6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options or some other form of equity participation. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant.

7. If I am setting up an LLC, is there any reason to form it under the laws of one state rather than another?

In most instances there is no reason for a business to organize in another state rather than the one in which is operates.

8. Should you ever form a general partnership?

Not in today’s world, no.

The general rule is that all partners in a partnership are liable jointly and severally for all obligations of the partnership.  Limited liability partnerships are a type of general partnership that provides its general partners with limited liability for certain obligations of the partnership.  It has the benefits of a partnership and limitations on liabilities.  For example, partners in LLPs are not liable for the debts caused by the negligence of other partners.

9. I have heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become “limited liability limited partnerships,” or LLLPs. In these states, even the general partner is shielded from partnership liabilities.

10. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. Typically, Secretaries of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State’s office has checked its database and determined that the name is available for use.

The Secretary of State’s office, however, usually does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry’s Homemade, Inc., or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.

Naturally, I have heard many more questions all over the map.  The ones we’ve just discussed are the ones I hear the most often.

1.  I understand the difference between an S and a regular C corporation, but what is a close corporation and how is it different?

There is a distinction between the classifying a business entity for state law purposes (which deals with issues like limited liability and requirements for running and maintaining the business) and the company’s federal tax classification.  Virtually all states permit the formation of “close corporations.” A close corporation has a limited number of shareholders typically no more than thirty-five, can operate without a board of directors, does not need to adopt bylaws, and generally operated with less formality than a “regular” corporation—without loosing any of the liability protection offered by “regular corporations.”  If you ran a entity without a board of directors, bylaws or failed to follow any of the required “corporate formalities,” you may be subject to personal liability.  By statue, statutory close corporations are exempted from taking such factors into account if the question of piercing the corporate veil ever arises.

For tax purposes, a close corporation’s status is an independent question.  A close corporation will be treated as a C corporation unless it qualifies for treatment as an S corporation and timely elects the “pass-through” treatment available under Subchapter S of the Internal Revenue Code (“IRC”).

2. With the drop in individual income tax rates does it make sense to organize my business as a regular C corporation?

When the top marginal rate for individuals was 39.6% and the top marginal rate for corporations was 35%, it was frequently advantageous to organize a business as a C corporation as long as the entity did not hold assets expected to appreciate in value and the business plan called for retaining earnings for capital investment. When the top tax bracket was reduced to 35% in 2006 many of the reasons were lost.  There are, however, still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the potential 50% capital gains exclusion. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corporations?

I hear this one a lot.  For start-up businesses generating losses, a flow-through entity such as an LLC generally provides tax benefits that make it preferable to a C corporation.  A profitable C corporation may distribute after-tax earnings to shareholders in the form of dividends. In computing their tax liability, however, shareholders must generally include C corporation distributions in income, and cannot use C corporation losses as deductions.  Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors.

Nonetheless, venture capital providers generally make conversion to a C corporation a condition for providing funding. One reason is the non-recognition treatment available to C corporations for mergers and other kinds of reorganizations under IRC § 368.  This non-recognition treatment is not available to LLCs–or to corporations that have converted to C corporations in anticipation of a re-organization. Second, only C corporations can take advantage of the 50% capital gains exclusion under IRC § 1202. Venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs.

The preference for C corporations also appears to be driven by non-tax reasons. Investors, familiar with the structure of corporations, find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corporations.

4. I sometimes get told that it is too expensive to form an LLC as a vehicle to operate hier sole proprietorship. Are they right?

No way! If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC, however, would generally be subject to a nominal fee to the state of filing.  If the LLC is a single member LLC, it is a disregarded entity for federal income tax purposes; it is not taxed as a partnership but as a sole proprietor is.

If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietor-ship, the activities of the LLC are reported on Schedule C to the individual’s IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number.  The benefits of operating through a limited liability entity far outweigh the small formation costs.

5. What is the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice advisors have steered clients away from LLCs to S corporations in order to minimize federal payroll taxes.  A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of their share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance, and hospitalization insurance) and unemployment taxes.

In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on “net earnings from self-employment,” which includes (with certain exclusions) the member’s distributive shares of income or loss from any trade or business carried on by the LLC.  Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member’s share of LLC profits will be subject to self employment taxes regardless of whether the member considers herself an “employee” of the LLC.

