Chapter 4: Deciding Whether to Incorporate

A business may be conducted as a:

sole proprietorship; a corporation (either a C corporation or an S corporation, which has special flow-through tax attributes but strict limits on the number and types of eligible shareholders); a general, limited, or limited liability partnership; or a limited liability company

sole proprietorship:

has little legal significance separate from the individual owner of the business

corporation:

is a distinct legal entity owned by its shareholders and managed by a board of directors

Most large business organizations operate as:

C corporations

partnership:

• a separate entity for some purposes and a group of individual partners for others

• It does not pay income taxes on its activities; instead, its partners pay income taxes on its activities based on their respective interests in its profits

The ____ attempts to combine the best attributes of the corporation and the partnership?

LLC

An LLC that has ____ is generally taxed the same as a partnership unless it elects to be taxed as a corporation?

multiple owners

A business that expects to raise capital from a venture capital fund will usually be formed as a C corporation because:

most venture capital funds raise money from tax-exempt entities such as pension and profit-sharing trusts, universities, and charitable organizations

Traditionally, limited partnerships were the entity of choice for:

activities such as investing in real estate or securities where flow-through tax treatment is desired

In addition to permitting profits and losses to flow through directly to the owners of the business, ____ can distribute property in kind without incurring tax on the partnership or the partner

partnerships

Many investment funds distribute highly appreciated securities to their partners after a liquidity event. These events can be:

an initial public offering or acquisition by a public company in a tax-free reorganization

• Due to this, each partner can make an individual decision as to when to sell the securities received

low-profit limited liability company (L3C):

a form of LLC specifically designed to accommodate the needs of hybrid social ventures that have both financial- and social-betterment goals

benefit corporation or public benefit corporation:

for-profit corporations that aim to earn profits and at the same time address social and environmental issues

B Lab, a nonprofit corporation, grants B Corporation or Certified B Corporation status to companies that:

meet its social, environmental, accountability, and transparency standards & B Lab charges an annual fee based on revenues for such certification

sole proprietorship =

a business owned by one person

Sole proprietorships usually requires:

no governmental filing except a fictitious-business-name statement, which discloses the name under which the business will be conducted and the owner’s name and address

The owner reports the income and expenses of the business on a schedule (usually Schedule C) to his or her personal income tax return in:

Sole Proprietorships

What is the most prevalent form of small businesses in the US?

Sole Proprietorships

Why are Sole Proprietorships often a poor choice?

because the owner has unlimited liability for the losses of the business, thereby putting all of the owner’s personal assets at risk

Corporation =

• a distinct legal entity owned by its shareholders

• It has an unlimited life and free transferability of ownership, so its existence is not affected by changes in its ownership resulting from transfers of stock by shareholders (or upon a shareholder’s death) or the issuance of new shares by the corporation

• If an individual shareholder dies, that person’s shares are transferred to the shareholder’s heirs

Unlike a partnership, a corporation may:

be owned by a single person who can be the corporation’s sole director and serve as any or all of the required officers (e.g., president, treasurer, and secretary)

The shareholders elect the corporation’s:

board of directors but are generally otherwise not active in the management of the corporation

Shareholder approval is required for certain major transactions, however, such as:

a sale of all the corporation’s assets

The board of directors is responsible for:

appointing the officers, who serve at the pleasure of the board; setting executive compensation; authorizing the sale of stock or the issuance of stock options; approving the corporate strategy; and making other longer-term corporate decisions.

Day-to-day management is carried out by the corporation’s:

officers

A principal advantage of the corporate form—which is a feature it shares with the LLC—is:

the limited liability it provides to its equity holders: creditors are limited to the assets of the corporation for payment and may not collect directly from shareholders if corporate assets are insufficient to pay all debts and liabilities

Other advantages of the corporate form include:

its familiarity and well-understood governance laws, its permanence, the ability to transfer corporate stock more easily than partnership or LLC interests (particularly in the public securities markets), and the ease of designing equity incentive plans for employees

Under the alter ego doctrine:

a court may disregard the corporate entity and hold the shareholders personally liable for the corporation’s obligations if the shareholders used the corporation to perpetrate a fraud or promote injustice

In determining whether to pierce the corporate veil, that is, whether to disregard the corporate form and make the shareholders directly liable for the corporation’s obligations, a court will examine many factors, such as:

1. Was the corporation undercapitalized, given the risks inherent in its business?

2. Were corporate assets used for personal reasons?

3. Were corporate assets commingled with personal assets?

4. Were the corporate and personal books kept separately?

5. Were corporate actions properly authorized by the board of directors or the shareholders?

To preserve limited liability for its shareholders, the corporation should observe at least the following procedures:

1. Start the business with sufficient equity and liability insurance in light of the future capital needs of the business and its inherent risks.

