Free ABA Guide to Operating a Small Business

Forming and Operating a Small Business

Contents
Introduction
Getting Started
Types of Business Organizations
Choice of Business Form
Getting Organized
Operational Problems and Organic Changes
Where to Get More Information

Introduction

This chapter deals with the legal and other issues that have to be resolved when forming
and operating a small business. It contains six sections. The first section discusses issues that are
common to all small businesses, regardless of their legal structure. Section two explores the
various types of business organizations that exist in the United States, comparing their strengths
and weaknesses and discussing the taxation of each type of business organization. Section three
discusses the considerations that must be taken into account when selecting a form of business
organization. Section four examines the steps that must be taken to get a new business
organized. Section five explores the legal problems that commonly arise during the life cycle of a
business, such as changing the legal format or otherwise reorganizing the business and buying,
selling or liquidating the business. Section five also provides a brief summary of what happens
when a business experiences financial difficulty or becomes involved in bankruptcy proceedings.
The sixth and final section explains where you can go to get help and additional information about
your business.
The material in this chapter is written from the perspective of a small business, such as
one owned and operated by you and a few other family members or other individuals. The rights
of the employees and customers of the business and transactions with your business by third
parties, such as landlords or banks, are considered only with respect to the impact they have on
the legal structure of the business and your exposure to personal liability for claims they may have
against the business. The rights of employees, customers and third parties are dealt with in more
detail in other chapters of this book. See the chapter on “Law and the Workplace” for more
information on employer/employee rights and responsibilities. The chapter on “Contracts and
Consumer Law” includes details on customer rights, seller responsibilities, and warranties.
Getting Started
This section deals with some of the major issues that you must resolve before becoming involved
in owning or operating a small business.
Q. What are the first steps that should be taken?
A. There are four preliminary steps that should be taken before deciding to start or buy a
business: development of sound business ideas, market research, financial planning and deciding
whether to have co-owners.
GETTING A SOUND BUSINESS IDEA
A sound business idea is a venture that makes economic sense, generally based on your
experience and background. You will generally want to choose a type of business with which
you are familiar and have some experience. It would not be advisable, for example, for an
individual who has no experience in food service operations to open up or buy a restaurant.
Because operation of a successful business requires hard work and expertise, prior experience in
the same or a similar business will save you the time and expense of developing the background
and knowledge of what the particular business requires to be successful.
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Q. How can market research help?
A. Because the failure rate for new business is so high it is important to determine whether a
market exists to purchase your service or product, and, if so, the best way to sell it. One
important issue to be decided is the location of the business. You may not want to open up a
greeting card shop across the street from another greeting card shop in a small town. But two
greeting card stores located in a different part of a major shopping center might both be
successful. In addition, if your market is specialized or has particular needs, market research will
help you to understand what your buyer wants and how to communicate that your business can
meet that need.
Q. How do I develop a financial plan?
A. Inadequate or unwise financing is one of the principal reasons why so many new
businesses fail. The financial requirements of businesses vary greatly. Trade associations are
often a good source of information about the capital needs of a particular business. The local
office of the federal Small Business Administration (SBA) and the equivalent state offices can
also assist with financial planning for a new business. If the business is going to be run as a
franchise operation, the franchiser will probably have a great deal of useful information about the
financial resources the franchisee will need. Franchise operations will be discussed in more detail
later in this chapter. Finally, banks and private business consultants can help with financial
planning. Once you have gathered this information, you are in a position to develop a financial
plan.
Q. How do I secure financing?
A. There are, as a general rule, three potential sources of capital for a new business:
1. contributions made by the investors who will be actively involved in the management of
the business;
2. banks and other financial institutions; and
3. capital raised from other individuals and institutions.
Capital contributions from the management investors will frequently be insufficient to
meet the needs of the business. Loans from financial institutions are a possibility for additional
working capital, though the long-term effect of paying off the debt has to be taken into account.
Most rates of profit are under 10 percent, making the assumption of an interest-paying burden a
severe strain on a beginning business.
If you do decide to borrow capital, the business must have collateral to secure the loan.
Financial institutions will also generally require personal guaranties and collateral from the owners
of the business, which means that you might have to risk losing your home or other valuable
property to get funding. The federal Small Business Administration has loan and lease guarantee
programs that are designed to encourage banks and other financial institutions to lend money to
small businesses. Many states also have special loan or guaranty programs or financial assistance
packages and tax relief plans for small businesses. Information about these programs can be
obtained from the local SBA office or the office of the equivalent state or local agency charged
with the responsibility of assisting small businesses.
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Q. What are consequences of bringing others into the business?
A. The fourth preliminary step is to decide whether you are going to own the business by
yourself or have other investors who will have an ownership interest in the business.
The decision to bring others into the business can affect its legal structure. For example,
you must have two or more owners to operate a business as a partnership. Partnerships and the
other legal forms of business will be discussed in section two of this chapter. The decision to
have-owners can trigger the applicability of federal and state securities laws, if the-owners are
not going to be actively involved in the operations of the business.
Obtaining capital from other individuals and institutions is a possibility but, because of the
potential applicability of federal and state securities laws, must be pursued with caution. The
securities laws apply to the sale of any ownership interest in a business where the profits are
expected to come from the efforts of others. Under this broad definition, virtually all types of
equity or debt ownership interest in a small business sold to persons may be securities. For this
reason, you should not contact anyone about investing in a business without fully reviewing your
investment plans with a securities lawyer. This includes stock, debentures, and other similar
corporate debt instruments, limited partnership interests, and even general partnership interests,
where one or more of the general partners does not have the expertise (or authority) to
participate in the management of the business.
Assuming a particular type of ownership interest is a security, the anti-fraud provisions of
the securities acts automatically apply. In addition, unless an exemption is available, a
prospectus, which is a very technical and complex disclosure document, must be prepared and
the securities must be registered with the federal Securities and Exchange Commission and the
equivalent state administration office in every state where the securities will be sold. Failure to
comply with the prospectus and registration requirements will trigger a variety of administrative
and private remedies, including money damages, and, in extreme cases, criminal sanctions.
In most cases, the particular ownership interest will qualify for an exemption from federal
and in some cases state registration requirements. An exemption is a statute or regulation that
says certain types of securities can be sold to the public without the expense of a prospectus, so
long as other specific requirements are met. There is an exemption from federal registration
requirements, for example, for a company issuing securities all of which are sold to persons in
one state. There are also several exemptions designed primarily for small businesses. These
exemptions, many of which are incorporated into what is known as Regulation D, have limitations
on the number of purchasers or the total dollar amount of the offering. These exemptions restrict
or prohibit advertising of the offering and also restrict resales of the acquired securities. Another
complicating factor is that the applicable state securities laws are frequently inconsistent with the
federal securities laws, and compliance with both is required.
Needless to say, no one should attempt to issue any securities without the assistance of a
lawyer, accountant and other experts. All the exemptions, however, have very technical
requirements with which you must strictly comply. Compliance is also expensive, although
complying with the exemptions is less expensive than complying with the full registration
requirements.
Q. Besides these four steps, what other issues need to be considered before going
into a new business?
A. The remainder of this section will discuss issues other than the legal format of the
business. These include the location of your business, insurance, various licenses and permits,
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tax identification numbers and tax registration, protection of any patents, trademarks and
copyrights that will be owned or licensed by the business, whether to operate your business as a
franchised operation, and employer-employee problems.
It is important that you carefully review all of these issues, even if it ultimately turns out
that some of them are not applicable to your particular business. Some businesses, for example
those that are involved in health care or food service, are subject to complex regulation by
numerous federal, state and local agencies. Other businesses, on the other hand, may only be
subject to minimal regulation. The size of the business can also affect the extent of the
regulations. The laws of most states, for example, exempt businesses with fewer than four or five
employees from having to carry workers compensation insurance covering injuries to employees.
Even if your business is exempt, you might still decide to carry workers compensation insurance
because of the protection it would give both you and your employees in the event one of your
employees is injured while working in the business.
Q. Why is the location of a business so important?
A. There is an old adage that goes something like this: What are the three most important
reasons for the success of a business? The answer is location, location and location. The
location of the business vis a vis your competitors has already been discussed in connection with
the need to conduct market research for your business. Location is important for other reasons
as well.
Q. What are these other reasons?
A. One is the necessity of being located in an area that is convenient for your customers and
clients. Your market research should help you to find a suitable location for your business; but
that’s not the only decision you have to make. Another important decision is whether to own or
lease the building where the business is to be located.
BUY OR LEASE YOUR PLACE OF BUSINESS?
Unless you already own a suitable building, this can be a difficult decision. Buying or building a
new building generally involves a larger capital outlay than a lease, but if the building is
mortgaged, the term of the mortgage will frequently be longer than the term of a lease of similar
space. On the other hand, commercial leases are generally much longer and more complex
documents than residential leases and should be reviewed by your lawyer before you sign the
lease agreement. Your lawyer should, of course, also review all the documents involved in the
purchase or construction of any building you buy or build.
Q. What are some of the most important issues involved in a commercial lease?
A. A detailed discussion of commercial leases is beyond the scope of these materials, but
four important issues to look for should be mentioned-the amount of the rent, an option to renew,
an option for additional space and protection against competitors.
Q. How do you determine the rent?
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A. In most cases the rent in a commercial lease will be expressed as so many dollars per
square foot. This is the annualized price for the unit, so the monthly rent is determined by
multiplying the rent per square foot by the total number of square feet in the unit and dividing by
twelve months. For comparative purposes with other suitable rental units, you need to know
whether the rent includes or excludes taxes, insurance on the building, and utilities. To the extent
it excludes them, you will have to pay these items in addition to the rent.
Sometimes rent escalation clauses permit the owner to raise the rent because of inflation
or when taxes or utilities go up during the year. Finally, many retail and restaurant leases will
include clauses that require the tenant to pay either a flat monthly rental or a rental based on a set
percentage of sales in the store or restaurant, whichever is higher.
Q. What is an option to renew?
A. A second important issue in commercial leases involves an option to renew the lease at
the end of the lease term for an additional term. Without an option to renew, you may be forced
to move or to pay an extraordinarily high rent to remain where you are just at the time the
business is becoming very profitable. To provide maximum protection, the rent, or at least a
formula for determining the rent during the renewed period, should be specified.
Q. What is the significance of an option for additional space?
A. A third issue that needs to be investigated is an option to lease additional space and the
rent for that space. That option allows the new business to lease only the amount of space it
needs, with the protection of being able to increase the amount of space when and if it is needed.
The advantage of an option is that you are not obligated to rent the additional space unless you
want to.
Q. Can the lease protect my business from competitors?
A. A fourth issue involving commercial leases that can be important in some types of
business is a provision prohibiting the lessor from leasing space to a competitor, or if the lessor
will not agree to this, a provision stating that space leased to any competitor must be located on a
different floor or in a different wing of a shopping center.
Q. What about operating a business out of my home?
A. For some types of businesses, especially those where you visit your customers rather
than being dependent on their coming to your place of business, this is fine. In some situations,
you may be able to deduct the value of the space you use for your business operations on your
income tax return. To qualify for the deduction, however, your home office must, as a general
rule, be your principal place of business (i.e., your main location for administrative/management
activities) and be regularly and exclusively used by the business.
One of the most prevalent types of businesses operated from homes is a day care center.
Many states have special license requirements for day care centers. In some states the licensing
and other requirements for day care centers in private homes having only a few children are less
rigorous than larger group day care centers. Finding out what regulations apply is important for
this and every type of business.
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Q. What types of licenses and permits are required for a business?
A. It depends on the type and location of the business. All states have statutes and
regulations that require tests, proof of financial responsibility and compliance with other
requirements to obtain a license to engage in a particular business or profession. A state license
to operate a day care center is one example. Doctors, lawyers and even barbers have to be
licensed by the state before they can practice their profession. The types of businesses subject
to these licensing requirements vary from state to state.
Some businesses exempt from state licensing regulations are required to obtain a license
or permit from a county or city to perform certain operations. Building contractors, for example,
have to get a city or county building permit to build a house or commercial building.
Most cities and many counties require businesses located in their jurisdiction to have a
business license. In reality, this is a tax based generally on the gross receipts of the business
rather than a regulatory license designed to protect the public against shoddy work and
incompetence. Avoiding this tax can be an important factor in choosing the location of a
business.
Q. What kinds of insurance will I need?
A. As is the case with most of the other issues discussed in this section, it depends to some
degree on the type and size of the business. The exemption from workers compensation
insurance for small businesses with very few employees is an example of this principle. Another
is employee fidelity bonds, which is a form of insurance to protect against embezzlement. Some
businesses are required to have fidelity bonds for employees such as bookkeepers who handle
money. Most businesses, however, can choose whether to bond all or some of the employees.
Some of the other types of insurance a typical small business will want to consider
include:
· business interruption insurance (often referred to a business continuation insurance)
to offset losses if the business is forced to shut down for a substantial period because
of a fire, flood or other catastrophe;
· liability insurance, including product liability insurance, to protect against damage
claims filed by third parties injured on the premises, by delivery trucks or other
company vehicles, or by a product produced by the business;
· malpractice and errors and omissions insurance for professional businesses;
· director and officers (D & O) liability insurance to pay the expenses and damage
awards against corporate executives as a result of suits filed against them by
shareholders of the corporation;
· medical insurance covering the owners and the employees of the business;
· disability insurance, which pays a portion of the salary of an employee or owner who
has a long-term disability and cannot work;
· life insurance that will provide a death benefit to the families of the owners and the
employees and possibly provide funds to compensate the business for the loss of one
of the owners (often called “key man” insurance) and funds to purchase the equity
interest of a deceased owner;
· unemployment insurance, which is really a tax based on the payroll of a business
used to pay benefits to all long term unemployed workers in a state.
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Q. What tax registration and identification numbers, tax forms and the like are
required for a new business?
A. There are several federal and state requirements. The Internal Revenue Service (IRS)
publishes a pamphlet entitled “Your Business Tax Kit,” which is available at any IRS office or on
the Internet at http://www.irs.ustreas.gov. It contains a great deal of helpful information on the various
federal taxes that apply to a business. Many state tax commissions have similar publications
describing the state taxes that apply to a business. Both types of publications contain samples of
the tax registration and other forms that must be filed.
All businesses must obtain a Federal Employer Tax Identification Number before
beginning to operate. Each state also requires tax registration by a new business. In most cases
the state will use the Federal Employer Tax Identification Number (see insert below). All states
that have sales taxes also require any business that is not exempt from the tax to register with the
appropriate state agency. The business is required to collect and remit to the state on a regular
basis (monthly or more frequently) the applicable sales tax.
Every business is required to withhold from employee wages federal and state income
taxes and FICA (social security and Medicare) taxes and regularly remit these funds to the IRS
(in the case of federal withholding and FICA) and the applicable state tax agency. Businesses
whose total federal payroll tax liability for the prior year is $50,000 or less must deposit payroll
taxes in a special account once a month. Businesses whose payroll taxes for the prior year
exceeded $50,000 must deposit the tax money two times each week. The total deposits must
then be paid to the IRS at the end of each quarter. The state requirements may or may not be
the same as the federal deposit requirements. It is important to know the requirements and
follow them, as there may be heavy penalties for late payment.
Most states require registration or at least periodic filing with the state agency that
administers the state unemployment insurance tax, which is a tax based on the businesses payroll.
A business must also pay the federal Unemployment Insurance Tax, which is also based on its
total payroll, on a periodic basis.
In addition, all businesses must file annual federal and state income tax returns. The
applicable forms vary with the type of business. Partnerships, “S” corporations, limited liability
companies and other businesses that as a general rule pass the tax consequences of their
operations to their owners file a different type of return from that of businesses that are operated
as “C” corporations. The differences in the way various types of business organizations are taxed
will be discussed in the next section of this chapter. “S and “C” Corporations are terms that are
applied to different types of corporations for tax purposes. The characteristics of these
designations are described later in this chapter.
GETTING AN EIN
The EIN, as it is known, is obtained by filing an IRS form SS4, which can be obtained from any
office that has IRS forms or online from the IRS website–www.irs.ustreas.gov. If the form is
mailed, the EIN will be issued in four to six weeks. Alternatively, the SS4 can be faxed to 816-
926-7988 and the number will be issued within 24 hours, or the applicant can call direct (816-
926-5999) and receive the EIN number verbally. If the latter method is used, the applicant must
place the number on the SS4 and mail the to the IRS for processing.
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Protection of Patents and Other Intellectual Property Rights
Q. How can patents, trademarks, trade secrets, trade names, and copyrights owned
or licensed by an investor or a business be protected?
A. These types of property are generally referred to as intellectual property rights. Each type
is subject to special legal and tax rules, which will be briefly described below. Because of the
highly technical nature of intellectual property rights, it is essential that competent legal counsel be
consulted as soon as possible once it becomes evident that such a right exists, in order to
maximize the protection of the developer or owner of the right.
Q. What kinds of inventions are patentable and what is the advantage of obtaining a
patent?
A. Not every invention is patentable. By statute, the invention must fall into at least one of
four classes: process (for example, manufacturing of chemicals or treating of metals), a machine,
an article of manufacture, or composition of matter (for example, mixtures of chemicals). In
addition, based on existing technology (known technically as prior art), the invention “would not
have been obvious at the time the invention was made to a person having ordinary skill in the art
to which said subject matter pertains.” This is usually referred to as the “unobviousness” test.
Not only must the invention meet the foregoing criteria, it must have some utility and not be
frivolous or immoral, and there must be proof that it can be made operative. Moreover, a patent
will not be issued if the invention has been described in any printed publication anywhere in the
world or was in public use or offered for sale anywhere in the United States for more than one
year prior to the time an application for a United States patent is filed. Assuming all these
conditions are met, the patent may still not be issued because of existing valid conflicting patents.
Even if it is not possible to obtain a patent, however, it may be possible to provide basic
protection for the owners of the invention through the trade secret doctrine, or in the case of a
design invention by means of a trademark or copyright. These and other possibilities, such as an
unfair competition claim against unauthorized users of the invention, should be explored with the
client’s patent counsel.
The application for a patent is filed with the Patent and Trademark Office in Washington,
D.C. You can contact them at U.S. Department of Commerce, Crystal Palace Building, 2121
Crystal Drive, Arlington, VA 22202; telephone, 800-786-9199; web address http://www.ustpo.gov.
The grantee of a patent has non-renewable exclusive monopoly in the United States to use or
assign rights to use the patent for seventeen years from the date of issue. A patent issued in the
United States does not provide any protection in another country, however. For such
protection, additional patents must be obtained. In order to have maximum protection in all other
countries that are signatories to various treaties and conventions establishing reciprocal priority
rights, foreign patent applications must be filed in this country. Since patents in many other
countries are subject to onerous taxes and in some cases compulsory licensing within the country,
it is often advisable not to seek foreign patents, or to seek them only in countries where it will be
economically worthwhile to do so.
The time involved in pursuing all the procedural steps in obtaining a final decision on a
patent may take several years. Since the seventeen-year life of a patent begins to run only from
the date of issue and an infringement claim can cover the period between the filing of the
application and the issuance of the patent, however, the inventor’s rights are not prejudiced by
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the delay, assuming a valid patent is ultimately issued.
USING A PATENT TO GENERATE INCOME
An inventor can maintain total control of a patent and manufacture and market goods employing
a patent as a sole proprietorship. Alternatively, the inventor can sell or license the patent to
others on an exclusive or non-exclusive basis in return for a payment called a royalty. One
option is for the inventor to sell or assign the invention to a new or existing business in which the
inventor is an investor with the expectation that the business will develop and market the patented
product. These various methods of marketing a patent have different tax consequences.
Q. What are the tax consequences of patents?
A. For tax purposes, marketing an invention involves two stages. The first is the research and
development stage, when the invention is refined and reduced to practice. The expenses
incurred in this stage are generally deductible. The second stage involves the tax consequences
of sale or license of the patent once it is issued. Self-exploitation of a patented invention has no
particular tax consequences. The sale or license of rights in an invention, however, can produce
either ordinary income or capital gains, taxable at a lower rate than ordinary income under
current law. The Internal Revenue Code has very stringent requirements, however, for obtaining
capital gains treatment, and it is very important to seek the early assistance of a lawyer who is
familiar with the tax consequences of patents. This is particularly true if there is any possibility the
patent will be transferred to a business with the expectation that the owners of the business will
receive capital gains treatment on the royalties generated by the patent. For this plan to work,
the invention must be transferred to the business prior to the time the invention has been tested
and successfully operated or has been commercially exploited, whichever is the earlier. It is
often difficult to determine when an invention has been reduced to practice.
If a patent is going to be transferred by the inventor to a business in which the inventor has
an ownership interest, it is generally easier to achieve favorable tax treatment if the business is a
partnership or limited liability company than if it is a corporation.
Q. What are trade secrets?
A. A trade secret, sometimes referred to as “know-how,” is generally defined as an
aggregation of data or information not generally known in the industry that gives the user an
advantage over competitors. Common examples of “know-how” are formulas, manufacturing
techniques and processes, designs, patterns, programs, systems, forecasts, customer lists,
specifications, and other technical data. A trade secret is not patentable, nor can it be registered
as a trademark. Trade secrets are recognized legally as proprietary rights and are protected
against unauthorized use by the courts. However, for information to continue its status as “trade
secrets,” its owner must take appropriate steps to protect it from disclosure and maintain its
confidentiality. The Trade Secrets Home Page—www.execpc.com/~mhallign/–has much helpful
information.
Q. How are trade secrets taxed?
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A. Trade secrets are not specifically covered anywhere in the Internal Revenue Code.
Nevertheless, the tax treatment of trade secrets and “know how” is fairly well established by the
courts.
The expenses incurred in developing a trade secret can be either amortized or deducted.
There are no other tax consequences associated with trade secrets unless they are transferred,
for example, as part of the sale of all the assets of a business. In some situations, the amount
allocated to the trade secrets may qualify for capital gains treatment.
Q. What are trademarks and trade names and how are they protected?
A. A trademark is generally defined as any work, name, symbol, or device used by a
manufacturer or distributor to distinguish its goods from those manufactured or sold by others. A
related property right is a service mark that is basically the same as a trademark except that it
relates to services rather than goods. Certification marks, such as seals of approval and
collective marks used to indicate membership in an organization, are also related concepts.
Applications for registering a trademark are filed with the Commissioner of Patents and
Trademarks, Crystal Park Building, 2121 Crystal Drive, Arlington, VA 22202, telephone (800)
786-9199, web address http://www.uspto.gov.
A trade name is generally the name that the business uses for advertising and sales
purposes that is different from the name in its articles of incorporation or other officially filed
documents. Most states authorize the protection of a trade name by filing in that state. Drawing
the line between a trademark and a trade name can sometimes be difficult. Is “McDonalds” or
“Holiday Inn” a trade name, a trademark, or both? It is often advisable to seek protection under
both sets of statutes in these situations.
Your lawyer will help you search to discover whether there is an existing trademark or
copyright that may conflict with yours.
Q. How are trademarks and trade names taxed?
A. The cost of developing and registering a trademark or trade name must be capitalized.
The advertising and promotional expenses incurred in marketing goods and services subject to a
trademark or trade name, are, however, deductible as selling expenses.
The sale of a trademark or trade name can generally result in capital gains treatments.
Instead of an outright sale, a trademark or trade name is frequently licensed to one or more third
parties, often as part of a franchise agreement. (Franchises are discussed in the next section
of this chapter.) The income received from this licensing arrangement will generally be treated as
ordinary income rather than capital gains.
ART THAT IS PROTECTABLE BY A COPYRIGHT
Seven types of artistic endeavors can be copyrighted:
1. literary works;
2. musical works;
3. dramatic works;
4. pantomimes and choreographic works;
5. pictorial, graphic and sculptural works, including fabric designs;
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6. motion pictures and other audio visual works; and
7. sound recordings.
Copyright protection is obtained by placing the symbol and the name of the copyright holder on
every publication of the material and filing a copyright application for the artistic work with the
Federal Copyright Office, Copyright Information Office, Library of Congress, 101
Independence Avenue, SE, Room #LM 401, Washington, D.C. 20559-6000, telephone, (202)
707-9100, web address http://www.lcweb.gov/copyright. See also the website of the
Copyright Society of America, http://www.csusa.org.
Q. How are artistic efforts protected by copyrights taxed?
A. An individual who creates an artistic work, unlike the inventor of a patentable product, is
unable to obtain capital gains treatment upon the sale or transfer of the rights to the work.
However, capital gains tax treatment is possible when the creator of the artistic effort is a
corporation or business entity taxed as a partnership. Thus, sales of films produced by a
corporation, partnership or limited liability company can, under some circumstances, qualify for
favorable capital gains tax treatment.
Sidebar: Need More Help?
