LEGAL CONSIDERATIONS

OBJECTIVE: The purpose of this class is NOT to make each student a legal scholar but rather to hopefully give each of them enough familiarity with the subject to be able to raise the right questions and to know when it is necessary to seek competent legal advice.

This course will cover 3 major areas of immediate concern for start-up businesses: The various forms of Legal Organization a new enterprise might choose to operate under; Employee relations; and Contracts.

The information presented is by no means intended to be all inclusive, but rather an overview . Because the laws vary from state to state and state legislators are revising, deleting and passing new laws constantly, you must not rely on this section as your legal guide to business.

Contact a competent lawyer in your area before deciding on your legal form of organization or entering into any form of contract.

When selecting a lawyer to advise you in a start-up situation, you would be best served in choosing one who has experience with start-up businesses. This advice is equally true in choosing an accountant or CPA.

Business Organizations

Employee Relations

Contracts

BUSINESS ORGANIZATIONS

Sole Propreitorship

Parenerships

Corporations

Limited Liability Companies

One of the first choices a new business must make is a decision as to what will be the form of legal organization the business operate under. This is a decision that is not to be taken lightly as it has far reaching impact the owners taxation, control of the business, management time, the future growth of the company, compliance with statutory regulations, ability to raise capital and, to some degree, liability protection for the owner

There is no "Best" form of organization. They all have some very attractive points and they all have their drawbacks. Consideration must be based on your particular circumstances and needs, on the future direction and growth you envision for the company, the future continuity of the business, on your management capabilities and so forth. It is a decision that should be made after consulting your accountant as well as your lawyer because the choices have a variety of tax implications as well as legal implications.

Sole Proprietorship In General, this is the simplest form of business. A sole proprietorship is not a separate entity itself. Rather, a sole proprietor directly owns the business and is directly responsible for its debts. Normally this form is used for one-person business or for business which will remain small . It is the oldest and most prevalent form of organization and the easiest to form with few legal financial expenses. Essentially all you have to do is buy a business license and start selling. There are few formalities involved in that you are not required to register with the State as you do with some of the other forms of organization nor is any record keeping required aside from that which one would normally do for management and tax purposes. With the exception of complying with any applicable licensing requirements, there are no formalities required of a sole proprietorship. Note, however, where the business is conducted under a name which does not show the owner's surname or implies the existence of additional owners, California, for example, requires that the owner file a fictitious business name statement and publish notice.

Fundamentally, there is no artificial "legal" entity created in a sole proprietorship. You ARE the business.

The income derived from the business in your personal income and reported as such for tax purposes. You are free to use the proceeds of the business as you see fit. Its yours! You are not even required to keep records as to the disposition of the money other than what you need to report the income for tax purposes. If you wish to pocket the proceeds of a sale you made today and use it to buy groceries on the way home, it is perfectly legal to do so. Of course, it is stupid management of your funds. You should keep detailed records of the business cash flows for management purposes, but legally, you are not required to do so.

Likewise, any inventory or equipment you purchase to conduct the business is considered your personal property and there are no restrictions as to their use. You may buy, sell or otherwise dispose of it as you wish since it is your personal property.

Most importantly, you have total, direct control over the business. You decide what needs to be done, when it needs to be done and how it needs to be done. Of course the down side to this is that in a one man operation, you are also the one who has to do it all. And, since there are only seven days in a week and 24 hours in a day, there is a limit as to what you are able to do, therefore the size of the business is somewhat self-limiting. Another downside if that with unlimited control also comes unlimited liability. You as an individual are totally responsibly for the debts of the business and if sued, you are totally liable for any judgements made against the business, which is why it is so important to have both a good lawyer and a good liability insurance policy which covers, among other things, Errors and Omissions.

In a sole proprietorship, the owner is personally liable for the company, thus placing his or her entire personal assets and wealth at risk. If an owner is married, that owner puts the community property at risk as well.

Since you ARE the business, capital resources are also limited. Your ability to acquire credit is limited to your personal balance sheet and financial worth, especially in the early stages of the business. The only avenue open to you to acquire capital resources rest on you ability to carry loans in some form or another. You cannot sell stock as a corporation can to raise capital and if you offer an investor a stake in the company you are, by definition, no longer a sole proprietorship.

All net income is taxable to the individual. Your tax rate depends upon your income bracket. You may be able to deduct from your gross income some personal expenses which are directly related to your business, for example, unreimbursed car expenses and share home expenses if business is located at home. This is unlike a corporation, where the income is taxed when generated by the corporation and taxed again when you draw your salary (Double- Taxation). However, you are subject to a "Self Employment" tax and must file AND PAY estimated quarterly taxes in advance.

Because you ARE the business, especially if you are a one-man concern, the business can only operate when you do. This means if you become ill or go on vacation, the business comes to a halt. This can be (an is) managed around every day in the real world. You can hire employees to attend to the business while you are not present. But in doing so, you must be very careful who you hire. Remember, in a sole proprietorship the finances you entrust to an employee when you are not there are your PERSONAL finances. And, in many instances, you are personally liable for the actions of your employees.

