Presentation on theme: "Business Entity Formations"— Presentation transcript:
1 Business Entity Formations Nema Koohmaraie and Matt HinrikusUNL College of Law – Entrepreneurship Legal Clinic
2 DisclaimerThe content of this presentation is intended solely as a brief summary of entity choices available to individuals starting a business operation. The information provided during this presentation shall not be construed as legal adviceWe are not tax experts. Consult your accountant or tax attorneys to supplement the tax considerations
3 Discussion Points Overview of Business Entity Structures Benefits & Values of Entity FormationTypes of EntitiesSole ProprietorshipPartnership – General or LimitedCorporation – C-Corp. or S-Corp.Limited Liability Company (LLC)Differences
4 Benefits of Entity Formation Corporate Shield – a.k.a., liability protectionAppearance of LegitimacyMeans to raise capital from outside investorsMethod of combining valuable assetsE.g., intellectual propertyBusiness continuity and planningWhat we mean by the “corporate shield’ is that by creating a Corporation or LLC (we’ll get to later in the presentation), shareholders, limited partners, and liability company members, among others, are generally not liable for the liabilities of the company in which they have an ownership interest.HOWEVER, until a company is formally incorporated by filing documents with the State, the entrepreneur is acting in a personal capacity and is personally liable
5 Sole ProprietorshipComposed of one individual who owns and operates a business – Default entityNo separation or distinction as between the owner and the businessNo statutory requirements to createTrade Name Application if going to conduct business in something other than the name of the ownerApplicable licenses or permitsUnlike corporations and LLCs, it is considered to be “without” a ‘legal’ structureUnlike all the other business structures we’ll discuss, sole proprietorships are “creatures of business engagement”Legally speaking, the business owner and the business are the SAME actual & legal person
6 Sole Proprietorship Taxation Liability of Owner Owner of the business reports income or loss directly on his or her personal income tax returnLiability of OwnerOwner of the business is personally liable for debts & obligations of business and for negligent acts committed by themselves and their employees if acting within the scope of employmentIt is important to note that in our hypothetical, or in any case where there remains only one business owner, he or she CAN have employees. In this case, because there is still only one business owner, the legal structure remains a sole proprietorship.Personally liable means in a lawsuit, the suing party can come after the personal assets of the business owner.**Business owners operating as a sole proprietorship CAN attempt to limit their liability via contract lawe.g., can only go after certain assets in a K claimLiability can be mitigated only to the amount of the liability insurance policy
7 PartnershipsAn association of two or more persons to carry on a business for profit as co-ownersTwo TypesGeneral PartnershipLimited PartnershipWhy choose a partnership? – simple way to pool resources amongst individuals“Persons” includes entities“Business” means any trade, occupation, or professionWhen these characteristics are present, a rebuttable presumption exists that the business is operating as a General P’shipNeb. Rev. Stat. presumption – profit-sharing is indicative of a partnership
8 General Partnership Partnership Formation Operations Default entity Automatically forms when two or more individuals are carrying on a business for profit as co-ownersOperationsPartnership Agreement; ORRevised Uniform Partnership Act (governing law)Nothing must be filed with the state.To override the state’s P'ship statute, the parties must execute a P'ship Agreement – GET IT IN WRITING!certain limitations and items that canNOT be overriddenunreasonably restrict right of access to books & recordseliminate duty of loyaltyunreasonably reduce duty of careeliminate obligation of good faith and fair dealingvary the power, of a partner, to dissociate as a partner [among others]
9 General Partnership Taxation Partnership files an informational income tax return, but the Partnership itself does not pay income taxesPass-Through EntityIncome or loss is attributed to the owners/partners equallyNote: Sharing of profits or losses can be determined by the Partnership AgreementSimilar to Sole Proprietorshipsall owners/partners of the business are personally liable for debts & obligations of business AND of torts committed by himself or other partners if acting in OCB or w/ authority of the P’ship
10 General Partnership Liability of Owners/Partners Shared liability by all partnersJoint and SeveralAny one partner can bind other partnersContractNegligence
11 General Partnership Advantages Disadvantages Simple and Inexpensive to createPartners report their share of profits or losses on their own income tax returnDisadvantagesPartners are personally liable for debts & obligations of the business
12 Limited Partnership Formation Operations – Two Types of Partners Must file a Certificate of Limited Partnership with Secretary of StateOperations – Two Types of PartnersGeneral Partners: Active investor and actively involved in the day to day operations and managementLimited Partners: Do not participate in day to day operations and management – passive investorsLimited partnerships are created when one or more partners would like to join the business venture, but wants to also limit their liabilityNote the difference! – first business entity structure that REQUIRES the individuals to file with stateNote: I.R.C. has Passive Activity rules which reduces the amount an individual can deduct as losses if the venture constitutes a “passive activity” w/in the I.R.C.Query: When does a limited partner do enough to be classified as a general partner?too much involvement by a limited partner could result in losing the liability protection – BE CAREFUL!