· For more on intellectual property generally, the Intellectual Property Owners (IPO) might be
able to help. The IPO is a membership association that represents intellectual property
owners. The IPO can be contacted at 1255 Twenty-third Street, NW, Suite 850,
Washington, D.C. 20037. Its web site is
· For more on patents, contact the National Patent Association, 216 Hulls Hill Road,
Southbury, CT 06488-9891; 800-672-2280; . A law firm
website contains much useful information and links about patents and
other forms of intellectual property.
· For copyrights, the Copyright Resource Page—-has copyright basics, FAQs, and other very useful material.
Franchises
Q. Is operating a business as a franchise something I should consider?
A. Franchising is essentially a method of marketing and distributing products and services that
usually involves the licensing of an established trademark or trade name or both. There are well
over 500,000 franchised outlets in this country in virtually every type of business. Franchises
employ several million employees and generate several hundred billion dollars of receipts each
year. In many industries, franchising is the dominant form of distribution. For example, most
automobile and truck dealerships and soft drink bottlers are franchisees.
Q. What are the advantages of franchising?
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A. From a manufacturer’s or distributor’s point of view, the logic behind franchising is simple:
it requires a great deal less capital to distribute goods and services by use of franchises than by
operating company-owned units, and additional income is generated from licensing trademarks
and trade names and from other services provided by the franchisor for the franchisee. The
major benefits to the franchisee are the use of the good will of the franchisor’s trademarks and
trade name, and expert guidance in such matters as site selection, training of employees,
bookkeeping and other managerial services. These items are particularly valuable to the
inexperienced businessperson who desires to own his or her own business but wants to minimize
the risk of failure. These services also make franchising an attractive vehicle for encouraging
minority-owned businesses.
Q. What kinds of fees and costs must a franchisee pay to the franchisor?
A. Typically, the franchisee will pay a franchise fee, which can often be spread out over a
period of years, for the right to use the trademarks, trade names, and trade secrets of the
franchisor and for managerial services involved in getting the franchise established. Frequently, a
franchisee will also be required to purchase all its initial equipment, including signs and trade
fixtures, from the franchisor. The franchisee may also be required to purchase many of its
supplies from the franchisor or from franchisor-approved sources. In addition, a franchisee will
normally pay the franchisor a royalty, which is usually based on a percentage of the gross
receipts from the franchised goods or services. The royalty covers such items as advertising and
continuing managerial services as well as a licensing fee for use of the franchisor’s trademark and
trade names. If the franchisor owns the franchised location, the franchisee will obviously have to
pay rent for the building to the franchisor.
Q. What type of business form should a franchisor or franchisee use?
A. The determination by a franchisor or franchisee to operate as a proprietorship, partnership,
corporation or limited liability company is essentially the same as for any other business. The size
and financial success of the business, tax considerations, and the potential exposure of the
investors to liabilities from the operation of the business are the principal factors that influence the
choice of business form.
In this connection, a franchisor may, in some circumstances, be held liable for the debts,
torts, or taxes of a franchisee. Increasingly, franchisors are being held liable for product liability
claims based on defective products manufactured or distributed to franchisees and ultimately sold
by the franchisees in retail sales. In many states the doctrine of privity, which at one time would
have barred any damage or injury claim directly against the manufacturer and any intermediate
distributor, has been abolished or curtailed. In addition, the Magnuson-Moss Warranty Act
authorizes a direct suit against a manufacturer in any case involving express written warranties
made by the manufacturer in connection with sales of consumer products. Franchisors are also
vulnerable to a variety of claims asserted by their franchisees.
Q. What legal protection does a franchisee have?
A. Considerable evidence suggests that historically the franchise marketing system has been
abused by both franchisors and franchisees, particularly by the former. This abuse has prompted
a considerable amount of litigation and remedial legislation in recent years both on the state and
federal level. Many states, for example, have statutes that regulate the sale, termination and
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transfer of franchises.
The most significant federal regulation of franchising is the Federal Trade Commission
(FTC) rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and
Business Opportunity Ventures.”
Q. What does the FTC franchise disclosure rule require?
A. Essentially the FTC rule requires that a franchisor give a potential franchisee a disclosure
statement (on twenty different topics) that is similar to a securities registration statement. Detailed
information about the business and financial history of the franchisor and its principals, the
franchise agreement, and financial obligations of the franchisee are required by this rule.
Provisions regulating statements by the franchisor concerning potential profitability are also
included in the rule. These projections must be related to the geographic area where the
franchisee is to operate, and the franchisor must disclose the factual basis of the projections. The
disclosure statement, which must be updated within ninety days after the close of the franchisor’s
fiscal year, and a copy of the franchise agreement, must be given to a prospective franchisee
before any person-to-person meeting between the franchisor and franchisee, or at least ten
business days before the franchisee signs any binding agreement to purchase the franchise or
makes any payment for the franchise, whichever date is the earlier. Violation of the rule is an
unfair trade practice subjecting the franchisor to a cease and desist order, damages, and fines of
up to $10,000 for each violation.
PRECAUTIONS BEFORE SIGNING A FRANCHISE AGREEMENT?
In addition to careful study of the disclosure statement and all proposed contract documents, the
FTC recommends that before investing in a franchise you take the following precautions:
1. consult with an attorney and other professional advisors before making a binding
commitment;
2. be sure that all promises made by the seller or its salespersons are clearly written into the
contracts you sign and be sure the franchisor provides training programs for new franchisees;
3. talk with others who have already invested in the business and find out about their
experiences; and
4. if you are relying on any earnings claims or guarantees, study the statement giving the basis
for the claims and find out the percentage of past investors who have done equally well.
Q. How can a lawyer help an individual or group considering a particular franchise?
A. There are a number of areas in which an attorney can provide valuable services to a client
considering a franchise. For example, though some state laws make it difficult to make major
changes in a franchise agreement, the franchisee’s lawyer can often help negotiate the critical
terms of the franchise agreement with the franchisor. It is sometimes possible to work out an
agreement to reduce the initial fee, to spread out payment of the initial fee over a longer term than
originally proposed, or to require a rebate of a portion of the initial fee if the franchise is
terminated before the expiration of the contract term. Additional protection of the franchisee
against excess competition from the franchisor or other franchisees can also frequently be
15
negotiated. Rights of the client to additional franchises in the area should be explored. Another
important area of negotiation concerns the circumstances under which the franchisor can
terminate or refuse to renew the franchise and the amount of the franchisor’s control over the
price and other terms of any sale or other disposition of the franchise. Although franchisors have
traditionally resisted any changes in their standard printed agreements, there is evidence that they
are becoming more flexible in their willingness to negotiate terms and to remove from their
standardized franchise agreements provisions that have resulted in successful claims of
overreaching and antitrust violations.
Besides negotiating the terms of the franchise agreement, the franchisee’s lawyer can also
provide valuable counseling services, for example, by assisting the client in obtaining additional
information on the franchisor from financial services companies such as Dun and Bradstreet,
Better Business Bureaus, and other franchisees, and in evaluating the economic risks of the
particular venture compared to other similar franchised and nonfranchised ventures. The amount
of initial fees and royalties and uses of the royalty income vary significantly even among
franchisors in the same line of business. Careful investigation may uncover improper hidden
charges and kickbacks. Frequently the franchisee will not be experienced in financial matters,
including knowledge of necessary start-up costs, working capital needs, and available financing
sources. The information provided a prospective franchisee under the FTC Disclosure Rule and
from other sources is of no real value if the client is unable to evaluate it properly. A lawyer can
also negotiate the business’s lease and other related agreements.
Employer-Employee Relations
Q. How are employer-employee relations regulated?
A. There are numerous federal and state statutes that regulate employer-employee relations.
Most of these statutes have been enacted in the past thirty years. A list of some of the
most important federal legislation in this field includes the following:
· The Norris-LaGuardia Act and the Labor Management Relations Act, which regulate
labor unions.
· The Fair Labor Standards Act, which primarily regulates minimum wages, maximum
hours and overtime.
· The Equal Pay Act, which prohibits sex-based pay differentials for equivalent work.
· Title VII of the 1964 Civil Rights Act, the principal statute that prohibits employment
discrimination based on race, color, sex, religion or national origin. Title VII also
established the Equal Employment Opportunity Commission, which is the main
administrative body with responsibility to enforce employment anti-discrimination
legislation.
· The Age Discrimination in Employment Act, which prohibits discriminatory practices in
hiring, firing, compensating and setting terms of employment of individuals forty years
of age or over.
· The Occupational Safety and Health Act of 1970, administered by the Occupational
Safety and Health Administration (OSHA), which sets safety and health standards for
production plants and machinery.
· The Americans With Disabilities Act, which requires removal of barriers to persons
with disabilities by all businesses “providing public accommodations,” a term which is
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much broader than it sounds and includes restaurants, theaters, and even doctors’
offices.
· The Employee Retirement Income Security Act of 1974, referred to as ERISA, which
establishes substantive and procedural rules for employee pension and welfare
benefits, such as medical coverage.
· The Family and Medical Leave Act, enacted in 1993, which requires employers to
allow individuals up to twelve weeks of unpaid leave per year to care for a child or
other family member without fear of dismissal or other penalty.
In addition to these statutes, there are a number of federal statutes that affect private
businesses only if they receive federal financial assistance. Examples are the Comprehensive
Employment and Training Act of 1973, which prohibits discrimination in special employment
incentive programs that receive federal assistance, and Titles VII and VIII of the Public Health
Service Act, which prohibit discrimination in health training programs that receive federal
assistance.
There are also many state statutes that regulate employment relations. Some of these state
statutes parallel and often overlap federal statutes. Others, however, deal with issues not dealt
with in federal statutes. The most prominent of these are the state workers compensation
statutes that compensate employees for job-related injuries on a no-fault basis.
Q. Is every one of these acts applicable to small businesses?
A. Almost all businesses are subject to one or more of these statutes. Some small businesses
may, however, be exempt from one or more of the acts, because of their size. For example,
Title VII of the Civil Rights Act covers only employers having fifteen or more employees, and the
Age Discrimination in Employment Act covers only businesses having twenty or more
employees. On the other hand, the Fair Labor Standards Act, the Equal Pay Act and the
Americans with Disabilities Act cover virtually all non-governmental employers.
PREVENTIVE LAW TO THE RESCUE
Because of the differing exemptions, the overlap between the various applicable statutes and the
involvement of various federal and state administrative agencies, there are many problems in
complying with all the regulations (many of which are inconsistent) and developing case law.
Moreover, the law in this area is developing and changing so rapidly that it is advisable for
businesses to invite employment law specialists to visit the business on a regular basis to review
recent legal developments and any existing and potential employment law problems the firm has.
This “preventive law” approach can help to reduce the incidence of employment law problems
and the severity of any problems that do arise.
Q. Can compliance with these regulations be avoided by the use of temporary
workers and independent contractors?
A. The answer is generally yes, assuming the contractual relation creating the arrangement is
bona fide. The use of temporary workers, including leased-employee arrangements, part-time
employees, and independent contractors, has been growing rapidly in recent years. By using
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these kinds of workers instead of full-time employees, a business may be able to qualify for an
exemption from many of the federal and state statutes that regulate employers. Moreover, having
very few employees saves on health insurance premiums and makes it less costly for a business
to have generous fringe benefit plans for the principal executives.
These cost savings must, of course, be borne by the company that provides the temporary
employees and the independent contractors providing services for a business, which in turn may
increase the amount the business must pay for these services. These companies, however, can
often provide compliance more efficiently and cost effectively than most small businesses.
The downside for companies using temporary and leased employees is the considerable risk of
lower morale on the job, reduced quality and productivity, and the need to be seeking and
training workers constantly. When figuring in these factors, many companies have concluded that
the cost savings are illusory and they’re better off with experienced, full-time employees.
TYPES OF BUSINESS ORGANIZATIONS
There is a wide variety of basic legal formats for structuring a business. Each type has its own
special characteristics, uses and limitations. The proprietorship, partnership, and corporation are
the most popular and well known. A newer but increasingly popular form of business
organization is a limited liability company. The principal characteristics of all these types are
described in this section.
For More on Proprietorships
You can find information about tax laws and sole proprietorships from
· http://www.intuit.com/turbotax/support/taxedge/ref/propriet.html
· http://www.irs.treas.gov/prod/tax_edu/teletax/tc408.html
Q. What is a sole proprietorship?
A. A sole proprietorship is an unincorporated business that is owned by one person. If there
is more than one owner or the business is incorporated as a corporation, a process that is
described later in this chapter, it cannot be a proprietorship.
A proprietorship can have employees, however, and, except for a few restrictions that
vary from state to state, can operate any type of business. If you conduct a business without coowners
and take no legal steps to become another form of business, then you are a sole
proprietor with respect to that business even if you are not aware of this fact. A person who, for
example, on a part-time basis paints pictures in her home which she exhibits and sells is a sole
proprietor with respect to her paintings and therefore must comply with all applicable tax,
licensing and other regulations.
Sole proprietorships are the most prevalent form of business in this country. Recent
published statistics indicate that there are over 14 million proprietorships compared to 3.5 million
corporations and 1.6 million partnerships.
Q. What are the advantages and disadvantages of a proprietorship?
A. The sole proprietorship is an inexpensive and informal way of conducting a small business.
Its drawbacks are full personal liability for the owner (explained below) and the danger of
liquidation at the death of the proprietor.
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The principal advantage of the sole proprietorship is that it is the simplest form of business
organization. No statutes similar to those applicable to corporations and partnerships govern its
organization or operation, though, as explained in the section of this chapter on getting organized,
if the person uses a name other than his or her own, he or she may need to file a “Doing Business
as Certificate” or “Assumed Name Certificate.” The sole proprietorship provides an
entrepreneur with an opportunity to own his or her own business without the formalities and
expense of incorporation or the necessity of sharing control of the business with others, as is the
case in a partnership or in a corporation having more than one shareholder.
The fact that the assets and obligations of a sole proprietor are not separate from those of
the proprietor results in the proprietor’s being fully liable for the debts and other liabilities of the
proprietorship, and avoids a separate level of taxation on the business. The taxable income,
credits, and deductions of the business must be reported by the proprietor on his or her
individual income tax return.
A proprietorship also has the least flexibility of all the business forms with respect to raising
capital. No ownership interests can be sold to other persons; and the ability to borrow money
for the business is dependent on the net assets of the sole proprietor.
WHEN THE PROPRIETOR DIES
The single-ownership principle combined with the lack of separate entity status creates severe
problems at the death of the proprietor. Legally a sole proprietorship ceases to exist at the
proprietor’s death. Unless the executor is authorized to continue the business during the
administration of the estate, a new owner is found, or the business is incorporated, the
proprietorship will have to be liquidated with the consequent loss of the going concern value.
For the same reasons, providing an optimum estate plan for a sole proprietor is more restricted
than with the other forms of business organizations.
Q. What are partnerships?
A. A partnership is an unincorporated association of two or more persons who carry on a
business for profit as-owners. A partnership exists if these conditions are met, even though the
persons involved do not know or intend that the business be a partnership. If a husband and
wife, for example, are jointly operating an unincorporated retail shoe store, unless it is clear from
their financial records that one of them is the true owner and the other is merely an employee (in
which event the company would be classified as a sole proprietorship), the business will be a
partnership and both the husband and wife will be considered as partners and-owners of the
business.
Q. What kinds of partnership exist and what are the differences between them?
A. There are two types of partnerships recognized in the United States: general partnerships
and limited partnerships. The fundamental distinction between the two types is that in a limited
partnership, there must be at least one limited partner and at least one general partner. The
advantage of being a limited partner is that if the business is unsuccessful, the limited partner may
lose the amount of money invested in the partnership, but has no other financial risk. In this sense
a limited partner bears the same risk of loss as a shareholder in a corporation or a member of a
limited liability company. General partners, including general partners in a limited partnership, on
19
the other hand, can lose not only whatever money or other property they have put into the
partnership, but in addition their personal assets can be used to satisfy the unpaid claims of the
partnership’s creditors. This is why general partners are said to have unlimited liability whereas
limited partners are said to have limited liability.
The following are the primary differences between general and limited partnerships: first,
only limited partners have limited liability; second, limited partners can lose their limited liability if
they take part in control of the business and third parties believe them to be general partners;
third, a change in the number or composition of limited partners is not potentially as disruptive as
the retirement, death, or disability of a general partner; and fourth, there are in general more legal
formalities connected with limited partnerships, including the necessity of filing limited partnership
certificates in one or more places, keeping them up to date, and maintaining certain records.
With the exception of compliance with state and local assumed name statutes, there are no
mandatory filing requirements for general partnerships in most states.
Q. What are the advantages of partnerships?
A. The principal advantage of partnerships is the ability to make virtually any arrangements
defining their relationship to each other that the partners desire. There is no necessity, as there is
in a corporation, to have the ownership interest in capital and profits proportionate to the
investment made; and losses can be allocated on a different basis from profits. It is also generally
much easier to achieve a desirable format for control of the business in a partnership than in a
corporation, since the control of a corporation, which is based on ownership of voting stock, is
much more difficult to alter.
Because it is possible to sell equity interests in a partnership, the ability to raise capital in a
partnership is greater than in a proprietorship. However, as a result of the greater familiarity with
the corporate form, and the potential of personal liability or lack of participation in control in a
partnership, a corporation may have a greater ability to raise capital than a partnership.
With careful advance planning, a partnership can avoid some of the problems inherent in a
proprietorship when an owner dies, retires, or becomes disabled. In fact, many believe that a
limited partnership is an ideal vehicle to provide for continuity and succession in a family business.
The mechanics of succession vary with the situation. If you want to pass your share of the
business to other family members (usually a spouse or children), it is relatively simple to transfer
your interest to them, perhaps by leaving the family members enough cash (possibly through life
insurance proceeds) to buy out the others and thus avoid conflicts. (In a small corporation, you
could leave voting stock to family members who will operate the business, and leave non-voting
stock to others.)
Things get slightly more complicated if you decide to pass ownership on to people who are
not beneficiaries of your will. If your business is a partnership, you will usually want your
partners to remain in operational control. A “buy-sell agreement” is the most common device for
transferring ownership of a business on the death of a partner. Under such an agreement, the
remaining partners agree to purchase your interest when you die. This allows the business to
continue running smoothly with the same people in charge, minus one.
Buy-sell agreements typically provide that at the owner’s death, his or her interest in the
business will be acquired by the remaining partners or shareholders, or by the business itself,
leaving the deceased owner’s relatives with the proceeds of the sale. Life insurance is usually the
vehicle used to finance these arrangements, which lets the business avoid a drain on its cash. The
partners buy life insurance on each other’s lives, and the proceeds go to the surviving spouse,
children, or other designated beneficiaries, in return for the deceased owner’s share of the
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business.
Partnerships are taxed on a conduit or flow-through basis under subchapter K of the
Internal Revenue Code. This means that the partnership itself does not pay any taxes. Instead
the net income and various deductions and tax credits from the partnership are passed through to
the partners based on their respective percentage interest in the profits and losses of the
partnership, and the partners include the income and deductions in their individual tax returns.
For More on Partnerships
· http://www.bizmove.com/starting/m1r.htm is the URL of a useful checklist on points to consider
when entering into a partnership. The site also has other useful information for the
businessperson.
· http://www.inc.com/bbs/list/19 is the URL of a “peer-to-peer” bulletin board on topics of interest
to business owners, including partnership disputes and other partnership issues.
· Azriela L. Jaffe, Let’s Go into Business Together: 8 Secrets to Successful Business
Partnering (Avon Books, 1998) looks at the personal dimensions of this sometimes difficult
business form.
· Robert L. Davidson, III, Small Business Partnership Kit, looks at the pros and cons and
provides guidance on many of the legal aspects.
Q. What are the disadvantages of partnerships?
A. The major disadvantages of a partnership, as with a proprietorship, stem primarily from the
fact that a partnership is not as stable as a corporation. This results from the fact that a general
partnership technically dissolves whenever a general partner dies, files bankruptcy, resigns or
otherwise ceases to be a partner (dissociates). A general partnership and a limited partnership
dissolve on the dissociation of a general partner unless either a remaining general partner
continues the business or all the partners (or under some statutes, a majority) agree to continue in
business. Upon dissolution, a partnership will normally be required to be liquidated, but in most
large professional general partnerships, the partners agree to continue the business. However, a
corporation, under most statutes, continues forever until some affirmative action is taken to
dissolve it.
It may be more difficult in a partnership than in a corporation to have a hierarchy of
management and to raise capital from outside sources. Careful planning and drafting, however,
can minimize or eliminate most of these and other supposed disadvantages of a partnership,
through agreements providing for a specific governance relationship and desired variations in
capital ownership in a partnership. This is particularly true with respect to limited partnerships.
Q. What are corporations and how do they differ from other types of business
organizations?
A. A corporation is a legal entity that is formed by filing what is known as articles of
incorporation or a certificate of incorporation with the Secretary of State in your state along with
the required filing and license fees.
One or more persons can form a corporation. Thus, a sole proprietor can incorporate if
he or she wants to. Although there are some exceptions (doctors and lawyers are prohibited by
ethical and regulatory constraints from operating in certain types of corporations), corporations
21
can generally operate any type of business.
The person or persons who file the articles or certificate of incorporation are called
incorporators. The equity ownership interest in a corporation is called stock and the owners of
shares of stock are called shareholders or stockholders. There are two types of stock, common
stock and preferred stock. They differ in that dividends generally must be paid on the preferred
stock before the common stock receives dividends. Another difference is that upon liquidation,
the owners of the common stock are paid the amount of the corporation’s assets left over after
paying all the creditors and the amount due the holders of the preferred stock (which usually
includes accrued but unpaid dividends and the par value or redemption value allocated to the
preferred stock). In short, the common stock is entitled to the residual value of the corporation.
That is why the value of the common stock fluctuates with the success of the corporation. If the
corporation is successful, the value of the common stock will increase to the extent the net profits
are not paid out in the form of dividends. On the other hand, if the corporation loses money, the
value of the common stock will decrease in order to reflect those losses. There are instances in
which the value of stock will increase even if the corporation is not showing a profit. This is
particularly true in start-up companies in which there are no profits available for reinvestment but
the business is growing or developing.
THE BASIC CHARACTERISTICS OF A CORPORATION
Acceptance of a corporation as a separate legal entity evolved during the 19th century. It is now
well established that a corporation has a legal status that is independent of its shareholders.
Partnerships and limited liability companies are also legal entities for some purposes. The
separate entity status of partnerships is, however, less complete than in corporations. The entity
status of limited liability companies, on the other hand, is virtually the same as corporations.
The corporation’s independent existence as an entity undergirds the basic corporate attributes of
limited liability, perpetual existence, free transferability of shares, and the ability to own property,
bring suit, and be sued in the corporate name. It also accounts for the tripartite system of
corporate management, consisting of shareholders, directors, and officers.
Q. What is the advantage of corporate limited liability?
A. Shareholders generally are at risk only for the amount of money or other property they
invest in the corporation, though some state laws impose shareholder liability for unpaid wages in
small corporations. Creditors of the corporation whose claims are greater than the assets of the
corporation cannot satisfy their excess claims against the personal assets of the shareholders,
unless the shareholders have previously obligated their personal assets by personal guarantees or
co-signing a note or other obligation in their individual capacity. This ability to shield personal
assets from the creditors of a corporation has long been the principal reason why investors have
been more willing to invest in a corporation than any other type of business organization. As was
pointed out earlier, sole proprietors and general partners are personally liable for all the debts
and other obligations of a business they own. Given a choice, an investor will always choose
limited liability to unlimited liability.
It is now possible to achieve at least some form of limited liability in most other types of
business organizations. Limited partners, for example, have limited liability. So do all of the
members in a limited liability company. Moreover, the shareholders of a corporation that is a
22
general partner also have limited liability, though the corporate general partner itself is liable.
Nevertheless, the corporate-style limited liability is generally thought to be more complete and to
provide more flexibility than in other types of business organizations. Limited partners, for
example, lose their limited liability if they take part in the control of the partnership in a manner
not permitted by the state’s governing statute, provided that creditors are led to believe by that
control that the limited partner is a general partner. Corporate shareholders do not, however,
lose their limited liability by exercising control rights. In fact, one of the most important attributes
of share ownership is that shareholders control the corporation through their voting rights.
When shareholders of a corporation guarantee its debts, co-sign its notes in their individual
capacity, or pledge their own assets as security for loans to the corporation, which frequently
occurs because of creditors’ demands, the shareholders waive their limited liability with respect
to those debts, notes or assets. But this is a limited waiver. The shareholders in question still
have limited liability with respect to any other debts or obligations of the corporation.
The following example will help to illustrate this distinction. Suppose the sole shareholder
in a corporation personally guarantees payment of a $20,000 bank loan that is used to purchase
a new delivery truck for the corporation. Subsequently the corporation ceases doing business
and is liquidated. At the time of liquidation the corporation has $50,000 of assets and the
creditors of the corporation other than the bank that made the truck loan have valid claims of
$75,000. Assume further that the unpaid balance on the bank note is $15,000. The bank can
recover the $15,000 owed it directly from the shareholder because of the personal guarantee.
