Why Do It?
It was perhaps a decade ago and one of our French clients was sitting across my desk from me as we discussed methods of incorporation when suddenly he looked up, grinning. “You are so lucky, you know. You live in the country made to do business. I can set up a business and be in operation with all the protections I need in a week or so. In France it would take me six months to two years. I am in heaven!”
Most Americans do not realize how business friendly the United States is, how it promotes and facilitates people taking the risk of starting their own business. We occasionally hear complaints about how difficult it is in California to meet various government requirements, pay the taxes, handle employment issues. In reality, anyone with common sense and willingness to learn the basics can start a successful business and there is nowhere in the world where it is so easy. The United States is the most business friendly nation in the world. It even allows you to choose the State in which to incorporate to meet your needs. Even California has a special tax break for new corporations, however small their capitalization. If you are considering starting a business…this is the place to do it.
You do need to do your homework. You need to make your business plan, check your market, plan your finances, pick the right associates, and get a skilled set of professionals to give you the right advice. Those professionals include a good accountant and a good attorney. You need to set up the right structures to protect you and your family, you need to learn some law and the taxes involved and you need to consult with your team as time goes by to adjust to changes in your business. It is not so difficult and will be second nature in a few months.
Is it worth it? One goes into business for a variety of reasons but most of them boil down to a single goal: to have control of your own financial life. To create something new that can bring you wealth and is your own creation. It may fail or not, but if it fails it will be based on your own actions, not a decision by someone else in a back office in the company you may work in now.
There is risk. Many start ups fail. But there is risk in all business and the massive layoffs at the largest entities have demonstrated that the risk of working in a large company…or even the government…is far from small. And if it is your own business, you have more control of the business decisions made. Another client put it well. “I may fail, but if I fail it’s because of my own mistakes, not some MBA who I never met going through figures in a back room.”
And if you succeed, there is no limit to the success possible. Look around. Every business you see was once a small operation begun by one or two people with dreams. The main reason you are doing this is you think you can do it. And you can. The stories are too numerous to cite, but our own firm has seen perhaps four dozen people begin with less than ten thousand dollars and end up with multimillion dollar businesses. We have seen an Italian immigrant come with twenty five dollars in his pocket and end up owning twenty five million dollars of property. We have seen holocaust survivors arrive with a few thousand dollars borrowed from local family and die owning over a hundred million dollars in apartment houses. We have seen doctors become rich selling a device that they made in their garage on weekends. We have seen college students fiddling with a computer create a program that is popular in Brazil and worth millions of dollars.
And we have seen some failures. One client, who saw his market share destroyed by a new multi state retail outlet opening up two blocks away, finally closed his doors and was considering what to do next.
Several weeks of turmoil within his family passed, his wife terrified of what their future may be. She wanted him to simply get a job with a weekly paycheck, at least for the time being.
Instead, he opened up a similar operation two miles down the road and after some rocky going for a year, he had a viable business. I once asked him why he jumped into yet another business. I still have his letter to me. “It is fun creating something. Owning something you created. It’s not fun getting a pay check. Of course there’s risk. Without the risk, there would be no fun.”
But he also took the steps to protect his family described below in detail and was careful in his creation of structures, tax planning, employment and, eventually, choice of partners. He was not a fool…but he did love the challenge.
This article gives the basic legal and structural issues you should ponder before beginning your business…or expanding it if you already have a business. Print it out and take the time to read it over a few days since it is thick with information and advice. And, if you still want to take the plunge after considering the issues and the market, do it. You may fail. One millionaire we represented failed three times before he hit gold and had a successful business. He told us that failure kept making him better at business. He joked that if he failed enough, he would be the best businessman in the world. “You learn from failure, not success,” he said.
The goal of this article is to minimize the chances of that type of lesson being forced upon you.
LIMITED LIABILITY ENTITIES-WHAT ARE THEY AND WHY YOU WANT ONE
A limited liability entity (a corporation or an Limited Liability Company (LLC)) provides both financial benefits and protection from liability. Among the financial benefits is the ability to deduct more business expenses from annual revenue when calculating taxable income than would be possible without an entity. Forming a limited liability entity also helps protect your personal assets in the event of a lawsuit or from creditors in a situation where your business’s liabilities exceed its assets.
