Basic Organization Documents Corporations Pre-incorporation agreement Articles of Incorporation...

Basic Organization DocumentsCorporations

• Pre-incorporation agreement• Articles of Incorporation• Bylaws• Organization Resolutions: Officers, Directors, stock issuance,

employment agreements, bylaws, bank account, transactions, etc.• Shareholder Agreement (Buy-Sell)• Employment Agreements• Stock certificates and record• Asset and liability transfer documents• Required government and tax filings

LLCs and Partnerships• LLC Operating Agreement or Partnership Agreement• Asset and liability transfer documents• Required government and tax filings

Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

4-1

Delaware or Not?

• Internal Affairs Doctrine

• Big Boy Requirements

• Dual Registrations

• Fees

• Hassles

• Lawsuit Jurisdiction


4-1

Key Article’s Issues (23B.02.010)

• Incorporator identity? 23B.02.010

• Corporate name? 23B.04.010

• Registered agent/office? 23B.05.010

• Authorized shares? Par Value? 23B.06.010 – 020

• Purpose and Perpetual Existence? 23B.03.010 – 020

• Initial directors?

• Number of directors or delegate to board? 23B.02.010

• Preemptive rights? 23B.06.240

• Cumulative voting? 23B.07.280

• Shareholder consent voting? 23B.07.040

• Majority voting overriding 2/3 requirements? 23B.07.270 (3)

• Limited liability for directors? 23B.08.320

• Maximum director indemnification and expense advance? 23B.08.510

• Special stock classes or voting restrictions? 23B.06.010

• Authorized “blank check” preferred stock? 23B.06.020

Mandatory Preemptive Right Problems

• Exceptions and dashed expectations.

• Timing problems and delays.

• New investor hurdles and mixed messages.

• Enhanced security law complexities.

• A weapon for trouble makers.

• It can happen even if not required.

Cumulative Voting Formula

A = B x C + 1 D + 1

A = Total shares needed by minorityB = Total shares voted by allC = Number of directors minority to electD = Total directors to be elected

Example: Minority want to elect 1 of 4 directors and 1000 shares outstanding. Minority would need 201 shares per formula.


23B.07.280 : Cumulative Voting

23B.07.300: Voting Trusts. Agreement and share transfer to trustees. 10 year max term, subject to extensions.

23B.07.310: Voting Agreements. Specifically enforceable; not subject to voting trust restrictions of 23B.07.300.

23B.07.310: Irrevocable proxy coupled with any interest. Term 11 months unless longer term specified. Couple interest holder includes stock pledgee, contract stock purchaser, corporation creditor, employee of corporation, party to voting agreement.

23B.07.320: Shareholder Agreements – The Big One

Washington Corporate Control Statutes


(1) Huge scope – Hard to imagine how it could be any broader.

(2) Must be in writing, signed by all shareholders, valid for 10 years unless provides for longer period. (Often does)

(3) Stock Certificate Legend Requirement. Failure does not invalidate agreement, buy gives new shareholder who has no knowledge (actual or constructive) rescission right or damage claim. Just do it!

(4) Terminates if shares listed or publicly traded.

(5) Board relieved of duties per agreement, but legal duties transferred to shareholders under agreement. The “Jerk” factor comes into play.

(6) Agreement not impose personal liability on shareholders – ala general partner of partnership.

Shareholder Agreements Under 23B.07.320

Client Non Buy-Sell Planning Process

Step One: Layout Potential Issues

Step Two: Identify Client’s Hot Issues

Step Three: Determine Key Facts that Impact Hot Issues

Step Four: Identify Potential Solution Techniques

Step Five: Select Best Solution Technique(s)

Step Six: Develop Rationale for Convincing Co-Owners

Step Seven: Present to Co-Owners (Lawyer’s role may range from passive advising, to strategic negotiation, to hardcore sales)


4-2

Important Non Buy-Sell Owner Issues

• Scope of Enterprise - liability exposure, “Tag along” issues

• Business Plan Changes - diversion, expansion, speed-ups

• Debt - Changing, expanding, personal guarantees

• Additional Capital - dilution risks, mandatory

• New Equity Owners - disruption, dilution, synergies

• Owner Roles - service commitments, inner circle

• Owner Employment Rights - tie to equity, expulsion

• Business Location - headquarters, changes

• Outside Owner Activities - competitors, supplies, customers

• Related Party Transactions - conflicts, disclosures, prohibitions


4-3

Important Non Buy-Sell Owner Issues

• Tax Elections - cost recovery, inventories, fiscal yr, etc.

• Confidentiality Covenants - extent to owners?

• AP Management - discount fast or normal slow?