The other creditors, however, can recover only $50,000 from the corporation. They cannot
recover the additional $25,000 they are owed from either the corporation, because it does not
have any more assets, or from the shareholder, because his other assets are protected by the
limited liability doctrine.
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For More on Corporations
· The Business Owner’s Toolkit is a very useful site for small business that contains much
useful information on starting corporations and other practical legal matters. Access the
material on corporations at http://www.toolkit.cch.com/text/P01_4770.asp
· Another good general site is the “law tools” of http://www.lawoffice.com/, which includes
helpful excerpts from West’s Encyclopedia of American Law, among other resources.
· The Quicken site on small business contains a number of steps to take in forming a
corporation, as well as FAQs. Access it at http://quicken.webcrawler.com/small_business.
· The IRS is a good source of info on the taxing question of S Corporations v. C
Corporations. See in particular Publication 542, Corporations; Publication 17, Your Federal
Income Tax; Publication 535, Business Expenses; Publication 533, Self-Employment Tax,
Self-Employment Income; and Publication 550, Investment Income and Expenses. The IRS
website–www.irs.ustreas.gov–has all of these on line, as well as much more.
· Cornell’s Legal Information Institute has many on-line resources about corporations. Access
http://www.law.cornell.edu/topics/corporations.html.
Here are some resources that focus on the questions to ask yourself in deciding if you
should incorporate and deepen your understanding of the steps involved.
· Carl R.J. Sniffen, The Essential Corporation Handbook (Oasis Press, 1995) answers
some important questions and will help you work with your accountant and lawyer.
· Robert L. Davidson, III, The Small Business Incorporation Kit, (John Wiley & Sons,
1992), offers plenty of explanations and guidance on actually running the corporation.
· Michael R. Diamond and Julie L. Williams, How to Incorporate: A Handbook for
Entrepreneurs and Professionals John Wiley & Sons, 1996) offers guidelines and
suggestions on how to avoid problems.
THE IMPORTANCE OF PERPETUAL EXISTENCE
When a general partner ceases for any reason to be a partner, the partnership will end up being
dissolved and liquidated unless the remaining partners agree to continue the business. Getting
necessary consent from the partners to continue the business can be very difficult and may be
impossible. Yet liquidation may result in significant losses to all the partners. This risk of
dissolution and liquidation is one of the principal drawbacks of operating a business as a
partnership. In a corporation, on the other hand, if a shareholder leaves, there is no risk of
liquidation (unless that departing shareholder has a contractual or voting right to force a
liquidation) because the life of a corporation is indefinite. Thus, perpetual existence gives a
corporation permanence, and this in turn is thought to make investments in a corporation
somewhat safer and less risky than investments in business organizations that have less inherent
permanence.
A reasonable form of perpetual existence can be obtained in both partnerships and limited
liability companies through buyout agreements and other contractual arrangements, but these
agreements must be carefully crafted to meet various legal and tax requirements.
Q. Is the ability to freely transfer shares of a corporation important?
A. In large corporations with many shareholders, the answer is yes. Being able to freely
transfer shares to anyone at any time gives an investor the right to liquidate his or her investment
24
at any time. This right to transfer makes shares of the stock very marketable, provided, of
course, there is someone who wants to buy them. The shares of all the corporations whose
stock is registered with a stock exchange like the New York Stock Exchange are, for example,
freely transferable.
But in a small corporation with only a few shareholders, free transferability of stock can
often be a detriment. Assume, for example, that one of the three founding shareholders of a
corporation that operates a camera store wants to sell his or her shares to someone the other
two shareholders intensely dislike. Assume further that in order for the camera store to be
successful, it is necessary for all three of the shareholders to work in the store on a regular basis
without undue friction between them. If the shareholder who wants to sell can freely transfer his
or her shares to anyone, and the other two shareholders cannot prevent the sale, disastrous
results may ensue. In many states, a complete prohibition against the transferability of stock is
not possible, and that is the reason why in most small corporations, the shareholders will enter
into what is known as a shareholders’ agreement or a share transfer restriction agreement, which,
subject to case law and statutory requirements, will impose restrictions on the sale of stock.
Legal counsel is needed to draft the terms of such an agreement.
Restricting the free transferability of the shares, however, can produce its own set of
problems, one of which is that the shareholder who wants to sell may not be able to find a buyer
acceptable to the other shareholders. To counteract this illiquidity problem, the shareholders
may want to enter into what is known as a redemption or cross-purchase agreement, under
which the corporation or the other shareholders agree under certain specified conditions to buy
the stock of a shareholder who wants to liquidate his or her investment in the corporation.
Q. How does the separate entity status of a corporation affect its right to own
property, bring suit or be sued in its corporate name?
A. A corporation as a separate legal entity has the right to own and dispose of property in its
own name and to sue and to be sued it its own name. This facilitates commerce by not requiring
action by all shareholders.
While partnerships for some purposes are not considered as entities, all states have
statutes that allow them to own and convey property in their own name. Moreover, most states
now have statutes that allow partnerships to sue and be sued in their own name. Suits by and
against partnerships used to be a significant problem, however, until these statutes were enacted.
A limited liability company, like a corporation or a partnership, may own property and
commence and defend lawsuits in its own name. A proprietorship, on the other hand, does not
have separate entity status, but this does not cause any practical problems because there is only
one person, the sole proprietor, in whose name title to property belonging to the proprietorship is
taken. Moreover, suits by and against a proprietorship must be in the name of the sole
proprietor, even if the proprietorship operates under a name different from that of the proprietor.
A DISTINCTIVE MANAGEMENT STRUCTURE
There are three levels of management in a corporation. The shareholders, as previously
discussed, own the equity stock and vote on fundamental issues affecting the corporation. One
issue of vital importance is the right of the shareholders to elect the directors of the corporation.
The directors are by statute in charge of managing the corporation. They in turn select the
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officers, who run the corporation on a day-to-day basis and as the agents of the corporation
implement the policies established by the board of directors.
Q. How are small corporations magaged?
A. The tripartite management scheme works well in a large corporation. But it can cause
difficulties in a small corporation having only a few shareholders. In a corporation with one
shareholder, or example, it is burdensome to go through the mechanics of having that shareholder
elect himself or herself as a director and then in a subsequent meeting elect himself or herself to
various offices. Yet that is what is required by the corporate statutes in most states.
Voting is based on number of shares, not number of shareholders. Consider a situation
where one of three shareholders in a corporation owns 67 per cent of the stock and the other
two own the remaining stock. Because directors are elected by a majority of the stock, the 67
per cent shareholder can nominate and elect all the directors, and the directors in turn will elect
all of the officers. Because the holders of two-thirds of the shares under corporate statutes can
approve any action that shareholders are entitled to vote on, the 67 per cent shareholder can
vote to merge with another corporation or to liquidate the corporation, regardless of the wishes
of the two minority shareholders.
It is possible to give the minority shareholders in the above example some protection
through various special provisions that have been incorporated into state corporate statutes in
recent years. One way is to have cumulative voting, where if three directors are to be chosen,
shareholders can use their votes for one director, rather than vote for each candidate. Another
way to enhance the rights of the minority shareholders would be to create two classes of shares
and allow each class to elect an equal number of directors. Since the directors elect the officers,
a slate of officers acceptable to the minority shareholders would have to be proposed in order to
elect any officers. Each class voting separately would also have to approve any fundamental
change in the corporation, such as a merger or liquidation. Thus, the minority shareholders
would, in effect, have equal management rights in the corporation even though they own only
one-third of the stock.
Q. How does the management structure of a corporation compare with that of a
general partnership?
A. The management structure of a general partnership is very different. Unless the partners
otherwise agree, each partner has one vote, and action in the ordinary course of business
requires approval by a majority of the partners. Extraordinary action, however, requires
unanimous consent of all the partners. Thus, in a general partnership with three partners, one of
whom has 67 per cent of the capital and profits, the 67 per cent partner can be outvoted on all
ordinary course of business decisions by the other two partners. The 67 per cent partner could,
however, prevent the partnership from merging with another partnership.
Another difference between general partnerships and corporations is that in most
partnerships the partners perform every management function in their capacity as partners.
Therefore, you do not need to have the three levels of management that exist in a corporation. In
a large partnership, however, for the sake of convenience and efficiency, the partners will often
select one or more managing partners to run the business on a day-to-day basis. In this type of
arrangement the managing partners are like the board of directors and officers of a corporation,
and the other partners function somewhat like the shareholders in a corporation.
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Q. Is the management structure of limited partnership different?
A. A limited partnership has a management structure that is a hybrid between a general
partnership and a corporation. The general partners are like the managing partners in a general
partnership. The limited partners are like passive non-management shareholders in a
corporation. However, they lose their limited liability if they take part in the control of the
business with respect to people who are misled by such participation in control into believing that
a limited partner is a general partner.
In a limited partnership, voting rights of the partners, including the general partners, may be
modified by the agreement of the partners. In the absence of such an agreement, decisions are
made by the general partners on a per capita basis, as is the case in a general partnership.
Q. What is the management structure of a limited liability company?
A. The management structure of a limited liability company has features of both partnerships
and corporations. Unless management is delegated to designated managers, the investors in a
limited liability company, called members, exercise all management rights. This is the same basic
scheme as exists in a general partnership. The various limited liability statutes differ, however,
with respect to whether the members have per capita voting rights, as in a general partnership, or
voting rights based on the respective percentage of total capital.
SIMPLE AS CAN BE
The management structure of a proprietorship is quite simple. The sole proprietor is the only
person who has management power so there are none of the complexities that exist in the other
forms of business organizations.
Q. How are corporations taxed?
A. There are two subchapters in the Internal Revenue Code that govern corporations. One is
Subchapter S, which corporations meeting designated criteria can elect. The other is Subchapter
C, under which the majority of corporations operate.
Q. How are corporations that elect to be under Subchapter S taxed?
A. S corporations, as they are commonly called, are taxed in a manner similar to partnerships,
although there are important differences between S corporations and partnerships. Except in a
limited number of circumstances, an S corporation does not itself pay any taxes. Rather, the
income and deductions generated by the S corporation are passed through to the shareholders,
who report their proportionate share on their individual tax returns. The requirements for
qualifying to elect to be taxed as an S corporation are discussed later.
Q. How are corporations taxed under Subchapter C of the Internal Revenue Code?
A. A corporation which has not made an election to be taxed as an S corporation must pay a
tax on its net taxable income, and then the shareholders must pay a second tax on any of the
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corporation’s net earnings that are distributed in the form of taxable dividends. In many cases,
the total of these two taxes, plus the tax on any money received by a shareholder as a salary for
working in the corporation, will be more than if the same income was subject to only one level of
taxation-as is the case with S corporations, proprietorships, partnerships and limited liability
companies, which are taxed on the conduit or flow-through theory. Although the corporation’s
income is taxed when earned, a shareholder is not taxed until property or cash is distributed to
the shareholder in an operating distribution, redemption of the shareholder’s shares, or
liquidation.
The double taxation of C corporation taxable income is definitely disadvantageous when
the combined taxes payable by the corporation and its shareholders exceed the total taxes
payable if the business were operated as a partnership, proprietorship, limited liability company
or S corporation. With respect to fringe benefits, however, C corporations enjoy a distinct tax
advantage over the other forms. Shareholders who are employed by a corporation in some
capacity-unlike sole proprietors, partners and the members of a limited liability company, who
are regarded as self-employed can qualify as employees of the company and, therefore, are
eligible for special life and medical insurance programs and other fringe benefits offering
advantageous tax results. For the most part, however, these fringe benefits must not discriminate
in favor of any highly paid corporate executives and therefore involve significant costs to the
business. The overall tax savings derived from these fringe benefits is usually marginal, and in
most situations it will not constitute a significant factor in deciding whether to incorporate a new
business.
SEVERAL TYPES OF CORPORATIONS
As is evident from the prior discussion of taxes, there is more than one kind of corporation, just
as there is more than one kind of partnership. The various types of corporations, however, are
not as distinct as are general and limited partnerships. From a non-tax perspective there are three
principal forms of corporation: the general business corporation and two specialized derivatives
of the general business corporation, the close corporation and the professional corporation. For
federal income tax purposes any of these corporations may be subject to double taxation (a C
corporation) or, if the corporation otherwise qualifies and elects to be taxed as such, an S
corporation.
Q. What is a business corporation?
A. A business corporation is a corporation, generally organized for profit, that is formed
under a state’s corporation act or business corporation act. If a general business corporation,
(including a professional corporation or a close corporation) does not qualify or elect to be an S
corporation, it will be treated as a C corporation and subject to double taxation under
Subchapter C of the Internal Revenue Code. Shares of stock in a business corporation are
securities subject to state and federal registration unless they or the transactions in which they are
sold are exempted from such laws.
Q. What is a close corporation?
A. A close corporation is one in which, as a general rule, all or most of the shareholders are
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actively involved in managing the business. Many state corporation statutes have special
provisions that are designed to meet the needs of close corporations. These special statutes vary
from state to state but generally provide that the shareholders may manage the corporation
directly rather than through directors or officers and that the shareholders may make other
agreements for management which are not available to other corporations.
The term “close corporation” is applied not only to corporations formed under close
corporation statutes, but also to those with a small number of shareholders, who are generally
actively involved in the management of corporation. Using this criterion, most corporations
qualify as close corporations. A study made several years ago concluded that 95 per cent of all
corporations in the United States had ten or fewer shareholders.
Q. What is a professional corporation?
A. This kind of corporation is limited to the practice of one or more professions with licensed
professionals as its shareholders. Tax advantages are now marginal, but protection from
malpractice on the part of other shareholders remains an important motive for incorporation
rather than practicing a profession as a sole proprietorship or in a partnership, although under
some state laws these corporations do not protect innocent shareholders from personal liability.
Historically, professionals such as doctors, lawyers, and accountants have been prohibited
from conducting business in a corporate form. The main rationale advanced for this policy is the
necessity of preserving full individual liability for professional malpractice and the fact that only
individuals could be licensed. Under traditional corporate law, the separate entity doctrine would
theoretically protect a professional doing business as a corporation from personal liability for
malpractice committed by his or her associates, even though a judgment in excess of the
corporation’s assets is recovered by a claimant.
A professional corporation is a business corporation and may be a close corporation with
a fancy name. The major differences are that:
1. most of the professional corporation statutes limit the purposes of a professional
corporation to the practice of single profession;
2. only licensed professionals employed by the professional corporation can be shareholders
or directors-a requirement that necessitates a mandatory buy-out plan if the professional
retires, dies, or has his or her license to practice suspended or revoked;
3. although a professional is individually liable for his or her own malpractice, in most states
there is no liability for the malpractice of other professionals in the professional
corporation; and
4. either the term “professional corporation” or “professional association,” or one of their
abbreviations, must be used in the corporate name and included on all letterheads,
contracts, and advertising material.
Several states in the past few years have enacted statutes, included as part of their general
partnership statutes, which protect partners against malpractice liability to the same extent, and in
some cases provide more complete protection than, professional corporation statutes.
Partnerships electing this status are called limited liability partnerships.
Because of the decrease in the tax advantage once enjoyed by professional corporations
and the advent of limited liability partnerships, there are likely to be fewer new professional
corporations founded in the future than in past years.
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Q. What is an S corporation?
A. An S corporation is a business corporation (including a professional corporation, a close
corporation or both) that has elected to be taxed in a manner similar to a partnership under
Subchapter S of the Internal Revenue Code rather than according to the provisions of
Subchapter C, the normal corporate tax sections. As previously explained, the principal
distinction between S and C corporations is that S corporation income for the most part is not
subject to double taxation at both the corporate and the shareholder level. Recent federal tax
legislation that has liberalized the eligibility requirements for S corporations and changed the
maximum rates on taxable income has dramatically increased the number of S corporations. At
the present time, approximately one-third of all corporations are S corporations.
The basic eligibility requirements are that the corporation be a domestic corporation and
not have:
1. more than one class of stock;
2. more than seventy-five shareholders,
3. or own 80 percent or more of the stock of another corporation.
All of the shareholders must be individuals (some trusts and estates can qualify, however),
and must be United States citizens or resident aliens. Any corporation, including a professional
corporation and an existing C corporation, can elect to be taxed under Subchapter S if the
eligibility requirements can be met. If it appears it may be advantageous at some point to be an S
corporation, however, it is generally advisable, because of some very complex potential adverse
tax consequences, to start off as an S corporation rather than converting from a C to an S
corporation sometime after incorporation.
Q. How does a corporation choose to be taxed as an S corporation?
A. The election to be taxed as an S corporation is made by filing a Form 2553, which must
be signed by all the shareholders. The Form 2553 must be filed not later than two months and
fifteen days after the beginning of the taxable year in which it is to be effective. For newly formed
corporations that wish to have subchapter S apply from their inception, the taxable year begins
when the corporation has shareholders, acquires property or begins doing business, whichever
occurs first. This technicality can be a trap for the unwary. For example, the period for filing the
Form 2553 begins to run from the day the corporation enters into a lease, even though it is not at
that time conducting any business operations and even though the incorporation process is
incomplete and no shares have been issued to the shareholders. If the Form 2553 is filed after
the two-month, fifteen-day period, the subchapter S election will not be effective until the
corporation’s second taxable year, and it will be taxed as a C corporation for its first taxable
year. Therefore, it is important that the Form 2553 be filed as soon as possible after the articles
of incorporation have been filed.
HOW STATES TAX S CORPORATIONS
The taxation of S corporations under state tax laws varies from state to state. For the most part,
S corporations are taxed the same under state law as they are under the Internal Revenue Code.
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Some states, however, exact a special tax on S corporations that is similar to the state’s income
or franchise tax on C corporations. The differences in state taxation of S corporations can also
cause technical difficulties for shareholders who are residents of states other than the state where
the S corporation has its principal place of business. These are issues that shareholders should
discuss with a lawyer and accountant before deciding whether to elect subchapter S status.
Q. What is a limited liability company?
A. A limited liability company (LLC) is an unincorporated business organization that provides
the same flexibility of organization as a general partnership, the same limited liability protection for
its owners, called members, as is provided to the shareholders of a corporation and, generally,
the same pass through taxation as a partnership. The combination of flexibility, limited liability
and the avoidance of the two-tiered tax on C corporations makes an LLC very attractive to
investors.
There are two other features of LLCs that make them attractive. First, the members may
have full management rights without the prohibition against taking part in the control of the
business that applies to limited partners in a limited partnership and the cumbersome three-tiered
management structure of shareholders, directors and officers of a corporation. Second, although
a member can, unless otherwise agreed, freely transfer his, her, or its financial rights in an LLC,
under many of the statutes rights to participate in the governance may not be transferred without
the consent of the remaining members. This protects the remaining members against
unacceptable transferees becoming involved in the management of the business.
Moreover, there are no restrictions on the number or type of persons who can be
members of an LLC or the types of interests. Consequently, LLCs can be used in far more
situations than S corporations, which can have no more than seventy-five shareholders, all of
whom, with the exception of certain types of trusts and estates, must be United States citizens or
resident aliens. An LLC, for example, can have a nonresident alien, corporation, partnership or
another limited liability company as a member.
Q. Aren’t limited liability companies fairly new?
A. Yes. The first LLC statute in this country was enacted in 1977 by
Wyoming. Florida adopted a similar act in 1982. Very few LLCs were formed,
however, until after 1988 when the Internal Revenue Service ruled that they
would be taxed as partnerships rather than as C corporations as long as they met
certain requirements. The two principal requirements are that the membership
interests not be freely transferable and that the limited liability company not have
the same type of continuity of existence as a corporation. These requirements
are relatively easy to meet under the existing LLC statutes.
New IRS regulations in the summer of 1996 further relaxed the
requirements for limited liability companies and other unincorporated businesses
to be taxed as partnerships. Now any unincorporated business organization is
automatically taxed as a partnership unless it elects to be taxed as a
corporation. This should mean that LLCs will be used much more widely than in
the past.
Almost all states now have LLC statutes. The statutes differ greatly, however, and these
differences can create uncertainty. State taxation of LLCs also varies. In addition, many
technical state tax issues are still being resolved. As these and other uncertainties, caused
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primarily by the newness of this type of business organization, are being resolved, an increasing
number of businesses are being formed as LLCs, and this trend is expected to continue. Some
experts predict that in time LLCs will supersede partnerships and S corporations as a preferred
form of business entity, but in all probability, LLCs will provide an alternative to existing business
structures, to be used only in appropriate circumstances.
For More on LLCs
The following provide more information to help you decide whether an LLC is
for you.
! Corporate Agents, et al., The Essential Limited Liability Company
Handbook (Oasis Press, 1995)
! Martin M. Shenkman, with Ivan Taback and Samuel Weiner, Starting a
Limited Liability Company (John Wiley & Sons, 1996)
! A good Web site—-is entirely devoted to
LLCs. It includes information for lawyers, accountants and business
people thinking of setting up an LLC, including resources and useful
links. Also available from the site is a 3-volume treatise, The Limited
Liability Company, by William D. Bagley and Philip P. Whynott.
Q. What kinds of businesses operate as limited liability companies?
A. LLCs can be used for virtually any type of business. The types of businesses where they
have been used most frequently have been those where taxation as a partnership produces
advantageous tax consequences. LLCs are widely used for real estate ventures; extraction of oil,
gas and minerals; high-tech ventures, for example, a company formed to exploit a patent;
corporate joint ventures; as a vehicle for acquisitions; agriculture; and venture capital companies.
Because of their corporate-style limited liability, LLCs are also becoming more widely used as a
form of business organization by professionals such as doctors, lawyers and accountants. Some
states, however, do not as yet allow certain professionals to practice as an LLC.
Choice of Business Form
CHOOSING THE BEST ORGANIZATIONAL FORM FOR YOUR
BUSINESS
There are many tax and non-tax factors that must be taken into account in making this critical
decision. As a general rule, more than one form will be available. Choosing the best of the
available forms is a complex task and requires expert assistance from your lawyer, accountant
and other advisors.
Q. What are the principal non-tax factors that should be considered?
A. For obvious reasons most investors want limited liability. Investors in businesses where all
32
or most of the owners will be actively involved in the management of the company will usually
also want restrictions on the transfer of ownership interests and a simple management structure.
In addition, most investors want to be able to continue the business even after one or more of
them leave.
All of these features can be achieved to a greater or lesser extent in most types of business
organizations, although it is more difficult to obtain the desired results in some forms. For
example, it is possible to have limited liability in a general partnership if all the general partners
are corporations or limited liability companies. Similarly, corporate-style limited liability can be
achieved in a limited partnership where all of the general partners are corporations or limited
liability companies. This type of structure may not be desirable, however, for other reasons.
Incorporating all the general partners can add unnecessary expense, especially when the
alternatives of forming a corporation or limited liability company are available, and may adversely
affect the tax consequences desired by the investors.
Restrictions on transfers and a simplified management structure, inherent characteristics of
partnerships, can be obtained in corporations by carefully crafted agreements among the
shareholders, although, except in close corporations, most formalities of the statutory
management structure in state corporation codes will need to be observed.
Finally, in most situations business continuation agreements authorize the purchase of a
departed owner’s investment and allow the business to continue. These agreements, however,
can be very complex and expensive.
Only a lawyer has the necessary training to analyze the deficiencies in a particular form of
business and to be able to draft the proper agreements to overcome these deficiencies, to the
extent it is possible to do so.
Q. Are there any other non-tax factors that should be taken in account when
soliciting a business form?
A. There are always factors that at first appear to be insignificant, but may in the end turn out
to be critically important. Therefore, it is important to be sensitive to the possibility that one or
more of these factors may be present.
Organizational and administrative costs are an example. Proprietorships and general
partnerships involve the least expense because no written documents or public filings (except
possibly to comply with an assumed name statute) are legally required. It would be prudent,
however, to have a written agreement or general partnership agreement defining the rights and
obligations of the partners. Also, there are generally no annual fees to be paid. Written
documents and various filing and annual fees are required for all the other business forms,
however. The total of these expenses can be significant.
When a business intends to do business in more than one state, the law of the various
states where it expects to operate must be investigated to determine if any special problems exist.
A limited liability company, for example, should probably not be used if a significant amount of a
company’s income is expected to come from sales in a state that does not have a limited liability
company act.
If the business organization will borrow money in a state that has usury laws, these laws
normally set maximum interest rates that can be charged for a loan, but provide exceptions for
corporations, meaning that the corporation is permitted to give up the benefits of the usury law to
obtain a loan. If a lender will only make a loan to the business at an interest rate in excess of this
limitation, it may be necessary to form a corporation to borrow the money. Having to
incorporate for this reason is less likely to occur today than in the late 1970s and early 1980s
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because general interest rates are relatively low. But interest rates are very cyclical and at some
point in time rates will increase substantially above today’s rates.
