California Law
California Closely Held Business Law
Closely Held Business Law
A closely held business--also called a small business--is one that is owned by a single individual or small number of persons. Attorneys who specialize in helping closely held businesses can help people starting or restructuring companies decide how best to organize. They also can help owners understand the consequences of the various organizational structures for governmental regulation, day-to-day operation, and tax purposes. This chapter discusses the legal aspects of starting, operating, and selling closely held businesses. Publicly held corporations are discussed in the Publicly Held Corporations Law Chapter.
Organization
One of the first, and possibly most important, decisions a person starting a closely held business will make is how to organize the business. There are many ways to organize small businesses, including sole proprietorships, partnerships, franchises, corporations, and limited liability companies.
Sole Proprietorship
The simplest form of small business is the sole proprietorship, in which the business is owned, managed, and controlled by one person. A sole proprietorship may have employees, but only the owner is in charge of the business. The owner receives the business profits and losses. The owner also is personally responsible for any debts the business may incur. Income, expenses, and losses are reported on the business owner's individual tax return.
A sole proprietorship is relatively easy to organize. The business owner is responsible for obtaining appropriate licenses and tax identification numbers, and for registering the business name. There are no specific state filing requirements in California for this business option.
The benefits of the sole proprietorship include having complete control over the business, ease of the initial set-up, and having business profits taxed at the individual taxpayer rate, which is lower than the rate charged to corporations. The primary drawback to sole proprietorship is the owner's personal responsibility for debts and liabilities of the business. For example, if a business owner does not pay business debts, creditors may access the personal assets of the business owner, such as a personal checking account, house, or car. A business owner may obtain insurance to minimize this drawback. Other drawbacks include lack of continuity--when the business owner dies, the business ceases to exist--and tax issues such as the sole proprieter not being able to deduct health, dental, and life insurance on his or her income tax return as business expenses.
Partnership
A partnership is formed when two or more people who have not filed for incorporation agree to carry on a business together and to share profits and liability. A partnership is relatively easy to form and some partnerships are valid even without written agreements setting forth their terms.
There are two types of partnerships: general and limited. State and federal tax codes make a number of distinctions between limited and general partnerships. In general, neither kind of partnership has to pay federal income tax; instead, each partner pays tax at the individual tax rate on his or her share of the profits.
In a general partnership, each partner has an equal voice regarding how the business is run. California courts have ruled that a partnership can be formed simply by the act of two people running a business together, even if they never had a formal, written agreement to do so. Usually, however, the partners draw up an agreement that specifies how partnership decisions will be made, when and how the partners can withdraw profits, and how the partners will be required to contribute to the business. A general partnership is relatively inexpensive to form, because the agreement need not be filed with any governmental entity (although a statement of partnership may be filed with the county recorder). In a general partnership, each partner is equally liable for the debts of the business.
A limited partnership sets limits on the power as well as the liability of the partners. A limited partner is prohibited from managing or making day-to-day decisions concerning the business, but is shielded from most debts incurred by the company. More legal formalities must be met under this type of arrangement than in a general partnership. In California, a limited partnership may be formed only in accordance with the California Uniform Partnership Act. Limited liability partnerships and companies are discussed further below.
Corporation
A corporation differs from a partnership in that it is treated as a separate legal entity in and of itself rather than as a collection of individuals. A corporation is owned by one or more shareholders and must meet certain legal requirements spelled out in its articles of incorporation. The corporation is managed by a board of directors, who are elected by the shareholders of the corporation. In California, the close corporation is a corporation with no more than 35 shareholders. It must be organized as a close corporation, and there are certain restrictions regarding its stock.
Corporations are taxed as entities separate from their shareholders, and the shareholders are not liable for corporate losses or claims. Under both state and federal tax laws, the corporation reports its income, losses, and expenses on a corporate income tax return.
One of the biggest drawbacks to incorporating a business is double taxation. Double taxation occurs because the corporation's income is taxed before dividends are paid to shareholders, but shareholders also have to report the gains as taxable income on their individual tax returns.
All corporations--even closely held corporations--are expected to adhere to certain formalities, such as holding regular meetings of the board of directors and of shareholders. However, the small size of most close corporations and the tendency for shareholders to take active roles in the operation and management of the corporation often mean that many close corporations ignore such formalities. The failure to observe corporate formalities is unwise.
