Business Planning from a Legal Perspective
Each business is highly individual in its goals and objectives as well as its ownership structure, financial standing and business specialty. Therefore, while there are general legal concepts applicable to the makeup and administration of a business, there is no one overriding strategy or approach that applies to all businesses. However, from a legal perspective the following are brief explanations of some of the more common considerations in business planning, and which may be helpful as a checklist to be considered by business owners, accountants and attorneys.
Choice of Entity - When a company is to be formed, the essential question is the type of entity to be created. Is it to be a corporation (and if a corporation, is it to be a regular "C" corporation or a "S" corporation), or is it to be a limited liability company (LLC) or a partnership or perhaps even a limited partnership? There is currently a general preference for utilizing LLCs, but this preference is no more than a starting point inasmuch as there are many factors to be considered when choosing the type of entity to be used.
LLC (Limited Liability Company) - LLCs have become increasingly popular, and in general many attorneys and accountants consider them to be the entity of choice. This is because LLC's provide the double benefits of (i) a pass through tax structure as well as (ii) the limited liability applicable to corporate shareholders. (A pass through tax structure means that there is no income tax at the entity level.) Real estate is generally recognized as a proper asset for an LLC, but increasingly operating companies are being formed as LLCs rather than either "C" or "S" corporations.
Partnership - A general partnership possesses a pass through income tax structure whereby the profits of the partnership are taxed directly to the partners. However, a major drawback to a partnership is that is that there is unlimited personal liability, and each partner is fully liable for the debts and obligations of the partnership. For this reason real estate and even operating entities are often held in LLC form, which provides the tax benefits of a partnership without the exposure of personal liability.
"C" Corp - A "C" corporation is taxed at the entity or corporate level and does not have the pass through tax benefits of an "S" corporation. Of course, salary paid to employees is deductible, but corporate earnings will be subject to a double tax, namely, corporate earnings will be taxed to the corporation and then again to the shareholders when distributed as dividends.
"S" Corp - An "S" corporation is a corporation that has elected to be taxed similarly to a partnership. That is, income is not taxed at the corporate level but the income is taxed directly to the shareholders. However, in several important respects, such as (i) the distribution of assets, (ii) the ability to "mortgage out", and (iii) the number and nature of permitted shareholders, there are substantial tax differences between a S corporation and an LLC or partnership.
Limited Partnership - A limited partnership provides an excellent vehicle for a company to be owned by various individuals, but with provision that only the general partner(s), and not the limited partners, shall control the company. The general partner may be an individual or for asset protection purposes it may be another entity, such as a LLC. Limited partnerships are often formed to provide parents with control over the company while permitting them to transfer limited partnership interests, in many cases on a discounted basis, to children and grandchildren and/or trusts for their benefit.
Professional Companies - Companies for professionals, such as doctors, dentists, lawyers and accountants, have other and different considerations then regular companies and, therefore, such professionals may wish to consider an LLP (limited liability partnership), a PLLC (professional limited liability company) or a PC (professional corporation). This article is not directly addressed to companies for professionals, although many of the matters discussed herein are pertinent to them.
Converting To An LLC - Because of the advantages of a LLC, many persons are tempted to convert their business to a LLC. Conversion of a partnership to a LLC is not usually difficult or complex. However, because of tax rules involving the transfer of corporate assets, the conversion of a corporation, even an S corporation, to an LLC may be fraught with problems and should be undertaken only after a careful review by tax counsel.
Check The Box Regulations - The IRS, in an effort to simplify the rules regarding the income taxation of various enterprises, permits unincorporated entities to "check the box" to determine whether it wishes to be taxed as a corporation or a partnership. While this article does not cover a detailed discussion of this matter, taxation as a partnership is generally preferred but the company's tax counsel should be consulted.
Voting and Non-Voting Shares - A corporation, even an S corporation, may be established or recapitalized to provide for voting shares and non-voting shares. This permits ownership to be partially transferred (in many cases to the children) without diluting control. LLCs and partnerships may also be set up to create voting and non-voting interests.
Terms Of Lease - There is far more to a lease than its term and rental payments. Among the factors to be considered are real estate taxes; escalation provisions; security requirements; personal guarantees; maintenance and upkeep; the right to assign or sublease; renewal options; ownership of improvements, such as trade fixtures; the right to cure a default; and apportionment or reduction of rent in the event of damages to the premises. Each lease situation is unique and there are many factors to be considered.
