All businesses, large and small, must choose an organizational structure that meets the company's needs. The decision regarding which business structure is best for your business should be made after consultation with an attorney and accountant.  In determining the proper entity choice you should consider issues regarding tax, liability, management, continuity, transferability of ownership interests, and formality of operation.

In the past, business planners were faced with a dilemma in choosing between only two organizational forms: corporations and partnerships. Partnerships offer certain tax benefits, but the partners themselves are responsible for the debts and obligations of the other partners. Corporations, on the other hand, tend to have additional tax burdens, but give the corporation's officers, directors and shareholders protection from liability. Today, however, there are a number of additional organizational forms, which offer solutions to this predicament.

A sole proprietorship is the business form most commonly used when a business has only one owner. In a sole proprietorship, a single individual owns all the business assets and is liable for any business debts.  Proprietorships are usually small business enterprises, with capital demands being met by the owner and with little or no need for outside investors.

A corporation is the most popular choice of businesses seeking investor capital. Corporations are required to pay federal, state and, in some cases, local taxes. An Arizona corporation is created by filing Articles of Incorporation with the Arizona Corporation Commission. A corporation is distinct from its owners, or "shareholders," and is treated as a separate "person" under the law with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests. The corporation itself, not the shareholders, is liable for the corporation's debts. Furthermore, absent wrongdoing on their part, officers and directors are not personally liable for corporate debts.

Many people believe that there are two types of corporations: “S” corporations and “C” corporations; however, this is incorrect. The name "C corporation" is derived from the fact that regular corporations are taxed by the Internal Revenue Service under subchapter C of the Internal Revenue Code. An S corporation is organized and operated just like a regular corporation except for the special treatment afforded it under subsection S of the federal Internal Revenue Code.

With some limited exceptions the S corporation is not taxed at the corporate level. Instead it is permitted to pass income and losses through to its shareholders who report the income on their federal tax returns. A business must meet certain eligibility requirements to qualify for incorporation as an S corporation. S corporation status is established under federal income tax law and, therefore, is not necessarily available for purposes of state income tax law.

So, how do you determine whether a C corporation or S corporation is best for your business?  You should consult with your tax advisor about the best tax election for your business, but here are some common situations that may also factor into your decision:

A limited liability company (LLC) is another type of business formation designed to protect its owners from personal liability for the debts of the business. The LLC is not a partnership or a corporation but rather a hybrid of the two that has the benefits and advantages of both a corporation and a partnership but few of the disadvantages of either.  An Arizona limited liability company is created by filing Articles of Organization with the Arizona Corporation Commission. Aside from this formality, the limited liability company can be structured to operate and/or taxed as a sole proprietorship, partnership or a corporation, depending upon the wishes of its owner(s).  An owner of an LLC is called a "member."

A general partnership is the simplest form for a business to take when two or more people own the business. A partnership exists whenever two or more people co-own a business for profit and share in the profits and losses of the business. A partnership arises automatically whenever this arrangement exists, and no further formalities are necessary. Partnerships themselves pay no taxes; instead, the business "passes through" any profits or losses to its partners who report them on their personal tax returns. Because partnerships entail more than one person in the decision-making process, development of a legal partnership agreement which sets the ground rules for the partnership is important. 

Importantly,  A general partnership offers no liability protection to the partners. Each partner is personally liable for the partnership's debts and all the partners are liable for debts and obligations resulting from the wrongful acts of another partner if that partner acted in the ordinary course of partnership business or acted with the authority of the other partners.

The limited partnership is a variation of the general partnership. In a limited partnership there are two types of partners: general partners and limited partners. The general partners are the partners who manage the business and have the power to bind the partnership. Only the general partners are personally liable for the partnership debts. The limited partners are essentially passive investors. They do not participate in the management of the partnership, they may not bind the partnership and are not personally liable for the debts of the partnership. The formation of both the limited liability partnership and the limited partnership requires special formalities, such as filing with the appropriate state official.

