Where to Incorporate
Selecting a State of Incorporation
The internal affairs of a corporation are governed by the laws of the state in which it is formed. A corporation does not have to have an office or do business in the state in which it is incorporated; it need only have a registered agent in that state. There are companies such as CT Corporation System that will act as a registered agent in the state of incorporation.
Delaware
Delaware often is the preferred state of incorporation. Initially, Delaware gave management better rights in the event of a takeover, so in the 1940's and 1950's many corporations moved there. Delaware set up a court system that has expertise in commercial transactions and well-developed corporate law. Other states improved their corporate legal systems, but virtually every corporate attorney is familiar with Delaware law.
Delaware also has the Delaware Asset Protection Trust, which permits one to set up a trust that cannot be touched by creditors but that allows one to get one's money. Most other states require irrevocable trusts that prevent one from accessing one's money once it is in the trust. The state of Alaska responded with a similar trust, but added spouses and children to the list of creditors that could not get at the money in the trust. Delaware responded likewise.
Advantage of Incorporating in One's Own State
If the company does not plan to obtain venture capital funding, it may be best to incorporate in the state in which the company plans to do business. Doing so has the following advantages:
* Local attorneys are familiar with the local law
* One can have an intrastate securities law exemption.
* There is the convenience of geographical proximity.
* The corporation does not need to register as a "foreign" corporation in the state of operation if it is incorporated there.
Name Availability
The selected name must be available in the state of incorporation. In choosing a corporate name, one needs a name that can be used in every state in which the corporation will do business. It is best to coin a name that is not a common word in the language. "Exxon" and "Pentium" are examples of such words.
Issues to Consider when Selecting a State
Some of these issues may be important to your corporation. In any case, they can serve as a starting point for questions to ask.
1. How many incorporators are required by the state, and whether the incorporator itself can be a corporation.
2. The minimum number of people required to form the corporation.
3. The minimum capital requirement, if any.
4. The state's fees for filing the articles of incorporation.
5. The state's annual corporate franchise tax.
6. The state's corporate income tax and whether earnings from operations outside the state are taxable. The State of Delaware taxes non-Delaware resident shareholders of S corporations on their distributive share of S Corporation income based on the percentage of that income derived from Delaware sources. If a Delaware corporation has no Delaware source income, these taxes should not be an issue.
7. Whether the corporation is allowed to keep its books and records outside the state.
8. The state's court system's reputation of fairness in business cases.
9. Whether the corporation is allowed to have its principal place of business outside the state.
10 Whether there is a state inheritance tax on non-resident shareholders.
11 Disclosure/privacy - whether the state requires public disclosure of the names of shareholders.
12. Whether the state requires a corporate bank account in that state (Delaware does not).
Saturday, January 15, 2011
Sole Proprietorship
The Sole Proprietorship
The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner. This characteristic has the advantage of simplicity but also has the disadvantage of personal liability.
Taxation
A sole proprietorship has pass-through taxation. The business itself does not file a tax return; rather, the income passes through and is reported on the owner's personal tax return.
Liability
The owner of a sole proprietorship has unlimited personal liability. However, with insurance for tort risk and contractual limitations for contract risk, the sole proprietor can insure against most risks and operate with near the same level of comfort as the owners of a corporation.
Continuity of existence
A sole proprietorship exists only as long as the owner is alive or until the owner decides to close the business.
Risk and Control
The control of a sole proprietorship belongs entirely to the owner, who also assumes the full risk of the business.
Transferability
Transferring one's interest in a sole proprietorship is very easy - one simply prepares an asset purchase agreement and sells the assets. The assets of a sole proprietorship are transferred with the estate of the owner upon death. To die testate means that there is a valid will; intestate means that there is no valid will and the intestate succession laws will determine the allocation of assets among heirs. These laws are logical, but it is better to use a will to specify one's wishes for the transfer of sole proprietor assets.
Expense and formality
The sole proprietorship is the simplest way of doing business. The costs of formation are very low and there is very little formality required. If the name of the business is different from the name of the owner, the sole proprietorship must be registered with the state. If the owner's name is used, it will be in the form of firstname lastname or simply lastname.
The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner. This characteristic has the advantage of simplicity but also has the disadvantage of personal liability.
Taxation
A sole proprietorship has pass-through taxation. The business itself does not file a tax return; rather, the income passes through and is reported on the owner's personal tax return.
Liability
The owner of a sole proprietorship has unlimited personal liability. However, with insurance for tort risk and contractual limitations for contract risk, the sole proprietor can insure against most risks and operate with near the same level of comfort as the owners of a corporation.