In even of your death, the business ceases to exist. The property used in the business goes to your heirs as would any personal property. So does liability for debts the business has incurred.

Of course, your heirs may wish to try to continue operating the business, but it would be a different legal entity than the one you operated as a sole proprietor. This also has some interesting implications as to any existing contracts you may have entered into prior to your death. Are your heirs still bound by them? They may or may not be, depending on how the contracts were written. Just one more reason to have a good lawyer. At the very least, it will be somewhat of a messy transfer. Your customers may not wish to continue doing business with your heirs.

Suppose you retire, or simply wish to get into another business. How can you dispose of the existing business.? Of course, you can sell off the assets of the business just as you can sell any personal asset, but it is difficult to sell the business, per se. Contracts that you have may or may not be transferable or assignable, depending on how they are written. You may have buildings and property that have value, but evaluating and selling "Goodwill" is difficult at best even if the business is a profitable, going concern. If not profitable, it is very difficult to sell the business other than liquidating the assets and closing the doors.

Because of the ease of entry, many business are formed initially as sole proprietorships with every intention of changing their legal identity later on as the need arises. This can be especially useful during the "research and development" phase of your business.

Partnership

A partnership is defined as an association of two or more persons (not limited to natural persons). In essence you are co-owners of the business with equal right to manage, equal right to profit and equal liability for debt.

The obvious advantage to forming a partnership is that you now have two people to share the responsibilities of the enterprise. It is a way you can involve another person and add capital without having to borrow or go through the legal formalities and expenses of forming a corporation. You can now rely on two personal balance sheets and credit ratings when borrowing from a bank. You can take vacations or sick days knowing that the business continues to operate.

The obvious disadvantages are that there are specific legal requirements set up by all states which govern how the partners relate to one another. Unlike a sole proprietorship, a partnership IS a separate legal entity. Ultimately, this means that the cash flowing through the business and the assets of the business are no longer yours to do with as you please. They belong to the partnership. And their use and disbursement are governed by law. Likewise, control of the business is no longer your sole domain. You have to share it with your partner just as you do the profits. The only thing you retain 100% of in a partnership is liability for debt. If your partner and the bookkeeper run off to Rio with the bank account you are liable for the entire debt of the partnership. (Then again, so is your partner should YOU and the bookkeeper run off to Rio!)

Under the law in almost every state, everything in a partnership is shared equally. This can lead to certain inequities. Take, as an example, the case of a partnership formed by two people. Person A invest $90,000 in the venture. Person B invest $10,000. Yet the law dictates that the profits are divided equally. Doesn't seem fair, does it?

Likewise, Management authority is shared equally. Well, Suppose you have a situation of two partners and one employee. Partner A tell the employee to do something a certain way. Partner B comes in later and tell the employee to do the task a different way. Who's instructions does the employee follow? Can partner A fire the employee for not following instructions? Partnerships can be messy.

The law recognizes that the total equality in all area of partnerships isn't always the best solution. So the law allows the partnerships to modify to some degree its operations if the partners execute what is call a PARTNERSHIP AGREEMENT.

This Partnership Agreement can modify any and all of the States requirements concerning a partnership EXCEPT liability of each partner for the Debts of the Partnership. It can modify the division of profits to reflect percentage of investment. In it a General Manager should be named with full details concerning length of tenure, compensation, duties, etc., that are clearly defined. Compensations for the partners must be spelled out because under the Partnership laws of most states, partners do not have a right to a salary, only a right to a share of the profits of the partnership.

One of the pitfalls concerning partnership agreements is that it is NOT required that the agreement be written out. It can be an oral agreement. However, enforcement of oral agreements can be difficult at best, so put it on paper.

• A Partnership Agreement should contain the following:
• Type of Business
• Amount invested by each partner.
• Division of profit or loss.
• Compensation for each partner.
• Distribution of assets on dissolution.
• Duration of partnership.
• Provisions for dissolving.
• Provisions for withdrawals or admission of new partners.
• Dispute settlement clause.
• Restrictions of authority - expenditures.
• Settlement in cases of death or disability.

The partnership agreement does not have to be filed with any state or local agency, but each partner should sign and retain a copy. In fact, when launching a partnership, all that is required is that you purchase a business license in the partnerships name, just as you would buy a license for a sole proprietorship or any other form of business.

What happens if you fail to obtain a business license? Penalties, if any, vary from jurisdiction to jurisdiction . Universally, however, the right of the unlicenced business entity to bring suit in a court of law MAY be denied. Not a good situation to be in if someone defaults on a contract with you. It best to say here that business licenses are not all that expensive, so why risk it? Get the license.

Property Interest of General Partnership. Each partner has a right to share in the profits and receives pro rata share of profits and any sale of assets upon dissolution of the partnership.

Interest in partnership may be transferred, such as in case of the death of a partner. His INTEREST in the partnership go to his or her heirs. Transferee receives only right to profit and pro rata share upon dissolution. However, the transferee does NOT become a partner and has no rights in the management of the partnership. This protects the remaining partners interest because a partner's interest is subject to attachment creditors and marital rights of the spouse.

