Small Business Essentials: Bringing Business Law Down to Earth

Transcription

1 Small Business Essentials: Bringing Business Law Down to Earth A SERIES OFFERED BY Attorneys aren t from Mars. Business clients aren t from Venus. PRESENTED BY

2 Business Risk Two phases of the business cycle where a business has the greatest risk of failure: Start up phase Initial formation The I love you phase Clearly define relationship of owners to avoid issues with future disagreement Business plan Financial forecast Clearly monitor progress Retirement/transition phase The transition of management and ownership to a new group of individuals.

3 Part I Start up Considerations Legal Structure Liability issues Future plans Corporate governance Complexity Possibility of future owners Tax Considerations Taxation at entity level Flow through taxation Owner compensation Compliance Responsible person issues

4 Part I Start up Considerations Internal Considerations Hierarchy Employee manuals Company policies (i.e. document retention, policy) HR issues Interaction with outside counsel and CPAs Liability Protection Personal guarantee Piercing the corporate veil Insurance (business, umbrella, E+O) Compensation issues 401(k), medical insurance, stock options, etc

5 Part I Start up Considerations Funding Owner contributions Venture capital Bank financing Additional capital calls (required? dilution?)

6 Typical Business Structures Sole proprietorship Partnership Corporation S Corporation Limited Liability Company

7 Characteristics of Sole Proprietorship No formal legal entity Alter ego of owner Business profits taxed as ordinary personal income Unlimited personal liability for owner Business ceases to exist on owner s death This is generally not a recommended form of business ownership

8 Characteristics of a Partnership Owned by two or more parties No formal business entity filing necessary, but may file statement with Secretary of State Management rights determined by statute unless all partners have adopted a partnership agreement Pass through taxation

9 Partnerships Liability Issues Two types of partners: General partners a partner who has management and financial rights in the company. A general partner has unlimited personal liability for company debts. Limited partner a partner who has only financial rights in the company (essentially just an investor). A limited partner s liability is limited to his investment in the company, no personal liability other than investment in partnership.

10 Characteristics of Corporations Formal legal entity formed by state filing One to unlimited number of shareholders Management authority vested in Board of Directors Double taxation income taxed at business level and upon distribution to owners Limited liability shareholders have no personal liability other than investment in corporation More corporate formalities No special allocations

11 Characteristics of Limited Liability Companies (LLC) Formal legal entity formed by state filing One to unlimited number of owners Management authority may be vested in all owners (members) or in selected managers Pass through taxation (unless elected otherwise) Limited liability generally owners have no personal liability other than investment in LLC Less formalities than a corporation Ability to have special allocations

12 What is an S Corporation? Structured like a corporation Pass through taxation shareholders (must be natural persons who are U.S. citizens with limited exceptions) Limitations on the types of shares that can be issued (only one class of stock) Shareholder compensation issues Both corporations and LLCs can elect to be treated as an S Corporation for tax purposes Limited liability generally owners have no personal liability other than investment in S corporation

13 What does limited liability really mean? Generally an owner of a company with limited liability (LLC, Corp, S Corp) will not be personally liable to creditors of the business. There are however, some limitations: Liability for your own personal actions For start ups, creditors will often ask owner to guaranty or cosign on loans or contracts Creditors may try to Pierce the Veil and collect company debts from owners personally

14 Piercing the Veil Piercing the Veil is a phrase commonly used to describe creditors breaking the liability protection of an LLC or corporation to hold an owner personally liable for company debts. This is relatively difficult for creditors to achieve, but not impossible Risk factors: i) Fraud ii) Failure to adhere to corporate (or LLC) formalities iii) Inadequate capitalization iv) Commingling of assets

15 How to Minimize Owner s Risk: Make sure that business is formed properly, i.e. registered with the proper state Don t commingle personal and business assets Ensure all business assets are titled in the company s name Business should have separate financial accounts Keep adequate records Execute documents in your capacity for the business, rather than individually. It is important that it is clear that the business is entering into an agreement rather than an individual.

16 Internal Organization When there are multiple owners, it becomes critically important to think about how a business will be run. Typically governed by agreement, but there are some default statutory provisions. Structure Partnership Corporation S Corp LLC Internal Agreement Partnership Agreement By laws or Regulations By laws or Regulations Operating Agreement

17 Internal Agreement Considerations Voting who will have control? What happens if there is deadlock? Supermajority/unanimous decision for certain items (i.e. additional borrowing, expenses over certain amounts, etc) Allocation of profits and losses Distributions Delineation of duties Will there be restrictions on transfer? What happens if someone dies, retires? Buy sell restrictions

18 Part II Retirement/Transition Phase I have a successful business, but I m ready to retire, now what? Failure to plan for the transition of owners and/or key individuals out of the business is a recipe for disaster.

