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BASIC Business
Volume Number:9
Issue Number:6
Column Tag:Legal Eagles

BASIC Business

The different ways you can set up your business

By Paul Goodman, Esq., P.A.S., New York, New York

Even when considering the amazing technical feats accomplished many by software developers, often what proves to be the most difficult task for them is understanding the complexities associated with forming and operating a successful business. As a lawyer, I often see very basic business mistakes being committed by otherwise brilliant individuals. These mistakes, under certain circumstances, could lead to law suits and possible financial ruin of these individuals. This article is intended to help prevent these types of basic mistakes by supplying background information regarding the formation and operation of a business.

The BASICs

Essentially, there are three ways you can conduct business, as a sole proprietor, as a partnership or as a corporation1. A sole proprietorship can be thought of as a mom and pop business without mom. The proprietorship is run by a single individual, most usually the founder. If the business is successful, the proprietor might hire employees, but the business remains a proprietorship (the best example of this might be the office your local country doctor operates, he is the proprietor but hires a staff of assistants, nurses, etc.). Running a proprietorship is simple, all income and expenses accrue to the proprietor personally and he or she reports them directly on their yearly income tax return (on Schedule C to be exact).

Although a sole proprietorship is the simplest way to do business (there are no formal requirements except possibly the filing of a business name certificate) there are several substantial drawbacks to doing business this way. The most significant of these is the potentially unlimited liability faced by the proprietor. In the event that the business is sued by a third party, the proprietor’s personal fortune is at stake. This is an onerous possibility, especially in the software business where errors and omissions insurance is usually not obtained. This potential liability should be enough to convince anyone thinking of doing business as a sole proprietorship not to. However, one finds a surprising number of individuals associated with the computer industry ranging from consultants to small software publishers doing business this way. Among the other problems normally associated with this form of business is the limited ways of expanding the business and difficulties in raising additional capital and borrowing money.

Partnerships

The next step up from a sole proprietorship is a partnership which can be thought of as two or more sole proprietors in business together. The main characteristic of a partnership is that, like a sole proprietorship, there are no formalities to forming a partnership (most states, however, requiring the filing of a simple business certificate). Like proprietors, partners in a partnership face unlimited liability for actions taken by the partnership including those taken by the other partners, with or without consent of the partnership (although you can seek reimbursement from the offending partner). With regard to taxation, the partnership itself is not a taxable entity but rather is considered by the Internal Revenue Service to be merely a “conduit” through which the profits and losses of the business flow directly to the partners.

Although no written agreement between the partners is required to form a partnership, the drafting of a “partnership agreement” is highly desirable. Without such a contract, the relationships between the partners will be determined by state law, which in most states is modeled after the Uniform Partnership Act (“UPA”). Under the UPA, all partners in the partnership are equal partners and share equally in both the profits and losses of the partnership (this is the first item usually addressed and changed in a partnership agreement). Being equal also gives the partners equal say in the management of the partnership. This very often results in an unmanageable company. Thus, a partnership agreement must also provide for the smooth management of the partnership as well as an apparatus for breaking a possible management deadlock. Other areas that should be covered in a partnership agreement are the initial monetary contributions to the partnership, employment duties of the partners, admission of new partners to the partnership, withdrawal and retirement of existing partners and so on. Regardless of the existence of a partnership agreement, a partnership is still not a good choice as a business entity for a software company. The risk of unlimited liability of the partners makes doing business as a partnership extremely risky.

There also exists a second type of partnership known as a “limited partnership” which deserves some mention. Unlike the type of partnership described above (also known as a “general partnership”), a limited partnership has two classes of partners, general partners and limited partners. The limited partners are protected from the potential liabilities of the partnership and risk only the amount of their investment in the partnership. However, the general partners still face unlimited liability. In order to be considered a limited partner, the individual must have no voice in the management of the partnership. If they should play a role in managing the company they would face the same liability as a general partner would.

Usually limited partnerships are formed as a way to raise investment capital, and you will find that most venture capital funds are organized this way. Formation of a limited partnership is a relatively complex task requiring the filing of a limited partnership certificate. In addition, if the limited partnership interests are to be sold to the general public, state and possibly federal securities laws will have to be carefully followed.

Corporations

As you may have already gathered from the tone of this article, corporations are the form of business organization most suitable for software development and publishing. But, just what is a corporation?

A corporation is a legal entity that exists apart from and independent of those who founded and operate it. It is often said that a corporation is legally a person (law professors call this type of concept a “legal fiction”) in the same sense that a natural person is. The corporation has a life of its own and its own legal obligations and responsibilities. Because of this separation between the obligations of the corporation and those of the individuals owning and operating it, the corporate form provides a way to limit the liability of those who own the corporation.

