SPLETT WELTERS Your First Business Formation · 2017-03-02 · Advantages and Disadvantages ... •...

Your First Business Formation

Presented by:Erik A. SplettAmanda L. Welters

Fredrikson & Byron, P.A.200 South Sixth Street, Suite 4000Minneapolis, MN 55402(612) 492-7000

March 6, 2017

© 2017 Fredrikson & Byron, P.A.

Overview

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I. Entity Selection II. Corporation Rules & Essential

Documents III. LLC Rules & Essential Documents


I. Entity Selection

The entity selected depends on the client’s situation. It’s an art, not a science.

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Big Picture Considerations• Nature of Business:

– Small business with the owners operating the business on a day-to-day basis

– Development stage business with potential to raise capital in the future; investment attractiveness

– Real Estate• Financing Expectations• Exit Strategy

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Sources of “Law”• “Entity” theory or selection is a state law

issue – states “entity” formation statutes • Taxation federal issue that also governs

state taxation • State of incorporation/organization

irrelevant of tax purposes• Internal Revenue Code and state business

statutes sources of law

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Taxation Choices• Pass Through• Double Taxation – Entity level tax and

shareholder level tax

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Pass Through Taxation• “Entity” (firm, business, etc.) pays no taxes

on income (revenue in excess of expenses)• “Profits” and losses “pass through” to the

equity holders who pay income tax at the equity holder level

• Income tax paid depends on the tax bracket of the equity holder

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Double Taxation• “Corporation” pays taxes on any income

(revenue in excess of expenses) it earns at the then corporate rate*

• If corporation distributes cash to its shareholders (in the form of a dividend), shareholders pay taxes on the “dividend” at the then current dividend rate of taxation

*Federal and State rates

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Entity Types

Unincorporated• General

Partnership• Sole

Proprietorship

“Incorporated” EntitiesPass Through“LP”“LLP”“LLLP”LLCS Corp

Entity Level Tax

C Corp

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Sole Proprietorship• One person, on his or her own, earning

money on a business activity (not as a W-2 employee)

• Liable for all debts and obligations• Pays personal income tax on any income

(revenue in excess of expenses)• Can take or use all the expenses or losses

to offset revenue• Schedule C on Form 1040

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General Partnership• Two or more persons carrying on an activity as

co-owners for profit, whether or not the persons intend to form a partnership. See Minn. Stat.§ 323A.2-02(a).

• Co-ownership of real property alone not enough. • Activities being conducted must be

“considerable, continuous and regular” with some profit motive.

• No filing with the Secretary of State to create initial legal existence.

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General Partnership• General Partnership may:

– own personal and real property in the name of General Partnership;

– sue and be sued in name of GP.

• Not a separate legal entity for all purposes; not a separate legal entity for:– state liability purposes; and – in certain cases, for federal tax purposes.

• Like a corporation, LLC, and LP:– General Partnership is liable for its own debts and obligations,

but all of the partners are jointly and severally liable for the debts and obligations of a general partnership.

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Domestic LP, LLP, LLLP1. State Law “Entity”

General and Limited Liability Partnerships – MN Stat.§321 Limited and Limited Liability Limited Partnerships – MN

Stat.§323A Professional Firms – MN Stat.§319B (LLPs only)

2. Limited Liability for Limited Partners3. Taxed as a Partnership – no entity level tax!4. Joint and Several Liability for General Partners

unless LLP (for general partnership) or LLLP (for LP)5. Multiple Classes of Partnership Interests Permitted6. Generally, Unlimited Number of Partners 7. No Restrictions on “Who” Can Be a Partner

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C Corporations1. State Law Corporation

Business corporations – MN Stat.§302A Nonprofit corporations – MN Stat.§317A Professional Firms – MN Stat.§319B

2. Limited Liability to Shareholders and Officers and Directors

3. Double Taxation on Profits4. Multiple Classes of Stock Possible5. Unlimited Number of Shareholders6. No Restriction on “Who” Can Be a Shareholder

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S Corporations1. State Law Corporation

Business corporations – MN Stat.§302A Nonprofit corporations – MN Stat.§317A Professional Firms – MN Stat.§319B

2. Limited Liability to Shareholders and Officers and Directors

3. No Corporate Tax on Profits; Shareholder Level Tax Only; Pro Rata Distribution of Income or Losses

4. Only 1 Class of Stock (voting and nonvoting is ok)5. No More than 100 Shareholders6. Eligible Shareholders - Only Certain Individuals (e.g.,

individuals that are U.S. citizens or U.S. residents, certain grantor trusts)

