Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

As I was doing my usual lunchtime surfing and Google Reader review, I came across an interesting quiz presented by Ben Blanquera at the Columbus Tech blog which is supposed to help you decide if you have what it takes to really be an entreprenuer.  It asks the usual sorts of questions about being willing to work hard and make sacrifices, but it also asks questions like your birth order and whether you had chores around the house before you were 10.  I took the test - my score indicates that I have the "necessary characteristics to be an entreprenuer". 

The Small Business Administration's webpage also explores "Is Entreprenuership for You?" and has a checklist to help aspiring entreprenuers answer the question, "Do You Have What It Takes?"

I've also been reading the Napoleon Hill classic, THINK AND GROW RICH which purports to contain the secret needed to identify your goals,  obtain whatever you want in life, and join the ranks of the super-successful.  Early on he says:

desiring riches with a state of mind that becomes an obsession, then planning definte ways and means to acquire riches, and backing those plans with persistence which does not recognize failure, will bring riches 

Do not wait for a definite plan through which you intend to exchange services or merchandise for the money you are visualizing.  Begin at once to see yourself in possession of the money, demanding and expecting meanwhile that your subconscious mind will hand over the plan, or plans, you need.  Be on the alert for these plans, sand when they appear, put them into action immediately.  They will probably "flash" into your mind through the sixth sense, in the form of an "inspiration.  

All of which got me to thinking about what it actually DOES take to be an entrprenuer.  It almost goes without saying that you must be willing to work incredibly hard and have enormous faith in yourself even when no one else really does.  But being a successful entreprenuer has to be more than that.

Some years ago when I was moving my law practice from a large firm to a much smaller one and became more responsible for finding my own work, I asked an attorney I knew from a smaller firm what the biggest difference would be.  "The highs are higher and the lows are lower," he said.  And I think that is also true for entreprenuers of any kind.        

Entreprenuers must have both a dreamer and and hard-headed realist within them.  Having the courage and fortitude to endure the uncertainties any new business will face and know the difference between when to forge ahead and when to change course is a special set of talents. 

Without a dream and vision, there's really no reason to be out on your own instead of working for someone else.  Seeing that dream and vision come true is a feeling unlike any other.  However, without the ability to adapt to events and circumstances as they occur and perhaps even modify the vision a bit, the project may stall or fail entirely.  

So you have to REALLY WANT IT to stay out there.  If you don't, the pain and difficulty of the journey could never be worth the effort and sometime even heartbreak along the way. 

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Suppose you've made an investment in an LLC running, say, a nightclub.  It's a manager-managed LLC so someone else is handling the day to day affairs of the company.  Then, what was once a popular hot spot becomes passe and the business becomes less profitable.  So you start to worry about how things are being done and may even suspect that there has been some financial mismanagement.  You decide to take a look at the company's books yourself, but are surprised to find that the manager of the LLC refuses to give you access.  Can he do that?  

Peter Mahler over at the New York Business Divorce blog (which has a terrific and very appropriate masthead of two hands engage in a tug-of-war) posted last week on divergent results reached in two New York cases concerning the right of non-managing LLC members to inspect the books and records of the company.  He also pointed out that the New York statutes governing access to a company's books and records differed depending upon whether the entity was formed as a corporation or a limited liability company.  

What LLC Members Have to Do to Get Information.   Because the pertinent Ohio statute (Ohio Rev. Code 1705.22) is similar to the New York statute, I became interested.  Like New York, Ohio law provides LLC members  with a right of access to certain specified types of information, including financial information "upon reasonable demand for any purpose reasonably related to [the member's] membership interest in the company".  In both states, one of the categories of information includes a catch-all "other information regarding the affairs of the company that is just and reasonable".  And what does that mean?

Peter describes two recent New York cases reaching opposite results, with one holding that the member was entitled to the documents sought and the other concluding that the request was too vague.  To be fair, in the case denying the member access to LLC records, there was already litigation pending and the member was refusing to pay for the expense of copying.  In dicta, however, the court said that the desire to obtain documents to determine if the LLC manager had engaged in fraud or other wrongdoing went "well beyond the scope of the type of documents detailed in the Limited Liability Company Law." 

In the other case described by Peter, the LLC members seeking access wanted to determine if the LLC manager had caused the LLC to improperly enter into a management contract with a certain third party in violation of Department of Health regulations.  The court determined that access to the books and records sought was required.  In contrast to the first case, the court chose to interpret the statute broadly, placing the burden on the company to justify the restrictions rather than on the member to justify inspection rights:

Respondent's assertion that petitioners must demonstrate a need to review the records before such records are made available is without merit.  The only statutotry requirements for obtaining full access to the records is that the person demanding access is a member at the time the demand is made and that the demand is reasonably related to the member's interest.

I didn't find any Ohio caselaw interpreting its version of the statute.  Ohio law in the analogous situation of shareholders seeking access to corporate books and records has been to place the burden on the company to demonstrate the sound basis for any restrictions.  However, to be certain access to company records is at the level desired, it is best to spell it out in the Operating Agreement.  

Comparison with Access to Books and Records of Corporation or Partnership.  Which brings me to Peter's other interesting point - namely, the statutes governing access to a company's books and records are not identical to one another, regardless of whether the entity has been formed as an LLC, corporation. or partnership.  In New York, there is apparently a statute that makes obtaining access to the books and records of a corporation a bit more complicated to obtain than in the LLC context.  Ohio doesn't have this sort of procedure, but Ohio Rev. Code 1701.37(C) does seem to establish a slightly different standard for shareholders seeking access to the corporation's books and records.  Here, the shareholder "upon written demand stating the specific purpose thereof" may have access "at any reasonable time and for any reasonable and proper purpose."  

Limited partners in Ohio are entitled pursuant to Ohio Rev. Code 1782.21 to access to partnership books and records "upon reasonable demand for any purpose reasonably related to the limited partner's interest as a limited partner."  This is quite similar to the LLC statute's language.  However, unless prohibited by the partnership agreement, the general partner does have the right under Ohio law

... to keep confidential from limited partners, for the period of time that the general partner considers reasonable, any information... which the general partner in good faith believes is not in the best intersts of the limited partnership or could damage the limited partnership or its business...

There is no similar provision with respect to LLCs.

