1.   If you’re leasing space for your business, find out from the landlord of the premises (and check your lease) what he/she requires in order to consent to an assignment of your lease to the buyer.  Usually the Landlord wants to see that the proposed buyer is credit worthy and has a good chance to continue your business successfully and consequently be able to pay his rent;

2.   Make sure you have a copy of your lease and all its extensions and modifications.  Check the requirements in the lease regarding the assignment of the lease to a buyer of the business.  If you’re lucky the lease “only” states “any assignment of this lease requires the consent of the Landlord, which consent may not be unreasonably withheld.”  This tells you that your landlord has to give your proposed buyer serious consideration.

3.   If you’re not of the super organized type, do a lien search on your business (the business owners) and its assets in order to find out if there are any forgotten liens outstanding.  You may have forgotten about some age old tax lien, equipment lien and so forth.  If you find liens, pay them off or disclose them to the buyer and arrange for pay off letters with the creditors.  Pay off letters provide for the payoff of debts at closing and guarantee the buyer that the creditor will release you, the seller, upon payment of the debt.  If the payoff occurs at the closing, the funds could come from the proceeds of the selling price.  Neglecting to disclose outstanding debts could make you liable for a breach of the representations and warranties in your sales agreement.

4.   Make a list of all relationships with vendors, service providers, large customers.   To the extent you have ongoing contracts with any vendors, service providers or customers, assemble all those contracts.  Read (or have your small business lawyer review) all these contracts to determine what happens to them in the case of a sale of the business.

5.   Make a list of all assets of the business and determine their initial cost and depreciation status (or have your accountant do it).  Have you accountant or small business lawyer advise you on the tax consequences of a sale of the business and how to best allocate any purchase price to various asset groups.  Get your financial statements in order and ready to be presented to the prospective buyer.

6.   Clean up your business, literally.   A little staging and polishing goes a long way to increase your selling prospects;

7.  If you have staff, determine all your operation procedures and manuals and other ways of doing business smoothly and day to day.  The more you can show that your business is not that dependent on you, the prior owner, the better it is for a prospective buyer of your business.  A “turn-key” business is what you’re going for.

8.  Get all your permits and licenses together and in order, determine if the licenses are assignable or if the new buyer has to get new licenses and permits;

9.   Get emotionally ready to let your business go!  Not sure what that would entail for you, but I think an overly attached business owner doesn’t make a good business seller.

What is Arbitration?

Litigation of disputes normally takes place in the various courts of New York State.  As an alternative, people can agree to resolve their disputes outside of the traditional courts and authorize arbitrators to hear and decide their case.  Technically, one could authorize any third party to be an arbitrator.  Such arbitrator would then decide your dispute based on his or her understanding of justice and fairness.  However, most contracts provide that disputes are to be arbitrated by specified arbitration associations, such as the American Arbitration Association or JAMS.  Most arbitration associations have arbitrators ready to spring into action and provide for a set of rules to be applied by the arbitrators in deciding the case.

Cost of Arbitration

Arbitration can be pretty expensive.  If your claim against your adversary is rather small, the cost of arbitration may be too steep.  To get the arbitration going, you have to pay the arbitration association’s fees, which can be quite costly.  Look at the fee structure of the American Arbitration Association here.  The filing of a complaint in  supreme court will cost you a “mere”  $210 and might be all you need for now to get serious settlement negotiations going.    On the other hand, litigation can quickly get very expensive in the long run.  The parties in a litigation may spend huge sums of money on discovery (production and review of evidence) and motion practice.  An arbitrator may be able to control such expenses by only allowing limited discovery and motion practice.

Arbitration is Non Public

The public has no access to your arbitration dispute, whereas civil and supreme court litigation is a matter of public record.  The court papers can be seen by anyone with rudimentary knowledge of the court system and court databases.  Anybody can appear to a hearing or trial in your small business dispute.  Depending on your outlook on publicity, this may play for or against you.

Discretion of Arbitrators

An arbitrator has much more discretion on how to lead the dispute proceedings, what evidence to allow and what law to follow.  Arbitrators are more inclined to let “fairness” and equity rule, even if not entirely within the constraints of prior case law.   This can make your arbitration case rather unpredictable.

No Appeal

An arbitration award is usually final.   There are only very limited possibilities of appealing an arbitration award.

