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Forming & Maintaining Business Entities

Whether a business should incorporate involves consideration of a number of factors. However, once a business decides to incorporate determining the type of corporation requires assessment of a variety of factors. The following summaries are designed to assist a business owner to decide whether a Subchapter S corporation or a limited liability company (LLC) or another entity - such as a sole proprietorship, C corporation or limited partnership - is best for your business. For further information contact our knowledgeable professionals. We have counseled numerous business entities throughout Southern California in developing a successful business plan.

Sole Proprietorship

In general, this type of entity is for a sole owner or a sole owner and spouse. If there will be other owners or investors, other than a spouse, a LLC or corporation should be considered or the law will consider you to have formed a general partnership and you are personally liable for any contracts your partner enters or acts your partner takes with respect to the business. Additionally, a Subchapter S corporation may well be better than a partnership in terms of the self-employment tax that must be paid. The tax advantages to a sole proprietorship is usually better than with a corporation or LLC as the cost and administrative time of establishing and maintaining a separate entity is avoided. Notably, a LLC or corporation has to pay the State an $800 annual minimum tax. A sole proprietorship does not have the benefits of a corporate shield and therefore its personal assets are not protected from litigation; however, a business can obtain sufficient protection through insurance.

"C" Corporation & LLC

A "C" Corporation provides valuable tax benefits to businesses that can set salaries and bonuses because certain fringe benefits are tax deductible and are not counted as income for employees. Employer payments for health insurance premiums and other medical expenses is deducted as a business expense, but isn't included in employees' gross income. Employer payments for the following are treated the same way: (a) employees' life insurance benefits; (b) accident and disability benefits; (c) death benefits; and (d) supplementary unemployment benefits; (e) employee parking expenses and employer-provided transit passes (up to certain limits); (f) child care; (g) meals and travel lodging.

If a C Corporation has profits, there is double taxation despite the benefit of offsetting of salaries and bonuses to minimize profits. Notably, passive investors will often insist that there be profits. This often results in the "C" corporation paying taxes on its profits and the owners paying taxes on their salaries and any dividends. In contrast, Subchapter S corporations and LLC permit profits and losses to flow through owners in proportion to their percentages of ownership.

Limitations to LLC and Subchapter S Corporations

California law prohibits individuals licensed under the California Business & Professions Code or under the California Chiropractic Act or the California Osteopathic Act from forming an LLC to practice those licensed services. This includes, but is not limited to, physicians, lawyers, accountants, licensed contractors, and similar like professionals.

Non-resident aliens are also prohibited from being owners of a Subchapter S corporation; however, beneficiaries of a small business trust may be an owner of a Subchapter S.

If a business entity is to have investors that are not individuals but rather corporations then a newly started business is limited to forming a LLC as it the only option for preserving profit and loss pass-through. Subchapter S corporations can only have individuals and certain trusts as owners. Similarly, if a business entity will eventually have more than 75 shareholders, counting a husband and wife as a single shareholder than it is limited to an LLC since a Subchapter S corporation cannot have more than 75 owners. Moreover, receipt of passive income should be considered by an organizer. Passive income is income from dividends, interest, royalties, rent payments, annuities, etc. - as opposed to income directly generated by your labor.

Another factor to consider when determining the type of business entity to be formed is whether paper losses are anticipated during the first year (or beyond). Paper losses are determined by multiplying anticipated percentage of ownership in the company by the total of those paper losses. The total amount that exceeds the value of items , such as cash, equipment and similar like items, can assist in determining the type of entity. For example, a Subchapter S, can only deduct losses up to the amount of your investment; an LLC's can deduct all losses.

The type of stock to be offered to the public or employees can also determine the type of entity. A Subchapter S corporation can only have one class of stock although differences in voting rights and deferred compensation are not considered different classes for purposes of S status. However, debt that is convertible to stock and stock with different distribution rights are considered different classes of stock. Straight debt is not considered a second class of stock provided the borrower cannot alter the due date and the interest payments are not contingent on profits or on the borrower's discretion. In general, an agreement to provide future services to a corporation is prohibited to purchase stock. Under California law, if a promissory note is used to purchase stock, the note must be adequately secured by collateral other than the stock itself, unless it is given pursuant to a stock purchase plan or a stock option plan. An LLC has no such restrictions.

