Internal Investigators: 7 Key Traits

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Sometimes, things just go sideways.

Despite the best intentions of your organization’s Board, Officers, staff, and key volunteers, one misstep can threaten the entire mission. Whether there are allegations of financial malfeasance, inappropriate conduct, insufficient entity formalities, or some other variant, the Board of Directors must take quick action to decide if an internal investigation is warranted.

Once you know you need independent inquiry, who should you call to help you?

At the very least, your internal investigator must be unbiased. Ideally, an investigation is conducted by outside counsel or a special committee. And, your choice of investigators is an important as what they uncover.

In order to be productive and get meaningful results, your investigator should:

  1. Understand the culture of your organization.
  2. Commit to interviewing the correct parties, including individuals who were involved with the organization at the time period under investigation.
  3. Be well versed in how to conduct an investigation and how to evaluate credibility.
    –(Remember, this is NOT a case of “he said/she said, so we’ll never know. Part of the investigator’s job is to make credibility assessments).
    –Your investigator should know how to rely on asking open ended questions.
    –Your investigator should have a delicate approach to asking questions that telegraph the subject or intention of the investigation, and should know when to ask them.
  4.  Be adept at conducting interviews with emotional witnesses.
  5. NEVER use the services of an investigator unless they are licensed or subject to a licensing exemption. In Colorado, employees, attorneys, and CPAs for the entity may conduct an investigation under an exemption. Other exemptions do exist. But, for the most part, your wise and level-headed HOA President is not an appropriate person to conduct the investigation without an independent relationship to the organization.
  6. Always work with an investigator who understands the importance of defining the scope and purpose of the investigation with the board at the outset. In particular, you should understand what standards of proof will apply to the findings and recommendations. Miscommunications on scope will not only waste time and energy, but may result in a contaminated investigation. Once interviews have been conducted, it is difficult to revisit witnesses and receive answers that are free from outside influence or revisionist reflection.
  7. Always work with an investigator who has the expertise to identify and recommend ways that your organization can strengthen its policies, procedures, and formal documentation. The most productive investigations will help you minimize risks in the future.

Once your investigator has completed the investigation, the Board of Directors should use the findings and recommendations to come to a good faith, well informed decision about how to respond. Only independent Directors, those who are not implicated in the underlying issue, should make the decision. As always, Directors have a duty to act in the best interests of the organization. Hiring a competent investigator will not only help the organization reach a reasoned decision, but will protect the Board from individual liability.

If your business or nonprofit organization needs assistance with an internal investigation, contact Caroline Kert, Esq. at 303-763-1615 or carolinekert@danieltgoodwin.com.

HELP! Does Our Art Organization’s Board Need to Do an Internal Investigation?

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By: Caroline R. Kert, Esq.

It is a volunteer Board member’s worst nightmare: after dedicating hours and hours of volunteer time supporting your favorite art organization, a scary issue raises its head. If you don’t deal with the concerns, you or your organization might be sued. Is the current Board to blame? What can you do to protect yourself and your organization? It may be time to hire a third party to do an internal investigation.

Arts organizations and nonprofits are unique creatures. The corporate structure is often the same as the largest for-profit companies, but many are headed by volunteers and operate on shoe string budgets. What the key employees or volunteers, Officers, and Directors sometimes lack in corporate governance experience, they make up in passion and belief in the organization’s mission.

Governance missteps can snowball into crucial issues and can leave the Board of Directors confused about what to do next. Even worse, bad PR surrounding the situation may have long term ramifications leading to the loss of committed volunteers, experienced employees, and donors. The types of issues I have helped organizations navigate cover the gambit:

  • A Board Member suggesting that the organization “cook the books”
  • A Board Member running personal expenses through the organization
  • A Board Member comingling corporate assets with those of other organization
  • An organization failing to properly pay employees under wage and hour laws
  • A Board Member accused of physically assaulting a participant at an official event
  • Volunteers serving alcohol to minors at an official event
  • Lead volunteer sexually harassing teammates

When confronted with these types of issues organizations must focus on three simple goals: reducing current liabilities, avoiding costly litigation, and minimizing the collateral damage.

Once a potential issue comes to the attention of the current Board of Directors it should ask, “If we assume the allegations are true, what are the ramifications?” Have local, state, or federal laws been violated?  Can the organization be held liable for an act or failure to act?  Have current or past board members or officers breached their fiduciary duties?  Does the swift resolution of this issue impact your very ability to survive?

If the answer to any of these questions is “Yes,” the Board has a duty to investigate and make a reasonable business decision regarding its response. If the issue is merely a staff dispute or a question of day to day operations, it may be in the Board’s best interest to allow its Executive Director or other leaders manage the problem.

Boards of all organizations have a fiduciary duty to apply good faith, care and loyalty to their actions. Under Colorado’s business judgment rule, officers and directors will not be held accountable for actions “taken in good faith and in the exercise of honest judgment in furtherance of a lawful and legitimate corporate purpose.” So, swift action that demonstrates the Board’s good faith inquiry into the circumstances will go a long way toward protecting the current Board and the organization. In order to fall under this business judgment rule, the action must be:

  • Made by independent/disinterested board members
  • Made in good faith
  • Informed

Hiring in an independent attorney to complete an investigation and present findings to the Board will help fulfill these criteria. If you or your organization need assistance with a current compliance issue or complaint, contact Caroline Kert at 303-763-1600 or carolinekert@danieltgoodwin.com.