Banking Loans and Credits - Most businesses require a good banking relationship which offers options for loans and a line of credit. Business loans are not casually given by a bank, but careful consideration is given to the enterprise, its business, profits and financial standing, and to personal guarantees. While most banks wish to accommodate their customers, banks are not ready to assume unnecessary risks. Therefore, the business must be operated in a manner that will permit the bank to feel confident concerning the ability of the business to meet its financial obligations.
Contracts and Agreements - A company's "standard" form of its various contracts and agreements should be regularly reviewed and updated, not only to ensure that it is legally sufficient and adequately protects rights and interests but also to make certain that it will meet the full requirements of the business. A lawsuit avoided is far superior to a lawsuit won and vastly superior to a lawsuit lost.
Patents and Intellectual Property - Intellectual property, such as a company name, logo or an idea, are often extremely valuable. If a name, logo or idea, such as invention or manufacturing process, is valuable and unique and should be protected, then the owners should promptly consult with counsel. Proceeding without adequate professional advice can result in its loss, with the consequence that not only might competitors be free to use the intellectual property, but perhaps a competitor might obtain rights which will prevent the person who first thought of the name, logo or idea from utilizing it. The first rule is to consult with counsel before utilizing a name, logo or idea that may be susceptible to trademark, patent or copyright protection.
Employee Relations - Employees are the lifeblood of any business, and their loss can undermine and even devastate a company's potential. This is especially true where job hopping occurs, and training new people, if you can find them, is often a lengthy and costly process. Therefore, every effort should be pursued to maintain job satisfaction and instill in all employees a sense of pride in the company and in its goals and objectives. Of course, employee manuals should be considered.
Compensation Planning - Some employees are extremely valuable. Therefore, if there is the possibility that a valued employee may leave, and especially in cases where he or she might not only take customers but go into competition with the company itself, every effort should be made to adequately compensate the employee. Such compensation may take the form of an increase in salary, bonus, deferred compensation plan, stock options or even an ownership interest. There is no hard and fast rule, but the employer must be realistic concerning the value of the employee and provide for same.
Stock Ownership and Stock Options - One way of compensating employees is with stock ownership and stock options, possibly under an employee stock ownership plan (ESOP). In smaller, non-public companies the employees may be given a direct ownership interest, subject to an appropriate shareholders agreement. Of course, for the employee the hope is that the company will prosper and that the value of such stock will appreciate, perhaps to such an extent as to provide compensation to the employee far in excess of the salary he or she may be earning.
Employment Contracts - An employment contract is often essential. It defines the duties and obligations of the employee, and it may also contain provisions restricting the employee from engaging in or assisting a competing business if he or she should leave the company, or from divulging trade secrets or client lists. Courts are wary of enforcing such covenants where it may unreasonably limit rights to gainful employment. Therefore, restrictions on employees, especially if they did not possess an ownership interest, are often difficult to enforce. Moreover, what an employer may consider to be confidential information may not be considered to be as such by the courts, especially if such information may be readily obtained from other sources. Because of these difficulties, restrictive covenants should be narrowly tailored in terms of scope and duration.
Key Man Insurance - Key man insurance is insurance taken out on the life of a key employee. Its purpose is to provide compensation to the company in the event of the death of a key employee. It is used where an employee is especially valuable, such as in the case of a loss which might undermine the future profits or even viability of the company. Key man insurance is often essential to insure that loans and other company obligations will be paid, and bank lending officers often give key man insurance major consideration in evaluating a company's credit standing.
Shareholders Agreement - Where a corporation is owned by more than one person, a shareholders agreement is often essential. It restricts the free transferability of the shares so that the other shareholders will not find that due to death, disability or withdrawal, they have a new "partner", such as the deceased shareholder's family. Depending on its terms, a shareholders agreement may give the corporation and/or the remaining shareholder(s) an option or a mandatory requirement to purchase the shares of a deceased, disabled or withdrawing shareholder at a price and on terms mutually agreed to in advance. In many cases a shareholders agreement is funded with life insurance. Shareholder agreements may also be used to set the terms for management and control of the company.
Operating or Partnership Agreement - A shareholders agreement relates to a corporation. However, an LLC has a similar type of agreement called an operating agreement, and a partnership has its own agreement called a partnership agreement. The agreements for an LLC or a partnership are similar to a shareholders agreement, but in many respects are more extensive, especially with respect to the operation and management of the company.
