Your Website: Tips to Stay Out of Legal Trouble – Part 2 (Domain Name/Trademark)

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An Internet domain name can be vital to branding and marketing, so it’s important for business owners to be familiar with some of the legal rules related to domain names, including the intersection of domain name rights with trademark rights.  This post also reviews actions you can take to dispute domain names that may infringe upon your trademark rights.

A domain name is the primary “address” of a web site, and nearly all website owners want to have a domain name that is identifiable and easy to remember.

If my company is called “Betty’s Plumbing, Inc.” and I have a trademark for “Betty’s Plumbing”, it would be most logical for my website to also be “www.bettysplumbing.com”.  This would be the best way for current and potential customers to find me online.

Domain Names vs. Trademarks

A trademark is a word, name or symbol used in commerce to indicate the source of the goods or services and to distinguish them from the goods or services of others.

Trademarks and domain names are not synonymous, but the two concepts often meet when there is an issue of whether use of the domain name is a trademark violation.

The United States Patent and Trademark Office (USPTO) has made clear: “Registration of a domain name with a domain name registrar does not give you any trademark rights.”  The USPTO also states that simply using a trademark as part of a domain name does not necessary serve the function of “indicating the source” of goods or services.  In other words, using someone else trademark in your domain name is not automatically infringement.  However, additional uses of the trademark by your business beyond your domain name could lead to trouble!

The biggest takeaway is that the issue is not black and white.  Generally, we recommend that before you spend money on acquiring a certain domain name, you do some research to make sure your desired domain name does not contain a trademark belonging to someone else who has not given you permission to use it.  Trademark violations occur when there is “confusion in the marketplace” – when a consumer could confuse the business represented by the domain name with another business represented by a trademark contained in the domain name.

Further domain name registrars such as GoDaddy and Google Domains do not perform any trademark ownership verification before registering a new domain name for you so it is your responsibility to consider intellectual property matters!  If you need any assistance with this, please contact our Intellectual Property team.

Domain Name Disputes

Domain name disputes often involve companies battling over the ownership of domain names from “cybersquatters.” Some cybersquatters register domain names with the intention of selling them at high prices to the companies who own the trademarks. Others exploit domain names by taking advantage of the online traffic that popular brands attract and misdirecting consumers to the cybersquatters’ own websites for such business as selling counterfeit goods, or at worst, websites loaded with viruses, malware, and other malicious content.

The Anti-Cybersquatting Consumer Protection Act (ACPA)

You can file a federal lawsuit to challenge a domain name under the ACPA, a law enacted in 1999.  ACPA allows you to challenge domain names that are similar to your business name and other trademarks.  ACPA makes it “illegal to register, “traffic in” or use a domain name that is identical or confusingly similar to a distinctive or famous.  If a trademark owner successfully wins a claim under the ACPA, the Court will grant an order that requires the domain be transferred back to the trademark owner.  In certain cases, the Court can also award monetary damages.

Uniform Domain-Name Dispute-Resolution Policy (UDRP)

Another (and likely cheaper) way to challenge a domain name is through the Uniform Domain-Name Dispute-Resolution Policy (UDRP), a process created by the Internet Corporation for Assigned Names and Numbers (ICANN), the non-profit corporation that manages and controls domain name registrations. UDRP provides a relatively quick legal mechanism to resolve a domain name dispute by providing a streamlined procedure to transfer or cancel ownership of domain names.

Beyond offering a quicker dispute resolution process beyond federal court litigation, UDRP proceeds are also nice because it does not matter whether the trademark owner and domain name holder live in different countries.  Filing a lawsuit in U.S. federal court generally comes with jurisdictional issues that are tricky if the domain name holder lives in another country.

If your business needs help with a trademark or domain name issue, please contact us today!

 

Tips for Preparing for Your Initial Attorney Consultation

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To improve the quality of the consultation, as well as the case once it is accepted by the Firm, it helps if you prepare for your initial meeting with the attorney.

Before you come to the meeting, gather all documents, contracts, agreements, statements, invoices, guaranties, tax documents, notices, witness statements and/or witness information, pictures and videos, etc., you have in reference to your matter.  If at all possible, sit down and make a timeline or a history of the issue so that dates and events flow in the proper order and the storyline is easier to understand.  A journal or diary would be beneficial throughout the matter.

