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Starting your own business can be one of the most fulfilling adventures of a lifetime. But you must protect your investment from liability and law suits in order to guarantee that it remains healthy and viable. Choosing the right business formation could make the difference between success and failure, for it directly affects the safety and security of your shareholders and the business itself along the way.
Businesses take many forms. Some of the most common include Sole Proprietorship, Partnerships, LLCs and Corporations. Sole Proprietorship and Partnerships are easy to create, as they do not require that you file any legal documents. But they do not offer any legal liability either. This guide addresses the three business formations that LegalACE offers:
C Corporations
S Corporations
Limited Liability Companies
If you are not sure which legal form you should choose, this guide will help you choose the most advantageous route for you and your business.
What is a corporation?
A corporation is a legal business entity that is treated like a person under the law. It exists separately from its owners and can take the form of a for-profit business or a non-profit organization.
Advantages of Incorporation
Limited Liability
A Corporation offers its owners - also called shareholders - protection from debts and liabilities. As a result, creditors cannot pursue the owners' personal assets to pay business debts. Corporations, however, must operate under specific conditions in order to maintain this prized shield of limited liability. (Those conditions are covered later in the "Piercing the Veil" section.)
Tax Advantages
Corporations enjoy tax advantages that other business formations do not. For example, a number of expenses that are paid on behalf of owners or employees can also be deducted. Here are a few examples:
Health Insurance
Life Insurance
Self-employment Taxes
Compensation and Medicare Taxes
Another tax perk: corporate income is not subject to Social Security tax.
Credibility
Incorporating your business adds a degree of status and credibility. It says that you are serious about your business, not just here today, gone tomorrow, which ultimately will boost your ability to build relationships and make sales.
Unlimited Life
Because a corporation is treated as a unique entity, its life is not dependent upon the life of its owners. When shareholders die, or they wish to transfer their shares to someone else, the shares simply change hands, and the corporation lives on. In fact, when forming a corporation, the founders can choose whether they want the corporation to have an unlimited life or they can designate a date for the end of its life. (Not exclusive to corporations, LLCs also share this feature.)
Transferability of Ownership
Ownership in a corporation, as referenced in the previous section, can be transferred to another person quite easily. There are, however, more restrictions on the transfer of S corporation ownership.
Raising Capital
When they need to raise money, corporations simply use the built-in tools they have just for that task; they sell shares of their stock. When approaching private sources of capital, however, such as banks, all businesses - whether corporations or not - must establish credit. So, the caveat here is that while incorporating elevates your status as a business, it doesn't mean that lending organizations will start throwing money at you.
More Established Law
Since they have been in existence longer than LLCs, Corporations have clear-cut rules guiding their governance. LLCs, on the other hand, are relatively new on the scene, creating more room for interpretation in the law regarding the way they are governed.
Types of Corporations
C and S Corporations
C Corporations and S Corporations, named for the sections of Chapter 1 of the IRS Code that relates to their tax treatment, are similar in many ways. They both offer limited liability to their shareholders and some tax advantages. One difference, however, is tax treatment.
When revenue flows into a C Corporation, it is taxed, and then it is taxed again at the shareholder level. This is commonly referred to as "double taxation." S Corporations, however, do not pay taxes on revenue. Profits and losses are instead passed through to the individual shareholders and paid by them through their individual tax returns.
Criteria for S Corps
Most corporations want to avoid taxes, and S Corps are no different. However, there is a set of criteria that S Corporations must meet in order to qualify for exemption from taxes. Here are a few of them:
It cannot have more than 100 stockholders
It must have only one class of stock
Its shareholders must be U.S. citizens or resident aliens
Limited Liability - With a sole proprietorship, the owners are personally liable for any debts the business incurs, and as a result, their personal assets are vulnerable. With an LLC, the owners are not only protected from business debts, but also from legal liability, such as lawsuits against the company.
No Double Taxation - LLCs have the option of being taxed as a corporation or a partnership, depending on how they are set up. LLCs can be set up to mimic the tax treatment of S Corporations, in that earnings and losses flow through the business to the owners, who then pay taxes on the earnings through their personal income tax. Or they can be set up like a corporation and taxed separately.