Corporations are a figment of state law and are formed by petitioning the state for authority to form a corporation. A corporation need not be chartered by the state in which it intends to primarily do business in. Many corporations are formed in Delaware by corporations but maintain their offices in other states. This is because the corporate laws of Delaware provides certain advantages for large corporations. However, for the small, newly formed corporation, it is probably not worth the added expense of incorporating in Delaware in order to gain some benefits that the corporation will probably never need.

Before we discuss the mechanics of forming a corporation, it would be helpful to understand the relationship between the various parties involved in the corporation. In corporations, the roles of ownership, management and operation of the company are distinct and separate. A corporation is owned by its shareholders, the individuals who have invested in the corporation by purchasing stock or having purchased shares of stock from other shareholders. The shareholders have the right to vote for the selection of individuals to manage the corporation (the board of directors) and have the right to approve certain significant changes in the operation of the corporation such as the sale of substantially all of the assets of the corporation or a merger with another corporation. These rights are exercised by the shareholders at their annual meeting or at a special meeting called for a specific purpose. Except for these specific rights, the shareholders have no say in the day-to-day operation of the corporation (at least not in their capacity as shareholders). The liability of a shareholder is limited to the price they paid for the shares. This applies even to the founders of the corporation.

The responsibility of management of the corporation falls to the board of directors elected by the shareholders. How many directors does a corporation need? The number is set by the corporation itself, however the laws of most states require that there by at least one director for every shareholder up to three. Normally, the corporation sets the number of directors to some manageable odd number such as 3, 5 or 7. It is the function of the board of directors to set the overall management policy and direction of the corporation. Although no director individually has the power to bind the corporation to some course of action, the board of directors as a whole has the power to commit the resources of the corporation. Finally, the board of directors selects and employs the officers of the corporation.

The officers are those employees charged with the day-to-day operation of the corporation. By law, every corporation must have a president and a secretary and may also have a treasurer and one or more vice presidents. Many corporations have an officer known as a “chief executive officer” who is usually either the president or someone to whom the president reports. Although perfectly legal, this office is not required by law.

This is the basic structure of the corporation, shareholders, director and officers. In most small corporations, the same individuals play more than one role and in many, the same people play all three. However, no matter how small a corporation may be, it is important that proper corporation formalities be maintained.

Taxation of Corporations

Since corporations are legally viewed as individuals, they are, in most instances, taxed as if they were a living person (although possibly at different rates). This often leads to so-called “double taxation” with the corporation first taxed on its net income and with the excess profits of the corporation being (as personal income) once they distributed to the shareholders. Thus, the net effect to the shareholders is to have the same funds taxed twice. In order to avoid this tax trap (legally), there exists a corporate tax status known as a Subchapter “S” corporation (named for a section of the Internal Revenue Code). In an “S corp.”, the income to the corporation is passed directly to the shareholders and taxed as though the corporation was really a partnership. This makes Subchapter S corporations ideal for small corporations where the shareholders are also the employees and especially suitable for those involved in service industries. There are some minor requirements to qualifying for Subchapter S status. The corporation must have no more than 35 shareholders, all the shareholders must be natural persons (rather than corporations) and all the shareholders must agree on the Subchapter S status.

Forming a Corporation

How do you go about organizing your new company as a corporation? The easiest way is to find a competent attorney to handle the incorporation. Although you may encounter other professionals like accountants who will also incorporate businesses, it is best to steer clear of these individuals since many aspects of the incorporation have legal significance and they may not have sufficient knowledge to help you plan for future corporation transactions.

What should it cost? This will depend upon the fees charged by the particular state for the incorporation (from $150-$400) and the legal fees charged by your attorney. In general, legal fees will range from $99 to $600 (in addition to the state fees) depending upon the attorney. Although you may be able to find an attorney who will do the incorporation for a bargain basement fee, they will almost certainly not provide the level of care and service that you require. It is best to find an attorney who will carefully explain to you the process and then take the time necessary to evaluate your plans for your new company. In the long run, paying a few dollars more for this type of service will yield substantial benefits.

What steps are necessary for the formation of a corporation? First, the attorney drafts a simple document known as the certificate of incorporation (or in some states the “charter”), has the certificate filed with the state, prepares the by-laws and initial minutes of the board of directors, attends the organizational meeting and issue the shares of stock. (Here is an insiders hint: much of the actual work of having the state approve the incorporation is performed by a service company such as Prentice-Hall Corporate Service hired by the attorney).

Starting-Up

Now that we’ve covered some background regarding the different forms of business organizations, let’s look at the specific issues to be considered when starting a new corporation.

