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Entity Formation - 2nd Draft

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by

Cory Hauser

on 6 November 2013

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Transcript of Entity Formation - 2nd Draft

Entity Formation

Jargon Archive
Document Archive
Brian is a retired teacher.
He has a passion for photography.
He decides to turn his passion into an income.
C-Corporation
Brian's Photography has done well, but Brian is getting bored.
Brian has recently started working with programmers to create a photo editing software to sell.
Conclusion
Why worry about choosing an entity?
Business Structures
Default Business Entities
Non-Default Business Entities
Business Entity Types
Sole Proprietorship
General Partnership
Limited Liability Company (LLC)
C-Corporation
S-Corporation
Does Brian have a business entity?
Yes!

Brian is operating as a Sole Proprietor.
What business entity would be best for Brian?
C-corporations provide a great structure for high growth technology start-ups.

They're also the main entity type used to draw in investors.
Pass-Through vs. Corporate Tax
"Piercing the corporate veil"
LLC's
Articles of Organization ("Certificate of Organization")
C-Corp & S-Corp
Taxes
Pass-through taxation
Sole Proprietorship
General Partnership
LLC
S-Corporation

Double Taxation
C-Corporation
Brennon Malcom
Cory Hauser
Certified Senior Law Students
Entrepreneurship Legal Clinic
University of Nebraska College of Law

Introduction
Taxation Consequences
Liability Issues
Ownership
Control
Complexity
Cost
Sole Proprietorship
Brian creates "Brian's Photography" and starts taking family photos for $100.
Brian isn't concerned about having a brick and mortar location.
Brian's friend, Joe, approaches him about joining his new coffee bean roasting venture.
Brian has little time but invests $10k.
General Partnership
In return, Joe agrees to consult Brian before he uses any of the $10k.
Brian and Joe also agree to split profits equally.
Brian has continued operating his photography business.
He recently started photographing weddings.
Limited Liability Company (LLC)
To power the required equipment for weddings, there are power cords all over the floors.
This tripping hazard has led Brian to worry about potential liability.
S-Corporations
Limited Liability
Limited liability protects against personal liability for:
Business debts
Contract and torts
You
Co-owner
Employee
Business liability for other members' personal debts
IRS
Pass-Through
Entity
Owners
Taxes Assessed
Taxes Paid
Income
Double Tax
IRS
Entity
Shareholders
Dividends
Taxes Paid
Taxes Assessed
Taxes Assessed
Taxes Paid
Losses
What can Brian do?
One possibility is for Brian to create an LLC.

Action required!
How to Form:
Default business structure.

Examples:
Farmers market sales
Independent contractors
Mowing yards
Ownership & Control
The sole proprietor has 100% ownership and control.
Taxes & Cost
Taxation
Pass-through
Individual income

Costs
Minimal
Liability
Unlimited to the sole proprietor:
Taxes
Losses
Debts
Torts
Contract
Owner and Agents
Pros and Cons
Pros
Pass-through taxation
Easy to create and dissolve
Cheap

Cons
Liability
No opportunity for investors
Do Brian and Joe have a business entity?
Yes, unless Brian is a lender.
How to Form:
Another default business structure.

No formal steps.

Simply two or more persons sharing control & profit.
Partnership Agreement
Contract
Highly recommended
Allocates:
Profits
Ownership
Control
No partnership agreement?
Must rely on default rules
Ownership & Control
2 or more owners

Control
Rely on default rules, unless a partnership agreement is in place.
Tax & Liability
Taxes
Pass-through
Must file return for partnership AND partners
Liability
No limited liability
All partners liable for obligations of business
Partners = Agents. Tort (OCB) and Contract
Pros and Cons
Pros
Pass-through taxation
Easy to create
Cheap

Cons
Unexpected income
Unlimited liability
Transferability
Minimal investment opportunity
Why an LLC?
The owners of an LLC are protected from personal liability for business related debts and claims.
How to Form:
File Articles of Organization with the secretary of state in the state of formation.

Nebraska calls it the "Certificate of Organization"
Cost
Fee to file Certificate of Organization in NE:
$100 + $5/page
No annual or biennial fee
Additional Document
Operating Agreement
Default Rules:
Nebraska Uniform LLC Act

Allows you to address issues such as:
Company ownership responsibilities;
Profit sharing; and
Ownership changes, just to name a few.

Operating Agreement is not filed with the Secretary of State.
Ownership & Control
One or more owners

Owned by members

Flexible control
Member managed
Manager managed
Liability
Limited liability

Members are not personally liable
UNLESS, the corporate veil has been pierced
Taxes
LLC's are treated as partnerships, which means the tax passes through directly to the members.