Piercing the Corporate Veil
Corporations and LLCs enjoy a veil of protection against law suits and confiscation of personal assets to satisfy business debts, among other things. That protection, however, is bestowed only to those businesses that can meet the criteria. In other words, businesses cannot simply pose as corporations, go through the motions, and enjoy the rewards of the business formation; they must look, act, feel and operate as limited liability companies and corporations.
Corporations and LLCs must follow many rules on the road to the “veil of protection.” Once the owners start to slip, treating the business like a sole proprietor, mixing corporate and personal funds, for example, they run the serious risk of losing its corporate status – or piercing the corporate veil.
Here are some examples of behavior that has brought about civil cases against businesses that are merely posing as LLCs and corporations – also called shell corporations:
Not filing or filing inaccurate corporate records;
Dishonesty or misrepresenting members;
Not maintaining arm's length relationships with related entities;
Not observing corporate formalities in terms of behavior and documentation;
Failure to pay dividends;
Intermingling assets from the corporation and the shareholder.
So, taking the step to creating a corporation or an LLC should not be taken lightly; it’s a serious endeavor with serious responsibilities. But with all great responsibilities come great rewards.
What is an LLC?
Limited Liability Companies or LLCs represent the business formation of choice for many looking to carve out their piece of the American dream. These business formations, mistakenly called Limited Liability Corporations, offer the limited legal liability of a corporation with the simplicity and flexibility of a partnership; that’s why they are seen as hybrids of the two.
Like sole practitioners or partnerships, LLCs may offer pass-through taxes, in which the owners report the profits or losses on their personal tax returns. Due to their relative simplicity compared with corporations, LLCs tend to be popular among companies with a single owner.
Advantages –
Limited Liability
No Double Taxation
Related Services
DBA -
Creating a DBA or "Doing Business As" enables you to create a new business identity or name underneath an existing one -- without having to create an additional corporation. It lets you expand your business easily and simply.
EIN -
Every new corporation and LLC must have an EIN or Employer Identification Number. You can do it yourself, or LegalACE can register it for you.
Trademark Search-
Choosing a business name, identity or domain that has already been taken can result in a law suit, financial damages, and potentially thousands of dollars - from redesigning and reprinting marketing collateral to signage to changing your domain name - it's just not worth it. LegalACE offers national searches for marks or phrases that are similar to yours, and therefore, might not pose legal problems for your business in the future. Having a trademark search done at the very beginning of the process can save you a great deal of grief. Plus, it can serve as the first step toward registering a trademark on the item - a move that will protect your logo and/or tagline from being infringed upon by others in the future.
Corporation Comparison Chart
Additional Resources
Here are additional links to the LegalACE Web site and other sites that may be helpful along the way:
LegalACE Corporation and LLC Easy Decision Guide – LegalACE’s “Easy Decision Guide” takes you through a series of questions that will help you determine the best business formation for you. Just go to http://www.legalace.com/business_law/default.aspx, click on “Easy Decision Guide,” answer the questions and make your decision.
The only way to protect your personal assets from the risk of doing business, such as legal liability, is to start your own Corporation or LLC. Form your corporation with LegalACE, knowing you are receiving the best deal for your dollar, the best customer support in the industry and that your business has a shield of legal protection around it.
Go to www.LegalACE.com or,
Call us at (866) 434-3706, and we’ll walk you through the process.
An LLC, or Limited Liability Company, is a legal business structure which limits the personal liability of its owners for the debts and actions of the LLC. While an LLC is a unique business structure, it shares certain characteristics common to corporations, sole proprietorships, and partnerships. LLCs provide the owner(s) with multiple benefits, such as management flexibility and pass through taxation, while retaining the full limited liability previously enjoyed only by corporations. If you are interested in forming a business, an LLC may be the most efficient, affordable, and secure choice.
An LLC may have one or more owners, who are referred to as members. Initially some states required LLCs to have more then one owner. Now many states allow a single owner to acquire an LLC. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members for an LLC.
The LLC functions best as a small business, requiring less organization and oversight than a large corporation. As a separate legal entity, the LLC must have its own bank account through which all income and expenses must flow. The LLC conducts all business in its name, and its members act as authorized agents on behalf of the company. Just as shareholders of a corporation are insulated from liabilities of the corporation, LLC members are protected from liabilities of the company.