Property brought into the partnership or acquired on account thereof is partnership property. Property acquired by partnership funds is partnership property. Partnership property may be transferred without the consent of all the partners if transferred in the partnership's name. Partnership property conveyed by a partner in his own name passes equitable interest of the partner, if acting in the ordinary course of business. Partnership property does not need to be in partnership name. Intent of the partners is paramount. Property acquired with partnership funds presumed partnership property. Conveyance of partnership property with title by individual partners may be recovered by non-conveying partners.

Partner's use of partnership property is limited . There is no right to possess business property for non-business purpose without consent. Partnership property (not interest) is not assignable, subject to attachment or subject to marital rights.

Financial Rights and Obligations of Partners. Each partner has equitable rights to profits unless there is a formal partnership agreement stating otherwise. Liability for losses are shared equally - absent agreement. There is right to require contribution from co-partners. There is the right to reimbursement for reasonable expenses paid out within course of business or preservation of partnership, right to indemnification for liabilities incurred while acting on behalf of partnership, the right to interest on loans and advances made to partnership. However, there is NO right to compensation for working for the business unless stated in the agreement.

Surviving partner entitled to reasonable compensation for winding up dissolved partnership.

Management Rights of Partnership. As stated above, there is equal right in management and conduct of partnership - unless contrary to agreement. Management rights are NOT transferable with interest of partnership.

What happens when the partners don't agree? Ordinary business disputes are decided by majority of partners, not based on contributions and/or right to profits. Agreements contrary to the partnership agreement are valid only if ALL of the partners agree.

New Partners may be admitted with unanimous consent of the partners.

Rights and Liabilities of the Partners. Each partner has equal right to use or possess partnership property for partnership purposes. They each have equal access to financial books and records of partnership. The books are best kept at the ordinary place of business of the partnership - unless contrary to agreement.

Each partner is an agent of the partnership with fiduciary duties to the partnership. Partner may not bring suit in an action at law against another partner or the partnership based on business operation. Personal actions between partners unrelated to business may be maintained at law.

Obligations and Liabilities to Third Parties . Each partner has personal liability for all debt of partnership. There joint and several liability for torts, and joint liability for debts and obligations under contracts. However, Incoming partners are not automatically liable for pre-existing debt but does have personal liability for debts incurred after admission as partner. Partner remains liable after withdrawing from partnership and a Partner's estate remains liable for debts incurred before his death.

The general rule is that all personal assets are on the line for business debts incurred by you OR YOUR PARTNER. This may include your home, in which case the personal liability is the same as a sole proprietorship, unless your wife is your partner. If you have more money than your partner, you may have to bear the brunt of the business debts, even though the Partnership Agreement says you split the debts fifty-fifty. A Partnership Agreement does not bind third parties who are not aware of it.

Dissolution Of Partnership. There are a number of ways a partnership can come to an end. The purpose for which the partnership was formed, for interest the pursuit and compilation of a particular contract. This is termed Dissolution by natural expiration. A partnership is dissolved by the withdrawal of any partner, or by the by mutual consent of all the partners.

The effects of Dissolution for any reason essentially means the termination of authority of partners to act for partnership except in cases involving the Completion of pending transactions, acts necessary for winding up and good faith advances by third parties. Dissolution does not discharge liabilities of any partner existing at the time of dissolution.

What we have discussed in this section concerns GENERAL PARTNERSHIPS. There are other forms of partnerships such as Limited Partnerships, Partnerships by estoppel, Silent partnerships, all of which have their own particular uses and regulations. Consult with your attorney for the details of these special forms of partnerships.

Corporations

A Corporation is a separate legal entity created and regulated by state laws. Because a corporation is a legal entity, it is a legal "person" capable of entering into contracts, incurring debts, and paying taxes. The many advantages of incorporation flow from this distinction between the business and the people who own it.

The corporation is responsible for its own debts. Because the corporation is a separate legal entity, creditors and others with claims against the corporation can only reach as far as the corporation's assets and cannot take the personal assets of those who own the corporation.

Normally, the shareholders, directors, and officers are not responsible for corporate liabilities. If there are losses, the corporation bears them to the extent of its own resources. Unless, as in the case with many newly formed or small corporations, the officers or stockholders have personally guaranteed or "co-signed" for the debt. By "co-signing" for the debt they have accepted personal liability if the corporation should default.

Normally, management and control is vested in the board of directors who are elected by the shareholders of the corporation. Directors generally make policy and major decisions regarding the corporation but do not individually represent the corporation in dealing with third persons. Rather, dealings with third persons are conducted through officers and employees to whom authority is delegated by the directors.

A corporation is created by substantial compliance with General Corporation Law which requires filing of Articles of Incorporation containing certain essential provisions and prepayment of certain fees.

As a separate legal entity, a corporation is capable of continuing indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers , or directors or by transfer of its shares from one person to another.

Although a corporation is not a "citizen" under the privileges and immunities clause of the Fourteenth Amendment to the U.S. Constitution, a corporation may exercise some of the constitutional protections granted to natural persons:

Right to Due Process and Equal Protection: Corporations enjoy the right to protection and due process of law under the Fourteenth and Fifth Amendments to the U.S. Constitution.