If you are seeking assistance with preparing a contract or a promissory note, take a moment to create an outline of the points to be addressed in the contract and note the consideration and who will be responsible to perform which point.

If you are an individual seeking assistance with an employment matter, sit down and make a timeline or a history of the issue so that dates and events flow in the proper order and the storyline is easier to understand.  Include your start date, your title at start, your pay at start.  You will want to include any changes to that information up to the present date.  Also include any problems there were, evaluations, and any commendations or awards you received.  Please provide any company policies you may have.  All of this information is important in the resolution assessment.

If you are an employer seeking assistance with an employment matter, please bring the employment file, company policies, and an outline of the issues to be discussed so that a proper resolution can be assessed.  If you are seeking to create company policies, then bring in an outline of the issues you have and ideas on policies you desire to create to address those issues.

If you are seeking a consultation in reference to a potential litigation matter (collections, business and owner disputes, real estate dispute, evictions, appeals, partnership conflicts, minority shareholder suits, family business issues, breaches of contract, employment matters, etc.), please make certain to bring all the documentation to show your position from start of the relationship to the present.  In this type of matter, it might be an easier presentation of your matter if you make a timeline and then support the timeline with any documentation, etc., that you have.  As many names of involved parties should be ready to be provided.

If you are seeking a consultation in reference to tax resolution (tax liens, levies and garnishments, audits penalty abatements, offers in compromise, etc.), then please bring whatever documentation you have regarding the situation, including copies of notices and your tax records for the past few years (or more if the situation in question began before then) to the present.  Here again, a timeline or history of how you got into the situation, along with any supporting documentation would be beneficial.

If you are seeking a consultation for intellectual property, bring (as best you can) the property with you when you meet with the attorney.  A copy will be needed for any application.

If you are seeking assistance for a small business or arts and entertainment (contracts, partnership agreements, business sales and purchases, franchises, etc.), bring whatever contracts or agreements for which you seek assistance with you.  If you do not yet have a contract or agreement, bring the outline of the points you are looking to incorporate into a contract or agreement.  If you are considering the start of a business or seeking to form an entity or obtain a liquor license, then bring your ideas and any documentation you have accumulated surrounding those ideas.

If you were involved in a collision and have sustained injuries, you might want to bring pictures of the damaged vehicles, videos of the scene, a rough sketch of the positions of the vehicles drawn out, a complete copy of your insurance policy, a copy of the police report and/or card of the responding officer, any witness information provided to you, and any pharmaceutical, medical, billing, and other expense records that you have in your possession related to the incident.  Keeping a journal or diary of who you treated with and when, work/school you missed and why, prescriptions, out of pocket costs and expenses, limitations and the steps taken to work around those limitations now in your day-to-day life due to the injury would be beneficial through the matter.  You might also include a list of equipment, people and companies or organizations (along with their cost) you have had to depend on and their expenses and limitations that they have had in providing you the assistance you have required since your injury.

Likewise, if you were involved in a personal injury resulting from a slip and fall, you might want to bring pictures of the location of the slip and fall in order to show what caused the slip and fall.  You will want to compile as many of the same things you would had you been involved in a collision.

If the matter you have involves a wrongful death or a medical malpractice, bring a copy of the medical records from the date you were first aware of the potential malpractice or the treatment that caused the wrongful death, and a written statement from a doctor identifying the potential malpractice or other information, witnesses and evidence surrounding the wrongful death.  Before a wrongful death or medical malpractice case can be filed, an expert in the subject field will need to be located and services paid for a determination that there was (or was not) practice below the standard of care.  The attorney can help you to find an appropriate expert.  The cost for the expert opinion varies.

If you seek assistance with a real estate matter, please note that no one in this Firm is a licensed broker.  That being said, as attorneys, there are a number of real estate matters that can be handled such as disputes (including non-litigation and litigation), contracts of any kind, transactions, closings, transfers, deeds, lien review and placement or removal.  You will want to prepare an outline of the issues, people involved, real estate involved, and lien information so that it is clear the type of assistance you will require that can be provided.

If you seek a power of attorney for some reason, then decide exactly what the power of attorney is for, the length of authority to be given, and who you trust to responsibly handle that authority.  Bring in any documents that might pertain to subject matter of the power of attorney you desire.

