Should You Incorporate Your Business and, if so, How Do You Maintain Its Protections

• Why incorporate your business to avoid or lessen personal liability?
  If you are a sole proprietorship or partnership, then all of your personal assets including your house, car, savings accounts, etc. (subject to certain debtor exemptions) are at risk, if you should be sued
  

• How does personal liability for business claims arise?
  If you or one of your employees, in the course of employment, injures another person, that person may seek money damages in a court action against you. Examples include someone slipping and falling in an entrance way or office floor, an employee who thinks he or she faced unfair treatment, a customer who feels that you may have committed some negligent act that cost him or her money damages. Some of these risks can be covered by liability insurance, but they may not be adequate for the amount claimed or may be subject to exclusions. We live in a time when everyone sues if they think that they have been wronged and they can obtain a money judgment. If you have such risks and business is subject to bad times, you may have to file personal bankruptcy, when you could be in a much better position if you were a corporation. Another example is that both sole proprietors and partnerships are liable for the acts, including the negligence, of their employees. Partners are liable for the negligent acts of other partners.

• How does incorporating avoid or lessen personal liability?
  When you properly incorporate in the Commonwealth of Massachusetts, you have created a new legal person or entity completely separate, if done correctly, from your own person and your own personal assets. A judgment creditor or other person, seeking to obtain money damages from your business, can reach only assets of the corporation and not your personal assets. In other words, the law recognizes and creates a business entity known as a business corporation that is separate from the individuals who invest in it as shareholders. Those shareholders will only be liable to the extent of their investment paid into the corporation provided they both properly set up and maintain it
  

• Are there other advantages to incorporating?
  There are a number of advantages to being incorporated. Marketing image is one; you will seem to be a more substantial business with more lasting power. A sole proprietor or partnership usually ends on the death of the owner(s). Corporations may survive the death of their owners. There is also flexibility in dividing your business. Corporate stock provides an ease of transfer of interest in the business. You can divide up the business among family members or others. You can give different types of rights for different kinds of stock including preferred or common stock. In addition, use of the corporation may make estate planning easier in making gifts of stock in the business to family members. The corporate form may make much simpler the sale of the business to others if at some point a sale is contemplated. If the business becomes very successful but needs to raise more money, it may be necessary to incorporate to sell the shares to the public. The central management of the corporation is an advantage. Provisions to pay back officers and/or directors for any losses that may occur to them personally for their action on behalf of the corporation must be properly written into the articles of organization and/or by-laws.
  

• Are there disadvantages to incorporating?
  There are additional administrative expenses, particularly legal and accounting fees and administrative costs. In particular, a corporation needs annual meeting votes, a minute book, financial records, separate income tax forms, and an annual report with a filing fee to the Secretary of State. A corporation should consider filings in other states in which it does business in order to "qualify" to do business in those states. There may be more taxes with a minimum corporation excise tax of $456 in Massachusetts. Double taxation on a C corporation's income occurs with income taxed to the corporation and again to the owners when distributed to them as dividends. To avoid it, the Sub S election, available for most small businesses, allows the sub S corporation owner to be treated like an individual. It must be filed within three months of incorporation or starting to do business. There are numerous factors to consider in making this election and they may change with changes in your priorities and number and tenure of employees.
  

• What does it mean to "pierce the corporate veil" and how do I avoid it happening to me?
  There are dangers in failing to properly maintain the corporation. If you do not treat your personal assets and your corporate funds and property as totally separate legal entities and co-mingle them, you may face a "piercing of the corporate veil." In other words, a judgment creditor may be able to reach through the corporation to your personal assets if you do not properly set up the corporation or maintain it. If you neglect to sign contracts and agreements in your corporate capacity as president or other officer of the corporation rather than just with your own name, you may find yourself personally liable. You need to have separate corporate stationery, signs and checking account with the company name, including "Inc." or "Incorporated."
  

• What is involved in properly setting up and maintaining your business as a corporation?
  You should employ an experienced business attorney and a certified public accountant to be sure that corporate formation and maintenance are properly done. The attorney will draw up articles of organization with protective language. We adopt corporate by-laws and indemnification provisions particularly applicable to Massachusetts Law . Experience of a business law attorney in corporate law, commercial real estate, civil litigation, and estate planning all are needed by business clients.

What Are the Duties that Officers, Directors, & Shareholders In a Closely Held Corporation Owe One Another?

• What are the duties of the Directors of a Closely Held Corporation?
  Directors of a Massachusetts corporation, including small closely held companies, stand in a fiduciary relationship to the company. As fiduciaries, their primary duty is to the Corporation and their personal interest are subordinate to that duty. Directors' basic duties comprise both the duty of care and the duty of loyalty. Dealings between a corporation and its directors are held to the standard of good faith and inherent fairness. Massachusetts courts will examine carefully self-dealing where the directors' self-interest and duty of loyalty to the Corporation may be in conflict.

