CHOICE OF ENTITY. rev 02 20docx

FUNDAMENTALS OF BUSINESS FORMATION
O’Reilly Law Group

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BUSINESS START UP BASICS


This profile provided by O’Reilly Law Group is intended to present guidance with
respect to several often complex and frequently highly regulated issues regarding
business start-up. It is not intended and should not be considered legal, tax, or
securities advise. Every situation is different and the legal, tax, and regulatory
environments are constantly changing. No topic is addressed in depth, and not all
potential structures or decision points are referenced.


CHOICE OF ENTITY

By carefully considering the forms of business entity that are available and then
logically choosing an appropriate form, you can reduce exposure to liabilities, save
taxes, and launch the business in a form capable of being financed and conducted
efficiently. In addition, formalizing the business helps prevent misunderstandings
among the participants by defining their ownership, roles and duties in the
business.

Protect Your Personal Assets And Minimize Your Tax Liabilities.

Some of the primary considerations in the choice of business entity will be the
protection of your personal assets from liabilities of the business; tax strategies such
as maximizing the tax benefits of startup losses, avoiding double (or even triple)
layers of taxation, and converting ordinary income into long term capital gain
(which, at least for now, is taxed at lower rates); selecting an entity that will be
attractive to potential investors and lenders; availability of attractive equity
incentives for employees and other service providers; and cost (startup and
operational).

The principal forms of business entities are:

• Corporations (including the S Corporation which has special flow-through
tax attributes);
• General or limited partnership;
• Limited liability company (“LLC”); or
• Sole proprietorship.

Because of its simplicity and the lack of any formal entity formation requirements,
the sole proprietorship is probably the most prevalent form of small business due in
large part to the number of family owned businesses in the United States. While no
formal organizational documents are required, there will almost always be business
licenses and fees. A sole proprietor reports and pays taxes based on his or her
Social Security Number.


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Each state has its own laws under which businesses may organize and operate. A
corporation is a distinct legal entity owned by its stockholders and managed by a
board of directors. Each stockholder usually has one vote per share, although it is
possible to have different classes of stock, some of which have voting rights and
some of which do not. A partnership is a separate entity for some purposes but for
other purposes is treated as a group of individual partners. It does not pay taxes
directly; instead taxes are paid by its partners on the personal returns based on
their respective interest in the company. An LLC is intended to take advantage of
some of the best attributes of corporations and the partnerships.

If properly structured, the LLC is taxed the same as a partnership; however, a single
member LLC is considered a “disregarded entity”, for purposes of taxation and the
single member will pay taxes on his or her individual return.

Despite simplicity of organization and the tax incentives to utilize the partnership or
LLC form of doing business, most large business organizations operate as
corporations. The principal attractions to the corporate form are the limited
liability it provides to its stockholders, its familiarity and well-understood
governance laws and the ability to transfer corporate stock more easily than
partnership or LLC interests (particularly in the public securities markets).

Some (but not all) states allow Series LLCs in which there is a master LLC with any
number of separate series companies. For example if a hypothetical Vegas
Apartment Investors, LLC intends to own multiple apartments, it may want to
register each separate location as a different series LLC. This device prevents cross
liability between the different locations such that if one location is sued and suffers
a loss, the assets of no other series are at risk. Series LLCs also offer the advantage
of the need to file annual reports with the Secretary of State for only the master LLC.
Thus, if our hypothetical apartment Series LLC owns 20 separate locations, it will
file (and pay annual fees) for only the master LLC instead of 20 separate filings.

Many venture capital and other investment funds are unable or simply unwilling to
invest in partnerships and LLCs because their major investors are pension and
profit sharing trusts and other tax-exempt entities that are subject to certain tax
restrictions. Corporations are also the most familiar business entity and is governed
by the most highly developed laws. However, partnerships, proprietorships and,
increasingly, LLCs are also widely used for smaller businesses and where, raising
outside capital, tax and other considerations warrant.

