Choose Your Own Company Part II
So, in our previous chat together, we discussed the types of questions you absolutely need to think about - BEFORE - you choose your type of business structure.
This is important, because so many of your decisions regarding how many of you are there, the manner in which you want to get paid, who will contribute what, etc. will impact you in many different ways.
Your lawyer (accountant, business development professional, etc.) can help you, but their assistance will only be as good as the information you provide them, i.e. I’m tempted to think of the old computer programmer adage - garbage in, garbage out.
By contrast, if you at least begin to ponder some of these issues ahead of time, and give good information to the professionals assisting you, your overall business plan likely will be stronger and more viable in the long run. So, let’s pick up where we left off with a few more helpful inquires.
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding. This article, although educational in purpose and substance, nevertheless, might be deemed attorney advertising, and prior results do not guarantee future success.
6. Management Power & Responsibility
Last time we looked at who put in what for what. For instance, in the company of “Ultra Chocolate,” out of three partners, one contributed a truck (for 40% of the company), another the recipe (for 40%), and the third one actually sold the ice cream from the truck (20%).
We discussed a bit of the property and tax implications, but we really didn’t talk about management, other than to point out a means of enforcing the salesperson’s duty to actually sell. One obvious question that comes immediately to mind is … who will *control* Ultra Chocolate?
6A. Company Types & Management
Corporation: If it’s a corporation, the shareholders will choose Board Members based on control of stock, and the Managers will hire the staff, if any. In practical close-corporation terms, very likely, whoever owns the majority of all the shares will have total control of the company. If that’s 40% (truck owner), 40% (recipe owner) and 20% (salesperson) then any two combined will over-power the third (i.e. 60% over 40% or 80% over 40%).
LLC: In a limited liability company, by default, typically, those controlling a majority of the “profit interest” will control the company.
Partnership: And, in a partnership, by default, major decisions require unanimity, whereas “ordinary” decisions require a majority of partners, without consideration of their actual ownership or profit interest.
LLC or Partnership: However, did you know that the Partnership Agreement (or Operating Agreement in the LLC) can provide greater management power out of proportion to asset contribution or profit ownership? There is tremendous flexibility there!
6B. Management Generally
Flexibility: The key question for you as the entrepreneur (or plural entrepreneurs) is to figure out, in plain English, how you would prefer management to function; then you (or your lawyer) can figure out how to structure it. By the way, do not forget to think about the way you would like to alter management authority when you bring in future partners or let other ones go.
IRS Point Person: Also, depending on your structure, you may need someone who will be the point person with the IRS, or perhaps even a President, Treasurer and/or Secretary.
Leaving: Finally, keep in mind, very likely, anyone disgruntled enough will leave, irrespective of their voting power (or lack thereof). You can make it painful for them to do so (breach of contract or penalty provisions), but you can’t force someone to stay with you. So, my advice to you, is make it fair, equitable, and regardless of actual power, strive for consensus, focusing on shared goals, and less on conflict.
7. Powers in General
Closely related to how you want to divvy up the powers of partners or managers or what have you, you might want to think about if there is anything you want specifically prohibited, under some or all circumstances.
For instance, you could demand:
“no partner or combination of partners may ever sell the ice cream truck, unless it is to purchase a new such truck, or the partnership will be dissolved in accordance with other provisions.”
Or, how about:
“Ultra Chocolate recipe may never be shared with anyone outside the partnership, by any partner, including by the original inventor, until such time as the partnership is dissolved, and no partner may compete, by using this recipe, with Ultra Chocolate Partnership, until all partnership activities cease and all existing inventory is sold or otherwise disposed.”
Also, some partners may have unilateral powers apart from the usual management decisions.
For example: “The Truck Partner will be the point person, exclusively, for all dealing with the IRS, subject to any other requirement under law, and shall have full authority to act in the usual course of business in terms of any routine filings or dealings with the IRS, providing Truck Partner communicates such dealings, in a reasonably timely manner, to his fellow partners. At no time may Truck Partner, commit Ultra Chocolate to any binding settlements or agreements with the IRS, without unanimous consent from the other partners.”