The advantage of this pass-through taxation is there is only a single level of taxation.
Pros and Cons
Pros
Limited liability
Pass-through taxation
Not free, but in Nebraska, LLC's are quite cheap to start.
Some states have higher fees plus annual fees.
Cons
Require you to create and file Articles of Organization
Less developed case law when it comes to legal battles.
Before Brian's software can take full flight, he needs to bring on some large investors.
Brian's goal is to sell his editing software company to further his retirement.
Costs
Nebraska:
Depends on authorized capital stock
$65 and up

Additional Publication Requirement
$30-$50

Biennial fees
Taxes
Separate taxable entity

Double Taxation
Corporate Level
Shareholder Level
BUT only on dividends paid
Additional Considerations
Documents
Stock Purchase Agreement
Shareholder Agreements
Voting Agreements
Stock Certificates

Formalities
Meetings
Minutes
Stock ledger

Annual or Biennial reports
Pros and Cons
Pros
Well developed case law
Highly structured
Tangible equity
Transferability of stock
Investment potential

Cons
Complicated
More paperwork
Most expensive to set up
Must follow the structure
How to Form:
Articles of Incorporation
Filed with Secretary of State

Publication
Some states

Bylaws
Governing documents
Not filed
Ownership & Control
Ownership does not equal control
Board of Directors
High level management

Officers
CEO, COO, President, etc.
Day-to-day

Shareholders
May have rights to vote in largest matters: dissolution, merger, etc.
Liability
Separate entity

Limited liability
Limited to contributions

Limitations
Lender requirements
Piercing the corporate veil
Investor Potential
C-corporations provide the best business entity for attracting investors.

Why?
Investors love the certainty
Developed law
Rigid structure
Tangible equity
Transferability of stock
At this point, Brian has caught the entrepreneur bug and decides to start a marketing company.
Through the years, Brian has created a number of business entities.
S-Corporation
Brian's experience has provided him with a great deal of insight.
Brian loves the structure of a c-corp, but hates the double taxation that comes with it.
What is Brian's best option?
Brian's best option is to create an s-corporation.

This business entity incorporates the pass-through taxation concept of an LLC and the business structure of a c-corporation.
Requirements
There are multiple requirements:
Shareholder Requirements
1.) No more than 100 shareholders;
2.) All shareholders must be individual human beings (no entities); AND
3.) All shareholders must be legal U.S. residents.
Stock Requirements
Only one class of stock
How to Form:
Same as C-Corp:
Articles of Incorporation
Publication requirement
Bylaws

EXCEPT:
Each shareholder must also file a timely Form-2553 with the IRS to get pass-through taxation.
Consult an attorney or accountant prior to making your 2553 election.
Cost
Same fee schedule as c-corp
Based on amount of authorized capital stock
$65 and up

Publication Requirement
$30-$50

Biennial fees
Ownership & Control
Same as C-Corporations
Board of Directors
High level management
Officers
CEO, COO, President, etc.
Day-to-day
Shareholders
May have rights to vote in largest matters: dissolution, merger, etc.
Taxes
Same as C-Corporation, UNTIL you make your Form-2553 election.

The filing of that form by each shareholder moves you out of double taxation and into pass-through taxation.
Liability
Same as C-Corporations

Separate entity

Limited liability

Limitations
Lender Requirements
Piercing the corporate veil
Rigid Structure
Same as C-Corporations
Documents
Stock Purchase Agreement
Shareholder Agreements
Voting Agreements
Stock Certificates
Formalities
Minutes
Meetings
Stock ledger
Biennial fees and filings
Investor Potential
Not many large investors like S-corps

Why?
Only one class of stock
Cap on # of shareholders
100 shareholder max
No entities as shareholders
Many large investors are actually set up as entities
Pros and Cons
Pros
Highly structured
Tangible equity
Pass-through taxation
Limited liability
Cons
More paperwork
Must file timely Form-2553 with IRS
Must adhere to the structure
Less investment potential
The "corporate veil" refers to the protection afforded an entity with limited liability.
The "corporate veil" is everlasting, UNLESS it's pierced.
This means the court can disregard the existence of the "veil" when limited liability would cause injustice.
To the shareholders/owners, it means they could incur personal liability ABOVE the amount of investment.
Examples of misconduct:
Fraud
Complete disregard of formalities
Siphoning or commingling funds
Grossly undercapitalized
Among others
IRS Form 2553
Articles of Incorporation
Liability
Unlimited Liability
Sole Proprietorship
General Partnership

Limited Liability
LLC
C-Corporation
S-Corporation
Summary
Sole Proprietorship
Minimal assets & liability
No need for investors

General Partnership
Multiple owners
Minimal assets & liability

LLC
Pass-through taxation
Limited liability

C-Corporation
High growth, technology co.
Limited liability with investment potential

S-Corporation
Structure of a c-corp w/pass-through taxation
Limited liability
Tort
Civil wrong against another, which causes legal damages to the victim.

Examples:
Slip and fall issues.
Negligence
Car accidents
Defective products
Full transcript