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

When considering an exit strategy for leaving the ownership of a business, don't forget to factor in the rights and input on the subject to which your fellow owners may be entitled. In many cases, finding a buyer for your equity stake is only part of the process.

Whether it's a closely held corporation or LLC whose equity holders are owner-operators or an investment vehicle LLC with sophisticated equity holders, the Operating Agreement or Close Corporation Agreement is quite likely to contain some restrictions on the manner in which ownership interests can be transferred to nonowners. Often one such restriction will be a "right of first refusal" which requires that one's fellow owners, and/or the company itself, be given an opportunity to purchase the ownership interest before any sale or transfer to a third party is permitted.

The typical "right of first refusal" generally follows the following sort of sequence:

1.  Getting the Purchase Offer in Writing. The equity holder wishing to sell to someone outside the existing ownernship must obtain a WRITTEN bona fide offer from the propsective purchaser setting forth the material terms and conditions of the offer and the amount of consideration offered.

• YES, it really does need to be written. It doesn't necessarily have to be in the form of a formal purchase agreement, but a few notes on the back of an envelope or business card will probably not be adequate. 
• Bona fide just means it needs to be something that the prospective purchaser really will follow through on and there are not any questionable side transactions (e.g., part of the purchase price is immediately refunded to the purchaser) required to support the proposed transaction. 
• Yes, it does need to be specific. If, for example, payment is going to be made over time, that needs to be explicitly stated.

2. Notifying the Remaining Owners. A copy of the written bona fide offer, together with some sort of written notice setting forth the desire to sell, must be provided to all of the remaining equity holders.

• NO, an e-mail to the remaining equity holders from the owner wishing to sell out which summarizes the terms of a verbal offer is probably not good enough. 
• The precise form of the notice required is generally not spelled out in the Operating Agreement. However, nothing more complicated than indicating it is a notice of the desire/intent to sell is necessary. Some Operating Agreements do require the notice to contain a summary of the terms and conditions of the offer.

3. Waiting for a Response. The company and the remaining equity holders are given a period of time to consider whether they wish to "meet" the offer made and buy back the equity interest. Usually, but not always, the company is given the first "right of refusal" with the remaining equity holders being given a chance to purchase if and only if the company decides not to exercise its right of refusal.

• The amount of time given for consideration of the offer varies, although 15, 30, or 60 days are common choices. Generally the length of consideration time is the same for all parties having a rights of first refusal, i.e. both the company and the remaining owners will each be given 30 days.
• The consideration time is usually cumulative, i.e. the company has 30 days to decide and then the remaining owners get 30 more days after that to make their decision.
  o Occasionally, Operating Agreements provide that the presentation of a bona fide offer permits the remaing equity holders to purchase the subject equity interest at predetermined price, perhaps "fair market value", as determined by an agreed upon formula or method.
• The purchase by the company or remaining equity holders in the aggregate must be for the entire portion of ownership interest being offered for sale - no partial purchases are permitted, although it is often possible for the equity interest to be divided among the remaining owners.

4. Exercising the Right of First Refusal. If the parties holding "rights of refusal" wish to exercise them, they must provide the party wishing to sell with written notice of that intent within the time required. The transaction must then be closed within the time specified by the Operating Agreement which can vary considerably from one Operating Agreement to another. Some Operating Agreements may even prevent a closing prior to the expiration of at least some period of time, i.e. 30 or 60 days.

5. Right of First Refusal NOT Exercised. If the parties holding the rights of refusal choose not to exercise them, the party wishing to sell may proceed to consummate the offer under the terms and conditions disclosed. Generally, if the transaction is not consummated within a certain period of time, perhaps as short as 30 or 60 days, the party wishing to sell will have to go through the entire right of first refusal process again.

Make sure you understand the "big picture" once you've decided it's time to move on and want to transfer your ownership interest in a business to ensure you don't lose valuable time.

• Email This
• Print
• Comments (1)
• Trackbacks

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.   

• Email This
• Print
• Comments
• Trackbacks

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.

• Email This
• Print
• Comments
• Trackbacks

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.  

• Email This
• Print
• Comments (1)
• Trackbacks

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.

• Email This
• Print
• Comments
• Trackbacks

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.

• Email This
• Print
• Comments (1)
• Trackbacks (1)

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.

• Email This
• Print
• Comments
• Trackbacks (1)

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

• Email This
• Print
• Comments
• Trackbacks (1)