Business Entity Formations Nema Koohmaraie and Matt Hinrikus UNL College of Law – Entrepreneurship Legal Clinic

Disclaimer The content of this presentation is intended solely as a brief summary of entity choices available to individuals starting a business operation. The information provided during this presentation shall not be construed as legal advice We are not tax experts. Consult your accountant or tax attorneys to supplement the tax considerations

Discussion Points Overview of Business Entity Structures Benefits & Values of Entity Formation Types of Entities Sole Proprietorship Partnership – General or Limited Corporation – C-Corp. or S-Corp. Limited Liability Company (LLC) Differences

Benefits of Entity Formation Corporate Shield – a.k.a., liability protection Appearance of Legitimacy Means to raise capital from outside investors Method of combining valuable assets E.g., intellectual property Business continuity and planning What we mean by the “corporate shield’ is that by creating a Corporation or LLC (we’ll get to later in the presentation), shareholders, limited partners, and liability company members, among others, are generally not liable for the liabilities of the company in which they have an ownership interest. HOWEVER, until a company is formally incorporated by filing documents with the State, the entrepreneur is acting in a personal capacity and is personally liable

Sole Proprietorship Composed of one individual who owns and operates a business – Default entity No separation or distinction as between the owner and the business No statutory requirements to create Trade Name Application if going to conduct business in something other than the name of the owner Applicable licenses or permits Unlike corporations and LLCs, it is considered to be “without” a ‘legal’ structure Unlike all the other business structures we’ll discuss, sole proprietorships are “creatures of business engagement” Legally speaking, the business owner and the business are the SAME actual & legal person

Sole Proprietorship Taxation Liability of Owner Owner of the business reports income or loss directly on his or her personal income tax return Liability of Owner Owner of the business is personally liable for debts & obligations of business and for negligent acts committed by themselves and their employees if acting within the scope of employment It is important to note that in our hypothetical, or in any case where there remains only one business owner, he or she CAN have employees. In this case, because there is still only one business owner, the legal structure remains a sole proprietorship. Personally liable means in a lawsuit, the suing party can come after the personal assets of the business owner. **Business owners operating as a sole proprietorship CAN attempt to limit their liability via contract law e.g., can only go after certain assets in a K claim Liability can be mitigated only to the amount of the liability insurance policy

Partnerships An association of two or more persons to carry on a business for profit as co-owners Two Types General Partnership Limited Partnership Why choose a partnership? – simple way to pool resources amongst individuals “Persons” includes entities “Business” means any trade, occupation, or profession When these characteristics are present, a rebuttable presumption exists that the business is operating as a General P’ship Neb. Rev. Stat.  presumption – profit-sharing is indicative of a partnership

General Partnership Partnership Formation Operations Default entity Automatically forms when two or more individuals are carrying on a business for profit as co-owners Operations Partnership Agreement; OR Revised Uniform Partnership Act (governing law) Nothing must be filed with the state. To override the state’s P'ship statute, the parties must execute a P'ship Agreement – GET IT IN WRITING! certain limitations and items that canNOT be overridden unreasonably restrict right of access to books & records eliminate duty of loyalty unreasonably reduce duty of care eliminate obligation of good faith and fair dealing vary the power, of a partner, to dissociate as a partner [among others]

General Partnership Taxation Partnership files an informational income tax return, but the Partnership itself does not pay income taxes Pass-Through Entity Income or loss is attributed to the owners/partners equally Note: Sharing of profits or losses can be determined by the Partnership Agreement Similar to Sole Proprietorships all owners/partners of the business are personally liable for debts & obligations of business AND of torts committed by himself or other partners if acting in OCB or w/ authority of the P’ship

General Partnership Liability of Owners/Partners Shared liability by all partners Joint and Several Any one partner can bind other partners Contract Negligence

General Partnership Advantages Disadvantages Simple and Inexpensive to create Partners report their share of profits or losses on their own income tax return Disadvantages Partners are personally liable for debts & obligations of the business

Limited Partnership Formation Operations – Two Types of Partners Must file a Certificate of Limited Partnership with Secretary of State Operations – Two Types of Partners General Partners: Active investor and actively involved in the day to day operations and management Limited Partners: Do not participate in day to day operations and management – passive investors Limited partnerships are created when one or more partners would like to join the business venture, but wants to also limit their liability Note the difference! – first business entity structure that REQUIRES the individuals to file with state Note: I.R.C. has Passive Activity rules which reduces the amount an individual can deduct as losses if the venture constitutes a “passive activity” w/in the I.R.C.   Query: When does a limited partner do enough to be classified as a general partner? too much involvement by a limited partner could result in losing the liability protection – BE CAREFUL!

Limited Partnership Taxation Liability of Owners/Partners Based on value of individual contributions Tax liability is not equal among partners Liability of Owners/Partners General Partners: Subject to personal liability for debts & obligations of business (similar to General Partnership) Limited Partners: Not subject to personal liability for debts & obligations of business

Limited Partnership Advantages Disadvantages Limited partners are not personally liable for business debts (generally) General partner can raise capital from the passive investors (limited partners) without giving up management in business Disadvantages General Partners are personally liable for business debts

Alternatives Is there a way to limit the liability of all owners while allowing easy transferability of ownership interests? YES – Corporations or Limited Liability Companies

Limited Liability Entities Our purpose today  Corporations or LLCs Legal entity, separate & distinct from the owners Created by statutory law Limited liability of business owners Not liable for debts incurred by the business Unless exceptions apply – Piercing Corporate Veil Nebraska Business Corporation Act Nebraska Uniform Limited Liability Company Act (NULLCA) Limited Liability  THE reason why people incorporate; it protects their personal assets and well-being from the business risks and obligations Explain PCV doctrine  essentially, corporations and LLCs (more so corporations) are required to follow certain corporate formalities such as annual meetings. Failure to do so may result in a Court invoking the PCV doctrine which essentially treats the business entity and the owners as own, thereby making the owners personally liable for the debts of the business – Courts say the owners have treated the business as their “Alter Ego”

Requirements Must file with the Nebraska Secretary of State Articles of Incorporation (Corporations) Certificate of Organization (LLCs) Must draft and execute – governing document Corporate Bylaws (Corporations) Operating Agreement (LLCs) Depending on the statute, certain information is required to be included in the Articles of Incorporation and Certificate of Organization For example, for Articles of Incorporation (1) corporate name, (2) # of shares corporation is authorized to issue and type of classes, (3) street address of registered office and agent (4) name and address of each incorporator, (5) provision if you’re limiting or eliminating the requirement of annual meeting of SH Governing document must be drafted and executed, but is NOT required to be filed with the Secretary of State essentially, it governs the operations of the business

Limited Liability Entity or Not Increased Likelihood of incurring liability Selling products or services Hiring more employees Entering into contracts – e.g., leases, loans, sales Multiple owners Additional investors What are some things to consider when deciding to “incorporate”

Corporation or LLC Things to Consider: Financing needs Management Investors, Venture Capitalists, Angel Capitalists tend to prefer corporation status Management Board of Directors & Officers (Corporations); OR Member- or Manager-Managed (LLCs) Tax & Liability They prefer the corporation status because of the stock and governance traits corporations have been around much longer so Courts have much more familiarity with them and the issues surrounding them Some investors may also consider State of Incorporation Delaware, as compared to Nebraska, has a long and rich history of interpreting, deciding and developing corporate law

Corporations Corporate law is state law Approx. 50% of corporations incorporate in Delaware Internal Affairs Rule: the laws of the state of incorporation govern internal corporate affairs Foreign Business Rule: if incorporated in a state other than where conducting business, must qualify/register to operate business in the “foreign” jurisdiction

Corporations Operations Shares of Stock = Ownership Interest = Shareholder Board of Directors = primary decision makers Election process is established in the Articles or Bylaws Can reserve certain decision-marking authority to Shareholders Officers = day to day decision makers Elected by Board of Directors President, VP, Secretary, Treasurer, etc. **In most closely-held corporations (aka, small businesses) many of the same people with be the Owner/Shareholder, on the Board of Directors, and an Officer Thus, it is absolutely critical that when you are acting on behalf of the business, you are cognizant of what “HAT” you’re wearing

Corporations Liability of Owners/Shareholders Separate legal entity, distinct from Owner/Shareholders General Rule: Entity is liable for corporate debts & obligations Exceptions: Piercing the Corporate Veil (PCV) Personal Contractual Guarantees PCV, as explained earlier, is a judicially-created exception to the rule of limited liability. It is a fact intensive analysis that varies from case to case.

Corporations Two Choices: C-Corporations (C-Corp.) S-Corporations (S-Corp.) There are two main types of corporations one should consider **Note, in the eyes of the State of Nebraska, there is no difference. Only in the eyes of the IRS is there a difference. Difference is what Subchapter of the I.R.C. is the corporation taxed under

C-Corporation Taxation Double Taxation First, taxed at the corporate level – corporation reports and pays income taxes Second, taxed at the individual level – shareholders report and pay income tax on any distributions paid out to them Note: this does NOT mean you pay twice as much in taxes!

S-Corporation Corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code File Form 2553 Taxation Pass-Through No taxation at corporate level Only taxed at individual level if shareholders are paid distributions Election – must intentionally seek status as an S-Corp. Pass-Through Taxation is the MAIN benefit in S-Corp. status Liability – same as the C-Corp.  limited, unless an exception applies

S-Corporation Restrictions on S-Corporation Domestic Corporation Allowed only 1 class of stock Maximum of 100 shareholders Shareholders must be U.S. citizens or residents Profits and Losses allocated proportionately Restrictions on S-Corp. status: All SHs must be an actual human being, not an entity – could provide issues with investors that want to invest through another business entity Can only have 1 class of stock – could provide issues with investors that want preferred stock CAN have voting and non-voting classes of stock, though Maximum of 100 SHs Domestic Corporation Profits & Losses allocated proportionately

Limited Liability Company Flexible structure: Can take the form of a General Partnership, but provides the limited liability of a corporation Formation Must file Certificate of Organization with Nebraska Secretary of State In legal jargon, LLCs are relatively “young” – first state passed legislation in 1978 – so there just is not as much case law or judicial interpretation or development of LLC law

Limited Liability Company Operations Operating Agreement (governing contract) Nebraska Limited Liability Company ct (governing law) Management Structure Member-Managed – Default All members (owners) have decision-making authority in day to day operations of business Manager-Managed Must be elected in the Operating Agreement Decision-making authority is given to one or more persons

Limited Liability Company Taxation – various possibilities Default: Pass-Through entity Election C-Corporation treatment: taxed at corporate and individual levels; OR S-Corporation treatment: Pass-Through entity Liability Neither members or managers are subject to personal liability for debts & obligations of business Liability  same exceptions from the corporate context apply here as well!

Limited Liability Company Advantages Owners have limited liability for business debts even if they participate in management of the business Profit and Loss can be allocated differently than ownership interest Choice of taxation structure Disadvantages More expensive to create than a Partnership or Sole Proprietorship

Summary Business Entity Formation matters greatly Tax Implications Liability of Owners Future Financing & Investor Preference Internal Operations Default Rules

Contact Us Write us: Entrepreneurship Legal Clinic University of Nebraska College of Law 7 McCollum Hall Lincoln, NE 68583-0902 Give us a call: 402-472-1680 Visit our website: http://law.unl.edu/eclinic