CHOOSING THE RIGHT BUSINESS STRUCTURE

A common business is known as a sole proprietorship and it is a very old-fashioned way of doing business. There are no protections from civil liabilities and all taxes flow to the individual. Tax deductions are treated on an individual basis. Benefits of corporate tax deductions are nonexistent for sole proprietorships and such a business venture is generally not a good method to do business.

The real issue in setting up a business is trying to determine what business structure works for the corporation under specific circumstances and the type of business the corporation is going to enter. One of the best advantages of a corporation is that it protects its owner’s personal assets from liability in many circumstances. The corporation is a separate entity and should something go wrong in the business or any negligence by the business causes harm, the business owner can protect its house, savings or other assets that have not been invested in this business entity. A lot of business ventures fail; embarking on new business is risky and most people do not want to lose what they own. In many circumstances, the use of a corporation can protect personal assets that were not contributed to the company. It is important that the corporation be set up properly and that the entity follow certain guidelines so as to make sure that the corporate entity is recognized as a separate entity. The mere filing of the papers with the Secretary of State is generally not sufficient to protect one’s personal assets and to keep a corporate entity separate. Care must be taken to set up the corporation properly and proper procedures must be followed (for example, proper accounting procedures) in order to prevent the corporate entity from being treated as a separate entity. The failure to do so may result in loss of personal assets. 

In addition, there are many tax advantages to which corporations are entitled. It is critical that one pay attention to the type of industry, the type of assets being contributed to the entity, the long run plan and the exit strategy for the company or entity as well as the number of parties and types of stockholders that actually own an interest in the company. Many of these tax decisions are irreversible and can be costly. 

In dealing with more than one person owning a business entity, it becomes very important that the parties consider and set forth in writing what would happen if one party wants to buy the other party, or one party becomes disabled or dies, or what would happen if one party wanted to sell the business and the other party did not. These are a few of the many questions that need to be addressed when multiple parties are entering a business or corporate type structure. Even sole shareholder companies, family companies and friend companies should consider these issues carefully.

We have set forth below the different types of business entities which will include at least Subchapter "C" corporations, Subchapter "S" corporations, limited liability companies, partnerships, limited partnerships and limited liability partnerships.  The use of various corporations, limited liability partnerships and limited liability companies are many times advantageous to medium to large companies.  This type of flexible planning allows for different tax treatments, different products and liabilities, different types of ownership and estate planning issues.  Top

CORPORATIONS 

Corporations are legal entities created by filing with the Secretary of State. A corporation issues shares of stock to shareholders who, in turn, own the corporation. The law treats a corporation as a legal existing entity as if it were actually alive under the law. A corporation may sue, may be sued, is required to pay taxes and may even be subject to criminal liability.

There are different types of corporations with respect to federal tax regulations and these are key concerns in the creation of a corporation. A normal corporation is generally a taxable entity and pays its own income taxes under what is referred to as Subchapter "C" of the Internal Revenue Code. Another way of creating a corporation is the creation of a Subchapter “S” corporation which is identical legally to the Subchapter "C" corporation except to the treatment of its taxes. A Subchapter “S” election allows a corporation to receive similar taxation as those of partnerships and limited liability companies. The taxation flows through the corporation to the individual shareholders. A Subchapter "C" corporation pays taxes on its profits and then issues dividends. Dividends are then taxable as income to the shareholders. A Subchapter "C" corporation normally is subject to double taxation, but they do enjoy several tax related advantages.  In many cases, a Subchapter "C" corporation can retain capital to fund purchases of assets on a regular basis, whereas in most other entities, the owners would be taxed for the earnings that were used to make these acquisitions.  In addition, the corporation is not required to distribute earnings through its shareholders and may retain them for corporate purposes up to limitations before they face an additional tax on these accumulated earnings.  Subchapter “S” corporations are very common for small businesses, but are difficult for large enterprises because there are restrictions on the types of ownership of stock and number of shareholders. Subchapter  “S” is essentially a special tax purpose issued for small closely held corporations which are  common among a small number of individuals that create a business or for family held corporations.  A Subchapter "S" corporation requires that an "S" election be made with the Internal Revenue Service.  There are certain transactions by Subchapter "S" corporations that were previously Subchapter "C" corporations that may result into a tax to the entity.  This is one of the reasons it is critical in determining the business structure correctly at the onset.  In addition, some states do not recognize those corporations for tax purposes or tax them at a reduced rate.  

Professional corporations are also authorized by statute and generally include lawyers, doctors, accountants, engineers and other professionals that are generally licensed within the state.  Only these licensed professionals can be actual shareholders of the corporation.  They generally enjoy the same status as limited liability companies and partnerships.  The rules of liability for professionals may vary from state to state, however, in general a professional in a professional corporation would only be liable for his own acts and the acts of those that he directly supervises.  A professional corporation can either be a Subchapter "C" or a Subchapter "S" corporation. 

