Business Law

Entity Formation: Factors to Consider

4 Basic Entity Types: An Overview

Sole proprietorship Individual owner; everything belongs to the

proprietor

General partnership Partners = owners; no agreement needed (can

be implied by actions)

4 Basic Entity Types: An Overview

Limited partnership Gen partner = day to day; Limited partner = $

Corporation Close vs publicy held

Other Entity Types: An Overview Limited Liability Companies (LLCs)

Like a corp, its own distinct entity (can sue/be sued in its own name; can buy/sell property)

Can also create PLLC – professional LLC for professionals (doctors, lawyers, accountants) – limited liability for malpractice of other members, unlimited liability for own malpractice

Limited Liability Partnerships (LLPs) Allow partnerships, but shield assets of one partner from

wrongdoing committed by other partners Franchises Joint Ventures Cooperatives Syndicates

Entity Formation Decisions: The 7 FactorsLimited liabilityTaxationFormalitiesFinancingManagementLife of the businessLiquidity of investment

Factor 1: Limited Liability “Is my house safe?” Concern for all, especially investors Sole proprietors: no limited liability General partners: no limited liability Limited partners: investments are unprotected, but personal assets

are protected Shareholders: investments unprotected, but personal assets are

protected absent contractual agreement otherwise LLC Members: Limited liability (but not for own malpractice) LLP partners: Limited liability (but not for own malpractice) BUT – see next slide!

Factor 1: Limited Liability

Not even a limited liability entity always protects personal assets

LaMontagne Builders v Bowman Brook Specific issue: General issue:

Factor 1: Limited Liability

When you don’t treat the entity properly, you might lose is protection (piercing the corporate veil – if undercapitalized;

if used as an alter ego for shareholder/director/officer.)

See also Estate of Countryman p. 476

Factor 1: Limited Liability

Back to George, Kim and Martha:Which form provides greatest protection

for Kim & Martha’s savings? Kim: “large sum of $”; not able to operate the

day-to-day business Martha: $20k, but needs to keep some for son’s

college; wants to co-manage

Factor 2: Taxation Sole Proprietorship: “It’s all personal” – SP taxed

personally on income/loss Partnership: Income/loss “passed through” to the

partners and taxed to them personally according to their level of contribution

LLC: Taxation benefits of partnership LLP: Taxed like a general partnership Advantages:

Savings on taxes during early years if SP/P have other sources of income (take other income minus business losses)

Lower taxes on operations than with corporations

Factor 2: Taxation Corporation: usually taxed as its own entity based on its

income. Shareholders usually pay income taxes on dividends they receive (“double taxation”)

$ (income)(taxed to corp) Corporation $ (dividends)(taxed to SH) Shareholders

Exception: S-Corp Taxed like a partnership – entity doesn’t pay corporate tax. 100 or fewer shareholders Shareholders can only be individuals (or estates) Shareholders must agree in writing to partnership taxation

Corp tax rate varies from year to year (or administration to administration); many mechanisms available to reduce tax burden on shareholders

Factor 3: Formalities

Sole proprietorship; general partnership: Few formalities

Limited partnerships; corporations; LLCs: Many formalities

LLP: Must file with state, maintain professional liability insurance

Factor 3: Formalities

Back to G, K & M: which form of business is easiest to organize?

Why do we have formalities?

Factor 4: Financing

How can we obtain financing? Loans, lines of credit, securities…

Large corporation: Limited liability for shareholders; can work w/ securities; seems “safer”

Small corporation: Limited liability for shareholders; continuity of life (unlike with partnerships/sole proprietorships)

Factor 5: Management Sole proprietorship: “It’s all personal” – the SP

can decide everything about running the organization

General partnership: All GPs can make decisions; usually, they split it up, but to an outsider, any of them can usually make decisions on behalf of the partnership (“apparent authority”). Deadlocks/drawn-out discussions are possible.

Limited partnership: No difference for the GP(s), but limited partners can’t participate in management

Factor 5: Management Close corporation: Possible to have deadlocks;

may have a CEO charged with day-to-day decision-making

Corporation: Officer(s) manage day-to-day; board may control policy; shareholders don’t usually participate (but are allowed to, generally)

Limited Liability Company: All investors share in the management; no restriction on number of members (akin to shareholders); may hire managers; duty to act in LLC’s best interests

Factor 5: Management

S-Corps Minority Shareholder Oppression

Minority shareholder gets “frozen out” – can stem from personality conflict, business decision disagreement…

Brooks v Hill • Specific issue: Is Leroy liable for minority shareholder

oppression?• General issue: If a majority shareholder uses the

business for his/her personal purposes, resulting in lower share value, and subsequently seeks to buy out a minority shareholder, is the majority shareholder liable for oppression?

Factor 6: Life of the Business

Sole proprietorship: “It’s all personal” – business usually ends when SP can no longer run it b/c of death/disability

Partnership: Without advance written agreement to the contrary, partnership dissolves when a partner dies, becomes insolvent or leaves; termination at will, but can contract to provide damages to remaining partners. Partnership can be inherited.

Factor 6: Life of the Business

Corporation: Strongest continuity of life – death/disability of a shareholder doesn’t affect legal status of the corporation. Easy to transfer ownership of shares. Easiest to preserve good will. (But, think about Apple and Steve Jobs)

LLC: Generally dissolved by death, retirement, bankruptcy, being left by one of the members. Remaining members can unanimously agree to continue the business operations.

Factor 6: Life of the Business

In Re Garrison-Ashburn, LC Specific issue: General issue:

Factor 7: Liquidity of InvestmentCan you get your money back? Sole proprietorship: “It’s all personal” – SP puts in own $;

can take any of it not committed to third parties whenever General partners: Can sell their stake at buyout time, but

buyer doesn’t become a partner w/o unanimous consent of other Ps; hard to sell before buyout time; doesn’t benefit from goodwill if other Ps continue the business

Limited partners: Can sell, but not much of a market Close corp: Restrictions may apply; market is small

(strings attached; no incentive unless board influence is possible)

Public corp: Easy – just sell the shares on the public market.

Factor 7: Liquidity of Investment

LLC: Member can transfer ownership interest. Transferee receives member’s share of profits, but not ability to manage w/o other members’ consent.