Business Law Basics

Part 1: Different Business Entities

 Types of Legal Entities
• Sole proprietorship- 1 person in business to make
money; unlimited authority; does not survive death;
• Associations- 2 or more people in business to make
money
– Partnership- General & Limited, Limited Liability
– Limited Liability Company-hybrid corp/pship
• Manager or member managed

• Corporations- Requires intent, formality and agreement

– Closely-held---small bus., family, few people;
– public--min. # of people, $ assets
– Professional corporation-licensed professionals
 Critical Factors
• Limited Liability
• Management
• Tax-free conversion
• Eligibility
• Transferability of Interest
• Dissolution
• Taxation
 Business Basics

Part 2: Understanding the Deal

 Financing a Business
1. Debt vs. equity- Reflects the characterization of the contribution of
an investor. Affects priority in getting return, i.e. debt-repaid before
return contribution or distribute profits but limited to amount owed
plus interest; or equity-return on contribution plus a pro rata share of
profits.

2. Retaining control vs. maximizing return via Preferences (priority in

distribution), and Preemptive- right of first refusal. Preferences give
the investor priority in distribution or first in line, e.g preferred
shares. Preemptions allow the investor to restrict rights of other and
protect against dilution. E.g. right of first refusal.

3. Leverage- use of other people’s money to purchase or invest. Cost

of borrowing must be lower than interest earned in investing.

4. Marginal (tax rate from chart) vs. Effective tax (actual rate applied)
 Contribution of Capital
• Partnerships: Any or no consideration is required

• LLC: Owners can contribute $, property, services rendered or

binding obligation to contribute these so future services with a
contract is OK.

• Closely corporation: Capital for a corp can be $, property, past

services, debt securities. In Calif. no future services or promissory
notes. There must be some consideration. Calif Corp. 409(a)
• -Under MBCA 6.21(b) allows bd to authorize shares for cash,
promissory note, services performed, contracts for future services.
-Bd. Assigns reasonable value to the noncash contribution.
Characterization of Contribution
• Co. has interests different from individual
owners:
-Company usu. prefers more capital and less
debt no obligation to repay so don’t spend
your money on debt service; easier to leverage
‘cause it is not encumbered; better financial
condition for lenders.
• Individual owners:
-Based upon risk tolerance, need to get
money back, tax treatment, so may want more
debt than capital ‘cause greater assurance for
repayment, but low upside.
Business Basics

Part 3: Tax Planning

 Tax Terms-Basis
1) Basis: The cost or purchase price of an asset.
Example: If Harry buys a car for $20,000, the basis in the car is $20,000.

2) Adjusted basis: Basis + improvements - deductions from depreciation of

certain improvements.

Example: If Harry buys a house for $100,000 and puts an additional $25,000 in
improvements and upgrades to the house, then the adjusted basis equals
$125,000. Some upgrades, such as a furnace or boiler is amortized or
depreciated over a period of time, meaning that a portion of the cost is
deducted over the useful life of the building.

3) Stepped-up basis: Equals the fair market value of property at the death of a
person that becomes the basis of the beneficiary. This means when someone
dies and the beneficiaries receive property as part of a bequest, the basis in the
property for tax purposes will be the current value of the property, not the
original purchase price to the decedent.
Example: Harry buys some stock in 1980 for $10,000 and holds it until his
death and bequeaths the stock to Joe. The current value of the stock is
$50,000. At the time of Harry's death, Joe's stepped up basis in the stock is
$50,000.
 Profits & Losses
4) Amount realized, Gain or Profit: The cash received-adjusted basis
upon sale or disposition of property; otherwise considered what is
taxable as gain or profit.
Example: In our previous example, if Harry has an adjusted basis in
a house for $125,000 and later sells it for $200,000, then the
amount realized from the transaction is $75,000, or the difference
between the adjusted basis and the sale price.

5) Loss: The amount lost if the sale price of property is less than the
purchase price or adjusted basis. Losses are sometimes deductible,
or can offset similar types of gains.