• Cash Distributions - priority or no or low expectations?

• Loss Allocations - deficit restoration obligation, three hurdles

• Professionals - selection process and criteria

• Indemnification - words vs. reality, insurance

• Dispute Resolution Procedures - fast, cheap vs. slow, costly

• Life After Rights - fast, easy restarts

• Sell-Out Options - who and how many must bless


4-4

Solution Techniques

• Definitive Contract

• Supermajority Vote

• Designated Board or Management Committee

• Specified Conditions

• Individual Veto Right

• Opt-Out Rights

• Buy-Out Trigger

• Cumulative Voting

• Preemptive Rights

• Different Equity Interests


4-5

Debt Levels

Solution Techniques






• Opt-Out Rights

• Buy-Out Trigger





4-6

New Owner

Solution Techniques






• Opt-Out Rights

• Buy-Out Trigger





4-7

CashDistributions

If Section 351 Does Not Apply?


4-11

C Corp

Stock

Tax Impacts:• Linda recognizes 100k income

• Linda stock basis equals 200k

• Linda has new holding period in stock

• Corp’s basis in equipment 200k

• Corp has new holding period in equipment

• Corp has no income recognition per 1032ShareholderLinda

Equipment - Basis 100k- FMV 200k

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No gain or loss is recognized by the transferor on the transfer of property to a corporation in exchange for stock of the corporation if:

1. Property is transferred 2. Solely in exchange for stock

3. Transferor(s) in “control” “immediately after exchange. Two 80% requirements – 80% of all voting stock and 80% of total shares of all classes of stock.

Example: XYZ Inc issues 100 share of its stock to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim recognizes no gain or loss on the exchange.

Rule 1: The 351 Rule

If Section 351 Does Apply?


4-13

C Corp

Stock

Tax Impacts:• Linda recognizes no income (Rule 1)

• Linda stock basis equals 100k (Rule 3)

• Linda has tacked holding period in stock (Rule 4)

• Corp’s basis in equipment 100k (Rule 6)

• Corp has tacked holding period in equipment (Rule 7)

• Corp has no income recognition per 1032 (Rule 5)

ShareholderLinda


Note: Double basis impact trade-off for shareholder

non-recognition. What is future impact?

Section 351 Eligibility Traps Trap Solution

Stock for services Keep under 20% or have dual consideration and meet 10% standard of Rev. Proc. 77-37

Multiple transfers Document part of integrated planat different times

Subsequent stock sale Prohibit; require time lapse; no prearrangement; gifts generally not a problem

Accommodation transfers Meet 10% threshold of Rev. Proc. 77-37

Subsequent corp property Consistent with ordinary business or insure sales time lapse and no pre-arrangement

Nonvoting stock 80% of each class. Only direct ownership counts

Nonqualified preferred Boot for income recognition purposes

Investment company risk? Diversification issue is ballgame


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If 351 would apply except that corporation issues property in addition to stock (“boot”) to the shareholder, then shareholder recognizes gain on the property transferred to corporation equal to the lesser of:

1. The built-in gain on the property transferred – the excess of FMV over basis

2. The FMV of boot received by the shareholder.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim recognizes gain equal to boot – 80k. If 120k boot was paid by XYZ Inc in addition to stock, Jim would recognize gain equal to 100k – excess of 200k FMV over 100k basis.

Rule 2: The 351(b) Boot Rule4-15


Section 351 With Boot


4-16

C Corp

Stock and 80k cash

Tax Impacts:• Linda recognizes 80k income (Rule 2)

• Linda stock basis equals 100k (Rule 3)





ShareholderLinda


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Rule 3: The 358 Basis Rule

If 351 applies to an exchange of property for stock in a corporation, the basis of the stock received by the shareholder equals:

1. The basis of the property transferred to the corporation in the hands of the shareholder, plus

2. Any gain recognized the shareholder ala the 351(b) rule, less

3. The FMV of any boot received.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim recognizes gain equal to boot – 80k. Jim’s basis in stock is equal to 100k (basis in equipment), plus 80k gain less 80k boot = 100k.

If 120k boot was paid by XYZ Inc in addition to stock, Jim would recognize gain equal to 100k. Basis in stock would equal 100k, plus 100k gain, less 120k boot = 80k basis.

4-18


If 351 applies to an exchange of property for stock in a corporation, the holding period of the property transferred by the shareholder is “tacked on” to the holding period of the stock if the transferred property was a capital asset or a 1231 asset (asset used in trade or business). No inventories or receivables.:

Example: XYZ Inc issues 100 share of its stock and 80k

cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim’s holding period of equipment is “tacked on” in determining holding period of stock.