A.        Establishing Independence and Neutrality

The most important early step to take in the investigation process is to make certain that your independence and neutrality are established among the players in the investigation.  This independence often must be established with both the employer (possibly your client or your supervisor) and with the complainant.

Take time at the initial meeting with the employer to clarify your role as an independent investigator, including discussions regarding information sharing during the investigation, employer direction as to who, when or where to interview and requests for a verbal or preliminary report.  Likewise, be careful not to allow the complainant in your initial interview with him or her to dictate the who, when or where of the investigation.

B.        Establishing the Scope of the Investigation

The scope of an investigation must be established before interview questions are drafted by examining the allegations that are currently known.  The investigator must then make a specific decision as to whether claims of unrelated, but potentially actionable misconduct will be incorporated into the current investigation or whether they will be investigated separately.

For an independent or outside investigator, this issue should be clarified in writing.

C.        Create Investigation Questions

Once you have determined the scope of an investigation, it is very helpful to create a list of investigation questions to assist you in maintaining focus and assuring efficiency in your execution of the investigation.

Investigation questions ARE NOT the same as interview questions, but rather are a list of questions that will need to be answered by the investigator in order for the investigation to be completed.  They are often dynamic throughout an investigation.  As some questions are resolved, others will emerge.

D.        Interim Actions

In the case of a harassment investigation, the employer must consider whether interim actions are necessary to avoid reprisals or new allegations involving the same parties.  Possible actions include:

i.            Requiring a paid leave of absence for the accused;

ii.            Offering a paid leave of absence to the complainant;

iii.            Offering or requiring a shift change or transfer;

iv.            Otherwise minimizing contact and increasing supervision.

In the case of the interim actions above, be prepared concerning what information will be communicated, and to whom, regarding the reason for the transfer, shift change or leave of absence.  In addition, be sure to clearly communicate to the affected employee the terms of the leave or other change (i.e., duration, compensation ramifications, expectations regarding workload, etc.).

Interim actions might also be necessary to preserve evidence and provide for the safety and stability of the work environment.  For example, if electronic communications are involved, freeze access or have immediate backups made.  Also restrict access to company property or documents, if necessary.

E.        Other Investigation Preparation Issues

Establish a Contact Person Establish a person in the organization who can help you implement the investigation with the least amount of disruption.  Your contact person should inform employees of their interviews with you.  Prepare a short script for this individual in order to assist them in what to say; stress that they don’t stray from the script.  Some employees (particularly executives) will need to be told more about the appointment than others.

Confirmation Memorandum The investigator or employer should send a confirmation memo to the complainant, confirming the issues that will be investigated, the facts provided, who will be investigating and the employers expectations of the complainant during the investigation.

Tour Worksite Often witnesses will refer to locations and interactions at a particular site.  If you have viewed the worksite, you will be in a better position to ask probing questions as well as understand the answers you receive.

Review Documents Prior to drafting interview questions and finalizing your initial list of interviewees, you should review all relevant documentation such as any written complaint, personnel files of those employees involved and any policies or handbooks relevant to the investigation.

Determine Who to Interview and When You will need to determine who you want to interview first and often will have a short list of potential interviewees before the start of the first interview.  In most interviews, you will also add to that list as you learn more information from interviewees.  Generally, it is most useful to interview the complainant(s) first to make certain that you have a very detailed understanding of each of his or her complaints.  Normally, it makes sense to follow with the accused and then other witnesses, although certain situations might dictate otherwise.

Select Interview Location The location should be neutral, private and well-lit.  There might be situations where you need to go to the office or even home of a witness.  The location should take place outside of the interviewees regular work area.  There should be a copier nearby.  Phones should be off the hook and water, tissues and a restroom should be available.

Well as a general rule, when one corporation sells or otherwise transfers all of its assets to another corporation, the purchasing corporation is not liable for the debts and liabilities of the selling company (unless the debts are specifically assumed by the purchaser).  There are a few narrow exceptions to this rule of thumb:

(1) When the purchaser expressly or impliedly agrees to assume such debts or liabilities;

(2) When the transaction amounts to a consolidation or merger instead of the sale of assets;

(3) When the purchasing corporation is merely a continuation of the selling corporation; or

(4) When the transaction is entered into fraudulently in order to escape liability for the seller’s debts and liabilities.

Part of the first exception to the rule of thumb, where a purchaser expressly agrees to assume certain debts or liabilities is simple enough.  However, there a little case law examining whether or not a purchaser impliedly agree to accept any debts or liabilities—probably because it would be a difficult case to make.  Be that as it may, it obviously does not come up too often or courts would have examined it more thoroughly.

