Choosing the Right Business Structure: the Basics

Congratulations. The program you’ve just finished developing is destined to make you rich, famous, happy, and more attractive to the opposite sex (hard to imagine, isn’t it?). Now that the programming is done, you’ve got some practical business concerns, not the least of which is how to structure your business.

Will you operate as a sole proprietorship? Partnership? Corporation (general, closely-held or S corporation)? Or some hybrid of the above? Which entity you choose will affect a variety of business and legal issues such as marketplace perception, personal liability for the acts and omissions of the business, lifespan of the entity, ownership interests of co-associates and management of operations. The following examples will give you a helpful understanding of business structuring.

Adam’s Sole Proprietorship

Adam, a lone software developer, has without any assistance developed and currently sells a children’s educational software game entitled, “Finding Knowledge in the Garden of Eden.” Adam pays all his business expenses from personal funds and keeps all the profits from sales himself.. Adam calls his venture “First Man Technologies.” He’s the owner/operator of his business and sole decision maker. While Adam believes his enterprise is strong and sound, others perceive his business as lacking the resources (human and financial) to make a significant impact in the marketplace.

In this example, Adam is a sole proprietor. As the owner of his business, Adam must obtain all necessary licenses, permits and other documents relating to the conduct of his business. In addition, Adam realizes he’s personally liable for the acts and omissions of his business, including business debts, contractual responsibilities and liability for damages to persons injured on his business premises.

If Adam’s business fails, he can terminate his sole proprietorship without the need to file termination or transfer documents. Adam, as owner, can merely cease operating his business.

The Partnership Between Adam and Eve

Having grown tired of working alone, Adam decides to associate with a talented colleague, Eve. Eve has what Adam needs: extensive experience in finance and marketing. Adam and Eve agree that each will share equally (50%) in the profits or losses. They further agree that the new partnership will be named “The Forbidden Fruit Partnership” (“FF Partnership”). Adam and Eve sign a General Partnership Agreement, which discloses, among other things, the distribution of profits, income allocation, management of the business, transfer of partnership interest and causes for termination.

While Adam and Eve have effectively formed a partnership, FF Partnership will not itself constitute a legal entity separate from Adam and Eve. Therefore, Adam and Eve will each be personally liable for FF Partnership’s liabilities.

FF Partnership, unlike Adam’s sole proprietorship, will have a status for tax purposes and will be required to file a federal information tax return. Adam and Eve will be taxed on their respective 50% shares of FF Partnership’s taxable income, whether or not such income is distributed to them. Adam and Eve will be treated as self-employed and will pay self-employment taxes.

For as long as FF Partnership exists, Adam and Eve will owe a fiduciary duty to each other not to engage in a software development business in competition with FF Partnership unless the other party consents to such competitive activity.

A transfer by Adam or Eve of their respective partnership interest will terminate the FF Partnership unless each party consents to the other’s transfer. FF Partnership will also terminate upon the death of Adam or Eve or the withdrawal as a partner by either of them.

Forming the Corporation

Miraculously, FF Partnership has substantial earnings and Adam’s and Eve’s personal net worth has greatly increased. Two gentlemen, Cain and Abel, approach Adam and Eve to arrange for a joint venture between FF Partnership and them. Since Adam and Eve have known Cain and Abel for only a brief period of time and desire to protect their respective personal assets, Adam and Eve wish the association between the parties to be in the form of a general corporation, rather than a closely-held corporation where all shareholders directly manage the business operations. From a marketing standpoint, each of the parties believes incorporating will foster an image of strength, size and sophistication. From a liability standpoint, the corporation itself, and not its individual shareholders, will be legally responsible for the acts and omissions of the corporation during the normal course of business.

Adam, Eve, Cain and Abel agree to name the corporation “Eden Software, Inc.” They each further agree to be equal percentage shareholders (25%) of the corporation. Each of them signs a Shareholders Agreement, similar in content to the General Partnership Agreement between Adam and Eve for FF Partnership. The Shareholders Agreement contains provisions governing the employment of Adam, Eve, Cain and Abel, and the payment, valuation and transferability of stock during their lifetimes, as well as upon their death, disability or retirement. It also covers issuance of stock to future shareholders and issuance of additional stock to the original shareholders.

To cause Eden Software, Inc. to become a valid corporation, Adam must file and record its Articles of Incorporation with the appropriate governmental authority (in Illinois, the Secretary of State). The Articles of Incorporation state the name of the corporation and the registered agent (the person who will receive personal service of all legal documents), the desired duration of the corporation, the corporation’s purpose, the number of shares authorized and issued to the shareholders and certain optional provisions which disclose the number of directors and specific voting rights.

Upon incorporation, Eden Software, Inc. will be a separate taxable entity required to pay tax, except if the shareholders elect Subchapter S status. A Subchapter S corporation, as created under the Internal Revenue Code with certain limitations, is a pass-through entity under which corporate income and losses pass through to the shareholders. Generally, the result is that the corporation is not subject to income tax. Shareholders often elect to incorporate as a Subchapter S corporation because corporate income tax rates are generally higher than individual rates.

After the incorporation of Eden Software, Inc., Adam, Eve, Cain and Abel, as shareholders, will elect the Board of Directors. The directors will be responsible for the general policies and business affairs of the corporation. Each director will owe a fiduciary duty to act in the best interests of Eden Software, Inc. and its shareholders when conducting the business affairs of the corporation. Assuming Eve and Cain are elected directors, they will elect or appoint corporate officers. The corporate officers will be responsible for the day-to-day business operations and decisions.

The Hybrid: Limited Liability Company

Certain states have enacted statutes offering owners of business entities the opportunity to incorporate as a limited liability company (“LLC”). In Illinois, this option became available January 1, 1994. An LLC is a hybrid between a partnership and a corporation. Generally, the owners of an LLC have the personal liability protection of a corporation while also maintaining the tax advantages of a partnership, subject to meeting certain federal revenue rulings and procedures.

Conclusion

Deciding on the optimal legal structure for any business requires an analysis of current and future business operations and needs. The law provides choices to address personal liability concerns, tax planning needs and the potentially varying interests of one’s business associates. It is critical to fully understand the legal, tax and business implications of whatever option is chosen.

(The authors intend all entity names used in this article to be fictional for illustrative purposes only.)

Attorney Eric Freibrun specializes in Computer law and Intellectual Property protection, providing legal services to information technology vendors and users. Tel.: 847-562-0099; Fax: 847-562-0033; E-mail: eric@freibrun.com.

March 1st, 1994|