Finally, state law restrictions can limit the possible choices. A sole proprietor who wants
both limited liability and basic partnership taxation, for example, can achieve these goals by
incorporating as an S corporation, but because most limited liability company statutes require a
minimum of two members, cannot operate the business as a limited liability company.
Q. What are the principal tax factors that should be taken into account in selecting a
business form?
A. The applicable tax factors are even more complex than the non-tax factors, and changes in
the tax statutes and regulations can dramatically alter the way taxes affect the various types of
business organizations. Bearing this limitation in mind, four generalizations might provide some
useful guidance.
First, under the present income tax structure, there is a presumption that a business should
be formed as a proprietorship, partnership, limited liability company or S corporation rather than
as a C corporation.
Although the following chart indicates that except for taxable income between $75,000
and $155,950 the C Corporation tax rate for 1998 is less than the individual rates applicable to
other types of businesses, tax rates per se do not tell the whole story.
Comparison of 1998 Individual Joint Tax Rates With C Corporation Tax Rates
[these are federal tax rates; the states may apply additional taxes]
Dollar Amount Individual C Corp Differential
Up to $42,350 15% 15% None
$42,350 to $50,000 28% 15% C Corp. + 13
$50,000 to $75,000 28% 25% C Corp. + 3
$75,000 to $102,300 28% 34% C Corp. – 6
$102,300 to $155,950 31% 34% C Corp. – 3
$155,950 to $263,750 36% 34% C Corp. + 2
$263,750 to $10,000,000 39.6%* 34%** C Corp. + 5.6
$10,000,000 to $15,000,000 39.6% 35% C Corp. + 4.6
Over $15,000,000 39.6% 35%*** C Corp. + 4.6
* Includes 10% surtax
** +5% or $11,750, whichever is less
*** + 3% or $100,000, whichever is less
NOTE 1: Professional Corporations that are C Corporations are taxed at a flat rate of 34%
NOTE 2: The dollar levels for the various rates are adjusted each year based on increases in the consumer
price index
As previously explained, C Corporation taxable income is
subject to a double tax. First, a C corporation must pay taxes on its taxable income at the rates
specified in this chart. In addition, the shareholders must pay taxes at the individual rates
applicable to them for any income they receive from the corporation in the form of salaries or
dividends. The combination of both these taxes can often be higher than the taxes that would be
34
payable if the business was operated as an S corporation, partnership or limited liability company.
Even if the total taxes paid by the C corporation and its shareholders on taxable income generated
by the corporation are less than if the business were operated in another form, the difference in
most cases will not justify operating a small business as a C corporation. Moreover, there are
other tax disadvantages of operating as a C corporation, including the potential application of the
higher corporate alternative minimum tax and the tax liabilities incurred in liquidating a C
corporation or converting it to another business form, which more than offset the possibility of
lower annual taxes based entirely on a tax rate structure that can be changed at any time. In this
connection, it is worth noting that from 1986-1992, the tax rate for C corporations was higher than
that of business forms for most levels of taxable income.
Second, as a general rule, if flow-through taxation is important, partnerships and limited
liability companies provide more flexibility than S corporations because of the ability in
partnerships to authorize special allocations of income and losses and to make distributions of
capital without triggering adverse tax consequences.
Third, consider the possibility that at some point in the expected life cycle of the business
it might be advisable to change the organizational format. For this reason it is important to
remember that it is possible to go from a proprietorship to any other form, to convert a
partnership to another form of partnership or to a limited liability company or corporation, and to
convert a limited liability company to a partnership, all on a tax-free basis. It is also possible to
convert an S corporation to a C corporation without adverse tax consequences. But it is not
possible to convert any type of corporation into a proprietorship, partnership, or limited liability
company, or to convert a C corporation into an S corporation without serious tax problems.
Finally, as is the case with non-tax factors, be alert to special facts that may end up
limiting the available choices. For example, if the business will have a corporate shareholder,
then Subchapter S will not be available and a partnership or limited liability company will have to
be used if pass-through tax treatment is desired.
GETTING ORGANIZED
This section will describe in general terms the legal steps that must be taken to organize a new
business and get it to the operational stage.
Q. In which state should the business be organized?
A. In the state where the business will have its principal place of business. This will
generally also be the state where the principal investors live. Every state’s laws have some
shortcomings, but as a general rule these can be overcome by carefully drafted agreements.
INCORPORATING IN A “FRIENDLY” STATE
Some states have a reputation for having laws favorable to a particular form of business. This is
true, for example, with respect to the Delaware Corporation Code. The features of the
Delaware Corporation Code that are touted as being important reasons for incorporating there
are for the most part applicable only to large corporations with hundreds of shareholders. For
example, if a small corporation whose investors and business operations are in Oregon were to
incorporate in Delaware, the corporation would have to qualify as a foreign corporation in
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Oregon. Moreover, annual fees and license taxes would have to be paid in both states and a
lawyer admitted to practice in Delaware would have to be retained whenever a corporate law
problem involving the business arises. These extra expenses are rarely justified.
Q. What steps are involved in organizing a proprietorship?
A. Very few, as a general rule. A sole proprietorship is the simplest form of business. The
only legal requirements are usually a business permit or license and tax identification numbers. If
the business is to operate in a name other than that of the proprietor, it may be necessary to
comply with a state or local assumed name statute. No written documents will be necessary
unless the proprietorship is buying or leasing property or will operate a franchise.
Q. What steps are involved in organizing a general partnership?
A. From a strictly legal point of view, the same as in a proprietorship. Although there is no
requirement that a general partnership have any kind of written agreement, it would be foolish not
to have one, if for no other reason than to provide concrete evidence of the partners’ agreement.
A written partnership agreement will typically contain provisions relating to capital
accounts and drawing accounts, partner salaries, reimbursement of expenses, vacations and
fringe benefits, voting rights, the rights of the partners when one of them leaves the partnership,
admission of new partners and what happens if the partnership liquidates. A well-drafted
partnership agreement that is carefully tailored to the particular needs of the partners is a lengthy
and very complex document.
Q. Is organizing a limited partnership any different from a general partnership?
A. Yes. The most significant difference is that limited partnership statutes require a
document known as a certificate of limited partnership to be filed, together with a specified filing
fee. While the information required to be in the certificate of limited partnership varies, all the
statutes require the name of the limited partnership, the address of its principal place of business
and the name and address of the agent for service of process, the name and business address of
each general partner, and the latest date when the partnership will dissolve. Some of the statutes
also require the business purpose to be specified and also the circumstances under which
additional capital may be required. All the statutes also authorize the partners to include any
other information they wish in the certificate.
Q. What steps are necessary to organize a limited liability company?
A. There are two documents that a limited liability company must have.
The first is a document generally referred to as “articles of organization” which must be
filed in the Office of the Secretary of State in your state. The statutory requirements vary, but
generally the articles of organization must contain the same type of information as is required in a
certificate of limited partnership. One difference is that most of the limited liability company
statutes require the articles of organization to specify whether the LLC will be member managed
or manager managed (a situation similar to having managing partners in a partnership) and the
names and addresses of the members or managers.
The second required document is generally referred to as an operating agreement. It is
also sometimes called a member control agreement or referred to as “regulations.” This
36
agreement is similar in format and content to a partnership agreement. It does not have to be
filed in any public office.
Every member of an LLC should have a copy of both the articles of organization and the
operating agreement.
Q. What steps are required to form a corporation?
A. The legal formalities for a corporation are more complex than in the other forms of
business organizations. Corporate codes require the filing of a document generally known as
either “articles of incorporation” or a “corporate charter”, bylaws, the issuance of share
certificates and an organizational meeting. In addition, in most situations other written documents
designed to protect the rights of the investors will be advisable.
Q. What are the requirements for the articles of incorporation?
A. The statutes vary, but generally corporate codes require the inclusion of the following
information in the articles of incorporation: the name of the corporation, its duration, the
corporation’s business purposes, the amount of stock that will be authorized, certification that any
required minimum capital has been paid into the corporation, the address of the registered office
and the name and address of the registered agent, the names and addresses of the initial
directors, and the names, addresses and signatures of the incorporators. Corporate statutes also
authorize other information to be included in the articles of incorporation. Examples of the kind
of optional provisions often included are share transfer restrictions and elimination or curtailment
of the usual powers of the board of directors.
There are some differences between the articles of incorporation of regular corporations,
close corporations and professional corporations, but these differences are for the most part
technical and not that significant.
Q. What are bylaws?
A. The purpose of bylaws is to provide guidelines for regulating the internal affairs of a
corporation. Typically corporate bylaws deal with the mechanisms of shareholder, director and
committee meetings, the issuance of stock and dividends, and the appointment, duties and
removal of the officers.
STOCK CERTIFICATES
Stock certificates are documented proof of share ownership. A share certificate is like the title
certificate you receive when you purchase an automobile. State corporation codes contain
detailed requirements for stock certificates. Unless a transfer restriction is clearly noted on them,
stock certificates are freely transferable.
Q. What takes place at the organizational meeting?
A. Some state corporation codes require two organizational meetings, one by shareholders
to elect the directors and a second by the directors to approve everything else. Most state
37
statutes, however, require only one meeting, which will typically ratify all the actions taken by the
promoters and incorporators, adopt the bylaws and the corporate seal, select and set the salary
of the officers, authorize the issuance of shares, approve resolutions designating one or more
banks as depositories and establishing check signing authority, approve contractual agreements
among the shareholders or with third parties, approve resolutions authorizing the corporation to
be taxed as an S corporation (assuming the shareholders want the corporation to be an S
corporation) and authorize designated officers to take the appropriate action to complete the
incorporation process, including, if necessary, qualification as a foreign corporation in another
state.
Q. What other documents are commonly advisable at the time a corporation is
organized?
A. Because of gaps in most corporate statutes and the need to protect the rights of minority
shareholders to a greater extent than is provided by statute, it is often advisable for the
shareholders and the corporation to enter into one or more of the following documents: a
shareholder voting agreement or voting trust, a long-term employment agreement for the
investors who will become executive officers, a shareholder-management agreement which in
effect can create the same type of management scheme as exists in a partnership, a share transfer
restriction agreement, and a buy-out agreement providing for the purchase (under specified
conditions) of the shares of a shareholder who leaves the employment of the corporation or for
some other reason wants to liquidate his or her investment. These are very complex, technical
documents that must be drafted by a lawyer.
Other contracts that will typically need to be reviewed or drafted include one or more
leases, a franchise agreement and loan agreement.
If the corporation is electing S corporation status, then a Form 2553 must be completed
and filed with the Internal Revenue Service. The Form 2553 or a similar document must also be
filed with the state tax commission of the state where the S corporation was incorporated. Other
forms, such as a patent or trademark application or an application for a tax identification number,
may also be necessary. (See the section at the end of this chapter for ways to
accomplish these applications or filings.)
In addition, applications for any required licenses and for assumed or trade names need
to be filed. Most business licenses, however, are state and/or local, as are assumed and trade
names filings. Consult a lawyer for what is required in your area.
Operational Problems and Organic Changes
This section will discuss the legal issues that commonly occur during the life cycle of a business. It
is divided into three parts. The first deals with the normal kind of legal problems that an
operational business encounters. The second part deals with the principal issues involved in
buying and selling a business. The last part discusses the basics of a bankruptcy proceeding
involving a business organization.
Operational Problems
Q. What legal problems does a business typically encounter after it is organized
and operational?
38
A. There are four general types:
1. major transactions such as a bank loan, or a purchase or lease of equipment or
real estate that involves the drafting or review of various legal documents and the
preparation of minutes authorizing the transaction;
2. changes in statutes and regulations that necessitate changes in the company’s
contractual documents and internal manuals;
3. ongoing regulatory compliance-for example, timely filing of corporate annual
reports, assumed name refilings and the like; and
4. the necessity of periodically reviewing and updating the company’s legal
structure.
Q. Must a business have a lawyer involved in all these transactions?
A. At the very least a business should regularly consult a lawyer about major transactions
and compliance problems. Even if the law firm representing a bank prepares the loan documents
and the borrower has to pay for this work, which is customary, the borrower’s attorney should
review all of the documents before they are signed.
To provide adequate legal protection for a business, its general counsel needs to review
all of the company’s legal documents on a regular basis, preferably at least once a year. This
annual legal audit can uncover omissions, such as the absence of corporate minutes and changes
in documents necessitated by changes in statutes and regulations. The review of the annual audit
with the client will also provide the lawyer with the opportunity to discuss with the client recent
legal changes so that the executives and employees will be alerted to potential problems and
better able to comply with the changes. As part of this process, the lawyer may uncover
potentially serious legal problems at a time when they can be resolved in an efficient costeffective
fashion.
Timing Your Annual Legal Audit
The best time is a month or so before the end of the company’s taxable year. This
enables the audit to include year-end tax planning issues. Frequently, significant amounts of taxes
can be saved by either completing a transaction this tax year or deferring the transaction until the
next taxable year.
Many businesses have the audit done a month or so before the company’s annual
meeting and use the audit as a planning vehicle for action that needs to be approved at the annual
meeting. Most small businesses, however, operate on a very informal basis and do not hold
regular annual meetings. This informality is now built into the corporate statutes, which require an
annual meeting but allow the requirement to be met by the use of consent minutes signed by all
the shareholders and directors. Consent minutes ratify the action taken even though no meeting
is held. Even though it is possible to legally avoid having an annual meeting, however, one should
be held if for no other reason than to review the annual legal audit.
Q. What kinds of issues should be dealt with in the annual legal audit?
39
A. The following is a partial list of the issues to be reviewed:
· basic constituent documents, for example, articles of incorporation, bylaws and stock
transfer records of a corporation; the articles of organization and operating agreement of a
limited liability company; the partnership agreement, and in a limited partnership, the
certificate of limited partnership;
· employment agreements;
· all leases, licensing agreements and other contracts with third parties, with particular
emphasis on termination dates, renewal options and the like;
· insurance policies;
· all standardized contract forms used by the business, for example, purchase order forms,
warranties, brochures and the like;
· internal policy and procedural manuals, for example, employee policy and procedure manual,
antitrust compliance handbook;
· transactions that require additional documentation, such as official minutes;
· regulatory compliance, for example, environmental regulations, ERISA problems, Securities
and Exchange Commission requirements;
· structural changes in the business organization, for example, conversion to another business
form, adoption a retirement plan or a fringe benefit plan;
· tax planning issues, for example, S Corporation status, legal audit, alternative minimum tax
review;
· filing of tax returns, licenses and reports;
· pending and potential litigation involving the company; and
· recent legal developments affecting the business.
Business Acquisitions
Q. What are the ways in which one business can acquire another?
A. There are four basic acquisition methods: merger, consolidation, sale of assets and
exchange of ownership interests. Each type is briefly described below.
The distinctive feature of a merger is that one or more of the merging business entities
disappears into the surviving business entity, which automatically becomes vested with all the
assets and liabilities of the disappearing entities. For example, if the merger agreement between
A, B, and C corporations calls for C to be the surviving corporation, A and B will be merged
into C, and after the merger C will own all of the assets and will have to pay all of the liabilities of
A and B, both of which no longer legally exist.
A consolidation is in essence a type of merger but differs from a typical merger in that all
of the merging entities disappear into a new entity. Using the prior example, a consolidation
would occur if A, B, and C were merged into D, a new entity, which was probably created and
owned by A, B, or C or all of them.
A sale of assets differs from a merger or consolidation in several respects, the most
important being that the acquiring company buys only the acquired company’s assets and
therefore is not legally responsible for payment of the acquired company’s liabilities. The
acquiring company can, however, be liable in some situations for some of the acquired
corporation’s liabilities, even if the acquired corporation stays in existence. The acquiring
company, for example, may be liable for environmental clean-up costs caused by the acquired
40
company under the Comprehensive Environmental Response, Compensation and Liability Act of
1980 (CERCLA). Moreover, a sale-of-assets transaction may, unlike a merger or
consolidation, require consents from third parties to transfer leases, mortgages, franchises and the
like, which may not be forthcoming.
An exchange of ownership interests, the final basic acquisition method, involves the
owners of one business offering to purchase the ownership interest of another business or one
business offering to pay cash or issue ownership interests for the outstanding ownership interests
of the other business. All kinds of combinations can result from this type of transaction. The
most typical is for the acquired company to be operated as a subsidiary of the acquiring
company. For example, assume that corporation A agrees to purchase all of the outstanding
stock of B corporation for cash. After the transaction A will own all of the stock of B, which will
as a consequence be a subsidiary of A.
There is danger in the outright purchase of stock in a corporation. When such a
purchase is made, all of the undisclosed liabilities of the corporation are purchased. As a
preventive measure, it is common for an acquisition agreement to provide for a period of diligent
investigation, and for the buyer’s approval of the results of the investigation.
Q. How do you determine which of these acquisition methods to use?
A. You determine which acquisition method to use with the advice of your company’s legal
counsel, accountants and other experts. Every type of acquisition is complex and fraught with
legal problems. As a general rule, more than one acquisition method will be available, and the
acquisition can be structured as either a taxable or a non-taxable event, depending on which
produces the best overall tax results.
Selecting the best method, however, is only one of the problems that must be resolved.
The mechanics of the transaction can be incredibly complex. Corporate codes have detailed
statutory provisions setting out the approval process and the rights of shareholders who vote
against the acquisition (called dissenters’ rights). These statutes are complex but at least provide
some basic guidance. Very few partnership statutes, however, currently have any statutory
provisions that describe the mechanics of a merger, and none of the partnership statutes deal
specifically with sales of assets or exchanges. Moreover, the coverage of mergers and other
acquisition techniques by limited liability companies is also incomplete, and the existing statutes
are often confusing and inconsistent. An additional problem is that very few existing statutes deal
with the possibility of a cross-entity acquisition, for example a merger between a partnership and
a corporation or between a partnership and a limited liability company.
Regulatory compliance problems can also present difficult issues in any type of
acquisition. Antitrust clearance is not a problem for most acquisitions but it is sometimes
required by both the Federal Trade Commission and the Antitrust Division of the Department of
Justice under the Hart-Scott-Rodino Act. Federal and state securities law compliance is also
imperative, and environment law compliance issues are becoming increasingly important. These
are only a few of the compliance issues that must be reviewed.
In short, acquisitions are very complex transactions, and a company should consult a
lawyer about a proposed acquisition in the initial planning stage and before any binding
commitments about the method or tax consequences have been made.
Bankruptcy
41
Q. What happens if the business gets into financial difficulty?
A. Frequently, it is possible for the business to work out accommodations with its creditors
on a voluntary basis that will enable the business to survive through a rough period. Banks and
mortgage companies, for example, are often willing to refinance indebtedness, especially if they
can be convinced that the business’s financial difficulties are temporary. Trade creditors are also
amenable to stretching out payments for the same reason. After all, the last thing a creditor
wants is to foreclose on property securing a debt or reduce a debt to judgment. Everyone loses
in that situation.
Even in these difficult straits, it is important for the company to continue paying its payroll
taxes, since these are not dischargeable in bankruptcy and will become a personal liability of the
owners.
Two Kinds of Business Bankruptcy
If a business’s difficulties cannot be resolved, bankruptcy may be the only viable option. There
are two types of bankruptcy proceedings available to businesses. The first is a liquidation
proceeding under Chapter 7 of the Bankruptcy Code. The second is a rehabilitation proceeding
under Chapter 11, or in the case of proprietorships, Chapter 13 of the Bankruptcy Code.
Q. What happens in a Chapter 7 liquidation proceeding?
A. Any type of business can file a Chapter 7 proceeding. It is also possible for creditors of
the business to file a Chapter 7 proceeding, but this occurs infrequently.
Once the proceeding is filed, a trustee, who is appointed by the court and technically
represents the creditors, is in charge of the debtor business and will proceed to sell all the
business assets and distribute the net amount realized to the company’s creditors in accordance
with the priorities in the Bankruptcy Code.
Q. What happens in a Chapter 11 or Chapter 13 rehabilitation proceeding?
A. These proceedings differ from a Chapter 7 proceeding in two fundamental respects. In a
rehabilitation proceeding the ultimate objective is not the payment of the company’s creditors out
of the liquidation proceeds but rather to have the business continue in a reorganized form and to
pay the creditors out of its future earnings. The second major difference is that in most cases the
executives who were managing the business before the rehabilitation petition is filed can continue
to manage the business during the bankruptcy proceedings. This continuity can be helpful in
dealing with customers and creditors.
The business has the first option to submit to the court for approval a rehabilitation plan.
If it is not approved, the creditors can submit their plan. If a plan is approved, the proceeding is
dismissed and the business continues to operate under the provisions of the plan. If no plan is
approved, the proceeding will be converted into a Chapter 7 liquidation proceeding.
Q. When should the business seek legal advice about the possibility of bankruptcy?
A. At the first sign of serious problems. A lawyer can be very helpful in advising the
42
business about its options and in assisting with negotiations with creditors. The timing of the
bankruptcy filing can be very important because the filing of the proceeding results in an
automatic stay of all legal actions against the debtor business. This means that no further action in
the pending law suit can take place without the permission of the bankruptcy court. The ability to
get the stay is often the primary reason for filing a petition, even in circumstances where the
company is not currently unable to meet its ordinary debts as they become due.
Partnerships and limited partnerships present special problems under current law. Expert
legal advice is, therefore, especially important for businesses operating in these formats. The
difficulties with partnerships stem primarily from the personal liability of the general partners for
the partnership’s debts. The bankruptcy of the partnership will often force all of the general
partners also to file bankruptcy petitions. Limited liability companies are so new that there is no
case law resolving the questions that are bound to arise. It is not yet certain, for example,
whether a limited liability company will be treated as a partnership or a corporation under the
Bankruptcy Code.
Where to Get More Information
The best source for general information is the Small Business Administration (SBA),
which has branch offices through the United States. The SBA, Washington Office Center, 409
3rd Street, SW, Washington, DC 20416, telephone, (1-800-827-5722), website, http://www.sba.gov
The SBA offers many “free” and “for sale” management assistance publications to aid
small businesses. Examples are: Incorporating a Small Business, Checklist for Going Into
Business, The ABC’s of Borrowing, Planning and Goal Setting for Small Businesses and
Woman’s Handbook.
In addition, the SBA offices regularly offer workshops and counseling sessions for small
businesses.
The SBA also has a number of financial assistance programs for small businesses.
Information about these programs and applications can be obtained from any branch office.
The Internal Revenue Service publishes a pamphlet entitled Your Business Tax Kit,
which contains helpful information about the various federal business taxes. You can access it at
http://www.irs.ustreas.gov. Similar kits and pamphlets, many of which contain other useful
information such as business license applications, are available in most states through the state’s
tax commission or other state administrative offices.
The Secretary of State’s office, located in your state capital, can provide you with a great
deal of useful information about filing requirements for corporation, partnerships, limited liability
companies and other business forms.
Most states have a state development board that provides various forms of assistance to
businesses, particularly new businesses and existing businesses that are planning to move to the
state. Some states also have regional development boards. Illinois, for example, has Small
Business Development Centers located throughout the state.
Many states authorize special financial assistance for businesses, such as industrial
revenue bonds. There will generally be one or more agencies or commissions that are in charge
of administering these programs and can provide information about them.
Local and state Chambers of Commerce can be useful sources of information about
businesses.
Trade associations are excellent sources of statistical information about a particular type
of business.
43
The business section of the public library has directories, manuals, association lists and
statistical and demographic data on businesses. In addition, the Federal Trade Commission
(FTC) has a number of manuals for business owners, informing them of how to comply with
various laws. Included are: How to Write Adverse Action Notices, Offering Layaways,
Writing a Care Label, How to Write Readable Credit Forms, Writing Readable Warranties,
and Road to Resolution: Settling Consumer Disputes. For information about these
publications, call or write the Federal Trade Commission, 6th and Pennsylvania Avenue, NW,
Washington, DC 20580; telephone, (202) 326-2222. Many of them are available on the Internet
at http://www.ftc.gov.
Small business incubators exist in many parts of the country. Their purpose is to provide
consulting services, access to research and rental space at favorable rental rates for new
business.
44
For trade or service mark applications:
Commissioner of Patents and Trademarks
Crystal Park Building
2121 Crystal Drive
Arlington, VA 22202
Telephone: (703) 305-8600
http://www.ustpo.gov
For tax information, contact your local IRS office or check out their web site at
http://www.irs.ustreas.gov.
For Federal Securities and Exchange Commission:
Federal Securities and Exchange Commission
450 5th St., NW
Washington, DC 20549
Telephone: (202) 942-8642
Website: http://www.sec.gov
For copyright:
Federal Copyright Office
Library of Congress
101 Independence Ave., SE
Rm. LM 401
Washington, DC 20540
Telephone: (202) 707-9100
Website: address http://www.lcweb.gov/copyright. See also the website of the Copyright
Society of America, http://www.csusa.org.