Continuity of existence
A sole proprietorship exists only as long as the owner is alive or until the owner decides to close the business.
Risk and Control
The control of a sole proprietorship belongs entirely to the owner, who also assumes the full risk of the business.
Transferability
Transferring one's interest in a sole proprietorship is very easy - one simply prepares an asset purchase agreement and sells the assets. The assets of a sole proprietorship are transferred with the estate of the owner upon death. To die testate means that there is a valid will; intestate means that there is no valid will and the intestate succession laws will determine the allocation of assets among heirs. These laws are logical, but it is better to use a will to specify one's wishes for the transfer of sole proprietor assets.
Expense and formality
The sole proprietorship is the simplest way of doing business. The costs of formation are very low and there is very little formality required. If the name of the business is different from the name of the owner, the sole proprietorship must be registered with the state. If the owner's name is used, it will be in the form of firstname lastname or simply lastname.
General Partnership
The General Partnership
A general partnership (or simply partnership) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. The intention or lack thereof of having a formal partnership is not important.
Existence of a Partnership
Rules for determining the existence of a partnership are outlined in Part II of the Uniform Partnership Act (UPA). Some of these rules are summarized as follows:
1. Joint tenancy, common property, part ownership, etc. does not by itself establish a partnership, regardless of whether the owners of the property share any profits from it. Three ways to jointly own property are:
1. Tenants in common - when one dies, one's portion of the partnership is transferred to one's heirs.
2. Joint tenancy - right of survivorship - when one dies, the entire interest goes to the other person.
3. Tenancy by entirety - for example, a husband and wife. Each tenant owns by whole and by part. If a third party has a claim against the husband, the claimant cannot go after the property since it belongs wholly to the wife as well. For this reason, banks often require both the husband and the wife to sign a loan.
2. Sharing of gross returns from jointly held property also does not by itself establish a partnership.
3. The receipt of a share of profits from a business is evidence of being a partner of that business, unless the profits were received as payment on a debt, interest, wages, rent, etc.
A person may be considered a partner even if not formally included in the partnership. This is known as partnership by estoppel. "Estoppel" means that one is not permitted to deny. In the context of partnerships, it means that a person cannot deny being a partner if he permits the partnership use his name. Take for example, a situation in which partner A and partner B start a business and offer non-partner C a profit interest in the company if they can use C's name in the business. If a bank lends money to the partnership and the partnership becomes insolvent, C would be considered a partner and could be held liable.
Partnership Taxation
Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting entity, not a tax-paying entity. Profits pass through to the owners and are divided in accordance with what is specified in the partnership agreement. There are no restrictions on how profits are allocated among partners as long as there is economic reason, so there is latitude in allocating income according to which partners have the best tax rates.
Liability
While pass-through taxation is an advantage, owners of a partnership have unlimited personal liability. In general, each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that the partners can be sued as a group. Several liability means that the partners are individually liable. In some states, each partner is both jointly and severally liable for the damages resulting from the wrongdoing of other partners, and for the debts and obligations of the partnership.
Three rules for liability in a partnership are:
1. Every partner is liable for his or her own actions.
2. Every partner is liable for the actions of the other partners.
3. Every partner is liable for the actions of the employees of the business.
As an example to illustrate liability in a partnership, suppose there is a partnership formed by partners A, B, and C. If partner A accidentally runs over somebody while driving on a personal trip to the grocery store one weekend, then A alone has unlimited personal liability. If partner A accidentally runs over somebody while making a delivery for the partnership, then A still has unlimited personal liability, but all three partners would be jointly and severally liable. If the victim wins a judgement of $1 million against the partnership, and only partner B has the money, then B would have to pay the judgement. Partner B could assert a right of contribution against partner A, but if A has no money it would not be worth the effort. If an employee of the partnership, employee E, accidentally runs over somebody during the course of work, then the partnership is liable since the employer is responsible for the actions of an employee within the scope of business. If the accident happened while the employee stopped for something personal, then the employer would not be responsible (frolic and detour).
Risk and Control
Absent an agreement to the contrary, UPA gives partners equal voting rights, even if they contributed different amounts of capital. Squeeze-outs are a common issue in partnerships.
Expense and formality
As in the case of a sole proprietorship, if the partnership chooses a ficticious name (different from the names of the partners), it is required to file that name with the state.
Fiduciary Duty in a Partnership
Partners owe both a contractual duty and a fiduciary duty to one another. According to Black's Law Dictionary, a fiduciary duty is the duty to act for someone else's benefit while subordinating one's personal interests to those of the other person. These days however, many operating agreements waive the fiduciary duty so that one can pursue other opportunities that may come along.
