Small Business Essentials: Bringing Business Law Down to Earth

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Small Business Essentials:

Bringing Business Law

Down to Earth

Attorneys aren’t from Mars. Business clients aren’t from Venus.

PRESENTED BY A SERIES OFFERED BY

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Business Risk

• Two phases of the business cycle where a

business has the greatest risk of failure:

–

Start‐up phase

• Initial formation • The I love you phase • Clearly define relationship of owners to avoid issues with future disagreement • Business plan • Financial forecast • Clearly monitor progress

–

Retirement/transition phase

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Part I ‐Start‐up Considerations

• Legal Structure

– Liability issues – Future plans – Corporate governance – Complexity – Possibility of future owners

• Tax Considerations

– Taxation at entity level – Flow through taxation – Owner compensation – Compliance

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Part I ‐Start‐up Considerations

• Internal Considerations

– Hierarchy – Employee manuals – Company policies (i.e. document retention, email policy) – HR issues – Interaction with outside counsel and CPAs

• Liability Protection

– Personal guarantee – Piercing the corporate veil – Insurance (business, umbrella, E+O) – Compensation issues – 401(k), medical

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Part I ‐Start‐up Considerations

• Funding

– Owner contributions – Venture capital – Bank financing – Additional capital calls (required? dilution?)

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Typical Business Structures

‐ Sole proprietorship

‐ Partnership

‐ Corporation

‐ S‐Corporation

‐ Limited Liability Company

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Characteristics of Sole Proprietorship

‐ No formal legal entity

‐ Alter ego of owner

‐ Business profits taxed as ordinary

personal income

‐ Unlimited personal liability for owner

‐ Business ceases to exist on owner’s

death

This is generally not a recommended

form of business ownership

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Characteristics of a Partnership

‐ Owned by two or more parties

‐ No formal business entity filing

necessary, but may file statement with

Secretary of State

‐ Management rights determined by

statute unless all partners have

adopted a partnership agreement

‐ Pass‐through taxation

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Partnerships – Liability Issues

Two types of partners:

‐ General partners – a partner who has

management and financial rights in the

company. A general partner has unlimited

personal liability for company debts.

‐ Limited partner – a partner who has only

financial rights in the company (essentially

just an investor). A limited partner’s liability

is limited to his investment in the company,

no personal liability other than investment in

partnership.

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Characteristics of Corporations

‐ Formal legal entity formed by state filing

‐ One to unlimited number of shareholders

‐ Management authority vested in Board of

Directors

‐ Double taxation – income taxed at business level

and upon distribution to owners

‐ Limited liability – shareholders have no personal

liability other than investment in corporation

‐ More corporate formalities

‐ No special allocations

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Characteristics of Limited Liability Companies

(LLC)

‐ Formal legal entity formed by state filing

‐ One to unlimited number of owners

‐ Management authority may be vested in all

owners (members) or in selected managers

‐ Pass‐through taxation (unless elected otherwise)

‐ Limited liability – generally owners have no

personal liability other than investment in LLC

‐ Less formalities than a corporation

‐ Ability to have special allocations

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What is an S‐Corporation?

• Structured like a corporation • Pass‐through taxation • 1‐100 shareholders (must be natural persons who are U.S. citizens with limited exceptions) • Limitations on the types of shares that can be issued (only one class of stock) • Shareholder compensation issues • Both corporations and LLCs can elect to be treated as an S‐Corporation for tax purposes • Limited liability – generally owners have no personal liability other than investment in S‐corporation

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What does limited liability really mean?

Generally an owner of a company with limited

liability (LLC, Corp, S‐Corp) will not be

personally liable to creditors of the business.

There are however, some limitations:

‐Liability for your own personal actions

‐For start‐ups, creditors will often ask owner to

guaranty or cosign on loans or contracts

‐Creditors may try to “Pierce the Veil” and

collect company debts from owners personally

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“Piercing the Veil”

“Piercing the Veil” is a phrase commonly used to describe creditors breaking the liability protection of an LLC or corporation to hold an owner personally liable for company debts. This is relatively difficult for creditors to achieve, but not impossible Risk factors: i) Fraud ii) Failure to adhere to corporate (or LLC) formalities iii) Inadequate capitalization

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How to Minimize Owner’s Risk:

• Make sure that business is formed properly, i.e. registered with the proper state •Don’t commingle personal and business assets – Ensure all business assets are titled in the company’s name – Business should have separate financial accounts – Keep adequate records

•

Execute documents in your capacity for the business, rather than individually. It is important that it is clear that the business is entering into an agreement rather than an individual.

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Internal Organization

When there are multiple owners, it becomes critically important to think about how a business will be run. Typically governed by agreement, but there are some default statutory provisions.

Structure

Internal Agreement

Partnership

Partnership Agreement

Corporation

By‐laws or Regulations

S‐Corp

By‐laws or Regulations

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Internal Agreement Considerations

• Voting – who will have control? What

happens if there is deadlock?