Corporations do not have to pay the California $800 minimum franchise tax during their first year; however, LLC are required to all taxes due as well as tax on revenue. A Subchapter S is still required to pay 1.5% of any profits it has during the first year.

Partnership

In California a partnership is formed whenever two or more persons associate as co-owners to carry on a business for profit, whether formed under UPA (Uniform Partnership Act) or RUPA (Revised Uniform Partnership Act), unless they explicitly form another type of entity. Even if you do not intend to form a partnership, as long as you have a business for profit, unless you have fulfilled the requirements to form some other entity, you will have formed a GP by implication.

There are specific requirements for most entities to be formed. For instance, if a corporation is intended, Articles of Incorporation must be filed with the Secretary of State; if an LP is intended, the partners must have a written limited partnership agreement and file Form LP-1; if an LLC is intended, its members (as LLC owners are called) must have a written operating agreement and file Articles of Organization (Form LLC- 1). By comparison, if the persons intend to have no formal entity at all, have not signed a written agreement, and have filed no documents, but are considered to have gone into a business together for profit, they are partners in a General Partnership.

Since general partners have specific duties to each other, and since each general partner is (usually) fully liable to third parties for actions taken in the course of the business, it is dangerous to enter a business relationship with others without carefully defining the relationship and considering the consequences.

Authority to Bind Partnership

A major source of litigation among partners, as well as between partnerships and third parties, results from actions taken unilaterally by one partner. The typical questions are, did the partner create a partnership obligation to a third party, and if so, is the partner liable to the other partners for acting outside his or her authority?

To address these questions, RUPA has established a system of filing statements with the Secretary of State that provide notice to third parties in major transactions. A GP may file a Statement of Partnership Authority to name those partners authorized to sign an instrument transferring real property, and to specify the authority (or limits of authority) on some or all partners to enter into transactions.

Fiduciary Duties

Partners in a General Partnership have always been considered "fiduciaries" to each other. The current UPA makes no explicit mention of fiduciary duty, but a large body of case law has developed in the courts. RUPA however, attempts to define the nature of partners' fiduciary.

RUPA fiduciary duties include the following:

(1) The duty of loyalty, which the statute says includes:

(i) accounting to the partnership for any property, profit or benefit derived by the partner in operating the partnership business or using partnership information (including the use of a business opportunity that would, under customary circumstances, be an opportunity that the partnership would take);

(ii) not dealing with the partnership as or for an adverse party, except in the partner's capacity as a lender to the partnership ( i.e. conflict of interest); and

(iii) not competing with the partnership until the partnership has dissolved.

(2) The duty of care, which is limited to avoiding grossly negligent or reckless conduct, intentional misconduct or a knowing violation of law.

(3) The duty of good faith and fair dealing, which underlies all contractual relationships.

The partners may not agree to eliminate the duty of loyalty, nor to "unreasonably" reduce the duty of care, nor to eliminate the obligation of good faith and fair dealing. However, as long as it would not be "manifestly unreasonable", they may identify specific types of activities or authorize (after full disclosure) specific actions that do not violate the duty of loyalty. They may also agree on standards to measure good faith and fair dealing.

RUPA's fiduciary duty rules will apply to Limited Partnerships (LP) insofar as general partners of an LP have fiduciary duties to each other and to limited partners. The rules will also apply to LLCs insofar as LLC managers (who may also be members) have fiduciary duties to other members, LPs and LLCs should also check their agreements to ensure compliance with RUPA's fiduciary rules.

Dissociation:

Another major source of uncertainty and dispute in partnerships has involved a partner's withdrawal from the partnership and the resulting dissolution of the partnership. Under the current UPA, unless the partners have agreed otherwise, a partner's withdrawal or resignation requires the partnership to dissolve and liquidate. There has been no firm assurance of continuity of the partnership business by the remaining partners. RUPA reverses the situation by making a partnership continue on a partner's withdrawal (now called a "dissociation") unless the partnership agreement expressly provides for dissolution when a partner dissociates. Dissociation generally denotes the change in the relationship caused by a partner's ceasing to be associated in the carrying of the business.