2. Conduct annual shareholders’ meetings and regular board meetings.

3. Obtain and record shareholder and board authorization for corporate actions.

4. Prepare accurate minutes of shareholders’ and board meetings and maintain as part of the corporate records.

5. Keep corporate funds separate from personal funds.

6. Maintain complete and proper records for the corporation separate from personal records.

7. Make clear in all contracts with others that they are dealing with the corporation, and sign all contracts as shown

8. Maintain an arm’s-length relationship between the corporation and any principal shareholder. Transactions with any of the directors or principal shareholders (or entities in which they have an interest) must be fair to the corporation and should be subject to approval by the disinterested members of the board, if any, without the vote of the interested directors, after all facts material to the transaction have been fully disclosed.

Make clear in all contracts with others that they are dealing with the corporation, and sign all contracts as shown:

[CORPORATE NAME]

By: ________

________

[Name and Title of Person Signing]

Unless a corporation elects to be taxed as an S corporation, it is taxed on its net income as a:

separate legal entity

A corporation that does not elect S corporation treatment is sometimes referred to as a:

C corporation because it is taxed under Subchapter C of the Internal Revenue Code

Under federal income tax law in effect on January 1, 2016, a corporation is taxed on its:

net income (gross income less allowable deductions) at rates ranging from 15% to 35% (e.g., the rate generally is 34% on income greater than $75,000 up to $10 million)

The gain on property, other than money, contributed to a corporation (generally equal to the fair market value of the property at the time of transfer less its cost) will generally be subject to tax payable by the contributor unless:

the person, or group of persons, contributing the property (including persons in the group contributing cash in the same transaction) owns at least 80% of the corporation after the contribution of property

For example, if three individuals contribute a combination of appreciated property and money in exchange for 85% of the corporation’s stock, then:

no tax is due at the time of transfer

When a corporation distributes money or other property to its shareholders in the form of dividends, the shareholders must:

pay the tax on the fair market value of that dividend income

f the property the corporation distributes to shareholders has increased in value since its acquisition by the corporation, then the corporation also incurs:

income taxes on that appreciation as if it sold the property for an amount equal to its fair market value then distributed the proceeds to its shareholders

Although most of the tax aspects of C corporations are generally unfavorable as compared with the forms discussed below, a potential tax benefit of the C corporation form is:

its ability, depending on the circumstances, to issue qualified small business stock (QSBS)

QSBS is generally stock that:

(1) is acquired by a shareholder directly from the corporation at original issue in exchange for money, property (other than stock, with certain exceptions), or services and

(2) meets various requirements, including most notably that the issuer’s aggregate gross assets at the time of issuance not exceed $50 million.

Benefits of QSBS:

• sale of QSBS after more than five years qualifies for partial or full (depending on the year in which the QSBS was acquired) exclusion of the resulting gain from taxable income, subject to certain statutory limits

• certain reinvestments of proceeds of sales of QSBS in other QSBS can qualify for tax-free rollover of the gain

QSBS can only be issued by:

domestic C corporations

An S corporation is the same as any other corporation except for:

the way it is taxed

For S corporations, the IRS permits:

certain shareholders to operate as a corporation while taxing them on the corporation’s net income as individuals

S corporations generally do not:

pay federal income tax but pass the tax liability for their profits through to their shareholders

Consequently, profits earned by an S corporation typically will be taxed only:

once

Similarly, an S corporation’s losses flow through to the:

shareholders and may be deducted by the shareholders on their individual tax returns, subject to certain significant limitations, including the inability to use the S corporation’s “passive losses” to offset the shareholders’ salary or other earned nonpassive income

For S corporations, Profits and losses must be allocated based on:

share ownership for taxation purposes

A distribution of earnings by an S corporation to its shareholders is generally not taxed a second time. In contrast, a similar distribution by a C corporation will be taxed:

twice: the C corporation must pay federal corporate income tax on profits when earned, and shareholders must treat distributions as dividends subject to tax