This means that as the owner of limited liability entity, your personal assets will not be placed at risk because of the actions of your company, provided you maintain the company's assets and activities separate from your personal ones.
See our articles on Limited Liability Entities and Why Create a Corporation?.
To avoid personal liability despite the limited liability structure, you have to:
- Ensure that the company is initially adequately capitalized (it has the money necessary to cover the reasonably predictable legal and business responsibilities of the business);
- That the company keeps clean accounting books and has accounts that are separate from the personal accounts of its owners or employees;
- and that all legal documents are adequately maintained and the company complies with corporate governance laws. See our article Piercing the Corporate Veil for a longer discussion.
Forming a corporation or LLC also usually makes it easier for a business to borrow money and to sell all or parts of the business in the future. It is important to note that the longer a business operates without a legal entity, the more complicated and expensive it becomes to transform it into one. For this reason it is very important to form a legal entity as soon as feasible.
THE CHOICE BETWEEN A LLC AND A CORPORATION
The corporation is the oldest limited liability structure invented and has more statutes and case law involving it so that the rules are crystal clear as are the rights and duties of various owners and officers. Limited Liability Companies are relatively recent creations, at least in the United States, have far less law and case law, are more flexible in their structures, and require more thinking as to the initial creation since the owners have far more power to alter the roles and duties.
The corporation is made up of three groups of people – the shareholders, the board of directors and the officers, although the same person can and usually do hold multiple positions. If the company is sold publically, very stringent State and Federal requirements apply and it is quite expensive to set up. Assuming stock is not sold publically but to a relatively small group of people, it is considered a non public company and easily created.
The board of directors is formally elected by the shareholders and represents their interests. It is the board of directors that hires the officers of the company, also known as the management. The management’s job is to oversee the day-to-day operations of the company. Major decisions, however, require the approval of both the shareholders and the board of directors. See our article on Who Has Power When Push Comes to Shove.
A corporate structure is thus a highly organized and rigid structure of governance that can be seen as burdensome though the actual annual paperwork and meetings probably takes less than four or five hours. A corporation requires annual meetings be held for shareholders and the board of directors. However, the structure is known and trusted worldwide, has worked well for almost two hundred years and having clear rules and duties can help when there is dispute among the owners.
LLC stands for “limited liability company”. Generally it provides the same legal protections from personal liability as a corporation, but is governed more like a partnership than a corporation. Whereas a corporation’s owners are called shareholders, the owners of an LLC are known as members. An LLC does not require a board of directors or even officers and can simply be managed directly by its members, if so desired. It can also be structured more like a corporation, with managers that are distinct from its owners.
LLCs allow for significantly more flexibility in structure than do corporations. For instance, the owners of an LLC can allocate distributions in whichever way they see fit. Even if the ownership of an LLC is split 60/40, the owners can decide to split the profits 50/50 - something that is not possible in a corporation without a significantly more complicated structure, though simply adjusting salary among the owners of the corporation can achieve much the same thing.
Both an LLC and a corporation cost about the same to create, with the LLC in California being slightly more expensive in the cost of documents to be created and with the LLC, as of 2012, not receiving a waiver of the first year’s minimum franchise tax which is allowed to corporations in California. The reader should assume that both types of entities will cost between $2500-4500 to create, once taxes, lawyer fees, CPA fees and books and seals are taken into account. The LLC may cost a thousand or two thousand more. One can seek to create one’s own structure and there are numerous books and on line sources with prefabricated forms for creating the documents. You will still need good tax advice, thus a CPA, but can save a perhaps $1500.00 in attorney fees by creating your own documents. There are risks, so before deciding to make your own structure without counsel, read Preprinted Forms Don’t Go to Trial.
CORPORATION OR LLC?
If the business only has a few investors and does not anticipate receiving third party outside financing in the near future, an LLC is a useful choice because of its flexibility, simplicity, and pass-through taxation as discussed below which allows the likely initial losses for the start up period to be deducted from personal tax returns. This is especially true if the entity does not meet the S-corp. election requirements.
However, if one wants a board of directors that is distinct from the officers and/or shareholders of the company, or if outside investors are a goal, then a corporation is probably a better form of entity because of its more organized and established structure of governance.
