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If you wish to incorporate a business it is important to keep two principles in mind – limited liability and an efficient tax structure. The two types of corporate entity that best provide these for small business, the S-corporation and the limited liability company, are discussed below.
The limited liability company is a relatively new form of corporate entity. It provides limited liability for its owners who are called members. It is extremely flexible, because it can be managed by its members or by managers appointed by the members. In addition, there are fewer corporate formalities to be observed by a limited liability company than by a corporation.
The limited liability company does not pay income tax on its profits. Instead the owners (or members) of the limited liability company pay income taxes on the profits of the limited liability company in proportion to their ownership interest in the limited liability company.
To form a limited liability company articles of organization are filed with the New York Secretary of State. In addition, notice of the formation of the limited liability company must be published once a week for six successive weeks in two newspapers published in the county in which the limited liability is formed. An operating agreement between the members is executed to govern the running of the limited liability company.
An S-corporation, like a regular corporation, provides limited liability for its shareholders. The difference between a regular corporation, sometimes called a C-corporation, and an S-corporation is how profits are taxed. A C-corporation is subject to double taxation. That is to say the corporation must pay income tax on the corporation’s profits and shareholders of the corporation must pay income taxes when the corporation’s profits are paid out to them in the form of dividends. On the other hand, an S-corporation does not pay income taxes on it profits, instead the profits of the S-corporation “flow through” to the shareholders of the S-corporation who pay income taxes on the profits of the S-corporation in proportion to their share ownership.
An S-corporation has two levels of governance. The shareholders elect directors to oversee the overall operation of the corporation. The directors then elect officers, e.g., the CEO, the Treasurer and the Secretary, who manage the day to day running of the corporation. An S-corporation must follow certain corporate formalities such as holding annual shareholder and regular director meetings.
An S-corporation cannot have more than 100 shareholders and all shareholders must be either U.S. citizens or permanent residents of the U.S. In addition, an S-corporation cannot have more than one class of stock. This can become an issue if you wish to raise capital for your business, as in many cases you would offer investors a class of stock different from that owned by the principal shareholders of the business.
An S-corporation is formed by filing a certificate of incorporation with the New York Secretary of State. The shareholders then elect the directors and adopt the bylaws of the S-corporation and the directors elect the officers of the S-corporation. In addition, the S-corporation must file an election with the IRS to elect to be treated as an S-corporation.
A Buy/Sell Agreement is an agreement by owners of an incorporated business to place conditions on their ability to sell their equity interest in the business. Note that by equity interest I am referring to shares of stock in a corporation, a membership interest in a limited liability company or a partnership interest in a partnership.
Equity interests in an incorporated entity can be freely sold by their owner. Buy/Sell Agreements are designed to prevent a business owner from selling his or her equity interest to a third party that the other owners do not want to be in business with. Therefore, the most basic provision in a Buy/Sell Agreement requires an owner wishing to sell his or her equity interest in the business to a third party to obtain the consent of the other equity holders to the proposed transaction.
However, if the non-selling equity owners refuse to permit the sale by an equity owner to a third party a stalemate may result. To address this problem a “right of first refusal” can be included in the Buy/Sell Agreement. A “right of first refusal” requires a selling equity owner to first offer his or her equity interest to the non-selling owners who can purchase the equity interest on the same terms as the proposed third party sale. Only if the other equity owners do not exercise their right of first refusal can an owner sell his or her equity interest to a third party.
A right of first refusal can also state that a selling equity owner must offer to sell his or her equity interest to the corporation or limited liability company as the case may be. This makes a Buy/Sell Agreement useful in preparing an estate plan for owners of equity interests in small businesses.
When an owner dies, his or her equity interest will pass either by will or intestacy to his or her heirs. The heirs may not want an equity interest in a business and the surviving equity owners of the business may not want the heirs as an equity holder, especially if the heirs have no experience in that particular business. Moreover, unlike shares of publicly-traded corporations, there is not a large market for equity interests in small private businesses. So the heirs may struggle to sell the equity interest unless the corporation or limited liability company purchases the equity interest from the heirs. However, even if the surviving owners wish to purchases the equity interest from the heirs, they may not have the funds. A Buy/Sell provision that requires the corporation or limited liability company to purchase the equity interest of an owner upon death can solve this problem where the purchase price for the equity interest of the deceased owner is financed by a life insurance policy on the life of the owner payable to the corporation. The estate will receive the cash for the equity interest and the surviving owners will not have the heirs as an co-owner.
