Introduction

When you start a new business, you must choose a legal format. For most small businesses, the choices come down to these:

• sole proprietorship
• general partnership
• regular corporation (sometimes called a C corporation)
• S corporation, or
• limited liability company (LLC).

Other legal formats—limited partnership, professional corporation, and nonprofit corporation— are unlikely to meet the needs of the typical small business.

If you start a one-person business or work as a freelancer or independent contractor, your business will automatically be treated as a sole proprietorship unless you establish a corporation or LLC . Similarly, if you start a business with two or more people, your business will automatically be treated as a general partnership unless you form a corporation, LLC , or limited partnership.

The most important factors in deciding which way to go are:

• Personal liability. Will you be personally liable for business debts? (Personal liability means that a business creditor—a person or company to whom your business owes money—can get a judgment against you for the debt. The creditor can then collect the judgment out of your personal assets such as a personal bank account or your home.) The fast answer is that as a sole proprietor or a partner, you’ll face personal liability for business debts. But as the owner of shares in a corporation or as a member of an LLC , you’ll generally face no personal liability— unless, of course, you voluntarily agree to assume it by signing a personal guarantee (such as for a business loan).

TIP: Limited liability isn’t a big deal for many microbusinesses. A great many small service and retail businesses simply don’t subject their owners to significant debt or lawsuit risk. And often even in the few cases where they do, a good insurance policy will provide needed protection. This means that there’s often no compelling need to form a corporation or LLC when you’re just starting out.

• Taxes. Will you and the other business owners simply report your portion of profits and losses on your own income tax returns, or will the business itself be taxed on its profits? Sole proprietors, partners, owners of S corporation stock, and members of LLC s need only contend with one level of taxation: All taxes are paid by the owners on their individual returns. By contrast, a regular or "C" corporation pays taxes on its corporate earnings in addition to the taxes paid by the shareholders who receive dividends.

TIP: Sometimes being taxed twice is cheaper. Although you’d think that being subject to the income tax at both the corporate and personal levels would be more expensive than being taxed once on all business income on your personal return, you’d sometimes be wrong. Because the initial federal income tax rates are lower for incorporated businesses than for individuals, and because businesses often prefer not to pay out all earnings to owners, but instead want to keep money in the business from one year to the next (for example, to pay for future expansion), operating as a regular corporation can result in tax savings. This usually applies only to companies that have been in business a few years and have become profitable. For more detailed information, see the eGuide Save Taxes With Corporate Income Splitting, by Anthony Mancuso, available for purchase at www.nolo.com.

• Time and expense. Will it be time-consuming and costly to form and maintain the business? Sole proprietorships and partnerships are relatively easy and inexpensive to start and keep up. Corporations and LLCs typically require more time and effort and cost a bit more—but the cost needn’t be a tremendous burden. You can handle all or most of the paperwork yourself by using one of the Nolo books listed below.
• Fringe benefits. Will the business be able to provide fringe benefits (health insurance, retirement plans, and the like) to the owners and deduct the cost of those benefits as a business expense? This question is only relevant to businesses with enough income to pay fairly generous fringe benefits in the first place. But if your business is lucky enough to be in this category, the regular C corporation offers the best tax-saving opportunities.

Resources For in-depth information on choosing a legal format for your business, see Chapter 1 of Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo). For specifics and useful forms to create various types of business entities, see the following publications from Nolo:

• Form Your Own Limited Liability Company, by Anthony Mancuso, shows you how to establish an LLC in all 50 states.
• Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State, by Anthony Mancuso, shows you how to form a corporation in all 50 states.
• Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner, shows you how to form a partnership and create a lasting partnership agreement.
• LLC Maker, Windows software, by Anthony Mancuso, will form an LLC for you in all 50 states.

Tip: It’s often smart to start with the simplest legal format and convert later if necessary. It can be eminently sensible to start out as a simple, inexpensive sole proprietorship or partnership. Later you can convert to a corporation or LLC if your risk of personal liability increases or there are compelling tax reasons to do so. Fortunately, changing a partnership or sole proprietorship to a corporation or LLC is usually quick and easy.

To guide you through the steps you must take to form any type of business, read Form 2A: Checklist for Starting a Small Business.

The other forms in this chapter help you start a partnership, corporation, or LLC . No formal document is required to start a sole proprietorship. However, there are several practical and legal steps you must take to put your business on the right track. (This is covered in Form 2A: Checklist for Starting a Small Business, mentioned above.)

Partnerships. If you are starting a partnership, preparing a written partnership agreement allows you to provide a sound footing for your legal relationship with your partners and helps prevent or resolve disputes that may later arise. Use Form 2B: Partnership Agreement for this purpose.

Limited Liability Companies (LLCs). Many business owners who want to limit their personal liability prefer the simplicity and flexibility of the LLC over the corporation. To form an LLC , owners must file articles of organization with the state and sign an operating agreement. Although, strictly speaking, states do not require a single-member LLC to have an operating agreement, Form 2F: LLC Operating Agreement for Single-Member LLC can help preserve your limited liability status. (This book does not provide an operating agreement for multimember LLC s; however, the instructions for Form 2A: Checklist for Starting a Small Business gives other resources for multimember LLC s.)

