So You Want to Start a Start-Up
Over the past four decades as an attorney (I know it’s been that long!), I have assisted uncountable optimistic and fresh entrepreneurs in building and maintaining their start-up companies. Starting and building a business from the ground up is certainly a challenge many wouldn’t expect as a company grows. For certain, threshold legal and tax issues will spring up and surprise you; they must be dealt with properly, promptly, and professionally to prevent your fledgling company from faltering unnecessarily.
The most reliable way to approach legal and tax issues is by hiring an experienced attorney to guide you. The first legal question a start-up entrepreneur is likely to confront is, “what type of entity should I use to conduct my business?” Entrepreneurs commonly think of filing to form a corporation or a limited liability company (“LLC”). But in fact, there is no legal requirement to take any formal action to create an entity. There are advantages to each type of entity, which should be your first conversation with counsel.
- What’s the difference between a sole proprietorship and a partnership?
You can operate your start-up in your own name (a “sole proprietorship”) or with co-owners (a “partnership”) without filing to create any sort of formal entity. This saves on some legal startup, can be a perfectly fine way to run your business, especially in the very beginning before your business is likely to have revenues or create significant liabilities.
In the case of a partnership, various state laws provide default provisions regarding ownership, allocation of profits, and management rights. These provisions apply in the absence of the partners writing their own agreement governing these issues. But partners are free to agree to pretty much any arrangement that they wish. You don’t need a partnership agreement if you are the sole proprietor.
- How are sole proprietorships and partnerships taxed?
Sole proprietorships and partnerships are “pass-through” entities for tax purposes. That means that these entities don’t pay taxes themselves. Instead, a partnership’s income or losses are deemed to pass through to the owner(s) responsible for including the income or losses in the calculation of their own taxes, regardless of what distributions the entity makes to its owner(s). This pass-through feature of sole proprietorships and partnerships can be highly beneficial for some businesses, especially where depreciation deductions are significant.
Ownership of real estate is an excellent example of this. For revenue-producing property, (property that is used to conduct your business) the annual depreciation deductions can offset a significant portion of the annual cash flow from the property for tax purposes. This reduces taxes in the early years of owning a property and effectively increases the property’s return of capital.
Although the deductions reduce the owners’ tax basis and increase taxes at the time of sale of the property, those taxes typically qualify for lower capital gains tax rates. This means that your total amount of taxes will be reduced, and it defers the time of the taxes’ payment.
- What are the downsides to pass-through entities?
Unfortunately, sole proprietorships and partnerships have significant disadvantages. The first is pass-through liability—i.e. each owner has personal liability for all liabilities of the business. This can be an extremely daunting prospect, especially in the case of any business where accidents or damages to third parties are foreseeable. This problem of personal liability has led to the evolution of a number of business entities, including LLCs, limited partnerships, and corporations.
One of the key characteristics of a corporation is “limited liability”. This means that investors are typically liable only liable to pay the subscription price for their ownership interest. But it is important to note that there are atypical situations where shareholders of a corporation may not be protected from liability.
For instance, a creditor of a corporation can sue shareholders of a corporation for the corporation’s debts (referred to as “piercing the corporate veil”) if:
- the corporation did not maintain the corporate “formalities” (how a company operates its rules and guidelines) or if,
- the capitalization for the corporations was grossly inadequate for the business being conducted, or if
- the shareholders intermixed personal funds and expenses with the funds of the corporation.
A creditor trying to pierce the corporate veil has a heavy burden of proof, and the shareholders of an entity that follows the rules (and advice of legal counsel) are unlikely to be at risk. The rules for corporations are too numerous and varied among states to discuss in any detail, but some basics tend to be true in most jurisdictions.
- What rights do I have as a shareholder or owner of a company?
Ownership interests in a corporation are called “shares of stock” and their owners are called “shareholders” or “stockholders”. The basic rights and privileges of shareholders (and different classes of shares), along with certain basic information like the corporation’s name and the name and address for the corporation’s registered agent is required to be spelled out in a certificate of incorporation (or amendment) filed in the state where the corporation is formed.
The shareholders of the corporation then elect a board of directors. The number of directors and the timing of elections is included in a set of rules adopted by the shareholders (or in some cases the directors) called the corporation’s “By-Laws.” The Directors approve major corporate decisions, such as the issuance of shares and major commitments. Such approval is typically provided by a vote of the Directors at Director’s meetings—although typically, Directors can affect their authorization in a written consent signed by all the Directors. The directors are also authorized to elect corporate “officers” (such as the President) and delegate duties and rights to each such officer, such as making day-to-day decisions of the corporation and signing contracts on behalf of the corporation.
Many states have a provision for so-called “Closed Corporations,” which is a corporation with a small number of shareholders and make the election according to the state’s provisions. The formalities of corporate governance can be relaxed or eliminated for these Closed Corporations. In some cases, major decisions require the shareholder’s and the director’s approval. In some states, shareholders may approve matters by written consent of shareholders and in some states, this consent does not have to be unanimous.
In addition to maintaining corporate formalities, corporations are taxed differently than sole proprietorships and partnerships. This can be an advantage in some situations and a disadvantage in others. To learn more about corporations and how you can effectively build your company, call the attorneys at Warren Law Group at (866) WLGROUP, or email firstname.lastname@example.org to schedule your complimentary consultation.
Paul Share, Partner & Chair of Corporate Transactions
Chris Warren, Managing Partner