Freedom of Speech: Absent some narrowly drawn restrictions serving compelling state interests, corporations have the right to express themselves on matters of public importance whether or not those issues "materially affect" corporate business.

Right to Counsel: While a corporation cannot be imprisoned, a criminal action can result in fines and other penalties that could harm Shareholders, officers, and other persons. Thus, a corporate criminal defendant has a Sixth Amendment to a Right to Counsel. But note, because a corporation faces no risk of incarceration, it has no right to appointed counsel if it cannot afford to retain private counsel.

No Privilege Against Self-Incrimination: Corporations have no privilege against self-incrimination (e.g. to prevent disclosure of incriminating corporate records)

Corporations as a form of business organization have been available in the U.S. to anyone since about 1812. This is important because since then there has been a large body of case law developed which defines fairly clearly what a corporation is (and isn't), what it can and cannot do and how the various States relate to and govern corporations across state lines.

Many use this form of organization because they assume that they will have limited liability when it comes to their personal assets. While this is usually true, it isn't always the case as we will see shortly.

Advantages of forming corporations.

One of the primary purposes for forming a Corporation is the ability of the corporation to raise capital by selling stock . When you sell stock you are actually selling a share of the ownership of the company. Many private investors insist on stock shares in return for investing their capital in your corporation. It assures them that the worst comes to pass and the corporation goes out of business that at least they will be able to recoup some of their loss through sales of the assets of the company. An important point to remember, however, is that stock is usually easily transferable. The owner of a share of stock can usually sell or give it to anyone he or she wishes and typically this is beyond the control of the Corporation.

Other advantages of corporations include the perpetual life of the corporation. Unlike a sole proprietorship the corporation is a separate entity under the law and it can continue as long as the stock holders and Board of Directors wish to engage in business, regardless of wether or not the founding members of the corporation are still involved with the corporation or even living. The centralized management structure of a corporation (Board or Directors, President, Financial officers, etc.) Helps avoid the management problems that can occur in a Partnership. Unlike a sole proprietorship and partnership, case law and state regulations guide the actions of a corporation in many business dealings. While some see this as limiting to their freedom of action it should be seen as a safeguard, assuring you that in dealing with another corporation you are all playing by the same rules.

In cases of widely help public corporations, stockholders are usually protected from personal liability for the actions of the Corporation. In a small, closely held Corporation this may not always be true.

Some of the disadvantages of a corporation are, not surprisingly, related to the advantages of a corporation. For example, stock ownership. Stockholders own the company. They have certain rights which the corporation must respect. Stockholders vote for the Board of Directors, thereby indirectly they have some say in the management and direction of the corporation. Stockholders, as owners of the corporation, have a right to examine the corporate books. Stockholders have the right, in most cases, to dispose of their stock as they see fit. They can sell or give it to anyone. This all can lead to some potentially unexpected consequences if you are not careful as to who owns your stock. For example, suppose you have an employee who owns just a few shares of stock and you have to fire that employee. Happens everyday and is usually not big deal. But what if that employee decides to sell or give his shares to your biggest competitor? The employee has every right to do so and now your competitor has partial ownership of your company and can demand to see the financial records of the corporation. If they are good at reading financial records, they now know a great deal about the workings of your corporation....opps!

In all forms of corporations there are limits as to the number of stockholders you can have without falling under the regulations of the Federal and State Security and Exchange Commissions. This may vary from state to state, but it suffices to say, the regulations are something you want to avoid in that they are very costly and very detailed.

Banks are not, by the way, too impressed with newly formed corporations, especially small, closely held corporations. If you seek a loan in the name of the corporation, the banks will require that the assets of the new corporation are sufficient to collateralize the loan. If they are not, you will be required to guarantee the loan personally with YOUR PERSONAL ASSETS. If for some reason the corporation fails, the banks will then collect from you. So much for limited liability.

Another disadvantage of a corporation is that there are numerous legal requirements as to forming and operating a corporation, many of which incur legal fees. You must file incorporation papers with the Secretary of State in the state in which you plan to conduct you business, as well as the home state of the corporation. ( In your home state you will be considered a Domestic Corporation. If you wish to do business in another state you must register with their Secretary of State and you will be considered a Foreign Corporation. In both States you will probably be subject to an annual "Franchise Fee", a tax that allows you to do business in that state.) When filing, you will be required to file your Articles of Incorporation, which are the ground rules you establish for how you will operate the corporation. (More about the Articles of Incorporation. These are in essence the corporate constitution and have a great deal to say about how the corporation is internally governed.) As a corporation you are required to have periodic Board Meeting and are required to have at your principle place of business all financial records for the stockholders to examine ( in most states, examination must take place during normal business hours.) You are required by law to keep an accurate minutes of all Board Meetings. (These, too, must be made available to stockholders in many states.) Finally, the corporation is required to keep financial records on all matters concerning the operations of the corporation. Remember, THE CORPORATION IS A SEPARATE LEGAL ENTITY. Even in cases where states allow a one man corporation, the monies and assets of that corporation belong to the corporation. IT IS NOT YOUR MONEY OR ASSETS. You cannot do with it as you please as you can in a sole proprietorship. This is exactly where small, closely held corporations get into liability difficulties.