An LLC has qualities similar to those of C and S Corps. It is important to understand the difference between the various kinds of corporate entities as illustrated below:
Administration Requirements
. LLC - Relatively few requirements.
. C Corp - Election of board of directors/officers, annual meetings, and annual report filing requirements.
. S Corp - Election of board of directors/officers, annual meetings, and annual report filing requirements.
Management
. LLC - Members can set up structure as they choose.
. C Corp - Shareholders elect directors who manage business activities.
. S Corp - Shareholders elect directors who manage business activities.
Term
. LLC - Perpetual, unless state requires fixed amount of time.
. C Corp - Perpetual: can extend past death or withdrawal of shareholders.
. S Corp - Perpetual: can extend past death or withdrawal of shareholders.
Double Taxation
. LLC - No
. C Corp - Yes, taxed at corporate level and then again if distributed to shareholders in the form of dividends.
. S Corp - No
Pass Through Tax Treatment
. LLC - Yes
. C Corp - No
. S Corp - Yes
Ownership Rules
. LLC - Unlimited number of members allowed.
. C Corp - Unlimited number of shareholders; no limit on stock classes.
. S Corp - Up to 100 shareholders; only one class of stock allowed.
Ease of Operation
. LLC - Easy, some states may require more than others.
. C Corp - Must have annual meetings, Board of Directors meetings, corporate minutes, and stockholder meetings.
. S Corp - Must have annual meetings, Board of Directors meetings, corporate minutes, and stockholder meetings.
The 3 main advantages of an LLC are limited liability, taxation, and management flexibility.
Limited Liability
. Limited liability - The owners of the LLC, called "members," are protected from personal liability for acts and business debts of the LLC. With a sole proprietorship, or partnership, the owners are personally liable for any debts and other obligations the business incurs. As a result, their personal assets are vulnerable. With an LLC the owners are not only protected from business debts, but also from losing their personal assets dues to litigation.
Taxation: No Double Taxation, flow-through tax advantages, tax deductibility
. Pass-through taxation - Under the default tax classification, profits are taxed at the member level, not at the LLC level (i.e., no double taxation). LLCs have the option of being taxed as a corporation or as a partnership, depending on how they are structured. LLCs can be set up to mimic the tax treatment of S Corporations, in that earnings and losses flow through the business to the owners, who then pay taxes on the earnings through their personal income tax. LLCs can also be set up like C corporations and be taxed separately.
. Tax Deductibility - Business owners will want to deduct as much of their expenses as possible, thereby reducing their overall tax payments. The IRS specifically allows the deduction of reasonable and necessary business expenses. Many taxpayers overlook legitimate deductions for business expenses. To the extent possible, LLC owners will want to deduct the following types of business expenses: Vehicle expenses, travel expenses, start-up and organizational costs, entertainment expenses, legal fees, rent, materials and supplies, interest expense and bank charges, state local and sales taxes, salaries and other compensation for personal services, insurance, and advertising costs.
Management flexibility
. Simplicity of operation with much less administrative paperwork and recordkeeping.
. LLCs are enduring legal business entities, with lives that extend beyond the illness or even death of their owner(s), thus avoiding problematic business termination or sole proprietor death.
. No loss of power to a board of directors (although an operating agreement may provide for centralization of management power in a board or similar body).
. Flexible distribution of profits and losses.
. Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership), without transferring the title to the membership interest (i.e., See VA and Delaware LLC Acts).
No. Limited liability is not absolute, for either LLC's or corporations. If an LLC owner engages in illegal or intentional misconduct they can be held personally liable. Below are some examples of instances in which an LLC owner could be held liable:
. Personally and directly injures someone
. Personally guarantees a bank loan or a business debt on which the LLC defaults
. Fails to deposit taxes withheld from employees' wages
. Intentionally does something fraudulent, illegal, or reckless that causes harm to the company or to someone else, or treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.
