Chapter 21 - Starting a Business: LLCs and Other Options

Question 1

What is a Sole Proprietorship?

Answer 1

An unincorporated business owned by one person.

Question 2

What happens when an individual runs a business without taking any formal steps to create an organization?

Answer 2

She automatically has a sole proprietorship.

Question 3

What are some basic business things a sole proprietorship is not required to do?

Answer 3

• Not required to hire a lawyer
• Not required to register with the government
• Not required to register a separate tax return

Question 4

How does the sole proprietorship’s profits and losses get reported?

Answer 4

They flow through to the owner and are reported on their personal return.

Question 5

What are the two main disadvantages of a sole proprietorship?

Answer 5

• The owner of the business is responsible for all of the business’s debts.
• 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 membership to sell. If someone else brings in capital and helps with the management of the business, then it is a partnership, not a sole proprietorship.

Question 6

What are the five areas in which a corporation can be an improvement over a sole proprietorship?

Answer 6

Limited Liability
Transferability of Interests
Duration
Logistics
Taxes

Question 7

What is the liability situation for a corporation and/or the shareholders?

Answer 7

Shareholder of a corporation have limited liability. They can lose their investment, but not their other assets.
However, individuals are always responsible for their own acts.

Question 8

What is the transferability of interest benefit in a corporation?

Answer 8

Ownership interests in a partnership are not transferable without the permission of the other partners, whereas corporate stock can be easily bought and sold.

Question 9

What is the duration benefit of a corporation?

Answer 9

A corporation exist perpetually, beyond the death of the founders (unlike a sole proprietorship).

Question 10

What are the logistics of having a corporation? 4

Answer 10

• Require large expense and effort to create and operate
• Cost of establishment includes legal and filing fees and cost of annual filings that states require.
• Must hold annual meetings for both shareholders and directors.
• Minutes of the annual meetings must be kept indefinitely in the company minute book.

Question 11

What is the tax situation of a corporation?

Answer 11

They are taxable entities. They must pay taxes and file returns. They pay income tax on their profits, and then their shareholders must then pay taxes on dividends from the corporation resulting in the possibility of double taxation.

Question 12

What is a close corporation?

Answer 12

Generally, a company whose stock is not publicly trades. Also known as a closely held corporation. This is a state designation.

Question 13

What is an S Corporation

Answer 13

A small corporation as termed by the federal government

Question 14

Are a close corporation and an S Corporation the same thing?

Answer 14

Both a regular and a close corporation can be either a C or an S Corporation, and vice versa.

Question 15

What is the benefit to shareholders of an S Corp?

Answer 15

They have both the limited liability of a corporation and the tax status of a partnership.

Question 16

Is an S Corp a taxable entity?

Answer 16

No. All the profits and losses pass through to the shareholders, who pay tax at their individual rates. They can deduct losses against their other income as well.

Question 17

What is the term for a regular corporation?

Answer 17

A C Corporation.

Question 18

What are the major restrictions of an S Corp? 5

Answer 18

• There can only be 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
• Shareholder must be citizens of the US, not nonresident aliens.
• All shareholders must agree that the company should be an S Corporation.

Question 19

What are the common themes of the provisions granted to close corporations by some states?

Answer 19

• Protection of minority shareholders
• Transfer Restrictions
• Flexibility
• Dispute Resolution

Question 20

What is covered under the transfer restrictions provisions sometimes granted by states to close corporations?

Answer 20

The shareholders of a close corporation often need to work closely together in the management of the company. Therefore, statutes typically permit the corporation to require that a shareholder first offer shares to the other owners before selling them to an outsiders. In that way, the remaining shareholders have some control over who their new co-owners will be

Question 21

What is covered under the flexibility provisions sometimes granted by states to close corporations?

Answer 21

Close corporations can typically operate without a board of directors, a formal set of bylaws, or annual shareholder meetings.

Question 22

What is covered under the protection of minority shareholder provisions sometimes granted by states to close corporations?

Answer 22

Being as there is no public market for the stock of a close corporation, a minority shareholder who is being mistreated by the majority cannot simply sell his shares and depart. Therefore, close corporation statutes often provide some protection for a minority shareholder. For example, the charter of a close corporation could require a unanimous vote of all shareholders to choose officers, set salaries, or pay dividends. It could grant each shareholder veto power over all important corporate decisions.

Question 23

What is covered under the dispute resolution provisions sometimes granted by states to close corporations?

