LLCs, LLPs and Subchapter S Status

Lately, I’ve had several inquiries lately about electing Subchapter S status for LLCs and LLPs.

You would think that tax classification for a business entity is determined by the type of entity that is formed under state law. But, that is not the case. Tax classifications for business entities is largely independent from the state laws under which the company was formed. In other words, the tax code provides a default classification for

a business entity based on state laws (a corporation’s default tax classification is to be taxed as a corporation, a partnership’s default is partnership tax status), but allows entities to elect a different classification if desired.

There are limits on the election.

What type of matters do you handle?

Our services for startup companies and people starting a business typically include:

  • incorporation for startups
  • angel & venture financing transactions
  • employment & human resource matters
  • copyright and trademarks
  • stock option plans
  • standard contract preparation
  • vendor contract negotiations
  • international corporate and transactional matters

The corporate lawyers of Fitzgerald, Franke & Hewes also engage in a general corporate practice and represent a number of corporations and organizations with varying size and in different industries. The firm serves as general counsel to some clients, and also represents startup businesses and joint ventures. FF&H brings experience to companies and their management in business governance matters, handles mergers and acquisitions, and negotiates all types of complex business transactions. In addition, members of the firm have helped clients with human resource matters, and establishing policies and procedures that

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assist organizations when interfacing with employees and outside consultants. The members of the firm frequently advise clients regarding secured transactions and the Uniform Commercial Code, the perfection of security interests in property, equipment leasing, and in copyright and trademark matters and some general aspects of patent law (we are not licensed patent attorneys).

Do you only work with businesses? What about individuals?

Because of the nature of our practice, we usually represent businesses. We do, on occasion,

represent an executive who is leaving his or her current position in the negotiation of an exit package, or an individual investors who is investing in a business.

Are all of your law firm clients in Chicago?

The clients of our Chicago-based law firm are located in many different states in the U.S. and we have several

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Do you handle litigation?

We work with our clients to manage disputes before a lawsuit is

filed. However, we will not serve as your primary counsel once a lawsuit is filed. We can work with you and your litigation counsel to manage costs and advise on litigation strategy, if required.

Can your firm file a patent for our company?

Fitzgerald, Franke & Hewes attorneys are not licensed as patent attorneys and, therefore, we cannot file

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a patent for your company. We can recommend several highly qualified patent attorneys who we’ve worked with in the past. We would be happy to provide a referral if you contact us.

Do you provide a free initial consultation?

We realize that choosing a law firm

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How do you bill clients?

For most matters we charge an hourly rate. If requested, we

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will provide an estimate of our time to complete a matter and, in some cases, we can provide you with a flat rate for the matter. We also will invoice for any out of pocket expenses such as filing and recording fees, notary service, overnight or special delivery service, and international telephone calls. We will notify you of any expenses in advance. No charge will be assessed for either secretarial services or staff overtime.

We invoice clients at the end of each month for services provided during that month plus any out of pocket expenses. Invoices are due in 30 days.

How do I switch law firms?

Notify your current firm that you are switching law firms and would like your files sent to your new firm. They should comply with this request in

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Do I need to incorporate my business?

The main benefit of incorporating your business (or forming a Limited Liability Company) is to protect your personal assets from the liabilities of your business. Having a formal

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entity can give credibility to your business as it shows you have taken formal steps to set it up and have the follow-through to maintain the company. Corporations and LLCs continue to exist even if ownership or management changes. Sole proprietorships (and partnerships, to some extent) end if an owner dies or leaves the business. Both corporations and LLCs may deduct normal business expenses, including salaries, before they allocate income to owners. There are tax consequences which arise from establishing your business as either a corporation or a LLC, but depending on your goals, you may be able to avoid double taxation of profits.

Illinois Non-Compete Agreements – Additional Compensation Required

In Illinois, many companies have relied on the offer of employment or continued employment as “consideration” or adequate payment for an employee’s promise not to work for a competitor (a “non-compete” or “restrictive covenant”). In Fifield v. Premier Dealer Services, Inc. the Illinois Appellate Court recently held:

“there must be at least two years or more of continued employment to constitute adequate consideration in support of the restrictive covenant . . . .This rule

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is maintained even if the employee resigns on his own instead of being terminated.”

If you’re an Illinois employer who typically uses non-competes or restrictive covenants with employees, it is time to review your Illinois non-compete agreements to make sure they are enforceable. If there is no additional compensation or benefits provided to employees when they sign the agreement, it will now be unenforceable until the employee receives two years of compensation after signing an Illinois non-compete agreement.

https://www.isba.org/cases/illinois/appellate/2013/06/24/fifieldvpremierdealerservicesinc

LLC or Corporation? Which entity type should I chose?

Should I form an LLC or corporation? Choosing the form of entity for your new venture depends on your goals. Sitting down with your attorney and your accountant will help you sort through the differences and come up with the right choice.

Formality

Corporations require more formality (and therefore more potential expense): a formally elected board of directors, statutory officers, stockholders meetings, class votes on certain issues, and records of meetings. While LLCs have some formalities they must follow, the rules and requirements are not generally as strict or burdensome as the formalities that corporations must follow. For example, the laws do not generally require LLCs to have any annual meetings (although some LLC operating agreements require meetings – but that’s a choice you make at the time you are organizing your company).

Familiarity

Corporate law is better developed and thus more predictable, should there be any litigation. However, as the LLC entity is becoming more common, the law regarding such entities is developing as well.

Double taxation

C Corporations result in higher overall tax payments through “double taxation”. A business operated in corporate form must pay federal and state income tax on the corporate level. When those earnings are distributed by way of dividends, they ordinarily generate additional tax again, payable by shareholders.