Example: In our previous example, if Harry has an adjusted basis in

a house for $125,000 and later sells it for $75,000, then Harry will
recognize a loss of $50,000 or the difference between the adjusted
basis and the sale price.
 Treatment of Assets/Income
6) Capital asset: An asset held for use in a business for more than 1
year, depending upon income, the maximum tax is 15%.

Example: Harry buys some equipment and holds it for 1 year. He

actively uses the equipment in his business. If he sells it after 1
year, it will be considered a capital asset.

7) Passive income: Income earned from investments that are held for
more than 1 year. Taxed at a maximum rate of 15%. Does not apply
to income earned from an asset or activity in which the taxpayer is
actively engaged in the business.

Example: Harry owns some stock worth $10,000 in a company in

which he is not actively engaged. If he holds the stock for more than
1 year and then sells it for $15,000, the gain from the sale of the
stock, or $15,000 will be taxed at a maximum rate of 15%.
 Tax Treatment
8) Passive Loss: Income lost from investments that are held for more than 1 year. You
can offset passive income from passive losses to determine net passive income.

Example: Harry owns some stock worth $10,000 in a company in which he is not
actively engaged. If he holds the stock for more than 1 year and then sells it for
$7,500, the loss can be offset against other passive income he has realized.

9) Capital gains: Gain realized from profits earned from disposition of passive income.
Passive income can be offset from passive losses. The current capital gains rate is a
maximum rate of 15%.

Example: Harry owns some stock worth $10,000 in a company in which he is not
actively engaged. If he holds the stock for more than 1 year and then sells it for
$15,000, the gain from the sale of the stock, or $15,000 will be taxed at a maximum
rate of 15%.

10) Short term gain: Income earned from investments held or activity engaged in for
less than 1 year. Taxed as ordinary income.

Example: Harry earns $50,000 in profit from a business in which he is actively

engaged. This is taxable income and will be taxed under the applicable tax rate.
 Tax Plan Questions
1) Goal: What is the tax liability to the individual? What is the tax liability of
company? Must compute separately by running the numbers to determine
projected.

2) Objective: What are all sources of income? What are deductible expenses
and how will they be deductible, e.g. ordinary or capitalized over term? Any
carry forward of deductions?

3) Result: At what rate will the investor be taxed? Marginal (schedule rate on
income) vs effective rate (based upon computation of actual tax).

4) Impact: How should contribution of capital be characterized? Equity vs. Debt

What is the optimal return on capital and how should it be characterized?
Tax interest as ordinary income vs dividends taxed as capital gain.
 Taxation Rules
• Individual taxation: Taxed on income less allowable
deductions; Based upon Marginal rate or formula (See
chart)

• Partnership taxation: Partners taxed on pro rata share of

earnings (profits); Partnership does not pay separate tax;
Allocate according to Partnership agreement re percent
of interest; not what actually distributed;

• Corporation: Taxed as entity and then salary and

distributions taxed to individual. Since individual is a
shareholder and employee, same pot of money is taxed
twice, although the corporation can take a deduction as
a expense for the salary.
 For Each of the Following:
• Who will likely drive the terms of the deal?
• Who would be most interested in long
term goals of the company?
• What type of entity should be created?
Module 3

Problems
 What type of entity should be
created?
1) Prescription Drug Is a manufacturer of PMS and menopause-
related treatment. The industry is subject to heavy government
regulation by the FDA, including extensive trial tests, documentation
and consumer information, and strict liability for negligence in
handling or dispensing the drug. Company has 4 departments and
a heavy investment in research and development. Investors include
individual chemists and scientists who are leading experts in this
field of research, university and institutional investors
pharmaceutical companies.

2) Group of 5 lawyers who have a varied corporate law practice in

related and complementary fields. They propose to divide profits
and losses in accordance with valuations assigned to client lists,
cash investments. Their practice requires that they issue opinion
letters on the feasibility of deals. They will have 4 associates on an
independent contract basis based upon billable hours and an hourly
rate of $75.00, and 2 salaried secretaries and 1 office manager.