Answer 23

The shareholders are allowed to agree in advance that any one of them can dissolve the corporation if some particular event occurs or, if they choose, for any reason at all. If the shareholders are in a stalemate, the problem can be solved by dissolving the corporation. Even without such an agreement, a shareholder can ask a court to dissolve a close corporation if the other owners behave “oppressively” or “unfairly”.

Question 24

What is the liability and tax status of an LLC?

Answer 24

It offers limited liability of a corporation (members are not personally liable for the debts of a company) and the tax status of a partnership (income flows through the company to the individual members, avoiding the double taxation of a corporation.

Question 25

How does the formation of an LLC work? What is a charter? What is an operating agreement?

Answer 25

To organize an LLC, you must have a charter and you should have an operating agreement

A charter contains basic info, like name and address, and it is filed with the Secretary of State in the jurisdiction in which the company is being formed.

An operating agreement sets out the rights and obligations of the owners, called members.

Question 26

What are the aspects of the flexibility an LLC has?

Answer 26

Unlike S Corps, LLCs can have members that are corporations, partnerships, or nonresident aliens. LLCs can also have different classes of memberships. Unlike corporations, LLCs are not required to hold annual meetings or maintain a minute book.

Question 27

What are the aspects of transferability of interests in an LLC?

Answer 27

Unless the operating agreement provides otherwise, the members of an LLC must obtain the unanimous permission of the remaining members before transferring their ownership rights. This is yet another reason to have an operating agreement. LLCs cannot issue stock options, which is a potentially serious problem because options may be an essential lure in attracting and retaining top talent.

Question 28

What is the duration of an LLC?

Answer 28

The trend in state laws is to permit an LLCs to continue in operation, even after a member withdraws.

Question 29

What happens when an LLC goes public? What are the advantages and disadvantages of taking an LLC public?

Answer 29

Once in LLC goes public, it loses its favorable tax status and is taxed as a corporation, not a partnership.

There are no advantages

Disadvantage
-Unlike corporations, publicly trades LLCs do not enjoy a well-established set of statutory and case law that is relatively consistent across many states. For this reason, privately held companies that begin as LLCs usually change to corporations when they go public

Question 30

Can the LLC Veil be pierced? Why, why not?

Answer 30

If corporate shareholders do not comply with the technicalities of corporation law, they may be held personally liable for the debts of the organization.

Question 31

Why is there legal uncertainty for LLCs?

Answer 31

It is a relatively new form of organization without a consistent and widely developed body of law. One area of uncertainty involves manager’s duties to the members of the organization (It is unclear in many jurisdictions if managers of an LLC have a legal obligation to act in the best interest of members).

Question 32

What are the four main reasons venture capitalists almost always refuse to invest in LLCs, preferring C Corps instead?

Answer 32

• Complex tax issues
• C Corporations are easier to merge, sell, or take public
• Corporations can issue stock options
• General legal uncertainty involving LLCs

Question 33

What are two advantages of a Partnership?

Answer 33

• Easy to Form

- They do not pay taxes

Question 34

What are four disadvantages of a Partnership?

Answer 34

• Liability - Personally liable for debts of the enterprise
• Funding - Financing may be difficult because it can’t sell shares. Money must come from borrowing or the partners
• Management - Can be difficult because in the absence of an agreement to the contrary, all partners have an equal say in running the business.
• Transferability - Partner only has right to transfer the value of her partnership interest, not the interest itself.

Question 35

What is a Partnership?

Answer 35

An unincorporated association of two or more co-owners who operate a business for profit. Each co-owner is a General Partner.

Question 36

What is required for a partnership?

Answer 36

While it should have a written agreement, the law does not require anything in the way of forms, filings, or agreements.

Question 37

What is Joint and Several Liability

Answer 37

An injured third party has the right to recover the full amount of his damages from one, some, or all of those who caused his harm. He may not recover more than 100% of his damages.

Question 38

What is the taxation on a partnership?

Answer 38

A partnership is not a taxable entity, they are passed on to the partners.

Question 39

What is the liability of a partnership and/or the partners?

Answer 39

Every partner is an agent of the partnership. Thus, the entire partnership is liable for the act of one partner in, say, signing a contract. A partnership is also liable for any torts that a partner commits in the ordinary course of the partnership’s business.
If a partnership does not have enough assets to pay its debts, creditors may go after the personal property of individual partners whether or not they were in any way responsible for the debt. (Joint and Several Liability). Even if creditors have a judgement against an individual partner, they cannot go after that partner’s assets until all the partnership’s assets are exhausted

Question 40

What are the management rights in a partnership?

