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Business Formation

John Maher:  Hi, I’m John Maher. Today, I’m here with Dan Doherty, an attorney and shareholder of MacLean Holloway Doherty, Ardiff & Morse, one of the most prominent law firms on the North Shore of Boston, Massachusetts. Today, we’re talking about business formation. Welcome, Dan.

Dan Doherty:  Hi, John. How are you?

John:  Good, thanks. Dan, what entity choices do I have in forming a business?

Dan:  In Massachusetts, John, the simplest form of conducting business is a sole proprietorship. It’s simply you’re a contractor. Rather than creating a corporation or anything else, you just hang your shingle, and you’re in business. It’s that simple.

The problem with that choice is that if you have employees or you’re incurring obligations in the business, you are personally liable for any of those business debts.

The next simplest choice if two people get together and they’re going to join in a business together, that business is just a doubled‑up sole proprietorship or, in other words, a partnership.

The problem again with a partnership is the partners are individually liable for all of the business debts. If your partner were to incur obligations or liability in the business, driving the truck to a delivery site and injuring somebody, you, as his partner, are also personally liable for his negligent actions.

Partnerships, depending upon the circumstance, can be a risky proposition, depending upon what kind of business is involved.

The next more common and more prominent is the corporation. A corporation is a statutory vehicle, whereby each state has laws under which an individual or entity can form a corporation by filing paperwork and a filing fee with the Secretary of State’s office.

Once those papers are accepted and the formation takes place, it’s as if another individual or another person was created. The corporation has its own life. That life is unlimited. Unless it’s dissolved by way of statute or by voluntary dissolution, merger, or acquisition, that corporation is going to continue into existence, in perpetuity.

The benefit of the corporation is that that business is being conducted within what is commonly referred to as a “corporate veil.” Look at it as a circle. All of the business operations are conducted inside that circle. As long as the individual shareholders have not engaged in any personal negligence, then the business obligations, the business debts, if the shareholders have guaranteed debts, well, that’s something different. That was a voluntary act, but as long as they haven’t done any of those things, they will be insulated by the corporate veil, that circle that protects them from individual personal liability.

There are really two types of corporations. This is a vernacular that is found in the Internal Revenue Code. There are C Corporations. Those are corporations that are more commonly your publicly held enterprises. Their profits are held within the corporation, and only do the shareholders receive those profits if dividends are declared and paid to the shareholders. The entity itself, files tax returns, pays the taxes, retains the earnings on a day‑to‑day basis.

The other type of tax corporation is called a “S Corporation.” An S Corporation is taxed more like a partnership in that the profits of the business flow through to the individual shareholders on an annual basis.

There are restrictions with S Corporations. There are prohibited shareholders. You can’t have another corporation owning an S Corporation. They have to be held by individuals or certain trusts. That can be complicating in Estate Planning, when you’re trying to accomplish a number of different objectives with the ownership of the business. It can complicate subsidiary type relationships.

With that, a lot of States began to look at alternatives to the S Corporation and to the C Corporation. Legislation was passed in now all 50 States, which allow for limited liability companies. Limited liability companies are kind of a hybrid entity. They take the pass‑through form of taxation that you find in partnerships. They combine that with the corporate veil of corporations.

If an individual is a member of a LLC, he or she will each year receive a ratable share of the profits that will be reported on a tax federal K‑1. That K‑1 will then be incorporated into their individual 1040, and would be reporting the income that is assigned to them within the Limited Liability Company.

Limited Liability Companies also have that corporate veil so that if there are business debts, and the member hasn’t committed any act of individual negligence, the assets of the business will be subject to entity level liabilities, but an individual’s personal assets will not be.

It really is the best of both worlds. There are no limitations on number of shareholders like you would find in an S Corporation. There is no limitation on the kind of shareholders. If you’re looking for seed capital, maybe from a major player, a corporation, that corporation could put money into the LLC, and receive back in interest.

That interest in S Corporations, there can only be one class of stock. Oftentimes, venture capital firms and so forth, will want to have a form of priority distribution. With an LLC, they’ll have the ability to do that.

Typically, prior to the LLC’s enactment, what would happen is if you previously were conducting business in an S Corp, and you’re looking for venture capital financing, or institutional financing, that institution would require you to convert to a C Corporation, and become more like a public enterprise.

Here, these are attractive, because a lot of times in early business cycles, you will see losses. Those losses with a Limited Liability Company can flow through to the investors. They can claim those losses on their Individual Tax Returns. There are restrictions on that, but for the most part that is foreseen as a benefit that LLC’s have over S Corporations.