The limited liability partnership is another variation on the basic partnership model that evolved mainly in response to the desire to reduce the exposure to personal liability for the obligations of the partnership. In order to limit the liability of its general partners, a general or limited partnership may opt to register as a limited liability partnership. The limited liability partnership resembles a regular partnership in all respects except with respect to the allocation of liability. In a limited liability partnership, each partner is protected from personal liability arising from negligence, malpractice or improper conduct of other partners, agents or employees of the partnership, but not from his or her own actions of negligence, malpractice or improper conduct.

The advantages and disadvantages of the organizational forms described above must be considered when choosing the appropriate organizational form. For one, certain structures are more expensive to set up and maintain than others, and more formal steps may be required to establish them. Corporations must comply with strict statutory formalities regarding their creation and continued existence. In Arizona, corporations must file annual reports, whereas LLCs are not required to do any ongoing filing after their formation.  Tax rules also must be observed. For example, failure to continually meet the requirements for S corporation eligibility will result in termination of S corporation status and thus result in potentially serious tax consequences. On the other end of the spectrum, general partnerships require no formalities whatsoever.

The management and control of the business is another big consideration. Corporations are not actually operated by the owners (shareholders) of the business. Instead, the shareholders elect a board of directors and officers to manage and control the business. By contrast, the partners in a general partnership have complete control over business operations, as does the sole proprietor. The general partners manage a limited partnership, and an LLC may be managed either by its members or by managers selected by the members.

Personal liability for the obligations of the business is critical. The protection of the owner's personal assets from the claims of business creditors is generally not available to a general partner in a limited partnership, all partners in a general partnership and the owner of a sole proprietorship.  In these business forms the owners are all subject to unlimited personal liability for the debts of the business.  This means that the owner's personal bank accounts, investment accounts, real and personal property and other assets are at risk.

Because different organizational forms are taxed differently, the tax consequences of the chosen organizational form should be explored. As a separate entity, the C corporation is subject to what is known as "double taxation."  First, the corporation pays income tax on its earnings. Then, if the corporation chooses to distribute its after-tax income to the shareholders in the form of dividends, the shareholders must pay tax on that income as well. The same income is taxed twice at the corporate and at the shareholder level. Money passing through partnerships, limited partnerships, limited liability companies and S corporations are not taxed as separate legal entities. Instead, the profits and losses of the business flow through to the owners themselves. There are many other factors to be considered, such as, how the owners will be compensated, whether benefits will be offered to owners and employees, whether there will be more than one class of stock, and, whether there will be restrictions on the transferability of ownership. 

The decision as to which organizational form to use depends on numerous factors, including the limitation of personal liability of the owners, tax consequences, and the roles of the various owners.  An experienced business attorney can help you decide which business structure is right for you in light of your specific business needs.

As a small business owner and a business attorney, Jeana Morrissey has the experience to help you sort out these factors and form your business entity.  Contact us today by email or by phone at (602) 556-1902. 

By Jeana Morrissey

You are finally about to land that much sought-after client, job, project, rental space or sales agreement, and you are ready to prepare or sign the business contract.  It is vitally important that you not only put your agreement into a written contract, but that you review, negotiate and understand the terms and provisions to which you are agreeing in order to protect yourself and help prevent future problems.  More than a binding legal agreement, a contract serves as an important point of reference for each of the parties, defines the relationship of the parties and irons out all your terms and conditions in advance. 

If a dispute arises, the parties will look to the contract to determine how to proceed.  The dispute is much more likely to be resolved if the contract is clear as to how the parties are to deal with that particular issue.  

In addition, a well-drafted contract that protects your rights will benefit you if you must go to court.  Say you’ve entered a contract to provide services to a customer. If the customer refuses to pay and you have to file a lawsuit in order to recover your money, the contract will be the primary key to your success or failure.  The court will always look first and foremost to the written contract to determine the rights and obligations of the parties.  For this reason, it is important that your contract clearly defines these terms. If the contract terms are vague or are missing key elements, it opens the door to arguments that the contract means something other than what you intended. 

Moreover, an attorney reviewing the adverse party's rights and defenses will be more likely to advise the other party to pay or settle with you where the contract is solid as to your rights, thereby greatly reducing your legal costs in the long run. On the other hand, a poorly drafted contract might make it more difficult to collect from a customer, and may even expose your business to unanticipated liability.