Among the first issues to be decided is how the ownership in the corporation will be divided among the principals. It is difficult to generalize about this subject since there can be so many variables involved. Among the things to be considered is what part did each individual play in forming the corporation and what expertise do they bring to the new company? How much is each person investing and how do you value intangibles such as technology, products and trademarks being transferred to the new company? And, what role will each individual play in the new company?

Once these issues are analyzed, an appropriate way of dividing ownership in the company can be decided and a capital structure for the new company can be planned. A corporation’s capital structure describes the number and types of shares of stock authorized by the corporation. The different types of corporate securities are beyond the scope of this article but generally, there are two classes of stock, common and preferred, with certain additional statutory rights being available to preferred stock holders. The number of shares of stock that can be issued by the corporation, known as the number of shares “authorized”, is limited in the practical sense only by the tax structure the state of incorporation imposes on the authorization of shares of stock.

In general, you should authorize as many shares of stock as possible for the minimal amount of tax charged by the state for the authorizing of corporation stock and you should never issue all the authorized shares so that there is room for new investors. It should be remembered that ownership in a corporation is not measured by the number of shares owned but rather by the percentage of ownership vis-a-vis the other shareholders. Thus, if Corporation A issues 100 shares to each of its three shareholders and Corporation B issues 5,000 shares to each of its three shareholders, each shareholder owns the exact same percentage of their respective corporation.

Once the group organizing the corporation decides the corporate structure, it is advisable that they negotiate and execute an agreement between all the shareholders. This is a little thought about process but may be the single most important act during the start-up phase which will help assure the long term success of the new business. Often referred to as a “shareholder’s agreement” or sometimes a “buy-sell agreement”, this contract is intended to protect the rights of all shareholders in a variety of situations. Since corporate stock can be easily sold to a person not a member of the group founding the corporation, there constantly runs the risk that stock of the corporation will be sold to outsiders and result in a loss of control of the corporation. This might happen when a disagreement occurs among the founders (or maybe other initial investors) or when, unfortunately, a stockholder dies. Thus, one of the purposes of the shareholders agreement is to present some controls on the sale of corporate stock in either situation. Although there are a myriad of ways of structuring these so-called “buy-sell” provisions, the majority of these agreement provide that in event that a shareholder (or the executor of their estate) desires to sell stock in the corporation, they will first have to offer to sell the shares to the other shareholders or to the corporation itself before being allowed to sell the shares to outsiders. In order to prevent the other shareholders from being out priced, the shareholders agreement may also provide that the other shareholders will not pay the offered price for the shares, but rather will pay an “insider’s price.” The agreement can provide for the determination of this price in any number of ways including a value agreed upon from time to time by the shareholders or a percentage of the book value of the company. Many companies, in order to have the available money to buy the shares of a deceased shareholder will “fund” the shareholder’s agreement with life insurance. When this is done, life insurance on the life of the shareholder is purchased by the corporation and the corporation is made the beneficiary of the policy. In the event of the untimely demise of the shareholder, the corporation collects the insurance proceeds and uses the money to purchase the deceased shareholder’s stock (usually the purchase price is set to be the benefit value of the policy). Generally, term life insurance is purchased by the corporation rather than whole life policies.

In addition to covering the sale of stock, the shareholders agreement will often contain provisions regarding the management of the corporation. Among the topics often covered are voting for directors of the corporation and officers, salaries for shareholders employed by the corporation, other employment provisions for shareholders, and other items of special interest to the parties involved.

Following the formalities

Among the major problems of small corporations is that many do not follow the formalities required in order to protect the advantages of doing business as a corporation. What are these formalities? Essentially, the law requires that every corporation be treated as a separate entity from its owners. This means that every year the necessary meetings of shareholders and directors take place, all activity which requires board of directors approval receives such approval and the proper corporate minutes are drafted and maintained. Finally, the shareholders or directors should never ”commingle” their personal funds with the funds of the corporation. That is, personal expenses should never be paid with corporate funds. All of these formalities are important to follow since if the corporation is just an “alter ego” of its shareholders, a plaintiff might be allowed to “pierce the corporate veil” and hold the shareholders personally liable in a law suit against the corporation. Although this situation might be rare, what is more common is that the Internal Revenue Service refuses to honor the corporation’s tax status and declares expenses taken by the corporation to be income to the shareholders.

Obviously, this relatively short article cannot possibly cover every aspect of forming and operating a business. It is hoped, however, that the reader has been convinced that they should always do business in the form of a corporation and should always observe the necessary formalities of doing business as a corporation. If this is done, the full protection made possible by law will be available to you should you ever need it.

1 Several states have no authorized a new form of business known as a “limited liability company” which combines some of the tax advantages of a partnership with some of the liability protections of a corporation. Use of the LLC has been very limited to date and will probably remain so until more states recognize their existence.

 

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