There are also fairly complex differences on how franchise taxes are calculated for S-Corps and LLCs depending on the jurisdiction, revenue, and profit of the company, so good advice from a good CPA is required to determine which fits the specific financial situation.
What is pass-through/flow-through taxation?
In a pass-through (or flow-through) entity, the entity’s income and expenses "pass through" the entity and are treated as the income and expenses of its owners. LLCs and S-Corporations are pass-through entities. This differs from a C-Corporation which is taxed a corporate income tax at the end of the fiscal year in addition to the personal income taxes and dividend taxes that its owners and employees pay.
Federal corporate income tax is about 15% to 35% of profits, and most states also have corporate income tax. This means after a C-Corporation has paid its expenses for the year, it will be taxed at least 15%-35% of whatever is left above the amount the company started with that year. If the company is an LLC or an S-Corporation, there is no corporate tax, and indeed the owners can even apply losses of the company against their personal income. This is more of a theoretical advantage than a real one since most small corporations utilize salaries and bonuses to shift all income to the owners in any event.
What is an S-Corporation and what are its requirements?
S-Corporations are corporations that elect to be treated as pass-through entities by the IRS by filing an S-Corp election. In order to qualify for S-Corporation status a corporation needs to satisfy several conditions, including the following: 1) all shareholders must be residents of the United States; 2) the corporation may only have one class of shareholders and may not have more than 75 shareholders; and 3) the company’s shareholders must be any of the following: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S corporations (but only if the other S corporation is the sole shareholder). This means S Corporations may not be owned by other C-Corporations, LLCs, or foreign residents. If any of the requirements are not met at any time, the corporation automatically loses its S-Corporation status and will be treated as a C-Corporation.
There are other numerous decisions inherent in electing Sub S status and if there is a dispute within the company the fact that it is an S type corporation can have significant ramifications for the individual shareholders. Good tax and legal advice is critical before electing Sub S status.
What are the tax benefits of making an S-Corporation Election?
Many small business owners incorporate their businesses not only for legal protection, but also to reduce owners’ payroll taxes through S-Corp tax election with the IRS. One advantage of an S-Corp over a sole proprietorship, partnership, or disregarded entity is that it gives business owners the ability to reduce their self employment taxes. Any small business owner who has not made an S-Corp election and uses Schedule C for their personal tax return is subject to both employer and employee FICA and Medicare payroll taxes. If the owner of an S-corporation pays himself/herself a “reasonable salary”, the rest of the net income is not subject to these payroll taxes.
Often sizable losses are suffered by companies during their start up periods. Such losses can be valuable to potential owners who may have income they wish to offset. And it is possible when the business turns around to convert to a C status though it is vital to get good tax advice before abandoning the Sub S election and note that not all shareholders may have the same tax situation.
Can an LLC get the tax benefits of an S-Corp Election?
An LLC can be treated as an S-Corporation for tax purposes if it makes an S-Corporation election as long as the entity meets the IRS criteria to be taxed as an S-Corp, files an S-Corp election and gets approved by the IRS to be taxed as an S-Corporation. Without an S Corporation election, single member LLCs default to be taxed as sole proprietors and a multimember LLCs defaults to be taxes as partnership since they are considered “disregarded entities” unable to get the tax benefits of an S-corp. election. However, if a single or multiple member LLC agreement meets the IRS criteria to be classified as an S-Corp, and the S-corp. election is filed and approved by the IRS, then for tax purposes (not legal purposes), the entity is treated like an S-Corporation.
Where should I form my entity?
This can be an important question and the answer depends on goals. Much depends on the initial plans for the company and the relationship between the parties. There are states which seek to have potential companies chose them as the locale to incorporate to increase their own tax base and they offer such incentives as low tax rates and laws that favor the majority owners and officers of the company at the expense of the minority owners. There are other states whose business climate is healthy and vibrant enough that they do not need to offer such incentives and have developed much statute and case law that protects third parties and minority owners and which are often held in high regard by potential investors. Put simply, California, Illinois, Massachusetts, Florida, Texas and New York have fair and extensive law for entities and do not need to bias the law to the majority owners and directors to encourage companies to want to do business in those states and incorporate there.
