Corporate Formation - Business Law & Order Event Series


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This presentation was given by Carrie Leahy of Bodman PLC, Russ Brown of R.D. Brown PLC and Jerry Grady of UHY Advisors.

When forming a business one of the first decisions an entrepreneur will make is choice of entity. This session will cover the possible legal structures for your business activities, including the advantages and disadvantages of each type of entity in terms of limited liability, management of the business, employee compensation and tax matters. Learn the basics of Corporate Formation and understand the pros and cons of incorporating in Michigan and Delaware.

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Corporate Formation - Business Law & Order Event Series

  1. 1. Business Law & Order: Corporate Formation September 17, 2012 © Ann Arbor SPARK
  2. 2. R.D. Brown, PLC Attorney & Counselor at Law Corporate Formation 543 Marlpool Drive, Saline, MI 48176(734) 604-1522 -
  4. 4. Most Common Forms ofBusiness Entities• Sole Proprietorship• General Partnership• Limited Partnership• Limited Liability Partnership• Corporation• Limited Liability Company
  5. 5. Important Considerations in Choosing A Form of Business EntityThe primary goal of our sessions is to provide a basicunderstanding of the legal aspects on starting a business,with a focus on choosing the proper entity type.• Taxation• Limited Liability Protection• Management• Transferability of Interests• Flexibility
  6. 6. Sole Proprietorship• Definition: A form of business in which one person owns all of the assets of the business. Black’s Law Dictionary, 6th Ed.• Formation: There are no legal formation requirements. Michigan does require a person operating a business under a name to register the business with the county (file a Certificate of Assumed Name in county where office is located).• Tax Treatment: Income and loss are recognized by the owner directly on his or her personal tax return. No separate entity tax return is required.• Liability: The owner is personally liable for all of the liabilities of the business.• Management: Decisions regarding the management and operation of the business are wholly in the control of the owner.• Governing Law: There is no governing statute.
  7. 7. Sole Proprietorship (Cont.)• Costs: There are no direct costs related to the formation or continued existence of the business.• Transferability of Interests: A transfer of the business is accomplished through the sale of the business. Advantages:• It is simple and cheap; there are no legal formation requirements.• There are no non-tax recordkeeping requirements.• Single level of taxation. Disadvantages:• There is unlimited personal liability.• Co-owners are not permitted.• Discontinuation of business upon owner’s death
  8. 8. General Partnership• Definition: An association of two or more persons to carry on as co-owners a business for profit.• Intent to form a partnership is not necessary.• Sharing in the profits is evidence that you are a partner (subject to certain exceptions). Formation:• A general partnership files a Certificate of Co-Partnership with the county where the business is located.• A Partnership Agreement is not required, but is highly recommended. • The agreement would set forth the terms of ownership, voting rights, distribution of profits, ability to transfer interests, dissolution, etc.• Tax Treatment: A general partnership is a flow through entity, meaning that there is no entity level taxation and the income and loss of the partnership are reported and recognized by the partners on their personal tax returns. Partnership distributions of cash are taxable if they exceed a partner’s tax basis in his or her partnership interest, However, a federal partnership tax return must be filed.• Liability: Each partner has joint and several liability for his or her acts and the acts of the other partners and for the debts and obligations of the business; provided, however, that a partner does not have liability for obligations of the partnership incurred before the partner’s admission to the partnership in excess of partnership property.
  9. 9. General Partnership (Cont.)• Management: Management of the partnership is vested in the partners, unless specifically delegated to one or more partners. Delegation of management, however, will not limit a partner’s liability for the obligations of the partnership or the actions of the managing partner(s).• Governing Law: Uniform Partnership Act.• Costs: Because formal organizational requirements are minimal, formation and maintenance costs associated with general partnerships are limited.• Transferability of Interest: A partner’s economic interest (i.e., profits, losses, and the right to receive distributions) in the partnership is transferable, but the rights of a partner to manage the partnership or vote are not transferable unless all partners consent (or unless otherwise provided by the Partnership Agreement or under applicable state law). Advantages:• It is simple and cheap.• There are no non-tax record-keeping requirements.• There is an ability to allocate profits and losses specially among the partners (i.e., other than in accordance with their percentages of ownership interest).• Single level of taxation.• Generally use only where liability is minimal. Disadvantages:• Partners have unlimited personal liability.• There may be problems inherent in shared management responsibility.