Do these language differences mean anything?  Francis Pileggi of the Delaware Corporate and Commercial Litigation blog also recently noted a difference in the access to records in Delaware statutes governing LLCs and corporations.  He describes a recent Delaware case involving an LLC in which the Delaware Chancery Court chose to turn to caselaw regarding the question in the context of corporations.

Whether access to the books and records of a company is given to equity holders will undoubtedly be determined on a case by case basis.  However, to me, it makes little sense to distinguish among types of entities regarding the level of access equity holders should have to the books and records of the company.  Why should an equity holder in a 3 person manager-managed LLC have different rights than the shareholder in a close corporation with three shareholders? 

  On the other hand I can see logic in distinguishing between entities depending on the sopistication of the company and number of equity holders.  In the case of "closely held" entities with only a few owners, the presumption ought to favor the equity holder.  As the entity grows larger, and is perhaps even a public company, the burden on the company and the possiblity of abuse of the right by dissident equity holders seems greater.  So here I would tend to support placing more of a burden on the equity holder to justify the need and purpose for seeking access.   

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Mike Bonasera of the Ohio Trust & Estate Blog recently gave some helpful guidelines for safely using "family" LLCs for estate planning purposes to transfer assets to the next generation while minimizing adverse tax consequences.  His post, "Family LLCs Still Work... If You're Careful", explains that IRS "enforcement" has made this sort of business entity less popular, but offers several pointers on how it can still be a viable possibility, including:

• State the reasons for the LLC in the Operating Agreement 
• Leave enough assets outside the LLC to live on and pay taxes
• Make sure the senior generation does not have the power to allocate profits and losses.

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Suppose your fellow LLC member starts a new business which competes with the LLC's business.  Can he or she do that?  Well the answer depends upon what state your LLC is organized in and what your Operating Agreement says.  It may also depend on how sophisticated the members are.

In Ohio, the default presumption is that fiduciary duty among members of an LLC, especially in what might be called a "closely held" LLC with few owners, exists and would prevent this sort of behavior.  However, Ohio courts have shown a willingness to allow parties to restrict or modify this obligation with the provisions of the operating Agreement itself. 

McConnell v. Hunt Sports Enterprises.  In Ohio, the key case is McConnell v. Hunt Sports Enterprises, 132 Ohio App.3d 657, 725 N.E.2d 1193 (10th App. Dist. 1999).  The case involved Lamar Hunt and Columbus' "Mr. Mac" who eventually became the majority owner of the Columbus Blue Jackets NHL hockey team.  It arose in the context of Columbus' efforts to attract a professional sports team.  McConnell and Hunt were both members of an LLC called Columbus Hockey League, LLC ("CHL") which was formed according to its Operating Agreement to "invest and operate a franchise in the National Hockey League". 

At some point along the way, Mr. Mac and some of the Columbus members of CHL, individually and not on behalf of CHL, went ahead and signed a lease and ownership agreement for an NHL team.  This group then filed a declaratory judgment against Lamar Hunt's entity to the effect that they had not violated CHL's Operating Agreement.  The Hunt group then counterclaimed alleging breach of fiduciary duty and seeking an injunction preventing the NHL from granting the franchise to Mr. Mac's group.  

Both the trial court and the Ohio Court of Appeals found that the Operating Agreement itself allowed competition and held that consequently no breach of fiduciary duty occurred.  Indeed section 3.3 of the Operating Agreement provided:

Members May Compete.  Members shall not in any way be prohibited from or restricted in engaging or owning an interest in any other business venture of any nature, including any venture which might be competitive with the business of the Company...  

The Court further explained:

In the case at bar, a limited liability company is involved which, like a partnership, involves a fiduciary relationship.  Normally, the presence of such a relationship would preclude direct competition between members of the company.  However, here we have an operating agreement which by its very terms allows members to compete with the business of the company.  Hence, the question we are presented with is whether an operating agreement of a limited liability company may, in essence, limit or define the scope of the fiduciary duties imposed upon its members.  We answer in the affirmative.

In reaching this conclusion, the Court considered existing caselaw which established a fiduciary duty in the close corporation context.  It harmonized these cases with its holding as collectively standing for the proposition that both close corporation agreements and operating agreements could permissibly limit the scope of fiduciary duties that would otherwise apply.  It also made it clear that "[i]n general terms, members of limited liability companiesowe one another the duty of utmost trust and loyalty." 

Recent Ohio Caselaw.  More recently, in All Star Land Title Agency v. Surewin Investment, Inc., 2006 Ohio 5729, (8th App. Dist.), the Cuyahoga County Court of Appeals held:

In the present case, a limited liability company is involved which involves a fiduciary relationship.  Normally, the presence of such a relationship would prevent direct competition between the members of the company.  However, here we have an operating agreement which, by its very terms, allows members to compete with the business of the company.

Delaware.  Delaware is even more accepting of a contractual waiver of fiduciary duty.  Section 18-1101 of the Delaware limited Liability Company Act specifically authorizes the restriction or even elmination of any fiduciary duty:

(c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing....

(e) A limited liability company agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement; provided, that a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.

As explained by Francis Pileggi in his Delaware Corporate and Commercial Litigation blog post entitled "Chancery Gives Victory to 'Freedom of Contract'and Refuses to 'Find' Fiduciary Duties in LLC Agreement When Not Clearly Stated", the recent Delaware case of Fisk Ventures, LLC v. Segal underscores this willingness to accept the parties' contractual agreement that no fiduciary duty applies.  Francis believe this case will gather much attention in an ongoing discussion regarding whether fiducairy duties should differ between LLCs and corporations.

Virginia.  A recent post "Members of Virginia LLCs May Not Owe Fiduciary Duties to Each Other" on the Womble Carlyle Unfair Business Practices blog by Mike Holm explores two Virginia cases which found the absence of statutory provisions regarding fiducary duty in the Virgina LLC Act, as compared with their presence in the Virginia Partnership Act to be dispositive in determining that LLC members have no fiduciary duties towards one another.     