If the owner of an LLC treats the company as an extension of his or her personal affairs he or she risks the existence of the LLC. A court can rule that an LLC is non-existent if the owners seem to be conducting business as individuals. The owners then become liable for their debts and actions. Often referred to as "piercing the corporate veil," an LLC or corporation can be stripped of its status as a legal business entity if it fails to meet certain requirements.
Although the requirements are similar, there is generally more administration overhead required for a corporation than for an LLC. For example, corporations must have board elections, keep corporate minutes, hold annual meetings, and report filings. While LLC's are required to file certain documents and keep proper records, they generally require less paperwork.
No. Insurance can be of great benefit; however, it is not a substitute for limited liability. Insurance does not protect against all risk. There is often a limit to the amount insurance will cover, and there are many third party claims that may not be covered. Insurance should be viewed as something to complement a proper business structure, not replace it.
It is not always advantageous to form an out-of-state LLC. Some business owners choose to form an out-of-state company in order to maintain anonymity. Often out-of-state LLCs are formed as a method of avoiding state income taxes. Regardless of where the business is formed, you are required to pay the state income taxes of the state in which the business is located. Sometimes a business owner will have to pay fees in both the state of incorporation as well as the state of the business. For this reason, forming an out-of-state entity can lead to double costs.
Entrepreneur Charles Ferraro wanted to develop a chain of three big and tall men’s clothing shops in El Paso. First, he formed an LLC under his name: Charles Ferraro LLC. He opened his first store under the DBA – or Doing Business As –Big Chuck’s Smile and Style. He opened his second shop on the other side of town under the DBA Haberdashery by Charles, and then the third shop two years later under the DBA Vestidos Para Hombres Grandes.
DBAs are legal filings that enable business owners to name their businesses something other than their legal company name, save money and keep their business formations simple. By creating one corporation or LLC, rather than three, as Ferraro did in the example above, he was able to expand his business simply and inexpensively.
“DBAs offer business owners a fantastic tool to multiply your business reach without over-complicating your business structure,” said Adam Pollicino, Chief Operating Officer with LegalACE, an online document preparation company based in Scottsdale, Ariz.
DBA and Proper Representation
When you register a DBA, you are essentially getting permission to call your businesses something other than its legal name. That DBA registration lets you legally accept payments under the DBA name and use the name on checks and in advertising. If, on the other hand, you name a business something other than its legal name, and you don’t register a DBA, you could be accused of fraud. And you certainly don’t want that mess on your hands.
Let the Buyer Beware
Just as you have the right to know who you are buying from, so do others, of course. That’s why states and other municipalities require businesses with fictitious names to register their DBA statements with the government, letting the public know who its owners are. Let’s say a woman purchases defective tires from a business and she wants to file a complaint with the owners of the company. With a fictitious name, the owners of the business aren’t readily apparent, but because of the law and the legal filing that the owners must submit, the woman can find out who owns the company by doing a little research with her local government. In addition to the legal filing, some jurisdictions also require business owners with DBAs to publish notices in a local newspaper to further notify the community of the relationship between the entities.
“Each state or county is different,” says Pollicino. “Make sure you are meeting your particular jurisdiction’s criteria.”
The DBA Registration Process
One of the first steps in registering a DBA should involve doing a trademark search to make sure the name you’ve chosen for your business isn’t trademarked by someone else. Keep in mind that just because a domain name is available, it doesn’t necessarily mean that the business name hasn’t been taken. So, either do the search yourself through your Secretary of State’s office or hire someone to search both the state and federal trademark database for the business name. Once you are confident the business name has no existing trademarks on it, you will pay between $10 and $100 to register each name with your county or state government.
Whether you are creating a series of Web sites, retail stores, restaurants or another type of business, using DBAs or fictitious names may be the way to grow inexpensively and simply. Just remember that registering the appropriate DBAs are essential to being within the law and representing yourself honestly to the public.
Filing a DBA enables you to create new business names under your already established business entity. Once you file, here are some of the advantages you enjoy as a DBA. You can:
Do business under the new name
Use the business name in contracts
Print checks with the new business identity
Get a business telephone listing and number
Advertise
Accept Payments
DBAs have other names. Here are a few of them:
Doing Business As
DBA
Trading As
Fictitious Business Name
Fictitious Name
Trade Name
Assumed Name
Trade Styles
Assumed business name
This article was contributed by Cecile Duhnke, marketing communications manager with LegalACE.com, a Scottsdale, Ariz. legal document preparation firm. The information in this article should not be considered legal advice. For legal advice, please contact an attorney.