  10. 10. Limited Partnership• Definition: A type of partnership comprised of one or more general partners who manage [the] business and who are personally liable for partnership debts, and one or more limited partners who contribute capital and share in profits but who take no part in running [the] business and incur no liability with respect to partnership obligations beyond contribution. Black’s Law Dictionary, 6th Ed. Formation:• Creatures of state law.• Can only be formed in compliance with the applicable state statute (i.e., filing a Certificate of Limited Partnership with the State).• A Partnership Agreement is not required by statute, but is highly recommended.• Partners do not have to be individuals; they can be entities.• Tax Treatment: As with a general partnership, a limited partnership is a flow- through entity. Income and loss are reported and recognized by the partners on their personal tax returns. However, a federal tax return must be filed by the partnership. Liability:• General Partner: The general partner(s) has unlimited personal liability for the obligations of the partnership. The general partner operates the business.• Limited Partner: The liability of a limited partner is limited to the extent of his or her capital contribution to the partnership; however, a limited partner who participates in the management of the partnership may lose his or her limited liability protection. Limited partners are generally “silent partners.”
  11. 11. Limited Partnership (Cont.) Management:• Management of the partnership is vested in the general partner(s).• Limited partners’ interests are akin to investments; they are not intended to participate in the management of the partnership.• Governing Law: In Michigan and Delaware, limited partnerships are governed by the Revised Uniform Limited Partnership Act.• Transferability of Interest: A partner’s economic interest is transferable, but the right to manage/vote is subject to restrictions on transferability contained in the Partnership Agreement and under applicable state law. Advantages:• The general partner retains control of the partnership.• Limited partnerships have more flexible capital structures than general partnerships.• There is limited liability for limited partners.• Single level of taxation. Disadvantages:• General partners have unlimited personal liability.• Limited partners may lose their limited liability protection if they participate in the management and control of the partnership. Practical Note:• The introduction of limited liability companies has greatly reduced the use of limited partnerships due to the fact that owners of an LLC are not liable for the debts or obligations of the LLC.
  12. 12. Limited Liability Partnership• Definition: A partnership that files a statement of qualification or registration as a limited liability partnership in accordance with the applicable state statute. Formation:• A creature of state law.• Can only be formed in compliance with the applicable state statute (i.e., filing an Application to Register a Limited Liability Partnership).• A Partnership Agreement is highly recommended.• Tax Treatment: Like general and limited partnerships, limited liability partnerships are flow-through entities; however, a federal LLP tax return must be filed.• Liability: Generally, a partner is not liable for acts or omissions of other partners (“full-shield liability”); however, in some states, a partner is liable for the debts of the LLP and for acts of persons under the partner’s direct supervision and control (“partial-shield liability”). • In Michigan, a partner is not liable for debts, obligations and liabilities chargeable to the entity arising from negligence, wrongful acts, etc. A partner remains liable for his or her own negligence and/or wrongful acts (a “partial-shield liability”). Also, partners are liable for tax obligations.• Management: Like a general partnership, management of an LLP is vested in the partners, although management may be delegated to one or more partners.• Governing Law: In Michigan, limited liability partnerships are governed by the Uniform Partnership Act.
  13. 13. LLP (Cont.)• Transferability of Interest: A partner’s economic interest in an LLP is transferable, but the right to manage/vote is subject to restrictions on transferability contained in the Limited Liability Partnership Agreement and under applicable state law. Advantages:• Flexibility: LLPs permit more control by partners than limited partnerships, with greater limited liability protection.• A useful alternative for regulated professions which are not permitted to organize as LLCs or corporations.• Single level of taxation. Disadvantages:• Limited liability protection may vary greatly by state.• States have shown a willingness to apply the “piercing the corporate veil” theory to LLPs to void a partner’s limited liability protection.• Formalities and expense are similar to an LLC.• The statutes are generally new and the case law is relatively undeveloped.• Limited ability to deduct fringe benefits. Practical Note:• Typically used for accounting and law firms.
  14. 14. Corporation• Definition: An artificial legal entity which is formed in accordance with the applicable state law, in which the ownership interest (i.e., stock) is owned by one or more shareholders. Formation:• Can only be formed in compliance with the applicable state statute (i.e., filing of Articles of Incorporation with the State). There is a $10.00 fee to form a corporation and an additional fee depending on authorized shares:• By-laws addressing the management and control of the corporation are required by state corporation law.• Significant corporate formalities (e.g., authorizing resolutions, issuing shares, subscription agreements, preparing minutes of board and stockholder meetings, maintaining books and records, etc.) must be observed.• Provide for buy-sell arrangements and transfer restrictions in a Shareholder or Founder Agreement.