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1. State Law “Entity” Limited Liability Company: MN Stat.§322C Professional Firms – MN Stat.§319B

2. Limited Liability for Members and Managers3. Taxed as a Partnership (unless make tax election to tax

LLC as a C corporation) Single Member LLCs generally not recognized for tax

purposes – disregarded entity4. Multiple Classes of Membership Interests5. Unlimited Number of Members 6. No Restrictions on “Who” Can Be a Member

Domestic LLCs

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Comparison of Pass Through EntitiesPartnerships/LLCs-Subchapter K of Code-Flexible allocation of income and losses among classes

-Owners are considered self-employed

-Borrowing of entity increases members basis in interests

-Distribution of appreciated assets easier

S Corporations-Subchapter S of Code-Profit and loss allocated pro rata

-Owners can be “employees”-Easier to have incentives for employees such as an ESOP or a stock option plan

-Entity borrowing does not change shareholder basis

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Structure of Ownership and Management

S/C Corporations LLCs Partnerships- Shareholders - Members - General Partner- Directors - Governors - Limited Partners- Officers - Managers

Stock (Shares) Membership Interests Partnership Interests(Units)

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Non-Tax Considerations• Ownership

– Control– Voting & Non-Voting Interests– Capital Structure

• Management• Liability of Owners• Business Life Expectancy

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• See Comparison Chart – Chapter 2 Appendix• Use of Entity’s tax losses by Owners:

• C Corporations – no• S Corporation – yes, up to shareholder’s basis and

subject to “at risk” and “passive loss rules”• LLC – yes, up to member’s basis and subject to “at

risk” and “passive loss rules”• LP/GP - yes, up to partner’s basis, including partner’s

share of liabilities, and subject to “at risk” and “passive loss rules”

Advantages and Disadvantages of Various Entity Types (Tax Issues)

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• Dividends and Distributions:• C Corporations – pro rata based on stock

ownership

• S Corporation – pro rata based on stock ownership

• LLC/GP/LP/LLP/LLLP – need not be pro rata


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• Tax Returns & Accounting Complexity• Corporation – 1120 or 1120S

• LLC – 1065 or no separate return

• GP/LP/LLP/LLLP – 1065

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• Owners as Managers/Officers/Employees:• C Corporations – permitted

• S Corporation – permitted

• LLC – permitted but a member who is an employee (is treated as self-employed with member responsible for all payroll taxes quarterly estimates and withholding, etc.)

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• Fringe Benefits Deductible to Owners:• C Corporations – permitted subject to top heavy

limits

• S Corporation – if shareholder is more than a 2% shareholder, the benefit is treated as taxable income to shareholder and no deduction to corporation

• LLC – no, benefits are included in member’s guaranteed payment and are taxable to the member. May be deductible by member

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General Rules of Thumb• If owner(s) intend to work exclusively for

entity, S Corporation may be best choice• Real estate holdings or inside borrowing

(entity going to borrow) pushes choice toward LLC

• Institutional investors cannot invest in an S Corporation and may not care about pass through taxation so C Corporation may be the best choice if financing is required

• Consider tax bracket issues if a multi-generational business

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II. Corporation Rules & Essential Documents

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Rules

• Governance- Board of Directors- Fiduciary Duties (Care & Loyalty)- Officers

• Ownership & Limited Liability- Piercing the Limited Liability Shield- Shareholders

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Entity Formation Steps

• Collect information from client – See Chapter 3 Appendix A

• Draft Articles of Incorporation• File Articles with Secretary of State• Draft Governance Documents

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Articles of Incorporation

• Minnesota Business Corporations Act –Chapter 302A

• See Chapter 3, Appendix B

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Articles of Incorporation• Incorporator requirements:

– Actual person over age of 18• Who should actually sign as incorporator?