Both LLCs and S Corporations avoid double taxation because all company profits are “passed through” and reported on the personal income tax return of the shareholders or, in the case of an LLC, the members. S Corporations have limits as to the number of shareholders (no more than 100) and their citizenship (all individual shareholders of an S Corp must

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Raising Capital?

If your company is considering raising venture capital, VC firms are traditionally more likely to choose the C Corporation as the type of legal entity for their investments (this relates back to the predictability of corporate law, and the fact that it is very unusual for LLCs to go public).

Best of the Web on Raising Capital

There are many experienced entrepreneurs and startup lawyers who write about the legal aspects of raising capital. Here are some of the best articles and posts that I’ve found on the topic:

Convertible Notes:

http://www.startupcompanylawyer.com/category/convertible-note-bridge-financing/

http://techcrunch.com/2012/04/07/convertible-note-seed-financings/

http://www.feld.com/wp/archives/2011/10/how-convertible-debt-works.html

http://www.techstars.com/docs/

Series Seed:

http://www.startupcompanylawyer.com/2010/03/14/how-do-the-sample-series-seed-financing-documents-differ-from-typical-series-a-financing-documents/

http://www.seriesseed.com/posts/

http://www.geekwire.com/2011/fred-wilsons-5000-startup-lawyer-challenge/

Series A:

http://www.theventurealley.com/understanding-vc-financings/understanding-vc-financings—transaction-costs-and-attorney-fees/

http://www.nvca.org/%0Bindex.php?option=com_content&view=article&id=108

Working

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with your startup lawyers:

http://www.bothsidesofthetable.com/2010/01/21/how-to-work-with-lawyers-at-a-startup/

Free Speech in the Cloud

US-centric companies should keep in mind that there are different approaches to “free” speech in Europe and elsewhere from those in the United States. Because of the different treatments, questions about which jurisdiction’s* laws govern content on the internet become important, especially when content is stored in data centers (the “cloud”) that are accessible over the Internet from different countries

A recent case in France involving Twitter is focusing on the disparity in jurisdictional approaches. A French court ordered Twitter to identify people who had posted anti-Semitic and racist entries, breaking a French law against racist speech. Twitter has said it only divulges identity of users in response to a valid US court order, the jurisdiction where its data is stored. It has already removed the content from its site in France, the jurisdiction where the posting was violating the law.

Twitter does not have an office in France, which also plays into the jurisdictional question. In the past the physical presence of a thing or a person helped determine which government’s laws prevailed, but the ability to access data makes this issue irrelevant. Complicating the issue is that in other circumstances and in other jurisdictions, Twitter has touted itself as a special defender of free speech. Think of the uprising in Egypt. There is a natural tug of war between security concerns and the need to protect privacy.

This conflict between the laws of different jurisdictions makes it difficult for companies doing business around the world over the internet.

 

*Jurisdiction indicates which legal authority has the right to deal with and make pronouncements on

legal matters and to administer justice within a defined area of responsibility or geographical area such as a sovereign nation.

What does a Best Efforts clause mean in a contract?

I draft a lot of agreements. I like writing and I enjoy working with business people to document the specific terms of a transaction. Occasionally, I’m tasked with defining the indefinable. The parties want to document their agreement, but factors are unknown or they honestly can’t state with certainty what will happen during the performance of the agreement. This is when our old friend, the “best efforts” clause comes into play. The parties propose using their “best efforts” or “commercially reasonable efforts” to address these unknown future factors.

While the various types of “efforts” clauses can be a convenient stop-gap measure, Lawyers often cringe at using them. Some courts have created a perfect storm of uncertainty by determining that “best efforts” clauses are indefinite, but not so vague as to be unenforceable. Illinois is an exception. Here, the courts have determined that best efforts clauses, without a further definition in the contract, are unenforceable.

According to Kenneth Adams, an expert and author on contract drafting, the conventional wisdom among corporate attorneys and business people is that “best efforts” is the most onerous provision and other “efforts” provision (e.g. “commercially reasonable” or “reasonable” efforts) are less onerous. However, courts have not followed this interpretation when deciding cases.

The case law, in general, has held that “best efforts” do not require a party to make every conceivable effort to fulfill the contractual provision. Rather, “best efforts” requires good faith by the performing party. Some courts have held that the slightly higher standard of diligence applies. Diligence

is defined as industry standard performance if a business is obligated to perform. Both of these standards, good faith and diligence, are based on “reasonableness” – what a reasonable person or business would do in a similar situation. Therefore, whether you use the term “best efforts,” “commercially reasonable efforts” or just “reasonable efforts,” the court often applies the same standard.

“Reasonable” is a relative term – doing is appropriate for a particular situation. Under the law, this is a fact-based determination that is best made by a jury. If there is a contract dispute, this means, worst case, expensive litigation and, best case, protracted negotiation of a settlement while the parties parse out whether actions were reasonable for the specific situation.

To avoid expensive litigation, protracted settlement negotiations or lack of enforcement in Illinois, the parties to a contract should include a clear set of guidelines for measuring performance of “best efforts” provisions.

For example, a clause could state that the party who is required to perform with its “best efforts” is required to do X, but not required to go as far as Y. In a technology support agreement, a clause might read: “Best efforts requires Tech Company to escalate problems to the highest level within its standard customer support organization, but not does not require Tech Company to send personnel to the customer’s location.”

Best Efforts – friend or foe? A “Best Efforts” clause can be a friend when writing a contract just remember to take the time to incorporate specific parameters for measuring performance or you may end up with an unruly foe to contain if there is a dispute.