Case: Meinhard v. Salmon
Facts
Salmon wanted to lease some property in New York. The lease was to run from 1902 to 1922. He formed a partnership with Meinhard who put up 50% of the money. Salmon would be the active manager and would pay Meinhard 40% of the profits for the first five years, and 50% thereafter. In 1922 the lease was up for renewal and the owner of the property, speaking only with Salmon, offered to make some adjacent property available. Salmon signed a lease for the property on behalf of his own firm, Midpoint Realty Company, of which Meinhard was not an owner. Salmon had not told Meinhard anything about the new lease or even the possibility of a new project.
Issue
Meinhard claimed that Salmon had a fiduciary duty to provide him the opportunity to participate in the deal.
Holding
The court ruled in favor of Meinhard.
Reasoning
The new deal was an extension of the old one. While Salmon did not act in bad faith, he had a fiduciary duty to Meinhard.
-----
As one person put it, "a partnership is just like a marriage."
Issues to Address when Forming a Partnership
To reduce the chances of disputes among the partners, a written partnership agreement always should be drawn up before going into business as a partnership.
The Revised Uniform Partnership Act (RUPA) was issued in 1994. It is a revision of the original Uniform Partnership Act that dates back to 1914. UPA is interstitial; it fills in the gaps in the specific partnership agreement.
Issues to address in forming a general partnership:
* Amount of capital contributed by each person, and if more is needed at a later date, who contributes it, and any limitations to someone's maximum contribution.
* Rights and responsibilities of each partner.
* Division of profits among the partners.
* Distribution of assets upon dissolution of the company. If one partner wakes up one day and wants out, the partnership dissolves. But liquidation would destroy the value of the business, so the partnership agreement should provide rules for a partner's exit. One partner can transfer a profit interest to an external party, but not control. Some options for distribution of assets include:
o Right of first refusal - a provision that requires the departing partner to allow the remaining partners to buy his or her share of the business at the same price of a bona fide external offer.
o Right of first offer - since the time delay associated with giving existing partners the right of first refusal may discourage external parties' interest in bidding, the right of first offer may be used instead. The right of first offer is a provision that requires the departing partner to offer to sell his or her share of the business to the other partners before offering it externally.
o Dutch auction - a provision in which one partner offers to sell to the other partner at a particular price. If the other partner refuses, the first partner must buy the other partners share at that price. This arrangement provides strong incentive for a fair asking price. Note that the term "Dutch auction" has other meanings as well - it also refers to both a descending price auction and to an auction in which several identical items are auctioned and all successful bidders pay the either the price of the lowest successful bidder or their bid prices, depending on the specific auction rules.
o Third party arbitrator - an outside party sets the price.
A general partnership (or simply partnership) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. The intention or lack thereof of having a formal partnership is not important.
Existence of a Partnership
Rules for determining the existence of a partnership are outlined in Part II of the Uniform Partnership Act (UPA). Some of these rules are summarized as follows:
1. Joint tenancy, common property, part ownership, etc. does not by itself establish a partnership, regardless of whether the owners of the property share any profits from it. Three ways to jointly own property are:
1. Tenants in common - when one dies, one's portion of the partnership is transferred to one's heirs.
2. Joint tenancy - right of survivorship - when one dies, the entire interest goes to the other person.
3. Tenancy by entirety - for example, a husband and wife. Each tenant owns by whole and by part. If a third party has a claim against the husband, the claimant cannot go after the property since it belongs wholly to the wife as well. For this reason, banks often require both the husband and the wife to sign a loan.
2. Sharing of gross returns from jointly held property also does not by itself establish a partnership.
3. The receipt of a share of profits from a business is evidence of being a partner of that business, unless the profits were received as payment on a debt, interest, wages, rent, etc.
A person may be considered a partner even if not formally included in the partnership. This is known as partnership by estoppel. "Estoppel" means that one is not permitted to deny. In the context of partnerships, it means that a person cannot deny being a partner if he permits the partnership use his name. Take for example, a situation in which partner A and partner B start a business and offer non-partner C a profit interest in the company if they can use C's name in the business. If a bank lends money to the partnership and the partnership becomes insolvent, C would be considered a partner and could be held liable.
Partnership Taxation
Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting entity, not a tax-paying entity. Profits pass through to the owners and are divided in accordance with what is specified in the partnership agreement. There are no restrictions on how profits are allocated among partners as long as there is economic reason, so there is latitude in allocating income according to which partners have the best tax rates.