The filing of the Articles of Incorporation is generally filed in the state in which the company intends to do business.  Although corporations are governed by state statutes, consideration is sometimes given to filing in a different state due to the statutes of the various states.  In coordination with the filing of the Articles of Incorporation, there is generally some form of bylaws, organizational minutes, an issuing of subscription agreements, share certificates, shareholder agreements and other documents that may be necessary considering the complexity of the business.

In addition, the corporation will generally have to file annual reports with the Secretary of State and if it intends to do business in another state, it may be required to become qualified to do business in that state.  Some of the provisions of the state's statutes must be exactly followed, while other provisions may not be required to be followed.  The adoption of the bylaws is generally a separate set of rules governing how a corporation is to be run.  Although there are many types of formed bylaws, it is important to pay attention to the bylaws especially when more than one shareholder owns a company.  The bylaws may sometimes provide for a provisional director to break a tie or a deadlock in corporate voting.  In addition, the bylaws may sometimes set up what requires notice of when meetings must be held and when notice is required for shareholders and directors meetings.  The shareholders are the stockholders and the shareholders elect the directors.  The directors are generally responsible for the overall management and exercise the rights of power of the corporation.  They usually exercise direction and elect the officers such as the president, vice president, secretary and treasurer to carry out the policies of the board of directors and to run the corporation on a daily basis.  Most state's statutes give shareholders the right to either approve or dissent from major corporate action such as the sale of substantially all of the corporation's assets or a merger.  

One of the advantages of corporations is the continuity of corporation in spite of the death or departure of a shareholder.  Most of the companies on a stock exchange are corporations, although there are smaller corporations often known as "closely held" corporations.  It is almost mandatory for the shareholders of closely held corporations to have shareholder agreements. Top

LIMITED LIABILITY COMPANIES

A very unique and common type of organization that has been recently created is called a limited liability company, or otherwise an L.L.C. The L.L.C. is created very similarly to the creation of a corporation except it does not have shareholders. It has managers and members that split the profits and the tax is directly passed through to the individuals as specified in an "Operating Agreement" which is similar to a Partnership Agreement.  The major differences between this and a Subchapter "S" is that there are no shareholders, no required board meetings and the principal of the company is called the managing agent. The key benefit is that it creates an organization shielding the owners from personal liability, but creates a simple entity to operate without the complexities and requirements of a board of director meetings, by-laws, shareholder agreements or otherwise.  

The L.L.C. is typically formed by filing a certificate with the Secretary of State, but generally will not disclose its members.  An L.L.C. agreement is in many ways similar to a partnership agreement and usually contains all the terms related to management, ownership, the buying and selling of interest, and may include a disproportionate sharing of profits and losses among many other things.  An L.L.C. may have more than one class of equity interest and may be used to own subsidiaries.  An L.L.C. is quickly becoming an entity of choice for new businesses due to the protection from personal liability, multiple tax advantages, and a managerial flexibility without the requirements of a multiple levels of a corporation.  Unless the L.L.C. elects to be taxed as a corporation, it will be taxed as a partnership or sole proprietorship. Top

PARTNERSHIPS 

A general partnership is very similar to a sole proprietorship, but it involves one or more persons engaging in a business enterprise. Tax directly flows through to the individuals and there is no shield from law from legal liability. The general partners are liable for all of the partnership debts and legal actions against the partnership subject the general partners to legal liability.  General partnerships and joint ventures (which are general partnerships with a specified limited purpose) must be carefully considered in light of the liability issues, which may cause one partner to be liable to the other partner.  Partnerships and joint ventures may be formed not just by individuals but with all the various corporate entity or partnership choices.

A limited partnership which is commonly referred to as an L.P. is one in which the general partner has personal liability and the limited partners have no liability. This occurs in Georgia by filing with the Secretary of State and the taxation is strictly a pass-through. This avoids double taxation such as in a case of a Subchapter "C" corporation and avoids limitations as to ownership in Subchapter “S” corporations. The limited partners are shielded from liability where the general partner is not shielded from liability. This type of partnership creates some protection for investors, but provides no protection for general partners. It is a very common entity used in real estate transactions where the general partner offers services and the limited partners offer the money.  Since the creation of the L.L.C. the use of the L.P. has declined due to the better liability protection for the general partner by the L.L.C.

A limited liability partnership, referred to as an L.L.P., is similar to a general partnership except the partners do not have personal liability. Taxation is passed through as in a general partnership and a limited liability partnership does not pay income tax itself. A filing with the Secretary of State is not required to create a limited liability partnership in Georgia as it is done by the creation of filing with the county in which the company is located. For a general partnership, this is the best practical entity to use because it shields the general partners from liability while providing the tax benefit of a general partnership.  This form is not universally recognized in all states as having limited liability and would usually not be chosen over an L.L.C.