If you seek to establish an estate plan, you will need to bring information on your family and potential heirs (names, addresses, relationships to you).  You will also need to make a list of your assets and determine what you would like to have happen to them.  You might want to determine how you would like to proceed in the event of your death, i.e., funeral, memorial service, cremation, burial instructions.  Further considerations might be whether you want a power of attorney or a medical power of attorney (also known as a living will) and the extent to which you desire to allow your power to be shared and/or your health care plan should you become incapacitated.  If you would like your estate plan brought up to date, then please bring your current estate plan with you.

If you seek assistance with a probate matter, please bring a copy of the will (assuming there is one) and any other documentation you have regarding the probate estate.

The more information you bring with you, the easier it is for the attorney to see and understand the overall picture and how you are affected by the circumstances.  The attorney can review the documents and information and make a more knowledgeable assessment of your matter and advise you accordingly.

Your Website: Tips to Stay Out of Legal Trouble – Part 1 (Copyright)

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A good website for your business can be an invaluable marketing tool.  However, if you’re not careful, you could get into trouble for using images, photos, videos and other content in violation of copyright law.

Rights Granted under Copyright

Under the U.S. Copyright Act, the owner of a creative work is granted certain rights, including the right to prevent others from reproducing or copying their work, publicly displaying their work, or distributing their work.

Posting copyrighted material, say, a photograph, on your website arguably violates all these rights!  Moreover, your Internet service provider (ISP) can also be found liable for copyright infringement, even if they played no part in designing or maintaining your website.

All small business owners must therefore be extremely careful about what goes on their website!

Even big companies with sophisticated marketing campaigns get into trouble.  In May 2017, world-renowned luxury brand Tiffany & Co. was sued by photojournalist Peter Gould for using his photograph in an ad campaign for a line of jewelry designed by Elsa Peretti.  The photo at issue was a shot of Ms. Peretti back in the day.  The case was quickly settled and dismissed in July 2017, presumably because Tiffany’s agreed to write a nice fat check to Gould.

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Tiffany certainly had the deep pockets to quickly deal with the lawsuit and settle, but your small business may not have these kinds of resources.

Get Permission

As a general rule, we tell our clients to assume any content they may want to use for their website, brochure, promotional video or other project is protected by either copyright or trademark law unless they can confirm otherwise.  A work is not in the public domain simply because you found it up on the Internet already (a common misconception) or because it lacks a copyright notice (another misconception).  Just because you are a local small business with not a lot of revenue and not a great understanding of copyright law does not mean you can claim “fair use” for the content either.  There are no safe harbors in the Copyright Act if you just made a mistake or misunderstood.

Finally, be aware:  If you do see an image or video is affixed with a copyright notice (or “copyright management information“) and choose to remove the info and use it anyway, this makes you liable for additional statutory damages under copyright laws.

Statutory damages range from a few hundred dollars to $25,000 per violation, meaning a mistaken infringement on your website can cost you a lot.

Investigate Infringement Claims Promptly

If someone complains about an unauthorized use on your website, remove the offending material at once and begin to investigate the claim immediately.   If necessary, consult with an attorney on how to handle the investigation and how to respond to the claimant appropriately.

You may find after your research that your use is perfectly legal.  However, you should remove the material while you investigate in order to limit your possible damages should the claimant file a lawsuit.  Continuing to use the infringing material after receiving notice will increase the chances of you being found liable and increase the amount of damages you may have to pay.

Removal of infringing material is also an element of the Digital Millennium Copyright Act (DMCA), a 1998 law establishing that an ISP can avoid liability by following certain rules, including speedy removal of infringing material.  Thus, if you don’t stay on top of copyright infringement complaints about your website, your ISP may get dragged into your mess as well.

Independent Film Finance

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Filmmaking is rarely a cheap endeavor.  Even a “budget” independent film may require tens or hundreds of thousands of dollars to produce, market and distribute.  Here are the most common ways an independent filmmaker can finance his or her project:

Studio Financing

 This is where a studio agrees to pay for the costs of the film in exchange for the right to distribute the film.  It is difficult to get this type of funding without some proven money-making element attached to the film, for example, a well-known director, screenwriter or actor, or valuable story rights to a bestselling novel, comic book or game.

Investor Financing

This is where the film is financed by one or more persons who either buy shares of the company through which the film will be produced, or execute some form of “investment contract” related to the future revenues of the film.

