requires careful planning. A main consideration of your planning includes selecting the specific type of entity under which you will conduct your business.
As a business owner, you have various options available under which to operate your business. The options available include: a sole proprietorship, a general partnership, a joint venture, a limited partnership, a corporation or a limited liability company. The type of business you choose will affect your potential personal liability and tax treatment, as well as impact the level of formalities the entity will be required to adhere to and maintain.
Each form of business requires that its owners/members maintain accurate books, accounts and records. Some entities may require more formal accounting than others, but every business needs to track income and expenses properly. All contracts should be in writing, complete and accurate, and should identify the goods sold or purchased, the terms of the sale and the conditions for payment.
No matter which entity you choose, certain requirements apply across the board: every business should file sales and transaction privilege tax reports, obtain a business license, an employer tax identification number, purchase worker’s compensation insurance and protect its trademark or trade name. During the formation process, most business owners/members will create and agree upon terms and conditions of the bylaws or the operating agreement, which will govern the rights, obligations and responsibilities of the owners, officers and directors for the business entity. In addition, the owners of a partnership, joint venture, corporation or limited liability company should prepare an agreement that sets a procedure for the owners to sell their interest to each other or to third parties. Such agreements are commonly called “buy-sell agreements” or “cross-purchase agreements.” It is most advantageous to draft and execute these agreements when the business is being started, rather than at a point when the parties are preparing to separate, dissolve or, worse, when they are fighting with each other.
What follows is a discussion of the various types of business entities. Whichever type of entity you choose, the key considerations during the selection process should remain tax consequences and the level of protection from personal liability.
A sole proprietorship is the simplest form of business. It is an unincorporated business, conducted by an individual or a married couple.
Starting the business requires no written agreements. However, the owner of a sole proprietorship is personally liable for all business debts. Although an owner can purchase insurance to protect against certain claims of negligence, in the event the business is unable to pay creditors, the personal assets of the owner will be exposed to judgment and collection.
Income earned by a sole proprietorship is fully taxable to the owner. While this is the simplest form of doing business, the owner risks his or her entire savings and assets in the hope that business debts will not exceed income and that insurance will cover all work-related claims.
A partnership is the association of two or more persons who, as co-owners, carry on a business for profit. In a general partnership, each partner is liable for all business debts. Generally, unless restrictions are placed upon a partner’s authority, each partner has full authority to manage the business and to bind the partnership by contract.
If a partnership does not use the names of the owners as its business name, although not required, the partnership should record a Certificate of Fictitious Name in each county in which it does business. The certificate names the business and lists the owners and their addresses.
Each partner owes a fiduciary obligation to the other. This means that each partner must account to the partnership for any benefit or profit derived from the partnership, and must provide true and full information of all matters affecting the partnership.
Partnership agreements should identify the partners, as well as the cash, property or services each partner is expected to contribute. The agreement also should state whether additional contributions of money or property will be considered as loans and, if so, whether interest will be paid. They also should delineate the conditions under which any partner can withdraw capital previously contributed.
The partnership agreement should identify whether the partners are required to devote full time to the partnership, or can engage in other outside business. The agreement should also include: a method for resolving disputes; a statement addressing whether the partners can compete with the partnership; the requirements for the admission of new partners; and the authorization of the partners for checking accounts, leases and other acts required to start the business.
Unless the partnership agreement provides otherwise, each partner is entitled to an equal share of partnership profits after all liabilities have been paid and capital contributions repaid.
Limited partnerships are comprised of a general partner who has unlimited liability and one or more limited partners who are typically shielded from personal liability. If properly formed and operated, the liability of limited partners is limited to the contributions they have made to the limited partnership. However, if limited partners execute personal guarantees or participate in the control of the limited partnership, their personal assets may be liable for partnership debts.
A joint venture is a type of partnership usually formed for a specific purpose. It may have a limited time of existence. A joint venture may be formed by individuals, partnerships or corporations to cooperate on a specific task. As opposed to many other types of partnerships, the parties to a joint venture typically retain their right to compete with each other in other business areas.
The parties to the venture should execute a joint venture agreement. Among the terms included in such an agreement should be the purpose for which the joint venture is formed, the contribution each party will make, the control that each party will have, and the division or allocation of costs and profit.