Florida.  In Florida, Fla Stat. Section 608.4225 sets forth a number of fiduciary duties for members of limited liability companies.  In addition, pursuant to Fla Stat. Section 608.423 prohibits elimination fo the duties found in Fla. Stat. 608,4225, but does allow the operating agreement to

      1. Identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; and

      2. Specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty;    (c) Unreasonably reduce the duty of care under s. 608.4225;    (d) Eliminate the obligation of good faith and fair dealing under s. 608.4225, but the operating agreement may determine the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable;

 California.  In California,  in a manger-managed LLC, a manager owes members the same duties as a partner does to a partnershiop and to the other partners under Cal Corp. section 17153.  According to Cal Corp Code section 17005, "[t]he fiduciary duties of a manager to the limited liability company and to the members of the limited liability company may only be modified in a written operating agreement with the informed consent of the members."  No similar specific provision appears to exist with respect to the obligations between members.

Other States and Resources.  For discussions of the law in other states, visit:

• Illinois - "The Illinois Limited Liability Company Act After a Dozen Years - What Guidance have the Courts Gven Us About LLS in Illinois" by William Knee.
• Tennessee - "Getting Your fair Share: What Are the Fiduciary Duties When one member Takes a Piece of the LLC Pie?" by Richard Spare.  See also a more recent post on "Delaware LLCs for Tennessee Lawyers?" by the same author for an exhastive comaprison of the differences in philosophies between Delawar and Tennessee with respect to LLCs.
• Wisconsin - "The First LLC Case" by Joseph Boucher and George Kamperschroer

And for those really wanting to get into detail on a slightly different related topic, check out Miller, "What Fiduciary Duties Should Apply to the LLC Manager After More Than a Decade of Expermimentation?", 32 Iowa J. Corp. L. 565 (2007).

Analysis.  I like the Ohio approach of very strong presumption of a fiduciary duty among LLC members, especially in "closely held" LLCs.  When only a few owners are involved and are engaged in the day-to-day running of the company, there seems to be little rationale for varying the standard of care owed one's fellow owners by virtue of the form of business entity chosen. 

For more sophisticated LLCs,  I suppose a case can be made for allowing members to decide among themselves what level of loyalty and care they want.  However, what about publicly traded LLCs or privately held LLCs in which some members are individual investors who responded to a private placement memorandum?  In this case, it seems hard to me to explain why the form of entity chosen will determine the level of loyalty and care owed these perhaps less sophisticated members.  

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Many a franchise, including Wendy's, White Castle, and Max & Erma's, got their start here in Columbus, Ohio where I practice business and commercial law.  So it is really not very surprising that budding entreprenuers in Central Ohio, as elsewhere, often consider a franchise opportunity when looking to start a business.

Concept and Information Availability.  Basically, the concept behind a franchise relationship is that in exchange for fees which can run into the several thousands of dollars, the franchisee new business owner receives the benefit of a proven business system and the associated experience.  And franchising may well be the way to go.  Franchisors often will provide resources and experience not otherwise available to a new business owner.  However, there will also be some loss of autonomy when it comes to how you run the business from day to day.

For better or worse, there is no shortage of information available regarding franchising.  (Interestingly, franchising is also apparently extremely popular in the Phillippines based on the results I got from the Google search I just did.)  But how do you know which information is reliable and correct?  How can you determine which franchise opportunity, if any, is right for you?

Begin by Assessing Personal Strengths and Weaknesses.  You should begin by taking a close look at yourself and weigh your strengths and weaknesses.  For example, are you a "team player"?  Because a franchise relationship is all about following someone else's system, you need to be able to picture yourself in that role.  Do you have particular knowledge about certain industries?  The Small Business Administration offers a helpful  "Is Franchising Right for Me?" workbook to help make this assessment.

Understand General Franchising Fundamentals.  Next you should make sure you understand at least the fundamentals of how franchising works.  Here again the SBA website excels in providing useful information on franchising and how to proceed if you are interested in this means of starting a business.  Entrepenuer.com's "Franchise Basics"  and "Franchise Terminology" posts also provide useful information about franchising, its terminology, and some of the details to which you should pay attention; other posts cover other questions on franchising. 

In addition, Mike Hamblin of the Michigan Business Lawyer Blog has written a four-part series on "Could a Franchise Be a Viable Opportunity for a Michigan Entreprenuer?" which provides a good overview of franchising, whatever state you live in:

• Part 1 - General Overview of Franchises (explaining the types of franchises available
• Part 2 - What Constitutes a Franchise? 
• Part 3 - Franchisors' Federal Disclosure Obligations [under the Uniform Franchise Operating Circular - more on that later]
• Part 4 - Franchisors' State Law Disclosure Obligations (Note that although Ohio Rev. Code 1334.02 does require certain disclosures with respect to "Business Opportunity Plans", these are not applicable to franchise opportunities offered in Ohio so long as they comply with federal disclosure requirements.)

Evaluate Specific Franchise Opportunities.  Once you understand the basic idea behind franchising and how it works in general, you are ready to start focusing more specifically on particular franchise opportunities.  How should you go about evaluating what's available?  What's important to look at? 

• The Small Business Administration provides an excellent Consumer Guide to Buying a Franchise on its website which does a great job of highlighting important issues to consider.  

• Rush Nigut of the Rush on Business blog (Congratulations Rush on your new position at Central Iowa-based Brick Gentry, P.C.) frequently posts on franchising.  He offers posts on "Fundamentals of Franchising - Franchisee's Perspective" and "Franchises: Four Things to Make You Go 'Hmm" which address certain "red flags" you should watch for and be wary of, as well as many other fine posts on the subject.

• The American Franchisee Association warns about "The Twelve Worst Franchise Agreement Provisions" you should avoid at all costs and also discusses "The Problems Franchisees Face" of which you should be aware.

There are also several good sources of information about particular franchise opportunities:

• Rush Nigut offers some suggestions in his "Looking for a Franchise?  Be Sure to Pick the Right Resources" post on the Rush on Business blog.

• The Franchise Law Blog published by the attorneys at Connecticut-based Wiggin & Dana LLP provides frequent news items about particular franchises that could be helpful in evaluating the viability of specific franchises.

• The Franchise King blog, published by self-described "Northeast Ohio's franchise guru" Joel Libava, is a bit more glitzy, but also offers information about specific franchises and going about evaluating them, as well as numerous links to other sources of information.  (This one took a little while to load on my home computer the first time I visited so you may need to be patient.)  