Finally, in addition to lawyers who practice business law, accountants, insurance agents, bankers
and management consultants can be helpful sources

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Free ABA Guide to Operating a Small Business

Forming and Operating a Small Business

Contents
Introduction
Getting Started
Types of Business Organizations
Choice of Business Form
Getting Organized
Operational Problems and Organic Changes
Where to Get More Information

Introduction

This chapter deals with the legal and other issues that have to be resolved when forming
and operating a small business. It contains six sections. The first section discusses issues that are
common to all small businesses, regardless of their legal structure. Section two explores the
various types of business organizations that exist in the United States, comparing their strengths
and weaknesses and discussing the taxation of each type of business organization. Section three
discusses the considerations that must be taken into account when selecting a form of business
organization. Section four examines the steps that must be taken to get a new business
organized. Section five explores the legal problems that commonly arise during the life cycle of a
business, such as changing the legal format or otherwise reorganizing the business and buying,
selling or liquidating the business. Section five also provides a brief summary of what happens
when a business experiences financial difficulty or becomes involved in bankruptcy proceedings.
The sixth and final section explains where you can go to get help and additional information about
your business.
The material in this chapter is written from the perspective of a small business, such as
one owned and operated by you and a few other family members or other individuals. The rights
of the employees and customers of the business and transactions with your business by third
parties, such as landlords or banks, are considered only with respect to the impact they have on
the legal structure of the business and your exposure to personal liability for claims they may have
against the business. The rights of employees, customers and third parties are dealt with in more
detail in other chapters of this book. See the chapter on “Law and the Workplace” for more
information on employer/employee rights and responsibilities. The chapter on “Contracts and
Consumer Law” includes details on customer rights, seller responsibilities, and warranties.
Getting Started
This section deals with some of the major issues that you must resolve before becoming involved
in owning or operating a small business.
Q. What are the first steps that should be taken?
A. There are four preliminary steps that should be taken before deciding to start or buy a
business: development of sound business ideas, market research, financial planning and deciding
whether to have co-owners.
GETTING A SOUND BUSINESS IDEA
A sound business idea is a venture that makes economic sense, generally based on your
experience and background. You will generally want to choose a type of business with which
you are familiar and have some experience. It would not be advisable, for example, for an
individual who has no experience in food service operations to open up or buy a restaurant.
Because operation of a successful business requires hard work and expertise, prior experience in
the same or a similar business will save you the time and expense of developing the background
and knowledge of what the particular business requires to be successful.
3
Q. How can market research help?
A. Because the failure rate for new business is so high it is important to determine whether a
market exists to purchase your service or product, and, if so, the best way to sell it. One
important issue to be decided is the location of the business. You may not want to open up a
greeting card shop across the street from another greeting card shop in a small town. But two
greeting card stores located in a different part of a major shopping center might both be
successful. In addition, if your market is specialized or has particular needs, market research will
help you to understand what your buyer wants and how to communicate that your business can
meet that need.
Q. How do I develop a financial plan?
A. Inadequate or unwise financing is one of the principal reasons why so many new
businesses fail. The financial requirements of businesses vary greatly. Trade associations are
often a good source of information about the capital needs of a particular business. The local
office of the federal Small Business Administration (SBA) and the equivalent state offices can
also assist with financial planning for a new business. If the business is going to be run as a
franchise operation, the franchiser will probably have a great deal of useful information about the
financial resources the franchisee will need. Franchise operations will be discussed in more detail
later in this chapter. Finally, banks and private business consultants can help with financial
planning. Once you have gathered this information, you are in a position to develop a financial
plan.
Q. How do I secure financing?
A. There are, as a general rule, three potential sources of capital for a new business:
1. contributions made by the investors who will be actively involved in the management of
the business;
2. banks and other financial institutions; and
3. capital raised from other individuals and institutions.
Capital contributions from the management investors will frequently be insufficient to
meet the needs of the business. Loans from financial institutions are a possibility for additional
working capital, though the long-term effect of paying off the debt has to be taken into account.
Most rates of profit are under 10 percent, making the assumption of an interest-paying burden a
severe strain on a beginning business.
If you do decide to borrow capital, the business must have collateral to secure the loan.
Financial institutions will also generally require personal guaranties and collateral from the owners
of the business, which means that you might have to risk losing your home or other valuable
property to get funding. The federal Small Business Administration has loan and lease guarantee
programs that are designed to encourage banks and other financial institutions to lend money to
small businesses. Many states also have special loan or guaranty programs or financial assistance
packages and tax relief plans for small businesses. Information about these programs can be
obtained from the local SBA office or the office of the equivalent state or local agency charged
with the responsibility of assisting small businesses.
4
Q. What are consequences of bringing others into the business?
A. The fourth preliminary step is to decide whether you are going to own the business by
yourself or have other investors who will have an ownership interest in the business.
The decision to bring others into the business can affect its legal structure. For example,
you must have two or more owners to operate a business as a partnership. Partnerships and the
other legal forms of business will be discussed in section two of this chapter. The decision to
have-owners can trigger the applicability of federal and state securities laws, if the-owners are
not going to be actively involved in the operations of the business.
Obtaining capital from other individuals and institutions is a possibility but, because of the
potential applicability of federal and state securities laws, must be pursued with caution. The
securities laws apply to the sale of any ownership interest in a business where the profits are
expected to come from the efforts of others. Under this broad definition, virtually all types of
equity or debt ownership interest in a small business sold to persons may be securities. For this
reason, you should not contact anyone about investing in a business without fully reviewing your
investment plans with a securities lawyer. This includes stock, debentures, and other similar
corporate debt instruments, limited partnership interests, and even general partnership interests,
where one or more of the general partners does not have the expertise (or authority) to
participate in the management of the business.
Assuming a particular type of ownership interest is a security, the anti-fraud provisions of
the securities acts automatically apply. In addition, unless an exemption is available, a
prospectus, which is a very technical and complex disclosure document, must be prepared and
the securities must be registered with the federal Securities and Exchange Commission and the
equivalent state administration office in every state where the securities will be sold. Failure to
comply with the prospectus and registration requirements will trigger a variety of administrative
and private remedies, including money damages, and, in extreme cases, criminal sanctions.
In most cases, the particular ownership interest will qualify for an exemption from federal
and in some cases state registration requirements. An exemption is a statute or regulation that
says certain types of securities can be sold to the public without the expense of a prospectus, so
long as other specific requirements are met. There is an exemption from federal registration
requirements, for example, for a company issuing securities all of which are sold to persons in
one state. There are also several exemptions designed primarily for small businesses. These
exemptions, many of which are incorporated into what is known as Regulation D, have limitations
on the number of purchasers or the total dollar amount of the offering. These exemptions restrict
or prohibit advertising of the offering and also restrict resales of the acquired securities. Another
complicating factor is that the applicable state securities laws are frequently inconsistent with the
federal securities laws, and compliance with both is required.
Needless to say, no one should attempt to issue any securities without the assistance of a
lawyer, accountant and other experts. All the exemptions, however, have very technical
requirements with which you must strictly comply. Compliance is also expensive, although
complying with the exemptions is less expensive than complying with the full registration
requirements.
Q. Besides these four steps, what other issues need to be considered before going
into a new business?
A. The remainder of this section will discuss issues other than the legal format of the
business. These include the location of your business, insurance, various licenses and permits,
5
tax identification numbers and tax registration, protection of any patents, trademarks and
copyrights that will be owned or licensed by the business, whether to operate your business as a
franchised operation, and employer-employee problems.
It is important that you carefully review all of these issues, even if it ultimately turns out
that some of them are not applicable to your particular business. Some businesses, for example
those that are involved in health care or food service, are subject to complex regulation by
numerous federal, state and local agencies. Other businesses, on the other hand, may only be
subject to minimal regulation. The size of the business can also affect the extent of the
regulations. The laws of most states, for example, exempt businesses with fewer than four or five
employees from having to carry workers compensation insurance covering injuries to employees.
Even if your business is exempt, you might still decide to carry workers compensation insurance
because of the protection it would give both you and your employees in the event one of your
employees is injured while working in the business.
Q. Why is the location of a business so important?
A. There is an old adage that goes something like this: What are the three most important
reasons for the success of a business? The answer is location, location and location. The
location of the business vis a vis your competitors has already been discussed in connection with
the need to conduct market research for your business. Location is important for other reasons
as well.
Q. What are these other reasons?
A. One is the necessity of being located in an area that is convenient for your customers and
clients. Your market research should help you to find a suitable location for your business; but
that’s not the only decision you have to make. Another important decision is whether to own or
lease the building where the business is to be located.
BUY OR LEASE YOUR PLACE OF BUSINESS?
Unless you already own a suitable building, this can be a difficult decision. Buying or building a
new building generally involves a larger capital outlay than a lease, but if the building is
mortgaged, the term of the mortgage will frequently be longer than the term of a lease of similar
space. On the other hand, commercial leases are generally much longer and more complex
documents than residential leases and should be reviewed by your lawyer before you sign the
lease agreement. Your lawyer should, of course, also review all the documents involved in the
purchase or construction of any building you buy or build.
Q. What are some of the most important issues involved in a commercial lease?
A. A detailed discussion of commercial leases is beyond the scope of these materials, but
four important issues to look for should be mentioned-the amount of the rent, an option to renew,
an option for additional space and protection against competitors.
Q. How do you determine the rent?
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A. In most cases the rent in a commercial lease will be expressed as so many dollars per
square foot. This is the annualized price for the unit, so the monthly rent is determined by
multiplying the rent per square foot by the total number of square feet in the unit and dividing by
twelve months. For comparative purposes with other suitable rental units, you need to know
whether the rent includes or excludes taxes, insurance on the building, and utilities. To the extent
it excludes them, you will have to pay these items in addition to the rent.
Sometimes rent escalation clauses permit the owner to raise the rent because of inflation
or when taxes or utilities go up during the year. Finally, many retail and restaurant leases will
include clauses that require the tenant to pay either a flat monthly rental or a rental based on a set
percentage of sales in the store or restaurant, whichever is higher.
Q. What is an option to renew?
A. A second important issue in commercial leases involves an option to renew the lease at
the end of the lease term for an additional term. Without an option to renew, you may be forced
to move or to pay an extraordinarily high rent to remain where you are just at the time the
business is becoming very profitable. To provide maximum protection, the rent, or at least a
formula for determining the rent during the renewed period, should be specified.
Q. What is the significance of an option for additional space?
A. A third issue that needs to be investigated is an option to lease additional space and the
rent for that space. That option allows the new business to lease only the amount of space it
needs, with the protection of being able to increase the amount of space when and if it is needed.
The advantage of an option is that you are not obligated to rent the additional space unless you
want to.
Q. Can the lease protect my business from competitors?
A. A fourth issue involving commercial leases that can be important in some types of
business is a provision prohibiting the lessor from leasing space to a competitor, or if the lessor
will not agree to this, a provision stating that space leased to any competitor must be located on a
different floor or in a different wing of a shopping center.
Q. What about operating a business out of my home?
A. For some types of businesses, especially those where you visit your customers rather
than being dependent on their coming to your place of business, this is fine. In some situations,
you may be able to deduct the value of the space you use for your business operations on your
income tax return. To qualify for the deduction, however, your home office must, as a general
rule, be your principal place of business (i.e., your main location for administrative/management
activities) and be regularly and exclusively used by the business.
One of the most prevalent types of businesses operated from homes is a day care center.
Many states have special license requirements for day care centers. In some states the licensing
and other requirements for day care centers in private homes having only a few children are less
rigorous than larger group day care centers. Finding out what regulations apply is important for
this and every type of business.
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Q. What types of licenses and permits are required for a business?
A. It depends on the type and location of the business. All states have statutes and
regulations that require tests, proof of financial responsibility and compliance with other
requirements to obtain a license to engage in a particular business or profession. A state license
to operate a day care center is one example. Doctors, lawyers and even barbers have to be
licensed by the state before they can practice their profession. The types of businesses subject
to these licensing requirements vary from state to state.
Some businesses exempt from state licensing regulations are required to obtain a license
or permit from a county or city to perform certain operations. Building contractors, for example,
have to get a city or county building permit to build a house or commercial building.
Most cities and many counties require businesses located in their jurisdiction to have a
business license. In reality, this is a tax based generally on the gross receipts of the business
rather than a regulatory license designed to protect the public against shoddy work and
incompetence. Avoiding this tax can be an important factor in choosing the location of a
business.
Q. What kinds of insurance will I need?
A. As is the case with most of the other issues discussed in this section, it depends to some
degree on the type and size of the business. The exemption from workers compensation
insurance for small businesses with very few employees is an example of this principle. Another
is employee fidelity bonds, which is a form of insurance to protect against embezzlement. Some
businesses are required to have fidelity bonds for employees such as bookkeepers who handle
money. Most businesses, however, can choose whether to bond all or some of the employees.
Some of the other types of insurance a typical small business will want to consider
include:
· business interruption insurance (often referred to a business continuation insurance)
to offset losses if the business is forced to shut down for a substantial period because
of a fire, flood or other catastrophe;
· liability insurance, including product liability insurance, to protect against damage
claims filed by third parties injured on the premises, by delivery trucks or other
company vehicles, or by a product produced by the business;
· malpractice and errors and omissions insurance for professional businesses;
· director and officers (D & O) liability insurance to pay the expenses and damage
awards against corporate executives as a result of suits filed against them by
shareholders of the corporation;
· medical insurance covering the owners and the employees of the business;
· disability insurance, which pays a portion of the salary of an employee or owner who
has a long-term disability and cannot work;
· life insurance that will provide a death benefit to the families of the owners and the
employees and possibly provide funds to compensate the business for the loss of one
of the owners (often called “key man” insurance) and funds to purchase the equity
interest of a deceased owner;
· unemployment insurance, which is really a tax based on the payroll of a business
used to pay benefits to all long term unemployed workers in a state.
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Q. What tax registration and identification numbers, tax forms and the like are
required for a new business?
A. There are several federal and state requirements. The Internal Revenue Service (IRS)
publishes a pamphlet entitled “Your Business Tax Kit,” which is available at any IRS office or on
the Internet at http://www.irs.ustreas.gov. It contains a great deal of helpful information on the various
federal taxes that apply to a business. Many state tax commissions have similar publications
describing the state taxes that apply to a business. Both types of publications contain samples of
the tax registration and other forms that must be filed.
All businesses must obtain a Federal Employer Tax Identification Number before
beginning to operate. Each state also requires tax registration by a new business. In most cases
the state will use the Federal Employer Tax Identification Number (see insert below). All states
that have sales taxes also require any business that is not exempt from the tax to register with the
appropriate state agency. The business is required to collect and remit to the state on a regular
basis (monthly or more frequently) the applicable sales tax.
Every business is required to withhold from employee wages federal and state income
taxes and FICA (social security and Medicare) taxes and regularly remit these funds to the IRS
(in the case of federal withholding and FICA) and the applicable state tax agency. Businesses
whose total federal payroll tax liability for the prior year is $50,000 or less must deposit payroll
taxes in a special account once a month. Businesses whose payroll taxes for the prior year
exceeded $50,000 must deposit the tax money two times each week. The total deposits must
then be paid to the IRS at the end of each quarter. The state requirements may or may not be
the same as the federal deposit requirements. It is important to know the requirements and
follow them, as there may be heavy penalties for late payment.
Most states require registration or at least periodic filing with the state agency that
administers the state unemployment insurance tax, which is a tax based on the businesses payroll.
A business must also pay the federal Unemployment Insurance Tax, which is also based on its
total payroll, on a periodic basis.
In addition, all businesses must file annual federal and state income tax returns. The
applicable forms vary with the type of business. Partnerships, “S” corporations, limited liability
companies and other businesses that as a general rule pass the tax consequences of their
operations to their owners file a different type of return from that of businesses that are operated
as “C” corporations. The differences in the way various types of business organizations are taxed
will be discussed in the next section of this chapter. “S and “C” Corporations are terms that are
applied to different types of corporations for tax purposes. The characteristics of these
designations are described later in this chapter.
GETTING AN EIN
The EIN, as it is known, is obtained by filing an IRS form SS4, which can be obtained from any
office that has IRS forms or online from the IRS website–www.irs.ustreas.gov. If the form is
mailed, the EIN will be issued in four to six weeks. Alternatively, the SS4 can be faxed to 816-
926-7988 and the number will be issued within 24 hours, or the applicant can call direct (816-
926-5999) and receive the EIN number verbally. If the latter method is used, the applicant must
place the number on the SS4 and mail the to the IRS for processing.
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Protection of Patents and Other Intellectual Property Rights
Q. How can patents, trademarks, trade secrets, trade names, and copyrights owned
or licensed by an investor or a business be protected?
A. These types of property are generally referred to as intellectual property rights. Each type
is subject to special legal and tax rules, which will be briefly described below. Because of the
highly technical nature of intellectual property rights, it is essential that competent legal counsel be
consulted as soon as possible once it becomes evident that such a right exists, in order to
maximize the protection of the developer or owner of the right.
Q. What kinds of inventions are patentable and what is the advantage of obtaining a
patent?
A. Not every invention is patentable. By statute, the invention must fall into at least one of
four classes: process (for example, manufacturing of chemicals or treating of metals), a machine,
an article of manufacture, or composition of matter (for example, mixtures of chemicals). In
addition, based on existing technology (known technically as prior art), the invention “would not
have been obvious at the time the invention was made to a person having ordinary skill in the art
to which said subject matter pertains.” This is usually referred to as the “unobviousness” test.
Not only must the invention meet the foregoing criteria, it must have some utility and not be
frivolous or immoral, and there must be proof that it can be made operative. Moreover, a patent
will not be issued if the invention has been described in any printed publication anywhere in the
world or was in public use or offered for sale anywhere in the United States for more than one
year prior to the time an application for a United States patent is filed. Assuming all these
conditions are met, the patent may still not be issued because of existing valid conflicting patents.
Even if it is not possible to obtain a patent, however, it may be possible to provide basic
protection for the owners of the invention through the trade secret doctrine, or in the case of a
design invention by means of a trademark or copyright. These and other possibilities, such as an
unfair competition claim against unauthorized users of the invention, should be explored with the
client’s patent counsel.
The application for a patent is filed with the Patent and Trademark Office in Washington,
D.C. You can contact them at U.S. Department of Commerce, Crystal Palace Building, 2121
Crystal Drive, Arlington, VA 22202; telephone, 800-786-9199; web address http://www.ustpo.gov.
The grantee of a patent has non-renewable exclusive monopoly in the United States to use or
assign rights to use the patent for seventeen years from the date of issue. A patent issued in the
United States does not provide any protection in another country, however. For such
protection, additional patents must be obtained. In order to have maximum protection in all other
countries that are signatories to various treaties and conventions establishing reciprocal priority
rights, foreign patent applications must be filed in this country. Since patents in many other
countries are subject to onerous taxes and in some cases compulsory licensing within the country,
it is often advisable not to seek foreign patents, or to seek them only in countries where it will be
economically worthwhile to do so.
The time involved in pursuing all the procedural steps in obtaining a final decision on a
patent may take several years. Since the seventeen-year life of a patent begins to run only from
the date of issue and an infringement claim can cover the period between the filing of the
application and the issuance of the patent, however, the inventor’s rights are not prejudiced by
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the delay, assuming a valid patent is ultimately issued.
USING A PATENT TO GENERATE INCOME
An inventor can maintain total control of a patent and manufacture and market goods employing
a patent as a sole proprietorship. Alternatively, the inventor can sell or license the patent to
others on an exclusive or non-exclusive basis in return for a payment called a royalty. One
option is for the inventor to sell or assign the invention to a new or existing business in which the
inventor is an investor with the expectation that the business will develop and market the patented
product. These various methods of marketing a patent have different tax consequences.
Q. What are the tax consequences of patents?
A. For tax purposes, marketing an invention involves two stages. The first is the research and
development stage, when the invention is refined and reduced to practice. The expenses
incurred in this stage are generally deductible. The second stage involves the tax consequences
of sale or license of the patent once it is issued. Self-exploitation of a patented invention has no
particular tax consequences. The sale or license of rights in an invention, however, can produce
either ordinary income or capital gains, taxable at a lower rate than ordinary income under
current law. The Internal Revenue Code has very stringent requirements, however, for obtaining
capital gains treatment, and it is very important to seek the early assistance of a lawyer who is
familiar with the tax consequences of patents. This is particularly true if there is any possibility the
patent will be transferred to a business with the expectation that the owners of the business will
receive capital gains treatment on the royalties generated by the patent. For this plan to work,
the invention must be transferred to the business prior to the time the invention has been tested
and successfully operated or has been commercially exploited, whichever is the earlier. It is
often difficult to determine when an invention has been reduced to practice.
If a patent is going to be transferred by the inventor to a business in which the inventor has
an ownership interest, it is generally easier to achieve favorable tax treatment if the business is a
partnership or limited liability company than if it is a corporation.
Q. What are trade secrets?
A. A trade secret, sometimes referred to as “know-how,” is generally defined as an
aggregation of data or information not generally known in the industry that gives the user an
advantage over competitors. Common examples of “know-how” are formulas, manufacturing
techniques and processes, designs, patterns, programs, systems, forecasts, customer lists,
specifications, and other technical data. A trade secret is not patentable, nor can it be registered
as a trademark. Trade secrets are recognized legally as proprietary rights and are protected
against unauthorized use by the courts. However, for information to continue its status as “trade
secrets,” its owner must take appropriate steps to protect it from disclosure and maintain its
confidentiality. The Trade Secrets Home Page—www.execpc.com/~mhallign/–has much helpful
information.
Q. How are trade secrets taxed?
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A. Trade secrets are not specifically covered anywhere in the Internal Revenue Code.
Nevertheless, the tax treatment of trade secrets and “know how” is fairly well established by the
courts.
The expenses incurred in developing a trade secret can be either amortized or deducted.
There are no other tax consequences associated with trade secrets unless they are transferred,
for example, as part of the sale of all the assets of a business. In some situations, the amount
allocated to the trade secrets may qualify for capital gains treatment.
Q. What are trademarks and trade names and how are they protected?
A. A trademark is generally defined as any work, name, symbol, or device used by a
manufacturer or distributor to distinguish its goods from those manufactured or sold by others. A
related property right is a service mark that is basically the same as a trademark except that it
relates to services rather than goods. Certification marks, such as seals of approval and
collective marks used to indicate membership in an organization, are also related concepts.
Applications for registering a trademark are filed with the Commissioner of Patents and
Trademarks, Crystal Park Building, 2121 Crystal Drive, Arlington, VA 22202, telephone (800)
786-9199, web address http://www.uspto.gov.
A trade name is generally the name that the business uses for advertising and sales
purposes that is different from the name in its articles of incorporation or other officially filed
documents. Most states authorize the protection of a trade name by filing in that state. Drawing
the line between a trademark and a trade name can sometimes be difficult. Is “McDonalds” or
“Holiday Inn” a trade name, a trademark, or both? It is often advisable to seek protection under
both sets of statutes in these situations.
Your lawyer will help you search to discover whether there is an existing trademark or
copyright that may conflict with yours.
Q. How are trademarks and trade names taxed?
A. The cost of developing and registering a trademark or trade name must be capitalized.
The advertising and promotional expenses incurred in marketing goods and services subject to a
trademark or trade name, are, however, deductible as selling expenses.
The sale of a trademark or trade name can generally result in capital gains treatments.
Instead of an outright sale, a trademark or trade name is frequently licensed to one or more third
parties, often as part of a franchise agreement. (Franchises are discussed in the next section
of this chapter.) The income received from this licensing arrangement will generally be treated as
ordinary income rather than capital gains.
ART THAT IS PROTECTABLE BY A COPYRIGHT
Seven types of artistic endeavors can be copyrighted:
1. literary works;
2. musical works;
3. dramatic works;
4. pantomimes and choreographic works;
5. pictorial, graphic and sculptural works, including fabric designs;
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6. motion pictures and other audio visual works; and
7. sound recordings.
Copyright protection is obtained by placing the symbol and the name of the copyright holder on
every publication of the material and filing a copyright application for the artistic work with the
Federal Copyright Office, Copyright Information Office, Library of Congress, 101
Independence Avenue, SE, Room #LM 401, Washington, D.C. 20559-6000, telephone, (202)
707-9100, web address http://www.lcweb.gov/copyright. See also the website of the
Copyright Society of America, http://www.csusa.org.
Q. How are artistic efforts protected by copyrights taxed?
A. An individual who creates an artistic work, unlike the inventor of a patentable product, is
unable to obtain capital gains treatment upon the sale or transfer of the rights to the work.
However, capital gains tax treatment is possible when the creator of the artistic effort is a
corporation or business entity taxed as a partnership. Thus, sales of films produced by a
corporation, partnership or limited liability company can, under some circumstances, qualify for
favorable capital gains tax treatment.
Sidebar: Need More Help?