Be VERY aware of state and federal securities laws that may kick in, depending on the form of your production entity or the number of investors involved.  Even if you plan to finance your film with friends and family investors, reviewing state and federal securities laws with a knowledgeable attorney is mandatory.  Consequences of violating securities laws can include rescission (meaning you must legally give all the money back, even if you’ve already spent it!), civil fines, or even criminal liability.

Crowdfunding

This is becoming a more common and more popular avenue for film financing.  Spike Lee raised nearly $1.5 million via Kickstarter to produce his film, Da Sweet Blood of Jesus.  The team behind 1998 cult classic SLC Punk also raised money for the sequel, Punk’s Dead:  SLC Punk 2, through Indiegogo.  If you go this route, be sure you review individual website rules carefully to ensure compliance.

Self-Funding

 You may just be lucky enough to have a significant amount of spare cash or disposable income to devote to your independent film.  If so, the tales you may have heard about Hollywood’s creative accounting aside, keep in mind that only about 20% of all films actually turn a profit.  Hollywood’s multibillion dollar production companies play a numbers game – hoping a few hits can cover all the other films that lost money that year.  You probably don’t have the business model or resources to follow a similar plan.

If you do decide to proceed with self-funding however, consider taking advantage of local film tax credits. Numerous states offer tax credits for productions made, at least in part, in their state. Such tax credits can also be sold to a third party, typically at a discount, to raise cash for the production or marketing of the film.

The Colorado Office of Film, Television & Media, for example, offers a 20% cash rebate program for up to $100,000 of eligible production costs.  Nevada’s revamped film tax credit law took effect in 2014 and allocated $80 million in credits to be issued to qualifying productions over a 4-year period.  Other states offering tax incentives include California, New York, Louisiana, Georgia, and New Mexico

Limit Your Liability!

Keep in mind that, as with most other business ventures, you should ultimately work through a corporate shield for protection from personal liability.  The form and timing of establishing this shield (typically an LLC) will depend on your particular circumstances.

However, if you’ve already started some activity for your independent film, make sure that all the contracts you have already entered into (or are imminently about to enter) are freely assignable.  That way, you can assign those contracts to your new entity without problem.

If you need assistance with any of the legal issues discussed here, please do not hesitate to contact our Arts & Entertainment team at DTG!

Entity Formation Basics: The Cooperative

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Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company (LLC), partnership, non-profit, or some other type of business entity.

This post is about one useful form of business entity that is frequently overlooked by business advisors and attorneys – the cooperative!

A cooperative or “co-op” is a type of legal entity that is distinguishable from standard, for-profit corporations, LLCs, and partnerships.  Co-ops offer a flexible business model that can be used by any group of people who are interested in creating a democratic decision-making company that benefits all members.  In other words, co-ops strive to be patron- or member-oriented, rather than investor-oriented like traditional corporations or LLCs.

At their core, co-ops are formed by a group of people who either work or shop there (a brewery co-op or a food co-op), use its services (a credit union or health insurance co-op), or product goods and items for it (a food producers co-op).  Co-op members are not to be held liable for any debt, obligation or liability of the co-op.

The International Cooperative Alliance, a global membership association of co-ops and co-op support organizations, has established Seven Cooperative Principles including Democratic Member Control and Concern for Community, among others.

The “common purpose” of individuals wishing to form a co-op can include a number of things, including employee-ownership, group marketing, or group purchasing.  Some of the most nationally well-known co-ops include Ace Hardware and REI, as well as dozens of successful agricultural co-ops such as Land-O-Lakes, Sunkist, and Ocean Spray.

Today, artist and freelancer co-ops are becoming more common due to the rise of the “sharing economy” and the realization of individual artists, photographers, software developers and other freelancers there can be great benefits to pooling resources, infrastructure or ideas.

Colorado Cooperatives

Colorado cooperative law has developed cumulatively over more than five decades.

Today, a standard co-op should be formed under Article 56 of Title 7 of the Colorado Revised Statutes.  Article 58 contains the “Colorado Uniform Limited Cooperative Association Act”, recently enacted in 2011.  Also, Article 33.5 of Title 38 is a special Colorado code section for housing co-ops.