Answer 40

Unless the partnership agrees otherwise, partners share both profits and losses equally, and each partner has an equal right to manage the business. In large partnerships they are usually run by one or a few partners who are designated as managing partners or members of the executive committee.

Question 41

What does partners having fiduciary duty to the partnership mean?

Answer 41

• Partners are liable to the partnership for gross negligence or intentional misconduct.
• Partners cannot compete with the partnership.
• A partner may not take an opportunity away from the partnership unless the other partners consent.
• If a partner engages in a conflict of interest, he must turn over to the partnership any profits he earned from that activity.

Question 42

What does a partnership begin with? End with?

Answer 42

Association

Dissociation

Question 43

When does dissociation occur?

Answer 43

When one partner quits. A partner always has the power to leave a partnership but may not have the right.

Question 44

What are the two possibilities during dissociation for the business?

Answer 44

• Partnership can either buy out the departing partner and continue in business
• Wind up the business and terminate the partnership.

Question 45

What are the three steps to terminate a partnership business?

Answer 45

Dissolution
Winding Up
Termination

Question 46

What is a term partnership?

Answer 46

Partnership where the partners agreed in advance how long the partnership will last

Question 47

What is a Partnership at Will?

Answer 47

A partnership where any partners can leave at any time, for any reason.

Question 48

When in a partnership at will will the partnership automatically dissolve? 1

Answer 48

When a partner withdraws

Question 49

When in a term partnership will the partnership automatically dissolve? 3

Answer 49

• A partner is dissociated and half of the remaining partners vote to wind up the partnership business.
• All the partners agree to dissolve, or
• The term expires or the partnership achieves its goal.

Question 50

What automatically causes dissolution in any partnership? 3

Answer 50

• An event occurs that the partners had agreed would cause dissolution,
• The partnership business becomes illegal
• A court determines that the partnership is unlikely to succeed. If the partners simply cannot get along or they cannot make a profit, any partner has the right to ask a court to dissolve the partnership

Question 51

What is winding up, in the process of terminating a partnership?

Answer 51

When all the debts of the partnership are paid, and the remaining proceeds are distributed to the partner

Question 52

What is termination? How does it happen? What is required?

Answer 52

It is the final ending of the partnership. It happens automatically once the winding up is finished. The partnership is not required to do anything official.

Question 53

What the liability benefit of a Limited Liability Partnership over a general partnership?

Answer 53

In an LLP, the partners are not liable for the debts of the partnership. They are still liable for their own misdeeds, just as if they were a member of an LLC or a shareholder of a corporation.

Question 54

What does an LLP need to do to form? What are any further requirements after formation? 1 & 1.

Answer 54

To Form:
-File a statement of qualification with state officials.
Requirements:
-File annual reports

Question 55

What is the taxation on an LLP or its partners?

Answer 55

It is not a taxable entity, the taxes flow through to the partners.

Question 56

What are Limited Partnerships and Limited Liability Limited Partnerships mainly used for?

Answer 56

• Estate planning purposes, usually to reduce estate taxes

- Highly sophisticated investment vehicles.

Question 57

What is the structure requirement for limited partnerships?

Answer 57

They must have at least one limited partner and one general partner

Question 58

What are the attributes of a limited partner?

Answer 58

• Not personally liable, they risk only their investment in the partnership
• Essentially passive investors, with few management rights beyond the right to be informed about the partnership business.

Question 59

What are the attributes of a general partner?

Answer 59

• Personally liable for the debts of the organization.

- Have the right to manage the partnership

Question 60

When is a general partner not liable for the debts of the partnership?

Answer 60

When he is part of a Limited Liability Limited Partnership.

Question 61

How or when do/can you make a Limited Partnership a Limited Liability Limited Partnership?

Answer 61

Under the Uniform Limited Partnership Act it is permitted for a limited partnership, it its certificate of formation and partnership agreement, simple to declare itself a limited liability limited partnership.

Question 62

What is the taxation on a limited partnership?

Answer 62

Limited partnerships are not taxable entities.

Question 63

What must be done to form a limited partnership?

Answer 63

General partners must file a certificate of limited partnership with their Secretary of State.

Question 64

How is transfer of ownership handled in a limited partnership?

Answer 64

Limited partners have the right to transfer the value of their partnership interest, but they can only sell or give away the interest itself if the partnership agreement permits.

Question 65

What is the duration of a limited partnership?

Answer 65

Unless the partnership agreement provides otherwise, limited partnerships enjoy perpetual existence-they continue even as partners come and go.

Question 66

What business organization are business professionals allowed to incorporate in?