Calling All Electronic Entreprenurs!
Online Legal Document Services Simplify the Process
It’s one of the biggest decisions of your life: starting your own business. You’ve decided a corporation – rather than a partnership or LLC -- best meets your needs. Now what? Go online, of course! You can prepare the legal documents necessary to form a corporation on the Internet.
“It has never been easier or more affordable to form a corporation,” says Adam Pollicino, chief operating officer of LegalACE, a Scottsdale, Arizona. an online legal document preparation company. “We have simplified the process and made it extremely comprehensive.”
Why Incorporate?
Before you get rolling, you’ll need to be confident about your choice of business entities. Make sure you educate yourself about the advantages of corporations over, say, partnerships and limited liability companies (LLCs), for example. Here are four reasons to choose a corporation, according to “Get Ready: Forms of Business Ownership,” an article which appeared on the Small Business Administration’s Web site: http:/www.sba.gov/smallbusinessplanner/plan/getready/Corp_learn_more.html
Advantages of Corporations
Shareholders have limited liability for the corporation's debts or judgments against the corporations.
Generally, shareholders can only be held accountable for their investment in stock of the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)
Corporations can raise additional funds through the sale of stock. A corporation may deduct the cost of benefits it provides to officers and employees.
Can elect S corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership.
Limited Liability
Probably the biggest advantage of creating a corporation over other legal business entities is the financial shelter it offers its owners. It affords the officers, shareholders and their families protection against creditors in case the company files bankruptcy or experiences other financial setbacks. Family belongings like cars and homes are shielded from creditors (unlike sole proprietorships or partnerships, for example).
“Shelter from creditors ranks high among businesspeople who choose corporations,” says Pollicino. “Tax benefits are next.”
Tax Advantages
Corporations enjoy tax advantages that other business types don’t. As the owner of a corporation, you can deduct health insurance premiums that you have paid on behalf of an owner-employee. You also save on self-employment taxes, as corporate income isn’t subject to Social Security, Workers Compensation and Medicare taxes. Life insurance can also be deducted in most cases.
Raising Money/Profile
When it’s time to raise cash for the business, corporations have a ready-made system: they can sell their stock. Plus, when it’s time to ask for a loan from a bank, corporations tend to have more clout over other business types.
“Creating a corporation not only protects you from liabilities, but it can also boost your credibility in the business community,” says Pollicino.
Unlimited Life
The life of a corporation doesn’t depend on the lifespan of its members. In fact, the officers could die, but the corporation would live on. Likewise, even if the owners sell their interest, the corporation would continue to function, as always.
Why Online?
With soaring gasoline and food prices and recessionary fears everywhere, the smart businessperson should want to cut costs where he or she can. One way is to avoid the attorney’s office is by incorporating online. I don’t just mean ordering the documents and filling them out yourself. It’s easy enough to find the documents you need online. But navigating them and filling them out correctly is an entirely different story. They are made so that the legal jargon and convoluted circular language can only be interpreted by an attorney.
“You could order the documents and fill them out by yourself,” says Pollicino. “But why would you when we can help you through the process?”
On the other hand, going through an online legal document preparation company gives you the peace of mind. You know you’ve filled out the forms correctly, you’ve gotten the blessing of the staff and you know the paperwork is ready to be filed. So, go ahead! Incorporate your business online. It’s inexpensive, easy to do and painless.
This article was contributed by Cecile Duhnke, marketing and communication manager with LegalACE, a Scottsdale, Ariz. legal document preparation firm. The information in this article should not be considered advice. For legal advice, please contact an attorney.
In this electronic age, every business with a Web site automatically possesses an international reach, a global business identity. Internet domain names – the unique information after http://www. in a URL – take on tremendous marketing and branding significance for any company. Double that for companies that operate exclusively online. Unfortunately, there are unethical people in the marketplace who want to illegally capitalize on business’s successful domain names. One way companies can defend themselves against this is by trademarking their domain name.