· For more on intellectual property generally, the Intellectual Property Owners (IPO) might be
able to help. The IPO is a membership association that represents intellectual property
owners. The IPO can be contacted at 1255 Twenty-third Street, NW, Suite 850,
Washington, D.C. 20037. Its web site is
· For more on patents, contact the National Patent Association, 216 Hulls Hill Road,
Southbury, CT 06488-9891; 800-672-2280; . A law firm
website contains much useful information and links about patents and
other forms of intellectual property.
· For copyrights, the Copyright Resource Page—-has copyright basics, FAQs, and other very useful material.
Franchises
Q. Is operating a business as a franchise something I should consider?
A. Franchising is essentially a method of marketing and distributing products and services that
usually involves the licensing of an established trademark or trade name or both. There are well
over 500,000 franchised outlets in this country in virtually every type of business. Franchises
employ several million employees and generate several hundred billion dollars of receipts each
year. In many industries, franchising is the dominant form of distribution. For example, most
automobile and truck dealerships and soft drink bottlers are franchisees.
Q. What are the advantages of franchising?
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A. From a manufacturer’s or distributor’s point of view, the logic behind franchising is simple:
it requires a great deal less capital to distribute goods and services by use of franchises than by
operating company-owned units, and additional income is generated from licensing trademarks
and trade names and from other services provided by the franchisor for the franchisee. The
major benefits to the franchisee are the use of the good will of the franchisor’s trademarks and
trade name, and expert guidance in such matters as site selection, training of employees,
bookkeeping and other managerial services. These items are particularly valuable to the
inexperienced businessperson who desires to own his or her own business but wants to minimize
the risk of failure. These services also make franchising an attractive vehicle for encouraging
minority-owned businesses.
Q. What kinds of fees and costs must a franchisee pay to the franchisor?
A. Typically, the franchisee will pay a franchise fee, which can often be spread out over a
period of years, for the right to use the trademarks, trade names, and trade secrets of the
franchisor and for managerial services involved in getting the franchise established. Frequently, a
franchisee will also be required to purchase all its initial equipment, including signs and trade
fixtures, from the franchisor. The franchisee may also be required to purchase many of its
supplies from the franchisor or from franchisor-approved sources. In addition, a franchisee will
normally pay the franchisor a royalty, which is usually based on a percentage of the gross
receipts from the franchised goods or services. The royalty covers such items as advertising and
continuing managerial services as well as a licensing fee for use of the franchisor’s trademark and
trade names. If the franchisor owns the franchised location, the franchisee will obviously have to
pay rent for the building to the franchisor.
Q. What type of business form should a franchisor or franchisee use?
A. The determination by a franchisor or franchisee to operate as a proprietorship, partnership,
corporation or limited liability company is essentially the same as for any other business. The size
and financial success of the business, tax considerations, and the potential exposure of the
investors to liabilities from the operation of the business are the principal factors that influence the
choice of business form.
In this connection, a franchisor may, in some circumstances, be held liable for the debts,
torts, or taxes of a franchisee. Increasingly, franchisors are being held liable for product liability
claims based on defective products manufactured or distributed to franchisees and ultimately sold
by the franchisees in retail sales. In many states the doctrine of privity, which at one time would
have barred any damage or injury claim directly against the manufacturer and any intermediate
distributor, has been abolished or curtailed. In addition, the Magnuson-Moss Warranty Act
authorizes a direct suit against a manufacturer in any case involving express written warranties
made by the manufacturer in connection with sales of consumer products. Franchisors are also
vulnerable to a variety of claims asserted by their franchisees.
Q. What legal protection does a franchisee have?
A. Considerable evidence suggests that historically the franchise marketing system has been
abused by both franchisors and franchisees, particularly by the former. This abuse has prompted
a considerable amount of litigation and remedial legislation in recent years both on the state and
federal level. Many states, for example, have statutes that regulate the sale, termination and
14
transfer of franchises.
The most significant federal regulation of franchising is the Federal Trade Commission
(FTC) rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and
Business Opportunity Ventures.”
Q. What does the FTC franchise disclosure rule require?
A. Essentially the FTC rule requires that a franchisor give a potential franchisee a disclosure
statement (on twenty different topics) that is similar to a securities registration statement. Detailed
information about the business and financial history of the franchisor and its principals, the
franchise agreement, and financial obligations of the franchisee are required by this rule.
Provisions regulating statements by the franchisor concerning potential profitability are also
included in the rule. These projections must be related to the geographic area where the
franchisee is to operate, and the franchisor must disclose the factual basis of the projections. The
disclosure statement, which must be updated within ninety days after the close of the franchisor’s
fiscal year, and a copy of the franchise agreement, must be given to a prospective franchisee
before any person-to-person meeting between the franchisor and franchisee, or at least ten
business days before the franchisee signs any binding agreement to purchase the franchise or
makes any payment for the franchise, whichever date is the earlier. Violation of the rule is an
unfair trade practice subjecting the franchisor to a cease and desist order, damages, and fines of
up to $10,000 for each violation.
PRECAUTIONS BEFORE SIGNING A FRANCHISE AGREEMENT?
In addition to careful study of the disclosure statement and all proposed contract documents, the
FTC recommends that before investing in a franchise you take the following precautions:
1. consult with an attorney and other professional advisors before making a binding
commitment;
2. be sure that all promises made by the seller or its salespersons are clearly written into the
contracts you sign and be sure the franchisor provides training programs for new franchisees;
3. talk with others who have already invested in the business and find out about their
experiences; and
4. if you are relying on any earnings claims or guarantees, study the statement giving the basis
for the claims and find out the percentage of past investors who have done equally well.
Q. How can a lawyer help an individual or group considering a particular franchise?
A. There are a number of areas in which an attorney can provide valuable services to a client
considering a franchise. For example, though some state laws make it difficult to make major
changes in a franchise agreement, the franchisee’s lawyer can often help negotiate the critical
terms of the franchise agreement with the franchisor. It is sometimes possible to work out an
agreement to reduce the initial fee, to spread out payment of the initial fee over a longer term than
originally proposed, or to require a rebate of a portion of the initial fee if the franchise is
terminated before the expiration of the contract term. Additional protection of the franchisee
against excess competition from the franchisor or other franchisees can also frequently be
15
negotiated. Rights of the client to additional franchises in the area should be explored. Another
important area of negotiation concerns the circumstances under which the franchisor can
terminate or refuse to renew the franchise and the amount of the franchisor’s control over the
price and other terms of any sale or other disposition of the franchise. Although franchisors have
traditionally resisted any changes in their standard printed agreements, there is evidence that they
are becoming more flexible in their willingness to negotiate terms and to remove from their
standardized franchise agreements provisions that have resulted in successful claims of
overreaching and antitrust violations.
Besides negotiating the terms of the franchise agreement, the franchisee’s lawyer can also
provide valuable counseling services, for example, by assisting the client in obtaining additional
information on the franchisor from financial services companies such as Dun and Bradstreet,
Better Business Bureaus, and other franchisees, and in evaluating the economic risks of the
particular venture compared to other similar franchised and nonfranchised ventures. The amount
of initial fees and royalties and uses of the royalty income vary significantly even among
franchisors in the same line of business. Careful investigation may uncover improper hidden
charges and kickbacks. Frequently the franchisee will not be experienced in financial matters,
including knowledge of necessary start-up costs, working capital needs, and available financing
sources. The information provided a prospective franchisee under the FTC Disclosure Rule and
from other sources is of no real value if the client is unable to evaluate it properly. A lawyer can
also negotiate the business’s lease and other related agreements.
Employer-Employee Relations
Q. How are employer-employee relations regulated?
A. There are numerous federal and state statutes that regulate employer-employee relations.
Most of these statutes have been enacted in the past thirty years. A list of some of the
most important federal legislation in this field includes the following:
· The Norris-LaGuardia Act and the Labor Management Relations Act, which regulate
labor unions.
· The Fair Labor Standards Act, which primarily regulates minimum wages, maximum
hours and overtime.
· The Equal Pay Act, which prohibits sex-based pay differentials for equivalent work.
· Title VII of the 1964 Civil Rights Act, the principal statute that prohibits employment
discrimination based on race, color, sex, religion or national origin. Title VII also
established the Equal Employment Opportunity Commission, which is the main
administrative body with responsibility to enforce employment anti-discrimination
legislation.
· The Age Discrimination in Employment Act, which prohibits discriminatory practices in
hiring, firing, compensating and setting terms of employment of individuals forty years
of age or over.
· The Occupational Safety and Health Act of 1970, administered by the Occupational
Safety and Health Administration (OSHA), which sets safety and health standards for
production plants and machinery.
· The Americans With Disabilities Act, which requires removal of barriers to persons
with disabilities by all businesses “providing public accommodations,” a term which is
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much broader than it sounds and includes restaurants, theaters, and even doctors’
offices.
· The Employee Retirement Income Security Act of 1974, referred to as ERISA, which
establishes substantive and procedural rules for employee pension and welfare
benefits, such as medical coverage.
· The Family and Medical Leave Act, enacted in 1993, which requires employers to
allow individuals up to twelve weeks of unpaid leave per year to care for a child or
other family member without fear of dismissal or other penalty.
In addition to these statutes, there are a number of federal statutes that affect private
businesses only if they receive federal financial assistance. Examples are the Comprehensive
Employment and Training Act of 1973, which prohibits discrimination in special employment
incentive programs that receive federal assistance, and Titles VII and VIII of the Public Health
Service Act, which prohibit discrimination in health training programs that receive federal
assistance.
There are also many state statutes that regulate employment relations. Some of these state
statutes parallel and often overlap federal statutes. Others, however, deal with issues not dealt
with in federal statutes. The most prominent of these are the state workers compensation
statutes that compensate employees for job-related injuries on a no-fault basis.
Q. Is every one of these acts applicable to small businesses?
A. Almost all businesses are subject to one or more of these statutes. Some small businesses
may, however, be exempt from one or more of the acts, because of their size. For example,
Title VII of the Civil Rights Act covers only employers having fifteen or more employees, and the
Age Discrimination in Employment Act covers only businesses having twenty or more
employees. On the other hand, the Fair Labor Standards Act, the Equal Pay Act and the
Americans with Disabilities Act cover virtually all non-governmental employers.
PREVENTIVE LAW TO THE RESCUE
Because of the differing exemptions, the overlap between the various applicable statutes and the
involvement of various federal and state administrative agencies, there are many problems in
complying with all the regulations (many of which are inconsistent) and developing case law.
Moreover, the law in this area is developing and changing so rapidly that it is advisable for
businesses to invite employment law specialists to visit the business on a regular basis to review
recent legal developments and any existing and potential employment law problems the firm has.
This “preventive law” approach can help to reduce the incidence of employment law problems
and the severity of any problems that do arise.
Q. Can compliance with these regulations be avoided by the use of temporary
workers and independent contractors?
A. The answer is generally yes, assuming the contractual relation creating the arrangement is
bona fide. The use of temporary workers, including leased-employee arrangements, part-time
employees, and independent contractors, has been growing rapidly in recent years. By using
17
these kinds of workers instead of full-time employees, a business may be able to qualify for an
exemption from many of the federal and state statutes that regulate employers. Moreover, having
very few employees saves on health insurance premiums and makes it less costly for a business
to have generous fringe benefit plans for the principal executives.
These cost savings must, of course, be borne by the company that provides the temporary
employees and the independent contractors providing services for a business, which in turn may
increase the amount the business must pay for these services. These companies, however, can
often provide compliance more efficiently and cost effectively than most small businesses.
The downside for companies using temporary and leased employees is the considerable risk of
lower morale on the job, reduced quality and productivity, and the need to be seeking and
training workers constantly. When figuring in these factors, many companies have concluded that
the cost savings are illusory and they’re better off with experienced, full-time employees.
TYPES OF BUSINESS ORGANIZATIONS
There is a wide variety of basic legal formats for structuring a business. Each type has its own
special characteristics, uses and limitations. The proprietorship, partnership, and corporation are
the most popular and well known. A newer but increasingly popular form of business
organization is a limited liability company. The principal characteristics of all these types are
described in this section.
For More on Proprietorships
You can find information about tax laws and sole proprietorships from
· http://www.intuit.com/turbotax/support/taxedge/ref/propriet.html
· http://www.irs.treas.gov/prod/tax_edu/teletax/tc408.html
Q. What is a sole proprietorship?
A. A sole proprietorship is an unincorporated business that is owned by one person. If there
is more than one owner or the business is incorporated as a corporation, a process that is
described later in this chapter, it cannot be a proprietorship.
A proprietorship can have employees, however, and, except for a few restrictions that
vary from state to state, can operate any type of business. If you conduct a business without coowners
and take no legal steps to become another form of business, then you are a sole
proprietor with respect to that business even if you are not aware of this fact. A person who, for
example, on a part-time basis paints pictures in her home which she exhibits and sells is a sole
proprietor with respect to her paintings and therefore must comply with all applicable tax,
licensing and other regulations.
Sole proprietorships are the most prevalent form of business in this country. Recent
published statistics indicate that there are over 14 million proprietorships compared to 3.5 million
corporations and 1.6 million partnerships.
Q. What are the advantages and disadvantages of a proprietorship?
A. The sole proprietorship is an inexpensive and informal way of conducting a small business.
Its drawbacks are full personal liability for the owner (explained below) and the danger of
liquidation at the death of the proprietor.
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The principal advantage of the sole proprietorship is that it is the simplest form of business
organization. No statutes similar to those applicable to corporations and partnerships govern its
organization or operation, though, as explained in the section of this chapter on getting organized,
if the person uses a name other than his or her own, he or she may need to file a “Doing Business
as Certificate” or “Assumed Name Certificate.” The sole proprietorship provides an
entrepreneur with an opportunity to own his or her own business without the formalities and
expense of incorporation or the necessity of sharing control of the business with others, as is the
case in a partnership or in a corporation having more than one shareholder.
The fact that the assets and obligations of a sole proprietor are not separate from those of
the proprietor results in the proprietor’s being fully liable for the debts and other liabilities of the
proprietorship, and avoids a separate level of taxation on the business. The taxable income,
credits, and deductions of the business must be reported by the proprietor on his or her
individual income tax return.
A proprietorship also has the least flexibility of all the business forms with respect to raising
capital. No ownership interests can be sold to other persons; and the ability to borrow money
for the business is dependent on the net assets of the sole proprietor.
WHEN THE PROPRIETOR DIES
The single-ownership principle combined with the lack of separate entity status creates severe
problems at the death of the proprietor. Legally a sole proprietorship ceases to exist at the
proprietor’s death. Unless the executor is authorized to continue the business during the
administration of the estate, a new owner is found, or the business is incorporated, the
proprietorship will have to be liquidated with the consequent loss of the going concern value.
For the same reasons, providing an optimum estate plan for a sole proprietor is more restricted
than with the other forms of business organizations.
Q. What are partnerships?
A. A partnership is an unincorporated association of two or more persons who carry on a
business for profit as-owners. A partnership exists if these conditions are met, even though the
persons involved do not know or intend that the business be a partnership. If a husband and
wife, for example, are jointly operating an unincorporated retail shoe store, unless it is clear from
their financial records that one of them is the true owner and the other is merely an employee (in
which event the company would be classified as a sole proprietorship), the business will be a
partnership and both the husband and wife will be considered as partners and-owners of the
business.
Q. What kinds of partnership exist and what are the differences between them?
A. There are two types of partnerships recognized in the United States: general partnerships
and limited partnerships. The fundamental distinction between the two types is that in a limited
partnership, there must be at least one limited partner and at least one general partner. The
advantage of being a limited partner is that if the business is unsuccessful, the limited partner may
lose the amount of money invested in the partnership, but has no other financial risk. In this sense
a limited partner bears the same risk of loss as a shareholder in a corporation or a member of a
limited liability company. General partners, including general partners in a limited partnership, on
19
the other hand, can lose not only whatever money or other property they have put into the
partnership, but in addition their personal assets can be used to satisfy the unpaid claims of the
partnership’s creditors. This is why general partners are said to have unlimited liability whereas
limited partners are said to have limited liability.
The following are the primary differences between general and limited partnerships: first,
only limited partners have limited liability; second, limited partners can lose their limited liability if
they take part in control of the business and third parties believe them to be general partners;
third, a change in the number or composition of limited partners is not potentially as disruptive as
the retirement, death, or disability of a general partner; and fourth, there are in general more legal
formalities connected with limited partnerships, including the necessity of filing limited partnership
certificates in one or more places, keeping them up to date, and maintaining certain records.
With the exception of compliance with state and local assumed name statutes, there are no
mandatory filing requirements for general partnerships in most states.
Q. What are the advantages of partnerships?
A. The principal advantage of partnerships is the ability to make virtually any arrangements
defining their relationship to each other that the partners desire. There is no necessity, as there is
in a corporation, to have the ownership interest in capital and profits proportionate to the
investment made; and losses can be allocated on a different basis from profits. It is also generally
much easier to achieve a desirable format for control of the business in a partnership than in a
corporation, since the control of a corporation, which is based on ownership of voting stock, is
much more difficult to alter.
Because it is possible to sell equity interests in a partnership, the ability to raise capital in a
partnership is greater than in a proprietorship. However, as a result of the greater familiarity with
the corporate form, and the potential of personal liability or lack of participation in control in a
partnership, a corporation may have a greater ability to raise capital than a partnership.
With careful advance planning, a partnership can avoid some of the problems inherent in a
proprietorship when an owner dies, retires, or becomes disabled. In fact, many believe that a
limited partnership is an ideal vehicle to provide for continuity and succession in a family business.
The mechanics of succession vary with the situation. If you want to pass your share of the
business to other family members (usually a spouse or children), it is relatively simple to transfer
your interest to them, perhaps by leaving the family members enough cash (possibly through life
insurance proceeds) to buy out the others and thus avoid conflicts. (In a small corporation, you
could leave voting stock to family members who will operate the business, and leave non-voting
stock to others.)
Things get slightly more complicated if you decide to pass ownership on to people who are
not beneficiaries of your will. If your business is a partnership, you will usually want your
partners to remain in operational control. A “buy-sell agreement” is the most common device for
transferring ownership of a business on the death of a partner. Under such an agreement, the
remaining partners agree to purchase your interest when you die. This allows the business to
continue running smoothly with the same people in charge, minus one.
Buy-sell agreements typically provide that at the owner’s death, his or her interest in the
business will be acquired by the remaining partners or shareholders, or by the business itself,
leaving the deceased owner’s relatives with the proceeds of the sale. Life insurance is usually the
vehicle used to finance these arrangements, which lets the business avoid a drain on its cash. The
partners buy life insurance on each other’s lives, and the proceeds go to the surviving spouse,
children, or other designated beneficiaries, in return for the deceased owner’s share of the
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business.
Partnerships are taxed on a conduit or flow-through basis under subchapter K of the
Internal Revenue Code. This means that the partnership itself does not pay any taxes. Instead
the net income and various deductions and tax credits from the partnership are passed through to
the partners based on their respective percentage interest in the profits and losses of the
partnership, and the partners include the income and deductions in their individual tax returns.
For More on Partnerships
· http://www.bizmove.com/starting/m1r.htm is the URL of a useful checklist on points to consider
when entering into a partnership. The site also has other useful information for the
businessperson.
· http://www.inc.com/bbs/list/19 is the URL of a “peer-to-peer” bulletin board on topics of interest
to business owners, including partnership disputes and other partnership issues.
· Azriela L. Jaffe, Let’s Go into Business Together: 8 Secrets to Successful Business
Partnering (Avon Books, 1998) looks at the personal dimensions of this sometimes difficult
business form.
· Robert L. Davidson, III, Small Business Partnership Kit, looks at the pros and cons and
provides guidance on many of the legal aspects.
Q. What are the disadvantages of partnerships?
A. The major disadvantages of a partnership, as with a proprietorship, stem primarily from the
fact that a partnership is not as stable as a corporation. This results from the fact that a general
partnership technically dissolves whenever a general partner dies, files bankruptcy, resigns or
otherwise ceases to be a partner (dissociates). A general partnership and a limited partnership
dissolve on the dissociation of a general partner unless either a remaining general partner
continues the business or all the partners (or under some statutes, a majority) agree to continue in
business. Upon dissolution, a partnership will normally be required to be liquidated, but in most
large professional general partnerships, the partners agree to continue the business. However, a
corporation, under most statutes, continues forever until some affirmative action is taken to
dissolve it.
It may be more difficult in a partnership than in a corporation to have a hierarchy of
management and to raise capital from outside sources. Careful planning and drafting, however,
can minimize or eliminate most of these and other supposed disadvantages of a partnership,
through agreements providing for a specific governance relationship and desired variations in
capital ownership in a partnership. This is particularly true with respect to limited partnerships.
Q. What are corporations and how do they differ from other types of business
organizations?
A. A corporation is a legal entity that is formed by filing what is known as articles of
incorporation or a certificate of incorporation with the Secretary of State in your state along with
the required filing and license fees.
One or more persons can form a corporation. Thus, a sole proprietor can incorporate if
he or she wants to. Although there are some exceptions (doctors and lawyers are prohibited by
ethical and regulatory constraints from operating in certain types of corporations), corporations
21
can generally operate any type of business.
The person or persons who file the articles or certificate of incorporation are called
incorporators. The equity ownership interest in a corporation is called stock and the owners of
shares of stock are called shareholders or stockholders. There are two types of stock, common
stock and preferred stock. They differ in that dividends generally must be paid on the preferred
stock before the common stock receives dividends. Another difference is that upon liquidation,
the owners of the common stock are paid the amount of the corporation’s assets left over after
paying all the creditors and the amount due the holders of the preferred stock (which usually
includes accrued but unpaid dividends and the par value or redemption value allocated to the
preferred stock). In short, the common stock is entitled to the residual value of the corporation.
That is why the value of the common stock fluctuates with the success of the corporation. If the
corporation is successful, the value of the common stock will increase to the extent the net profits
are not paid out in the form of dividends. On the other hand, if the corporation loses money, the
value of the common stock will decrease in order to reflect those losses. There are instances in
which the value of stock will increase even if the corporation is not showing a profit. This is
particularly true in start-up companies in which there are no profits available for reinvestment but
the business is growing or developing.
THE BASIC CHARACTERISTICS OF A CORPORATION
Acceptance of a corporation as a separate legal entity evolved during the 19th century. It is now
well established that a corporation has a legal status that is independent of its shareholders.
Partnerships and limited liability companies are also legal entities for some purposes. The
separate entity status of partnerships is, however, less complete than in corporations. The entity
status of limited liability companies, on the other hand, is virtually the same as corporations.
The corporation’s independent existence as an entity undergirds the basic corporate attributes of
limited liability, perpetual existence, free transferability of shares, and the ability to own property,
bring suit, and be sued in the corporate name. It also accounts for the tripartite system of
corporate management, consisting of shareholders, directors, and officers.
Q. What is the advantage of corporate limited liability?
A. Shareholders generally are at risk only for the amount of money or other property they
invest in the corporation, though some state laws impose shareholder liability for unpaid wages in
small corporations. Creditors of the corporation whose claims are greater than the assets of the
corporation cannot satisfy their excess claims against the personal assets of the shareholders,
unless the shareholders have previously obligated their personal assets by personal guarantees or
co-signing a note or other obligation in their individual capacity. This ability to shield personal
assets from the creditors of a corporation has long been the principal reason why investors have
been more willing to invest in a corporation than any other type of business organization. As was
pointed out earlier, sole proprietors and general partners are personally liable for all the debts
and other obligations of a business they own. Given a choice, an investor will always choose
limited liability to unlimited liability.
It is now possible to achieve at least some form of limited liability in most other types of
business organizations. Limited partners, for example, have limited liability. So do all of the
members in a limited liability company. Moreover, the shareholders of a corporation that is a
22
general partner also have limited liability, though the corporate general partner itself is liable.
Nevertheless, the corporate-style limited liability is generally thought to be more complete and to
provide more flexibility than in other types of business organizations. Limited partners, for
example, lose their limited liability if they take part in the control of the partnership in a manner
not permitted by the state’s governing statute, provided that creditors are led to believe by that
control that the limited partner is a general partner. Corporate shareholders do not, however,
lose their limited liability by exercising control rights. In fact, one of the most important attributes
of share ownership is that shareholders control the corporation through their voting rights.
When shareholders of a corporation guarantee its debts, co-sign its notes in their individual
capacity, or pledge their own assets as security for loans to the corporation, which frequently
occurs because of creditors’ demands, the shareholders waive their limited liability with respect
to those debts, notes or assets. But this is a limited waiver. The shareholders in question still
have limited liability with respect to any other debts or obligations of the corporation.
The following example will help to illustrate this distinction. Suppose the sole shareholder
in a corporation personally guarantees payment of a $20,000 bank loan that is used to purchase
a new delivery truck for the corporation. Subsequently the corporation ceases doing business
and is liquidated. At the time of liquidation the corporation has $50,000 of assets and the
creditors of the corporation other than the bank that made the truck loan have valid claims of
$75,000. Assume further that the unpaid balance on the bank note is $15,000. The bank can
recover the $15,000 owed it directly from the shareholder because of the personal guarantee.