Interestingly, Colorado law explicitly prohibits the ability to use the word “cooperative” or any abbreviation or derivation of as part of your business name, trade name, trademark or brand unless you are actually formed as a co-op under these statutes, so be careful if you are loosely using the term “co-op” or “cooperative” in your business!

Under Colorado law, co-op members and those on a co-op’s Board of Directors are protected from personal liability from the activities of the company, similar to corporations and LLCs.  Co-ops are also allowed to limit membership only to persons engaged in a particular business, persons who will use the goods or services of the co-op, and other membership conditions stated in the co-op’s Articles of Incorporation or Bylaws.  Because they are so member-oriented, Colorado law requires a co-op to keep detailed membership lists with contact info.

Limited Cooperatives

Under the newer Limited Cooperative Association Act, a co-op can have investor members who do not participate as much in the common purposes of the company.  This kind of co-op would have “patron members” who fully own and participate in the co-op and “investor members” who participate in the co-op on a more limited, financial basis.

Because the Article 58 was designed with maximum flexibility in mind, a co-op’s Bylaws and Membership Agreements can set forth all kinds of rules and arrangements for the patron members and investor members as far as how the company is run, how patron member votes versus investor member votes are counted towards certain decisions, and how allocation and distributions are made to these different kinds of members.

Cooperatives and Securities Laws

Both Articles 56 and 58 state that any unit or evidence of a membership interest in a co-op is exempt from the Colorado Securities Act or our state’s “Blue Sky” laws.  This means a co-op can offer and sell its membership interests without needing to registered as a broker-dealer, unlike the ownership in a corporation or an LLC.  This takes a lot of legal headache and expense away from co-ops who are looking to have dozens or even hundreds of members.

Nevertheless, if your co-op needs to raise a lot of capital and wants to do so by securing many membership fees or contributions, we strongly recommend this is done through a Regulation D private placement offering under the federal Securities and Exchange Commission’s (SEC) rules.

Worker Cooperatives

Worker co-ops (i.e., employee-owned companies) are gaining traction like never before as the socially-conscious business movement and sharing economy continue to gather momentum.

The common purpose of the worker co-op is each member’s livelihood – their job and income – as it relates to the success and sustainability of the company as a whole.  In a worker co-op, the employees democratically control the management and operations of the company, with each employee-owner having an equal vote.

Generally, this means that all employees, no matter their salary, job title, or years of employment, are entitled to one vote per person on all matters brought before the membership of the company.  However, this does not mean all employees have to be involved in every company decision.  A worker co-op should still have a Board of Directors, and can also have other officers (for example, a President or a CEO) to set policies, manage day-to-day operations of the company, and determine when important decisions should be put to the members.  Of course, the members vote for who is on the Board and can also vote for who the President or CEO is to be.

Taxation of Cooperatives

Co-ops have unique income tax structures governed by Subchapter T of the Internal Revenue Code.  This tax structure is similar to partnership taxation, but with some different terminology.  Profits of a co-op are called “net margins”.   The members of a co-op are deemed “patrons”.

Under Subchapter T, net margins are not taxed a the co-op level, but are instead allocated to the patrons on an annual basis similar to a partnership distribution.  Unlike a partnership distribution however, co-op allocations are based on a patrons use of the co-op rather than their investment.  For example, in an agricultural co-op, if Farmer A uses 3,000 acres of the co-op’s land and Farmer B uses 10,000 acres, Farmer B had more “patronage” of the co-op and should expect a larger allocation.

Subchapter T states at least 20% of the allocation to a co-op’s patrons must be in cash.  The remaining 80% can also be distributed in cash, or in can be retained on the books of the co-op as “patronage equity”, to be redeemed sometime in the future.  Consequently, patronage equity allows a member of a worker co-op to build personal assets and net worth by having an equity account that can be redeemed when he or she retires or leaves the company.

Each patron should receive a Form 1099-PATR from the co-op every year reporting the allocation (both cash and non-cash).  Then, each patron is responsible for paying his or her own income taxes based on the reported allocation.

If you would like to form a co-op or have a question related to an existing co-op, contact our offices today!

 

 

 

 

 

 

Colorado Legislative Watch: Encouraging Employee Ownership of Small Businesses

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UPDATE (4/21/2017):  House Bill 17-1214 passed both the House and the Senate and is on its way to Governor Hickenlooper’s desk for signature!