When it comes to selling or buying a business that has a lease, the lease becomes an important part of the selling/buying process.  The buyer should carefully check the lease terms to not only determine the rent and the remaining term of the lease, but also whether the lease can be assigned.  What does that mean?  If the buyer wants to buy the business, the buyer should be able to step almost entirely into the shoes of the prior business owner, including the right to occupy the business premises.  In order to do that, the buyer has to take over the existing lease for the premises or make sure that the landlord of the premises is willing to give him/her a new lease.  If the buyer plans to take over the existing lease, he/she has to make sure that the current lease allows an assignment of the lease to a buyer of the business or if not, that he/she gets the approval of the landlord to take over the lease.

Leases vary greatly in what they state regarding the assignability of the lease.  Some state “this lease can not be assigned without the express consent of the landlord” or “this lease can not be assigned without the express consent of the landlord, which consent may not be unreasonably withheld.”  Others may spell out specific requirements for a potential new tenant before a landlord even considers an assignment of the lease.  There may be additional security deposit requirements or even fees for the landlord for allowing another tenant to take over the lease.

In most cases it becomes necessary for the buyer to prepare an application and submit it to the landlord.  With the application, the landlord will determine whether the proposed buyer is creditworthy and has the financial resources to carry on the business and pay the rent on the lease.  If the lease does not have the aforementioned clause “which approval may not be unreasonably withheld”, the landlord has wide discretion to turn down the buyer and thereby cancel the deal.  No buyer would want to buy a business without having the approval of the landlord to take over the lease.

You can out vote a minority LLC member without a formal meeting, without even notice to the minority LLC member, by simply doing the following:

You need a writing that sets forth the decision(s) of the majority LLC members.

The writing has to be signed by all of the members constituting together the majority in interest of the LLC members.

Each member’s signature on the consent has to include the date of such signature.

Within 60 days of the earliest signature date on the written consent, the consent has to be delivered to the office of the limited liability company, its principal place of business or a manager, employee or agent of the LLC having custody of the records of the LLC.  Delivery has to be made by hand or by certified or registered mail, return receipt requested.  If I were involved, I would recommend the certified mail route, so that there is evidence that it was actually sent.

Finally, prompt notice has to be given of the consent to the minority LLC member.  I am not aware of any case law on this, but it is safe to assume that you should send the notice immediately after delivery of the consent as described above.  And make it a certified mail letter with delivery acknowledgement.

The picture is an example of a written consent overruling a minority LLC member.

Now, one question I didn’t address is how to determine the majority members.  All too often, when no operating agreement exists or the situation is otherwise murky, parties fight endlessly over who was actually entitled to make certain decisions or not.  In those cases everything hinges on the question of who has what “ownership percentage interest” in the LLC.  I will explore that in the next post.

LIABILITIES FOR DEBTS

Scenario 1:  The business is operated by a corporation.  All of the business’ assets (equipment, reputation, customer lists, leases for physical locations) are owned by a legal entity, the corporation.  By buying the corporation, you will certainly get everything that the corporation owns, i.e.  the business.  You would buy the corporation from its owners (called shareholders), who would transfer all their ownership in the corporation to you by way of transferring all of their shares of the corporation.  However, by buying the corporation, you will automatically also get everything else the corporation “owns”, such as debts and liabilities, even the ones you never knew existed.  This makes buying a business in a stock sale a somewhat risky undertaking.  You will be saddled with all liabilities of the corporation.

Enter scenario 2:  You buy the business by buying individually every piece that makes the business.  Because a business is just a collection of many assets.  So you would buy all the equipment, leases, reputation, inventory piece by piece.  Liabilities don’t travel with these pieces, they will stay with the corporation, which you are not buying.  So one advantage to a buyer of a business is that the buyer can rest easy knowing that he doesn’t buy undisclosed liabilities attached to the corporation.

TAXES

Then there are important tax consequences resulting from the questions of asset sale versus stock sale.  In most cases, Seller and Buyer of the business are in conflict with respect to their desired tax consequences.  What is good for the Seller tax wise, may be bad for the Buyer.

The Seller usually favors a stock deal, since this will assure that he has to pay capital gains tax on any gain achieved from the sale.  Capital gains tax rates are much lower than ordinary income tax rates.

The Buyer usually favors an asset deal, because he can take depreciation or amortization deductions on the purchased assets with the purchase price of the assets as his cost.