The best way to effectively resolve disputes and avoid a potential adverse ruling in a lawsuit is to craft a solid contract in which you’re confident that you have negotiated the best terms for you or your business.  We can prepare your business contracts or review contracts presented to you for the following situations:

Hiring, or being employed as, an employee or independent contractor
· Employment contracts
· Confidentiality agreements
· Non-compete agreements

Buying or providing services or goods
· Contract for services
· Product sales contracts
· Vendor contracts

Entering into leases and other real estate agreements
· Commercial leases
· Residential leases
· Purchase and sales contracts
· Promissory notes
· Deeds of trust
· Security agreements

Buying or selling a business
· Asset purchase agreements
· Stock purchase and sale agreements
· Consulting agreements
· Promissory notes
· Security agreements
· Non-compete agreements

Entering into business affiliations and common ventures
· Co-ownership agreements
· Partnership agreements 
· Joint venture and other agreements between parties

A well-drafted contract for goods and services is just one way to prevent needless costs before they arise. In other words, you may not want to spend money on an attorney before you enter into a contractual obligation or make a business decision, but it could end up cutting your costs significantly in the long run.


About the Author:  Jeana R. Morrissey is a Business and Real Estate Attorney practicing in Gilbert, Arizona.

If you start your business as a general partnership or sole proprietorship instead of a limited liability entity, not only are your investment in the business and the business assets at risk in the event of a lawsuit or other problem, but so are your personal assets.  It is important to separate and protect your personal assets from your business by forming an LLC, corporation or even a limited liability partnership.  Choosing the right entity type is also important. Incorrectly setting up a legal business entity can potentially cost your company thousands of dollars in revenue, affect potential funding and raise other issues.  

You must put all your business agreements in writing and to be sure that those written agreements clearly define each of the roles/obligations/duties of each party as well as the remedies available if either party violates any of the terms of the agreement. This is essential not only for your contracts related to goods and services, but also for your contracts with your business partners.  It is vital for business partners to discuss and clearly define in a written agreement issues such as:

• How much time and effort is each person expected to contribute? 
• How much capital will each person contribute? 
  
• What happens if the business needs more capital? 
  
• What happens if one person wants to leave the business? 
  
•  If the partner is married, what rights and interest in the business will the spouse have in the event of divorce or death of the partner?
  
• Will the company buy back the stock or interest from the estate of the deceased partner or from the partner leaving the business?
  

The internet is full of websites offering free and low-cost documents that promise to take the place of spending time and money with an attorney.  The problem with these forms is that they are typically very generic, full of legalese that few people understand completely, and rarely contain particular nuances required by state and local laws in order to be upheld in your local jurisdiction. Every business situation is unique and you increase your legal risks if you attempt to apply a generic one-size-fits-all contract or generic legal advice to your situation without having a professional evaluate the facts, terms and understanding of the parties, as well as federal, state and local requirements, and confirm that your contract addresses all of the relevant issues.  

If you are presented with a contract to sign by another party, you should have it reviewed by a business attorney before signing it to have the attorney explain all the key provisions in the document so you can ensure that you understand what it is that you are agreeing to and what the consequences are of failing to abide by its terms.

Make sure that all of your written contracts with customers, business partners and affiliates, employees vendors, landlords or renters are executed in the name of your entity and never by you personally.  When you sign a contract using only your name, you are obligating yourself personally to fulfill the terms of that contract.  For example, if your company is entering into a contract with another party, the contract should be between your company and the other party - you should avoid being identified personally as a party to the contract.  Moreover, you should sign the contract only in your capacity as the owner, president, or manager of your business.  

If you are named on the contract and due to unanticipated circumstances your business is unable to fulfill its obligations under the contract, the other party can sue you personally, which places your personal assets at risk.  If, however, you ensure that you are not personally named in the contract other than as a signer on behalf of your company, the other party is limited to suing your company.  Also, try to avoid signing personal guaranties whenever possible.  If you fail to observe these rules, you lose the limited liability protection for which you formed your legal entity.  