A limited liability limited partnership, referred to as an  L.L.L.P. is a limited partnership which gives a proper shield to the general partner. An L.L.L.P. provides the same protection of the general partner as an L.L.P. and provides the same protection of a limited partner as an L.P. This is created with the filing of the Secretary of State similar to that of a limited partnership and the tax of the  L.L.L.P. is identical to the taxation of an L.P.  An  L.L.L.P. is the most cumbersome of the partnerships and probably would not be used except by an existing L.P. that wanted to give the general partner limited liability through a limited liability election. Top

The most commonly used method to raise capital to operate a business without going into debt is the issuance and selling of shares of stock. This can be done both with standard Subchapter "C" corporation and Subchapter “S” corporations for smaller enterprises. The differences are discussed under the heading of “Business Organizations.” Interest in Partnerships and Limited Liability Companies can also be sold.

The number of the shares issued and the number of shareholders together with the location will determine what filings are required with local state entities and with the Securities and Exchange Commission. Securities law governs all transactions, but there are exceptions from registration  for smaller enterprises involving limitations to the number of shareholders and locations of shareholders. There are exemptions for intra-state transactions as well as a limited number of shareholders. Notwithstanding exemptions,  selling shares to individuals which cause exemptions not to apply just requires proper legal work and disclosures. This requires legal maneuvering and legal documentation to be filed with the appropriate entities. There are various levels of raising investments and care must be given as to the solicitation for investments. The key ingredient involved in selling shares is truth telling. This occurs by the filing of certain documents which are provided to the shareholders. Top

Shareholder Agreements and Buy/Sell Agreements.  A very common method to control a corporation that has shareholders with varying levels of interest is through the creation of Buy-Sell Agreements and Shareholder Agreements. This agreement is critical when there is more than one party. Several of the issues that are addressed in this agreement are what would happen if one party wanted to sell his or her interests, a party becomes disabled or dies. The multiple interests related to these types of decisions govern matters like who would be entitled to the first right to purchase, if any, what the value and terms would be of the purchase, and other general matters relating to ownership in the company. Included in this type of agreement can be voting trusts where certain parties agree to vote their interest in a certain way. These are issues which should be discussed thoroughly prior to entering into any business with any other party including, family or friends.  Top

The Buy-Sell Agreement is an agreement that is set up providing the first right of refusal of the corporation or other shareholders in the event that one shareholder desires to sell his or her interest or upon the shareholder's death. This is a way of maintaining continuity in the management of the business and it is quite often funded with life insurance. The life insurance provides the corporation with the funding to purchase the shares from the estate and the estate receives cash instead of unliquid stock which, many times, is a greater benefit to the heirs. Top

Private Placement Memorandum. A private placement memorandum is generally used when a company or individual intends to raise money to a limited number of shareholders and not sell to the general public. A Private Placement Memorandum which is commonly referred to as a PPM involves the selling of shares to individuals and not on the open market. The Private Placement Memorandum is a tool used for issuing a limited number of shares for a limited amount of money. Generally the Seller has a target audience that it desires to go to. The Private Placement Memorandum is created by the disclosure of the financial situation of the company, the amount of money being raised, the business organization instructor, identification of key shareholders and other matters which are legally required. This is the tool used to obtain sales for smaller amounts which is not required to go into the open market. This does involve the hiring of attorneys that are experienced to create the Private Placement Memorandum, together with accountants to prepare the financial criteria required to go into the Private Placement Memorandum. Top

Initial Public Offering. An initial public offering is a procedure in which information is provided to the public with an offer memorandum that is first filed with the Securities and Exchange Commission. This document contains detailed information for potential investors and is first filed with the various States before the offering goes to the public market in that State. This type of filing is required where the offering is issued to the public in general regardless of what exchange the offering is made on or if the offering is simply over the counter stock. Many times a corporation will first do a Private Placement Memorandum to get start up capital and, once a corporation is up and running, will look at whether or not it will go public to raise additional funding and to even sell stock for the initial investors to actually cash out. Top

Credit Lines and Secured Lending. Everything is negotiable when dealing with Lenders. The most minute detail can be the most important aspect of any deal. Those who do not shop around, negotiate documents and act hastily when dealing with Lenders frequently end up with unlivable terms and too much property tied up. Credit Lines involve a revolving line of credit secured by assets of a business. What assets become tied up by the lender is important and negotiable. Terms of the line as to rate and length are important issues. Getting stuck with a line that is short and ties up all of the business assets can be disastrous.  Top

Choosing the Right Structure