A three-pronged look at setting up your business
By Jeffrey L. Cohen
How can I manufacture or acquire my product? Who will buy it? Where can I get a reasonable location?” These are typical questions running through an entrepreneur’s mind. They are among a daunting menu of sales, employee, office and cash-flow issues to be digested when starting a new business. Legal matter sometimes are pushed aside. Those who postpone such issues, however, later may regret their lack of foresight.
Legal issues for new business can be divided into three stages: initial planning, long-term operation and facilitating the future of a successful enterprise.
THE INITIAL STEPS
Planning the structure of a business is an entrepreneur’s first legal task. The choice among a corporation, partnership or other forms is affected by a surprisingly large number of factors – including the tax, treatment of the entity and its owners, limited liability, expense of formation and maintenance of the entity, the number of owners and rules relating to public offerings.
Making the entity choice is important before would-be owners open for business. A midstream choice or change of entity might be inconsistent with earlier actions, which can cause tax problems, accounting difficulties, liability issues and disagreements among the principles. The various entity choices are:
- Sole proprietorship is the oldest and simplest form of doing business. Being easy and inexpensive, it is the de facto choice of many individuals. No formalities are required, and planning options are limited in the areas of taxes, liability and growth.
- Add one more owner and automatically you have a partnership. Although not required, a partnership agreement should be put in writing. While it does not have to be complex, an agreement between two or more partners should be written to protect each person’s interests and possibly their friendship. Matters that must be covered include: the method for determining and distributing profits; withdrawal and admission of future partners; and termination of the business. Be aware that partners are liable for all debts of the partnership, not just their proportionate share. Also, any one partner can legally bind the entire entity usually is chosen for real-estate or similar investment ventures.
- The limited partnership is a variation of general partnership. Although the tax treatment to partners is similar, only general partners are liable for partnership debts. Limited partners will not be liable for such obligations, and their identity also can be withheld from the public. This choice requires the filing of documents with the Georgia secretary of state and, therefore, the general partner’s name will be on public record. Limited partners now can participate in the business without losing their limited liability. This entity usually is chosen for real-estate or similar investment ventures.
- Corporations, though widely misunderstood and too often sloppily constructed, remain the entity of choice for many businesses. It requires formalities such as registration with the secretary of state and regular, sometimes complex, paperwork to ensure its existence. Entrepreneurs who entrust their incorporation to anyone other than a corporate attorney may save money, but likely will multiply the chances of future nightmares, including judicial dissolution (piercing the corporate veil), shareholder litigation, IRS disallowances and reallocations, or worse.
A properly maintained corporation, however, rewards its shareholders with limited liability, continuity, separate tax status, a variety of planning options and legitimacy in the business world. Even when entrepreneurs are wise enough to have a corporate attorney incorporate their business, it is important to ensure that all conceivable original documents and tax elections are preformed, and request that attorney properly instruct you in the rules of corporate governance.
A commonly overlooked point is that the well-known “S” corporation and “C” (or regular) corporation are identical, from a state corporate-law viewpoint. These respective corporations refer to subchapters of the Internal Revenue Code and therefore deal only with the tax treatment of the entities and their shareholders. Regular corporations are separate, legal taxpayers and pay taxes on taxable income. Any dividends to be paid to shareholders necessarily come from funds remaining after taxes have been paid.
Not surprisingly, S corporations are popular because they do not pay taxes. Earnings are taxed to the individual shareholders, based on their proportionate ownership. It is crucial, however, that the entrepreneur discuss taxation of these earnings with a tax advisor because they are taxable, even if such dividends are not distributed to shareholders. Deciding whether the corporation should be required to distribute enough of its earnings to enable shareholders to pay the taxes mandates understanding the differences between S and C corporations.
- The new kid on the business block is the limited liability company (LLC). Courtesy of Georgia General Assembly, this hybrid exhibits the best characteristics of the limited partnership and the corporation, and will be available March 1. Offering a single level taxation, limited liability, flow-through tax treatment, and an unlimited number of member-owners, the LLC likely will not be used by small businesses, but rather by real-estate ventures and groups unable to qualify as S corporations.
After choosing the entity’s structure, an entrepreneur needs to look at legal issues affecting business operations. Some of these are common to most businesses, and others, while not so common, still provide the potential for headaches.
- Employment agreements are not something the law forces the business owner to consider. An owner can fire an employee at any time for almost any reason, keeping in mind that impermissible factors behind a termination include sex, race, age and certain disabilities. The intelligent entrepreneur will understand that key employees may want agreements to protect their income and careers. The entrepreneur will want written employment agreements that protect his or her ownership of crucial elements of the business. Although the possibilities are unlimited, common elements of employment agreements include: whether advances are to be repaid on termination; whether there is a guaranteed minimum term to the job; whether any income level is guaranteed; who owns patents or inventions developed on the job; who owns customer lists or the customers; and when do profit-sharing or stock options begin. If either the employer or employee makes a verbal agreement that is important to the other, he or she should put it in writing.
Non-complete clauses often are seen in employment agreements as well as sales of entire businesses. Although non-competes are enforceable against employees and former owners of a business, they must be drafted carefully to withstand court scrutiny, which clearly discourages them; Georgia courts generally feel a person should not be restricted from earning a living. An attorney can tell you whether the previous owner of your business can legally compete with you, if the restrictions signed by employees are enforceable, and what the enforceable limits are.
- Although not known as a traditional legal field, the subject of payroll tax deposits deserves mention. Approximately 30 percent of businesses incur late payment or late filing penalties each year because of the old tax deposit system’s complexities. (Others incur penalties because they simply don’t have the funds to pay the government). Ask a CPA to explain the simple, new, monthly/semiweekly deposit system or use a payroll company. Additionally, owners, partners and key employees need to be aware they might individually be held liable for unpaid business payroll or sales taxes. Although this is a company obligation, the 100 percent penalty means individuals can be held liable for taxes withheld form employees and not paid to the IRS.
- Leases generally are unpleasant documents on which every entrepreneur will be forced to spend a lot of time. First, do not assume the only important issue is the square-foot rental rate. This intimidating document is rife with traps, from common-area expenses to relocation clauses. Despite what the landlord’s agent says, this document is negotiable. Pay close attentions to items such as the grace period for late payments; the landlord’s remedies upon default; repair obligations for specific, expensive items; renewal provisions; notice periods; early termination; and every single cost you will be responsible for paying. Of utmost importance is the personal guarantee: do not sign this without giving your best effort toward negotiating this potential land mine. Consider a declining guarantee balance, a short-term, limited dollar amount, and other creative methods that still will afford some comfort and protection to the landlord.
- Many business owners rely on a special logo, name or trademark as a key ingredient in their companies; sales. Consequently, they will be very interested in protecting use of that mark. Do not assume simply because you are using a mark, or because you have registered a state trademark, that your right to use it is protected. This is a very specialized field of law and experienced counsel may be necessary to protect your sacred name or secret formula.
The future of your company someday will be just as important as its present. Among the issues you and your professional advisors will discuss are retirement plans (the best tax shelter available), shareholder agreements and buy/sell plans.
Finally, the entrepreneur will reach a stage when planning for succession of ownership will become a paramount concern. Whether the business will be sold to employees, minority shareholders or a third party, or even if it is to be transferred to a younger generation, legal planning for a variety of such possibilities, along with maintenance of the corporate and financial records will be indispensable when the time for succession occurs.