Or how about a hybrid rule?:
“Recipe Partner, may at their own discretion, seek interested licensees to use the recipe for Ultra Chocolate. Recipe Partner is similarly empowered to negotiate all facets of such deals provided: (i) at no time will Recipe Partner exclusively sell all rights to any other party so that Ultra Chocolate Partnership can no longer sell its main product and (ii) Recipe Partner must keep the other partners reasonably informed of all such deals and (iii) Recipe Partner may not actually bind the company or sign the contract, without management approval as per the partnership agreement.”
Stuff like that. Sorry, I know that was kinda technical up there. Children please do not try “legalese” at home.
Seriously, though, the point is you can have the sort of usual every day and big decisions governed by your standard management clauses in your partnership agreement (or operating agreement in an LLC), but you also have broad flexibility to give special powers to certain people or prohibit specific activities.
There is SO MUCH flexibility. You may not need it all or care about it, and that’s totally ok, too. But you should know it’s out there - in case you want it.
8. Property & Taxes
Anything to consider are tax implications of property you contribute. Also, I'm not an accountant, so take this with a grain of salt and consult with one if you have questions.
Truck Partner $50,000: Above, Truck Partner contributed a $50,000 truck. This means Recipe Partner and Salesperson Partner immediately could receive tax consequences, if they share in ownership of this partnership property. Why? Because the IRS values Salesperson “future service contribution” (i.e. sweat equity) at zero for current purposes. Recipe Partner may or may not be contributing valued property (the intellectual property of the recipe).
If Recipe Has No Value: If Recipe Partner's recipe is currently valued at $0, then Recipe Partner gets 40% of $50,000 or $20,000 for "free." The IRS will see that as income or at least a gain. Sales Partner will get 20% of $50,000 or $10,000 gain.
If Recipe is Worth $50,000: What if the recipe actually has value? Say the same amount as the truck? Then Recipe Partner contributed the same as Truck Partner. Only Sales Partner recognizes a gain; but now Sales Partner has double trouble, because Sales Partner gets 20% of $100,000 or $20,000 gain (!!). Recipe Partner and Truck Partner actually might realize a loss of $10,000 each.
Why the IRS Does This: If that doesn't make sense to you, try this. Say you had a company but wanted to pay your employee $100,000 - but tax free. So instead, you make them a 50% partner and you transfer $200,000 of your money into the partnership which they can take out 50% at any time, but you hold all the management rights and they have to do what you tell them to do. Look, they aren't making any income right?? Tax free salary!! They are just taking their share of the partnership! Right? Yah, no. Doesn't work that way. The IRS is not fooled.
Other Situations, Later Vesting: What if Salesperson Partner only “vests” ownership of the truck after leaving the partnership? Then that tax liability might be deferrable until then, which means upon leaving, serious tax liability! Again, I recommend working with an accountant who will be more familiar with tax implications than me. Just be aware that a partner’s withdrawal could trigger unintended problems, like tax issues, if you don't plan.
Future Income: But wait, what about future income? That's generally ok. If you make $100,000 in the coming year, and Truck Partner takes $40,000, and Recipe Partner takes $40,000 and Sales Partner takes $20,000 that's fine.
9. Breaking Up Is Hard To Do
I know I mentioned in this in a few places already, but you should give some serious thought about how you want to handle people leaving. If you plan to have people come and go frequently, and you are counting on professional managers anyway, a standard corporation could be just right for you.
If it’s your two best buddies or gal pals or whatever, and anyone leaving, for whatever reason, is like the world ending for you (and your company), then you should plan accordingly. Make sure you know what everyone will take when they leave, that everyone will be happy about it, and that no one will have unpredicted tax consequences because of it (i.e. speak to an accountant).
Also, you can have punitive or merciful standards for leaving. What if someone needs to leave the partnership because they are moving, bought a house, got married, or had a child? Do you want to soften the standards or penalties for leaving prematurely for “change of life circumstances?”
Maybe you don’t want any penalties at all. Could the leaving partner sell their interest to someone else, or even assign it? With or without the permission of all or some of the other partners? Stuff like that. Chew on it for a bit.
10. Boring Matters
Have your eyes glazed over yet? Mine sure did. I mean I had an accounting class in college, but it’s not my bag. However, being an entrepreneur is living on the edge - you are the James Bond of the corporate world! Like Mr. Bond, you will need to know a lot of things to survive. Best to think about some of them now.