– Agent – lawyer, paralegal, accountant– Business owner

• Incorporator liability – see§302A.171, subdivision 1

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Incorporator Liability• 302A.171, subdivision 1• If first board not named, incorporator elects

first board and has same powers, duties and liabilities as a director until directors are named

• Drafting Point: All formation documents should be dated effective as of the date of incorporation especially if incorporator is an agent

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Articles of Incorporation –Road Map• 302A.111 – Subd. 1 – Required Provisions

– Name– Address of registered office and name of the

registered agent if there is one– Authorized capital– Name and address of each incorporator

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Articles of Incorporation - Name

• Must be in English• Corporation (Corp.), Incorporated (Inc.) or

Limited (Ltd.)• Cannot contain a word that indicates or

implies that entity was formed for a purpose other than a legal business purpose

• Distinguishable on the records– Check availability– Consent to use of name– Assumed names

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Articles of Incorporation –Registered Office/Registered Agent• Actual street address - no post office boxes• Within State of Minnesota• Registered agent only necessary if no

physical presence in state– Services will serve as registered agent

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Articles of Incorporation –Authorized Capital• Aggregate number of shares that can be

issued• Series and Classes

– Specifically authorize series and classes– Blank check

• Company can only issue what it has authorized!

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Articles of Incorporation –Authorized Capital• Percentage ownership dictates voting rights

so set authorized capital based on hundreds (unless specific situation dictates otherwise) to make the math easy

• Consider initial issuance as well as future issuances– Authorized versus issued– convertible

• Consider “value” of each share

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Articles of Incorporation –Authorized Capital Examples

37 © 2017 Fredrikson & Byron, P.A.


Articles of Incorporation –S Corporation• Only difference from C Corporation is the

Authorized Capital article• Only one class of stock allowed!

– No blank check language can be in articles– Code does allow voting and nonvoting of same

class which is done in the Capital Stock section of Articles

– Important to remember that Articles do not create the S status; separate filing

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S Corporation Filing


Articles of Incorporation –Additional Provisions• Modification of Statutory Provisions

– 302A.111, subd. 2. - Statutory provisions that must be modified in Articles or Shareholder Control Agreement

• Statutory default– Preemptive rights – Cumulative voting – Always modify unless client wants these rights

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Articles of Incorporation –Additional Provisions Examples



Articles of Incorporation• Required:

- Name - Address- Authorized Capital- Incorporator

• Mandatory Statutory default modifications:– Preemptive rights– Cumulative Voting

• Other Default modifications to consider– Repeating statutory language

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Articles of Incorporation –Directors• First Board

– Board members named in public record; incorporator liability is eliminated

– Practice: generally not named• Written Action

– Default is all must sign– Modification is required at meeting

(recommended)

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Other Default Modifications• Written Action by Shareholders

– Default is all shareholders must sign written action unless Articles provide for same as a meeting

– Relatively recent change. Less Minority Shareholder friendly

– Mirrors Delaware

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Other Default Modifications• Approval of a Merger, Exchange or Sale• Default is majority of shares allowed to

vote (more than 50%)– Minority protection

• Example:

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Higher than Statute• Not permitted to modify per section• If modifiable would state:

– “If the articles so provide . . .”– “unless modified by the articles or bylaws or an

agreement described in section 302A.457 . . .”• If modifiable can generally go higher than

minimum but not lower

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Bylaw Amendments• Default is board can amend the bylaws• If shareholders want more control than

modify default to protect shareholder’s rights

• Caution: if there is a large group of equity holders this may become cumbersome

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Feel Good Provisions• Limitation of Director Liability

– Refers to statute directly– Minnesota is a mandatory state

• Statute says “shall” not “may”

• Included to remind and reassure• Example:

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Removing Minority Protections• Dissenters Rights• In Minnesota arise under two circumstances:

– Amendment of Articles– Sale or Merger

• Statutory remedy for minority shareholders• Can only eliminate dissenters rights for

amendment to articles (see 302A.471, Subd. 1(a))

• If no dissenter’s rights then remedy is litigation

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Governance Documents –Bylaws• Chapter 3 Appendix C• Not required but good idea• Often recite the statutory requirements• Ease of administration• Mostly boilerplate• A few items to consider

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Bylaw Details• Directors

– Terms (how elect and limits)– Board Stagger– Note: only need 1 board member

• Meetings (shareholders and board)– Notice requirements– Quorums

• Regular Meetings– Not required– Can be demanded by 3% of shareholders if not held within

last 15 months• Special Meetings

– Who can call (10% of voting power regularly or 25% for business combination)

• Officers and Duties– Required officers are President and Treasurer; same person

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First Meeting Minutes• 302A.171• Items to be covered:

– Acknowledgment of Filing of Articles of Incorporation– Payment of Incorporation Expenses– Adoption of Bylaws– Corporate Seal– Adoption of Form of Stock Certificate– Issuance of Stock– Election of Officers– Election Pursuant to Subchapter S to Have Corporate Income

Taxed Directly to Shareholders– Fiscal Year– Adoption of Banking Resolutions

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III. Limited Liability Company Rules & Essential Documents

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Limited Liability Company• Creature of contract versus statute• 322C – Minnesota Revised Uniform Limited

Liability Company Act• Derived from partnership law• For an LLC, operating agreement, not articles,

contain the provisions of concern

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Rules• Governance

- Member-Managed- Manager Managed- Board Managed- Officers- Fiduciary Duties- Indemnification

• Ownership & Limited Liability- Piercing the Limited Liability Shield- Membership Interests

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Entity Formation Steps

• Collect information from client – See Chapter 3 Appendix A

• Draft Articles of Organization• File Articles with Secretary of State• Draft Governance Documents

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Articles of Organization• Required:

– Name – Registered Office – Organizer

• Optional:– Operating Agreement

• Formed when filed with Secretary of State

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Articles of Organization -Example

ARTICLES OF ORGANIZATION OF

NEW COMPANY, LLCThe undersigned organizer in order to form a limited liability company under Minnesota Statutes Chapter 322C, hereby adopts the following Articles of Organization.

ARTICLE INAME

The name of the limited liability company is NEW COMPANY, LLC, referred to in these Articles of Organization as the “Company.”

ARTICLE IIREGISTERED OFFICE AND AGENT

The street address of the registered office of the Company is _______________________ __________________________________________. The Company’s agent appointed to accept service of process at that address is ________________________________________________.

ARTICLE IIIORGANIZER

The name and street address of the organizer of this Company is ___________________________ ___________________________________________________.

IN WITNESS WHEREOF, the organizer has executed these Articles of Organization on this ______________ day of ______________________, 20__.



Operating Agreement Language

• May be oral, written, implied, or a combination thereof. See Minn. Stat. 322C.0102, subd. 17.

• Governs the relations among members of the LLC, rights and duties of a person in the capacity of a manager or governor, the activities and conduct of the company, and amendment of the operating agreement. Minn. Stat. 322C.0110, subd. 1.

• If the operating agreement does not cover these matters, the MNRULLA acts as a gap filler. Minn. Stat. 322C.0110, subd. 2.

• The operating agreement must not restrict certain matters listed in 322C.0110, subd. 3.

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Operating AgreementSource:• Minnesota Revised Uniform Limited Liability

Company Act – Chapter 322C, specifically Section 322C.0110

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Management• Member-managed (default)

– Default– Members govern based on percentage

interests (unless modified in Operating Agreement)

• Manager-managed– Managers are appointed and removed by the

members• Board-managed

– The Board acts through board actions


Member Managed– Default, but should expressly state in Operating Agreement– Each member has equal rights in the management and conduct

of the company and its activities– Differences in ordinary course of company’s activity settled by a

majority of members. Members govern based on percentage interests (unless modified in Operating Agreement)

– Acts outside ordinary course require unanimous approval (statutory without reference to those activities (except amendment of Operating Agreement), can modify in Operating Agreement)

– Can have officers (even though statute doesn’t explicitly reference)


Member Managed – Example Provision

ARTICLE [X]MEMBER MANAGED

3.1 Generally. The management and conduct of the Company are vested in the Members.3.2 Equal Rights. Each Member has equal rights in the management and conduct of the Company’s activities.3.3 Action. Any act, within or outside the scope of the ordinary course of the activities of the Company, may be undertaken by Members holding a majority of Percentage Interests entitled to vote.3.4 Amendment. Notwithstanding Section 3.3, the consent of all Members is required to amend this Operating Agreement.


Manager Managed (elect in Operating Agreement)

– Managers are appointed and removed by the members (statutory threshold is majority of members, can be modified in Operating Agreement)

– Operating Agreement should set forth requirements for manager term, resignation, removal, etc.

– Each manager has authority to conduct company’s ordinary course activities. If differences arise, subject to majority of managers (can be modified in Operating Agreement)

– Acts outside the ordinary course require member approval (statutory, i.e. merger, amending Operating Agreement)

– Can have officers


Manager Managed – Example Provision

Article [X], ManagersManager Management. The management of the Company will be vested in the Manager and

the Company will be manager-managed.