Generally (and each jurisdiction should be examined) the second exception to the general rule–i.e., that the transaction effectively amounts to a merger or consolidation (a de facto merger) are:   (i) a continuation of the selling company’s management, personnel and general business operations; (ii) a continuity of shareholders resulting from the purchasing corporation paying for the assets with shares of its own stock so the selling corporation stockholders remain a shareholders of the purchasing corporation; (iii) the selling corporation’s ceasing ordinary business operations and dissolving as soon as possible; and (iv) the purchasing corporation’s assuming the obligations of the selling corporation necessary to continue normal, ordinary business operations.  Some thing else to keep in mind that it is not necessary for a court to find all of these elements in order to find a de facto merger.

In finding de facto mergers, courts generally examine the following types of evidence in coming to their decision: (a) the agreement by which the purchasing corporation acquired the seller’s assets is silent about most of the sellers employees, but does provide employment of the seller’s officers and other higher level management while the purchaser continued the seller’s general business operations; (b) the seller’s assets were purchased by issuing stock of the purchasing company, which was given to the selling company’s stockholders, making them shareholders of purchasing entity; (c) the transaction agreement required the seller to be dissolved as soon as possible; and (d) the purchaser assumed the obligations of the seller that were necessary to continue the sellers ordinary course of business.  These types of circumstances all point to a de facto merger.

The third exception to the general rule–i.e., when the purchasing corporation is a mere continuation of the selling corporation some jurisdictions use a narrow construction to the requirement the purchaser is a “mere continuation” of the selling party (in my opinion the better rule from a policy perspective).  Otherwise simply the continuation of the enterprise or its product line might lead a court to conclude that the purchaser is a mere continuation of the seller.

In a jurisdiction which applied a narrow interpretation of the “mere continuation rule” the court rejected the claim that a purchaser was a “mere continuation” of the seller even when: (1) the purchaser did not purchase all of the seller’s assets; (2) the seller remained in business for more than a year after the transfer of its assets to the purchaser; (3) upon the liquidation of the seller, none of its remaining assets were sold to the purchaser; (4) the seller and the purchaser had no common incorporators, directors, officers or shareholders; and (5) the purchaser was not created to acquire the seller’s assets.

The fourth exception is also relatively self explanatory.  Often called a “flush and switch” when the sale of assets is a mere shell game designed to enable the seller, through fraud, to escape liability for its obligations to its creditors, courts will impose successor liability on the purchasing entity.

In short, I assured my client that none of these circumstances applied to our transaction since it was completely above board.  I am glad he asked though because it showed that he was really thinking through the consequences of buying this business—something too many clients don’t do.

When you are paying for advice listen to it! Recently I had a client who was working as a pharmacist for huge retail chain and just could not stand it any more so he wanted to buy a pharmacy. We came across what initially looked like a great deal—the seller had just been through a divorcee, was desperate to sell and was willing to finance the entire purchase price. The seller made numerous representations to that business was operating just fine and that it would be a turn key operation. Despite the rosy picture the Seller was painting after some digging we discovered that the store was almost 6 months behind in its rent, was in default to it main vendor who had initiated litigation and the ex-spouse would need to sign off on the deal since she was still part owner of the company. I don’t know what more could have been wrong with the deal.

Though my guy was anxious to leave his current employer, he did the right thing he listened to his team when we told him he would be crazy to move forward with this transaction. Too many times though a buyer gets a case of the “first time home owners syndrome.” The syndrome often afflicts first time home buyers who are so desperate to close on that first house that they will overlook any problems with the property—only to have buyers’ remorse down the road.

Just like buying a house, often buyers who are unhappy with their present situation and are longing to move on will catch the syndrome and overlook material problems with the deal just to close or leave or whatever. They always regret the day they decided to move forward instead of listening to the people they hired to look out for them. Buying a business is one of the most significant steps than a person can take. The transition from employee to owner is stressful enough without the added headaches of a company rife with problems from day one.

How do you know if you have the “first time home owners’ syndrome”? One test I use is to see if the client can get up and walk away from the table without looking back. If you can’t get up and walk away, then you’ve probably got the syndrome since and will probably do something you will regret down the line. What is the cure? Simple, listen to the people you’ve hired to guide you through the process—they have an objective perspective and can see more clearly than you.