Read - Carefully - the Disclosure Documentation the Franchisor is Required by Law to Give You.  When you have narrowed the choice down to a couple of franchise opportunity possibilities, it's time to review (if you have not already done so) the disclosure documents provided by the franchisor as required by federal law.  Until recently, these disclosures were contained in a document called a Uniform Franchise Offering Circular.  Now being phased in and becoming mandatory after July 1, 2008, these disclosures will instead appear in a Franchise Disclosure Document.  The disclosures required will remain largely the same, but some additional information will be provided in a franchisor's Franchise Disclosure Document.

• Rush Nigut of the Rush on Business blog provides a relatively concise overview highlighting "Key Differences Between UFOC and New Franchise Disclosure Document".

• Take the time to listen to  "A Close Look at Pitfalls in the Franchise Disclosure Document" podcast.  This podcast features about a half hour interview of franchisor attorney Warren Lewis and franchisee attorney Julie Lusthaus and does a great job of presenting both perspectives.  It also does a tremendous job of explaining how the new Franchise Disclosure Document will differ from the UFOC, as well as the importance and usefulness of the various disclosures required - all in easily understandable language.  This is an excellent resource for anyone considering entering into a franchise relationship and is well worth the time to hear.   

• For those wanting a more technical discussion of disclosure requirements, visit the Federal Trade Commission's website.   

In many cases, entering a franchise relationship is a good option for someone wanting to start a new business, but apprehensive of possible consequences stemming from inexperience.  It can also be a way to jump start the path to profitability if you choose the right franchise.  However, it is extremely important to do extensive "due diligence" research to be sure you are making a good choice. 

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Joel Labiva has written a useful post over at the Small Business Trends blog, complete with links, about a variety of free tools for business folk available on the Small Business Administration's website. They include information on:

• Small Business Planner (with information about what it means to be an entreprenuer anyway and including resources to help you write a business plan)
• Starting Your Business (including practical, legal, and financial issues)
• Managing Your Business (conceptual and practical advice about a variety of issues you're likely to face on a day-to-day basis)
• Exit Strategies (useful information about getting out of the business both when it has been successful and when it has not)
• Other Tools (audio, video, and written materials covering a wide array of issues)

There's also links to local SBA offices across the country, including Central Ohio, which contain information about local programming, resources, and success stories.

In addition, a related Business.gov website also published by SBA is worth a click.  Anita Campbell of Small Business Trends blog wrote about "Ten Ways Business.gov Helps Your Business" several months ago. 

I wholeheartedly agree with Anita's assessment of this website.  It has a tremendous amount of well organized information about governmental regulation and resources, as well as general information about a variety of concerns business owners may have.  In addition, one thing I thought was especially useful was the available links to state and local governmental regulation and resources.  See what there is for Ohio.  There's even a link to the Ohio Business Gateway which does a good job of aggregating information about conducting a business in Ohio in an accessible manner.

As Joel suggests, the SBA website (and the information available there), as well as Business.gov, are much improved from even a few years ago.  Check out all that these websites now have to offer.

N.B. - For those of you who think you saw this post before and then it was gone and now it's back, you're right.  I had a really bad day with the blog yesterday in which I accidentally managed inextricably to delete my biographical information, three draft posts (including a nearly complete one about franchising which is next up), and this post.  So basically I had to rewrite this entire post.   

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A statutory agent is the "official" representative of a corporation or LLC.  In conjunction with filing the appropriate paperwork with the Ohio Secretary of State to form a corporation or limited liability company,  the new business entity must appoint a "statutory agent".  Sometimes, this person is the attorney assisting in the formation of the business.  Other times, one of the principals of the business is named.  Occasionally, a company offers this service for a fee.  So what does it mean to be a statutory agent?  What are the responsibilities?

The statutory agent may be an individual who is an Ohio resident, a business entity organized or formed in Ohio, or a foreign corporation qualified to do business in Ohio which has an Ohio business address.  The statutory agent appointed must sign the appointment before it is filed with the Ohio Secretary of State and the appointment must contain an Ohio address.

Statutory agents are required in Ohio and every other State to ensure that individuals or companies with a claim against a business entity have someplace where those alleged claims can be presented.  Thus the primary obligation of a statutory agent is simply to act as a "contact person" for the business.  The statutory agent accepts "service" of legal pleadings, as well as other correspondence and documentation being directed to the company. In addition, the statutory agent is expected to pass what they have received on behalf of the company on to the company for it to handle.

The statutory agent has no personal liability for any claim being asserted against the company simply by virtue of being the statutory agent.  Nor does the statutory agent have any responsibilty to ensure that the company on whose behalf he or she has accepted service does in fact do anything to respond.  Once the statutory agent gives the company's representative the materials received on behalf of the company, his or her job is complete. 

The company can choose to replace the statutory agent with another at any time.  All that is required is that the company file the new appointment with the Secretary of State using the very simple form prescribed by the Secretary of State.  The filing fee is $25.00.  There is no need for the prior agent to resign or to consent to the appointment of the subsequent statutory agent.

A statutory agent can likewise make a unilateral decision to resign at anytime by completing and filing the requisite form with the Ohio Secretary of State.  There is no need to obtain the consent of the company.  The filing fee is $25.00.  The resignation takes effect sixty days after the form is filed with the Ohio Secretary of State.  Thus, individuals who were once principals of a company but are now no longer affiliated with the business should take the time to resign as a statutory agent in an abundance of caution.   

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I have written before about the various factors one should consider in choosing a legal entity for your business.  Click here and here for my past posts on the subject.  Like many others, I have ultimately suggested that the choice in many cases comes down to a limited liability company and a corporation.  But which one?  For some clients, the balance sometimes seems to tip towards an S-corporation by the prospect of perhaps saving on the payment of self-employment payroll taxes - something which may or may not come to fruition. 

Not being an accountant, I have generally been content to let my client's CPA influence the choice of entity decision in this direction.  Recently, however, I decided to actually look into this and learned that this touted benefit may be illusory for all but single shareholder corporations.  Why?  Well, basically because the Internal Revenue Service has issued no clear regulations and, however payments to owners are nominally characterized, overly aggressive taxpayers are likely to be penalized.  For an in-depth and fairly technical analysis of the issue,as well as one possible sophisticated "work -around" click here.