  15. 15. Corporation (Cont.) Tax Treatment:• S Corporation: An S corporation is a corporation electing to be taxed under Subchapter S of the Internal Revenue Code. S corporations are taxable in a manner similar to partnerships (i.e., they are flow- through entities), thus avoiding double taxation. However, S corporations are required to file federal corporation tax returns. S corporations are subject to certain restrictions, including: • They can have no more than 100 shareholders. • Generally, their shareholders must be individuals or certain types of trusts (i.e., corporations, partnerships, and certain trusts are not eligible). • They cannot have shareholders who are non-resident aliens. • They cannot have more than one class of stock, but they may have both voting and non-voting common stock.• They must file an election to be treated as an S corporation on or before the 15th day of the third month of the year for which such treatment is desired• C Corporation: A C corporation is a corporation taxed under Subchapter C of the Internal Revenue Code. C corporations are subject to double taxation; that is, the income of the corporation is taxable at the entity level and then distributions to the shareholders are taxable to the shareholders. No election for Subchapter C treatment is required.
  16. 16. Corporation (Cont.)• Liability: A shareholder’s liability is limited to the extent of his or her investment in the corporation, unless a court finds reason to “pierce the corporate veil.” State corporation laws generally also provide for limited liability protection and indemnification of corporate officers and directors, absent a breach of fiduciary duty.• Management: Corporations have centralized management, with management being vested in the board of directors and the officers of the corporation. The board of directors is elected by the shareholders. The officers are appointed by the board of directors.• Transferability of Interest: Shares are freely transferable unless restricted by a Shareholders’ Agreement or under securities law.• Stock: There are no magic numbers as to how many shares need to be issued.• Professional: A separate statute applies if providing professional services (such as law, health care, architects, engineers, surveyors, etc.)
  17. 17. Corporations (Cont.) Advantages:• Shareholders enjoy limited liability protection.• Familiarity with corporate structure is appealing to lenders and investors.• State corporation statutes are well-developed.• There is a large body of interpretive case law.• Tax advantages may result in taxation at a reduced rate in a broader range of liquidity transactions.• Corporations can maximize the use of incentive compensation (e.g., incentive stock options) with employees; LLCs cannot.• Ability to have more than one class of stock in a C corporation is appealing in venture capital transactions where preferred stock is the investor’s equity form of choice.• Minority shareholders have little control. Disadvantages:• Double taxation, with C corporations.• Significant on-going formalities and filing requirements.• Somewhat less flexible than LLCs.• State corporation laws are more detailed and are more restrictive; their terms are more difficult than LLC statutes to pre-empt by contract.• Unlike partnerships and LLCs, income and loss cannot be allocated specially; they must be allocated only in proportion to the shareholders’ ownership in the corporation.• Minority shareholders have little control. Other types of Corporations:• Many states have acts or provisions that relate to special corporations (e.g., professional service corporations and medical service corporations). Michigan requires any entity providing professional services (i.e., requiring a license) to be formed as a professional corporation.
  18. 18. Limited Liability Company• Definition: A company -- statutorily authorized in certain states -- that is characterized by limited liability, management by members or managers, and limitation on ownership transfer. Black’s Law Dictionary, 7th Ed.• Ownership interests (called “membership interests”) are held by the members of the company.• All 50 states now have limited liability company acts.• Michigan (and most other states) allows you to form a limited liability company (“LLC”) with only one member. Formation:• A creature of state law.• Can only be formed in compliance with applicable state statute (e.g., by the filing of Articles of Organization with the State.) (Pay a $50.00 fee to form.)• The company and the members should execute an Operating Agreement (also called a limited liability company agreement) setting forth the agreement of the members as to the management of the affairs of the LLC and the conduct of its business.• Relatively new business forms, as most states adopted Limited Liability Company Acts in the mid-1990s.• Generally considered the most popular form of business entity given its mixture of corporate and partnership characteristics
  19. 19. LLC (Cont.) Tax Treatment:• Since the enactment of the “check the box” rules in 1996, LLCs have been able to be treated as partnerships for federal income tax purposes, without having to meet the formational requirements previously required under the Internal Revenue Code to avoid taxation as a corporation. The flow-through tax treatment of a partnership allows LLCs to avoid double taxation.• LLCs may also elect to be treated as corporations for federal tax purposes; no election is required for an LLC to be treated as a partnership for federal tax purposes. (It can be stated on Form SS-4.)• Since not all states automatically adopted the federal “check the box” rules for state income tax purposes, it is possible that an LLC may be treated as a partnership for federal tax purposes and as a corporation for state tax purposes. In addition, if an LLC has operations in multiple states, the tax treatment afforded the LLC from state to state may differ. Consideration should be given to this potential problem when choosing a business form and before an LLC becomes a taxable presence in more than one state.• Single-member LLCs are “disregarded entities” for federal income tax purposes and the assets of the LLC are treated as if they are owned by the sole member of the LLC (you can file a schedule with your personal return).