In a small, closely held corporation the limited liability protections granted by Corporate Status can easily be lost if the owners of the corporation do not respect the separateness of the Corporations funds and assets. In a sole proprietorship, the monies and assets are your to do with as you please. You can take funds from the business account and buy groceries, pay your mortgage, go on vacation or whatever. Its your money. This is not the case in a corporation, even if it is a small, closely held one with just you or you and your wife owning 100% of the stock. It is not untypical in a law case for the council of the party suing a small, closely held corporation to subpoena the corporate minute book and the corporate checkbook. First they will go through the minute books and see if the required corporate meetings were held, with the proper notification of the board members as set by state regulations. Next they will go through the corporate check book, looking for expenditure of corporate funds for personal purposes. If they find anything not on the up and up, they will petition the judge to "PIERCE THE CORPORATE VAIL" which is a judgement that the corporation is a shame, typically that it was formed for the sole purpose of avoiding liability, and in effect removes any and all liability protection to the stockholders.

To reiterate one more time, "Piercing the Corporate Veil" is justified by lack of corporate formalities meaning failure of stockholders and directors to meet and failure to keep minutes of any business meetings of the Board or stockholders. It can be caused by intermingling or co-mingling of corporate and personal funds (i.e., paying your personal electric bill with corporate funds), excessive or frequent withdrawal of funds in the form of loans to officers, directors or shareholders that are never paid back. This last is to prevent someone from attempting to avoid Income and payroll taxes and withholdings by taking compensation in the form of "loans" which are never intended to be repaid instead of salary.

A financial disadvantage to a corporation is one of double taxation. Profits made by the corporation are taxable and must be paid by the corporation. When those profits are transferred to the stockholders in the form of dividends, they are taxable again as income to the taxholder. Of course this can be eliminated in a small, closely held corporation by simply not paying dividends. In the case of small, closely held corporations, the stockholders are typically employed by the corporation and receive compensation in the form of salaries, which are an expense to the corporation and therefore deductible on the corporate taxes, offsetting double taxation.

Another way to avoid some of the tax consequences of a regular corporation (C-corps) is to use the Sub-Chapter S election. A Sub-S corporation has certain tax advantages, such as allowing losses of the corporation to "flow through" to the personal taxes of the stockholders. This may be attractive to an investor in a company who, in the early stages at least, project considerable losses in its early stages. At any time, the S-corp election may be dropped and the corporation reverts to a regular C-Corp. However, once the election is dropped, it can never be regained. S-corps have a number of their own restrictions as to the number of stockholders and, believe it or not, certain citizenship requirements. Foreign nationals are barred from owning stock in S-corps. Starting with the Tax Reform acts of the late '80's and continuing with the tax reforms of the '90's many of the advantages of the Sub-S election have been lost. Your accountant and lawyer should be able to explain the current advantages and disadvantages fully.

Formation of Corporation

It is not required that you have a lawyer to incorporate. You can do it yourself. It is not required that you have a Doctor remove your appendix. It IS possible to remove your own. However, in both cases, you will probably regret you did not seek competent professional advice.

In most states you file with the Secretary of State. First you file your preferred corporate name. If the name is not already in use, it is reserved for you. Then you formally file your Articles of incorporation, pay any statutory fees required and you are incorporated.

Typically, the Articles of Incorporation must include the Corporate Name, The address of the corporate office, the name s and addresses of the original board of directors, a description of the capital structure of the corporation ( par value and number of shares of stock initially being offered for sale, the duration of the expected life of the corporation and the purpose for which the Corporation was founded. The wording of the purpose for which the corporation is founded is critical, for it can limit the corporation if worded too narrowly. If it is stated that "XYZ Corporation shall engage in the manufacturing and sale of nuts and bolts..." all XYZ corporation can do is sell nuts and bolts. Many lawyers preparing corporate filings would phrase it something like "XYZ Corporation is being formed to engage in any commerce legal in the state of....." Broadly written and you can do anything that isn't illegal.

Articles of Incorporation can be amended by a majority vote of the stockholders but the amendment must be filed with either the Probate Court or the Secretary of State, depending on your state regulations.

While the Articles of Incorporation deal with the legal, external structure of the Corporation, the internal structure is dealt with in the Bylaws of the Corporation. The Bylaws of Corporation regulate internal affairs of the corporation. They are adopted by directors who then have the responsibility of informing the shareholders.

In many way, the by-laws are the heart of the Corporation. They define management structure, responsibilities and compensation, among other things. Most importantly for an entrepreneur establishing a corporation with an eye on selling stock to finance the venture, carefully structured by-laws can define control of the corporation. It is a common misunderstanding on the part of new entrepreneurs that if they sell more than 49% of the stock, they will loose control of the corporation. This may be the case if the By-laws state that corporate decisions are made on the basis of a simple majority vote of the stockholders, but there is no legal requirement that restricts the by-laws to a "simple" majority. The by-laws could just as easily state that it takes an 85% vote of the stockholders. This would allow the founding entrepreneur to sell all but 16% of the stock and still retain voting control of the corporation. Of course, this in effect sells off most of the dividends realized when profits are distributed by dividends, but there is no requirement that a corporation ever declare a dividend. There are many way to structure the corporate By-laws to protect the founding entrepreneur in terms of control and compensation. Again, this underscores why you should seek competent legal advice rather that go it alone when setting up a corporation. And also remember that you have the legal requirement of full disclosure of the By-laws to stockholders and any potential stockholder. If you sell someone stock without revealing the By-laws which explain the corporate structure, you will have committed fraud.