• What are the duties of the Shareholders of a Closely Held Corporation?
  Stockholders, other than stockholders in a "close" corporation may have no duty at all. For closely held corporation, in 1975, the Massachusetts Supreme Judicial Court in the Donahue v. Rodd Electrotype Company of New England, Inc. established a higher standard: Stockholders in a close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another, namely, a duty of the utmost good faith and loyalty. It defined a close corporation as "typified by: (1) a small number of stockholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operations of the corporation."

• What are the duties of Officers or Employees of a Corporation?
  Massachusetts courts have ordinarily not distinguished the duty of corporate officers from the fiduciary duty of directors. M.G.L.A. Ch.156B, § 65 does not distinguish among directors, officers and incorporators in establishing a fiduciary standard. Likewise, Massachusetts cases state that "employees occupying a position of trust and confidence owe a duty of loyalty to the employer and must protect the interests of the employer." Chelsea Industries, Inc. v. Gaffney, 389 Mass. 1,11 (1983) Nonetheless, our courts have been vigilant to leave the managers of the Corporation broad discretion in the management of corporations business. Although the business judgment rule found in Delaware has not been adopted by Massachusetts courts, corporate officers and directors are not to be held liable for "mere errors of judgment" or "bad business judgment" and the courts will not substitute their business judgment for that of the corporation' s management.

• How do Massachusetts Courts apply the strict Donahue fiduciary standard to corporate opportunities?
  When the greedy uncle Demoulas ran his supermarket chain so as to obtain most of the benefits of the business’s growth for himself, his deceased brother’s family as shareholders sued. In 1997 in Demoulas v. Demoulas Super Mkts. the SJC sternly applied the Donahue standard, stating that "the directors of a corporation stand in a fiduciary relationship to the corporation. Durfee v. Durfee & Canning, Inc., 323 Mass. 187, 196. They owe to the corporation both a duty of care and, more significantly for this case, a paramount duty of loyalty. "They are bound to act with absolute fidelity and must place their duties to the corporation above every other financial or business obligation. . . . They cannot be permitted to serve two masters whose interests are antagonistic." Spiegel v. Beacon Participations, Inc., 297 Mass. 398, 410-411 (1937). In the case of a close corporation, which resembles a partnership, duties of loyalty extend to shareholders, who owe one another substantially the same duty of utmost good faith and loyalty in the operation of the enterprise that partners owe to one another, a duty that is even stricter than that required of directors and shareholders in corporations generally.

• Who has the burden of proof in claims of violations of the standards of good faith and fair dealing?
  The rule in Massachusetts is that the burden of proving a breach of fiduciary duty is on the complaining party, the plaintiff. It has often been stated specifically that this burden is to prove "mismanagement or misappropriation of corporate assets." The burden of proof does not shift to the defendants when the plaintiff can demonstrate the defendants have a conflict of interest and are on both sides of the transaction- the Commonwealth stands almost alone in placing the burden of proving unfairness on the complaining shareholder. Under certain circumstances, however, courts will deviate and find that the defendants have the burden of showing the inherent fairness from the viewpoint of the corporation and those interested therein.

What is a Limited Liability Company, a "LLC," and What Are its Advantages and Disadvantages?

• What is a Limited Liability Company and how is it set up?
  Your business may have the flexibility of a partnership and the legal protection of a corporation if it is a limited liability company ("LLC") - the most recent addition to the choices of new business entity. Because of its dual character of corporation protection against personal liability and partnership tax treatment, the LLC may come to replace general partnerships, limited partnerships and S corporations as the entity of choice. The LLC uses an operating agreement, similar to a partnership agreement, to control business, financial and tax provisions. The operating agreement may be oral, although it should be in writing and signed by all the LLC's members. It is not filed with the Secretary of State. Management of an LLC may be vested either in the members or in certain designated "managers." Managers do not have to be members of the LLC, and even corporations may serve as managers. Through its provisions, the operating agreement determines whether the LLC is taxed as a partnership or corporation.

• What are the primary advantages of an LLC that should be considered when starting a business?
  LLC Members are protected from personal liability just as corporate shareholders. Usually the LLC will be treated as a partnership as to tax treatment: it will be a flow-through entity for which income and losses are reported directly by its members. Unlike an S corporation, special allocations of income, expenses, deductions and losses can be made among its members, and an individual member's losses are not limited by the amount of a member’s investment in the LLC. It differs from a partnership in that management may be by nonmembers. It differs from a limited partnership in that members may be actively involved in the LLC's management, without the danger of personal liability faced by an active limited partner. An LLC should be used rather than an S corporation when a business plans to have foreign persons, corporations or trusts as shareholders. It is a useful entity for estate planning purposes since trusts and estates are eligible shareholders. LLC s may soon eliminate both general and limited partnerships as business entities, having the same tax treatment and management opportunities, yet with the added advantage of limited liability to all its members.