John:  It sounds like there’s a lot to think about there. Do I need to incorporate my business?

Dan:  No. It depends really on your business. One of the things that everybody has to look at when they’re choosing an entity is determining how complicated their business is.

Let me give you an example. I’m a lawyer. If I was not involved in a partnership, and I was the only person providing professional services to clients, then I’m the only one that could potentially be held liable if there negligence in the providing of those services. Am I really going to get a benefit if I incorporate?

From a legal liability standpoint, one fundamental precept of the law is that the actor is always liable for his or her actions. If I’m the only one that’s providing those services, I’m the only one that has the potential for being held liable.

Now, as soon as I hire an employee, and that employee is also providing legal services to the public, then the question becomes, “Will I be held responsible for that individual’s liability or that individual’s negligence?”

As soon as that happens, that’s when I want to incorporate or form a Limited Liability Company. By incorporating, I can insulate my personal assets from my employee’s negligent acts. Obviously, the corporation or the Limited Liability Company will be held liable for that, but not me.

The next question you have to ask is, “Are there any tax benefits that I can enjoy by being in an entity form of ownership, as opposed to a sole proprietorship?” A number of years ago that answer was, “Probably, there were tax benefits to it,” but the Internal Revenue Code has modified that over a passage of years.

Now, for the most part, the benefits that are afforded a corporation are also available in the S Corporation context and also in the individual context, a Sole Proprietorship.

John:  You talked a lot about the different entities, and some of the differences between them. What advantages do LLC’s have over corporations?

Dan:  I think the primary advantage is a couple of things. They’re really in the tax area. One, you don’t have limitations as to shareholders. You don’t have limitations as to the quality of shareholders. You don’t have limitations as to the number of shareholders when you have a Limited Liability Company. You don’t have the restrictions on only having one allowed class of stock. You can have multiple levels of ownership interests in a Limited Liability Company.

From a creditor protection standpoint, it’s as simple as this. There is no statute on any of the books of the 50 states that says shares of stock are an exempt asset from creditor claims. If you and I were in a business together and we owned stock together in that business and you were out one night having a good time and got in an accident and were sued, your creditor could potentially gain access to your shares of stock and now input themselves into the business with me. That would be a problem for me. I’m sure it would also be a problem for you.

With an LLC, the law has taken the concept of partnerships where understanding that it is a very personal relationship to engage in a business with someone else, and if an individual member of the LLC commits an act of negligence outside of the business, a creditor of that individual member can only obtain what’s called in the law a charging order.

A charging order entitles that creditor to obtain the profits of the business that relate to that member’s interest in the business only if and when those profits are distributed. The IRS or the Internal Revenue Code takes the position that, if a creditor has gone so far as to obtain a charging order, the creditor is responsible for paying the taxes associated with that interest in the business.

What happens? The creditor goes forward, obtains the charging order, but the business needs to plow the profits back into the business for business expansion or other legitimate business reasons.

That creditor is now forced to report the income on his or her tax return, yet they’re not receiving the profits distributed out to pay that tax. That is a disincentive to obtain a charging order. There is a strong creditor protection benefit with limited liability companies over corporations.

John:  Likewise, do corporations have any advantages over LLCs?

Dan:  Yeah, the corporation has been around really since the statutes have been enacted in any of the 50 states and even before that if we look back to the common laws of England and Europe. In the law, people like to refer to it as predictability of result.

The corporate form of doing business is old. It’s cold. People understand those and there’s a lot more case law out there that you can look to, to guide you and to predict what the result will be under a particular fact pattern.

Limited liability companies, although they’ve been around now since the ’70s, Wyoming ironically was the first state to enact legislation authorizing limited liability companies. From a statutory standpoint, in most of the 50 states, they’re relatively new.

There isn’t a body of case law. It’s difficult for people like lawyers to really give a client an answer as to what the actual answer will be if tested in court. I think the biggest benefit of corporations over LLCs is there’s a little more predictability of result with regard to corporations than limited liability companies.

Each person has to weigh that against the clear tax benefits and creditor protection benefits that limited liability companies offer over the corporation. It’s a balancing test. Certainly the limited liability company is now becoming much more prominent. In my practice, it tends to be the entity that gets formed after a discussion with the client.

John:  Dan Doherty, thanks very much for speaking with me.

Dan:  Thank you, John.

John:  For more information, you can visit the firm’s website at MHDPC.com or call (978) 774‑7123.

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