If you are contemplating putting in place a Buy/Sell Agreement, it is advisable for all of owners of the business to become a party to it. A Buy/Sell Agreement can be included in a shareholders agreement for a corporation, an operating agreement for a limited liability company or a partnership agreement for a partnership.
Most people or businesses will retain the services of a lawyer to draft or review certain types of legal agreements, or contracts. For example, for the sale of real estate or a business, most people realize that a lawyer is needed. Even for an employment or consulting agreement, many people will seek professional legal help. But what about distribution agreements, supply agreements, non-disclosure agreements, licensing agreements including software licensing agreements; why is a lawyer needed to review such documents? Often one party will have its attorneys prepare a contract and the other party will just sign it without having an attorney review it. On other occasions two parties to a contract may decide to set out the terms of the contract (perhaps using forms purchased from the internet) without the help of an attorney.
There are many issues that can be solved by using lawyer prepared and reviewed agreements. Moreover, it is good business practice to put in place tightly drafted contracts at the beginning of a business relationship. This will bring clarity to the business arrangement or transaction and will help to resolve any disputes that may arise. While the best drafted contract does not guarantee that you will avoid litigation, you can avoid disputes that are generated by vague or ambiguous language.
Below is a summary of some issues of which you may not have been aware that you should consider next time you are faced with the choice of whether to hire a lawyer to review or draft a contract for you or your business.
Is There A Contract?
In order for a contract to be formed a number of items must be present. First, there must be “a meeting of the minds”. That is to say that the parties to the contract must have come to an agreement about the essential elements of the business arrangement or transaction. If the language of the agreement is not specific enough, a court could find that there was no meeting of the minds, and, therefore, no valid contract.
Does The Contract Actually Say What You Think It Does?
The language of a contract should be tightly drafted so that there is only one possible meaning of each provision. It is also important to make sure that the contract does not contradict itself by, for example, stating one thing on the first page and the opposite on the second page. Any possible ambiguity should be fixed so far as possible. Contracts often use legal terms of art that a non-lawyer may not understand. Contracts drafted without the aid of an attorney may be inconsistent and may not properly record the agreement between the parties. Forms of contracts obtained from the internet may contain legal terms that the parties do not understand. It is not advisable to sign something that you do not understand or only understand in part.
Who are the Parties to the Contract?
It is important to make sure that the correct parties are named in the contract. The parties’ full legal name and not an assumed or doing business as, or dba, name should be used. If you are dealing with an entity that is part of corporate ownership structure consisting of more than one corporate entity, care should be taken to make sure that the correct legal entity enters into the contract. For example, should you enter into a contract with the parent corporation or the subsidiary actually providing the products or services that are part of the proposed transaction or with both entities?
Is The Contract The Final Agreement?
It is important for all of the terms and conditions of your business relationship to be contained in the written contract between the parties. You do not want the other party to challenge the contract by alleging that written or oral agreements previous or subsequent to the written contract in question supersede or amend that agreement. In addition, you want to make sure that the course of dealing between the parties does not amend or supersede your written contract. Uncertainty about the provisions of the written contract can often lead to disputes, and if a dispute arises it will be more difficult to resolve if the terms of the agreement are at issue. A simple provision called a “merger provision” should be in every agreement to specify that the written agreement constitutes the entire agreement between the parties and that it supersedes any previous written or unwritten agreements between the parties. The contract should also specify that it can only be amended by a written amendment signed by all parties and not by the course of conduct of the parties subsequent to execution of the written contract.
Can The Contract Be Assigned To Another Party?
You enter into a contract with another party, but unless the contract specifies otherwise, the other party may transfer its rights and obligations to another unrelated party. That is to say, you enter into a contract with one party and without any action on your part you end up in a contract with a totally different party. There could be many reasons why you do not want the counterparty to your agreement to transfer or assign its rights and obligations in this manner. The new party may not be as credit-worthy as the original party or may not have the ability or reliability to deliver the products or services you contracted to receive under the terms of your contract. To avoid any unwanted assignments and to give you the opportunity to some due diligence on the proposed new party to the contract, your contract should contain a provision prohibiting any transfer of rights and obligations without consent of the parties to the contract.