Funding A Buyout - Shareholder, operating and partnership agreements generally provide for the purchase of an interest in the company in the event of death, disability and/or withdrawal of the owner. In cases where the purchase price is or may be substantial, there is need to consider obtaining proper funding for the purchaser(s). This especially applies where, considering the prospect of death, the estate may wish assurance that the purchase price will be paid or where the estate may be looking to obtain a substantial upfront payment. In such situations, it is common to provide that the business or the owners obtain life insurance on the life of each owner.
Split Dollar Life Insurance - A shareholder may desire to obtain life insurance, but is concerned with laying out the funds to pay the premiums, and would like the corporation to contribute a portion thereof. Under one type of split dollar arrangement the shareholder advances a portion of the premium and the corporation advances the remainder, and on the death of the shareholder the corporation will be repaid the amount advanced and the balance of the proceeds will be paid to the insured's beneficiary or perhaps an insurance trust. As a result of recent IRS income tax regulations, a split dollar plan is more complex and less desirable than in the past.
Business Succession Planning - Business owners often fail to properly contemplate the possibility of death, disability or withdrawal. Succession planning should always be considered, especially for mature business owners, since it is not usually something that can be undertaken on the basis of short term planning. If the business is to be sold purchasers may not be readily available, and if it is to be retained then family members and/or employees may not be adequately prepared to take over and carry on the business.
Sale of Business - The sale of a business raises many legal and tax questions including but certainly not limited to (i) whether to structure the sale as an assets sale or as a sale of the business as an entity, (ii) the purchase price and allocating it among the various assets sold, (iii) the down payment and the installment payments, (iv) security for the installment payments, (v) warranties and assurances concerning the business, (vi) restrictive covenants, and (vii) income tax considerations.
Acquisition of A Business - The acquisition of a business implies not only taking over a business but expanding an existing business. While business expansion is often achieved internally, opportunities often present themselves whereby the purchase of a similar or related business may increase the total business for an enterprise, add product lines, increase market share, permit a broader allocation of overhead and thereby increase overall net income. Some of the most successful businesses are the result of not just pursuing the original business, but over a period of years adding, divesting and adjusting the various units, products and/or services comprising the business.
Mergers, Spinoffs, Splitoffs and Splitups - If two or more businesses are being separately operated, and there is value to combining them, then consideration should be given to a merger or consolidation. Also, under appropriate circumstances the owners of one business, with two (2) or more divisions or departments, may wish to spin off a portion of the business so as to form two or more separate entities. Mergers, spinoffs, splitoffs and splitups are highly technical and the tax effects should be thoroughly considered.
Sale of Business Interests to Children - It may be advisable for the children to purchase business interests that are yielding substantial income and/or are appreciating rapidly. If the purchase price is paid in installments, the payments are frequently facilitated by the income earned on the interests purchased. Of course, capital gains taxes should be considered in connection with a sales transaction, and since it is a family transaction the accuracy of the price should be confirmed by outside sources, such as a qualified appraisal.
Gifts of Business Interests - There are two excellent reasons for gifting business interests to the children. One is to divest assets and thereby reduce potential estate taxes, and the other is to encourage family members who are involved in the business to remain with the business and possibly take it over at some future time.
Company Accountant - An accountant can be especially valuable in guiding the enterprise. . The accountant not only prepares the financial documents for the company but will advise the owner concerning tax and financial issues and in dealing with banks and lenders. Moreover, an accountant will work with legal counsel, especially with respect to business and estate planning.
Company Counsel - The attorney for a company should have a solid understanding of both corporate and tax laws and also be able to not only serve as company counsel but to work with attorneys who function in specialized areas, such as labor law, patents and trademark, securities work, pension and profit sharing plans and litigation. Company counsel who maintains a close relationship with the owners and possesses a broad understanding of their concerns and interests and who can also work with specialized counsel, can be invaluable.
Legal Audit - In far too many businesses legal matters are hardly ever considered and reviewed on a regular basis. Therefore, it may be helpful to undertake a legal audit of the business, checking the adequacy of corporate records, employment agreements, shareholder agreements, partnership agreements, contracts of sale, labor law matters, employment matters, etc. Business owners are frequently surprised at the extent of important information and concerns that may be brought to their attention as a result of a legal review. This is to be expected, as the focus of many owners is on day-to-day business details and planning and not on legal matters which can arise suddenly with little warning but have critical implications for the business.