• Supermajority/unanimous decision for

certain items (i.e. additional borrowing,

expenses over certain amounts, etc)

• Allocation of profits and losses

• Distributions

• Delineation of duties

• Will there be restrictions on transfer?

• What happens if someone dies, retires?

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Part II – Retirement/Transition Phase

I have a successful business, but I’m

ready to retire, now what?

Failure to plan for the transition of

owners and/or key individuals out of the

business is a recipe for disaster.

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Why Plan Ahead?

• Taxes Transfers of business interests, whether by sale, inheritance or otherwise, could have major tax implications. –Planning must be done in advance to minimize taxes • Risk The smaller the business, the more likely it is that a few key individuals drive the company’s success. Failure to have a succession plan in place raises the risk that the exit of a key individual will lead to business failure. –Key man insurance to provide funds to replace individual

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Why Plan Ahead?

• Control

Having a plan in place allows the owners to

exercise some control over their exit and the

future of the business.

• Value

Failure to have a succession plan in place could

result in the rapid decline of the business (and

its corresponding value) upon the departure of

a key person.

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Succession Planning Considerations

• What are the owners’ personal goals? – Keep the business in the family? – Continued income stream? Lump sum buyout? • Will successors have the knowledge and skills to adequately operate the business? • Protecting the longevity of the business and all parties involved. – Co‐owners may want to avoid dealing with a deceased owner’s spouse or family – A plan should appropriately compensate an exiting party without destroying the viability of the business

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Common Exit Strategies

• Buy‐Sell Agreements

• Gifting (for family owned businesses)

• Management Buyouts

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Buy‐Sell Agreements

A buy‐sell agreement is a binding agreement among the owners that governs the terms of sale and purchase of an exiting owner’s business interest. •Typically defines: –Who can purchase –If purchase is required or at option of remaining owners –Timing of purchase –Purchase price and security for payment –The terms of the purchase and payment of the purchase price –Permitted transfers (i.e. Grantor trusts or immediate family members)

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Buy‐Sell Agreements

Common Buy‐Sell Events

–Death

–

Bankruptcy

–

Disability

–

Divorce

–

Voluntary Withdrawal

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Common Types of Buy‐Sell Agreements

• Stock Redemption

– The company will purchase an exiting owner’s interest upon specified events – Results in proportionate increase in remaining owners’ interest

• Cross Purchase

– The other owners will purchase an exiting owner’s interest upon specified events – May bind all owners equally or specific owners – Could change the management dynamics

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Funding the Buy‐Sell Agreement

• Life or Disability Insurance – Owners can insure others lives or company can insure owners lives or disability to fund the buyout. Important to evaluate coverage periodically. • Installment Payout – The exiting owner can be bought out over a set period of years. Avoids large cash outlays by purchasers up front. Owners will need to determine interest rate and security for repayment. • Sinking Fund – A sinking fund is an investment fund contributed to by the company over time to pay for a buyout. • Debt

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Gifting of Family Owned Businesses

• If a business is solely or largely family owned,

the owners may desire to pass the business on

to their children.

• Additional planning techniques are available

in this situation.

• Tax considerations may shift to federal and

state estate tax issues, as well as income tax

considerations.

• Part sale/part gift

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Gifting of Family Owned Businesses

• Current estate tax laws are very favorable, but

are subject to change

• Annual Gift Exclusion

– Owners may gift assets (including business interest) with value up to the federal annual gift exclusion (currently $14,000) yearly with no estate tax impact

• Trusts

– There are several types of trusts that can be used as transfer vehicles in tax neutral or tax advantageous ways. These may be tailored to meet the current owner’s needs and control the future of the business

• Appraisal necessary

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Management Buyouts

• Sale of business to management team • May be financed by individual (cash, bank or seller financing, personal notes, etc) or by business (cash flow, pledges of future income, etc). • Depending on structure, seller may have risk based on the future success of the business. • Employee Stock Option Plans (ESOP) – Company can purchase owner stock through ESOP – Ability to use pre‐tax dollars (tax savings) – Qualified employment benefit plan – No tax on participants (employees) until they cash them out

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Sale to Outsiders

• Cleaning up the business – to make the business marketable it will need to be “clean”. Action should be taken to minimize liabilities, tax issues, lawsuits, etc. • Valuation ‐ a valuation should be obtained to give the owners a sense of the market value of the business • Owners should engage outside individuals to assist with marketing, negotiating, and structuring sale of business

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Keeping The Succession Plan Updated

A business succession plan is often built around

the circumstances that exist at the time the

plan is formulated. As such, it is important that

it be revisited periodically to ensure that it still

meets the needs of the business and its

owners.

• The plan should be revisited at a minimum

every two years by the owners. This should be

more often if dramatic changes occur for the

business or any of its owners.

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Keeping The Succession Plan Updated

• Additionally, the plan should be reviewed

upon the occurrence of any of the following:

–Divorce or remarriage of an owner –Death, disability, retirement or other exit of a major stakeholder –Substantial change in the profits of the business –Substantial change in tax laws