Liability
While pass-through taxation is an advantage, owners of a partnership have unlimited personal liability. In general, each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that the partners can be sued as a group. Several liability means that the partners are individually liable. In some states, each partner is both jointly and severally liable for the damages resulting from the wrongdoing of other partners, and for the debts and obligations of the partnership.
Three rules for liability in a partnership are:
1. Every partner is liable for his or her own actions.
2. Every partner is liable for the actions of the other partners.
3. Every partner is liable for the actions of the employees of the business.
As an example to illustrate liability in a partnership, suppose there is a partnership formed by partners A, B, and C. If partner A accidentally runs over somebody while driving on a personal trip to the grocery store one weekend, then A alone has unlimited personal liability. If partner A accidentally runs over somebody while making a delivery for the partnership, then A still has unlimited personal liability, but all three partners would be jointly and severally liable. If the victim wins a judgement of $1 million against the partnership, and only partner B has the money, then B would have to pay the judgement. Partner B could assert a right of contribution against partner A, but if A has no money it would not be worth the effort. If an employee of the partnership, employee E, accidentally runs over somebody during the course of work, then the partnership is liable since the employer is responsible for the actions of an employee within the scope of business. If the accident happened while the employee stopped for something personal, then the employer would not be responsible (frolic and detour).
Risk and Control
Absent an agreement to the contrary, UPA gives partners equal voting rights, even if they contributed different amounts of capital. Squeeze-outs are a common issue in partnerships.
Expense and formality
As in the case of a sole proprietorship, if the partnership chooses a ficticious name (different from the names of the partners), it is required to file that name with the state.
Fiduciary Duty in a Partnership
Partners owe both a contractual duty and a fiduciary duty to one another. According to Black's Law Dictionary, a fiduciary duty is the duty to act for someone else's benefit while subordinating one's personal interests to those of the other person. These days however, many operating agreements waive the fiduciary duty so that one can pursue other opportunities that may come along.
Case: Meinhard v. Salmon
Facts
Salmon wanted to lease some property in New York. The lease was to run from 1902 to 1922. He formed a partnership with Meinhard who put up 50% of the money. Salmon would be the active manager and would pay Meinhard 40% of the profits for the first five years, and 50% thereafter. In 1922 the lease was up for renewal and the owner of the property, speaking only with Salmon, offered to make some adjacent property available. Salmon signed a lease for the property on behalf of his own firm, Midpoint Realty Company, of which Meinhard was not an owner. Salmon had not told Meinhard anything about the new lease or even the possibility of a new project.
Issue
Meinhard claimed that Salmon had a fiduciary duty to provide him the opportunity to participate in the deal.
Holding
The court ruled in favor of Meinhard.
Reasoning
The new deal was an extension of the old one. While Salmon did not act in bad faith, he had a fiduciary duty to Meinhard.
-----
As one person put it, "a partnership is just like a marriage."
Issues to Address when Forming a Partnership
To reduce the chances of disputes among the partners, a written partnership agreement always should be drawn up before going into business as a partnership.
The Revised Uniform Partnership Act (RUPA) was issued in 1994. It is a revision of the original Uniform Partnership Act that dates back to 1914. UPA is interstitial; it fills in the gaps in the specific partnership agreement.
Issues to address in forming a general partnership:
* Amount of capital contributed by each person, and if more is needed at a later date, who contributes it, and any limitations to someone's maximum contribution.
* Rights and responsibilities of each partner.
* Division of profits among the partners.
* Distribution of assets upon dissolution of the company. If one partner wakes up one day and wants out, the partnership dissolves. But liquidation would destroy the value of the business, so the partnership agreement should provide rules for a partner's exit. One partner can transfer a profit interest to an external party, but not control. Some options for distribution of assets include:
o Right of first refusal - a provision that requires the departing partner to allow the remaining partners to buy his or her share of the business at the same price of a bona fide external offer.
o Right of first offer - since the time delay associated with giving existing partners the right of first refusal may discourage external parties' interest in bidding, the right of first offer may be used instead. The right of first offer is a provision that requires the departing partner to offer to sell his or her share of the business to the other partners before offering it externally.
o Dutch auction - a provision in which one partner offers to sell to the other partner at a particular price. If the other partner refuses, the first partner must buy the other partners share at that price. This arrangement provides strong incentive for a fair asking price. Note that the term "Dutch auction" has other meanings as well - it also refers to both a descending price auction and to an auction in which several identical items are auctioned and all successful bidders pay the either the price of the lowest successful bidder or their bid prices, depending on the specific auction rules.
o Third party arbitrator - an outside party sets the price.
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