Business owners face a myriad of choices throughout the lifecycle of the business. Some issues are relatively straightforward while others are more complex. Because each business is unique (size, purpose, management, duration, etc.), there is no handbook that appeals to all owners.
A business owner’s goal should be to spot issues in advance and know what alternatives exist to make educated determinations. Variables such as planning, reduction of exposure to liability, management efficiency, compliance with licensing and regulatory schemes, and taxation are germane.
Below, we provide a non-exhaustive overview of business law considerations, highlighting selected areas for business owners and entrepreneurs that require further independent exploration.
A fundamental decision to be made is choosing a business structure that suits the particularities of the enterprise. The objective in selecting an entity structure is to balance the concepts of limited liability, tax efficiency, and ease of management. Some businesses will need to change entity forms as the business develops.
Regardless of the entity type selected, business owners should also consider the formalities and cost to form the entity, need for an employer identification number (EIN), and procuring any business licenses or certificates that might be required. There may also be intellectual property needs to address.
Sole Proprietorships and General Partnerships
The default form of business that an individual conducts in which nothing else is formally organized is referred to as a “sole proprietorship.” In many ways, this is the simplest form of business. The proprietor is the sole equity owner and, aside from licensing/regulatory and tax compliance, there are no formalities required to organize the proprietorship. The proprietor has great discretion in managing the business and reports income on personal tax returns. However, the proprietor does not reap the benefits of limited liability, meaning that he or she is personally liable for all liabilities of the business. This is a significant drawback and a common reason for forming an entity rather than a proprietorship.
A general partnership is created when two or more persons associate to carry on a business for profit as co-owners but do nothing additional to organize the business. Whether a partnership has been created is a question of fact, and intent to become partners is not necessary. In other words, a partnership is created when the definition of that term is met – even if the individuals agree in writing that they are not partners in some instances. The consequences can be dramatic for a person who unknowingly becomes a partner and is then held liable for certain obligations of the other partner(s) to the extent of the person’s personal wealth. Other governance may be controlled by statute in the absence of an agreement, including voting/decision-making, sharing in profits and losses, and treatment of partnership property.
Limited Liability Partnerships (LLPs)
This form of business is similar to a general partnership but has some noteworthy distinctions: An LLP can only be formed by filing articles with the Secretary of State; it is required to carry liability insurance in the specified amount; and partners retain a certain amount of insulation from torts committed by the LLP.
Limited Partnerships (LPs)
An LP is formed by filing a certificate with the Secretary of State that sets forth certain information. A general partner(s) manages operations while limited partners are more passive. As a result, general partner(s) has unlimited liability to third parties while limited partners are generally liable only up to their contributions to the LP. However, limited partners may lose this protection if they engage in certain conduct that makes them more akin to a general partner. A limited partnership interest is often considered a security, which might bring about additional compliance responsibilities for the LP.
A corporation is formed by filing its articles of incorporation, holding an organizational meeting, and adopting bylaws. Power, authority, and governance are controlled by statute as well as the corporation’s articles, bylaws, and shareholders’ agreements. Although there are numerous possible variations, the basic corporate model contemplates shareholders who are passive equity investors, a board of directors that is charged with management, and officers who conduct the day-to-day business of the corporation.
Owning a “share” of the corporation entitles the owner to a set of rights, including election of the board, voting on specific matters, receipt of profits, the ability to bring derivative actions, and protection from personal liability for corporate obligations – known as the “corporate veil.” If shareholders ignore the corporate form, a concept known as “piercing the corporate veil” can be used to attempt to hold shareholders personally liable for corporate obligations. A share is always deemed to be a security, implicating federal and state laws.
An S corporation is a flow-through entity that has validly elected to pass income, losses, deductions, and credit through to its shareholders. In order to make this election, the corporation must meet a set of qualifications. By contrast, a C corporation is taxed separately from its owners, creating two layers of taxation. Whether making the election is advisable will depend on a number of factors, including the desired nature and structure of the entity, its size, its owners, use of profits, employment issues, and tax efficiency.
