Gregory S. Connor, Attorney-at-Law

B.A. History, B.A. Political Science – Boston College,
magna cum laude
J.D. – Duke University School of Law
2004-2010 – General Counsel, Chapel Hill Chamber of Commerce
1995 – Admitted to North Carolina State Bar
U.S. District Court, Middle and Eastern District of NC
United States Fourth Circuit Court of Appeals

Business Law – Entity Formation

TYPES OF BUSINESS ENTITIES AND THEIR FORMATION

1. What are the different business entities that I can form?

Sole Proprietorship
A form of business in which one person own all the assets of the business. The sole proprietor is solely responsible for all the liabilities and debts of the business.

Partnership
A business that is organized by two or more persons and does not enjoy limited liability. That is, the partners are personally and jointly liable for all the liabilities and debts of the business. A partnership may be formed by tacit agreement, oral agreement, or written agreement.

Limited Partnership
A limited partnership is a legal entity created by making application to the State of North Carolina. A limited partnership has two kinds of partners: general partners and limited partners. The general partners are subject to liability for the liabilities and debts of the partnership. Generally, the limited partners enjoy limited liability from the liabilities and debts of the partnership because they do not participate in the management of the partnership.

Limited Liability Partnership
A limited liability partnership is a legal entity created by making application to the State of North Carolina. Generally, partners are not subject to personal liability for the liabilities or debts of the partnership.

Corporation
A corporation is a legal entity created by making application to the State of North Carolina. It is an artificial legal entity with an existence separate from its shareholders / owners. The law treats the corporation as a person with the capacity to sue and be sued. Generally, the shareholders cannot be sued individually for the actions of the corporation.

S-Corporation
A corporation as above, but with a special tax designation from the U.S. Internal Revenue Service.

Limited Liability Company
A limited liability company is a legal entity created by making application to the State of North Carolina. Instead of the term shareholders, as in a corporation, the owners of an LLC are the “members”. LLCs may be managed by all of its members or by a manager, or according to agreement among the members.

2. What are some of the primary considerations in forming a business entity in North Carolina?

Primarily, business owners are concerned about (1) limited liability, (2) favorable tax treatment, and (3) succession planning.

Limited liability: Every business owner wants to limit their liability for claims made by customers, employees, and vendors. One easy way to do this is to form a business entity that grants limited liability to its owners. Under North Carolina law, corporations and limited liability companies enjoy limited liability. That is, if the company is sued, the owner is insulated from personal liability. In addition, limited liability partnerships grant some, but not comprehensive, protection to their partners.

Favorable tax treatment: Owners should consult their accountants about the best form of tax entity to choose. In general, tax issues can be very complex and depend on the individual situation. However, many times accountants advise small business owners to form “S-Corporations”. An S-corporation is an election made to the IRS to be treated as a Small Business corporation and receive partnership-like taxation. That is, the corporation pays no taxes itself, but rather, like a partnership, the individual shareholders are taxed on their pro-rata amount of the corporation’s profits. The benefit of an S-corporation is that the company can pay some of the net income (typically no more than 1/3) to the shareholders as dividends. These dividend payments are not subject to self-employment taxes. The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

EXAMPLE 1: You have an S-corporation and you have a great year making donuts and coffee! You earn $80,000 in net income after expenses. Ordinarily, if you had a limited liability company, sole proprietorship, or a corporation that did not pay dividends, you would pay employment taxes equal to 15.3% on the first $80,000 for a total employment tax liability of $12,240. But because you have an S-corporation you paid yourself $26,400 in dividends (1/3 of the net income). Now you’ll pay employment taxes on 15.3% of $53,600.00 equal to $8,200.80, a savings in employment taxes of $4,039.20 for that year. This would apply to each owner/shareholder.

Limited liability companies (LLC) are beneficial when the company will own real property (i.e. land or a building) and the company has more than one owner. This is because when the company dissolves or is forced to dissolve, or divided property among the owners, there are no additional transfer taxes if the property is divided among the owners in proportion to their ownership interests. Many property companies are formed as LLCs for this purpose.

Succession planning: Owners are often faced with the question of what happens to the company if one or more of the owners dies, quits, is permanently disabled, wants to sell his interest to a third party, or is subject to legal process. Without proper planning, the answer unfortunately is often that the company is either forced to accept a new owner that inherited or bought the previous owner’s interest. More often than not, the original owners are very unhappy with this arrangement. All of the issues are addressed by succession planning using “buy-sell” provisions that provide for these contingencies. Usually these agreements set contingencies upon which the other owners are permitted to buy the deceased, disabled, fired, or selling owner’s interest. A price is set in advance either by fixed amount or formula.

EXAMPLE 2: You have a corporation that serves British style teas at private homes. You own the business with two other shareholders. One of the other shareholders decides that she doesn’t want to work any more; she’d rather drink her tea herself. The two remaining shareholders decide that they have no choice but to fire the dilatory shareholder. However, under the law they are unable to redeem her shares and she remains a shareholder entitled to dividends and to sell her shares to any third party. If the corporation had an agreement among the shareholders to sell their shares to the other shareholders at a certain price, this could be used in the event of the death, firing, or disability of the employee, or in the event of an attempted sale

Other business owners are concerned about planning for their children to take over the business or for another owner to buy out their interest upon retirement. Business owners should resolve all of the issues from the beginning before the misunderstand begins.

3. Can I offer shares in my new corporation to twenty people I know to help raise money, six of whom are actually interested in passively investing?

NO. If you are selling interests in a company to anyone, you are subject to state and federal securities laws. The law of securities is very complex, but generally in North Carolina you may sell shares in a business to non-participating parties, if the offeror offers them to five or fewer individuals in the state of North Carolina. Please check with an attorney before selling any shares or other ownership interests, especially to individuals outside the state or to more than five individuals within the state.

4. What other issues should a business consider when it is forming?

This is a short list of common issues faced by new business entities:

(1) Do you have proper licenses for your trade, if any, from the state?

(2) Do you have a proper lease agreement for your space or if you are operating out of your home, do you have a certificate of occupancy from the city?

(3) Do you have a tax ID number for your company?

(4) Do you need business insurance for your company?

(5) If you have employees, have you obtained worker’s compensation insurance?

(6) Did you have your employees sign agreements to protect your trade secrets, to safe guard your confidential information and/or to refrain from competing against you?

E-mail: gc@connorlaw.com
Connor Law Group (c) 2012

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