Sometimes, individuals use the corporate entity to insulate themselves from personal liability and the consequences of their actions. In such cases, if creditors find themselves unable to pursue their claims against a close corporation, the creditors may ask a court to ignore the organization's corporate status and impose liability upon the shareholders. Courts are more likely to take this action, called "piercing the corporate veil," in cases in which shareholders have not regularly conducted the business like a corporation, when the business has a seriously inadequate financial base for operations, or when it would be unfair not to do so. In California, however, a close corporation's failure to observe corporate formalities, if it is pursuant to a shareholder's agreement, is not considered in determining whether to impose personal liability on individual shareholders.
Professional Corporation
Professional corporations are formed by professionals such as doctors, lawyers, and accountants primarily to save money on their taxes through pension plans and deferred-income programs. The professional corporation is much like any other corporation except that it can be formed by only one person. In addition, the professional corporation may engage in only one category of professional service, and generally only individuals licensed to practice in that particular profession may own shares. The shares cannot be transferred easily. Although forming a professional corporation does not shield the professional from liability for professional negligence, it can shield a professional from liability for negligence by other persons with whom he or she associates.
Limited Liability Company
Since 1994, companies in California have another option for organization. The limited liability company allows business people to take advantage of the favorable tax treatment of a partnership while preserving the limited liability of a corporation. A limited liability company must have at least two members and be organized under the Limited Liability Company Act. The company must file initial articles of organization with the California Secretary of State and must file a statement of information annually. The name of the company must end with "limited liability company" or "LLC." The company can engage in any lawful business except banking, insurance, or the trust company business. California also permits the formation of limited liability partnerships, but only for those engaged in the practice of law or public accountancy.
A limited liability company limits the amount an investor can lose through a lawsuit against the company or from other losses. Generally, a member is not personally liable for the debts, liabilities, or obligations of the company except to the extent that a corporate shareholder would be liable for corporate debts, liabilities, or obligations. The failure to observe meeting formalities is not a factor in determining personal liability. If it has no more than two of the following corporate attributes, a limited liability company is treated as a partnership for California tax purposes: 1) limited liability, 2) continuity of life, 3) free transferability of interests, and 4) centralized management. If the company has more than two of those attributes, it is taxed as a corporation.
Franchise
A franchise is an agreement, sometimes in the form of a contract, that allows the franchisee (the person buying the franchise) to use a marketing system that has been designed by the franchisor (the manufacturer or seller). The business is closely associated with the trademark or commercial identity of the franchisor and the franchisee must pay a fee for the use of the marketing system.
Some have predicted that by the year 2000 more than one-half of all retail stores in the United States will be franchises. Generally, there is less of a financial risk associated with the purchase of a franchise than with other forms of business because the marketing strategy has proven successful. It often is easier for a franchise to obtain financing than it is for an independent business.
While a franchise does not guarantee success in business, the purchaser of a franchise usually can expect some services and support from the franchisor. Among other things, the purchaser might receive help choosing a site for the business, in the form of feasibility studies of the location and the demographics of the area where he or she hopes to locate the business. A franchisee might receive help in negotiating a lease for the business, and financial assistance with the start-up and initial operating costs. Finally, a franchisor often provides a franchisee with training, support, advertising, and product discounts.
In California, there are three specific elements that must be present in a franchise: a fee, a name, and a marketing plan or system. Any business offer that meets this definition may be subject to regulations found in the California Franchise Investment Law. A franchise must be registered with the California Commissioner of Corporations before any sales are made. In addition, certain fees are owed, such as a $675 application fee.
There are some exemptions to registration and a wide variety of state regulations with which franchises must comply. Information regarding franchise applications may be obtained by contacting the California Commissioner of Corporations. More general information about franchises may be found in the Franchise & Dealership Law Chapter.
Buying or Selling a Closely Held Business
Buying or selling a business is like buying or selling anything else, only much more complicated. In many small businesses, family concerns can influence--even dominate--business decision making. The decision to buy or sell a business may be motivated by a divorce, death, or personal animosity between business associates, so emotions may affect otherwise prudent business judgment. The advice of professionals is critical before buying or selling any business, especially a closely held business.
Transferability
The ease of transferability of ownership varies depending on how the business was organized. The assets of a sole proprietorship are easy to transfer. A sole proprietorship can be sold by selling all the assets of the business to another person, who then becomes the new sole proprietor of the business. A partnership is not easily transferable. Unless otherwise specified, no person may become a partner unless all of the other partners agree. If a partner sells his or her share in the business to someone who is not already a partner, the purchaser does not become a partner but merely earns the profits that the former partner would have received. To avoid this situation, most partnership agreements specify the conditions under which partnership status is transferred. Sometimes partners have buy-sell agreements between themselves. Buy-sell agreements may be mandatory, requiring the remaining partners to buy out the interest of a departing partner, or optional, giving the remaining partner or partners the right of first refusal when one partner wants to sell his or her interest. Members of limited liability companies may sell their rights to share in the profits and losses of the company unless there is an agreement to the contrary. As with a partnership, the right to participate in the decision making of the company may not be sold unless all of the members agree.