If a corporation is properly incorporated and adequately funded, the potential personal liability of the owners will be limited. You can form a corporation by filing articles of incorporation and a certificate of disclosure with the Arizona Corporation Commission. You must then publish the articles of incorporation in a newspaper of general circulation in the county where the corporation initially intends to do business. The initial board of directors must then hold the organizational meeting.
The articles of incorporation must include: (1) the name of the corporation; (2) the object and purposes of the corporation, as well as its initial business; (3) the amount of authorized capital stock the corporation may sell; (4) the statutory agent; (5) the initial board of directors and the incorporators; and (6) provision for indemnification of corporate officers and directors.
After the articles of incorporation have been filed, the incorporators will hold an initial meeting, at which time the officers are elected, stock certificates will be issued, notices sent and other rules adopted for conducting corporate business. The bylaws will be prepared and executed which will govern the manner in which meetings will be called and held and address other corporate rights and responsibilities.
A corporation needs to select a fiscal year end, authorize the opening of bank accounts and identify the parties authorized to sign checks and contracts.
Corporations are designated as either “C” corporation or “S” corporation. A “C” corporation is taxed as an entity separate from the individual owners. The choice, however, will result in a “double tax” if dividends are paid to the owners. For this and other reasons, corporations may elect to be treated as “S” types. S corporations are not generally treated as a separate taxable entity and pay no income tax. All corporate income and deductions are “passed through” directly to the shareholders of the S corporation. However, S corporations are subject to certain restrictions concerning limitations on classes of stock that may be issued and other restrictions not applicable to C corporations. Finally, S corporations are taxed on income even if it is not distributed by the corporations.
Limited Liability Company
Like a corporation, a limited liability company offers the protection of limited liability for owners, but with the pass-through taxation similar to that of a partnership. A limited liability company can be organized by two or more persons, corporations or partnerships. An LLC is formed by filing articles of organization with the Arizona Corporation Commission and publishing the required notice. LLCs should adopt an operating agreement to govern the rights and obligations of the LLC as an entity and its individual members. The members of an LLC, like partners in a partnership, are not taxed at the entity level and have the benefit of pass-through taxation. But unlike a limited partnership, the LLC can be managed by its members or by an appointed manager.
Like a general partnership and an S Corporation, the profits and losses of an LLC pass directly to the owners (members), with no tax at the company level. Profits and losses are shared among the members, based on their operating agreement. As opposed to an S corporation, LLCs can create different classes of ownership and rights to distributions. S corporations are also subject to many limitations that don’t apply to LLCs.
Unlike a sole proprietorship, a general partnership or the general partner of a limited partnership, LLC members are not liable for the debts and obligations of the LLC simply because of ownership. The debts of an LLC are generally limited to the assets and capital contributions of the company. Members of an LLC incur liability only by executing personal guarantees for its debts. Presumably, the doctrine of “piercing the corporate veil” (allowing shareholders to be liable for corporate debts under certain circumstances) will apply to LLCs, including the issue of inadequate capitalization when the LLC was formed.
While sharing the pass-through tax status and limited liability of an S corporation, LLCs are not subject to the substantial limitations of an S corporation. S corporations can have a maximum of 35 members, all of whom must be residents of the United States. An LLC may be formed as a single member entity and there is no limit on the maximum number of members. Also, members may be foreign citizens or foreign entities.
An LLC can conduct and promote business and other activities for any lawful purpose except banking or insurance. In order to maintain the LLC’s tax status as a partnership, the Internal Revenue Service requires that the LLC lack two of four corporate characteristics: (1) limited liability; (2) centralized management; (3) continuity of life; or (4) free transferability of ownership. As opposed to corporate shares that are freely sold subject only to restrictions of stockholder agreements, the LLC operation agreement should limit the ability of members to transfer ownership. An LLC terminates upon the death, withdrawal or bankruptcy of a member, unless the operating agreement provides a different method to continue the LLC.
LLCs may be used by most professionals, though members remain personally liable for errors and omissions they commit or are committed by those working under their direct supervision and control. LLCs can be an excellent form of owning real estate and conducting other forms of business.