If you are to be a minority owner, states that protect the rights of minority owners (via cumulative voting, for example) should be your choice. If you are one of the founders and do not want to spend time and energy worrying about outside investors or the needs of minority owners, different states offer that option. And if you are going to engage in business mostly in a particular state, it is wise to choose that state for incorporation since the taxes and laws imposed are normally based on where the business is conducted.
If you are looking to grow the company and get outside investment money, then it is common to form an entity in Delaware. That state is famous for organizing companies that are anonymous, have few protections for shareholders, and allow easy operation for the officers and directors under their laws. Not surprisingly, more recently that state is under increasing scrutiny by various state and federal officials since the state’s efforts to attract new companies have resulted in numerous shells from off shore that may be of dubious integrity. The reputation of an entity in that state may actually be hurt by choosing it, though bringing in new shareholders may be easier than such states as California or New York.
As of this writing, Delaware is still a favorite state for startups that will engage in interstate business. Nevada is another popular state due to its low tax rate. Any attorney can normally incorporate you in any state in the United States.
BUY AND SELL AGREEMENTS FOR THE ENTITY RIGHT NOW
It is increasingly common for shareholders of a non public corporation to provide for the purchase of their shares by the company or the other owners in the event of death, disability or divorce. Usually, a formula for evaluation is created and a specified time period allowed for the buyout.
For a typical example, if a shareholder dies, his or her shares are repurchased by the company for a formula of book value plus his or her share of an average year’s gross sales. Ten percent down, five percent interest, ten years to pay the rest.
The benefits to all the parties are important. The company can cash out a potentially desperate family and avoid having inexpert owners hoping for cash from the income of the company. This can avoid fights as the spouse of the deceased shareholder demands monies from operations. The same method is used for divorce or disability of a shareholder. From the point of view of the deceased owner’s family, they have a cash flow, are not forced to try to influence a company owned by others, and have an entity willing to purchase them out for a fair price over time.
All this requires a buy and sell agreement which needs to be executed by all the owners and their spouses. It is well worth while. See our article Buy and Sell Agreements-The Purpose for a fuller discussion.
Note that the agreement can provide buy out in the event of divorce and the formula in the agreement, which must be fair, is enforceable in the divorce court. That can be critical to avoid the extremely expensive fights that can occur as the uninvolved exspouse either tries to influence the company or seek such a massive evaluation of the ownership in the divorce courts as to ruin the remaining divorced shareholder.
NON COMPETE AGREEMENTS-NON DISCLOSURE AGREEMENTS
While working for a company, the fiduciary duty prohibits a employee or officer from competing with the company. However, can that same restriction apply if they leave the company?
It is important to differentiate between confidential information protection and noncompetes. Confidential information, if truly kept confidential by the company, is subject to protection after the employee leaves. However, many states, including California, prohibit restrictions on competition after the end of the relationship unless it is coupled with a full buy out of the departing fiduciary’s ownership interest. If the interest is bought out, reasonable noncompetes are enforceable in this State, reasonableness in terms of length of time and physical locale being required. This is one more reason for a Company to seriously consider entering into a Buy and Sell Agreement as soon as created.
It is a good idea to have non disclosure agreements executed by all employees with restrictions of their use of confidential information as well. Your company’s ideas, methods, organization, and products are entitled to varying degrees of protection. With products and secrets more esoteric and virtual than ever before, it is essential that expectations and responsibilities are set forth in black and white.
A nondisclosure agreement serves a dual purpose: it educates the employee or contractor and it protects the company. A clearly written nondisclosure agreement will tell your workers what his or her responsibilities are toward the company and what the law considers to be company property.
EMPLOYMENT ISSUES AND AGREEMENTS
Once an employment relationship exists, a company is required to adhere to applicable labor laws, regardless of whether a newly formed company has one employee or more.
Three agreements are vital to consider:
1. Employment or Service Agreements. A new company should determine which of its workers are employees and which are independent contractors. The workers’ status will determine what benefits he or she is owed during employment and at its conclusion. A new company is building its reputation not just for its product, but for its staff and for fairness as an employer as well. To this end, a company should have a written agreement to clarify for its workers and itself a position’s expectations, benefits and responsibilities. A written contract delineates scope and hours of work, how the relationship is to continue, and how it is to be terminated.