Even if both parties can agree on an asset deal, there are remaining conflicts of interest with respect to the so called allocation of the purchase price, because, again, the allocation will have tax consequences for Seller and Buyer.  Seller and Buyer must agree on these points, since they both have to allocate the purchase price in the same way when reporting to the IRS later.  Allocation of the purchase price addresses the question of what part of the purchase price is allocated to which assets included in the deal.  In very general terms, a Seller usually prefers that as much as possible of the purchase price is allocated to capital assets, such as goodwill, rather than depreciable business property, in order to avoid having to pay ordinary income tax on the gain.

Photo courtesy of  cosmoflash

At the time I am being approached to help with the legal aspects of buying a New York business, a potential client usually already has a particular business in mind and has an idea of its value.  (The process of finding and valuing a potential business target is a post in itself and I won’t address it here)

My first task is to make sure that the client understands what steps are involved in the purchase of a New York business, what investigations are required and what risks and problems may lay ahead.

INVESTIGATION OF THE BUSINESS (“DUE DILLIGENCE”)

First, the client has to thoroughly investigate the New York business.  I am not usually involved in the actual investigation and inspection of the business, but I will guide the client with respect to what he/she should look for and explain the significance of the client’s findings.  I will review all agreements, leases and other contracts.

If problems are discovered in the course of the investigation, I am there to help the client overcome such roadblocks. For example, if the client finds that there are liens on the assets of the business, I might consider incorporating a provision into the sales agreement that requires the seller to pay off such liens on or before closing of the transaction.  Similarly, if an agreement to be transferred to the buyer (for example the lease of the business)  requires a consent from a third party, I’ll make sure that the sale is conditioned upon receipt of such consent.

My laundry list of things to ask from the Seller:

a.  Tax Returns

b.  Financial Statements

c.  Leases

d. Contracts with vendors, suppliers, licenses, distributor agreements, insurances, equipment leases, and so forth

e. Corporate Documents (or LLC Documents) if the business is owned by a corporate entity

f. A list of the Licenses and Permits maintained by the business or its owners  (I will determine if other licenses are necessary and whether the existing ones can be transferred or new ones have to be obtained)

g.  A list of all the assets of the business, such as equipment, inventory, intellectual property

h. UCC Liens/Tax liens/Business Credit Report (I will conduct independent research into these matters)

i. A list of all the Employees of the business

STRUCTURE

At some point I will confer with the client about the desired structure of the purchase of the New York business.  The structure of a business purchase has important consequences for the potential liabilities of the buyer and his/her tax bill resulting from the purchase.  On occasion, I will cooperate with the client’s existing accountant to fully investigate and analyze all issues involved.

By way of background:   If the business target is a limited liability company (LLC) or corporation, the client has two options in structuring the purchase. He/she can purchase all of the assets of the business piece by piece (Asset Sale) or purchase the entire corporate entity that owns the business (Stock Sale).

FORMATION OF ENTITY

It is often a good idea for the buyer to form a new entity, specifically for the purpose of buying and operating the to be purchased business.  If the buyer decides to do so, I will usually handle the formation and all issues surrounding the formation of such new entity.

TERM SHEET

Often, Seller and Buyer wish to document the rough terms of the proposed transaction in a  “term sheet” (also known as a “letter of intent” or a
“memorandum of understanding”). The term sheet is rarely longer than a
page or two, and should expressly state that it is non-binding on both
parties.  I may draft a term sheet or comment on one that has been provided by the Seller.


SALE AGREEMENTS AND OTHER SALE DOCUMENTATION

After a term sheet is signed (if there is one) and the client’s investigation of the business is almost completed, I
 will draft and/or review a number of agreements and
documents that are instrumental in the transfer of the business to the client, or to the entity formed for this purpose.

The most important document in a business sale is the “purchase
agreement” (also known as the “sales agreement” or “acquisition
agreement”). Often, the seller’s attorney will prepare the first draft
of this document. Unfortunately, that doesn’t always mean that I will have less work to do. If the seller’s attorney is inexperienced
or just plain unreasonable, the review of a bad or one-sided agreement
might take more time than preparing it in the first place.

I may also prepare a “closing checklist,” which is a
list of all of the documents and agreements that need to be drafted and
executed, and of all actions that need to occur on or before the
closing of the sale.