Shareholders generally elect S corporation status when they:

expect that the corporation will be profitable and distribute substantially all of its profits to the shareholders, or when the corporation is expected to incur losses and the shareholders wish to use the loss deductions on their personal income tax returns

The case for S corporation status is weaker when:

the corporation is owned solely by insiders who work for the company and receive their share of the profits in the form of salary and bonuses, which are normally deductible as expenses by the corporation

To qualify for S corporation status, the entity must be a domestic (U.S.) corporation and satisfy the following requirements:

1. The corporation must have no more than 100 shareholders.

2. All of the shareholders must be individuals who are U.S. citizens or resident aliens (noncitizens of the United States who hold green cards or otherwise are treated as residents for U.S. tax purposes), certain tax-exempt organizations, or qualifying trusts or estates, so none may be partnerships, limited liability companies, corporations, or nonresident aliens (non-U.S. citizens not entitled to reside and work permanently in the United States).

3. The corporation must have only one class of stock (although options and differences in voting rights are generally permitted).

The requirement that an S corporation essentially have no shareholders other than individuals will prevent:

any business that intends to raise equity capital from venture capital funds, corporations, or other institutional investors from qualifying as an S corporation after such investors acquire stock

In addition, because an S corporation can issue only common stock, it must issue the stock to founders and employees at:

the same price paid by the outside investors (unless the stock was sold to the founders and other employees well in advance of the sale to the investors) if the employees are to avoid being taxed on receipt of their “cheap stock”

In contrast, when there are two classes of stock, the company will usually issue:

convertible preferred stock to the outside investors and common stock to founders and other employees

common stock lacks:

the liquidation, dividend, voting, and other preferences that the preferred stock possesses

• so it can typically be issued at a cheaper price than the preferred stock without causing the founders and employees to incur any significant tax liability upon receipt of their common stock

the S corporation is most commonly used for:

family or other closely owned businesses that obtain capital from their individual shareholders or debt from outside sources and do not provide equity incentives to their employees on any significant scale

A qualified corporation may elect to be taxed as an S corporation by:

filing Form 2553 with the Internal Revenue Service, together with the written consent of all the shareholders & This election must be filed no more than two months and fifteen days after the beginning of the taxable year of the corporation for which S corporation status is to be effective

partnership =

a business carried on by at least two persons

A partnership is generally treated as:

a distinct legal entity separate from its partners

3 types of partnerships:

• general partnership

• limited partnership

• limited liability partnership

general partnership =

each partner is a general partner with unlimited liability for the debts of the partnership and the power to incur obligations on behalf of the partnership within the scope of the partnership’s business

In general partnerships, iability concerns, such as potential claims for personal injuries or those resulting from errors or omissions, can be alleviated through:

insurance

limited partnership =

has one or more general partners (each of whom has the same liability and power as a general partner in a general partnership) and one or more limited partners

The limited partners’ liability is limited to:

the amount of their capital commitment

Generally, limited partners may not participate in:

the control of the partnership, or they will be treated as general partners for liability purposes

limited liability partnership =

• a hybrid used by certain professional partnerships (such as law and accounting firms) that are restricted by state law from organizing as limited partnerships

• each partner can participate actively in the business and has unlimited personal liability for his or her own actions (such as medical malpractice) but is liable for the misdeeds of other partners only to the extent of the partnership’s assets

Unlike a corporation, a partnership generally will dissolve (cease to exist) on the:

death or withdrawal of a general partner unless the remaining partners elect to continue the partnership

the partnership agreement can provide for:

the buyout of a deceased or withdrawn partner, the election of a new general partner, and the continuation of the business of the partnership by the remaining partners

In a limited partnership, the death of a limited partner typically does not result in the liquidation of the partnership; the limited partnership interest can be passed on to:

the deceased limited partner’s heirs

How is a partnership created?

There must be a meeting of the minds: each party must intend to establish a business relationship with the other.

Unlike a general partnership, a limited partnership requires:

a written partnership agreement signed by all the partners

The limited partnership must also file a certificate with:

the applicable secretary of state

For the protection of the parties,

what is strongly suggested for both general and limited partnerships?

a detailed written partnership agreement

boilerplate =

standard forms in making partnership agreements — should be avoided, because they are not tailored to the particulars of the partners’ relationship

A key attraction of a partnership is that it pays no:

income tax at the entity level

tax law restricts the ability of partners to deduct ____ from salary and other forms of earned nonpassive income?