The powers of Corporation are both expressed (as stated in the Articles of Incorporation) and implied. By implied we mean that there are certain things a corporation can do in its normal, day to day operations that are accepted by law but not necessarily defined in the Articles. For example, Corporations can enter into partnership. They can conduct business outside the state of its corporation if the register with the Secretaries of State in those states as a foreign corporation. The corporation has the ability to borrow money, give security for loans and issue bonds, debentures and other indebtedness. It has the power to power to guarantee indebtedness of others, to purchase other corporate stock and to make gifts.

Corporate Directors are responsible for policy-making decisions. They must act as a body at a validly convened meeting. The time and place of board meetings are fixed in bylaws. Alabama permits boards to meet by conference call, fax or similar communication equipment. This may vary from state to state. Directors are elected by majority vote of shareholders entitled to vote and their term of service and compensation, is any, are defined in the By-laws.

There are certain areas requiring shareholder approval before a Board of Directors may act. These include mergers, consolidations, sale of assets, stock options, issuing of more stock than was originally issued at the time of incorporation and other organic changes that may effect the corporation. A Director has the right to inspect the books, records and papers of the Corporation at any time.

Corporate Officers are selected by and answerable to the Board of Directors. Alabama Law requires President and Secretary, but this may vary from state to state. Officers may be removed by the Board of Directors for best interest of corporation. The authority of Corporate Officers and Agents controlled by ordinary agency principals which will be discussed in detail later.

There are certain fiduciary obligations of Directors and Officers. The minimum required is basic exercise of good business judgement in management & control corporate affairs. They must act in good faith, and in a manner they reasonably believe is in best interest of the corporation, with care, skill & diligence of ordinary prudent person under the circumstances . In determining "best interests" they can consider shareholder interests, employee, suppliers, creditors & customer interest, community and society interest and ultimately the value of continued existence of the corporation itself.

In the area of compensation, Directors are not entitled to compensation unless authorized by Articles of Incorporation bylaws or resolution of the Board of Directors. A corporate officer is entitled to be paid a fair and reasonable salary for services rendered. Compensation contracts must be arranged in advance of the performance of services.

Directors or officers are not permitted to make personal acquisitions where the corporation has or might have an interest or expectation in the business transaction undertaken. The factors to be considered include Transaction involving types of business corporation is engaged in would desire to expand into; the financial ability to undertake a transaction, the discovery of opportunity while acting in a corporate capacity or Use of corporate funds to undertake transaction.

The Board and the officers have a fiduciary obligation to exercise its influence and power to further the interest of the corporation and the shareholders. They have fiduciary duty not to transfer control if shareholder knows or has reason to know his transferee will harm the corporation or its shareholders.

It is important to remember that a corporation does not simply "go out of business" as does a sole proprietorship or a partnership. Once started, a corporation continues until it is formally dissolved. This requires filing dissolution papers with the appropriate State agency or the Probate Court. It can be done voluntarily by consent of the shareholders. Until formally dissolved, the Corporation is liable for any Franchise Taxes imposed by the State.

PRO'S OF INCORPORATION:

• Limited liability for shareholders; i.e. the shareholders are not individually liable for debts of the corporation, such as a lease obligation or loan payback.
• A corporation may exist perpetually; unfortunately, all persons eventually die.
• Multiple classes of ownership; by using common stock and preferred stock with different rights, terms and conditions, a person forming a corporation has great latitude in providing its shareholders a return on their investment.
• Eliminate self-employment tax, which is payable by individuals engaged in business and by active members in a limited liability company.
• Some people think a corporation provides a much better image for conducting business operations, more sophistication, etc.
• Operating a corporation is relatively easy to understand; most of us are familiar with concepts of a board of directors, officers, and such.
• In most states the corporation can take formal corporate action by written consent instead of holding a meeting of the board or the shareholders, which simplifies and makes more inexpensive its operation.
• The laws are mostly settled concerning corporations, both from a tax status and for the duties and liabilities of the officers and directors. Most of the issues you would face in operating a corporation have already been dealt with and there will be a statute, case or administrative ruling concerning it.

CON'S of Incorporation

• Tax. The corporation's income is taxed at the corporate level. Then when you distribute earnings to the shareholders via dividend, the shareholders include the dividend in their taxable income and are all taxed on that income again. This is commonly referred to as double taxation.
•  Added administrative costs. You will now have a new set of accounting books to keep, bank accounts to balance, etc. However, the fees paid to a CPA and/or bookkeeper may be deductible from income.