Bookmark our page to read more on this topic, including important criteria to consider when selecting your investigator.

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!

Our Tips for a Successful Career in the Arts

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Don’t let your dad who wanted you to major in business administration tell you otherwise – In today’s economy, making a living as an artist is probably more viable than it has ever been before.

Many individuals (including your dad) are under the impression that the only way to succeed in the arts is to become a superstar.  Media representations tend to present the arts as an all-or-nothing proposition, with the spotlight only given to the celebrity successes.

However, a viable career in the arts can encompass a broad range of options for those of us who aren’t necessarily nobodies, but whose lives aren’t fodder for PerezHilton.com either.  The arts are not a competition, and you don’t need to be a superstar to make a living doing what you love!

Here are some key points, some legal but many non-legal, we try to relay to our artist and creative entrepreneur clients:

  1. Identify and Maximize Various Revenue Streams

It can’t be denied that those working in creative professions often lack traditional benefits and job security.  There is nothing in this post that offers solutions towards finding a tradition 9-to-5-with-health-insurance job in the arts.  Instead, those who are able to pursue multiple sources of income and become comfortable (or even thrive) with a lifestyle with no promises of a paycheck can find career sustainability.

Experimenting with a variety of moneymaking options allows artists to discover which methods are the most lucrative.  Here in Colorado, we unfortunately do not have a long-established art collector scene like on the coasts.  However, traditional gallery art sales and online art sales may be complemented by speaking gigs, public art commissions, publishing, teaching, commission projects, crowdfunding and grants.

In other words, we believe it is a good investment for artists just beginning to establish their careers (but also for those looking to give a boost to current careers) to participate a little in a lot.  If one revenue stream (for example, gallery sales) is not doing so well, you ideally should have multiple other sources of income to fall back on.  The downside is that your schedule may be very full.  The potential upside after several years of pursuing all options is that you’ve found something that really works for your medium, personality, lifestyle and business model, and you have found financial security.

  1. Be Weird

Being “weird” could be a bad idea at a lot of jobs, but it is definitely an asset in the creative professions.  To sell art or become known as an artist, it helps to grab your audiences’ attention by creating works that are distinctly different from what is already out there.

Moreover, artists who devote time beyond their actual artwork to create a unique brand around themselves will likely have more opportunities to engage in various projects and receive more invitations to work, speak, sell and teach (all towards, see above, diversifying income streams!).  Individuals who succeed in branding themselves aren’t necessarily the most talented and brilliant artists out there, but they do produce more bankable work.  Navigating the fine line of being your authentic self yet making an impression on those around you can be tricky, but finding that balance can yield profitable results.

  1. Be Professional

Passion, talent and weirdness aren’t the only qualifications for becoming a successful professional artist.  A creative individual pursuing a career in the arts should also be able to successfully navigate the business side of their own enterprise.

For example, grants can be a good source of income for an artist or arts organization.  There are even some arts grants where, if you’ve received it once and demonstrated you were able to meet the objectives of the grant program, you can receive the same grant several years in a row.

However, groups that award such grants want to ensure their money is going to be used appropriately.  They require clear and straightforward descriptions of how the grant funds will be used, and they also need assurances that the funds will be properly accounted for once received.  This kind of due diligence is legally required for most of the foundations, endowments, 501(c)(3)s, and other organizations who are in the business of making arts grants.

If you never know the balance of your bank account or choose a casual attitude towards the financial aspects of your business, this is trouble!  It is critical to establish, and continually maintain, a high level of professionalism in your arts business.  Certain actions that can go a long way include:

  • Setting yourself up as a legal business entity with a separate business tax ID (an EIN);
  • Having separate business bank accounts;
  • Staying on top of deadlines and document requests from grant organizations, vendors, and other collaborators or colleagues;
  • Recognizing and protecting your intellectual assets (copyrights and trademarks);
  • Having a good professional services contract when you are hired for projects, shows, etc.;
  • Maintaining an active and professional online presence (social media and your website); and
  • Sustaining a solid network of mentors, colleagues, and professional advisors such as accountants and attorneys who are on your team as you navigate your career in the arts.

 

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!

 

 

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

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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 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. 

 

 

10 Legal Documents Every Startup Should Have

Legal Documents
  1. Bylaws / Operating Agreement

 A company’s Bylaws (in the case of a corporation) or Operating Agreement (in the case of an LLC) provide the legal backbone for how it operates.  If your company does not have bylaws in place, state statutes will control how the company is run.  However, these default rules might not be the best fit for your company, so it is much better to strategically think through how you would like your company to be run.

For example, if there is a major disagreement among the owners that “deadlocks” the company from being able to do anything, generally one of the only remedies under state statutes is that an owner can file a lawsuit asking the court to wind up and dissolve the company.   This is usually a lose-lose for everyone, especially if the company was doing well prior to the deadlock.  The owners could avoid this scenario by having certain dispute resolution provisions in the bylaws, or by having a limited, advisory-only member of the company who effectively acts as a tie-breaker, the process for which would be set forth in the bylaws.