13 Limited Partnership Taxation Liability of Owners/Partners Based on value of individual contributionsTax liability is not equal among partnersLiability of Owners/PartnersGeneral Partners: Subject to personal liability for debts & obligations of business (similar to General Partnership)Limited Partners: Not subject to personal liability for debts & obligations of business
14 Limited Partnership Advantages Disadvantages Limited partners are not personally liable for business debts (generally)General partner can raise capital from the passive investors (limited partners) without giving up management in businessDisadvantagesGeneral Partners are personally liable for business debts
15 AlternativesIs there a way to limit the liability of all owners while allowing easy transferability of ownership interests?YES – Corporations or Limited Liability Companies
16 Limited Liability Entities Our purpose today Corporations or LLCsLegal entity, separate & distinct from the ownersCreated by statutory lawLimited liability of business ownersNot liable for debts incurred by the businessUnless exceptions apply – Piercing Corporate VeilNebraska Business Corporation ActNebraska Uniform Limited Liability Company Act (NULLCA)Limited Liability THE reason why people incorporate; it protects their personal assets and well-being from the business risks and obligationsExplain PCV doctrine essentially, corporations and LLCs (more so corporations) are required to follow certain corporate formalities such as annual meetings. Failure to do so may result in a Court invoking the PCV doctrine which essentially treats the business entity and the owners as own, thereby making the owners personally liable for the debts of the business – Courts say the owners have treated the business as their “Alter Ego”
17 Requirements Must file with the Nebraska Secretary of State Articles of Incorporation (Corporations)Certificate of Organization (LLCs)Must draft and execute – governing documentCorporate Bylaws (Corporations)Operating Agreement (LLCs)Depending on the statute, certain information is required to be included in the Articles of Incorporation and Certificate of OrganizationFor example, for Articles of Incorporation(1) corporate name, (2) # of shares corporation is authorized to issue and type of classes, (3) street address of registered office and agent(4) name and address of each incorporator, (5) provision if you’re limiting or eliminating the requirement of annual meeting of SHGoverning document must be drafted and executed, but is NOT required to be filed with the Secretary of Stateessentially, it governs the operations of the business
18 Limited Liability Entity or Not Increased Likelihood of incurring liabilitySelling products or servicesHiring more employeesEntering into contracts – e.g., leases, loans, salesMultiple ownersAdditional investorsWhat are some things to consider when deciding to “incorporate”
19 Corporation or LLC Things to Consider: Financing needs Management Investors, Venture Capitalists, Angel Capitalists tend to prefer corporation statusManagementBoard of Directors & Officers (Corporations); ORMember- or Manager-Managed (LLCs)Tax & LiabilityThey prefer the corporation status because of the stock and governance traitscorporations have been around much longer so Courts have much more familiarity with them and the issues surrounding themSome investors may also consider State of IncorporationDelaware, as compared to Nebraska, has a long and rich history of interpreting, deciding and developing corporate law
20 Corporations Corporate law is state law Approx. 50% of corporations incorporate in DelawareInternal Affairs Rule: the laws of the state of incorporation govern internal corporate affairsForeign Business Rule: if incorporated in a state other than where conducting business, must qualify/register to operate business in the “foreign” jurisdiction
21 Corporations Operations Shares of Stock = Ownership Interest = ShareholderBoard of Directors = primary decision makersElection process is established in the Articles or BylawsCan reserve certain decision-marking authority to ShareholdersOfficers = day to day decision makersElected by Board of DirectorsPresident, VP, Secretary, Treasurer, etc.**In most closely-held corporations (aka, small businesses) many of the same people with be the Owner/Shareholder, on the Board of Directors, and an OfficerThus, it is absolutely critical that when you are acting on behalf of the business, you are cognizant of what “HAT” you’re wearing
22 Corporations Liability of Owners/Shareholders Separate legal entity, distinct from Owner/ShareholdersGeneral Rule: Entity is liable for corporate debts & obligationsExceptions:Piercing the Corporate Veil (PCV)Personal Contractual GuaranteesPCV, as explained earlier, is a judicially-created exception to the rule of limited liability. It is a fact intensive analysis that varies from case to case.