On February 27, 2017, House Bill 17-1214 was introduced in the Colorado House of Representatives.  The goals of the Bill are to educate state policy makers on the benefits of employee ownership and to create a revolving loan fund through the Office of Economic Development to assist existing small business with converting to employee ownership.

Nearly half of Colorado’s workforce is employed by small businesses, but this workforce is approaching a potential economic crisis:  About 66% of small businesses in the U.S. are owned by “Baby Boomers” who are going to be retiring in ever-increasing numbers over the next decade.  However, many of these Boomer business owners have no succession plan for their businesses upon retirement, and market analysts are predicting there aren’t going to be enough buyers for all these small companies hitting the market.  Thus, not having a concrete succession plan increases the risk that these companies will simply be liquidated – assets sold, accounts closed, and employees laid off.

A number of recent studies on employee ownership show that employee-owned companies are statistically better for the economy than traditional ownership models.  For example, employee-owned companies have lower rates of layoffs and lower rates of failure after 5 years of business.  Employee-owned companies also have better annual sales figures, and employees in an employee-owned company earn 5-12% more than their counterparts at other businesses.  These benefits are rooted in the fact that in a democratically-controlled, employee-owned company, the goals and motivations between management and the workforce are aligned.

So, the goal of H.B. 17-1214 is to convince and assist these retiring Boomer business owners “sell” their companies to their employees!

Fundamentally, employee-ownership could be a meaningful way to address the growing income- and earnings-inequality that is plaguing our country.  If H.B. 17-1214 passes, it will be an exciting development in Colorado and perhaps, a model for the rest of the country on the economic benefits employee ownership!

 

 

Should I Form My Company in Delaware?

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Many savvy startups have heard they should form their corporation in Delaware.  Indeed, more than half of public and Fortune 500 companies are incorporated in this state.

Delaware advertises its General Corporation Law as one of the most advanced and flexible in the country for business entities.  In reality however, nearly all states have now modeled their own corporate laws to mimic the provisions of Delaware’s in order to provide the much-touted “business friendly” legal landscape for companies.

There are still some benefits for incorporating in Delaware.  First, if you have to go to court to settle a dispute, Delaware has a special Court of Chancery that focuses solely on business law, and decisions there are rendered by judges instead of juries.  This means your company’s legal fate will be in the hands of a well-trained business law expert instead of laypeople who might struggle to understand complex legal concepts.  Second, since Delaware’s corporate law is one of the oldest, there is a vast amount of case law that your company can rely on. Thus, most Delaware corporations do not end up litigating disputes because their professional advisers examine this case law and can construct deals to avoid lawsuits.

Despite these benefits, by no means should a startup believe forming is Delaware is the “default” rule.  More often than not, for administrative ease, forming your corporation in the state where you will reside and, at least initially, carry out most of your business activities is probably the state in which you should incorporate.  It lessens the risk of having to travel out of court for legal disputes.  Nevertheless, the fact that so many large, public companies choose Delaware should indicate that large, public companies tend to benefit the most from incorporating in Delaware.

Finally, one may argue if you incorporate in Delaware, you send a message: “This is a national company.”  You send a signal to investors that you understand their preferences and are serious about receiving investments.  From a marketing perspective, this may be important for customers and vendors as well.

Note:  Even if you incorporate in a foreign state like Delaware, your company may still be subject to registration as a “foreign entity” and compliance with the laws of states you transact business in.

If you’re considering starting a business or revisiting a current one, contact us today.

Entity Formation Basics: The S Corporation

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Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about a very common form of entity for smaller companies – the “S corporation.”

A corporation is defined as an independent legal entity that is owned by shareholders.  A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders.  Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.

While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.).  If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President.  Understandably, this may get confusing!  However, it is important to realize each role carries its own duties and responsibilities under the law.  As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.

Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here.  If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).

Forming an S Corporation

A corporation is formed under the laws of the particular state in which it is registered.  To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office.  The individual who actually files these formation documents is usually called the “Incorporator”.

Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors.  Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).

After the corporation, the IRS by default will treat it as a C corporation unless or until you file Form 2553 with the IRS.   In other words, an S corporation is really just a special type of corporation created through an IRS tax election.

“Pass Through” Taxation

 Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types.  (For a discussion of C corporations, click here.)