Other options that exist in South Carolina include statutory close corporations, professional corporations and nonprofit corporations. Of these, nonprofits are the most widely used. The term “nonprofit” does not mean the entity does not make money – quite the opposite is true. Rather, nonprofits do not have shareholders or equity owners that share in the profits. The draw to the nonprofit form is limited liability of members, special protections for directors, avoidance of securities laws, and qualification for tax exemption (although tax exempt status is not necessarily a guarantee).
Limited Liability Companies (LLCs)
LLCs can be thought of as a hybrid of corporate and partnership forms. They are popular because of their flexibility. An LLC is formed by registering with the Secretary of State and members of an LLC enjoy limited liability protection similar to the corporate veil. Very few provisions of the statutes governing LLCs are mandatory. Instead, operating agreements (a contract among the members) largely control how the LLC operates, allowing for a customized governance structure. In addition, LLCs can select how they want to be taxed.
LLCs decide whether to be member-managed or manager-managed. In a member-managed LLC, the members have apparent authority to bind the company in the ordinary course of business. In a manager-managed LLC, the managers have apparent authority while the members are more passive (making membership interests appear more like securities). Neither members nor managers are personally liable for the obligations of an LLC so long as they do not do anything to make themselves personally liable like, for example, committing a tort.
The contractual needs will be different for each business. However, a vital step at the outset of any venture (or later if not completed on the front-end) is reduction of business governing documents to writing. This is an opportunity to address problem areas before they mature. A buy-sell provision in a limited liability company’s operating agreement might prevent a costly dispute at a later point in time. This is also a chance to elect internal mechanisms rather than leaving them to the statutory defaults. The governing documents can and should dictate a number of other matters. A related item that should be reflected in writing is indicia of business ownership.
More than likely, a business will utilize a number of other contractual tools that relate to both internal and external operations. Internally, employment contracts should be well thought out to address items beyond compensation and duties of the employee. Examples of provisions include those that outline responsibilities in the event of termination like alternative dispute resolution, confidentiality, non-solicitation of customers and employees, non-competition, return of company property, etc.
Issuance of securities normally entails registration or seeking an exemption from registration. In either scenario, a number of documents are required.
Externally, a business that will have a physical presence must negotiate or write contracts pertaining to the lease or purchase/sale of real property. Third-party contracts with suppliers or buyers are common, as are contracts aimed at limiting exposure to liability such as customer consents.
Buying or Selling a Business
Some common milestones in the purchase or sale of a business are execution of a non-disclosure agreement between the parties and the beginning phases of negotiation, a letter of intent, which is often non-binding, a due diligence period, execution of an asset or stock (equity) purchase agreement, and closing.
The asset or stock purchase agreement allows the buyer to ensure it is buying what it bargained for and enables the seller to close as many loose ends as possible and set forth payment terms. There is a delay before closing to gather government approvals, deal with employment issues, assign third-party contracts, obtain financing, and finalize other elements of the transaction. With a stock purchase, generally the entire business is sold (although there may be liability carve-outs) and only the internal ownership structure appears to change. An asset purchase usually involves the sale of substantially all of the business, but the buyer can be, with limitations, somewhat more selective of what is purchased or excluded. The seller will consider tax consequences of the transaction – for example a C corporation might prefer a stock sale to avoid double taxation, while this might be less of a concern if the seller is an LLC or an S corporation. Because there are limitations on whom and what can be an S corporation shareholder, there might be a need for an S corporation seller of stock to convert to another entity form prior to the sale depending on who or what is making the purchase.
Other businesses will ultimately wind-down or dissolve in some manner. Some businesses are created for the express purpose of completing a finite number of transactions or will exist only for a specified period of time.
There is no shortage of material urging business owners to hire professionals as needed. While certain positions such as employees and managers might exist in-house, often there is a need to acquire outside assistance from attorneys, CPAs, financial advisors, and/or marketing consultants. These points of contact reduce time spent away from the operations of the business, provide advice, and catch pitfalls on the front-end with the goal of increasing efficiency and reducing exposure that might otherwise exist.
Learn more about Author Rick Callison here.
If you need a legal professional to advise on the current operations of your business, call PMC Law Firm for help. Our attorneys are standing by to take your call. Dial (800) 914-0620 or submit an online contact form to get started today.