Business Law

AUL: Business Law , MBA program , by Dr Kayyali Mohamed [email protected] • Module 1: Business Entities Step 1: Review Module lesson Step 2: In-class lecture and PPT Step 3: Answer Module questions Step 4: Complete Drafting Exercise (where assigned) Step 5: Go to next module

Introduction to Business Organizations • The way that a business is set up is often as important as how it is run and the choice of business entity often has a huge influence on the eventual success or failure of that business. Sole Proprietorships

• Sole proprietorships are both the oldest, and simplest, form of business structure. • In a sole proprietorship, there is a single individual who conducts all aspects of the business. Legal Liability of Sole Proprietors • If a sole proprietor is sued because of some business disagreement, his personal assets are in danger. • This is true because there is no legal boundary between a sole proprietor’s business assets and personal assets. The Advantages of a Sole Proprietorship • One of the most obvious advantages to a sole proprietorship is the freedom given to the owner to make business decisions. Tax Consequences of Sole Proprietorship • One of the major advantages of a sole proprietorship concerns income taxes. • When a sole proprietor sustains a major income loss during the year, he can pass this loss through on his personal income tax return. The Disadvantages of a Sole Proprietorship • Because the business is so closely associated with a single person, the death or incapacity of that person causes the business to fail. There is usually no way for the business to continue without the owner. • Sole proprietors also frequently suffer from undercapitalization. • With only their personal credit and financial resources to rely on, many sole proprietors find it difficult to expand their businesses or to pay unexpected bills. General Partnerships

• A partnership consists of two or more people working together in a joint business venture. Forming a General Partnership • The partners simply agree to be bound to one another in a business and to pledge their financial assets for the business. • Although many partners write out a General Partnership Agreement, in most situations it is not required. Advantages of General Partnerships • The advantages of a partnership are obvious: with two or more people, the business can expand and serve more customers. • Partners can also contribute more financial resources than a single individual. Disadvantages of General Partnerships • A general partner’s personal assets could be seized to pay a judgment, sometimes putting the general partnership in a precarious situation. Limited Partnerships

• In a limited partnership, there are two classifications of partners. There are general partners and limited partners • General partners are responsible for the day-to-day management of the business in the same way that general partners are in a regular partnership arrangement. • Limited partners, on the other hand, have no right to control day-to-day operations, but they also enjoy a protection that the general partners do not. Limited Liability

• Limited partners are protected by limited liability. • This means that the extent of their financial loss in the business is limited to the extent of their financial contribution. Limited Liability Companies

• A limited liability company is a cross between partnership and a corporation owned by members who may manage the company directly or delegate to officers or managers who are similar to a corporation’s directors. Forming a Limited Liability Company • In order to form a limited liability company, a company must file several documents with the state. • One of the most important is the Articles of Organization. Articles of Organization

• This document contains the basic information about the company, including the company name, registered agent and the names of the persons forming the company. Naming a Limited Liability Company • The name of a limited liability company must contain the phrase "Limited Liability Company" or some other easily recognizable abbreviation, such as “LLC.” Advantages of Limited Liability Companies • LLCs can take advantage of the protection of limited liability, as well as enjoying some of the flexibility of a partnership and the financial advantages of spreading investment over a larger pool of individuals. • LLCs also allow individual owners to pass through losses on their personal income tax returns.

Organization of a Limited Liability Company • Individuals who own shares in limited liability companies are referred to as “members,” not partners or shareholders. • The day-to-day management of a limited liability company is handled by "managers.” Corporations

• An organization that is formed under state corporate law exists, for legal purposes, as a separate being or an "artificial person." The stockholders have no liability for corporate debts beyond the value of their stock. Creating a Corporation

• A corporation is considered be an artificial person • Once created, a corporation continues to exist separate and distinct from the people that compose it. Types of Corporations

• There is a wide range of corporation types, ranging from small, privately held corporations to huge, multinational corporations with offices scattered across the globe. Corporate Shareholders

• The persons who own the corporation are called shareholders. • Shareholders are also entitled to an annual payment, referred to as a dividend, based on corporate profits. Corporate Officers and Directors • Corporations have officers who manage corporate affairs. These officers are responsible for negotiating with vendors, hiring and firing employees and all of the other tasks that we would associate with any business manager. Corporate Directors

• Directors decide on long-term goals and strategies for the corporation which they then put into effect through the corporate officers. Disadvantages of Corporations • Shareholders do not enjoy the "pass through" provisions for income tax purposes that are seen in sole proprietorships, general partnerships, and other business structures that we discussed in this chapter. • A corporation pays its own income taxes. Advantages of Corporations

• As an artificial person, a corporation may own property, negotiate contracts, and, in many ways, enjoy a degree of flexibility that resembles that seen in sole proprietorships or partnerships. Corporate Existence

• Corporations do not die. • Although a corporation may cease to exist because of bankruptcy or by merger with another corporation, it does not cease to exist when individual shareholders, directors or officers die. Transfer of Ownership

• Shares in corporations are bought and sold by millions every day on the various stock exchanges around the world. • Share ownership, in the form of stock certificates, is a source of wealth for millions of people. Steps in Forming a Corporation • All states have rules about how a corporation is formed. • In most situations, parties form a corporation by filing Articles of Incorporation with the state. Articles of Incorporation

• The articles of incorporation set out the basic details of the corporate entity. Articles of Incorporation

• The name of the corporation • The number of shares the corporation is authorized to issue • The classes of stock issued • The name and address of the Registered Agent • The names and addresses of the principal incorporators Corporate Organizational Meeting • This meeting, held among the people who create the corporation, has several purposes. • The parties elect officers for the corporation and then enact by-laws for the day-to-day management of the corporation. Piercing the Corporate Veil

• This doctrine holds that when a person uses corporate property interchangeably with his private property, the court may disregard the existence of the corporation and seize the person’s personal assets. The Role of the Legal Team in Creating a Business • Business people often seek out legal advice in both creating and running their businesses. • Legal professionals are often involved in every step of business activities and assist with the drafting and filing of Articles of Incorporation to bankruptcy actions if the business is not able to stay afloat. Licenses and Permits

• Local ordinances may require business licenses or other permits to run specific types of businesses. • If the business will be run out of the client’s home, there is also the issue of zoning permits. Critical Factors

• Limited Liability • Management • Tax-free conversion • Eligibility • Transferability of Interest • Dissolution • Taxation

Module 2: Business Basics

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. • 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.

Module 3: Business Basics

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.

Taxation Rules

• Individual taxation: Taxed on income less allowable deductions; Based upon Marginal rate or formula

• 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. Module 4:

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