The other creditors, however, can recover only $50,000 from the corporation. They cannot
recover the additional $25,000 they are owed from either the corporation, because it does not
have any more assets, or from the shareholder, because his other assets are protected by the
limited liability doctrine.
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For More on Corporations
· The Business Owner’s Toolkit is a very useful site for small business that contains much
useful information on starting corporations and other practical legal matters. Access the
material on corporations at http://www.toolkit.cch.com/text/P01_4770.asp
· Another good general site is the “law tools” of http://www.lawoffice.com/, which includes
helpful excerpts from West’s Encyclopedia of American Law, among other resources.
· The Quicken site on small business contains a number of steps to take in forming a
corporation, as well as FAQs. Access it at http://quicken.webcrawler.com/small_business.
· The IRS is a good source of info on the taxing question of S Corporations v. C
Corporations. See in particular Publication 542, Corporations; Publication 17, Your Federal
Income Tax; Publication 535, Business Expenses; Publication 533, Self-Employment Tax,
Self-Employment Income; and Publication 550, Investment Income and Expenses. The IRS
website–www.irs.ustreas.gov–has all of these on line, as well as much more.
· Cornell’s Legal Information Institute has many on-line resources about corporations. Access
http://www.law.cornell.edu/topics/corporations.html.
Here are some resources that focus on the questions to ask yourself in deciding if you
should incorporate and deepen your understanding of the steps involved.
· Carl R.J. Sniffen, The Essential Corporation Handbook (Oasis Press, 1995) answers
some important questions and will help you work with your accountant and lawyer.
· Robert L. Davidson, III, The Small Business Incorporation Kit, (John Wiley & Sons,
1992), offers plenty of explanations and guidance on actually running the corporation.
· Michael R. Diamond and Julie L. Williams, How to Incorporate: A Handbook for
Entrepreneurs and Professionals John Wiley & Sons, 1996) offers guidelines and
suggestions on how to avoid problems.
THE IMPORTANCE OF PERPETUAL EXISTENCE
When a general partner ceases for any reason to be a partner, the partnership will end up being
dissolved and liquidated unless the remaining partners agree to continue the business. Getting
necessary consent from the partners to continue the business can be very difficult and may be
impossible. Yet liquidation may result in significant losses to all the partners. This risk of
dissolution and liquidation is one of the principal drawbacks of operating a business as a
partnership. In a corporation, on the other hand, if a shareholder leaves, there is no risk of
liquidation (unless that departing shareholder has a contractual or voting right to force a
liquidation) because the life of a corporation is indefinite. Thus, perpetual existence gives a
corporation permanence, and this in turn is thought to make investments in a corporation
somewhat safer and less risky than investments in business organizations that have less inherent
permanence.
A reasonable form of perpetual existence can be obtained in both partnerships and limited
liability companies through buyout agreements and other contractual arrangements, but these
agreements must be carefully crafted to meet various legal and tax requirements.
Q. Is the ability to freely transfer shares of a corporation important?
A. In large corporations with many shareholders, the answer is yes. Being able to freely
transfer shares to anyone at any time gives an investor the right to liquidate his or her investment
24
at any time. This right to transfer makes shares of the stock very marketable, provided, of
course, there is someone who wants to buy them. The shares of all the corporations whose
stock is registered with a stock exchange like the New York Stock Exchange are, for example,
freely transferable.
But in a small corporation with only a few shareholders, free transferability of stock can
often be a detriment. Assume, for example, that one of the three founding shareholders of a
corporation that operates a camera store wants to sell his or her shares to someone the other
two shareholders intensely dislike. Assume further that in order for the camera store to be
successful, it is necessary for all three of the shareholders to work in the store on a regular basis
without undue friction between them. If the shareholder who wants to sell can freely transfer his
or her shares to anyone, and the other two shareholders cannot prevent the sale, disastrous
results may ensue. In many states, a complete prohibition against the transferability of stock is
not possible, and that is the reason why in most small corporations, the shareholders will enter
into what is known as a shareholders’ agreement or a share transfer restriction agreement, which,
subject to case law and statutory requirements, will impose restrictions on the sale of stock.
Legal counsel is needed to draft the terms of such an agreement.
Restricting the free transferability of the shares, however, can produce its own set of
problems, one of which is that the shareholder who wants to sell may not be able to find a buyer
acceptable to the other shareholders. To counteract this illiquidity problem, the shareholders
may want to enter into what is known as a redemption or cross-purchase agreement, under
which the corporation or the other shareholders agree under certain specified conditions to buy
the stock of a shareholder who wants to liquidate his or her investment in the corporation.
Q. How does the separate entity status of a corporation affect its right to own
property, bring suit or be sued in its corporate name?
A. A corporation as a separate legal entity has the right to own and dispose of property in its
own name and to sue and to be sued it its own name. This facilitates commerce by not requiring
action by all shareholders.
While partnerships for some purposes are not considered as entities, all states have
statutes that allow them to own and convey property in their own name. Moreover, most states
now have statutes that allow partnerships to sue and be sued in their own name. Suits by and
against partnerships used to be a significant problem, however, until these statutes were enacted.
A limited liability company, like a corporation or a partnership, may own property and
commence and defend lawsuits in its own name. A proprietorship, on the other hand, does not
have separate entity status, but this does not cause any practical problems because there is only
one person, the sole proprietor, in whose name title to property belonging to the proprietorship is
taken. Moreover, suits by and against a proprietorship must be in the name of the sole
proprietor, even if the proprietorship operates under a name different from that of the proprietor.
A DISTINCTIVE MANAGEMENT STRUCTURE
There are three levels of management in a corporation. The shareholders, as previously
discussed, own the equity stock and vote on fundamental issues affecting the corporation. One
issue of vital importance is the right of the shareholders to elect the directors of the corporation.
The directors are by statute in charge of managing the corporation. They in turn select the
25
officers, who run the corporation on a day-to-day basis and as the agents of the corporation
implement the policies established by the board of directors.
Q. How are small corporations magaged?
A. The tripartite management scheme works well in a large corporation. But it can cause
difficulties in a small corporation having only a few shareholders. In a corporation with one
shareholder, or example, it is burdensome to go through the mechanics of having that shareholder
elect himself or herself as a director and then in a subsequent meeting elect himself or herself to
various offices. Yet that is what is required by the corporate statutes in most states.
Voting is based on number of shares, not number of shareholders. Consider a situation
where one of three shareholders in a corporation owns 67 per cent of the stock and the other
two own the remaining stock. Because directors are elected by a majority of the stock, the 67
per cent shareholder can nominate and elect all the directors, and the directors in turn will elect
all of the officers. Because the holders of two-thirds of the shares under corporate statutes can
approve any action that shareholders are entitled to vote on, the 67 per cent shareholder can
vote to merge with another corporation or to liquidate the corporation, regardless of the wishes
of the two minority shareholders.
It is possible to give the minority shareholders in the above example some protection
through various special provisions that have been incorporated into state corporate statutes in
recent years. One way is to have cumulative voting, where if three directors are to be chosen,
shareholders can use their votes for one director, rather than vote for each candidate. Another
way to enhance the rights of the minority shareholders would be to create two classes of shares
and allow each class to elect an equal number of directors. Since the directors elect the officers,
a slate of officers acceptable to the minority shareholders would have to be proposed in order to
elect any officers. Each class voting separately would also have to approve any fundamental
change in the corporation, such as a merger or liquidation. Thus, the minority shareholders
would, in effect, have equal management rights in the corporation even though they own only
one-third of the stock.
Q. How does the management structure of a corporation compare with that of a
general partnership?
A. The management structure of a general partnership is very different. Unless the partners
otherwise agree, each partner has one vote, and action in the ordinary course of business
requires approval by a majority of the partners. Extraordinary action, however, requires
unanimous consent of all the partners. Thus, in a general partnership with three partners, one of
whom has 67 per cent of the capital and profits, the 67 per cent partner can be outvoted on all
ordinary course of business decisions by the other two partners. The 67 per cent partner could,
however, prevent the partnership from merging with another partnership.
Another difference between general partnerships and corporations is that in most
partnerships the partners perform every management function in their capacity as partners.
Therefore, you do not need to have the three levels of management that exist in a corporation. In
a large partnership, however, for the sake of convenience and efficiency, the partners will often
select one or more managing partners to run the business on a day-to-day basis. In this type of
arrangement the managing partners are like the board of directors and officers of a corporation,
and the other partners function somewhat like the shareholders in a corporation.
26
Q. Is the management structure of limited partnership different?
A. A limited partnership has a management structure that is a hybrid between a general
partnership and a corporation. The general partners are like the managing partners in a general
partnership. The limited partners are like passive non-management shareholders in a
corporation. However, they lose their limited liability if they take part in the control of the
business with respect to people who are misled by such participation in control into believing that
a limited partner is a general partner.
In a limited partnership, voting rights of the partners, including the general partners, may be
modified by the agreement of the partners. In the absence of such an agreement, decisions are
made by the general partners on a per capita basis, as is the case in a general partnership.
Q. What is the management structure of a limited liability company?
A. The management structure of a limited liability company has features of both partnerships
and corporations. Unless management is delegated to designated managers, the investors in a
limited liability company, called members, exercise all management rights. This is the same basic
scheme as exists in a general partnership. The various limited liability statutes differ, however,
with respect to whether the members have per capita voting rights, as in a general partnership, or
voting rights based on the respective percentage of total capital.
SIMPLE AS CAN BE
The management structure of a proprietorship is quite simple. The sole proprietor is the only
person who has management power so there are none of the complexities that exist in the other
forms of business organizations.
Q. How are corporations taxed?
A. There are two subchapters in the Internal Revenue Code that govern corporations. One is
Subchapter S, which corporations meeting designated criteria can elect. The other is Subchapter
C, under which the majority of corporations operate.
Q. How are corporations that elect to be under Subchapter S taxed?
A. S corporations, as they are commonly called, are taxed in a manner similar to partnerships,
although there are important differences between S corporations and partnerships. Except in a
limited number of circumstances, an S corporation does not itself pay any taxes. Rather, the
income and deductions generated by the S corporation are passed through to the shareholders,
who report their proportionate share on their individual tax returns. The requirements for
qualifying to elect to be taxed as an S corporation are discussed later.
Q. How are corporations taxed under Subchapter C of the Internal Revenue Code?
A. A corporation which has not made an election to be taxed as an S corporation must pay a
tax on its net taxable income, and then the shareholders must pay a second tax on any of the
27
corporation’s net earnings that are distributed in the form of taxable dividends. In many cases,
the total of these two taxes, plus the tax on any money received by a shareholder as a salary for
working in the corporation, will be more than if the same income was subject to only one level of
taxation-as is the case with S corporations, proprietorships, partnerships and limited liability
companies, which are taxed on the conduit or flow-through theory. Although the corporation’s
income is taxed when earned, a shareholder is not taxed until property or cash is distributed to
the shareholder in an operating distribution, redemption of the shareholder’s shares, or
liquidation.
The double taxation of C corporation taxable income is definitely disadvantageous when
the combined taxes payable by the corporation and its shareholders exceed the total taxes
payable if the business were operated as a partnership, proprietorship, limited liability company
or S corporation. With respect to fringe benefits, however, C corporations enjoy a distinct tax
advantage over the other forms. Shareholders who are employed by a corporation in some
capacity-unlike sole proprietors, partners and the members of a limited liability company, who
are regarded as self-employed can qualify as employees of the company and, therefore, are
eligible for special life and medical insurance programs and other fringe benefits offering
advantageous tax results. For the most part, however, these fringe benefits must not discriminate
in favor of any highly paid corporate executives and therefore involve significant costs to the
business. The overall tax savings derived from these fringe benefits is usually marginal, and in
most situations it will not constitute a significant factor in deciding whether to incorporate a new
business.
SEVERAL TYPES OF CORPORATIONS
As is evident from the prior discussion of taxes, there is more than one kind of corporation, just
as there is more than one kind of partnership. The various types of corporations, however, are
not as distinct as are general and limited partnerships. From a non-tax perspective there are three
principal forms of corporation: the general business corporation and two specialized derivatives
of the general business corporation, the close corporation and the professional corporation. For
federal income tax purposes any of these corporations may be subject to double taxation (a C
corporation) or, if the corporation otherwise qualifies and elects to be taxed as such, an S
corporation.
Q. What is a business corporation?
A. A business corporation is a corporation, generally organized for profit, that is formed
under a state’s corporation act or business corporation act. If a general business corporation,
(including a professional corporation or a close corporation) does not qualify or elect to be an S
corporation, it will be treated as a C corporation and subject to double taxation under
Subchapter C of the Internal Revenue Code. Shares of stock in a business corporation are
securities subject to state and federal registration unless they or the transactions in which they are
sold are exempted from such laws.
Q. What is a close corporation?
A. A close corporation is one in which, as a general rule, all or most of the shareholders are
28
actively involved in managing the business. Many state corporation statutes have special
provisions that are designed to meet the needs of close corporations. These special statutes vary
from state to state but generally provide that the shareholders may manage the corporation
directly rather than through directors or officers and that the shareholders may make other
agreements for management which are not available to other corporations.
The term “close corporation” is applied not only to corporations formed under close
corporation statutes, but also to those with a small number of shareholders, who are generally
actively involved in the management of corporation. Using this criterion, most corporations
qualify as close corporations. A study made several years ago concluded that 95 per cent of all
corporations in the United States had ten or fewer shareholders.
Q. What is a professional corporation?
A. This kind of corporation is limited to the practice of one or more professions with licensed
professionals as its shareholders. Tax advantages are now marginal, but protection from
malpractice on the part of other shareholders remains an important motive for incorporation
rather than practicing a profession as a sole proprietorship or in a partnership, although under
some state laws these corporations do not protect innocent shareholders from personal liability.
Historically, professionals such as doctors, lawyers, and accountants have been prohibited
from conducting business in a corporate form. The main rationale advanced for this policy is the
necessity of preserving full individual liability for professional malpractice and the fact that only
individuals could be licensed. Under traditional corporate law, the separate entity doctrine would
theoretically protect a professional doing business as a corporation from personal liability for
malpractice committed by his or her associates, even though a judgment in excess of the
corporation’s assets is recovered by a claimant.
A professional corporation is a business corporation and may be a close corporation with
a fancy name. The major differences are that:
1. most of the professional corporation statutes limit the purposes of a professional
corporation to the practice of single profession;
2. only licensed professionals employed by the professional corporation can be shareholders
or directors-a requirement that necessitates a mandatory buy-out plan if the professional
retires, dies, or has his or her license to practice suspended or revoked;
3. although a professional is individually liable for his or her own malpractice, in most states
there is no liability for the malpractice of other professionals in the professional
corporation; and
4. either the term “professional corporation” or “professional association,” or one of their
abbreviations, must be used in the corporate name and included on all letterheads,
contracts, and advertising material.
Several states in the past few years have enacted statutes, included as part of their general
partnership statutes, which protect partners against malpractice liability to the same extent, and in
some cases provide more complete protection than, professional corporation statutes.
Partnerships electing this status are called limited liability partnerships.
Because of the decrease in the tax advantage once enjoyed by professional corporations
and the advent of limited liability partnerships, there are likely to be fewer new professional
corporations founded in the future than in past years.
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Q. What is an S corporation?
A. An S corporation is a business corporation (including a professional corporation, a close
corporation or both) that has elected to be taxed in a manner similar to a partnership under
Subchapter S of the Internal Revenue Code rather than according to the provisions of
Subchapter C, the normal corporate tax sections. As previously explained, the principal
distinction between S and C corporations is that S corporation income for the most part is not
subject to double taxation at both the corporate and the shareholder level. Recent federal tax
legislation that has liberalized the eligibility requirements for S corporations and changed the
maximum rates on taxable income has dramatically increased the number of S corporations. At
the present time, approximately one-third of all corporations are S corporations.
The basic eligibility requirements are that the corporation be a domestic corporation and
not have:
1. more than one class of stock;
2. more than seventy-five shareholders,
3. or own 80 percent or more of the stock of another corporation.
All of the shareholders must be individuals (some trusts and estates can qualify, however),
and must be United States citizens or resident aliens. Any corporation, including a professional
corporation and an existing C corporation, can elect to be taxed under Subchapter S if the
eligibility requirements can be met. If it appears it may be advantageous at some point to be an S
corporation, however, it is generally advisable, because of some very complex potential adverse
tax consequences, to start off as an S corporation rather than converting from a C to an S
corporation sometime after incorporation.
Q. How does a corporation choose to be taxed as an S corporation?
A. The election to be taxed as an S corporation is made by filing a Form 2553, which must
be signed by all the shareholders. The Form 2553 must be filed not later than two months and
fifteen days after the beginning of the taxable year in which it is to be effective. For newly formed
corporations that wish to have subchapter S apply from their inception, the taxable year begins
when the corporation has shareholders, acquires property or begins doing business, whichever
occurs first. This technicality can be a trap for the unwary. For example, the period for filing the
Form 2553 begins to run from the day the corporation enters into a lease, even though it is not at
that time conducting any business operations and even though the incorporation process is
incomplete and no shares have been issued to the shareholders. If the Form 2553 is filed after
the two-month, fifteen-day period, the subchapter S election will not be effective until the
corporation’s second taxable year, and it will be taxed as a C corporation for its first taxable
year. Therefore, it is important that the Form 2553 be filed as soon as possible after the articles
of incorporation have been filed.
HOW STATES TAX S CORPORATIONS
The taxation of S corporations under state tax laws varies from state to state. For the most part,
S corporations are taxed the same under state law as they are under the Internal Revenue Code.
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Some states, however, exact a special tax on S corporations that is similar to the state’s income
or franchise tax on C corporations. The differences in state taxation of S corporations can also
cause technical difficulties for shareholders who are residents of states other than the state where
the S corporation has its principal place of business. These are issues that shareholders should
discuss with a lawyer and accountant before deciding whether to elect subchapter S status.
Q. What is a limited liability company?
A. A limited liability company (LLC) is an unincorporated business organization that provides
the same flexibility of organization as a general partnership, the same limited liability protection for
its owners, called members, as is provided to the shareholders of a corporation and, generally,
the same pass through taxation as a partnership. The combination of flexibility, limited liability
and the avoidance of the two-tiered tax on C corporations makes an LLC very attractive to
investors.
There are two other features of LLCs that make them attractive. First, the members may
have full management rights without the prohibition against taking part in the control of the
business that applies to limited partners in a limited partnership and the cumbersome three-tiered
management structure of shareholders, directors and officers of a corporation. Second, although
a member can, unless otherwise agreed, freely transfer his, her, or its financial rights in an LLC,
under many of the statutes rights to participate in the governance may not be transferred without
the consent of the remaining members. This protects the remaining members against
unacceptable transferees becoming involved in the management of the business.
Moreover, there are no restrictions on the number or type of persons who can be
members of an LLC or the types of interests. Consequently, LLCs can be used in far more
situations than S corporations, which can have no more than seventy-five shareholders, all of
whom, with the exception of certain types of trusts and estates, must be United States citizens or
resident aliens. An LLC, for example, can have a nonresident alien, corporation, partnership or
another limited liability company as a member.
Q. Aren’t limited liability companies fairly new?
A. Yes. The first LLC statute in this country was enacted in 1977 by
Wyoming. Florida adopted a similar act in 1982. Very few LLCs were formed,
however, until after 1988 when the Internal Revenue Service ruled that they
would be taxed as partnerships rather than as C corporations as long as they met
certain requirements. The two principal requirements are that the membership
interests not be freely transferable and that the limited liability company not have
the same type of continuity of existence as a corporation. These requirements
are relatively easy to meet under the existing LLC statutes.
New IRS regulations in the summer of 1996 further relaxed the
requirements for limited liability companies and other unincorporated businesses
to be taxed as partnerships. Now any unincorporated business organization is
automatically taxed as a partnership unless it elects to be taxed as a
corporation. This should mean that LLCs will be used much more widely than in
the past.
Almost all states now have LLC statutes. The statutes differ greatly, however, and these
differences can create uncertainty. State taxation of LLCs also varies. In addition, many
technical state tax issues are still being resolved. As these and other uncertainties, caused
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primarily by the newness of this type of business organization, are being resolved, an increasing
number of businesses are being formed as LLCs, and this trend is expected to continue. Some
experts predict that in time LLCs will supersede partnerships and S corporations as a preferred
form of business entity, but in all probability, LLCs will provide an alternative to existing business
structures, to be used only in appropriate circumstances.
For More on LLCs
The following provide more information to help you decide whether an LLC is
for you.
! Corporate Agents, et al., The Essential Limited Liability Company
Handbook (Oasis Press, 1995)
! Martin M. Shenkman, with Ivan Taback and Samuel Weiner, Starting a
Limited Liability Company (John Wiley & Sons, 1996)
! A good Web site—-is entirely devoted to
LLCs. It includes information for lawyers, accountants and business
people thinking of setting up an LLC, including resources and useful
links. Also available from the site is a 3-volume treatise, The Limited
Liability Company, by William D. Bagley and Philip P. Whynott.
Q. What kinds of businesses operate as limited liability companies?
A. LLCs can be used for virtually any type of business. The types of businesses where they
have been used most frequently have been those where taxation as a partnership produces
advantageous tax consequences. LLCs are widely used for real estate ventures; extraction of oil,
gas and minerals; high-tech ventures, for example, a company formed to exploit a patent;
corporate joint ventures; as a vehicle for acquisitions; agriculture; and venture capital companies.
Because of their corporate-style limited liability, LLCs are also becoming more widely used as a
form of business organization by professionals such as doctors, lawyers and accountants. Some
states, however, do not as yet allow certain professionals to practice as an LLC.
Choice of Business Form
CHOOSING THE BEST ORGANIZATIONAL FORM FOR YOUR
BUSINESS
There are many tax and non-tax factors that must be taken into account in making this critical
decision. As a general rule, more than one form will be available. Choosing the best of the
available forms is a complex task and requires expert assistance from your lawyer, accountant
and other advisors.
Q. What are the principal non-tax factors that should be considered?
A. For obvious reasons most investors want limited liability. Investors in businesses where all
32
or most of the owners will be actively involved in the management of the company will usually
also want restrictions on the transfer of ownership interests and a simple management structure.
In addition, most investors want to be able to continue the business even after one or more of
them leave.
All of these features can be achieved to a greater or lesser extent in most types of business
organizations, although it is more difficult to obtain the desired results in some forms. For
example, it is possible to have limited liability in a general partnership if all the general partners
are corporations or limited liability companies. Similarly, corporate-style limited liability can be
achieved in a limited partnership where all of the general partners are corporations or limited
liability companies. This type of structure may not be desirable, however, for other reasons.
Incorporating all the general partners can add unnecessary expense, especially when the
alternatives of forming a corporation or limited liability company are available, and may adversely
affect the tax consequences desired by the investors.
Restrictions on transfers and a simplified management structure, inherent characteristics of
partnerships, can be obtained in corporations by carefully crafted agreements among the
shareholders, although, except in close corporations, most formalities of the statutory
management structure in state corporation codes will need to be observed.
Finally, in most situations business continuation agreements authorize the purchase of a
departed owner’s investment and allow the business to continue. These agreements, however,
can be very complex and expensive.
Only a lawyer has the necessary training to analyze the deficiencies in a particular form of
business and to be able to draft the proper agreements to overcome these deficiencies, to the
extent it is possible to do so.
Q. Are there any other non-tax factors that should be taken in account when
soliciting a business form?
A. There are always factors that at first appear to be insignificant, but may in the end turn out
to be critically important. Therefore, it is important to be sensitive to the possibility that one or
more of these factors may be present.
Organizational and administrative costs are an example. Proprietorships and general
partnerships involve the least expense because no written documents or public filings (except
possibly to comply with an assumed name statute) are legally required. It would be prudent,
however, to have a written agreement or general partnership agreement defining the rights and
obligations of the partners. Also, there are generally no annual fees to be paid. Written
documents and various filing and annual fees are required for all the other business forms,
however. The total of these expenses can be significant.
When a business intends to do business in more than one state, the law of the various
states where it expects to operate must be investigated to determine if any special problems exist.
A limited liability company, for example, should probably not be used if a significant amount of a
company’s income is expected to come from sales in a state that does not have a limited liability
company act.
If the business organization will borrow money in a state that has usury laws, these laws
normally set maximum interest rates that can be charged for a loan, but provide exceptions for
corporations, meaning that the corporation is permitted to give up the benefits of the usury law to
obtain a loan. If a lender will only make a loan to the business at an interest rate in excess of this
limitation, it may be necessary to form a corporation to borrow the money. Having to
incorporate for this reason is less likely to occur today than in the late 1970s and early 1980s
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because general interest rates are relatively low. But interest rates are very cyclical and at some
point in time rates will increase substantially above today’s rates.