Traditional C corporations are separately taxable entities who pay taxes at the corporate level, and then shareholders who receive dividends pay taxes again at the individual level.

In contrast, S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level.  Instead, the profits and losses of the business are “passed-through” to the owners to be reported on their personal tax returns.  Any tax due from company profits are thus paid at the individual level by the owners, not the company.

If you are a small business owner contemplating receiving regular payments from your corporation’s net profits, ensuring your Form 2553 is filed right away is crucial.

Ownership Restrictions

An S corporation can have only one class of stock.  Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights, which is a strategy that might be desired if you are looking to have investor shareholders with less management and dividend rights than the company’s founders.  Additionally, the one-class-of-stock restriction also means an S corporation cannot easily allocate losses or income to specific shareholders, as is allowed in a partnership or LLC.

With some limited exceptions, a shareholder in an S corporation cannot be another entity; a shareholder can only be an individual.  Also, there cannot be more than 100 shareholders.  For this reason, startups who are seeking to fundraise through equity financing or going public might find they quickly hit the 100 shareholder limit.

Finally, foreign ownership of an S corporation is prohibited.  Every shareholder in an S corporation has to be a U.S. citizen.

Accounting Issues

 Bookkeeping and accounting issues for an S corporation may be more complex than other entity types.

 Money distributed to a S corporation shareholder can be in the form of distributions or a salary (assuming the shareholder is also running the company as an officer).  There are more burdens with taking a salary (higher tax rate, employer tax obligations, preparing a W-2 form, etc.), so the savvy S corporation owner may try to take as much of his or her income from the S corporation as distributions.  Of course, this ultimately means less tax money for the IRS, and so this is a hot button issue for them!  The IRS scrutinizes the payments an S corporation makes to its shareholders to make sure the characterization conforms to reality.   If the IRS targets your business, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid.  Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

 Also, as discussed above, the allocation to shareholders of an S corporation’s income and loss is governed by stock ownership, and there are complex rules for how this is to be done.  As such, maintaining an S corporation’s books properly can be cumbersome.  Having a good accountant to assist with this aspect of your business is absolutely essential!

If you’re considering starting a business or revisiting a current one, contact us today.

 

Entity Formation Basics: The C Corporation

C Corps (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about the standard corporation, also called the “C corporation”.

The corporation is one of the oldest forms of business entity, with predecessors identified both in ancient Rome and ancient India.  Complex societies needed a way to allow groups of people to form an independent body that had the right to own property, make contracts, sue and be sued, and perform various other legal acts.

Today, a corporation is defined as an independent legal entity that is owned by shareholders.  A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders.  Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.

While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.).  If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President.  Understandably, this may get confusing!  However, it is important to realize each role carries its own duties and responsibilities under the law.  As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.

Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here.  If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).

Forming a Corporation

A corporation is formed under the laws of the particular state in which it is registered.  (Read our post on incorporating in Delaware here.)

To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office.  The individual who actually files these formation documents is usually called the “Incorporator”.

Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors.  Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).

Double Taxation

Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types.   (For a discussion of S corporations, click here.)

Traditional C corporations are separately taxable entities with the IRS and nearly all state Departments of Revenue (corporate income tax rates range from 4% in North Carolina to 12% in Iowa).  C corporations file a corporate tax return (Form 1120 for the IRS) and pay taxes at the corporate level.  They then may face the possibility of double taxation if corporate income is distributed to the shareholders as dividends, because then tax is paid again at the individual Form 1040 level.

If you are a small business owner contemplating receiving regular payments from your company’s net profits, this double taxation issue could be very costly, and thus should be avoided.

Raising Capital

So then why do so many companies accept double taxation and form a C corporation anyways?

C corporations have no restrictions on ownership.  A shareholder can be an individual, another corporation, a trust, or any other type of legal entity.  Also, a shareholder in a C corporation does not have to be a U.S. citizen or a U.S.-based entity as in some other entity types.

Probably the biggest reason however is that C corporations can have multiple classes of stock.  This means a company can have “Class A” preferred stock with priority dividend payments, more voting rights, and a higher position on the priority ladder in the event of a liquidation or bankruptcy, and then “Class B” common stock that is lower-ranked and much more prevalent for equity financing, the process of raising capital through the sale of stock to outside investors.