Answer 66

Professional Corporation

Question 67

Why would someone form a professional corporation as opposed to a general partnership?

Answer 67

It provides more liability protection than a general partnership. If a member of a PC commits malpractice, the corporations assets are at risk but not the personal assets of the innocent members.

Question 68

Are the shareholders of a professional corporation liable for the contract debts of the organization?

Answer 68

No

Question 69

What are the limitations of a professional corporation? 3

Answer 69

• All shareholders of the corporation must be members of the same profession
• The required legal technicalities for forming and maintaining a PC are expensive and time-consuming.
• Tax issues can be complicated, a professional corporation is a separate taxable entity, like any other corporation. It must pay taxes on its profits, and then its shareholders pay taxes on any dividends they receive. Salaries, however, are deductible from firm profits. This the professional corporation can avoid paying taxes on its profits by paying out all the profits as salary. But any profits remaining in the firm coffers at the end of the year are taxable. To avoid tax, professional corporation’s must be careful to calculate their profits accurately and pay them out before year’s end.

Question 70

Who regulates franchises?

Answer 70

The Federal Trade Commission. It addition, some states impose their own franchise requirements. This is because, while they can be a great opportunity for entrepreneurs, historically they have been a magnet for fraudsters to trick the unwary.

Question 71

What are the requirements of a franchise?

Answer 71

-A franchisor must deliver to a potential purchase a Franchise Disclosure Document at least 14 calender days before any contract is signed or money is paid.

Question 72

What must a Franchise Disclosure Document provide? 7

Answer 72

Information about the franchise that includes:

• History
• Litigation
• Expenses
• Restrictions on products
• Suppliers and Territory
• Other franchisees
• Audited financials
• Earnings, if disclosed (not required) must be shown with the basis for that information.

Question 73

What the purpose of a Franchise Disclosure Document?

Answer 73

To ensure the franchisor discloses all relevant facts. Though it is not a guarantee of quality because the FTC does not investigate to make sure that the information is accurate.

Question 74

All the business forms listed below have limited liability except the:
Answer
1. corporation.
2. Subchapter "S" corporation.
3. limited liability company.
4. general partnership.

Answer 74

4

Question 75

The importance of a Subchapter S corporation is:

1. its small cost of formation.
2. its treatment of shareholders for income taxation purposes.
3. its requirement of restrictive transfer rights of the shares.
4. its organizational structure.

Answer 75

2

Question 76

At what stage are the partnership debts paid and the proceeds distributed to the partners?

1. During dissolution.
2. During termination.
3. During winding up.
4. During dissociation.

Answer 76

3

Question 77

The business form that is taxed as a partnership and gives all owners limited liability, is:

1. a close corporation.
2. a limited liability company.
3. a general partnership.
4. a limited partnership.

Answer 77

2

Question 78

Debra and Lawrence have an equal partnership. This year, after expenses, the partnership had a profit of $200,000. Debra and Lawrence will each pay taxes on:

1. whatever they receive from the partnership.
2. $50,000.
3. $100,000.
4. None of the above. The partnership itself will pay the taxes on the business’s profit.

Answer 78

3

Question 79

The advantage of a corporation over a partnership is:

1. shares are easily transferable to another person.
2. perpetual existence.
3. it is easier to raise funds.
4. All the above.

Answer 79

4

Question 80

Under the Uniform Limited Partnership Act a limited liability limited partnership may be formed.

1. filing an application with the secretary of state.
2. They are not allowed.
3. declaring so in its certificate of formation.
4. None of the above.

Answer 80

3

Question 81

Rachel and Cyndi started a retail business called Zebra Toy Company. The business is operated as a partnership. Under partnership law:

1. Rachel is personally liable for any business contracts entered into by Cyndi.
2. Rachel is personally liable for any business debts, regardless of whether she or Cyndi created the obligation.
3. Rachel is personally liable for any negligent act committed by Cyndi in the scope of the business activity.
4. All the above.

Answer 81

4

Question 82

What are the management duties in a partnership? 3

Answer 82

• Duty of Care - duty owed by partners to manage the partnership affairs without gross negligence, reckless conduct, intentional misconduct, or knowing violation of the law.
• Duty of Loyalty - duty of utmost loyalty. Duty to not compete with partnership, turn over any profit to partnership, and avoid conflicts of interest
• Duty of Good Faith & Fair Dealing - duty to deal with each other and the partnership in a fair way.

Question 83

What is dissolution?

Answer 83

Decision to end business, can be voluntary or automatic.