Finally, state law restrictions can limit the possible choices. A sole proprietor who wants
both limited liability and basic partnership taxation, for example, can achieve these goals by
incorporating as an S corporation, but because most limited liability company statutes require a
minimum of two members, cannot operate the business as a limited liability company.
Q. What are the principal tax factors that should be taken into account in selecting a
business form?
A. The applicable tax factors are even more complex than the non-tax factors, and changes in
the tax statutes and regulations can dramatically alter the way taxes affect the various types of
business organizations. Bearing this limitation in mind, four generalizations might provide some
useful guidance.
First, under the present income tax structure, there is a presumption that a business should
be formed as a proprietorship, partnership, limited liability company or S corporation rather than
as a C corporation.
Although the following chart indicates that except for taxable income between $75,000
and $155,950 the C Corporation tax rate for 1998 is less than the individual rates applicable to
other types of businesses, tax rates per se do not tell the whole story.
Comparison of 1998 Individual Joint Tax Rates With C Corporation Tax Rates
[these are federal tax rates; the states may apply additional taxes]
Dollar Amount Individual C Corp Differential
Up to $42,350 15% 15% None
$42,350 to $50,000 28% 15% C Corp. + 13
$50,000 to $75,000 28% 25% C Corp. + 3
$75,000 to $102,300 28% 34% C Corp. – 6
$102,300 to $155,950 31% 34% C Corp. – 3
$155,950 to $263,750 36% 34% C Corp. + 2
$263,750 to $10,000,000 39.6%* 34%** C Corp. + 5.6
$10,000,000 to $15,000,000 39.6% 35% C Corp. + 4.6
Over $15,000,000 39.6% 35%*** C Corp. + 4.6
* Includes 10% surtax
** +5% or $11,750, whichever is less
*** + 3% or $100,000, whichever is less
NOTE 1: Professional Corporations that are C Corporations are taxed at a flat rate of 34%
NOTE 2: The dollar levels for the various rates are adjusted each year based on increases in the consumer
price index
As previously explained, C Corporation taxable income is
subject to a double tax. First, a C corporation must pay taxes on its taxable income at the rates
specified in this chart. In addition, the shareholders must pay taxes at the individual rates
applicable to them for any income they receive from the corporation in the form of salaries or
dividends. The combination of both these taxes can often be higher than the taxes that would be
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payable if the business was operated as an S corporation, partnership or limited liability company.
Even if the total taxes paid by the C corporation and its shareholders on taxable income generated
by the corporation are less than if the business were operated in another form, the difference in
most cases will not justify operating a small business as a C corporation. Moreover, there are
other tax disadvantages of operating as a C corporation, including the potential application of the
higher corporate alternative minimum tax and the tax liabilities incurred in liquidating a C
corporation or converting it to another business form, which more than offset the possibility of
lower annual taxes based entirely on a tax rate structure that can be changed at any time. In this
connection, it is worth noting that from 1986-1992, the tax rate for C corporations was higher than
that of business forms for most levels of taxable income.
Second, as a general rule, if flow-through taxation is important, partnerships and limited
liability companies provide more flexibility than S corporations because of the ability in
partnerships to authorize special allocations of income and losses and to make distributions of
capital without triggering adverse tax consequences.
Third, consider the possibility that at some point in the expected life cycle of the business
it might be advisable to change the organizational format. For this reason it is important to
remember that it is possible to go from a proprietorship to any other form, to convert a
partnership to another form of partnership or to a limited liability company or corporation, and to
convert a limited liability company to a partnership, all on a tax-free basis. It is also possible to
convert an S corporation to a C corporation without adverse tax consequences. But it is not
possible to convert any type of corporation into a proprietorship, partnership, or limited liability
company, or to convert a C corporation into an S corporation without serious tax problems.
Finally, as is the case with non-tax factors, be alert to special facts that may end up
limiting the available choices. For example, if the business will have a corporate shareholder,
then Subchapter S will not be available and a partnership or limited liability company will have to
be used if pass-through tax treatment is desired.
GETTING ORGANIZED
This section will describe in general terms the legal steps that must be taken to organize a new
business and get it to the operational stage.
Q. In which state should the business be organized?
A. In the state where the business will have its principal place of business. This will
generally also be the state where the principal investors live. Every state’s laws have some
shortcomings, but as a general rule these can be overcome by carefully drafted agreements.
INCORPORATING IN A “FRIENDLY” STATE
Some states have a reputation for having laws favorable to a particular form of business. This is
true, for example, with respect to the Delaware Corporation Code. The features of the
Delaware Corporation Code that are touted as being important reasons for incorporating there
are for the most part applicable only to large corporations with hundreds of shareholders. For
example, if a small corporation whose investors and business operations are in Oregon were to
incorporate in Delaware, the corporation would have to qualify as a foreign corporation in
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Oregon. Moreover, annual fees and license taxes would have to be paid in both states and a
lawyer admitted to practice in Delaware would have to be retained whenever a corporate law
problem involving the business arises. These extra expenses are rarely justified.
Q. What steps are involved in organizing a proprietorship?
A. Very few, as a general rule. A sole proprietorship is the simplest form of business. The
only legal requirements are usually a business permit or license and tax identification numbers. If
the business is to operate in a name other than that of the proprietor, it may be necessary to
comply with a state or local assumed name statute. No written documents will be necessary
unless the proprietorship is buying or leasing property or will operate a franchise.
Q. What steps are involved in organizing a general partnership?
A. From a strictly legal point of view, the same as in a proprietorship. Although there is no
requirement that a general partnership have any kind of written agreement, it would be foolish not
to have one, if for no other reason than to provide concrete evidence of the partners’ agreement.
A written partnership agreement will typically contain provisions relating to capital
accounts and drawing accounts, partner salaries, reimbursement of expenses, vacations and
fringe benefits, voting rights, the rights of the partners when one of them leaves the partnership,
admission of new partners and what happens if the partnership liquidates. A well-drafted
partnership agreement that is carefully tailored to the particular needs of the partners is a lengthy
and very complex document.
Q. Is organizing a limited partnership any different from a general partnership?
A. Yes. The most significant difference is that limited partnership statutes require a
document known as a certificate of limited partnership to be filed, together with a specified filing
fee. While the information required to be in the certificate of limited partnership varies, all the
statutes require the name of the limited partnership, the address of its principal place of business
and the name and address of the agent for service of process, the name and business address of
each general partner, and the latest date when the partnership will dissolve. Some of the statutes
also require the business purpose to be specified and also the circumstances under which
additional capital may be required. All the statutes also authorize the partners to include any
other information they wish in the certificate.
Q. What steps are necessary to organize a limited liability company?
A. There are two documents that a limited liability company must have.
The first is a document generally referred to as “articles of organization” which must be
filed in the Office of the Secretary of State in your state. The statutory requirements vary, but
generally the articles of organization must contain the same type of information as is required in a
certificate of limited partnership. One difference is that most of the limited liability company
statutes require the articles of organization to specify whether the LLC will be member managed
or manager managed (a situation similar to having managing partners in a partnership) and the
names and addresses of the members or managers.
The second required document is generally referred to as an operating agreement. It is
also sometimes called a member control agreement or referred to as “regulations.” This
36
agreement is similar in format and content to a partnership agreement. It does not have to be
filed in any public office.
Every member of an LLC should have a copy of both the articles of organization and the
operating agreement.
Q. What steps are required to form a corporation?
A. The legal formalities for a corporation are more complex than in the other forms of
business organizations. Corporate codes require the filing of a document generally known as
either “articles of incorporation” or a “corporate charter”, bylaws, the issuance of share
certificates and an organizational meeting. In addition, in most situations other written documents
designed to protect the rights of the investors will be advisable.
Q. What are the requirements for the articles of incorporation?
A. The statutes vary, but generally corporate codes require the inclusion of the following
information in the articles of incorporation: the name of the corporation, its duration, the
corporation’s business purposes, the amount of stock that will be authorized, certification that any
required minimum capital has been paid into the corporation, the address of the registered office
and the name and address of the registered agent, the names and addresses of the initial
directors, and the names, addresses and signatures of the incorporators. Corporate statutes also
authorize other information to be included in the articles of incorporation. Examples of the kind
of optional provisions often included are share transfer restrictions and elimination or curtailment
of the usual powers of the board of directors.
There are some differences between the articles of incorporation of regular corporations,
close corporations and professional corporations, but these differences are for the most part
technical and not that significant.
Q. What are bylaws?
A. The purpose of bylaws is to provide guidelines for regulating the internal affairs of a
corporation. Typically corporate bylaws deal with the mechanisms of shareholder, director and
committee meetings, the issuance of stock and dividends, and the appointment, duties and
removal of the officers.
STOCK CERTIFICATES
Stock certificates are documented proof of share ownership. A share certificate is like the title
certificate you receive when you purchase an automobile. State corporation codes contain
detailed requirements for stock certificates. Unless a transfer restriction is clearly noted on them,
stock certificates are freely transferable.
Q. What takes place at the organizational meeting?
A. Some state corporation codes require two organizational meetings, one by shareholders
to elect the directors and a second by the directors to approve everything else. Most state
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statutes, however, require only one meeting, which will typically ratify all the actions taken by the
promoters and incorporators, adopt the bylaws and the corporate seal, select and set the salary
of the officers, authorize the issuance of shares, approve resolutions designating one or more
banks as depositories and establishing check signing authority, approve contractual agreements
among the shareholders or with third parties, approve resolutions authorizing the corporation to
be taxed as an S corporation (assuming the shareholders want the corporation to be an S
corporation) and authorize designated officers to take the appropriate action to complete the
incorporation process, including, if necessary, qualification as a foreign corporation in another
state.
Q. What other documents are commonly advisable at the time a corporation is
organized?
A. Because of gaps in most corporate statutes and the need to protect the rights of minority
shareholders to a greater extent than is provided by statute, it is often advisable for the
shareholders and the corporation to enter into one or more of the following documents: a
shareholder voting agreement or voting trust, a long-term employment agreement for the
investors who will become executive officers, a shareholder-management agreement which in
effect can create the same type of management scheme as exists in a partnership, a share transfer
restriction agreement, and a buy-out agreement providing for the purchase (under specified
conditions) of the shares of a shareholder who leaves the employment of the corporation or for
some other reason wants to liquidate his or her investment. These are very complex, technical
documents that must be drafted by a lawyer.
Other contracts that will typically need to be reviewed or drafted include one or more
leases, a franchise agreement and loan agreement.
If the corporation is electing S corporation status, then a Form 2553 must be completed
and filed with the Internal Revenue Service. The Form 2553 or a similar document must also be
filed with the state tax commission of the state where the S corporation was incorporated. Other
forms, such as a patent or trademark application or an application for a tax identification number,
may also be necessary. (See the section at the end of this chapter for ways to
accomplish these applications or filings.)
In addition, applications for any required licenses and for assumed or trade names need
to be filed. Most business licenses, however, are state and/or local, as are assumed and trade
names filings. Consult a lawyer for what is required in your area.
Operational Problems and Organic Changes
This section will discuss the legal issues that commonly occur during the life cycle of a business. It
is divided into three parts. The first deals with the normal kind of legal problems that an
operational business encounters. The second part deals with the principal issues involved in
buying and selling a business. The last part discusses the basics of a bankruptcy proceeding
involving a business organization.
Operational Problems
Q. What legal problems does a business typically encounter after it is organized
and operational?
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A. There are four general types:
1. major transactions such as a bank loan, or a purchase or lease of equipment or
real estate that involves the drafting or review of various legal documents and the
preparation of minutes authorizing the transaction;
2. changes in statutes and regulations that necessitate changes in the company’s
contractual documents and internal manuals;
3. ongoing regulatory compliance-for example, timely filing of corporate annual
reports, assumed name refilings and the like; and
4. the necessity of periodically reviewing and updating the company’s legal
structure.
Q. Must a business have a lawyer involved in all these transactions?
A. At the very least a business should regularly consult a lawyer about major transactions
and compliance problems. Even if the law firm representing a bank prepares the loan documents
and the borrower has to pay for this work, which is customary, the borrower’s attorney should
review all of the documents before they are signed.
To provide adequate legal protection for a business, its general counsel needs to review
all of the company’s legal documents on a regular basis, preferably at least once a year. This
annual legal audit can uncover omissions, such as the absence of corporate minutes and changes
in documents necessitated by changes in statutes and regulations. The review of the annual audit
with the client will also provide the lawyer with the opportunity to discuss with the client recent
legal changes so that the executives and employees will be alerted to potential problems and
better able to comply with the changes. As part of this process, the lawyer may uncover
potentially serious legal problems at a time when they can be resolved in an efficient costeffective
fashion.
Timing Your Annual Legal Audit
The best time is a month or so before the end of the company’s taxable year. This
enables the audit to include year-end tax planning issues. Frequently, significant amounts of taxes
can be saved by either completing a transaction this tax year or deferring the transaction until the
next taxable year.
Many businesses have the audit done a month or so before the company’s annual
meeting and use the audit as a planning vehicle for action that needs to be approved at the annual
meeting. Most small businesses, however, operate on a very informal basis and do not hold
regular annual meetings. This informality is now built into the corporate statutes, which require an
annual meeting but allow the requirement to be met by the use of consent minutes signed by all
the shareholders and directors. Consent minutes ratify the action taken even though no meeting
is held. Even though it is possible to legally avoid having an annual meeting, however, one should
be held if for no other reason than to review the annual legal audit.
Q. What kinds of issues should be dealt with in the annual legal audit?
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A. The following is a partial list of the issues to be reviewed:
· basic constituent documents, for example, articles of incorporation, bylaws and stock
transfer records of a corporation; the articles of organization and operating agreement of a
limited liability company; the partnership agreement, and in a limited partnership, the
certificate of limited partnership;
· employment agreements;
· all leases, licensing agreements and other contracts with third parties, with particular
emphasis on termination dates, renewal options and the like;
· insurance policies;
· all standardized contract forms used by the business, for example, purchase order forms,
warranties, brochures and the like;
· internal policy and procedural manuals, for example, employee policy and procedure manual,
antitrust compliance handbook;
· transactions that require additional documentation, such as official minutes;
· regulatory compliance, for example, environmental regulations, ERISA problems, Securities
and Exchange Commission requirements;
· structural changes in the business organization, for example, conversion to another business
form, adoption a retirement plan or a fringe benefit plan;
· tax planning issues, for example, S Corporation status, legal audit, alternative minimum tax
review;
· filing of tax returns, licenses and reports;
· pending and potential litigation involving the company; and
· recent legal developments affecting the business.
Business Acquisitions
Q. What are the ways in which one business can acquire another?
A. There are four basic acquisition methods: merger, consolidation, sale of assets and
exchange of ownership interests. Each type is briefly described below.
The distinctive feature of a merger is that one or more of the merging business entities
disappears into the surviving business entity, which automatically becomes vested with all the
assets and liabilities of the disappearing entities. For example, if the merger agreement between
A, B, and C corporations calls for C to be the surviving corporation, A and B will be merged
into C, and after the merger C will own all of the assets and will have to pay all of the liabilities of
A and B, both of which no longer legally exist.
A consolidation is in essence a type of merger but differs from a typical merger in that all
of the merging entities disappear into a new entity. Using the prior example, a consolidation
would occur if A, B, and C were merged into D, a new entity, which was probably created and
owned by A, B, or C or all of them.
A sale of assets differs from a merger or consolidation in several respects, the most
important being that the acquiring company buys only the acquired company’s assets and
therefore is not legally responsible for payment of the acquired company’s liabilities. The
acquiring company can, however, be liable in some situations for some of the acquired
corporation’s liabilities, even if the acquired corporation stays in existence. The acquiring
company, for example, may be liable for environmental clean-up costs caused by the acquired
40
company under the Comprehensive Environmental Response, Compensation and Liability Act of
1980 (CERCLA). Moreover, a sale-of-assets transaction may, unlike a merger or
consolidation, require consents from third parties to transfer leases, mortgages, franchises and the
like, which may not be forthcoming.
An exchange of ownership interests, the final basic acquisition method, involves the
owners of one business offering to purchase the ownership interest of another business or one
business offering to pay cash or issue ownership interests for the outstanding ownership interests
of the other business. All kinds of combinations can result from this type of transaction. The
most typical is for the acquired company to be operated as a subsidiary of the acquiring
company. For example, assume that corporation A agrees to purchase all of the outstanding
stock of B corporation for cash. After the transaction A will own all of the stock of B, which will
as a consequence be a subsidiary of A.
There is danger in the outright purchase of stock in a corporation. When such a
purchase is made, all of the undisclosed liabilities of the corporation are purchased. As a
preventive measure, it is common for an acquisition agreement to provide for a period of diligent
investigation, and for the buyer’s approval of the results of the investigation.
Q. How do you determine which of these acquisition methods to use?
A. You determine which acquisition method to use with the advice of your company’s legal
counsel, accountants and other experts. Every type of acquisition is complex and fraught with
legal problems. As a general rule, more than one acquisition method will be available, and the
acquisition can be structured as either a taxable or a non-taxable event, depending on which
produces the best overall tax results.
Selecting the best method, however, is only one of the problems that must be resolved.
The mechanics of the transaction can be incredibly complex. Corporate codes have detailed
statutory provisions setting out the approval process and the rights of shareholders who vote
against the acquisition (called dissenters’ rights). These statutes are complex but at least provide
some basic guidance. Very few partnership statutes, however, currently have any statutory
provisions that describe the mechanics of a merger, and none of the partnership statutes deal
specifically with sales of assets or exchanges. Moreover, the coverage of mergers and other
acquisition techniques by limited liability companies is also incomplete, and the existing statutes
are often confusing and inconsistent. An additional problem is that very few existing statutes deal
with the possibility of a cross-entity acquisition, for example a merger between a partnership and
a corporation or between a partnership and a limited liability company.
Regulatory compliance problems can also present difficult issues in any type of
acquisition. Antitrust clearance is not a problem for most acquisitions but it is sometimes
required by both the Federal Trade Commission and the Antitrust Division of the Department of
Justice under the Hart-Scott-Rodino Act. Federal and state securities law compliance is also
imperative, and environment law compliance issues are becoming increasingly important. These
are only a few of the compliance issues that must be reviewed.
In short, acquisitions are very complex transactions, and a company should consult a
lawyer about a proposed acquisition in the initial planning stage and before any binding
commitments about the method or tax consequences have been made.
Bankruptcy
41
Q. What happens if the business gets into financial difficulty?
A. Frequently, it is possible for the business to work out accommodations with its creditors
on a voluntary basis that will enable the business to survive through a rough period. Banks and
mortgage companies, for example, are often willing to refinance indebtedness, especially if they
can be convinced that the business’s financial difficulties are temporary. Trade creditors are also
amenable to stretching out payments for the same reason. After all, the last thing a creditor
wants is to foreclose on property securing a debt or reduce a debt to judgment. Everyone loses
in that situation.
Even in these difficult straits, it is important for the company to continue paying its payroll
taxes, since these are not dischargeable in bankruptcy and will become a personal liability of the
owners.
Two Kinds of Business Bankruptcy
If a business’s difficulties cannot be resolved, bankruptcy may be the only viable option. There
are two types of bankruptcy proceedings available to businesses. The first is a liquidation
proceeding under Chapter 7 of the Bankruptcy Code. The second is a rehabilitation proceeding
under Chapter 11, or in the case of proprietorships, Chapter 13 of the Bankruptcy Code.
Q. What happens in a Chapter 7 liquidation proceeding?
A. Any type of business can file a Chapter 7 proceeding. It is also possible for creditors of
the business to file a Chapter 7 proceeding, but this occurs infrequently.
Once the proceeding is filed, a trustee, who is appointed by the court and technically
represents the creditors, is in charge of the debtor business and will proceed to sell all the
business assets and distribute the net amount realized to the company’s creditors in accordance
with the priorities in the Bankruptcy Code.
Q. What happens in a Chapter 11 or Chapter 13 rehabilitation proceeding?
A. These proceedings differ from a Chapter 7 proceeding in two fundamental respects. In a
rehabilitation proceeding the ultimate objective is not the payment of the company’s creditors out
of the liquidation proceeds but rather to have the business continue in a reorganized form and to
pay the creditors out of its future earnings. The second major difference is that in most cases the
executives who were managing the business before the rehabilitation petition is filed can continue
to manage the business during the bankruptcy proceedings. This continuity can be helpful in
dealing with customers and creditors.
The business has the first option to submit to the court for approval a rehabilitation plan.
If it is not approved, the creditors can submit their plan. If a plan is approved, the proceeding is
dismissed and the business continues to operate under the provisions of the plan. If no plan is
approved, the proceeding will be converted into a Chapter 7 liquidation proceeding.
Q. When should the business seek legal advice about the possibility of bankruptcy?
A. At the first sign of serious problems. A lawyer can be very helpful in advising the
42
business about its options and in assisting with negotiations with creditors. The timing of the
bankruptcy filing can be very important because the filing of the proceeding results in an
automatic stay of all legal actions against the debtor business. This means that no further action in
the pending law suit can take place without the permission of the bankruptcy court. The ability to
get the stay is often the primary reason for filing a petition, even in circumstances where the
company is not currently unable to meet its ordinary debts as they become due.
Partnerships and limited partnerships present special problems under current law. Expert
legal advice is, therefore, especially important for businesses operating in these formats. The
difficulties with partnerships stem primarily from the personal liability of the general partners for
the partnership’s debts. The bankruptcy of the partnership will often force all of the general
partners also to file bankruptcy petitions. Limited liability companies are so new that there is no
case law resolving the questions that are bound to arise. It is not yet certain, for example,
whether a limited liability company will be treated as a partnership or a corporation under the
Bankruptcy Code.
Where to Get More Information
The best source for general information is the Small Business Administration (SBA),
which has branch offices through the United States. The SBA, Washington Office Center, 409
3rd Street, SW, Washington, DC 20416, telephone, (1-800-827-5722), website, http://www.sba.gov
The SBA offers many “free” and “for sale” management assistance publications to aid
small businesses. Examples are: Incorporating a Small Business, Checklist for Going Into
Business, The ABC’s of Borrowing, Planning and Goal Setting for Small Businesses and
Woman’s Handbook.
In addition, the SBA offices regularly offer workshops and counseling sessions for small
businesses.
The SBA also has a number of financial assistance programs for small businesses.
Information about these programs and applications can be obtained from any branch office.
The Internal Revenue Service publishes a pamphlet entitled Your Business Tax Kit,
which contains helpful information about the various federal business taxes. You can access it at
http://www.irs.ustreas.gov. Similar kits and pamphlets, many of which contain other useful
information such as business license applications, are available in most states through the state’s
tax commission or other state administrative offices.
The Secretary of State’s office, located in your state capital, can provide you with a great
deal of useful information about filing requirements for corporation, partnerships, limited liability
companies and other business forms.
Most states have a state development board that provides various forms of assistance to
businesses, particularly new businesses and existing businesses that are planning to move to the
state. Some states also have regional development boards. Illinois, for example, has Small
Business Development Centers located throughout the state.
Many states authorize special financial assistance for businesses, such as industrial
revenue bonds. There will generally be one or more agencies or commissions that are in charge
of administering these programs and can provide information about them.
Local and state Chambers of Commerce can be useful sources of information about
businesses.
Trade associations are excellent sources of statistical information about a particular type
of business.
43
The business section of the public library has directories, manuals, association lists and
statistical and demographic data on businesses. In addition, the Federal Trade Commission
(FTC) has a number of manuals for business owners, informing them of how to comply with
various laws. Included are: How to Write Adverse Action Notices, Offering Layaways,
Writing a Care Label, How to Write Readable Credit Forms, Writing Readable Warranties,
and Road to Resolution: Settling Consumer Disputes. For information about these
publications, call or write the Federal Trade Commission, 6th and Pennsylvania Avenue, NW,
Washington, DC 20580; telephone, (202) 326-2222. Many of them are available on the Internet
at http://www.ftc.gov.
Small business incubators exist in many parts of the country. Their purpose is to provide
consulting services, access to research and rental space at favorable rental rates for new
business.
44
For trade or service mark applications:
Commissioner of Patents and Trademarks
Crystal Park Building
2121 Crystal Drive
Arlington, VA 22202
Telephone: (703) 305-8600
http://www.ustpo.gov
For tax information, contact your local IRS office or check out their web site at
http://www.irs.ustreas.gov.
For Federal Securities and Exchange Commission:
Federal Securities and Exchange Commission
450 5th St., NW
Washington, DC 20549
Telephone: (202) 942-8642
Website: http://www.sec.gov
For copyright:
Federal Copyright Office
Library of Congress
101 Independence Ave., SE
Rm. LM 401
Washington, DC 20540
Telephone: (202) 707-9100
Website: address http://www.lcweb.gov/copyright. See also the website of the Copyright
Society of America, http://www.csusa.org.
Finally, in addition to lawyers who practice business law, accountants, insurance agents, bankers
and management consultants can be helpful sources

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