  20. 20. LLC (Cont.)• Management:• LLC law varies from state to state. Generally, the management of the company may, at the election of the members, be vested in the members or in a manager (who may or may not be a member of the LLC).• State LLC acts provide tremendous flexibility in the management of LLCs. • Some LLCs are managed like limited partnerships, with one member or manager managing the LLC with the remaining members acting as passive investors. • Some LLCs are managed like general partnerships, with all members sharing control of the company. • Some LLCs are managed like corporations, with control vested in a board of managers and officers appointed by the board.• Liability: The members of LLCs enjoy limited liability protection, having liability only to the extent of their contribution to the LLC. The liability of managers of LLCs is also generally limited by statute, absent a breach of fiduciary duty. Courts, however, have extended the “piercing the corporate veil” theory to LLCs to negate a member or manager’s limited liability protection if the facts demonstrate that such treatment is warranted.• Transferability of Interest: A member’s economic interest in an LLC is transferable, but transfer of the membership interest (the right to manage/vote) is subject to restrictions on transferability contained in the LLC’s Operating Agreement and in applicable state law.
  21. 21. LLC (Cont.) Advantages:• Members enjoy limited liability protection.• LLCs have flexibility in establishing a capital structure: • You could provide for (i) different classes of membership interests, (ii) admission to membership in the company without a capital contribution, and (iii) membership interests having no economic interest.• LLC acts permit flexible management structures.• There are fewer statutorily mandated on-going formalities than corporations. • Although written resolutions of the members and managers are generally not required by state law to authorize action by an LLC, lenders and other parties often require them in connection with loans, transactions and major contracts. As a result, it is generally advisable for an LLC to adopt written resolutions authorizing major actions and to maintain a “minute book” in the same manner as a corporation.• Partnership tax treatment. Disadvantages:• State LLC statutes are relatively new and undeveloped; there is more variance among LLC statutes than corporation statutes from state to state.• The existing body of case law applicable to state LLC acts is more limited than for corporations
  22. 22. Issues Re Formation Financing:• How will you finance your business? It can be difficult to obtain a bank loan (may require personal guaranty). Venture capital? Angel investors? Grant money? Choosing the State of Organization for Business Entities• Entities are typically organized under the laws of the state where the principal office is located (or under Delaware law.) • State filing fees, franchise taxes and state response times may vary. • Limited liability protection granted to owners and indemnification granted to officers and directors may vary. • Case law supporting the enabling statute is more developed in some states than others.• Corporate governance and liability issues are generally governed by the laws of the state of formation. • Exception: public companies are also bound by the rules and regulations promulgated by the Securities and Exchange Commission and, if publicly traded, by the rules and regulations of the exchange or quotation system on which the company’s stock is traded, including rules and regulations relating to corporate governance.• The business laws of some states are more favorable than others, and the applicable regulatory offices of some states are more flexible and efficient than others.
  23. 23. Issues Re Formation (Cont.) Intellectual Property:• You should consider obtaining trademark, copyright, patent, or other similar protection of your intellectual property. Consider Tax Issue• Federal• Michigan Corporate Income Tax• Sales Tax• Personal Property Tax Securities Issues• The definition of a “security” under the Securities Act of 1933 is very broad.• A determination should be made whether the ownership interests in the business entity being formed are securities.• The sale or transfer of a security is subject to the Securities Act of 1933 and the Securities and Exchange Act of 1934. • Private placement and other exemptions from registration may apply. • The burden is on seller of the securities to comply with the SEC’s disclosure and other requirements.• Typical Exemptions include: • Federal – Section 4(2): transactions not involving a “public offering.” • Federal – Regulation D (Rules 504, 505 and 506). • State – Exemptions for sales to institutional investors (e.g., investors with assets in excess of $10,000,000); sales to up to 25 purchasers in Michigan during any 12 consecutive months; and sales to existing security holders).
  24. 24. Issues Re Formation (Cont.) Foreign Qualification• Any statutory entity “doing business” in a state other than the state in which the entity is organized must qualify to do business in that other state. • The laws governing what constitutes “doing business” vary from state to state. There may be exceptions from qualification that apply to the operation of certain entities. The law is often vague, and careful consideration and review should be given to the need to qualify a business entity in a state. • Qualification is often necessary to give an entity standing to sue or respond to a suit in a court of a given state. • Qualification generally requires the filing of an application for admission (LLC) or certificate of authority (corporation) to transact business in the state. • Most states require the filing of annual reports and the payment of annual franchise taxes to maintain an entity’s foreign qualification in good standing. Pre-Formation Activities• In the eyes of the law, the entity does not exist prior to filing the applicable formation documents with the state. Thus, the owners cannot seek protection under the statute for action taken prior to formation.• Owners may be held personally liable (i.e., treated as a sole proprietorship or general partnership) for actions taken prior to the formal formation of the business entity, even though those actions were intended to be actions of a corporation (or other form of statutory entity).