Many people believe that they can avoid self-employment tax by calling payments to owners in S-corporations "dividends" rather than wages or salary compensation.  However, shareholders must still be able to justify and substantiate the amount paid as salary as constituting "reasonable compensation".  This means that shareholders paying themselves only a very miniscule amount as salary are running a significant risk that if audited, the overly large amounts paid as dividends are likely to be recharacterized as compensation for which self-employment tax should have been paid.  This is particularly true for professionals, service companies, consultants and sales companies in which it is difficult to demonstrate that money paid is for anything other than the performance of services on behalf of the company.  

Bizpointers:  Here's some basic pointers to keep in mind when analyzing the purported self-employment tax savings and what it really means:

• If earnings will be retained within the company and used to expand and grow the business rather than distributed to the owners, these amounts are less likely to be subject to self-employment tax if the corporate form is used than if an LLC is utilized. 

• The one situation in which tax planning may strongly indicate use of a corporation rather than an LLC is where there is, and probably will continue to be, a single owner.  In these cases, an LLC cannot be used to limit self-employment taxes because it is automatically characterized as a disregarded entity.  

• There is no magic test for what counts as "reasonable compensation".  Obviously, industry standards, profitability level of the business,  and what non-owner employees performing similar services in the company are paid can help support the "reasonableness" of particular owner compensation.

• LLC members (as well as corporation shareholders) may be able to mitigate some of the effect of self employment tax by having the business lease real or personal property from the owners, which would be a deductible business expense for the company while representing cash flow and income to the owner.

• Payments to inactive LLC members not participating in the day to day operation of the business (and not designated as managers) should generally not be subject to self-employment tax.

There are many factors that must be considered in choosing the appropriate form of legal entity for a particular business.  Consulation with professional advisors such as CPAs and business attorneys can result in helpful advice in evaluating the relative importance of those factors in specific contexts.

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Limited liability companies allow great flexibility for their Member-owners in structuring both economic and management matters. Consequently, when an LLC has more than a single owner, it is important for the Members to adopt an Operating Agreement spelling out how these matters should be handled. An Operating Agreement is similar in many respects and serves many of the same purposes as a Close Corporation Agreement does for corporations with only a few shareholders. Click here to read my blog post on Close Corporation Agreements.

In Ohio, if a written Operating Agreement is not adopted, Ohio Rev. Code Chapter 1705 contains a number of "gap filler" provisions that will be applied to govern the business and legal affairs of the limited liability company. While some of these may be just fine, others are not appropriate in every case. Moreover, in many cases, the "gap filler" provisions are rather vague and likely to lead to expensive litigation when applied to particular situations involving disputes among owners. I use an LLC Formation Client Questionaire with new clients to help gather information useful for tailoring an appropriate Operating Agreement for their particular circumstances.

A typical Operating Agreement sets forth the ownership interest (known as a Membership Interest) held -- and initial capital contribution made -- by each Member and also contains provisions regarding the following:

• purpose for the LLC
• allocation and distribution of profits and losses
• voting rights and procedures
• protocol for member (and manager) meetings
• admission of new members/restrictions and procedures for transferring ownership
• dissolution and winding up of the company

Sometimes an Operating Agreement will also include special provisions regarding the duties of Members and/or Managers. For example, Members or Managers may be required to devote their full attention to the business affairs of the LLC; alternatively, the Operating Agreement may specifically provide that they are free to engage simultaneously in other business ventures. Noncompete or confidentiality provisions similar to those often found in employment agreements may also be included in the Operating Agreement. Members or Managers who fail to comply with these restrictions may be subject to expulsion and forced to sell their Membership Interests if the Operating Agreement so provides.

Purpose for the LLC. Generally the Operating Agreement will provide for very broad purposes for the LLC. However, in particular cases, it may make sense to limit the particular activities in which the LLC is permitted to engage.

Allocation and Distributions of Profits and Losses. Unlike a corporation, the economic rights attached to equity ownership in an LLC do not automatically track the relative ownership interest held by the Member. Thus while a shareholder with 25% of the shares of stock in a corporation (regardless whether an S or C corp) must receive 25% of the corporation's profits and losses. By contrast, an LLC Member with a 25% Membership Interest might receive only 10% of the Company's profits and losses, or 50%, or any other amount the Members have determined to be appropriate. An Operating Agreement can also accomodate various creative arrangements such as ones in which particular Member(s) get a certain percentage of profits and losses up to an aggregate amount at which point a different formula becomes applicable. The possibilities are limited only by the imagination and desires of the Members.

In addition, the timing and rights, if any, for Members to insist on any minimum distributions is often included in the Operating Agreement; whether it should be delineated sometimes depends upon whether one is cosdidering it from the standpoint of the majority or minority owner. In the absence of any specific provision requiring distributions periodically or in any set amount, Members have no right to insist on distributions.

Voting Rights and Procedures. In a corporation, voting rights follow the number of shares held. In C-corporations, voting rights can be restricted by giving different classes of stock different rights, but in S-corporations, that is simply not an option. In an LLC, just as with allocations of profits and losses, the nature and procedure surrounding voitng rights is essentially completely up to the Members to determine. If the Operating Agreement does not otherwise provide, Ohio Rev. Code 1705.24 allows Members to vote in proportion to their contributed capital just as they would in a corporation.

An LLC can be governed in much the same way as a corporation with Members holding "Units" or it can more closely resemble the ways of a partnership. Members in an LLC can decide to vote by their "Uits" or Membership Interest percentage in a fashion similar to that of shareholders in a corporation. They can also decide to vote by "headcount" with each Member being entitled to one vote. It is also possible to have some issues determined by headcount and others by Membership Interest percentage. The Operating Agreement can also designate certain matters as requiring a unanimous vote or a specified supermajority to be properly authorized.

In addition, Members can choose to have the LLC's business and financial affairs handled solely by Managers (who function somewhat analogously to Directors or Officers in a corporation) rather than by the Members. Here the Operating Agreement spells out the procedure for selecting Managers and voting procedures governing their deliberations.