In drafting a purchase agreement and other documentation for the buyer, I will make sure that the term sheet is accurately reflected, that the buyer is properly protected from misrepresentations of the seller and from prior liabilities of the business.  If desired, I may draft provisions that provide for continued assistance of the old business owners for a period of time, provisions that prevent the old owners from competing with the buyer after the closing and any other specific terms of the deal.

Other documents usually required to be drafted are:  promissory notes (if the buyer purchases in installments), security agreements (if the buyer gives security for the outstanding purchase price in installment sale), guaranties by the buyer personally, financing documents, a bill of sale to transfer assets….and so forth, no deal is really like the other

CLOSING

The closing is the last step in the purchase process.  The parties and their
attorneys get together to exchange money and property and take care of
all remaining paperwork.   I make sure that every document is exchanged and properly executed.

Some closings are uneventful. Others can
include last-minute negotiation of agreement terms, waivers of
representations, temper tantrums, and so forth.
  If all documents are in final versions prior to  the closings, the parties may agree to exchange signature pages over email, wire the necessary funds, and conclude the closing over the phone.

WHAT DOES IT ALL COST?

I like to charge flat fees for my help in a New York business purchase.  However, no deal is alike and I usually first talk to a potential client to assess the likely work involved.

Determine what the Contract states

The other party to the agreement may demand all kinds of things, but before you get defeated, you’d better make sure that the contract actually obligates you to do what the other party demands.  Read the agreement in its entirety.  What does it state with respect to your particular problem?

Can you terminate the contract?  Check if the language of the agreement itself offers a way out of the obligation by terminating  according to its terms.

Sometimes contractual obligations have conditions.  In other words, you don’t have to perform unless the other party has fulfilled the condition.

If the contract in fact contains your obligation to do x y or z, you may be out of luck without more.  In most cases, courts will look first and foremost at the plain meaning of the agreement as it is written.  Courts do not care about what you or the other side were thinking at the time or what you expected the agreement to state.

The court presumes that an executed agreement documents the intention of the parties and you have to overcome this presumption in order to fight the enforcement of the contract against you.

Is the Contract enforceable?

Next, lawyers would check if the contract that you signed or the particular provision that you don’t like, is enforceable.  In other words, if the other party takes you to court for breach of contract, would you have a viable defense?  Would the court take that contract and enforce it against you?

Several possible scenarios come to mind that typically make an agreement or one or more of its provisions unenforceable.

The Basics

In order to be enforceable, a contract must be an agreement between at least two people exchanging something of value (consideration).  No consideration, no contract.  Also, if the language is so ambiguous that nobody can tell what it means and there is no indication outside of the written contract for the parties’ intention, there is no agreement to enforce.

Fraud

If you have been defrauded in the context of the contract, you may be able to avoid being obligated to perform.  The obvious example is when someone forged your signature on a contract.  Or if someone makes changes to the contract at the last minute and fails to notify of such changes, so that you literally get tricked into signing a contract that you did not approve.

Another example is when someone tricks you into signing a document by making false statements relating to the agreement.  Had you known the truth, you would have never signed the contract in the first place.

But these examples are rare and usually hard to prove.  You can protect yourself by always reading the contract prior to signing and making sure it states exactly what you think it should state.  You should also do your own investigations as to any representations that are being made to you in connection with the contract.  Ideally, these representations should be repeated and explicitly being written into the contract.  Otherwise it just may be very hard to prove that your were told “such and such” prior to signing.

Also, watch out for a provision that states the opposite:  a disclaimer by you that you did not rely on any representations not specifically stated in the contract.  This puts an even greater responsibility on you to conduct appropriate due diligence before signing the contract.

Is the Contract Illegal or against Public Policy?

For obvious reasons, courts will not enforce illegal contracts; A contract to provide illegal services (think prostitution) is void.

Then there are contracts or provisions that are against New York public policy and therefore not enforceable.  You are more likely to encounter this scenario  in day to day business dealings.

Contract Penalties

The prime example for a contract provision that violates New York public policy is a provision for penalties.   New York courts will not enforce contractual penalties that have no relation to the loss suffered by the non breaching party and such loss would actually be possible to determine without undue difficulties.    “Public policy is firmly set against the imposition of penalties or forfeitures for which there is no statutory authority.”