Making The Selection Among The C Corporation, S Corporation, Partnership,
And Limited Liability Company.

The two of the most critical factors in selecting the form of business entity are (i)
who the owners of the business will be and (ii) how the earnings of the business will
be returned to its owners. If the corporation intends to make a Subchapter S
election, there are specific rules, regulations, and timelines that must be followed. It

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is generally possible to convert from an S Corporation to a C Corporation but it may
not be possible to go the other direction. This is because IRS is happy to see the
double taxation inherent in a C Corporation but not so happy to see that double
taxation eliminated by reversing the election.

Who Will Be The Owners?

If a business is owned by a only a few individuals, any of the above entities may be
an appropriate business form and factors other than identity of the owners may be
determinative. For the following reasons C Corporations are usually the entity of
choice if equity in the business is going to be widely held:


• A corporation has unlimited life and free transferability of ownership.
Although there usually be restrictions on transfer of stock that has not been
subject to an SEC registration. Although changes in its ownership resulting
from transfers of stock (by a living stockholder or upon a stockholder’s
death) or the issuance of new shares (i.e. additional shares issued directly by
the corporation) will affect the election of directors and therefore corporate
management, the corporation’s existence is not affected. On the other hand,
free transferability of interests and unlimited life are more difficult to
achieve in a partnership or LLC, and if provided for in a partnership or LLC,
can adversely affect flow-through tax treatment.


• An S Corporation is not suitable for a widely held corporation because it is
limited to 100 stockholders all of whom must generally be individuals or
eligible trusts, and U.S. citizens or resident aliens. This means another
corporations can generally not be shareholders (although there is an
exception for a qualified Subchapter-S subsidiaries known as a QSSS).




• If the business is to be so widely-held that its ownership interests will be
publicly traded, a corporation is the entity of choice because the public
market is more receptive to offerings of corporate stock than partnership or
LLC interests and because a publicly traded partnership or LLC will be taxed
as a corporation (i.e. no flow-through tax treatment).


• If ownership interests in the business are going to be provided to employees,
a C Corporation will generally be the preferred entity for several reasons.
First, stock ownership is easier to explain to employees than equity interests
in partnerships and LLCs. Second, creating favorably priced equity incentives
is easiest to accomplish in a C Corporation because ownership can be held
through various classes of stock. Incentive stock options are only available
for corporations; not partnerships or LLCs. In the case of options that do not
qualify as incentive stock options, the option holder recognizes ordinary
income when the option is exercised in the amount of the difference between

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the exercise price of the option and the fair market value of the underlying
stock as of the time the option is exercised.

• If the business raises capital from a venture capital fund, the business will
usually be formed as a corporation because most venture capital funds raise
money from tax exempt entities such as pension and profit sharing trusts,
universities, and other charitable organizations and these entities would
incur taxable unrelated business income if the venture fund invested in a
flow-through entity such as a partnership or LLC.


How Does the Business Expect to Return Its Profits to Its Owners?

A business can either periodically distribute earnings to its owners or it can
accumulate and reinvest the earnings with the goal of increasing the value of the
business so that the business can later either be taken public or sold to another
business for cash or marketable stock of the acquiring business. Current earnings
are taxed as ordinary income whereas the gain on the sale of stock is presently
taxed at the more favorable long-term capital gain rates.

An entity that is allowed flow-through tax benefits such as partnerships, LLCs, or S
Corporations may be the entity of choice where a business intends to regularly
distribute its earnings so the earnings can be distributed without incurring a second
level of tax. If a C Corporation is used, earnings can be paid out without a second
level of tax only if paid as salary or other reasonably earned compensation to
stockholders who work for the business. This is allowed since such compensation
would be deductible by the corporation against its taxable income. This eliminates
the corporate level tax on earnings paid to the owners as salary or other
compensation. Most small businesses which are not expected to grow into public
companies and which have owners who do not work for the business (and therefore
cannot receive tax deductible compensation) but who desire the distribution of the
earnings of the business currently, have an incentive to use a tax flow-through entity
such as an S Corporation, partnership, or LLC.