Assuming a company has minority shareholders who work for the company, it may be vital for them to have employment agreements as well. In California, there is no obligation on the part of the company to pay dividends or to sell itself. Thus, a minority owner may find he or she is not employed by the company, thus receiving no income, or receiving dividends, while the majority owners pay themselves good salaries and bonuses. In a Sub S setting this can be disastrous for the minority owner who must pay taxes on a prorate share of the income…but may have no sums distributed to him or her.
Thus, employment agreements may be essential to protect minority owners and such agreements should provide performance criteria, terms of employment, and anticipated sums to be paid. And, if coupled with the provisions described below, they also protect the company.
Note that there are numerous laws protecting employees, ranging from drug testing restrictions to protection from various types of harassment. Getting legal advice in advance and perhaps having written employee policies is important before that first hire.
2. Nondisclosure Agreements. As discussed above, nondisclosure may be essential for the company and employment agreements are a good place to put such clauses. If not in the employment agreement, a separate nondisclosure agreement can be created.
3. Non−competition Agreements. Can a part-time employee hold another job while working for you? Can he or she work for a direct competitor a year after he involuntarily leaves his employment? Does this change if he owns part of your business? What if the competitor is anywhere in the world instead of in the same country? Different states have different laws regarding the strictures that will be enforced once a worker leaves your company. These laws are affected by the stability of the economy. It is important for your company’s future and stability that you take full advantage of whatever protections the applicable law affords. Note that California will only allow restrictions on competition of ex employees if coupled with a buy out of all ownership interest, hence the need for a buy and sell agreement.
STOCK OPTION AGREEMENTS AND RESTRICTED STOCK AGREEMENT
Why have a stock option plan?
Startups often prefer to compensate using stock options because it does not require a cash outlay. In addition, employees may prefer the favorable tax treatment associated with stock options. Stock options also often give employees a stake in the long-term success of the company that salaries or bonuses often do not. The disadvantages is that the methodology can be complex and one may have more owners in the company than one wants. One owner put it well- “Cash is the cheapest way to pay them rather than stock if the company is successful and if it is not successful, we won’t be here to worry about it anyway.”
But many employees insist upon some type of potential ownership, as described below.
What is a stock option?
A stock option is the right to acquire a certain number of shares of stock for a specific price (“exercise price”). Usually, the employer does not permit an employee to exercise the right to purchase immediately on the date the stock option is issued. Rather, the right to purchase stock typically “vests” or accrues over a period of time or upon meeting certain company performance goals. This encourages employees to remain with the company for the rest of the vesting period or helps the company meet its goals.
What is restricted stock?
Instead of issuing stock options, some companies issue “restricted stock.” Restricted stock refers to stock that is transferred to an employee as compensation for services, subject to a vesting schedule. The employee usually is not required to pay for the stock. If the employee does not remain with the employer until the end of the vesting period, the stock must be returned to the employer. If the employee has paid any amount for the restricted stock but then fails to become vested, the employer usually refunds the purchase price to the employee. A discussion of the tax consequences of restricted stock is beyond the scope of this article but should be discussed both with your attorney and your CPA.
Given the complex legal, accounting and tax issues, a company should seek advice before implementing an equity compensation plan.
Tax consequences of Incentive Stock Options and Nonstatutory Stock Options
There are two forms of stock options: incentive stock options (“ISO”) and nonstatutory stock options (“NSO”). ISOs are different from NSOs in that ISOs receive favorable federal tax treatment if the option meets certain requirements of the Internal Revenue Code.
When granted, both ISOs and NSOs should have an exercise price that is not less than one hundred percent of the fair market value of the underlying stock. Neither ISOs nor NSOs are taxable upon grant to the employee or when the option vests. The difference between them lies in the tax consequences when the option is exercised.
When an NSO is exercised, the employee recognizes compensation (ordinary) income in an amount equal to the spread at exercise. An employee does not recognize taxable income on exercise of an ISO. However, the spread at exercise is includible in the employee’s federal alternative minimum taxable (“AMT”) income and may give rise to AMT tax liability.