Shares in a corporation are easy to transfer because, by definition, a corporation is made up of shareholders who may transfer ownership of their shares to others. However, in the case of small and close corporations, there may not be much of a market for shares that are not publicly traded. Also, how frequently shares are sold may be strictly limited by the articles of incorporation.
Non-Compete Agreements
Usually when a business is sold, the buyer wants the seller to agree not to compete with the business being sold. Non-compete agreements in this context are generally enforceable in California as long as the buyer agrees to carry on the same or a similar business. Non-compete agreements are especially important in the context of closely held businesses because goodwill and name recognition may be what are most valuable to the buyer. Without an effective non-compete agreement, the seller is not prohibited from setting up a new business in direct competition with the old one and transferring the loyalty of longtime customers to the new enterprise. A buyer also may want to secure non-compete agreements from anyone else who worked closely with the seller in operating the business and who otherwise could go into competition with the buyer.
Consulting Agreements
Another common component of an agreement to sell a closely held business is a consulting agreement. Often, the advice of the former business owner is a valuable asset for a new owner during a transitional period. The former owner can give advice on how the business has been conducted, where supplies are kept, how to operate machinery, working effectively with suppliers, and generally keeping customers happy. The seller may be able to realize certain tax advantages by re-characterizing a portion of the purchase price as a consulting fee. The agreement must be clear on the extent and duration of the consulting arrangement. The advice of an attorney can be especially helpful when drafting a consulting agreement.
Business Succession
Succession may be more complicated for closely held businesses than for large publicly held companies. How a business is transferred following the death or withdrawal of an owner depends on how the business was organized.
In a sole proprietorship, the business ceases to exist when the proprietor dies. In a general partnership, the business can continue after one of the partners dies, but the remaining partners must pay the beneficiary of the deceased partner the fair market value of his or her portion of the partnership. If a partner in a limited partnership dies, his or her ownership in the corporation may be inherited and all attendant rights may be exercised by the new owner. In a limited liability company, the company dissolves unless there was prior agreement to continue in the event of a death or withdrawal. Also, if the remaining members of a company with more than one remaining member unanimously consent to continue operations, the company may do so.
Because a corporation is a freestanding legal entity, the death of an owner technically has no effect on the continuation of the business. Many smaller corporations, however, take out life insurance policies on certain key employees, such as the founder or the chief executive officer of the business. The shares held by those persons may be transferred to descendants or, by previous agreement, to remaining key individuals.
Because interests in a closely held business often lack liquidity and can be difficult to evaluate, they can be difficult to transfer after the death of the owner. Estate planning concerns for owners of small businesses are addressed in the Estate Planning, Wills & Trusts Chapter.
Resources
For information on forming or registering a corporation or limited partnership, contact the California Secretary of State, 1500 11th Street, Sacramento, CA 95814, Limited Partnership Division, (916) 653-3365 or Corporate Division, (916) 657-5448.
For additional information on corporations, contact the California Corporations Department, 3700 Wilshire Boulevard #600, Los Angeles, CA 90010-2901, (213) 736-3481.
For information on franchises, contact the Corporations Department, Franchise Information Division, 1390 Market Street #810, San Francisco, CA 94102, (415) 557-3787.
For tax forms and tax information for various forms of business, contact the California Franchise Tax Board, P.O. Box 115, Rancho Cordova, CA 95741-0115, (800) 852-5711 or the Fast Answers about State Taxes (F.A.S.T.) toll-free telephone service at (800) 338-0505. Federal tax forms are available from the Internal Revenue Service, (800) 829-1040.
New businesses with employees should contact the California Employment Development Department, 800 Capitol Mall, Sacramento, CA 95814, for a free copy of the California Employer's Guide.
Closely held businesses also should contact the California Trade and Commerce Agency, Small Business Division, 801 K Street #1700, Sacramento, CA 95814, (916) 322-2252. The Small Business Administration (SBA) also has useful information and programs for closely held businesses.
There also is a variety of information generally available on starting a new business. Two useful resources are How to Form a Nonprofit Corporation ($39.95 plus $5.00 shipping and handling) and The Partnership Book: How to Write a Partnership Agreement ($24.95 plus $4.00 shipping and handling) both available from Volunteer Lawyers for the Arts, Publications, 1 53rd Street East, New York, NY 10022).