For example, picture a commercial lease that requires a tenant to pay for certain utilities that are normally paid by the landlord.  The lease further provides that if the tenant fails to pay the electricity bill and landlord pays such bill, tenant automatically has to pay landlord 150% of the amount paid by the Landlord.  I think that would be unenforceable as a contract penalty.  Read more about contract penalties v. liquidated damages here.

Contracts that restrict Competition

Then there are contracts that could have a negative effect on competition.  Again, New York believes an undue restriction of competition in the marketplace is against its public policy.  Whenever a contract clause has the ability to restrict competition, enforceability depends on the reasonableness of such restriction.  It may be reasonable to restrict a seller of a business from opening the same exact business right next door, but it is probably unreasonable to forbid the same seller to engage in a similar business for all times and eternity.

Specifically, you must maintain the following records:

- if your LLC has managers, a list of the full names of all managers and their mailing addresses;

- a list of all members and their mailing addresses together with each member’s contribution to the LLC and his or her share of profits and losses;

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- a copy of the articles of organization and all amendments;

- a copy of the operating agreement;

- a copy of the LLC’s federal, state and local income tax returns for the three most recent years;

If you are in charge of managing the books of the LLC, you are well advised to adhere to these rules, so that nobody can blame you for being negligent in the management of the LLC.

Also, be aware that any member of the LLC has a right to demand access to such records and any financial statements maintained by the limited liability company for the three most recent fiscal years and any other information regarding the affairs of the limited liability company as is just and reasonable.  From that it follows that you should also keep accurate records regarding the financials of the LLC and any and all resolutions or similar LLC documents relating to the LLC.

Do you have to keep paper records?  No, they do feel for trees and provided that a  limited liability company may maintain its records in other than a written form if such form is capable of conversion into written form within a reasonable time.

While I have you thinking about keeping records, it also wouldn’t hurt to peruse this IRS publication:  Starting a Business and keeping Records.  Pay particular attention to the section “Record Keeping.”

A business break-up can be as stressful and emotionally draining as the breakup of a marriage.  And there is always a child involved….the business.  So when your business partnership has gone bad, you really want to find out where you are standing and what rights you may have vis a vis the other business partners and the business.

The Agreements

Whatever your gripe against your business partners may be, the first question is always: What does the agreement say?  You have to check whether you have an agreement with your business partners and what it says with respect to your problem.   If the business is run as a corporation, check your shareholder agreement;  if it is an LLC, check the operating agreement.

If you do not have anything in writing (like many small businesses, regrettably), you have to look to the default rules of the respective New York laws dealing with your specific entity.     For LLCs, it is the New York Limited Liability Company Law and for corporations, it is the New York Business Corporation Law.  These laws also apply if your agreement is silent with respect to your issues.

The following assumes that your relationship is governed by the default rules and that it is organized as a New York corporation or a New York limited liability company.  So always remember that your particular agreement may have different provisions.

Unfortunately, as a shareholder of a corporation or a member of an LLC, you may not be able to convince your estranged business owners to let you go and buy you out.  Unless your agreement provides for some withdrawal/buy-out remedy, you will remain a member/shareholder until the business dissolves or until the other owners agree to buy you out.

Forced Business Break-Up

Under certain circumstances you may be able to take your dysfunctional business family to court and ask the judge to dissolve the business and then distribute the assets to the owners.   If you can succeed with such a drastic step, depends on the facts of your situation and whether you are a shareholder in a corporation or a member of an LLC.

Forced Dissolution of a Corporation

If you (alone or together with other owners willing to go into battle with you) own  50% of the shares in the corporation, you can petition a court for dissolution of the corporation by showing either one or both of the below:

- management is hopelessly deadlocked; or

- management has been guilty of illegal, fraudulent or oppressive actions toward you.

If your ownership is at least 20%, you can still petition under the second showing above, namely, that the other owners have engaged in illegal, fraudulent or oppressive actions.  But in those cases, a judge has certain discretions and may conclude that the  liquidation of the corporation is too harsh a remedy and that there are other feasible means to give what you are owed and protect your rights.  In that context, a judge may conclude that a buy-out may be a proper remedy for your situation.

Buy-Out Election

If you decide to sue your estranged business owners based on oppression, you may be in for a surprise, because your opponents could force you to accept a buy-out of your stake in the business.  The business corporation law gives your opponents the option to buy you out for the fair value of your ownership share.  But they must make that election within 90 days after you have filed your papers.   What is the fair value of your ownership stake?  Unless you agree on such value, it will be a battle of the experts who follow specific rules and methods established over time.