19 Why Plan Ahead? Taxes Transfers of business interests, whether by sale, inheritance or otherwise, could have major tax implications. Planning must be done in advance to minimize taxes Risk The smaller the business, the more likely it is that a few key individuals drive the company s success. Failure to have a succession plan in place raises the risk that the exit of a key individual will lead to business failure. Key man insurance to provide funds to replace individual

20 Why Plan Ahead? Control Having a plan in place allows the owners to exercise some control over their exit and the future of the business. Value Failure to have a succession plan in place could result in the rapid decline of the business (and its corresponding value) upon the departure of a key person.

21 Succession Planning Considerations What are the owners personal goals? Keep the business in the family? Continued income stream? Lump sum buyout? Will successors have the knowledge and skills to adequately operate the business? Protecting the longevity of the business and all parties involved. Co owners may want to avoid dealing with a deceased owner s spouse or family A plan should appropriately compensate an exiting party without destroying the viability of the business

22 Common Exit Strategies Buy Sell Agreements Gifting (for family owned businesses) Management Buyouts Sale to Outsiders

23 Buy Sell Agreements A buy sell agreement is a binding agreement among the owners that governs the terms of sale and purchase of an exiting owner s business interest. Typically defines: Who can purchase If purchase is required or at option of remaining owners Timing of purchase Purchase price and security for payment The terms of the purchase and payment of the purchase price Permitted transfers (i.e. Grantor trusts or immediate family members)

24 Buy Sell Agreements Common Buy Sell Events Death Bankruptcy Disability Divorce Voluntary Withdrawal

25 Common Types of Buy Sell Agreements Stock Redemption The company will purchase an exiting owner s interest upon specified events Results in proportionate increase in remaining owners interest Cross Purchase The other owners will purchase an exiting owner s interest upon specified events May bind all owners equally or specific owners Could change the management dynamics

26 Funding the Buy Sell Agreement Life or Disability Insurance Owners can insure others lives or company can insure owners lives or disability to fund the buyout. Important to evaluate coverage periodically. Installment Payout The exiting owner can be bought out over a set period of years. Avoids large cash outlays by purchasers up front. Owners will need to determine interest rate and security for repayment. Sinking Fund A sinking fund is an investment fund contributed to by the company over time to pay for a buyout. Debt Cash

27 Gifting of Family Owned Businesses If a business is solely or largely family owned, the owners may desire to pass the business on to their children. Additional planning techniques are available in this situation. Tax considerations may shift to federal and state estate tax issues, as well as income tax considerations. Part sale/part gift

28 Gifting of Family Owned Businesses Current estate tax laws are very favorable, but are subject to change Annual Gift Exclusion Owners may gift assets (including business interest) with value up to the federal annual gift exclusion (currently $14,000) yearly with no estate tax impact Trusts There are several types of trusts that can be used as transfer vehicles in tax neutral or tax advantageous ways. These may be tailored to meet the current owner s needs and control the future of the business Appraisal necessary

29 Management Buyouts Sale of business to management team May be financed by individual (cash, bank or seller financing, personal notes, etc) or by business (cash flow, pledges of future income, etc). Depending on structure, seller may have risk based on the future success of the business. Employee Stock Option Plans (ESOP) Company can purchase owner stock through ESOP Ability to use pre tax dollars (tax savings) Qualified employment benefit plan No tax on participants (employees) until they cash them out

30 Sale to Outsiders Cleaning up the business to make the business marketable it will need to be clean. Action should be taken to minimize liabilities, tax issues, lawsuits, etc. Valuation a valuation should be obtained to give the owners a sense of the market value of the business Owners should engage outside individuals to assist with marketing, negotiating, and structuring sale of business

31 Keeping The Succession Plan Updated A business succession plan is often built around the circumstances that exist at the time the plan is formulated. As such, it is important that it be revisited periodically to ensure that it still meets the needs of the business and its owners. The plan should be revisited at a minimum every two years by the owners. This should be more often if dramatic changes occur for the business or any of its owners.

32 Keeping The Succession Plan Updated Additionally, the plan should be reviewed upon the occurrence of any of the following: Divorce or remarriage of an owner Death, disability, retirement or other exit of a major stakeholder Substantial change in the profits of the business Substantial change in tax laws

33 Miscellaneous Considerations Keeping business on cutting edge (new equipment, social media, knowledgeable employees, etc) Importance of up to date financial information Growth (internal and external acquisitions) Image protection (trademark, copyright, etc) Worker classification (employee vs. independent contractor)

34 Proudly Presented by Cors & Bassett, LLC Kenneth H. Kinder, II Nathaniel J. Arnett