A partner may not give up the power to dissociate, but the dissociation may be "wrongful" if the partnership agreement so provides, in which case the dissociated partner may be liable for damages to the partnership and the other partners. If the partnership continues after the dissociation, the dissociated partner is entitled to be paid for the value of his or her partnership interest, offset by the amount of any such damages and any other amounts he or she owes to the partnership.

RUPA sets rules for determining the buyout price and the time and manner of payment, depending on the circumstances of the dissociation. For instance, a partner who wrongfully dissociates is not entitled to receive payment until the partnership dissolves and winds up its business.

Litigation:

RUPA clarifies the relationships of parties involved in a partnership/nonpartner lawsuit. A partnership may sue in its own name without being joined by the partners. If a partnership is sued, its partners are not parties to the lawsuit unless they are also named. An action may be brought against both a partnership and its partners, either in the same action or in separate actions. A judgment against a partnership is not, by itself, a judgment against its partners.

Under RUPA, a judgment creditor against a partnership is not allowed to obtain the assets of any partner to satisfy the judgment except in limited circumstances, such as exhaustion of remedies against the partnership, determination that the partnership is clearly unable to satisfy the judgment, or the partner's independent contractual obligation to satisfy the judgment.

Conversion to Another Entity

Partners may want to consider converting their GP to an LLC or other form of entity in light of the limited liability advantages now available. RUPA provides a mechanism for a RUPA-governed GP to convert to an LLC or LP without dissolving the partnership; however, the laws governing LLCs and LPs do not yet contain express provisions for conversion from GPs, so the process is still cumbersome. Conversion from a GP to a corporation is not allowed; instead, the GP must dissolve and liquidate first, and the former partners may then contribute liquidated assets to a new corporation.

Professional Organizations

Some confusion has arisen in the choice of entities due to the proliferation in the number of choices now available -- GPs, LPs, LLCs, "C" corporations, "S" corporations, etc. Some professional groups are now organized as "limited liability partnerships." They operate much the same as GPs, but have some of the attributes of LLCs. These entities are limited to accounting and law partnerships, and may not currently be used by any other type of business.

Other professional or business entities that require state licensing may also be limited in the type of entity available. For instance, real estate brokerage companies may not currently organize as LLCs or GPs (although brokers may operate as a partnership, so long as all partners are licensed brokers). You should check with your particular licensing agency to determine what entity choices are available.

Out-of-State Entity Based in California

Individuals interested in forming a business entity often inquire as to whether setting up a out-of-state entity would be a means to avoid taxes. For example, the State of Nevada has no corporate or personal income tax. However, a California resident pays California tax on all of his/her income, even if that income comes from outside California. Moreover, it is very difficult to establish residency outside of California if you are doing anything in the State. Generally, an individual is not a California resident only if:

1. His/her presence in California does not exceed 6 months within a taxable year; AND

2. If he/she maintains a permanent home outside California; AND

3. If he/she does not engage in any activity or conduct within the State other than as a seasonal visitor, tourist, or guest.

It is presumed that an individual is a California resident if present in California for more than nine (9) months in any given tax year. Further details can be obtained at the Franchise Tax Board's Guideline for Determining Resident Status, which can be found at www.ftb.ca.gov.

For further information, contact the staff at the General Counsel Services. We have counseled numerous business entities throughout Southern California in developing a successful business venture.