Forced Dissolution of a Limited Liability Company

Many owners of a Limited Liability Company are surprised to learn that their business break-up rights and remedies are much less defined compared to a corporation.   A minority member of an LLC has limited possibilities to force a dissolution of the LLC and the majority members of an LLC are not able to force the minority member to accept a buy-out.

The only remedy for dissolution of an LLC is in Section 702 of the New York Limited Liability Law, whereby a member can force a dissolution whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement.   The law does not provide for a buy-out election or all the other specific rights in the business corporation laws.  Added to the sparse language of the law is the fact that there are also very few court cases interpreting the state of the business dissolution laws in the context of LLCs. So when can you force a dissolution?  New York’s highest court stated:

…..dissolution is reserved for situations in which the LLC’s management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.”

Yeah, still not very clear, is it?  I guess it is fair to assume that a deadlock over essential decisions necessary for the continued operation and financial success of an LLC would be sufficient for dissolution.   Unlike in corporations, “mere” oppression of the minority member by the minority members is probably not sufficient to justify dissolution.

The reality of many dissolutions fights over corporations and LLCs is that many end in settlement.  In certain situations, a court action towards dissolution may be the right strategic move to convince your business partners that they have to come to the table and negotiate with you, rather than spend a fortune on litigation.

Right to Profits – Access to Books and Records

Prior to dissolution, you have a right to profit distributions.  If the other members/shareholders pay themselves, most likely, you have a right to a similar distribution, based on your ownership percentage.

Each shareholder of a corporation or member of an LLC has a right to inspect the books and records of the business.  Write them a letter and demand to see them.  If they don’t let you, you can take the matter to court.

When it is just you and one other owner, certain important decisions have to be made by consent of all owners.  For example, the other business owner in an LLC cannot just take in another member without your consent.

When it is you against more than one other business owner, there is the possibility that they can outvote you, even on certain very important issues.  But they have to follow proper procedure and notify you of all decisions made without your consent.  Finally, they can’t just decide to do whatever pleases them.  If their decision is completely lacking any business judgment or just designed to damage you and your stake in the business, you may have a claim against them based on their breach of fiduciary duties against you.

Photo Cosmoflash

What is an S Corporation?

An S corporation is a (regular) business corporation that elected a special tax treatment with the federal tax authorities and/or the New York State tax authorities.

Otherwise, an S corporation’s characteristics are just like a regular business corporation, which means that it is a legal entity that can be formed by one or more persons. Once a corporation is formed, the S corporation (not its owners in their personal capacity) will enter into all contracts, issue all invoices and undertake all business activities.

Note: Professionals can only form a professional corporation.

What is a Limited Liability Company?

A limited liability company (LLC) is a business entity that can be formed by one or more persons or other business entities.

Once an LLC is formed, the LLC (not its owners in their personal capacity) will enter into all contracts, issue all invoices and undertake all business activities.

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Note: Professionals can only form a professional limited liability company.

How do I form an S Corporation?

You start by forming a regular business corporation.

The formation of a corporation requires the filing of a “certificate of incorporation” with New York’s Department of States.

Once the corporation is in existence, you will have to elect S corporation status with the federal and state tax authorities.

How do I form an LLC?

The formation of an LLC requires the filing of “articles of organization” with New York’s Department of State.

Who can form an S Corporation?

Only individual U.S. citizens or U.S. residents can form an S corporation.

Who can form an LLC?

Any person or business entity.

How many Shareholders can an S Corporation Have?

An S corporation can only have a maximum of 100 shareholders all of which have to be individuals (some exceptions apply).

How many Members can an LLC have?

An LLC can have an unlimited number of members.

Who are the Owners of an S Corporation?

The owners of an S corporation are called shareholders. The corporation issues share certificates to the shareholders in exchange for something of value, like cash, services or property.

Who are the Owners of an LLC?

The owners of an LLC are called members. You become a member by contributing something of value (cash, services, property) to the LLC and receiving a membership interest in return.

How much does it cost to form an S Corporation?

It costs about $195 to form a corporation in New York, excluding legal fees.

How much does it cost to form an LLC?

It costs about $1300 to form a limited liability company in New York, excluding legal fees.