Officers and Directors - The designation of persons as officers and directors is often perfunctory, such as designating the owner as President and his or her spouse as Secretary. Such designations are important, since acting as an officer and director carries potential for substantial liability, and perhaps officer's and director's liability insurance should be obtained. Moreover, a title is recognition of the value of an individual to the company; therefore it may be important to give a title to a valuable employee, especially if he or she is to be perceived of as especially essential to the company.
Annual Meetings - Annual meetings of the shareholders, directors, members or managers of a corporation or a LLC are usually required. This requirement should be carefully and regularly observed, as it evidences that the owners, directors or managers are operating the entity as required. In fact, observing the legal formalities makes it more difficult for a creditor to "pierce the corporate veil" and claim personal liability against owners, directors or managers.
Employee Claims - Claims by employees against companies and other employees are becoming more numerous and may constitute a substantial threat to the enterprise. Therefore, it behooves every owner or officer to make certain that employee practices are up-to-date and in accordance with existing law, and that the company is run in a manner that is as free as possible from claims of discrimination or harassment. This often requires the implementation of clear employment policies and the issuance of an employee manual in compliance with current law.
Employee Records - Since employee claims are becoming all too commonplace, employee records should not only be maintained but include such matters as notices to employees regarding the quality and nature of their services and any improper or questionable actions of the employee. Such records may be invaluable in case of later litigation, especially if a discharged employee's records reflect prompt and appropriate notices and warnings, and the discharge is carried out in a fair and nondiscriminatory basis.
Asset Protection - A business may represent a source of liability as well as profits. This liability may arise from the business, such as a partner being personally liable for partnership debts, but it may also be personal, such as guaranteeing bank loans, being the subject of an employee discrimination or harassment claim or simply the result of an accident or other catastrophe. Therefore, asset protection planning and risk management should be an integral part of business planning.
Insurance - There is more to insurance than life insurance. Insurance in connection with a business includes business insurance, directors and officers insurance, disability insurance, disability overhead insurance, business interruption insurance, umbrella coverage, fire and casualty insurance and credit insurance. Insurance is a complex area and while adequate insurance should always be considered an insurance specialist should be consulted.
Change of Address - When a corporation or LLC is formed, the company designates the Secretary of State as agent to receive legal process. Therefore, if the Secretary of State is served with a summons against a company, he will mail a copy to the company at the address last designated by the company, and such mailing will be considered as good legal service against the company. The concern is that if the company has moved and notice of the move is not given to the Secretary of State then, despite a lack of actual knowledge of the suit by the company, the company may soon find itself with a judgment against it. Therefore, the company should make certain that its address with the Secretary of State is always up-to-date.
Business Ownership Records - In many cases the owners of a business are unaware or inattentive of the need to clearly document ownership interests, such as maintaining stock or other ownership records. While some minimal records may be kept, in many cases there is a feeling among many business owners that such transactions and records could always be located, updated and explained. However, if an owner withdraws, becomes disabled or dies, or if a conflict arises or if the documents are lost, then such information may not be readily available, and this may lead to bitter, costly and ongoing litigation to determine ownership rights to the business.
Minute Books - Complete and up-to-date minute books are important. The minute book should contain the history of the entity including such matters as the articles of incorporation, filing receipts, the shareholders or operating agreement, and a record of those persons designated as officers, directors and/or managers. All important documents and information should be carefully retained and documented.
Estate Planning - Estate taxes can be substantial. In fact, the lack of a proper estate plan may devastate the ability of an owner to pass on his assets and business to his heirs. Therefore, every business owner must consider the effect of estate taxes on his business and those estate planning strategies that may be employed to reduce, postpone or possibly even eliminate such taxes. Estate planning is a separate subject by itself, and it should be carefully and fully considered.
IRS Circular 230 Disclosure Notice – The advice in this article is not intended or written to be used for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
Caveat - The foregoing statements have been condensed in an effort to clearly convey the essence of the matter. Business planning involving legal issues is highly technical and complex and requires the assistance of a knowledgeable corporate attorney. Business Planning From A Legal Perspective is intended to help keep clients informed on issues which relate to business planning and legal matters. However, the information is of a general nature and may not convey all of all of the essentials required or may not apply fully to your situation. For specific advice on how to apply this information to your particular situation or circumstance, contact the attorneys in the LBC&C Business Planning and Transactions Practice Group.
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