The income tax law provides an additional incentive to organize as a C Corporation
for any business that seeks to build long-term value rather than regularly
distributing earnings. Stock of a C Corporation (but no other business entity
including an S Corporation) that qualifies as a Small Business Corporation (“SBC”)
and which is held for at least five years, is generally eligible for a 100% capital gain
deduction. More importantly, if proceeds from the sale of stock of an SBC are
reinvested in stock of another SBC within 60 days, tax on the gain is generally
deferred. (Check back as these rules may change at any time.)





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ENTITY FORMATION

Select A Name. Once you have a name you believe works well for your business,
determine if it is available. The website for the Secretary of State is a good staring
point to see if the name you have chosen is already in use. Some states allow you to
reserve a name prior to formation. You may also want to conduct a thorough
Internet search to see if any other business is using the name you have selected. If
you intend to register the name as a trademark, you can check the website
maintained by the U.S. Patent and Trademark Office and perform a basic word
search using their TESS search tool. Sites such as GoDaddy and Network Solutions
will identify whether the name you have selected is available as a domain name and
register it for a fee. Multiple services have identified and registered (but never
used) domain names they thought someone might want to use. The perceived value
of the name, will determine the price for which they will sell it to you. For example,
if your new company will be marketing nutritional supplements, at the time this
profile was written, the name “Nutrivin.com” (along with a nifty logo) was available
to purchase for $2,995.00 from Domanify.

Required fillings. Necessary formation filings will vary from state to state. In
most instances (including in Nevada), the forms necessary to establish an LLC or a
corporation are available and can be complete on line at the Secretary of State
website.

Other documents. The LLC and corporation filings required by the secretary of
state are barebones organizational requirements. For LLCs an Operating Agreement
is required to set forth the agreement of the members of the LLC on operational and
ownership issues. For a corporation, Bylaws serve the same purpose. Both
Operating Agreements and Bylaws describe the contractual obligations of the
Company and the members (in the case of an LLC) and the stockholders (in the case
of a corporation).

POST FORMATION

Organizational Meeting. The LLC members (or shareholders) should conduct a
formal Organizational Meeting at which minutes are kept and resolutions are
documented. In reality, many of the decisions to be documented will have already
been made with respect to the number and classes of shares, the number of
directors on the Board of Directors, the Officers, and other matters. The minutes of
the Organization Meeting should formally document these elections, which will then
be memorialized first in the minutes and resolutions and subsequently in the
Bylaws (or Operating Agreement.)

While many ill advised LLCs and corporations overlook the importance of
Operating Agreements and Bylaws, they are not optional and formation should not
be completed until they are drafted and agreed to.


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Complete Issuances of the Founders’ Stock. Most companies issue stock to their
founders at a minimal price at the time of formation. It is important that for these
issuances to be finalized at time of formation because under IRS regulations, if stock
is sold at less than fair market value at the time of the sale, the difference between
the price paid and the fair market value will be considered compensation to the
stockholder, which means he or she will have to pay taxes on it. When a company is
in its infancy the fair market value of the equity is typically close to zero thereby
enabling the founders to purchase significant stakes in the company for minimal
consideration. However, the company value may increase quickly making issuance
of the same number of shares cost prohibitive. Initial issues of stock should be
completed as soon as possible, including collecting all signatures on the purchase
documents, receiving and cashing checks from the stockholders (assuming some or
all of the consideration being paid for the stock is in the form of cash) and
maintaining evidence of payment in the company’s records as well as the issuance of
stock certificates (although stock can be uncertificated).

Offerings and Registration; Securities Consultant. If you plan to raise money
from investors consult with a qualified securities advisor. Initially your fund raising
efforts by issuance of stock to “friends and family” may be exempt from registration.
Raising capital from any source other than the founders of the corporation is fraught
with legal and practical landmines. Failure to observe laws, rules, and regulations
with respect to an “offering” of any security can result in SEC and/or Department of
Justice Action. Included as the last page of this profile is a table offered by the SEC
setting forth some of the basic offering types, rules, and conditions.