Everyday Operations of the Business

Once a business is formed the hard part begins for the owners. Now contracts have to be signed, accounts opened and products sold and delivered. Every step of almost every business and or industry involves a decision that in one way or another hinges on making legal or semi-legal decisions. As an example a manufacturer would have to sign a manufacturing agreement, agree to the terms of a purchase order and/or send out an invoice before it can receive money for its products. We at the General Counsel Services assists our clients in making sure that the contract or document they sign, be it a manufacturing agreement, a purchase agreement, an employment contract, purchase order, an invoice, notice of termination of agreement, non-disclosure agreement, release of liability, settlement agreement or any other legally binding document that they might need to execute is thoroughly reviewed by an experienced attorney and that our clients know the options available to her or him. If requested, our attorneys can also contact the other party to the agreement or their attorneys to help negotiate the final execution of the document. Once the agreement is executed, the General Counsel Services offers our clients the ability to contact our attorneys with any questions that might arise as a result of parties' engagement in business dealings. The General Counsel Services, and our attorneys' wealth of experience comes specially helpful to our clients when faced with situations involving hiring or terminating employees or dealing with claims made by employees. We have had many instances in which we've been hired to correct a mistake made by a manager or owner when terminating an employee or responding to a claim.

By becoming a member of the General Counsel Services ™ you can take advantage of an experienced attorney's input in:

  • Drafting Employment Agreements with or without enforceable Arbitration Clauses;
  • Reviewing all proposals to make sure that our client's rights are protected;
  • Periodic review of our client's payroll to ensure that employees are classified correctly as either exempt or non-exempt;
  • Quarterly meeting with board of directors and or officers to discuss company's long and short term goals;
  • Responding to claims made by businesses or individuals;
  • Ensure compliance with State and Federal labor laws;

Case Example:

For instance we were recently retained after our client a major local laboratory received a negative verdict from the Labor Commissioner based on an ex worker's claim that he wasn't paid his check on time. The Commissioner had ruled that our client was responsible for the check and the waiting time penalties under Labor Code § 203 which added to almost twenty times the actual check. After we were hired we immediately filed an appeal of the decision to the Orange County Superior Court, and after a trial in front of a Superior Court Judge, we were able to obtain a complete verdict in favor of our client. Had the services of General Counsel Services been utilized by our client from when the ex worker was terminated we could have helped save our client thousands of dollars and tens of hours of their precious time.

Responding to Claims and Making Claims on Behalf of a Business (Business Litigation)

Contrary to popular opinion majority of lawsuits in the United States are not between individuals and or individuals and business. Rather, business against business lawsuits comprises the majority of cases now on dockets in California and most other jurisdiction. For this reason alone, many businesses feel that they have to have an in-house attorney to advise them on potential liabilities and claims. Following is a short list of some of the issues that can give rise to litigation involving a business:

1) Breach of Contract,

2) Breach of Fiduciary Duty,

3) Violation of Non-Compete Clause or Agreement,

4) Claim for Unfair Trade Practices,

5) Wrongful Termination Lawsuit,

6) Antitrust Violations, i.e., Business and Professional Code § 16700, Sherman Act, Clayton Act violations,

7) Breach of Personal Guarantees,

8) Trademark Violations,

9) Violation of Uniform Trade Secrets Act, California Civil Code § 3426.1,

10) Violations of Unfair Trade Practices statutes, California Business and Professions Code § 17200,

11) Violations of Unfair Competition Statutes, California Business and Professions Code § 17200

Our experience has shown that businesses can save a lot of money by outsourcing their legal department to a qualified firm that has the expertise and the resources to provide legal advice and services on an as needed basis. The General Counsel Services is currently helping many successful southern California businesses save hundreds of thousands of dollars in litigation costs. ( See Our Clients.) Our attorneys are involved in every stage of our clients' business transactions. As a result once and if litigation becomes inevitable, we can immediately "jump in" and provide legal representation to our clients without having to become familiar with the facts. In addition due to the fact that we have long terms business relations with our clients, we can offer our services at a reduced fee. Our litigation attorneys are highly experienced and have litigated multi-million dollar cases in federal and state courts all throughout southern and northern California counties such as Orange County, Los Angeles County, Riverside County, San Bernardino County, Alameda and San Diego County. We take pride in the fact that we have litigated and tried very complicated antitrust, employment law, licensing law, franchise law and business litigation cases.