What is a trademark? Trademarks are words, symbols, graphic elements or phrases that represent specific products or services from a unique source. Business owners pour time, money and talent into the choice of domain names, with the hope that they are truly memorable and will effectively embody the company brand. Having that domain high-jacked for someone else’s gain can be infuriating and pose significant business losses. The courts don’t take too kindly to it either.
Let’s look at the 2003 case of Yahoo! Inc. v. Yahoo Moving & Storage Inc. The search engine giant filed suit against the moving and storage company because Yahoo Moving & Storage had three domains with the word “yahoo” in them and failed to respond to a “Cease and Desist” letter. The four-employee, $500,000 moving and storage company then offered to sell its business to Yahoo! Inc. for $5 million, resulting in Yahoo! suing the company for cyber-squatting, infringement and dilution. The court awarded Yahoo! $225,000 in statutory damages.
The Yahoo! trademark infringement case and others prove the existence of this unethical practice on the Internet. These predators want to profit from successful companies that have established themselves in the marketplace, created strong brands and an Internet presence, but haven’t bothered registering a trademark for their domain name.
Trademark Transgressions
Internet highway robbers have a variety of ways to cyber-steal. They create domain names that are just a letter off of a successful domain, hoping to catch those people whose fingers slip off the keyboard as they type in the name of the site. They purchase domains that include the name of successful companies and hold them for ransom until the company buys them out, as in the Yahoo! case. They even embed misleading meta-tags and do what’s called deep-linking on their site, burying links to the more successful sites so that they will pop up in a search for the “real” company. No matter the strategy, they are all designed to lure unwitting Web visitors and steal business.
Trademarking a domain name is the best prescription for preventing this type of theft. It won’t keep people from trying to steal business from each other on the Internet, but it will protect the owner of a site from these illegal practices. If someone tries to profit from a domain name that is trademarked, the owners have legal recourse. They can file a Cease and Desist Order, ask that the site be “deregistered,” or sue the offending domain owners.
Unique Names Best Candidates for Trademark
Startups that haven’t chosen domains yet should take care to select names that can be protected with a trademark. If it’s too general, it probably won’t pass muster, because you it’s difficult to trademark words from our everyday vernacular. Think cheapfood.com or nicejeans.com. But if it is unique enough – think Google, eBay, Yahoo! –it can be trademarked and protected from cyber-poachers.
Look Before You Leap
Before buying a domain name, startups should thoroughly research existing trademarks or trademarks that are extremely close to theirs. By not doing their homework, businesses can shoot themselves in the foot by creating a domain too close to the name of another company and get entangled in trademark disputes – exactly what they are trying to avoid. Domain owners have some options when it comes to trademark searches: they can hire an attorney; they can hire an online firm; or they can do the research themselves through the U.S. Patent Office at www.uspto.gov.
Shopping for Trademark Registration Service
Whether they hire an attorney or register the trademark online by themselves, business owners should explore their options. When shopping around for the service, ask these questions:
What is the price, and what does that include?
Is the service for state or federal trademarks – or both?
Does the service include Internet monitoring for trademark infringement?
Once they have researched existing trademarks, settled on a domain name, purchased the domain and registered the trademark, startup owners can safely do business on the Internet without the fear that someone is going to steal their electronic mojo. Because even if it does happen, the startups are empowered with words that will scare even the most veteran Internet business owners: “See you in court!”
Cecile Duhnke is Marketing Communications Manager with LegalACE (www.LegalACE.com), an online legal document preparation company located in Scottsdale, Ariz. For more information, contact us at info@legalace.com or call (866) 434-3706.
Some call them prenups for businesses. Others refer to them as business wills. Still others call them shotgun clauses. Whatever you call them, Buy/Sell Agreements are designed to ensure continuity of ownership in a business when one owner/investor dies or leaves the business.
A closely held company’s owners and shareholders change over time, just as life changes. An owner can die, become disabled, retire or simply want to sell out. A Buy/Sell Agreement helps maintain stability in the ownership in the midst of that change.