File 83(b) Elections. If any stockholders are receiving stock that is subject to
vesting they should strongly consider filing an 83(b) election with the IRS. For an
83(b) election to be effective it needs be filed within 30 days of the time of the sale
of the stock, with NO EXCEPTIONS. You should seek tax advice regarding this issue
since it constitutes and election on whether you will be taxed on your equity such as
shares of restricted stock on the date the equity was granted or on the date the
equity vests.

Apply for an EIN. An Employee Identification Number, or EIN, is a unique number
that identifies a company to the IRS. It is required to open a bank account, hire
employees and file tax returns. You can apply for an EIN on the IRS’ website.

Open a Checking Account and Get a Company Credit Card. As already dicussed
on of the primary reasons for a formally organized business entity is to protect the
owners from personal liability for liabilities of the business. As part of ensuring that
these limitations on liability are respected, founders should set up a checking
account and credit card in the name of the company and use those accounts (rather
than personal accounts) for all payments made by or to the company. Founders can
loan capital to the company but should keep good records of these transactions and
avoid moving money back and forth between their personal accounts and the
company’s accounts.

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File State and Local Registrations. Most states require companies that are formed
in other states to register to do business in the states in which they are doing
business. If you are using a registered agent service such as Corporate Service
Company or Corporation Trust Company, this company can help guide you through
the process for a small fee, and your law firm should be able to help you coordinate
this process as well. You should also look into whether you need to apply for a state
level identification number and other state, county and/or city level registrations.

Get Insurance. As the business starts operating you will want to obtain some basic
insurance, including general liability insurance and, in connection with hiring your
first employees, workers’ compensation insurance. Your insurance needs and
recommended policies will expand as your business grows, you have publicly
available products and services, and your board of directors expands. A good
insurance broker can be a huge help with this process.

Prepare to Hire Your First Employees (if applicable). Employment is a highly
regulated area of law and there are several steps you should take to make sure you
are complying with applicable rules and regulations. Many early stage companies
outsource this task to payroll services providers. Substantial penalties are regularly
assessed as a result of the misclassification of employees, including for improper
classification of an employee as an independent contractor.

Create a Capitalization Table. A capitalization table often called a “Cap-Table”) is a
list of a company’s securities (i.e., stock, options, warrants, etc.) and who owns those
securities, usually maintained in a spreadsheet. You should create a capitalization
table so you understand the ownership structure of your company and can make
decisions accordingly. Capitalization tables are typically used by private companies
to provide information on a company’s investors and market value. It shows the
equity ownership capitalization of the company and is an essential tool for financial
decisions, equity ownership and valuation, market capitalization and market value.

Consider Hiring an Accounting Service. Each business has accounting,
bookkeeping and tax needs and these will grow as your business grows. Some
founders are comfortable doing this on their own, but many companies find that
they can outsource these tasks and receive high quality service at a reasonable
price.

Regular Records. The requirement for meetings, quorums, and votes in your
Operating Agreement or Bylaws were not included lightly. Meetings (including any
required notice in advance of a meeting) should be observed and documents with a
record of decisions made; normally in the form of resolutions. One of the primary
reasons you elected to organize your business as an LLC or a corporation is to
achieve limited liability—that is to protect your personal assets. Ignoring the
formalities in your bylaws or Operating Agreement can lead to the loss of that asset
protection under the legal doctrine of “piercing the corporate veil.”

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OTHER STRATEGIES


It may occasionally be advantageous to acquire a currently operating
business, to merge your start-up with another established business, or, if there is a
desire to have publicly started stock quickly, engage in a reverse merger which
allows a privately held company to “go public” through acquisition of (or merger
into) an existing registered company. There are thousands of “shell” corporations,
that have been established specifically for the purpose of facilitating (for a price) the
process for a privately held company to quickly gain public trading approval. These
transactions are commonly referred to as reverse mergers.