Buying and or Selling a Business

Common issues often arise in buying or selling of a business. An individual's awareness of these issues can preclude confusion and possible future litigation. Below is a checklist with further explanation following each category. For further information or inquiries contact the staff at the General Counsel Services. We have counseled numerous business entities throughout Orange, San Bernardino, Riverside, Los Angeles, San Diego and other California counties, in developing a successful business planning. Amongst our clients are a publicly traded semiconductor manufacturer with over 400 employees, a retail chain and a number of highly successful software start up companies. Every one of the clients referred to has had to rely on advice of our professionals for issues such as mergers and acquisitions, acquitting of another company and developing a successful business plan. Below are some of the topics that both the selling and the buying entity must pay attention to:

Confidentiality Agreements

A seller should require all potential buyers to sign a confidentiality agreement prior to providing proprietary information. This will not only provide protection to the seller but future buyer. Without an enforceable confidentiality agreement seller risks providing the potential buyer with information which the potential buyer could later on use to start the same type of business without acquiring the seller's assets. Therefore, before any information about the business is transferred parties should sign a well drafted confidentiality agreement.

Type of Sale

Next the parties must decide on what type of a sale are they planning to consummate. In an asset sale, the assets being purchased obviously must be listed in a sale of assets. All assets should be identified. A clause merely stating that the sale includes all equipment, furniture and supplies on the premises will inevitably lead to confusion and potentially to expensive and time consuming litigation. If we represent the buyer we would insist that the agreement should also list any liabilities being assumed by the buyer and expressly provide that no other liabilities are being assumed. In a sale of stock, a buyer should request a list of the seller's assets and liabilities, which should be incorporated into the agreement. If we represent the seller in a transaction we always ask for a comprehensive indemnification agreements to make sure our client would not be pursued by overly aggressive creditors.

Valuation of Business

A buyer should be aware of various valuation methods as the valuing of a business is subjective and is subject to negotiations. Common valuation methods include the following:

i. Market-based valuation. This is based on the sale prices of similar businesses in that geographic area.

ii. Asset-based valuation.This takes into account figures such as the book value and liquidation value of the business.

iii. Earnings-based valuation. This takes into account historical financial figures, including debt payments, cash flows (past, present and projected) and revenues.

Taxation Issues - Assets versus Stock

Consideration of tax issues should also be expressly addressed by the parties. For this reason we at the General Counsel Services work closely with reputable and professional C.P.As which provide invaluable advice to our clients.

Covenant Not to Compete

California Business and Professions Code § 16600 provides that "Except as provided in this Chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void." Sales of a business are one of the rare occasions where California will uphold a covenant not to compete provided a specific geographic area where the business has been carried is specified in the purchase agreement. This exception is codified in Business and Profession's Code § 16601. A covenant not to compete can be concluded in a separate agreement or incorporated into the purchase agreement. Payments specifically allocated to the seller's covenant not to compete must be reasonable in nature and amount.

Successor Liability

If the buyer is continuing the seller's business, it may be liable under a "successor liability" theory for any product-liability suits brought by "pre-closing" customers provided the buyer is continuing the seller's business. An indemnification clause running from the seller in favor of the buyer and adequate business insurance may safeguard a buyer.

Assignment of Leases and Contracts

An issue that should also be addressed in any purchase agreement is the status of any relevant leases. If existing leases are relevant to the sale, the buyer should include provisions stating that closing is contingent on the landlord's approval of the leases using the current rents and lease provisions and that the leases permit assignment or include provisions stating that closing is contingent on the other parties to the contracts agreeing to the assignment.

Licenses & Permits

A seller should expressly represent that it is in compliance with all local, state, and federal laws and that it has all licenses and permits needed to operate the business, which can all be transferred to the buyer. Further inquiry should be made by the buyer as to any additional and/or necessary fees from the issuing authorities for these transfers.

Intellectual Property

If intellectual property ( patents, trademarks, logos, etc.) is included in the purchase agreement, the buyer should require that the seller warrant that the seller owns the intellectual property and will indemnify the buyer for any third-party claims of infringement.


If you are an owner or manager of a Southern California small to mid-size business located in Orange County, Los Angeles County, Riverside County, San Bernardino County or San Diego County call 888-529-2188 for a free estimate on what our fees would be to provide your business with high caliber legal representation by a team of business lawyers and corporate attorneys well versed in the areas of: business law, corporate law, employment law, trademark law, breach of contract and, negotiations of agreements.