Protocol for Member (and Manager) Meetings. The Operating Agreement will typically set forth how often meetings will occur and explain how Members (and Managers, if applicable) can call a meeting. Members can also decide whether participation by telephone or other electronic means should be permitted

Admission of New Members; Transfer of Membership Interests. Generally, the Operating Agreement will contain some sort of restrictions on the transfer of the respective equity ownership interests held by individual Members. Often there will be a right of refusal granted the LLC and other Members which requires a Member wishing to sell his Membership Interest to allow the company and/or his remaining fellow Members to match any offer obtained from any third party. In addition, the Operating Agreement can require a Member to sell, or the LLC to buy, a Membership Interest under certain circumstances such as in the death, disability or termination of employment by the company; in these cases, the Operating Agreement should also specify a procedure or formula for determining the appropriate purchase price.

Dissolution of Company. The Operating Agreement should also provide for the circumstances under which the LLC can or should be dissolved. Generally this includes by uanimous consent of the Members or by judicial decree, but depending upon the nature of the LLC's business, other triggers may also be appropriate.

Conclusion. The process of working through the Operating Agreement can be a useful one for Members of the new company as it provides a vehicle for discussing many important issues.

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A "close corporation" is a special sort of privately held corporation which has only a few shareholders, generally individuals.  Both  C-corporations and S-corporations can be close corporations, but the shareholders must affirmatively elect to be a close corporation by entering into a written agreement to that effect. This Close Corporation Agreement allows the business and its shareholders to bypass many of the formalities more approproriate for larger companies.

In Ohio, a Close Corporation Agreement must affirmatively mention that that it is being adopted pursuant to Ohio Rev. Code 1701.591.  In addition, it must be signed by ALL of the shareholders; if additional shareholders are later admitted, they should also sign the Close Corporation Agreement, but are bound even if they do not sign the Close Corporation Agreement.  There also needs to be minutes of a shareholder meeting adopting the Close Corporation Agreement. 

Contents of Close Corporation Agreement.  So what's the point and what should be in this Agreement?  The point is that without a Close Corporation Agreement, a small company with perhaps three or four individual shareholders would have to keep the same sort of formal records of director and shareholder meetings as large public corporations.  In addition, a Close Corporation Agreement can address other important issues such as what happens if one of the shareholders wants or needs to leave, how dividends should be distributed, and how the company's business or financial affairs of the company should  be made.  Ohio Rev. Code 1701.591 lists the following by way of example of what the Close Corporation Agreement might include:

• Regulation of the management of the business and affairs of the corporation
• Rights to dissolve the corporation at will or upon the happening of a specified event
• Requirement to vote certain shares a particular way
• Requiring unanimous votes of all shareholders on specified issues
• Designation of company officers or directors
• Give authority to any individual holding more than one corporate office to execute, acknowledge, or certify in more than one capacity any instrument required to be executed, acknowledged, or certified
• Terms and conditions of employment for company officers or employees
• Provisions about the declaration and payment of dividends or distributions or the division of profits
• Elimination of board of directors or restrictions on their authority or delegation of a portion of the authority of the board of directors to particular shareholders
• Granting absolute right -- without the necessity of stating any purpose -- to examine company's books and records   
• Prohibition, or restrictions upon, issuance of additional shares of stock based upon a specified affirmative or unanimous vote of shareholders or unless other specified terms, conditions, or events occur
• Arbitration or other provisions in case of shareholder deadlock
• Dispensing with annual meeting unless specifically requested by a shareholder

If a Close Corporation Agreement eliminates the board of directors, then the shareholders are deemed directors for purposes of Ohio law unless a particular shareholder is not permitted to vote on a particular matter under the Close Corporation Agreement.

Change or Termination.  Once adopted, a Close Corporation Agreement can be changed upon the affirmative vote of the parties to the Close Corporation Agreement as specified in that Close Corporation Agreement, but no less than four-fifths of the outstanding shares of each class; shareholders can decide that a uanimous vote is necessary.  It also automatically terminates if shares are registered or listed on a national securities exchange.

In addition, a Close Corporation Agreement will terminate if shares subject to it are transferred to someone with no knowledge of the Close Corporation Agreement who then gives notice of rejection of the Close Corporation Agreement within the earlier of (A) ninety days after receiving notice of the existence of the Close Corporation Agreement or (B) three years after the transfer of the shares; UNLESS the company offers to buy the shares for the amount paid for them.  To prevent inadvertent termination of the Close Corporation Agreement in this way, it is important to put a legend on the shares that they are subject to the Close Corporation Agreement. 

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In my last post, I discussed the basic characteristics of the main choices available to those wishing to establish a new business in Ohio.  Essentially, there are three realistic choices: limited liability company (also known as LLC), S-Corp, and C-Corp.  Which choice is most appropriate in any particular circumstance depends on a number of factors (which you should of course discuss with your attorney and possibly your accountant as well), but here are some general considerations.

For Self-Sufficient Businesses.  If the business has only a few owners, is locally focused, and is relatively unlikely to be seeking substantial outside investment from venture capitalists or otherwise, the choice can be narrowed to either an LLC or an S-corporation in most cases.  For this sort of business, the double taxation aspect of a C-Corporation is a definite disadvantage without much redeeming benefit.  Moreover, if a business is not otherwise excluded from being an S-Corporation because of the nature of its shareholders or desire to have more than one class of shares, structuring it as an S-Corporation or an LLC in many cases is just a personal preference. 

The overall flexibility of the LLC and the greater recordkeeping and corporate formalities associated with an S-Corporation may give LLCs an edge for these more personal "lifestyle" owner-operated businesses.  If structured as an S-corporation, shareholders would be wise to enter into a Close Corporation Agreement meeting the requirements of Ohio Rev. Code §1701.591 to eliminate the necessity of complying with at least some corporate formalities.

Businesses Seeking Outside Investment.  What about businesses that realistically think they will ultimately be seeking outside investors in the form of institutional investors or angel investors?  Here the answer becomes more complicated.  Conventional wisdom suggests that C-corporations should be the vehicle of choice for these companies, in part because of perceived drawbacks with the LLC or S-corp form.  Click here for a more detailed discussion of this point of view.  The "market" is often said to be most familiar and comfortable with C-Corporations and to value the potential tax loss carry-forward a start-up company is likely to have. 