.
 What type of entity should be
created?
3) A group of four college roommates decide to develop three lots: one
for commercial and two residential multi-family dwellings. Only two
of the four roommates have any experience in real estate
development, one as a marketing agent and the other working for
an engineering firm. The other two have experience in banking, and
retail sales and $10,000 each. They do not have enough money to
develop all of the lots at the same time, so they will develop and
finance them in stages. They propose to sell units to up to 90
passive investors total (30 investors per lot) who are looking to take
the initial losses and profits from the business. Some investors want
to invest in the commercial, but not the residential development.
They are looking for an income stream. Banks will require personal
guarantees of all of the roommates. Some of the investors may be
foreign aliens. As part of closing, title insurance will be obtained
and they intend to use bonded contractors.
 What allocation of interest?
• What is the level of risk for A and B in each
of the following hypotheticals, assuming A
is contributing $100,000, no additional
contributions, veto power, no salary; and B
is contributing $10,000 plus sweat equity,
salary of $5000/mo., no cash contribution,
interest for cash, past and future services.
 Risk and Interest?
• a). ALT 1: A is a retired military who is a
widower. His contribution is his nest egg.
He relies on social security and disability
payments, owns 2 apartment buildings. He
is 60 years of age and in fair health.
 Assumptions
A is contributing $100,000, no additional contributions, veto power,
no salary
B is contributing $10,000 plus sweat equity, salary of $5000/mo., no
cash contribution, interest for cash, past and future services.

Question: A is a retired military who is a widower. His contribution is his nest egg.
He relies on social security and disability payments, owns 2 apartment buildings.
He is 60 years of age and in fair health.
Answer:
• Level of risk-
– Low-moderate
• Fixed income; no money to “play with”
• Age: old, less time to wait around for profits
• Proportion of debt and equity-
– More debt than equity?
• Debt has less risk, greater assurance of repayment
• A will want to make a conservative investment
• A is retired, probably does not want involvement in business operations
 Risk and Interest?
b) ALT 2: A is a real estate attorney, with a
profitable practice from which he receives
a salary of $120,000. He has other
investments that bring in $10,000 a year,
is 32 years of age, and is looking to retire
by the time he is 40 years of age.
 Assumptions:
A is contributing $100,000, no additional contributions, veto power, no
salary
B is contributing $10,000 plus sweat equity, salary of $5000/mo., no
cash contribution, interest for cash, past and future services.

Question: A is a real estate attorney, with a profitable practice from which he

receives a salary of $120,000. He has other investments that bring in
$10,000 a year, is 32 years of age, and is looking to retire by the time he
is 40 years of age.
Answer:
• Level of risk-
– High
• Income is NOT fixed; financially secure (can afford to risk the money)
• Age: middle aged, has time to wait for profits
• Proportion of debt and equity
– More equity than debt?
• Equity has a greater risk, but potential to make much more money
• B is an aggressive investor who wants to retire early, wants a greater return on
investment
• Stock is freely transferable w/ market interest
 Risk and Interest?
c) ALT 3: B is a recent college graduate
with $60,000 in school loans. He is single
and wants to use the business to create a
chain and eventually franchise the store.
He receives $2,000/month from a trust.
 Assumptions:
A is contributing $100,000, no additional contributions, veto power, no
salary.
B is contributing $10,000 plus sweat equity, salary of $5000/mo., no
cash contribution, interest for cash, past and future services.

Question: B is a recent college graduate with $60,000 in school loans. He is

single and wants to use the business to create a chain and eventually
franchise the store. He receives $2,000/month from a trust.
Answer:
• Level of risk-
– Medium- High
• Low income, but wants to grow big via franchise
• Age: young and energy to work hard
• Proportion of debt and equity
– Equal proportion of debt and equity
• B wants to participate in the operation and control of the company, but is not in the
position to take a great financial risk