Business Formation

The first step in structuring a company is deciding what kind of business entity to form.

There are six common business types:

1. Sole proprietorship
2. Partnership
3. S-corp
4. C-corp
5. Limited Liability Company
6. Single Member Limited Liability Company

You should consider these factors when selecting a business type:

• Limited liability vs. personal liability
• Tax Implications
• The complexity of formation and management
• Capital: The effect on the ability to raise capital through angel investment, venture capital, or initial public offering (IPO);
• Credibility in the business world

Types of business entities

Sole proprietorship

There are several advantages to choosing sole proprietorships:

• A sole proprietorship is good for an individual (or husband and wife team) who are carrying a business for profit
• Unlimited personal liability
• A single level of income tax, which means you report all income and expenses on Schedule C of the owners’ 1040
• Relatively simple to start
• Any transfer of the business would be of the underlying assets as opposed to transfering shares in the business

Partnership

There are several advantages and disadvantages to choosing to file as a general partnership.

Advantages

• General partnerships are typically associated with two or more co-owners carrying on business profit
• Partners have unlimited personal liability for partnership debts
• Pass-through tax treatment (partnership files form 1065, but all income and expense items pass through to individual partners on Schedule K-1)
• Relatively easy to start; partnership agreement is typically entered but is not legally required
• Managed by the partners or as described in the partnership agreement

 Disadvantages

• Any partner can bind the partnership;
• Ability to raise capital limited since most investors would prefer to invest in an entity offering limited liability;
• LLC is almost always the better choice if partnership tax treatment is the goal.

S-corp

Advantages

• Limited liability for shareholders even if they participate in the management
• Pass-through tax treatment under most circumstances but not as complete as for the LLC
• It is easier to convert S corp to a C corp than it is LLC to C corp if venture capital is sought

Disadvantages

There are a few limitations on the number of shareholders and raising capital:

• Limit of 100 shareholders
• Only one class of stock is allowed so ability to give priority return of capital to investors is compromised
• Differences in voting rights is allowed
• Partnerships and corporations cannot be shareholders
• Only citizens or residents of the USA can be shareholders

How to form an S-corp

When forming an S-corp, entrepreneurs and business owners should prepare to:

• File Articles of Incorporation with the Secretary of State
• File Sub S Election with IRS
• Adopt bylaws
• Adopt a shareholder (buy-sell) agreement

C-corp

Advantages

• Limited liability for shareholders even if they participate in management
• Tax at both the corporate and shareholder level. You can avoid this double-level tax to some extent by paying reasonable salaries to shareholders in exchange for services
• The formation is similar to an S-corporation, except the Sub S Election is not filed with the IRS
• Typically required for publicly traded corporations, businesses that require venture capital, or if a broad-based stock option program is used
• No limits on type or number of shareholders
• Different classes of stock allowed (common and preferred stock) thus enabling different priority for return capital

Limited Liability Company

Advantages

• Combines limited liability provided by a corporation with pass through partnership tax treatment
• LLC files a partnership tax return with all income and expenses being passed through individual owners of the LLC
• Can be managed by the members or, more often, by managers selected by the members. Can also elect officers
• Self-employment tax treatment less favorable than for S corporation

Advantages over an S-corp

• No limitation on the number of members
• No limitation on who may invest (corporations, partnerships, and more US residents can invest)
• Treatment of gain on the distribution of appreciated property more favorable
• Different classes of ownership are allowed, so there is the flexibility to provide for a priority return of capital to investors

How to form an LLC

When forming a Limited Liability Company entrepreneurs and business owners should be prepared to:

• File articles of organization with the Secretary of State
• Contribute an appropriate amount of capital
• Adopt an operating agreement

Single Member Limited Liability Company

Advantages

• Limited liability for owners, which makes it a better choice than a sole proprietorship unless the cost of formation or maintenance is a controlling factor
• Disregarded entity for an income tax perspective: All income and expenses are reported on the sole member’s tax return, and no income tax return needs to be filed by the LLC
• Formation process is simple to multiple-member LLC, except that the operating agreement will likely be less complex
• To circumstances where a sole proprietorship would be considered, a single-member LLC is often used by a corporation or LLC to insulate the liability associated with a particular line of business

Types of agreements

Typically, there are two types of initial agreements: bylaws and shareholder agreements.

Bylaws

• Procedures for shareholder and director meetings
• Terms of directors and how elected, types of officers and officer duties, and indemnification provisions for officers and directors

Shareholder Agreements

• Restrictions on the transfer of ownership (including upon the death, disability, or cession of employment)
• Provisions for resolving deadlock among the shareholders
• Method of establishing the price of shares
• Right to purchase additional shares issued by the corporation (preemptive right(s), rights to sell shares if other shares of the corporation are sold (co-sale rights)
• Ownership of Intellectual Property

There are some other types of agreements

LLCs have Operating Agreements

• Take the place of both the bylaws and shareholder/buy-sell agreement used for a corporation
• Address issues such as types of membership interests, who owns the membership interests, rights and duties of members, whether the LLC is member managed or manager managed, rights and duties of any officers, capital accounts, allocation of profits, transferability, and indemnification of managers, employees and agents

Some Notes on Piercing the Corporate Veil

• Limited Liability associated with a corporation or an LLC can be lost if appropriate formalities are not followed
• Corporation or LLC should be appropriately capitalized upon set up;
• Annual meetings of shareholders and directors (or members and managers if an LLC) should be conducted and minutes of those meetings placed in the corporate or LLC book
• Separate financial records and bank accounts should be maintained for corporation or LLC

Employment Agreements are designed to outline and ensure

• Nondisclosure of information trade secrets
• Non-competition
• No solicitation of employees and customers
• Assignments of ownership of instinctual property to company Illinois Employee Patent Act
• Employee duties
• Compensation
• Term of agreement and ability of parties to terminate

Four common ways to use company equity to motivate and retain Employees

• Incentive stock options
• Nonqualified stock options
• Restricted stock
• Phantom Stock

Common errors

Below are some of the common mistakes made by new business owners and entrepreneurs.

Errors which could prevent future funding opportunities

Entrepreneurs sometimes:

• Fail to consider employee’s or founder’s obligations to other employers
• Create a “cheap stock” tax problem by failing to incorporate early in the life of the company, or include all the ‘founders” before a funding event that will set the price of the stock
• Fail to make 83(b) elections on stock issued in return for services
• Considering only the valuation as investments are negotiated

Intellectual property errors

Entrepreneurs sometimes:

• Fail to properly register trademarks
• Fail to secure rights from founders to all needed IP by assignment or licensure
• Fail to address how jointly owned patents are to be licensed and utilized in joint development situations
• Fail to file US patent applications within one year of public disclosure or other statutory bar
• Fail to consider international patent protection prior to disclosure (no one year grace period)
• Fail to use nondisclosure agreements