Managers. The Members, by vote of a Supermajority, shall appoint one or more persons exercising the functions of the office of the Manager. A Supermajority may elect or appoint, and may remove, such Manager from time to time. The Manager may appoint such other officers or agents as are necessary for the operation and management of the Company, each of whom shall have such powers, rights, duties and responsibilities as the Manager may prescribe; provided that a Supermajority may at any time and from time to time elect, appoint, or remove any such other officers and/or alter their powers, rights, duties and responsibilities. The office of Manager and any other offices or functions of those offices may be held by the same person.

Duties and Responsibilities of the Manager. The Manager shall manage the day to day operations of the Company and carry out all duties and responsibilities permitted to a Manager pursuant to the LLC Act, subject to such applicable approval requirements as may be set forth in Section 4.2 herein.

Initial Manager. The initial Manager shall be [X].


Board Managed (elected in Operating Agreement)• Members appoint Board of Governors (must have at least 1),

default rule is majority vote (can be modified)• Board members (unless provided otherwise), can only act

through the Board actions– Can be at a meeting or through written actions. Operating

Agreement should provide specifics on each (i.e. frequency of meetings, notice provisions, proxies, etc.)

• Can elect officers (and should)• Operating Agreement should set forth provisions on

resignation, removal, etc.


Officers• 322C specifically authorizes Board structures to appoint

Officers, but member-managed and manager-managed may also appoint

• 322C provides specific duties for officers (i.e. CEO), but can be modified in Operating Agreement

• Best practice is to elect a President/CEO and a Treasurer/CFO, at the least. Can be the same person

• Should specify appointment provisions, resignation, removal, etc.


Officers – Example Provision5.1 Officers. The Members have the authority to appoint individuals as “officers” to be agents and representatives of the Company and to delegate any such person all or any of its powers pursuant to this Agreement. One or more natural persons shall exercise the functions of the positions of President, Secretary, and Treasurer. The Members may elect or appoint such other officers or agents as they deem necessary for the operation and management of the Company, with such powers, rights, duties, and responsibilities as may be determined by the Members, each of whom shall have the powers, rights, duties, and responsibilities set forth in this Agreement unless otherwise determined by the Members. Any of the positions or functions of those positions may be held by the same person.5.2 President. Unless provided otherwise by a resolution adopted by the Members, the President (a) shall have general active management of the business of the Company; (b) shall, when present, preside at all meetings of the Members; (c) shall see that all orders and resolutions of the Members are carried into effect; (d) may maintain records of and certify proceedings of the Members; and (e) shall perform such other duties as may from time to time be prescribed by the Members. The Members elect _______________ as President.


Nature of Membership Interests• Membership Interest = Economic Rights +

Governance Rights– “Governance Rights” means all rights associated with

Percentage Interests in the Company other than Financial Rights, including, without limitation, rights to vote, receive notices, and attend meetings of Members.

– “Financial Rights” means those rights associated with Percentage Interests to share in net income, net losses, and Distributions with respect to Percentage Interests, and the right to assign such rights, in accordance with the terms of this Agreement, and the Articles of Organization.



Financial Rights• Allocations

– Generally, profits and losses are allocated among the members, based on ownership percentage, on an annual basis.

• Distributions– Net profits are distributed to members when the

governing body of the LLC determines that cash is available to distribute.

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Classes of membership interests• Can have multiple classes of membership

interests, which likely affect financial and/or governance rights

• Ex: Class of Membership Interests. The Company initially shall have two classes of Membership Interests, Class A Membership Interests and Class B Membership Interests, having the Governance Rights and Financial Rights described in this Agreement.


Fiduciary Duties• Duty of Loyalty• Duty of Care• Contractual Obligation of Good Faith and

Fair Dealing• Can be limited by the operating agreement

so long as not “manifestly unjust.”



Indemnification• Generally, an LLC must indemnify a person

from liability arising out of the person’s official capacity in the LLC so long as the person:– Satisfied fiduciary duties– Acted in good faith– Received no improper benefit– Believed in best interest of the company

• Indemnification requirement can be limited or modified by the operating agreement

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Questions

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SPLETT WELTERS Your First Business Formation · 2017-03-02 · Advantages and Disadvantages ... •...

Documents

Transcript of SPLETT WELTERS Your First Business Formation · 2017-03-02 · Advantages and Disadvantages ... •...