Consideration of these other strategies is beyond the scope of this profile beyond a
simple reminder that these and other options exist.

In the event you are considering acquiring a business by merger or are considering a
reverse merger, specific advice is necessary. For the acquisition of any on-going
business, you will want to complete a thorough investigation in the form of due
diligence. A sample due diligence checklist is provided below. This checklist also
serves, however as a guide for proper record keeping for your new business since
should be become an acquisition target or decide to sell the business, it provides
guidance as to what a likely “suitor” will look for.


TYPICAL DUE DILIGENCE CHECK LIST

A. Actions And Minutes

1. All shareholder actions and meeting minutes.
2. All board actions and meeting minutes.

B. Charter Documents

1. The Company’s current Certificate of Incorporation/Articles of
Incorporation, including any amendments thereto.

2. The Company’s current Bylaws.

C. Capital Stock

1. Current shareholder and optionee lists, including issuance dates and
original issuance price. These lists should include any party who owns
securities of the Company or has any rights regarding securities of the
Company.

2. A summary of the vesting schedules of any stock or options subject to
vesting.

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3. Agreements relating to the purchase, repurchase, sale or issuance of
securities.

4. Agreements relating to voting of securities and restrictive share transfers.
5. Agreements relating to preemptive or other preferential rights to acquire

securities, including rights of first refusal.
6. Agreements relating to registration rights.
7. Shareholder agreements not involving the Company, including any

agreement by a shareholder relating to the sale, voting, or transfer of
securities of the Company.
8. Evidence of qualification or exemption under applicable federal and state
blue sky laws for issuance or transfer of the Company’s securities.

D. Legal And Regulatory

1. All documents and correspondence relating to any pending litigation,
threatened litigation, or disputes which could potentially lead to litigation
involving the Company, its executive officers or its directors.

2. Any consent decrees, injunctions, judgments, other decrees or orders,
settlement agreements or similar matters.

3. All correspondence between the Company and the U.S. Food and Drug
Administration.

E. Intellectual Property

1. Form of Proprietary Information and Invention Agreements signed by past
or present employees and consultants. Any documentation relating to the
transfer to the Company or any employee of any technology.

2. Copies of the Proprietary Information and Invention Agreements signed
by key employees and consultants.

3. A list of any employees or consultants who have not signed Proprietary
Information and Invention Agreements, including a list any periods of
time where key employees or consultants performed services for the
Company while not bound by such agreements.

4. Copies of any Proprietary Information and Invention Agreements that
contain any exclusions from assignment to the Company.

5. Any licenses or agreements of any kind with respect to the Company’s or
others’ patent, copyright, trade secret or other proprietary rights,
proprietary information or technology, other than licenses or agreements
pertaining to “off-the-shelf” or standard products.

6. A list of patents, copyrights and trademarks, and any searches relevant to
such items that have been done.

F. Management, Employees And Consultants

1. Any agreements, understandings or proposed transactions between the
Company and any of its employees, officers, directors, affiliates, or any

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affiliate thereof, including without limitation, employment agreements,
indemnification agreements and any loans or guarantees.
2. Consulting contracts.
3. Employee benefit and profit-sharing plans, including stock option, stock
purchase deferred compensation and bonus plans or arrangements and
forms of stock option grants or stock purchase agreements under such
plans.
4. A list of officers and directors. If any officers are not currently devoting
100% of their business time to the Company, please note them on this list.
5. Copies of offer letters.
6. A list and breakdown of all outstanding accrued salary, paid time off, and
reimbursable expenses.

G. Debt Financing

1. All debt instruments and credit agreements entered into by the Company,
including lease financing, which are currently in effect.

2. Any guarantees of third party obligations.

H. Other Agreements

1. Real property leases, including any amendments and all exhibits to such
documents.

2. Capital Lease Agreements.
3. Standard forms of agreements used by the Company.
4. Joint venture and partnership agreements.
5. Management, service and marketing agreements.
6. Confidentiality and nondisclosure agreements.
7. Agreements requiring consents or approvals in connection with the

financing.
8. Agreements, letters of intent or term sheets regarding any proposed

acquisition by the Company of any company, business or material amount
of assets.
9. Any other agreements material to the business of the Company, or outside
the ordinary course of business.