• What are the primary disadvantages of an LLC that should be considered when starting a business?
   With the LLC a new legal entity, there is little legal precedent concerning the law of LLCs. There is more involved in setting up an LLC than in organizing a corporation and the fee for filing with the Secretary of State is higher. No federal tax legislation yet establishes the LLC as a partnership for tax purposes. While the IRS has ruled that the LLC will qualify as a partnership for tax purposes, there is nothing in the Internal Revenue Code to assure continuation of such treatment. When there are no special advantages to using the LLC and there is a choice between using an S corporation or LLC, S Corporation should be used as it is an established business and tax entity.

• In what situations, in summary, is the Limited Liability Company best suited?
  An LLC is best used when two or more people are considering a business or investment venture. The LLC provides significant advantages over both general partnership and limited partnership structures. Similar to an S corporation, it does not have its restrictions. LLCs are available to professionals and may be advisable in place of a Limited Liability Partnership because more states recognize LLCs than LLPs for the protections discussed here.. They should not be used when a regular "C" corporation would be able to utilize the corporate reorganization tax provisions or the ability to have separate classes of stock.
   
  It is particularly appropriate for real estate ventures containing corporations, trusts or foreign investors or new business ventures involving existing corporations. The LLC is a fine tool as an estate planning entity for investments between an individual and his or her family corporation, trust or partnership.

What is a Buy-Sell Agreement and How Can It Protect the Owner (s) of a Closely Held Corporation and the Business in the Eevent of Death or Disability?

• How does a corporate buy-sell agreement deal with the death or disability or termination of employment of a key owner or owners of a closely held corporation?
  Your business may be the primary asset that provides income and security for you and your family. The owners, shareholders, of many closely held corporations understandably find it hard to plan for the risk of the death, disability, or voluntary or involuntary termination of employment of the company owner(s). Buy-sell agreements include provisions governing those situations and legally enforceable restriction on the transfer of stock. They provide for the redemption of stock by the corporation or purchase by one or more of the remaining shareholders. For the selling shareholder, the agreement assures a buyer for his stock at an agreed formula to determine a fair price. If a minority shareholder’s interest is being sold., the provision for a buyer at fair market value is peace of mind in situations where minority positions in closely-held businesses might not sell at all or for a very low price. Buy-Sell agreements allow for withdrawal of equity from a company, and, if properly drafted, can also establish the value of the company for estate tax purposes. For the buyer, the stock repurchase often can permit the business enterprise to continue according to agreed upon transfer of control provisions. It often prevents strain or even litigation between the selling shareholder or his or her estate and the remaining shareholder(s).

• What can a more sophisticated buy-sell agreement provide that simple right of first refusal provisions in the Articles of Organization cannot when there is one of those changes?
  While buy-sell agreements serve key corporate and individual shareholder’s purposes, the frequently encountered problem is that most closely-held businesses have only the simplest of agreements. They often fail to solve the financial and governance problems that may undermine an orderly transition in the ownership of the business. Many companies are incorporated with only boiler-plate first refusal language in their Articles of Organization.. A sophisticated buy-sell agreement will address key tax issues and also determine who is the selling party, the buying entity, and the source of the funds - usually either a promissory note secured by certain provisions for payment from future income or better yet a corporate split-dollar insurance policy or some combination of the two.

• What are the Three Common Types of Buy-Sell Agreements?
  The question arises as who is the appropriate buyer of the selling shareholder’s shares, there are three common types of Buy-Sell Agreements: (1) Corporate Redemption Agreement, (2) The Cross-Purchase Agreement, and (3) the Hybrid or "Wait-and-See" Agreement. In the Corporate Redemption Agreement, Corporate funds are used to purchase the shares, either directly through current or accumulated earnings, or through the payment of insurance premiums. If insurance is expected to be the funding source, this corporate approach can result in a simpler insurance program than a cross-purchase approach. The Cross-Purchase agreement provides for one or more of the remaining shareholders to purchase the stock of the departing shareholder. Each shareholder must own insurance on the life of every other shareholder. Flexibility can be provided by a hybrid approach. The corporation might have the first option to redeem shares, and if it did not do so, remaining shareholders would then have the option. If they did not do so, then the corporation would be required to purchase the shares.

• What are Other Provisions Commonly Found in Cross-Purchase Agreements?
  If there is a premature departure of one of the key owners, there arises issues of non-competition, non-solicitation, and confidentiality that should be put in the Buy-Sell Agreement. It can spell out the parties’ expectations of their duties to the enterprise. It may contain employment rights and identify expectations as to who the officers and directors will be. If the reason for termination of employment is for cause, then there might be a lower purchase price. Since payment will be made from corporate funds, security for the company’s promissory note should be provided. There may need to be certain limitations on the conduct of the business, future dividends, and sale of significant assets; subordination of such debt to bank debt; and prohibition against changes in the nature of the business or acquiring other. Violation of the agreed upon provisions could result in the acceleration of the debt and/or transfer of the stock back to the shareholder pursuant to a stock pledge.