Forming Businesses & Governing Corporations Flashcards
Why Establish a Business Entity?
Hint 3
Key Lesson?
- Using the right business entity to operate your business can be an essential tool to:
- Limit personal liability.
- Raise capital easily.
- Reduce tax burden.
Lesson: always make sure to get insurance
Make sure to have provisions for how to buy someone out
Make sure you talk about how you value the company
Key Factors in Choosing Form of Company
Hint: 6
1 Ease of Establishment
• Are government filings required?
2 Ease of Maintenance
• Are there formalities that must be followed, like meeting & recordkeeping requirements?
3 Ease of Capital Formation
• Are shares easily tradable?
• Ability to sell equity to foreigners & legal persons?
• Large number of owners allowed?
4 Control
• Can owners manage the entity directly?
5 Limited Liability
• Are owners personally liable?
6 Tax implications
• Single vs. Double tax
Note: Choose wisely because changing forms can be a costly headache.
Sole Proprietorship = ?
Created without state filings or formal agreements
Business Income or losses on personal income tax
**Proprietor bears personal liability for losses
**Hard to raise capital (i.e., no equity to sell, so must generally rely on personal funds & loans)
Terminates on death of the proprietor
Note: Registering a sole proprietorship as a “DBA” (Doing Business As) does not insulate from personal liability.
General Partnership = ?
Express or implied agreement between 2 or more people to carry on as co-owners a business for profit.
Written PA not required, but strongly recommended. No need to file paperwork with Sec’y of State.
**Profits/Losses shared equally unless otherwise agreed in PA.
Unless agreed otherwise, each partner controls the business.
Each partner has authority to bind partnership or incur obligations to the Partnership w/r/t 3rd parties.
Majority consent for ordinary business decisions; Unanimous consent required for big ones.
***Big Tax Advantage: Pass-through entity for tax purposes; so 1 level of tax only.
Can allocate income or loss flexibly unlike S Corp (e.g., losses can be allocated differently from income, so cash partner can use the losses; no need to allocate according to share %).
GP will dissolve upon death or withdrawal of any partner (and face liquidation), unless other partners elect to continue or take steps in P.A. to allow buy-outs.
***Although it’s a separate entity for some purposes (e.g., owning property in name of partnership), General partners face joint and several personal liability for partnership obligations, if partnership cannot satisfy its own debts.
Pro Tip: Choose your partners wisely & buy Insurance!
Limited Partnerships = ?
- LPs have 1 or more general partners (with same liability and power as partner in a GP), but also may have 1 or more Limited Partners.
- ***Limited Partners may not participate in control of partnership (otherwise they become GPs)
- ***But, Limited Partners’ liability is limited to their capital contribution (like a corp SH).
• Death of LP does not destroy partnership; the LP’s interest passes to heirs.
• Must have written partnership agreement
Must file Certificate of LP with Sec’y of State.
Limited Liability Companies (LLC) = ?
LLC combines favorable federal tax treatment of Partnership with limited liability advantages of a corporation.
It’s like a Limited Partnership without needing a General Partner.
***It’s a separate legal person, so it can own property, enter K’s, sue or be sued, etc.
Owned by “members”
Members generally have no personal liability for debts & obligations of LLC
But members can always be sued for their own wrongdoing (torts)
No limit on number of members (unlike S corp)
No requirement that members be individuals or non-foreigners (corps & partnerships can be members)
***Can be managed by members (“member-managed”) or by appointed managers.
Fiduciary duties owed by members/managers can be expanded or limited under OA (e.g., no duty of care or loyalty, but implied duty of good faith usually remains)
Formed by filing articles of organization / certificate of formation with Sec’y of State, and business name must include “LLC” to give 3rd parties notice.
***Governed by LLC Operating Agreement (like a Partnership Agreement)
Financial Obligations of Members (e.g., whether capital calls are forbidden, voluntary, required)
Rights to Assets (e.g., how losses, profits & distributions will be allocated – very flexible unlike S Corp)
Non-publicly traded LLCs taxed as pass through entity unless elect otherwise
Other things to note:
Limits:
You are always liable for your own wrong doing
Indemnity occurs under the LLC- wrong doing will fall on company
Control of company can be member managed (partnership/vote) you can structure it like a CEO (appointment mgr)
You can limit your fiduciary duties
In Operating agreement: you can expressly limit those
This explains financial obligations
Are there any capital calls? Make sure you agree to this in the beginning
Is it voluntary or required?
What happens if they cannot hold up their bargain
Corporations = ?
• **Separate legal person from its owners (SHs).