I. Miscellaneous

1. Any reports and studies prepared by the Company or outside consultants
on the Company or its subsidiaries’ or affiliates’ business or financial
condition.
2. Most recent audited financial statements and latest unaudited monthly
financial statements.
3. Brief description of any contract restricting the ability of the Company to
compete in any line of business with any person or entity, or committing the
Company or any subsidiary to continue in any line of business.

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4. Most recent Business Plan, Offering Memorandum or similar document of
the Company.
5. Any documents indicating environmental liabilities or potential
environmental liabilities, including violations of any environmental laws, or
agreements for indemnity or remediation of any adverse environmental
conditions.

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Overview of Exemptions* U.S. SECURITIES AND EXCHANGE COMMISSION
Division of Corporation Finance | Office of Small Business Policy

SECTION REGULATION D REGULATION REGULATION A INTRASTATE
4(a)(2) CROWDFUNDING

Rule 506(b) Rule 506(c) Rule 504 Tier 1 Tier 2 Section 3(a)(11) Rule 147 Rule 147A

Offering None None None $5 million $1.07 million $20 million $50 million None None None
Limit within
a 12-month
Period

General No No Yes Permitted in limited Permitted with Permitted; before qualification, testing Offerees must be Offerees must be Yes
Solicitation circumstances limits on the waters permitted before and after the in-state residents in-state residents
advertising after offering statement is filed
Form C is filed

Offering must be
conducted on an
internet platform
through a registered
intermediary

Issuer None “Bad actor” “Bad actor” Excludes blank- Excludes non-US, US or Canadian issuers In-state residents In-state residents In-state residents
Requirements disqualifications disqualifications check, reporting, blank-check, Excludes blank-check and “doing business” “doing business” and “doing
apply apply and investment reporting, and investment companies, issuers of and incorporated and incorporated business” in-state;
companies investment certain securities, and certain in-state; excludes in-state; excludes excludes
“Bad actor” companies companies with a Section 12(j) order investment investment investment
disqualifications “Bad actor” “Bad actor” disqualifications apply companies companies companies
apply disqualifications
apply

Investor Transaction by Unlimited Unlimited None Investment None Non-accredited Offerees and Offerees and Purchasers
Requirements an issuer not accredited accredited limitations investors subject purchasers purchasers must be in-state
involving any investors investors based on to investment must be in-state must be in-state residents
public offering Up to 35 Issuer must annual income limits residents residents
See SEC v. sophisticated but take reasonable and net worth
Ralston Purina non-accredited steps to verify
Co. investors that all purchasers
are accredited
investors

SEC Filing None Form D Form D Form D Form C, including Form 1-A, Form 1-A, None None None
Requirements Additional two years of including two including
information financial statements years of financial two years of
required for that are certified, statements audited financial
non-accredited reviewed or Exit report statements
investors audited, as required Annual,
Progress and semi-annual,
annual reports current, and
exit reports

Restrictions Yes. Restricted Yes. Restricted Yes. Restricted Yes. Restricted 12-month resale No No Securities must Yes. Resales Yes. Resales
on Resale securities securities securities securities limitations come to rest with within state for within state for
except in in-state residents six months six months
limited
circumstances

Preemption No Yes Yes No Yes No Yes No No No
of State
Registration or
Qualification

* All offers and sales of securities in the U.S. must be registered with the SEC or conducted pursuant to a federal exemption from registration. This chart provides a summary of certain exemptions and related requirements contained in the

Commission’s rules and regulations; it is not a substitute for the rules and regulations www.sec.gov/smallbusiness.

CONTACT THE OFFICE OF SMALL BUSINESS POLICY WITH ANY QUESTIONS AT 202.551.3460

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