Yeah! What can be more exciting than this?? I mean have you seen those cool Geico and Farmer’s ads? Those crack me up. But being liable for something and not having adequate insurance is no laughing matter. Your ice cream truck better be insured, for two reasons.
One: no fault liability insurance may be required by your state. Two: if there is an accident, and you have a general partnership (as opposed to an LLC or corporation), without any insurance, you can kiss your house goodbye.
That's just insurance for collision. Can you replace the truck if it's stolen? No? Better have property insurance for it as well. And, what about insurance for your recipe, like if someone is poisoned by it? Or if you sell it without proper allergy warnings?
Scared yet? What if you outsource production of your ice cream and the factory goofs and something gets in there, into the chocolate, and injures someone or makes them hate chocolate for the rest of their lives? (a fate worse than death for some!).
Sure, you will have a claim against the factory but that will not help you if the factory goes bankrupt, or if it is overseas and out of your jurisdictional reach, and/or runs out of insurance, itself - you could be on the hook next.
That’s fancy talk for all the blah blah rules each and every city, state, and federal agency might have for you to follow. What could all of them possibly want with you????
Just thinking off the top of my head, the City Department of Health probably will regulate how you sell the ice cream, the feds will regulate the advertising you put on your website (hi FTC!), and the State may or may not have stuff about vending food products or ice cream in particular.
You will need to plan to learn these regulations or hire competent professionals, set aside money for that, and/or pick a partner or plan for managers to deal with all of that for you.
There’s more to that, but that’s probably enough to keep you up late at night already.
10. Timing is Everything
The point of all these exercises, inquiries and scenarios is not to give you nightmares or anything, but just to get you thinking.
Right now, your “timing” is probably, “how can I get up and running right away and make this happen! I can’t wait to be the next unicorn hot property and buy my retirement island in the South Pacific. And the last thing I want to do is rain on your parade. Your needs probably will change over time which will make the timing of your issues change as well; I just want you to think about them, now and on an going basis.
Why? Even if you do all this yourself or with your partners, without professional assistance, just having a good idea of how to handle these different issues before they arise will save you a lot of grief, and provide great direction for the future. For example, at the beginning, maybe you just need a general framework: “we want all three of us to have equal voting rights even though capital and profit ownership rights are 40/40/20 and everyone should be able to leave at will.”
Also, "Trucking Partner will handle the accounting, Recipe Partner will handle all the government crap, and Salesperson will focus exclusively on the MAKING US MONEY!” Later on, as your enterprise grows, maybe you will want to ensure that “any new investors or partners, are approved unanimously and no one can assign their interest” (that prohibition means partners must fully sell their interest to leave).
Finally, when you are all ready to cash out, maybe you will want something like, “all partners share in the profits (and losses) as per their interest, but upon dissolution of the partnership all assets are distributed according to taxable basis" (this *might* prevent some tax issues). If you go one step further and put this kind of thing in your partnership agreement (or operating agreement), maybe with some “saving language,” i.e. “unless otherwise decided by a majority of the partners as determined by voting rights,” or something like that, you will be on a great track to success.
The point is, you don’t need to know all the rules and regulations and implications off hand, or all at once, but you should have a general idea of how you want to handle these things from the beginning, going forward, and as they evolve or even end. I know it’s tough work, but guess what? The only person who will benefit the most for doing their homework, is you. Good luck!
Hyperlinks Enabled: Click on cases, statutes and other references to be magically transported to original sources.
 Choose Your Company, Part 1, ended with #5, so we begin with #6 here.
 Actually, in an LLC, the default is the partner (or partners) controlling the majority of the “profit interest”. NY LLC Law, §402.
 “Tax Matter Partner” in IRS Form 1065 Instructions.
 NY BCL, §715.
 NY Partnership Law, §62(2); Gardiner International, Inc. v J.W. Townsend & Associates, Inc., 13 AD3d 246 (1st Dept. 2004).
 “Breaking Up Is Hard To Do” is a song recorded by Neil Sedaka, and co-written by Sedaka and Howard Greenfield. Sedaka recorded this song twice, in 1962 and 1975, in two vastly different arrangements, and it is considered to be his signature song.