The main costs of formation stem from the fact that limited liability companies are required to publish their formation in two newspapers. Depending on your location, this publication requirement can be quite costly. The estimated cost of formation above is based on New York county’s expensive newspapers (about $1000), it may be cheaper in other counties.

How long does it take to form an S Corporation?

For $195, your corporation will be in existence within 24 hours. However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your corporation has been formed. This may be necessary for opening a bank account.

How long does it take to form an LLC?

You can form an LLC within 24 hours. However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your LLC has been formed. This may be necessary for opening a bank account.

Many banks will also require you to show an operating agreement (see discussion below) before they will open an account for your LLC.

The publication requirement has to be completed within 120 days of formation. Notwithstanding, you can start doing business with your LLC as soon as it is born. If you fail to fulfill the publication requirement, your business loses the authority to conduct business in New York with the expiration of the 120 day period.

Does an S Corporation offer limited liability to Shareholders?

As long as you keep up with all corporate formalities, a corporation offers almost complete limited liability. Shareholders only risk losing the initial investment in the corporation. Creditors normally cannot reach the shareholder’s personal assets.

Does an LLC offer limited liability to its Members?

Yes, the LLC is liable on all business debts, not the members personally. If the business goes under, creditors of the business cannot reach the personal assets of the members.

What formalities are required to maintain an S Corporation?

Among other formalities, S corporations require annual shareholder and director meetings. Important decisions by the S corporation must be documented in “minutes” or “written resolutions” of shareholders’ or directors’ meetings.

Formalities are important to preserve the “limited liability shield” of the S corporation.

What formalities are required to maintain an LLC?

LLCs require less ongoing paperwork than S corporations; however, unless the operating agreement (see below) of the LLC states otherwise, the LLC must also hold annual member meetings.

Formalities are important to preserve the “limited liability shield” of the LLC.

Can an S Corporation issue Shares with different economic rights?

No. All shares of the S corporation must have the same economic rights to profits, distributions and liquidation of assets.  In other words, a shareholder who owns 50% of the shares of the S corporation can only receive 50% of the distributions of the S corporation.

Can an LLC have Membership Interests with different economic rights?

A special feature of an LLC is that the members can agree to share profits and losses in proportions different from their membership interests. In other words, the members could agree that 100% of the profits of the LLC are to be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.

But these so called “special allocations” have to follow quite complicated tax rules to make them permissible. This adds a layer of complexity and extra cost to the management and accounting for the LLC.

Who manages an S Corporation?

A “board of directors” manages the affairs of the corporation through officers. Officers of a corporation are often named president, vice president, treasurer, secretary, chief operating officer and so forth. Sometimes the law or the “bylaws” of a corporation provide that the shareholders have to approve certain actions by the corporation. Bylaws are rules that govern the corporation. When a corporation is formed, the initial directors approve the original bylaws of the corporation.

All three groups in the corporation, directors, shareholders, officers, can be the same person. In other words, if you form a corporation and are the only shareholder, you will also be the only director and may be several officers in one.

Who manages an LLC?

An LLC can be managed by its members or by appointed managers. Unless the articles of organization of the LLC provides for management by managers, the LLC is managed by its members.

What is a Shareholders Agreement and do I need one?

Shareholders can enter into a shareholders agreement to regulate certain matters that come with their share ownership. For example, unless you agree with your fellow shareholders in a shareholders agreement that the shares are not “freely transferable”, any shareholder would be able to sell his shares to a third person. Such person would then become a co-owner of the business.

Thus, unless you are the sole shareholder of your corporation, it is advisable to enter into a shareholders agreement.

What is an Operating Agreement and do I need one?

Members of an LLC (even a sole member of an LLC) must enter into a written operating agreement.

Similar to a shareholders agreement, an operating agreement regulates ownership of the LLC and the business affairs of the LLC. For example, you can put restrictions on the transferability of the membership interests.

Does the S Corporation pay Taxes?

Not on the federal level, but for exceptions in New York State and New York City, see note below.

A regular business corporation is a taxpayer separate from its shareholders. The corporation pays taxes on its profits. When the corporation distributes profits to the shareholders (called dividends), the shareholder have to pay tax again on such distribution. This is called “double taxation”. By electing S corporation status, S corporations avoid this double taxation.