Rule 4: The Shareholder Tacking Rule

4-19


Corporation recognizes no gain or loss on receipt of money or property in exchange for its own stock

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. XYZ Inc recognizes no gain or loss.


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A corporation’s basis in property acquired in exchange for its stock in a transaction that qualifies under 351 equals the shareholder’s basis in the property’s basis plus any gain recognized by the shareholder. But if net built-in loss, basis limited to FMV of property unless all elect to reduce stock basis of shareholder to FMV.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim recognizes gain equal to boot – 80k. XYZ Inc.’s basis in equipment is 100k (Jim’s basis in equipment), plus 80k gain recognized by Jim = 180K.

4-21


If 351 applies to an exchange of property for stock in a corporation, the holding period of the property transferred by the shareholder is “tacked on” in determining the holding period of the property in the hands of the corporation.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Jim for equipment worth 200k that has a basis of 100k. Jim’s holding period of equipment is “tacked on” in determining XYZ Inc.’s holding period of equipment.

Rule 7: The Corp Tacking Rule

4-22


General Rule: If corporation assumes liability of shareholder in 351 exchange:

1. Assumption not considered “boot” for gain or loss purposes. 357(a)

2. Assumption does reduce shareholder stock basis by debt amount. 358(d)

Exception: Debt treated as “boot” for gain purposes if:

1. Tax avoidance purpose or not bona fide business purpose. Burden on taxpayer to prove by clear preponderance of evidence.

2. Debt exceeds basis of all property transferred to corp – then excess treated as taxable boot.

Rule 8: The Assumed Liability Rule

Section 351 With Assume Debt


4-23

C Corp

Stock and 120k debt assumed

Tax Impacts:• Linda recognizes 20k income (Rule 8)

• Linda stock basis equals 0 (Rule 3)





ShareholderLinda


Section 351 Assumed Debt Traps Trap Solution

Tax avoidance purpose Bad purpose taints all debt. Proof burden on taxpayer. Recent debts suspect.

Lingering shareholder Leave no doubt as to parties’ expectations.Liability

Nonrecourse debts Specify amount to be paid from outside assets. Amount should never exceed FMV.

Future accountable debts Not debt for 351 purposes. Identity and exclude. Both deductibles (cash basis APs) and capital expenditures excluded. Rev. Rule 95-74

Basis pumping Helps to avoid debt in excess of basis problem. Will personal notes do job? The Peracchi impact.


4-24

4-30


Corporate Partnership

Rule 1: The 351 Rule 721: No gain or loss to partner and control requirement. But built-in gain allocated back to partner on sale per 704(c)

Rule 2: The 351(b) Boot Rule Portion of property allocated to Boot

treated as sale or exchange

Rule 3: The 358 Basis Rule Same per 722 & 733, except reduction for non-money boot limited to partnership’s basis in property and 721(b) gain

limited to investment companies

Partnership Rules Comparison

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Partnership Rules Comparison

Corporate Partnership

Rule 4: Shareholder Tacking Rule Same per 1223 (1)

Rule 5: The 1032 Rule Same per 721 if for property

Rule 6: The 362 Rule Same per 723 (Note limiting reference to 721(b) gain)

Rule 7: The Corp Tacking Rule Same per 1223(2)

Rule 8: The Assumed Liability Rule Similar result - New Game

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1. 752 Upside Twist: Increase in partner’s share of partnership’s liabilities deemed contribution of money to partnership. Basis increase.

2. 752 Downside Twist: Decrease in partner’s share of partnership’s liabilities deemed money distribution. If money distribution exceeds basis before distribution, then gain recognized to extent of excess per 731. No negative basis.

3. Recourse liability allocation: Allocated to partners according to how partners agree to bear ultimate risk for liability.

4. Non-recourse liability: Allocated to partners according to profits interests with some flexibility. But if property contributed with NR debt in excess of basis, debt first allocated to contributing partner to amount of gain allocated to such partner under 704(c) if property sold for debt.

Partnership Liability Game

4-33


Capital Interest: An interest that gives service partner a share of the partnership’s existing capital and future profits. A profits interest only gives share of future profits. Test: If partnership liquidated now, would service partner get anything?

Triple Impact: Capital interest for services

1. Partner has section 61 compensation income equal to FMV of interest,

subject to section 83 game.

2. Partnership gets section 162 deduction in same amount, allocated to

existing partners (not new partner)

3. Existing partners may share gain equal to FMV of interest transferred

over allocable basis of each partner. Deemed sale from existing to new.