“passive losses”

Other tax limitations prevent a partner from deducting losses that exceed his or her:

tax basis (the amount paid for the partner’s partnership interest plus his or her share of partnership liabilities, as adjusted over time to reflect allocations to the partner of income and loss)

Section 351 of the Internal Revenue Code generally permits a partnership to convert to:

a corporation without tax if the incorporation is properly structured

Once a partnership converts to a corporation, however, any distribution from the corporation will typically be subject to:

two levels of tax: a corporate tax and a shareholder tax

publicly traded partnerships are taxed as:

corporations

a business that expects to attract capital from a venture capital fund generally should not organize as a:

partnership, or the founders should expect that it may be necessary to convert to a C corporation as a condition to obtaining venture capital financing

A properly structured limited liability company (LLC) combines:

the pass-through federal tax treatment of a partnership with the liability protections of a corporation

The owners (referred to as members) of an LLC have no personal liability for the obligations of the LLC but:

as is also true for corporate directors and officers, members and managers still have personal liability for their individual acts and omissions in connection with the LLC’s business

all stationery and business cards used by managers and members of an LLC should include:

the name of the LLC and its status as a limited liability company if that is not clear from the name itself

as with officers of corporations, a member or manager of an LLC should execute contracts as follows:

[NAME OF LIMITED LIABILITY COMPANY]

By: _________

_________

[Name and Title of Person Signing]

4.5 From the Trenches Example:

The Colorado Supreme Court held that Lanham and Clark could be personally liable because they did not clearly disclose that they were acting for P.I.I., an LLC. Although P.I.I. was properly formed, the business card only said “P.I.I.” without identifying the company as an LLC. Under agency law, agents of a partially disclosed principal can be personally liable for the principal’s obligations.

ownership of an S corporation is limited to:

100 shareholders, all of whom must be individuals, certain tax-exempt organizations, qualifying trusts, or estates, and none of whom may be nonresident aliens; in addition, the S corporation can have only one class of stock

LLC can be formed with:

only one owner

What are the two principal charter documents for LLCs?

• certificate of formation (Delaware) or articles of organization (California)

• operating agreement

What is this certificate of formation (Delaware) or articles of organization (California)?

a short, one- to two-page document filed with the secretary of state, which sets forth the name of the LLC, its address, its agent for service of process, the term (which may be perpetual), and whether the LLC will be governed by the members or by managers appointed by the members

LLC operating agreement?

specifies how the LLC will be governed; the financial obligations of the members (e.g., additional capital calls could be forbidden, voluntary, or mandatory); and how profits, losses, and distributions will be shared

An LLC is generally not the optimal entity form for businesses financed by venture capital funds because of:

tax restrictions on the funds’ tax-exempt and foreign partners

An LLC is the entity of choice for a startup entity seeking to flow through losses to its investors because:

(1) unlike a limited partnership, which does not provide limited liability for its general partner, an LLC offers the same complete liability protection to all its members as does a corporation;

(2) an LLC can have corporations and partnerships as members (unlike an S corporation) and is not subject to any of the other limitations that apply to S corporations; and

(3) losses can be specially allocated entirely to the cash investors (in an S corporation, losses are allocated to all the owners based on share ownership).

Three issues are critical in selecting the form of business entity:

(1) Who will be the owners of the business?

(2) How does the business expect to distribute its earnings to its owners? and

(3) Is the business expected initially to generate losses or profits?

If ownership interests in the business will be widely held, however, the ____ is usually the entity of choice?

C corporation

If ownership interests in the business will be provided to employees, the ____ will generally be the preferred?

C corporation

If ownership interests in the business will be provided to employees, the C corporation will generally be the preferred entity for several reasons:

1. stock ownership is easier to explain to employees than equity interests in partnerships and LLCs

2. creating favorably priced equity incentives is easy to accomplish in a C corporation because ownership can be held through various classes of stock

3. the common stock can be sold to founders and employees at a discount from the convertible preferred stock issued to investors because of the special rights and preferences of the preferred stock

4. tax law gives favorable tax treatment to incentive stock options (ISOs) granted by a corporation

the holder of an ISO generally incurs no tax until:

the shares purchased through an option exercise are sold—other than potential alternative minimum tax upon exercise of the ISO. The recognized gain is taxed at the more favorable long-term capital gains rate, rather than as ordinary income, provided certain holding periods are met

Incentive stock options are available only for:

corporations