If your employees are "at will" employees, which means they can quit or be terminated at any time without exposing your business to liability, be sure to have them sign something acknowledging their understanding of this employment status. Inform your employees that discrimination, sexual harassment, and other illegal acts won't be tolerated, but be careful when preparing employee handbooks because they are often treated as an enforceable contract by Arizona courts. An employee handbook is a great way to outline your expectations for your employees and keep the employer-employee relationship on a professional level.  An employee handbook can also set forth the rules regarding the disciplining of the employee; however that is a double-edge sword in that the same document can be used against your business to protect the employee.  Work with a human resource consultant and attorney to draft a handbook that fits your situation and make sure you clearly understand what is contained in the handbook.

Use caution in how you deal with independent contractors.  Many business owners think that by calling someone an independent contractor they can save thousands of dollars in payroll taxes.  This can be true, but even if the business owner and the independent contractor agrees to this arrangement, the IRS can still step in and decide otherwise. The IRS provides detailed information and a multiple point test to determine whether the independent contractor you've hired is actually a W-2 employee in disguise (see, for example: http://www.irs.gov/pub/irs-pdf/p15a.pdf). It is imperative that you review that test and understand the legal risk and consequences of not complying with the rules related to independent contractors.

If you have a legitimate independent contractor situation, it is extremely important: (1) to ensure the contract you have covers the entire agreement and protects you in the case of a breach, and (2) that you continue to observe the rules and limitations relative to your relationship with the independent contractor throughout the term of your working relationship.

Whether you realize it or not, your company likely has intellectual property issues that may be important to the future success of the business and which should be protected.  For example, do you require your employees and consultants to sign confidentiality and non-disclosure agreements? How about invention assignment agreements?  Have you registered for a trademark for an important company logo or product? Are your trade secrets adequately protected? Do you have key employees sign non-compete/non-solicitation agreements so as to avoid a scenario in which an employee leaves your company, starts an identical business nearby, and takes your other key employees and customers with them? 

Whether you realize it or not, your company likely has intellectual property issues that may be important to the future success of the business and which should be protected.  For example, do you require your employees and consultants to sign confidentiality and non-disclosure agreements? How about invention assignment agreements?  Have you registered for a trademark for an important company logo or product? Are your trade secrets adequately protected? Do you have key employees sign non-compete/non-solicitation agreements so as to avoid a scenario in which an employee leaves your company, starts an identical business nearby, and takes your other key employees and customers with them? 

By helping you manage legal risk, a business lawyer can be the ounce of prevention your small business needs to keep it healthy.  You should always expect the best outcome for your business, but it's critical that you plan for the worst outcome.  Utilizing well-drafted contracts from the beginning that protect your legal rights will reduce the risk of your having to file a lawsuit later over a business issue that was not contractually provided for.  A well-drafted contract for goods and services is just one way to prevent needless costs before they arise.

I have seen countless situations that could have been avoided or at least minimized had the client sought legal advice early on.  It can cost ten times more to work though a legal problem than it would have to identify the potential legal issue early and handle it before it spirals of control.  Isn’t it better to identify and avoid potential legal problems with the help of an attorney than it is to watch your hard earned revenue pass directly to the legal system and an opposing party? 

Whether you run a small or large company, having sufficient general business liability insurance is important. Depending on your type of business, you should also have other types of insurance coverage, such as product liability, professional liability, commercial property or home-based business insurance. Insurance protects small business owners from things that can happen during the course of business -- whether a customer gets hurt using a product, you make a professional mistake, you damage someone's property or there is some kind of disaster. It covers the business and the business owner from any claims by covering investigations to defend the business and either settling with the claimant or by representing you in a lawsuit.

You will transition out of your business. Whether you work until you drop, or decide to sell or shut down your business at some point, it will happen.  It's never too early to begin making plans for the future of your business. By starting early, you can be sure you're the one at the wheel, building and managing your transition plan with your own team of advisers.  This becomes even more critical if you co-own your business with partners, as was discussed earlier.  Successfully transitioning out of your business is all about setting and reaching goals. 

Most of the time the legal mistakes made by new business owners are not intentional, but are simply due to lack of knowledge. You can prevent future costs by making sure that your company is organized properly and then educating yourself on the things you need to do and observe to protect not only your small business, but your personal assets as well. Having a good relationship with your business attorney is an effective way to manage your small business’ risk and to prevent unnecessary future legal expenses. If you have questions about your small business, contact us today. We'll help you reduce the risks faced by your business.