  1. Insurance

After establishing a well-thought out corporate structure and executing governance documents, every company should make sure that they have good insurance coverage.  This may not come cheap, but it’s an important investment for any business to make.

Beyond a general commercial liability policy, insurance can cover anything from cyber liability to director/officer liability to life insurance for key founders.  Also, if you are selling any kind of product to the public, consulting with an attorney who specializes in products liability is advised, as they will be able to assist you in mapping out this additional exposure to risk and preparing any contracts or disclaimers to include with the sale of your product.

  1. Shareholders’ Agreement

This agreement, which also may be called a “Founders’ Agreement” or “Buy-Sell Agreement”, can help you govern the relationship between the owners of your company.  You and your business partners may be on the best of terms now, but running a company might put a strain on your relationship sooner than you think.  Interpersonal conflict between founders is one of the most common and predictable reasons for why companies fail.  Thus, a shareholders’ agreement goes a long way to protect your investment in the new business.

This type of agreement should contain vital information such as who can be a shareholder or serve on the board of directors, what happens in the case of a shareholder’s death or impairment, or what happens when a shareholder files for bankruptcy, resigns, retires or is fired.  It should also outline how much shares of stock are worth and who will be required to purchase the shares of the owner who is leaving.

  1. Non-Disclosure Agreement (NDA)

NDAs protect the confidential information of your business.  They are used when one or both parties in a relationship wish to disclose confidential information, but want to ensure that the person or organization who receives it does not disclose it to anyone without consent.  For example, if you are looking for a manufacturer to produce your company’s new widget on a mass scale, you should probably have each potential manufacturer you interview sign an NDA so that they can’t turn around and start making your widget anyways.

Keep in mind, NDAs are worthless unless they are actually signed by the party against whom you wish to enforce it.  No matter what verbal promises were made before or after information was disclosed, it is advised you get your NDA in writing and signed by both parties before any confidential information is shared.  This way, both parties clearly know their duties and privileges as they are receiving business information from the other.

  1. Intellectual Property Agreement

This document is mandatory if you wish to acquire, sell or license intellectual property (e.g. copyrights, trademarks, patents).

If you are giving or receiving all the rights to a certain piece of intellectual property, that is called an “assignment”.  If you are giving or receiving only a few rights related to the intellectual property (for example, the right to print and distribute someone’s copyrighted book), that is a “license.”

Whether you are just starting out or a well-established business, intellectual property or “IP” is often a significant piece of your business’s value.  An IP agreement protects this value.

A good IP agreement should be comprehensive, covering the financial compensation, date of the assignment/license, the rights and obligations of the Assignor and Assignee and timelines for payment, representations and warranties, indemnities, and more.

  1. Privacy Policy

A privacy policy is essential for online businesses because data privacy issues are being subject to more legal scrutiny than ever before.  Your privacy policy should outline how your business collects information on customers, what that information is used for, and how it is stored and managed.  It should also explain the rights and control of a customer’s personal information.

Currently, data privacy laws are a patchwork of various state laws and federal regulations.  Some industries, such as education and finance, are also subject to special rules.  Some states, such as California, have enacted laws for any business that targets customers in that state.  If you have concerns about whether you are following the law in this complex area, consulting with an attorney is strongly advised.

  1. Terms & Conditions

This item is essential if you conduct any business online.  Your website’s terms and conditions regulate the online transactions where you sell your products or services to clients.

Well drafted website “Terms and Conditions of Use” will deal with issues such as returns and refunds, consumer guarantees, deliveries, disclaimers and competitors.  They will also have the effect of limiting liability for any information and material that may be on your site in relation to third party information or content that is included on your site.

Additionally, it should lay down the rules for people visiting the website as well as explaining that any intellectual property on the website is protected.  Your website’s terms and conditions should be easy to read and accessible before a transaction takes place.

  1. Founders’ Assignment of Intellectual Property

Each and every person who works in any manner for the company, including the founders, should execute an agreement assigning their creations to the company.  A founder’s IP contributions could be anything from patents, software, logos and marketing materials, customer data, and more.

Especially during the startup phase of a company, almost all of the value of the venture will be tied up in the IP, so if the company cannot prove it actually has legal title to these assets, the company is essentially worthless.

  1. Employee Contracts or Offer Letters

 Having a easy to understand contract or offer and acceptance letter with employees is essential for setting forth expectations and ensuring the employee is tied into the team.  Topics that could be covered in an employee contract or offer letter include who the employee reports to, who will own the employee’s work product, basic expectations, required commitments, share vesting and all other “rules” the employee must abide by. This prevents misunderstandings and thus can go a long way to protect the company from HR-related disputes.

  1. Liability Release Forms

 Startup companies tend to have a variety of fun work events that may involve risk.  For example, maybe your company has an annual dodgeball tournament against an important vendor or maybe you want to organize a company “hiking day” for bonding and team-building.  If so, you should have all employees sign a liability release form so that your company doesn’t become liable for an unexpected accident.