Congress responded many years ago to the double taxation issue by authorizing a "subchapter s" corporation. Subchapter s is a subchapter of the Internal Revenue Code which basically eliminates tax at the corporate level. A corporation figures up its income and expenses and passes both of those items through to its shareholders in proportion to their stock ownership. For example, a shareholder who owns 40% of the outstanding shares of stock would report, on his or her personal income tax return, 40% of the income and expenses of the corporation. The tax is levied only on the shareholders.

However, Congress also put some rather severe limitations on Subchapter S corporations. It is very difficult to use a fiscal year other than a calendar year. It can only have 35 total shareholders (husband and wife count as one shareholder). It can only have one class of stock. The shareholders can only be individuals or a qualified trust.

Limited Liability Companies

In response to these restrictions, in 1977 Wyoming became the first state to enact legislation recognizing the LLC business entity. The LLC is a hybrid of sorts. It has most of the same pros and cons as a regular corporation, except that it is taxed as the Subchapter S corporation, but adds an additional level of complexity in operation because it is very tax-sensitive. In other words, the tax treatment of an LLC is not guaranteed. It has to be properly designed and operated.

Under the typical LLC statute, the members (analogous to shareholders in corporations and partners in partnerships) are all shielded from the company's debts unless they affirmatively undertake responsibility for such debt, such as by a guarantee to a lender. Also, the Internal Revenue Service has ruled repeatedly in precedential rulings that if the LLC is formed in a particular manner the company would be treated as a partnership for tax purposes. This determination turns on the nature of the company's management structure, the transferability of member interests, and how the company would dissolve. If not formed appropriately in light of the IRS regulations, rulings, and case law, the LLC will be treated as a corporation for federal income tax purposes (and for state tax purposes in the many states that rely on federal tax classification). Caution, therefore, is the touchstone when forming LLCs that must be treated as a partnership for federal tax purposes.

Thus, in the right circumstances, there is no longer a need to use a corporation or a limited partnership with a corporate general partner to provide complete liability protection and there is no need to live with the statutory limitations of the S corporation in order to get federal income tax advantages. It should be noted that in some states the LLC itself will have to pay state income or franchise taxes on its income, despite it tax transparency for federal tax purposes. Also, the LLC might be subject to hefty filing fee requirements initially and annually depending on the states in which the LLC is formed and in which it is doing business.

LLC Certificate and Operating Agreement

The limited liability company, a creature of state law, is one created by the filing of a document similar to articles of incorporation with a state authority. However, the company is not governed by by-laws; instead is governed by an Operating Agreement (in Delaware, known as the LLC Agreement). The Operating Agreement is closer in form to a partnership agreement (or, to use a corporate analogue, by-laws plus a shareholders' agreement). The Operating Agreement sets the rules for governing the company (such as the rules for meetings, if any) as well as the rights and responsibilities of the members vis-a-vis the company and vis-a-vis each other. Thus, it states the members' understanding of who is responsible for contributions to capital and how much, who is to receive distributions and how much, who is to be allocated the various tax attributes of the company such as profits, losses, gains and credits, and under what circumstance the company will dissolve, among others. The Operating Agreement is not filed with any state agency.

Authorization To Do Business In Other Jurisdictions

If the company is organized in a state other than that in which it will be doing business, or will be doing business in several states, then the company must be authorized to do business as a foreign LLC in these other states.

Evidence of LLC Interests

The ownership interests in LLCs may be reflected in share certificates in many jurisdictions, but need not be. In fact it is not unusual for LLC interests to be stated as a percentage of the company's capital as in a partnership.

Management of the LLC

It is up to the members to define in the Operating Agreement how the LLC will be managed. In some cases, the members might vest virtually all control of the LLC in one or a few managers (analogous to the officers and directors of a corporation or the managing general partner in a limited partnership). In other cases, the members might want a more active hand in company policy and day to day management, in which case the Agreement will provide for an appropriate quantum of votes in a variety of circumstances.

Annual and Special Meetings

Depending on the management structure of the company, the Operating Agreement might require regular meetings, as does typical corporate by-laws, or the members might forego meetings altogether.

Dissolution of the LLC

The Operating Agreement will also set forth the events that cause dissolution of the company. For instance, there may be a requirement that it dissolve upon the death or bankruptcy of a member or of a manager. While this is an important operational issue to consider when forming the LLC, its significance is even greater than appears on it face, as this is one aspect of the company the IRS will examine to determine if the company should be taxed as a partnership or as a corporation. This is also one of the areas of greatest concern to LLC investors insofar as, depending on how a dissolution provision is formulated, the LLC might dissolve at an inopportune and unanticipated time.

Transfers of LLC Interests

The members will also provide in the Operating Agreement the rules governing when LLC interests may be transferred and which aspects of these interests may be transferred. These rules might include a right of first refusal for the remaining members. Again because of IRS criteria, the "economic rights" of the LLC interest might be freely transferable to an outsider, but the recipient of these rights might not be admitted as a full member, with full rights of LLC membership, unless admitted by an affirmative vote of the remaining members.

Tax Reporting for LLCs

When tax time roles around, the LLC will file a partnership tax return with the federal government and any requisite state tax forms. If treated as a partnership for federal tax purposes, the LLC will provide to each member a Form K-1.