To be sure, there are certain aspects of S-corporations and LLCs which make them unattractive to institutional investors.  Because of the restrictions on permissible shareholders of an S-corp, institutional investors are unlikely to qualify, thus making S-corporations unworkable for them.  In addition, in part because at least some of the ultimate end-investors in the venture capital fund may be nonprofit entities, institutional investors may be concerned about "unrelated business income" that would "flow through" from an S-corp or an LLC taxed as a partnership.

However, these are in reality "end game" considerations which, while important, should not be permitted to determine formation as a C-corporation in every case.  Obviously not every company that thinks it wants outside investment will get it.  And for others it may well be many years before they will be able to attract this sort of attention.  At least some entrepreneurs ask themselves whether it's possible to "hedge their bets" by starting with an S-corp or an LLC and converting to the C-Corp later.  The answer is yes, it is, although there may be some additional cost. 

The process of converting to a C-corporation from an LLC or S-corporation is relatively straightforward and becoming easier in every jurisdiction.  Converting from an S-corp to a C-corp is very easy, involving little more than notifying the IRS of the change.  Converting from an LLC to a C-corporation may require a merger and some tax planning to ensure it can be done without tax consequences, but is still a very manageable alternative.  In Ohio, conversion of an LLC into a corporation is governed by Ohio Rev. Code §1705.371.

Moreover, when it comes to "angel investors" who are almost by definition, high net worth individuals, the considerations driving selection of the C-corp may not apply.  These individuals are very focused on their "return on investment" and when they will start receiving cash flow and may very well welcome the creative capital structures LLCs allow to accommodate these concerns.  Depending upon who they are and their relationship with you, they might even prefer a manager-managed style LLC (in which they are passive investors) with certain "guaranteed" returns on the capital they have invested with you.  They may also appreciate being able to claim some losses on their individual tax return.  

The logic of focusing on what makes sense today becomes even clearer when the follow-up question to what form of business entity the company should be is considered.  Suppose the decision is made to go with a C-corp; now what state should the new company be incorporated in?  The institutional investor is likely to prefer Delaware.  However, incorporating in Delaware will also have a number of current consequences, including the possibility of having to defend a lawsuit filed in Delaware even though all business operations are in Ohio.  Ensuring compliance with not one, but two, states' business laws will also be required. 

In the short and medium run, the question is really what will work best for the entrepreneur, especially if the dream of outside money never comes to pass.   While there are certainly some start-ups and early stage companies that should select the C-Corp form, many others should give serious consideration to the other available alternatives.

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While it is by no means the only important legal decision to be made when buying or starting a business, would-be entrepreneurs tend to focus on what sort of legal entity that company should be - corporation, partnership, limited liability company, etc. The basic options are fairly clear:

• If you will be the only owner, either a corporation or a limited liability company (sometimes called an LLC) are possibilities. An individual can also operate his or her business without forming either, becoming a sole proprietorship by default.

• A business with multiple owners can be a general or limited partnership, a corporation, or a limited liability company. If no conscious decision is made, a business with two or more owners will automatically be a general partnership.

There are still other more esoteric options, but these are the basic entities available. Making the proper choice among these options requires both a fundamental comprehension of the characteristics of each and an ability to understand how you want to handle and respond to the inevitable challenges ahead for the business. In today's post, I will highlight the basic characteristics of these various entities. In my next post, I will discuss some of the factors to consider when making the choice between them.

Sole Proprietorship Disadvantages. For businesses owned by a single individual, remaining a sole proprietorship has a number of drawbacks. Unless the business is very small and very new, and perhaps even then, operating a business as a sole proprietorship is generally not the best choice. The legal costs of incorporating a business or forming an LLC with a single owner are relatively small (less than $1000) and a more formal business structure can enhance a company's credibility with both vendors and customers, thus leading to growth. At the same time, incorporation or forming an LLC can also offer protection from personal liability for company debts to vendors, for accidents not covered by insurance, and from other creditors if the business ever becomes unable to pay. In addition, transferring ownership of the company, especially for anyone hoping to eventually sell out to investors, is greatly simplified with a corporation or LLC.

If you choose to remain a sole proprietorship "for now", you should still open a separate business checking account to help you keep track of business revenue and especially expenses. In addition, this will help you form good habits regarding keeping business and personal financial affairs separate that will serve you well as your business matures and does require more formal structure.

Corporations as an Option. Corporations are the most established choice for those wanting the benefits of limited liability for their business. In Ohio, corporations are governed by the provisions of Chapter 1701 of the Ohio Revised Code. Corporations are rather easy to form, although contrary to some popular belief, it does require some additional steps beyond merely filing a 2-page Articles of Incorporation with the Secretary of State. Corporations formed in Ohio have Articles of Incorporation and are governed by a Code of Regulations which is analogous to what is sometimes called Bylaws in other states.

Corporations are managed by officers such as a President and Treasurer who answer to directors who are in turn elected by shareholders, with the exception of "close corporations" in which the shareholders act as the directors. While in smaller privately held owner-operated corporations these may all be the same people, technically shareholders - unless they are in a "close corporation" which has affirmatively made such a choice - do not participate in the management of the company's day-today business and financial affairs.

Ownership in the corporation is conferred by the issuance of shares of stock evidenced by stock certificates; in Ohio, technically you have shares - not stock -- in a corporation. Everything from voting influence to the amount of dividends received is directly dependent upon the number of shares one has relative to other shareholders; if one holds 35% of the stock, one has 35% of the voting power and the right to receive 35% of whatever dividends are being distributed. (This can be made modified and become more complicated in corporations with "preferred" stock or other classes of stock.) Ownership can also be diluted if additional shares are issued to others.

By statute, corporations are generally required to observe many formalities and do considerable recordkeeping in order for shareholders to enjoy the benefits of limited liability. Directors and officers must be appointed, even if they are also already in the role of shareholder. Shareholder and director meetings must be held periodically and minutes of those meetings maintained. Ledgers reflecting share ownership allocations must be kept up to date at all times.

To dispense with the necessity of complying with some of the statutory record-keeping and other requirements, shareholders of an Ohio corporation can enter into a written Close Corporation Agreement complying with Ohio Rev. Code §1701.591 if they make an affirmative decision to do so. This agreement can also include provisions sometimes found in a Buy-Sell Agreement dealing with circumstances and conditions under which ownership can be transferred or owners wishing to sever their ties to the business can receive the benefit of their investment.