23 Corporations Two Choices: C-Corporations (C-Corp.) S-Corporations (S-Corp.)There are two main types of corporations one should consider**Note, in the eyes of the State of Nebraska, there is no difference. Only in the eyes of the IRS is there a difference.Difference is what Subchapter of the I.R.C. is the corporation taxed under
24 C-Corporation Taxation Double Taxation First, taxed at the corporate level – corporation reports and pays income taxesSecond, taxed at the individual level – shareholders report and pay income tax on any distributions paid out to themNote: this does NOT mean you pay twice as much in taxes!
25 S-CorporationCorporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue CodeFile Form 2553TaxationPass-ThroughNo taxation at corporate levelOnly taxed at individual level if shareholders are paid distributionsElection – must intentionally seek status as an S-Corp.Pass-Through Taxation is the MAIN benefit in S-Corp. statusLiability – same as the C-Corp. limited, unless an exception applies
26 S-Corporation Restrictions on S-Corporation Domestic Corporation Allowed only 1 class of stockMaximum of 100 shareholdersShareholders must be U.S. citizens or residentsProfits and Losses allocated proportionatelyRestrictions on S-Corp. status:All SHs must be an actual human being, not an entity – could provide issues with investors that want to invest through another business entityCan only have 1 class of stock – could provide issues with investors that want preferred stockCAN have voting and non-voting classes of stock, thoughMaximum of 100 SHsDomestic CorporationProfits & Losses allocated proportionately
27 Limited Liability Company Flexible structure: Can take the form of a General Partnership, but provides the limited liability of a corporationFormationMust file Certificate of Organization with Nebraska Secretary of StateIn legal jargon, LLCs are relatively “young” – first state passed legislation in 1978 – so there just is not as much case law or judicial interpretation or development of LLC law
28 Limited Liability Company OperationsOperating Agreement (governing contract)Nebraska Limited Liability Company ct (governing law)Management StructureMember-Managed – DefaultAll members (owners) have decision-making authority in day to day operations of businessManager-ManagedMust be elected in the Operating AgreementDecision-making authority is given to one or more persons
29 Limited Liability Company Taxation – various possibilitiesDefault: Pass-Through entityElectionC-Corporation treatment: taxed at corporate and individual levels; ORS-Corporation treatment: Pass-Through entityLiabilityNeither members or managers are subject to personal liability for debts & obligations of businessLiability same exceptions from the corporate context apply here as well!
30 Limited Liability Company AdvantagesOwners have limited liability for business debts even if they participate in management of the businessProfit and Loss can be allocated differently than ownership interestChoice of taxation structureDisadvantagesMore expensive to create than a Partnership or Sole Proprietorship
31 Summary Business Entity Formation matters greatly Tax Implications Liability of OwnersFuture Financing & Investor PreferenceInternal OperationsDefault Rules
32 Contact Us Write us: Entrepreneurship Legal Clinic University of Nebraska College of Law7 McCollum HallLincoln, NEGive us a call:Visit our website: