"This month's column returns to nuts-and-bolts, this time business entities — partnerships, corporations, limited liability companies — and just a general rundown on how a business is organized. These issues are often neglected at the time of a business's startup, and business owners often pay dearly down the road for overlooking some necessary details.
The simplest example is a one-owner business. By default, it is a "sole proprietorship." The owner's personal tax return has an attachment called "Schedule C," which includes the business's financial statements in the form required by the IRS.
The most popular and desirable substitutes for the sole proprietorship are the corporation and the limited liability company (or "LLC"). Both are creatures of statute. Either type of so-called "artificial entity" can own property (including real property (i.e., land), intellectual property (e.g., trademarks, copyrights and patents) and personal property (most everything else), bring lawsuits, be sued, enter into contracts, and do most other things that a natural person can do.
There is little difference between corporations and LLCs. Both are created by filing something with the secretary of state, either articles of incorporation (sometimes called a charter) for a corporation or articles of organization for an LLC. Corporations are owned by shareholders; LLCs are owned by members. In either case, the owners designate people to operate the entity, directors and officers for corporations or managers for LLCs. Corporations have bylaws; LLCs have operating agreements. But where there is only one owner or a small number of them, the functionality of corporations and LLCs is identical as a practical matter. In such cases, the decision as to whether to use the LLC or corporate form is normally the accountant's call, not the attorney's. Accordingly, from this point forward, only corporations will be considered, because the only difference from one to the other at this level is the type of documents that your attorney draws up for you. LLCs are trendy, by the way, but not necessarily the better choice. By all means, consult with your accountant.
There are a number of "old wives tales" about corporations, most notably — after the misconception that it is a good idea to incorporate in Nevada regardless of whether you live there — the notion of limited liability. Liability is limited, but not entirely so.
This is how it works: Assume that a corporation owns a delivery truck and, in the course of making a delivery, the truck's driver negligently crashes into someone. Theoretically, the victim can sue both the driver and the corporation, and collect from either. (The particulars vary according to state law.) In a one-person corporation, likely the driver is also the sole owner of the corporate stock. So the corporation does not really insulate him from liability. The same would be true for copyright infringement.
However, if the driver of the delivery truck is a corporate employee that is not the owner, or if the one engaging in copyright infringement is a non-owning employee, there is a limit of liability. The plaintiff could sue the driver or the copyright infringer, as well as the corporation, but could not sue the shareholder on a personal basis, so long as the shareholder was not personally complicit. Note: These kinds of risks should be covered by insurance.
Where using a corporation becomes really important, however, is when a business venture fails. Suppose a business gets going, begins steadily making money and indeed thrives; but then things take a turn for the worse. The market dries up, or the company fails to keep abreast with technology. Suddenly, the corporation is deeply in the red, losing more and more money each month. This is where the difference between a sole proprietorship and a corporation becomes substantial. Assume that the owner decides to shut the doors to the business. If the business is operated by an unincorporated individual, the creditors can sue the owner personally for the business's debts, which makes sense because the owner and the business are the same. The owner of corporate stock, on the other hand, is not liable for the contractual debts of the corporation.
This is of particular significance in light of the recent reforms of the bankruptcy laws. If a corporation files Chapter 7 bankruptcy (which is the conventional version, rather than reorganization), it simply shuts down. The assets of the corporation are distributed to the creditors, as long as the assets last. The corporation then simply evaporates.
Under the new bankruptcy reform laws, being in business without a corporation can be very dangerous, since it is extremely difficult, if not impossible, for an individual to discharge business debts, thanks to the "reform." Contrary to what has been the practice for decades, an individual cannot file bankruptcy and be allowed to "start anew." A corporation still can be dissolved, and its owner can start anew with a substitute corporation.
There are exceptions to limited liability. Corporate officers and directors can be held responsible for corporate taxes and unpaid wages under circumstances that are beyond the scope of this article. And don't forget the delivery truck driver.
To avail yourself of corporate protections, there are several important rules. The first is to make sure that taxes get paid, especially employee withholdings, because you can be personally on the hook for those. Second, be sure you are properly insured. Third, it is important to follow corporate formalities, which means having an attorney and a CPA. All too often, a business owner can face personal liability because he overlooked the required formalities such as issuing corporate stock, drafting bylaws, conducting annual meetings (or executing waivers) or, most importantly, failing to keep corporate and personal funds separate. Also, it is especially important that the corporation remain in good standing with the secretary of state. Your attorney will draft the required documentation, and your CPA will be sure you are not undercapitalized, and explain to you how to maintain separate bank accounts and maintain the formalities of paying yourself a salary and taking draws. If you learn anything from this article, learn this: Have separate corporate and personal bank accounts; have corporate credit cards and personal credit cards; and use the corporate accounts for corporate expenses and the personal accounts for personal expenses. Always! No exceptions!
There are other good reasons to incorporate, the most significant being the perpetual existence of a corporation. For example, if the owner of a sole proprietorship dies, so does the business, and the business assets are distributed to the heirs. But a corporation survives intact. It maintains its contracts, leases, property ownership, and so on, notwithstanding the owner's demise. Also, a corporate business can be partially or entirely sold without affecting its day-to-day activities. For example, if a corporate owner is getting on in years and wants to turn the business over to her children, she can do so gradually, phasing out her ownership. Yet, the transition is seamless.
That brings us to the next step, which complicates things immensely: Partners. There are very good business reasons to have partners, but a business with two owners is 10 times as complicated as a business with only one.
For starters, the worst imaginable form of business entity is a general partnership, unless the partners are corporations. In addition to the good reasons for a sole owner of a business to incorporate, a multi-owner business that is not incorporated is, by definition, a partnership — and partners are each personally liable for all of the debts of the partnership. Thus, if you are a 10 percent partner, you are typically entitled to 10 percent of the profits, but always can be on the hook for 100 percent of the partnership's indebtedness.
There are many considerations when starting a multi-owner corporate business, and here are just a few of them: What happens if one of the partners dies? Gets divorced? Stops performing, either of his own volition or because of disability? Decides she wants to sell out? Goes personally bankrupt? This is complicated further by the fact that many partnerships are formed because one partner has money and the other has talent; or because the partners have differing kinds of talent (a simple example being a vocalist, a piano player, a bass player and a drummer).
While the nuances of this are beyond the scope of this article, there are several measures that can be put into place to avoid, for example, finding yourself in a partnership with your deceased partner's three children. One is a so-called "buy-sell agreement." Assuming the business is owned by two 50-50 partners, the partners might write a contract agreeing that the business is worth, for example, $2 million. The contract might go on to provide that if either partner dies, his stock will be bought out by the other for $1 million; and further that each partner buys a life insurance policy on the other for that amount, the proceeds of which are earmarked for the buyout. So, if Partner B dies, his life insurance pays $1 million to Partner A, which Partner A uses to buy all of Partner B's stock from his estate.
Another typical provision in a small-business arrangement is that nobody can sell his shares in the corporation without the approval of all of the other shareholders. (Otherwise, by default, shares of corporate stock can be sold.) Agreements also usually require that the partners devote to the business their full-time efforts (as defined in the agreement), and that they not invest in other businesses without consent of other shareholders.
There obviously is much more to all of this, and this is nothing more than an alert to some of the mines in the corporate minefield. Obviously, employing the services of an attorney, a CPA and a business insurance agent are imperative.
(Clyde DeWitt is a Los Angeles attorney whose practice has been focused on adult entertainment since the early 1980s. He can be reached through AVN's offices, or at [email protected]. Readers are considered a valuable source of court decisions, legal gossip and information from around the country, all of which is received with interest. Books, pro and con, are encouraged to be submitted for review, but they will not be returned. This column does not constitute legal advice but, rather, serves to inform readers of legal news, developments in cases and editorial comment about legal developments and trends. Readers who believe anything reported in this column might impact them should contact their personal attorneys.)