S-Corp or C-Corp. Businesses considering the corporation form must further choose between being an S-Corporation or a C-Corporation. This is primarily a taxation decision, but the choice does carry certain consequences with it. S-Corps can later convert to C-corps fairly easily, but generally C-corps cannot convert to S-corps later without tax consequences.

S-corporations are designed for smaller businesses. Under federal law, they are restricted to 100 shareholders who must be individuals (or their estate planning trust) who are either U.S. citizens or permanent resident aliens; partnerships, LLCs, or other corporations cannot be shareholders of an S-corporation. In addition, if there will be more than one class of stock or owners will otherwise have differing rights to manage or receive distributions, S-corps are off limits. Entitlement to dividends and voting rights must directly correlate to the corresponding ownership interest.

C-corporations, by contrast, tend to be larger more mature companies. Many, if not most, of America's best known companies are C-Corporations. There are no limitations in a C-corporation as to the number or type of shareholders; LLCs, S-corporations, C-corporations, partnerships, and foreign nationals or companies can all be shareholders of a C-corp. Nor are there any restrictions on the number of classes of shareholders or the types of voting and economic rights shareholders can be given. However, because profits of a C-corp are taxed twice (once as corporate income and once as dividends) and losses must remain at the corporate level rather than being utilized by shareholders, C-corps are generally not appropriate for small and medium sized privately held businesses, especially ones just starting out or ones that are sometimes referred to as "lifestyle" companies.

General and Limited Partnerships Both Largely Obsolete. Partnerships provide some level of limited liability and come in two flavors - general partnerships and limited partnerships. Because of the flexibility of the LLC structure, partnerships have largely been replaced by LLCs as a business form. Consequently, both limited and general partnerships are now obsolete choices except in some very specific and unusual circumstances such as certain estate planning situations.

In a general partnership, all partners participate in the management of the business venture and each is liable for the partnership's debts in proportion to their respective partnership interest (e.g. if three people are equal partners, they are each liable for one-third of the partnership's debt if the partnership has insufficient assets; if A has a 50% partnership interest while B and C each have a 25% partnership interest, A would have liability for 50% of the partnership debt if the partnership has insufficient assets). In a limited partnership, there is a general partner who is responsible for the day-to-day management of the partnership's business and who is likewise liable for the debts of the partnership in the assets of the partnership are insufficient. A limited partnership also has limited partners who must not participate in the management of the partnership's business and are protected from personal liability for partnership debts in return.

Limited Liability Company. The impetus for the emergence of the LLC alternative was the desire of owners to participate directly in management of a business as in a general partnership while retaining the protection from personal liability found in corporations. An LLC has members instead of shareholders and, if desired, managers instead of officers and directors. Instead of shares, members hold Membership Interests which in some cases are also called membership units.

Basically, an LLC is a cross between a partnership and a corporation, allowing owners to have the best of both. Instead of a partnership agreement or a Code of Regulations (or bylaws), LLCs have Operating Agreements. A Limited Liability Company, also known as a LLC, can be structured to include all of the informal decision-making, tax advantages and other benefits of either a General Partnership or a Limited Partnership. In addition, LLC Members do not have to forgo participation in managing the business (as they would need to do in a partnership) to enjoy the limited liability protection against company obligations to suppliers, vendors, and other creditors which is normally associated with corporations.

LLCs are a fairly new entity, first appearing in 1977 in Wyoming, but are now available in all states. Some states such as Delaware also have statutes permitting certain specialized versions. In Ohio, LLCs have only been an available option since 1994 and prior to 1997, Ohio law did not permit one member LLCs. Chapter 1705 of the Ohio Revised Code governs limited liability companies formed in Ohio and provides certain default provisions which will govern if not otherwise determined by the members of the LLC. LLCs can be structured like a limited or a general partnership, or even a corporation with respect to the management of the business. Under the IRS Check-the-Box Regulations adopted in 1997, LLCs can choose to be taxed as either (1) a partnership or sole proprietorship as applicable; or (2) a corporation.

Virtually unlimited flexibility is the hallmark of a limited liability company; essentially, virtually any business arrangement among owners can be easily accommodated. There are also fewer statutory recordkeeping requirements than are imposed on corporations. In addition, allocations and distributions of profits and losses, as well as management and voting rights, need not mirror and conform to the relative ownership interests held in the company. Typically, however, member-managed LLCs tend to duplicate the essence of a partnership, involving participation by all owners in management without giving up limited liability protection. Alternatively, a manager-managed LLC business operations may more closely resemble a limited partnership or corporation with day-to-day management being reserved for the manager(s).

Choice Narrowed to LLC or Corporation. Given the disadvantages of operating a sole proprietorship and the general obsolescence of the partnership alternative, the real choice for most business owners comes down to incorporating the business or organizing it as an LLC. Whether the corporation structure or the LLC alternative is better for a particular business depends on a number of factors. Those factors include the number and type(s) of owners and under what conditions, if any, there will be other owners. In addition, subjective complexities such as whether distinctions in the owners' respective equity and management rights are necessary or appropriate are important.

What really matters, regardless of the legal form chosen, is deciding more personal questions which will arise in every business. What will be the responsibilities of each owner with respect to the business? If a decision has to come to a vote, will each owner have one vote or will votes be by the level of ownership interest or some other formula? Will different kinds of decisions be decided by different kinds of votes, and if so, what will that be? How will profits (and losses) be allocated among owners? What happens if owners want to leave the business; how (and under what circumstances) will transfers of ownership be allowed?

For more details on all of these choices, view my PowerPoint seminar presentation The Legal Side of Getting a Business Up and Running.

For other perspectives focused on other states, see

• Michael Hamblin of the Michigan Business Lawyer blog has made a number of interesting posts recently on the subject of entity selection:

  • Michigan State Law: Choosing the Appropriate Corporate Entity is Crucial for Success of Your Business

  • Instead of Operating Your Business as a Michigan Partnership, Consider Forming a Michigan Limited Liability Company

  • A Michigan Corporation Could be the Right Entity for a New Michigan Business

  • The Basics of a Michigan S Corporation

• Illinois Business Law Journal blog - The Art of Registering a Business: Picking the Right Method of Registration for Your New Business

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