Proposed Regs would eliminate deemed sale

Partnership Capital Interest For Services

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1. Exemption from Registration

2. Re-sales of Securities

3. Anti-fraud

Securities Laws: The Three Big Ones

4-39


- No particular form

- Two factors:

1. Some one puts up money, and

2. Looks to the efforts of another for a return on the money

What is a Security?

4-40


• Section 5 of ’33 Act: Securities offering require

registration.

• Section 4 of ’33 Act: Securities sold by issuers, underwriters and dealers are subject to Section 5.

• Two big exemptions:

Section 4(2) non-public offering exemption (private placement)

Section 3(a)(11) “intrastate offering exemption

Registration Game

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It shall be unlawful for any person, directly or

indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Antifraud – 10b-5

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1. How much do we need?

2. What deal can we offer?

3. What money sources are available to us?

4. How do we stay legal? - Compliance legal - Mitigate personal liability exposure

The Start-Up Money Questions

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• Future Public offering: Big pay day; liquidity. Not a viable hope for

most.

• Strategic Sale: Establish envied position – then cash in on sale.

• Natural Liquidation: Return generated through asset liquidation. Example: real estate development; movie venture.

• Inside Buy-Out: Once established, inside management will secure debt financing to take out seed-money investors at profit.

• Inside Triggered Buy-Out: Event triggers buy-out under shareholder buy-sell agreement - right of first refusal, showdown clause, death, etc.

• Cash Flow Vehicle: Business perpetually throws off cash to shareholders.

How Does the Investment Pay

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Common Funding Sources

• Closest people - Family and real friends

• Acquaintances - Those you know

• Acquaintances of acquaintances

• Strangers

• Funds – Venture and Vulture

• The SMA – No free lunch

• Banks and financial institutions – Lousy up front; gold once established, up and running.

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• The fewer the better.

• The smarter the better.

• The wealthier the better.

• Money loss reactions – prepare for the worse; assume the worse.

• Your risk avoidance can be very expensive.

• Never count the other guys money.

• Never forget the “deal moment”.

Some Truisms

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Accredited Investors: - Issuer insiders (promoters, officers, directors) - Corps, partnerships and trust with over 5 mill assets - Natural persons with over 1 mill net worth or over 200k (300k if married) of income in prior two years.

Sophisticated, Non-Accredited: Knowledge or experience in financial and business matters, capable of evaluating the merits and risks of investment. (Rep may qualify person)

All-Others: The dumb, poor crowd

Legal Investor Types

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• $1 mill limit within 12 months

• Any number of any type of investor – for own account, not for resale.

• Must comply with state security laws.

• Required disclosures a must.

• General solicitation usually prohibited or limited by state laws.

• Purchasers must give signed proof of investment intent.

Rule 504 Exemption

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Rule 505 Exemption

• $5 mill limit within 12 months

• 35 non-accredited (both types) and any number of accredited.

• Must comply with state security laws.

• Required disclosures mandated for non-accredited.

• General solicitation and advertising prohibited. • Purchasers must give signed proof of investment intent.

• Securities restricted, not subject to resale

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Rule 506 Exemption

• No limit.

• 35 non-accredited sophisticated and any number of accredited.

• Need not comply with state security laws.

• Required disclosures mandated for non-accredited.

• General solicitation and advertising prohibited.

• Purchasers must give signed proof of investment intent.

• Securities restricted, not subject to resale

4-50


Intrastate Offering Exemption

• Issuer must be resident and doing business in state

• Tough three prong 80% tests for issuer - revenues, assets, and use of net proceeds in state

• Securities sold only to state residents

• Need comply with state security laws

• Required precautions against interstate offers or sales

• Resale restrictions

• Proof of residence precautions and purchaser representations

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1. Place “no resale” legends on certificates

2. Signed purchaser letter than says - Verify “accredited” status (backed up by numbers) - Can afford complete loss - Been given all disclosures - Understands risks and potential of complete loss - Been given full opportunity to ask questions - Purchase for investment, with no intent to resale - State of residency

3. Comprehensive, smart disclosure document (PPM or accredited investor disclosure document)

Protective Precautions

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• Tailored risk factors - Lay them all out. You are protecting here, not selling.

• Complete market discussion and analysis – nothing overstated.

• Stay clear of bold adjectives.

• Make sure financials are accurate – fair reserves if needed.

• Avoid projections. If required, use appropriate “forward looking” disclaimer and lay out specific and general risk factors.

• Do not overstate background, expertise or qualifications of key people.

• Make sure all deals, understandings, and conflicts are thoroughly disclosed.

Disclosure Precautions

Basic Organization Documents Corporations Pre-incorporation agreement Articles of Incorporation...

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Transcript of Basic Organization Documents Corporations Pre-incorporation agreement Articles of Incorporation...