-
**Owned by Shareholders.
- May be owned by 1 or more shareholders
- SH usually not personally liable beyond their capital contribution.
- **Ease of capital accumulation because shares are easily transferred, unless subject to particular SH Transfer restrictions.
- ** Managed by Board of Directors, which delegates day-to-day operations to appointed Officers, who serve at pleasure of Board
• **Perpetual Life, even if owners/directors/officers die.
• Shares simply transferred to heirs
• Board vacancies filled by SH election
• Officers replaceable by Board
• Two Classes of Stock are Allowed (in C-Corps only)
• Preferred Stock = Usually no voting rights, but priority claim to assets over common stockholder and receive fixed dividends.
Common Stock = Voting rights. Residual claim to assets. May receive variable dividend payments per BoD
C Corps vs. S Corps (Tax Differences) = ?
• C Corps (Double-Taxed):
• Corp is subject to federal tax on business net income and
• SH are subject to tax on dividends paid by Corp to SH.
• S Corps (Single-Taxed):
• Certain domestic corporations can opt for pass-through tax treatment whereby Corp form is ignored for tax purposes & it pays no federal tax.
• Instead, SH are taxed on corp profits (regardless of dividends/distributions) and losses may sometimes be deducted on personal returns.
• Profits and losses allocated based on share ownership.
• General Requirements:
○ 100 shareholders or less (who are individual US citizens or residents subject to tax, or are tax-exempt entities)
○ One class of stock only (common stock only, not preferred; but can have voting and non-voting shares)
○ File timely election for S-Corp treatment with IRS
• S corp will generally not work well for start-ups that plan to issue cheap founders stock, or seek funding from VC funds.
• Profits are shared according the percentage of ownership of the business
Public Benefit Corporations = ?
- In recent years, new corporate entities have been recognized in some states, which provide greater ability to make it a charter purpose of the corp to (A) make a profit, and (B) have a social-good mission.
- Public Benefit Corporation
- See also Low Profit LLC (L3C) in some states.
- Signals market about your social good intentions
- Often facilitates funding from unique sources (e.g., Charitable Foundations making Program Related Investments)
- Allows SHs/Members to hold management more accountable for achieving social good objectives (i.e., SH can sue for lack of social good)
- Requires annual report of social good mission progress (3rd party standard)
- IPO rare but not impossible for PBCs.
- NOTE: Don’t confuse Public Benefit Corporations (a type of entity) with “B-Corp” certification by a third party (B-Labs), even though PBC gets certified.
Bottom line: It’s purpose is Social good and for profit
It is single taxed
Fiduciary Duties, what are they?
Shareholders give their money to a corporation but have little ability to control how that money is used.
Corporations cannot act, except through agents
Officer and Directors are thus in a position of trust as “fiduciaries” as to the corporation and all shareholders generally, not individually.
D&Os (and sometimes controlling SH) have “fiduciary duties”
Duty of Care
Duty of Loyalty
Duty of Good Faith
Duty of Care = ?
D&O’s must exercise due care in performing their duties:
Must act in good-faith
Must act as reasonably prudent person would in same situation.
Must make informed decisions:
Must conduct “due diligence” (i.e., research)
Must attend meetings and presentations
Entitled to reasonably rely on info from other professionals; but not blindly.
Business Judgment Rule does what
Legal doctrine that shields Board decisions from judicial review (and effectively insulates directors from personal liability for bad choices) if:
Board took reasonable steps to become informed
Board had rational basis for decision
No conflict of interest, no fraud, no bad faith
Duty of Loyalty = ?
• D&O’s must put their personal interests behind corporation/shareholders.
• In practice, this means they must avoid self-dealing:
• Competing with the corporation
• Usurping corporate opportunity
• Avoid undisclosed conflicts of interest
• Avoid insider trading
• Loyalty requires disclosure of material facts. There is something new or keep people informed
• Interested transactions (like exec comp) are voidable unless approved by disinterested directors, or proven fair and reasonable.
Note: Be careful about conflict positions (e.g., PE fund puts partner on BoD of company in which it invests).
Duty of Good Faith = ?
Note: no direct definintion in the slides
This is from slack Chole’s definition
requires that neither party will do anything that will destroy or injure the right of the other party to receive the benefits of the contract. There is no specific definition, however, courts analyze the facts and determine what is fair under the circumstances. “Good faith” has generally been defined as honesty in a person’s conduct and requires that a party cannot act contrary to the “spirit” of the contract, for example, parties cannot evade the spirit of the bargain, lack diligence or slack off, perform incorrectly on purpose, abuse their power when specifying the terms of a contract, or interfere with or fail to cooperate in the other party’s performance