Creative Uses of LLCs

There is virtually no business enterprise for which an LLC would be inappropriate, except if the company is expected to be publicly traded, or if there are so many members of the LLCs that it could not legitimately be qualified for partnership tax treatment (unless of course partnership tax treatment was not desired). Real estate, oil and gas ventures, any operating business, professionals (in some states), businesses with foreign investors, businesses seeking venture capital, and joint ventures between established enterprises, including huge corporations, are just a few of the ventures that might benefit from doing business through an LLC. Also, in the context of estate planning, where family limited partnerships are now being used, LLCs are providing an alternative outlet. Finally, as outside creditors of LLC members typically can get only a charging order against that member's LLC interest LLCs provide an excellent component in an asset protection plan.

The LLC resembles a hybrid of the regular corporation in that it offers the same great asset protection for its members (owners) while the income on profits is handled much the same way as with a partnership.

This sounds a lot like the S-Corporation all over again, but here are 6 great differences:

• S-Corporations are limited to 35 shareholders while the number of members in an LLC is unlimited.
  
• Shareholders of S-Corporations can only be U.S. citizens, resident aliens, estates or certain trusts. There is no such limitation when you use an LLC.
  
• S-Corporations can only have one class of stock. Your LLC will have no such limitation.
  
• Members of an affiliated group are ineligible to become S-Corporations. Your LLC can control corporations, can be managed by a corporation, and can be owned by a corporation, partnership, trust or even another LLC.
  
• S-Corporations must file with the IRS to elect the status of S-Corporation. The LLC must be set up correctly (see below) to gain its preferred pass-through tax status and, after that, its status is much more secure as you will see in the next example.
  
• An S-Corporation's election is terminated when it has excessive income for three consecutive years or fails certain passive income rules. The LLC is not so affected.

The secret to gaining the preferred tax status must be exercised when setting up the LLC initially. The IRS ruled that the LLC lacks corporate status (qualifies for the preferred pass-through tax treatment) if it lacks two out of the four following corporate characteristics.

• Continuity of Life: A corporation has no automatic termination date. Common practice is to designate the LLC to dissolve after 30 years. This part of the test is easy to fail. (Failing, in these cases, really means winning. The jargon is merely devised to give the accountants and the IRS something to hang their hats on.)
  
• Centralization of Management: This is an area that requires attention when organizing the LLC. By default, the management of the LLC will go to the members similar to the formation of a corporation. The best choice is to elect a manager or mangers and so state in the Articles of Organization.
  
• Limited Liability: One of the great benefits of the LLC stems from the fact that the members and managers are not held liable for the legal acts of the company. This is like a corporation and you want to keep it that way. (This means you don't want to win this one or "fail.")
  
• Free Transferability of Interest: One of the characteristics of the LLC is the members must agree when any of the members wishes to sell or transfer his interest to anyone else. Once the interest is transferred, the new owner has only the rights of the previous member as he participates in the decisions of the company. The corporate characteristic of "free transferability" does not exist by the very nature of the LLC.

LLC Advantages

• Excellent liability protection for members, managers, and employees
• Single level of taxation
• No limitation on the number or type of members
• No restrictions on management participation by members
• May have more than one class of membership interest
• No citizenship requirements imposed on members
• Members are indemnified by statute for any judgement, debt or obligation of the company
• Simple to distribute profits
• Creditors of a member are treated as an assignee, and cannot force the sale or dissolution of the company.
• Debt of the LLC is included in the tax basis of the individual members
• Recognized by all states

LLC Disadvantages

Since LLC's are a relatively new form of legal organization, the first being authorized by the State of Wyoming in the late 1970's, there is not a great deal of case law established as to how the various states will deal with "foreign" LLC's.

EMPLOYEE RELATIONSHIPS

Employees vs. Independent Contractors

A common problem faced by employers is deciding whether an individual is an employee or an independent contractor. For federal tax purposes, an individual is an independent contractor only if he or she is not an employee. Unfortunately, there isn't any one single definition of who is an employee for tax purposes.

In Rev. Rul. 87-41, the IRS issued a 20-part test for determining employee vs. independent contractor status. The text of that 20-part test is included below. According to that ruling, however:

The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. The twenty factors are designed only as guides for determining whether an individual is an employee; special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee).

Thus, the question of employee vs. independent contractor is, for tax purposes, governed by a "facts and circumstances" analysis. No one factor is controlling. The legal issue boils down to a question of worker control. If a small degree of control exists, independent contractor status will be supported, but if a large degree of control exists, employee status will be found. However, that is not to say that all of the factors are equally weighted. The matter of working for only one organization at a time is often viewed as the most important single factor, but nonetheless, it is never the only factor. Whether a person is an employee will always depend on all the facts and circumstances.

Adding to this mixture of factors and circumstances is a ruling of the Tax Court, in Weber v. Comm'r (1994), which announced a 7-part test in place of the 20-part test of the IRS. Under that test, the seven factors to consider are:

• The degree of control exercised by the organization over the details of the work;
• Which party invests in the facilities used in th