Thus, if you are planning to seek venture capital or to go public one day, the C corporation is probably the better choice. VC firms prefer the familiar structure and management of a conventional corporation and are well-versed in Delaware corporate law.    Similarly, many investment bankers insist a company be incorporated in Delaware before they take it public through an Initial Public Offering (IPO).

If you’re considering starting a business or revisiting a current one, contact us today. 

Entity Formation Basics: The Limited Liability Company

LLC (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about one of the most popular entities for closely-held businesses – the limited liability company or “LLC”.

In 1977, Wyoming passed legislation allowing for an entirely new type of company called a “limited liability company” to very little notice or fanfare.  Today however, over two-thirds of all new companies formed are LLCs!

An LLC is a hybrid business entity having certain characteristics of corporations and certain characteristics of partnerships (or sole proprietorships, if there is only one owner).  An owner of an LLC is called a “member” and LLCs can have just one member or hundreds of members.

Like a corporation, LLCs offer limited liability to the company’s owners and have certain rules and requirements for management and maintenance set forth under state law.  Like a partnership, how an LLC is governed and how its owners get paid for their participation and/or investment depends on the bargained-for contract between the owners, i.e., the Operating Agreement.

Have a Good Operating Agreement!

Because LLCs are “creatures of contract,” there is a great deal of flexibility in how you can organize and run an LLC, but failing to set forth this information in a well-written Operating Agreement (your contract with the LLC and all your fellow members) is a recipe for disaster.  While a single member LLC’s operating agreement can be fairly simple and straightforward, multiple-member LLCs usually have more complex operating agreements to handle many things, including management responsibilities, the allocation of profits and losses, capital accounts, vesting provisions, dispute resolution, etc.

Even if you go into business with your very best friend and each of you is in perfect agreement at the onset, human nature is such that there will inevitably be a disagreement at some point down the road, especially if your business becomes very valuable.  If you do not have a comprehensive Operating Agreement to reference, you (or your lawyers) will be forced to cobble together scraps of evidence that reflected your prior decisions or understandings about the LLC.  A neutral third party, such as a judge or arbitrator, might not interpret this piecemeal information the way you hoped, and the process can be very expensive.

LLCs and the IRS

In the eyes of the IRS, an LLC is not a separate taxable entity like a corporation is.  This means there is no separate “limited liability company” tax return form or code section for LLCs.  Instead, the IRS refers to LLCs as “pass-through entities,” which simply means that the tax liabilities of the company “pass through” to the LLC’s members’ personal income tax.

If you are the only member of your LLC, the IRS will automatically classify your company as a sole proprietorship (and you will report the activity of your LLC on a Schedule C submitted with your Form 1040 income tax return).  If you have several members in your LLC, the IRS will treat it as a partnership (and you will file the Form 1065, U.S. Return of Partnership Income) and each member should receive a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., every year.

Some LLCs choose to be taxed as corporations.  To do this, you must file Form 8832, Entity Classification Election.

Why would an LLC make this choice?  The most common reason is if your business wants to keep a substantial amount of its profits as “retained earnings”.  Retained earnings for a corporation are generally taxed at a lower rate than they would be when “passed through” to a personal Form 1040 tax return.

Once you elect corporate taxation for your LLC, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences.  In other words, you should treat the decision to elect corporate taxation for your LLC very seriously, and with guidance from legal and tax experts and a solid understanding of how cash is going to be needed to operate your business.

Corporation or LLC?

The reason LLCs have surpassed corporations as far as choice of entity for closely-held businesses is because they are more flexible and generally easier to manage and maintain than a corporation.

If you are wondering if an LLC is right for you, however, be advised that anyone starting a new business should consult with his or her legal and tax advisors before making the big “choice of entity” decision.  There are many subjective considerations and factors which will weigh in favor or against any particular choice.

For example, if you are planning to seek venture capital or go public, forming a C corporation rather than an LLC is the better choice.  Venture capital firms don’t care for the unpredictable and unique management of LLCs, and prefer the familiar structure and management of a conventional corporation.

Morever, VCs generally cannot invest in an LLC.  If you set yourself up as an LLC, and then seek VC funding, you will have to spend a lot of money changing from an LLC to a C corporation, if your particular state’s law even allows this.  Further, the LLC ownership structure simply isn’t a good fit for a publicly-traded company.

If you’re considering starting a business or revisiting a current one, contact us today.