Where Will Disputes Arising Out Of The Contract Be Resolved?
When the parties to a contract are located in the same area, any dispute between the parties will most likely be brought in a court in that area. However, if you enter into a contract with a person or entity located in a different state, the other party could bring a lawsuit in its home state forcing you to appear or at least hire an attorney to appear on your behalf in that state. It is prudent to specify in your contract a location where any disputes related to the contract must be brought so you can try to make sure disputes are brought in a jurisdiction convenient for you or your business. Obviously, if you enter into a contract with a non-U.S. person or business, it is very important to specify the jurisdictions where disputes will be brought.
What About Arbitration?
It is possible to provide that any disputes will be settled by arbitration. The potential advantage of arbitration is that the parties can tailor the form of the arbitration process to their needs. Moreover, arbitration is often less expensive than traditional litigation. Among other things, the parties can select the numbers of arbitrators, whether arbitration will be binding and the venue of the arbitration. There are a number of professional arbitration organizations such as the American Arbitration Association or the International Chamber of Commerce that the parties can choose to facilitate the arbitration process.
What Law Governs The Contact?
If you are entering into an agreement with a person or entity from another state or even another country, it is important to specify what body of law will govern the contract. If the law governing your agreement is the law of a foreign country you will be faced with the prospect of dealing with a foreign lawyer and legal system in the event of a dispute.
Are You Obligated To Indemnify The Other Party?
Any provision of a contract pursuant to which you are required to indemnify another party should be carefully reviewed. If you agree in a contract to indemnify another party if certain circumstances occur, you will be required to pay that party an amount to make them whole for any losses covered by the indemnification clause. For example, if you agree to indemnify the other party for all losses arising from your actions under the terms of the contract, you will be required to pay the other party the full amount of any losses incurred arising out of your conduct. Indemnification obligations can be limited by capping the indemnification amount at a certain monetary value, and the types of circumstances in which the other party will be entitled to indemnification can also be tightly drafted to limit your exposure to indemnification claims.
On the other hand, you might want to ensure that your counterparty will have to indemnify you if you suffer losses due to that party’s actions. So, in that case you will want to draft and negotiate an indemnification clause designed to protect your interests. In either case, the expertise of a lawyer familiar with such matters will be invaluable.
What Do All Of Those Laws And Legal Citations Mean?
An important part of any contract is the representations and warranties section. This section consists of a number of statements that the parties to the contract state are true by signing the contract. For example, a party providing a service might represent and warrant that it has all of the licenses and approvals necessary to permit it to provide the service legally. Each party to the contract will usually make separate representations and warranties. Depending on the nature of the contract, one party may make more extensive warranties than the other party or parties to the contract. If it turns out that a representation or warranty is not true, this is a breach of contract. If a contract contains lengthy representations and warranties that state that you or your business are in compliance with state or federal laws and regulations you should consider engaging a lawyer to explain to you what you are signing up to. Because if you sign a contract containing representations and warranties that you are in compliance with certain laws and you are not, you will be in breach of contract.
Regulatory compliance can also become an issue in the covenants section of the contract. In the covenants section the parties agree to take certain actions in the future. If you or your business agree to comply with state or federal regulations during the term of the contract, you should make ensure you understand your obligations. If you do not remain in regulatory compliance you will be in breach of contract.
Conclusion
The issues raised above show just a few reasons why it is prudent to seek legal advice before entering into a contract. The most important thing to keep in mind is that if put in place a clear, concise agreement that both parties understand, you are very likely to save time and money in the event there a dispute arises.
Copyright 2009 Stephen P. McAndrew, PLLC. All rights reserved.
This web site is published by Stephen P. McAndrew, PLLC as a service to its clients and the public. You should not act upon this information without consulting Stephen P. McAndrew, PLLC or other professional advisors. No attorney-client relationship with Stephen P. McAndrew, PLLC will be established by viewing this web site or sending an e-mail to Stephen P. McAndrew, PLLC. Copyright 2009 Stephen P. McAndrew, PLLC. All rights reserved. Attorney advertising.
458 Potomac Avenue
Buffalo, NY 14213
ph: 716 308-2611
smcandre