Each individual S corporation shareholder will include her share of the S corporation’s income, loss, and deductions on her individual state and federal tax return.  For this reason, an S corporation is also known as a “pass-through entity.”

Note:

New York State does not exclude s corporations from all corporate level taxation.

New York City does not recognize S corporation status. Consequently, a New York S corporation having income form New York City sources will be taxed as a corporation for New York City tax purposes and has to pay New York City’s General Corporation Tax.

Does an LLC pay Taxes?

A one-member LLC is treated as a “disregarded entity.” The only member reports income, losses, and deductions of her LLC on her personal federal and state income tax return like a sole proprietor.

A multi- member LLC is normally treated as a partnership for tax purposes. Just like a partnership, the LLC does not pay taxes, but files an informational return

Members report their share of the LLC’s income, loss, and deductions on their individual state and federal tax return.  For this reason, an LLC is also known as a “pass-through entity.”

Can a Shareholder deduct Losses of the S Corporation?

Yes, a shareholder of an S corporation can deduct her share of the losses of the S corporation. However, there are limits. Compared to LLCs, S corporations allow for less loss deduction.

Can a Member deduct Losses of the LLC?

Yes, a member of an LLC can deduct her share of the losses of the LLC.

Do Shareholders have to pay Self-Employment Taxes on Money they receive from the S Corporation?

No. However, shareholders of an S corporation who work for the business have to pay themselves a reasonable salary. They are considered employees of the S corporation. Consequently, the S corporation has to withhold federal and state taxes from their salary, pay unemployment insurance and its share of social security and Medicare payments.

There still may be savings over the self-employment tax due from members of an LLC. S corporations can pay out all profits above a reasonable salary as dividends to their shareholders. There are no self-employment taxes or other employment taxes due on such payments.  In determining a “reasonable” salary, be aware of the audit risks involved.

Do Members have to pay Self-Employment Taxes on Money they receive from the LLC?

Members who are actively involved in the business of the LLC have to pay 15.3% self-employment taxes on the first $106,800 of their combined wages and net earnings, including the income allocated to them from the LLC.

Can a Shareholder be an employee of an S Corporation?

Yes, by default, anybody working actively in the S corporation is considered an employee; i.e. the corporation must do payroll for the employee: withhold federal and state taxes, pay its share of social security and Medicare, and pay unemployment insurance. The corporation can deduct the cost as expenses.

Can a Member be an Employee of an LLC?

No. A Member cannot be an employee of an LLC.  Even though a Member can actively work in the management of the LLC and receive so called “guaranteed payments” similar to a salary, technically he or she would not be considered an employee.

Can an S Corporation choose a different Tax Status?

An S corporation can choose to abandon s corporation status and become a regular corporation again. There are limits and restrictions on how often the switch can be done.

Can an LLC choose a different Tax Status?

An LLC can choose to be taxed as a corporation or a partnership.

Can I raise money for the S Corporation from outside investors?

The S corporation can issue shares to investors in exchange for capital that can be used to grow the business. Investors will become owners of the corporation, but can be excluded from management (if they agree).

Can I raise money for the LLC from outside investors?

The LLC can issue membership interests to investors in exchange for capital that can be used to grow the business. Investors will become owners of the LLC, but can be excluded from management (if they agree).

For their own valid reasons, certain venture capitalists will require a corporation for their investment.

Bottom Line for S Corporations:

Pros:

An S corporation is cheaper to form than an LLC.

More people are familiar with the structure of an S corporation.

It may be possible to save money on self-employment taxes.

Cons:

S corporations put serious limitations on the number and kind of permitted shareholders.

S corporations do not allow for special allocations and are less flexible than LLCs.

S corporations put limits on loss deductions on the shareholder level.

S corporations require ongoing formalities to preserve their limited liability shield.

S corporation status is not recognized by New York City, thus the s corporation is subject to corporate level tax.

Bottom Line for LLCs:

Pros:

The LLC offers a very flexible structure. Members can agree to special allocations of profits and losses.

The LLC offers more possibilities for loss deductions.

LLCs have no limitations on the number and kind of owners.

LLCs require less ongoing formalities.

Cons:

LLCs are expensive to form.

LLCs are expensive to maintain when special allocations are chosen by the members.

LLCs can be more complex with respect to accounting procedures.

LLCs can be more expensive for the members with respect to self-employment taxes.

**This post is for informational purposes only and does not constitute legal advice**