If stock acquired upon exercise of an NSO is held for more than one year, any gain realized on the disposition of the stock is taxed at favorable long-term capital gain rates. ISOs must be held for at least two years from the date of grant and at least one year from the date of exercise to qualify for favorable capital gain tax rates. Otherwise, the employee recognizes compensation income that is taxed at ordinary income tax rates.
The other difference between ISOs and NSOs is in the benefit to the employer: for NSOs, the employer can take a deduction equal to the amount recognized by the employee upon exercise of the NSO. For ISOs, there is no deduction. The different aspects of ISOs and NSOs provide flexibility in tailoring an equity compensation plan to fit a company’s needs.
Keep in mind that the tax laws alter relatively often so the information above must be discussed with professionals before relying upon it.
THE THIRD PARTY CONTRACTS NEEDED: TERMS AND CONDITIONS; SALES CONTRACTS; VENDOR AGREEMENTS
Often the new business does an excellent job of creating internal documents but fails to create the terms and conditions for its own sales of goods or services that are crucial for business success. Equally troubling, they sign purchase orders for sizable materials and fail to even read much less understand the often complex and aggressive terms and conditions they agree to.
Most businesses do not fail due to internal dispute in the first year. Most businesses fail in the first year due to lack of sales OR sales to customers that are not paid for. To collect what is due requires planning since the cost benefit of suing someone can easily make such legal relief practically unavailable. See our article on terms and conditions and on cost benefit in litigation.
It is critical to obtain a good set of sales forms, purchase order forms, credit applications, guaranties, etc. Preprinted forms are available, some good, many not. See our article on Preprinted Forms Don’t Go to Trial before relying on such forms. Such issues as warranties and implied warranties and product liability must be considered…and of course liability insurance should be considered seriously for potential tort claims against the company.
Two terms you may wish to consider seriously is putting in arbitration and the prevailing party getting attorney fees in each and every contract. See our article on Arbitration of Business Disputes and Buying Justice.
BUSINESS LICENSES AND LOCAL TAXES
Do not forget that your local jurisdiction may have its own requirements for obtaining business licenses and imposition of local taxes, such as city and county taxes. These can have large interest and penalty provisions and can normally be determined via web site. We know of more than one company that created its own structure via excellent forms on line, succeeded in business for several years, and came into our office shocked at receiving a local tax bill for over a two hundred thousand dollars. They did not even know such taxes existed.
Sales tax law is changing due to the internet/web based sales and the interstate or international aspect of many sales. It is vital to consult with a good CPA to make sure sales tax is rightfully paid and the cost of same incorporated into your sales documents.
And professionals need to understand the license and structural requirements that apply to them. See our article on Professional Corporations.
YOUR PROFESSIONAL TEAM:
Any smart business person will surround him or herself with experts that can assist in protection and prediction. Your task is to do your business. You are not a tax expert, a legal expert or, quite often, a marketing or web expert. You need to find people who are good, affordable, energetic and proactive so that you can find an answer in a telephone call that otherwise you would take you hours to determine or, worse yet, you would not even know to ask the question. It’s often not the answer to a question that is a problem but the fact that the question was never asked until it was too late.
The team should work together as a unit, should know and respect each other, and should take an active interest in your future. Shop for a good professional as you would shop for anything else of critical value. Interview them, ask the questions, and get advice from as to where to look from other business people you may know.
Any good experienced CPA will know lawyers to recommend and any business lawyer has a battery of good CPAs to recommend.
CONCLUSION
The above requirements can seem overwhelming to the new business owner and are too often ignored with negative results arising in months or years in the future. In reality, it is less difficult to put the package together than to apply for social security or select a medical insurance plan. And, if done right, all this maximizes the chances for success.
Once the package is complete, one can then concentrate on building and preserving the business that is created. Know that there is no other country in the world where a business can be started from scratch in a week or two, where the government encourages the creation of new businesses and where the populace, as a whole, holds entrepreneurs in such high regard.
Even those nations such as China which now encourage business are devoid of a legal system anyone can trust and often require constant bribes to most local officials. Those nations seeking to emulate the American system of entrepreneurship, such as Brazil and Argentina, consciously study the methods and laws of the United States to see how to create a vibrant economy.
And, as one new business owner commented to me as I complemented her on her efficiency in creation of the business, “If I can’t put this together right at the beginning, I’d better think twice about putting my money on the line.”