Buy/Sell Agreements offer a formula for owners or shareholders of a company on how to value shares when an owner/shareholder leaves. It can exist as a clause in a business partnership or operating agreement, or it can stand alone. It sets a precedent on these and other decisions:
Who can buy a departing partner’s or shareholder’s share of the business?
(Only other partners? Third parties? Family members?)
What events trigger a buyout (death, disability, retirement, bankruptcy, etc.)?
What price will be paid for a partner’s or shareholder’s interest?
Stock Redemption Agreement or Cross-Purchase?
Two basic forms of Buy/Sell Agreements exist, which directly address the death of an owner. In a Cross-Purchase Agreement, each owner of the corporation purchases a life insurance policy on the other owners and is named the beneficiary of the policy. In a Stock Redemption Agreement, on the other hand, the corporation purchases life insurance policies for each owner. In either case, the corporation or the other owners use the life insurance policies to redeem the deceased owners’ interest in the corporation.
Drag-along-and-tag-along Provision
When the majority owners want to sell their company to a third party, a drag-along-and-tag-along provision specifies that they can force the sale of the stakes of minority owners. On the plus side for the minority owners, it promises that they receive the same proportionate price as the majority owners.
Shotgun Clause
Especially helpful in two-person partnerships, Shotgun Clauses dictate that one partner can offer to buy the other out at a price the first partner chooses. The second partner must then accept the sale or buy the company for the same price. Since the clause favors the wealthier partner, the poorer partner may want to add another clause maintaining that the buyout can be funded over time or with profits from the ongoing business.
Right of First Refusal
Many maintain that any Buy/Sell Agreement should be accompanied by a Right of First Refusal, a clause created to prevent a company from being purchased by a stranger. So, if a partner finds an outside buyer for his shares, he must first offer those shares to the existing owners, who must match the outside buyer’s price to purchase the shares at issue. This shields the remaining partners from suddenly having strangers running the company.
The Up- and Downside of Using Life Insurance for Funding
Using life insurance to buy out a partner has its upside as well as its drawbacks. These agreements generally benefit both the corporation and the individuals that stand to inherit the remaining shares of the exiting partner.
A life insurance claim creates a lump sum of cash to fund the buy/sell agreement at death.
The proceeds are usually paid quickly.
Life insurance proceeds are generally income tax free.
If sufficient cash has built up in the policies, the funds can be used to purchase business interest following retirement or disability.
Cons
There is also a downside to using life insurance to fund the sale of a departing owner’s shares. Here are a few of the wrinkles:
Life insurance premiums are paid with after-tax dollars.
Premium requirements serve as an ongoing expense.
Some of the owners may be uninsurable due to age or illness.
If the owners’ ages vary widely, younger owners will have to pay higher premiums on the lives of the older co-owners.
You know what they say about an ounce of prevention? Well, it’s worth at least a pound of cure toward reducing the chaos and uncertainty that can ensue when a business partner dies or sells his or her shares. Protect the future of your business by setting up a Buy/Sell Agreement funded with life insurance. But remember, thoroughly research your particular situation, set the agreement up to meet many different contingencies and guard against negative tax consequences.
Structuring Your Buy/Sell Agreement
Here are a few of the questions that you should consider when creating a Buy/Sell Agreement. Should the agreement be structured to:
Require the buyer to buy and the seller to sell?
Give the buyer an option to require the seller to sell?
Give the seller an option to require the buyer to buy?
Give a right of first refusal to the buyer?
When an Owner Dies
Should the death of an owner cause an automatic buyout of the deceased owner’s interest?
Should the family of a deceased owner be given the opportunity to hold onto the interest in the company?
Buyout Price and Payout
Should the buyout price from the estate or heirs of a deceased owner be addressed? If so, when should it be paid?
What interest rate should the price bear?
How should the buyout price be addressed with a disabled owner? When would it be paid?
Applicability
Should the agreement apply to current owners or to all owners throughout the life of the business entity?
Should the agreement state that it supersedes all other agreements to redeem a business interest?
Should the agreement be reviewed annually?
Cecile Duhnke is Marketing Communications Manager with LegalACE (www.LegalACE.com), an online legal document preparation company located in Scottsdale, Ariz. For more information, contact us at info@legalace.com or call (866) 434-3706.
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