Corporations. If you decide to form a corporation, this book offers three useful documents for this purpose. Before forming the corporation, it’s sensible to have all shareholders agree in advance on the basic elements of the business, including the name and purpose of the corporation, how many shares each owner will acquire, and who will serve on the board of directors. Use Form 2C: Preincorporation Agreement to record this information.

To form the corporation, owners must file articles of incorporation with the state and create corporate bylaws. Form 2D: Corporate Bylaws lays out the legal rules for running the corporation and covers such matters as how many people will serve on the board of directors, when and where regular meetings will be held, who may call a special meeting, and what officers the corporation will have.

Finally, unless all shareholders create an agreement to restrict the sale or transfer of their shares, any shareholder can freely transfer them. Free transfer is okay for publicly traded stock but can create havoc in a small corporation where the shareholders (owners) usually run the business. If you’re in business with two other owners, for example, you probably wouldn’t want Owner #3 to sell his or her stock to a complete stranger, because the new person may have a completely different vision about how to run the company. Accordingly, Form 2E: Stock Agreement allows you to provide in advance what will happen if a shareholder wants to transfer shares or dies.

Form 2A: Checklist for Starting a Small Business

This checklist makes a great "To Do" list for starting your business.

Instructions for Form 2A: Checklist for Starting a Small Business

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CDROM. As you read the instructions for Form 2A, you may want to either tear out the form or open the form’s file on the CD-RO M so you can follow along. (For more information on using the forms CD-RO M, see Appendix A, "How to Use the CDROM.") If you don’t use the forms CD-RO M, be sure to photocopy the agreement so you’ll have a clean copy to use later.

Evaluate and Develop Your Business Idea

First, before you invest a lot of time and money in your business idea, you should determine if you’ve chosen the right business and if the business can make money. If you pass these tests, it’s time to do some initial planning and brainstorming. Next you should create a business plan, consider sources of financing, and think about a basic marketing plan.

Analyze Your Business Idea. To determine if your business idea makes sense for you, you may want to read "Starting and Researching the Right Business," a free article on Nolo’s website ( www.nolo.com).

Can Your Business Make Money? To determine if your business can be profitable, you should do a break-even analysis with expense and sales estimates. To learn how, read "Will My Business Make Money?"—a free article on Nolo’s website ( www.nolo.com).

Creating a Business Plan. Creating a business plan is important even if you won’t be seeking outside money from banks or investors. For more information on developing your business plan, including how to create a profit/loss forecast and a cash flow analysis, see Nolo’s book How to Write a Business Plan, by Mike McKeever.

Getting Loans or Equity Investments. To explore ways to raise money for your small business, read Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 9. If you decide to borrow money from friends or family members (rather than a bank or other financial institution), see Chapter 4 for promissory notes you can use to specify the details of the payment arrangements.

Market Your Idea. For information on setting up a marketing plan, see Marketing Without Advertising, by Michael Phillips & Salli Rasberry (Nolo). This book includes worksheets to help you create a marketing list and design marketing events.

Decide on a Legal Structure for Your Business

Next, you need to decide what type of ownership structure you’ll choose; that is, whether you’ll operate your business as a sole proprietorship, a partnership, a corporation, or an LLC.

Most business owners start out as sole proprietors, or if there are two owners involved, as a partnership. If their businesses are successful, they may consider becoming a corporation or an LLC.

Whether you’re better off starting as a sole proprietor or partnership or choosing one of the more sophisticated organizational structures depends on several factors, including the size and profitability of your business, how many people will own it, and whether it will entail liability risks not covered by insurance.

To learn more about the various legal structures, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 1.

Choose a Name for Your Business

Before you settle on a name for your business, you’ll need to determine if your proposed name is available for your use. Once you find an available name, you’ll have to register it as a "fictitious" or "assumed" business name, a corporate or LLC name, if applicable, and possibly as a federal and state trademark.

Finding an Available Business Name. Before using a business name, it’s wise to conduct a name search to avoid a conflict with a business that’s already using the same or a similar name. If you’re starting a small, local business, you can usually feel reasonably secure searching for name conflicts at the state and local level. If you’re starting a larger company or one that will do business in more than one state, you may need to do a more sophisticated federal trademark search. For more information on doing name searches, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 6.

Registering Your Business Name. In most states, if you do business under a name other than your own legal name, you’ll need to register it as a fictitious or assumed name.

If you’re forming a corporation or an LLC (limited liability company), you’ll register your business name with the office of the secretary of state or other agency when you file your articles of incorporation or articles of organization.

In addition, if you plan to do business regionally or nationally and will use your business name to identify a product or service, you should also look into registering your trademark or service mark at the state or federal level.

For more information on registering your business name, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 6. You may also want to see Trademark: Legal Care for Your Business & Product Name, by Stephen Elias (Nolo).

Prepare Organizational Paperwork

Skip Ahead: If you’ve decided to start out as a sole proprietor, you can skip this checklist item and jump ahead to "Find a Business Location."

If you’ve decided to create a partnership, an LLC , or a corporation, you’ll need to take an extra step or two. For example, partners need to form a partnership agreement, LLC members need to create "articles of organization," and corporate shareholders need to fill out "articles of incorporation."

Partnerships. Partners should sign a written partnership agreement before going into business together. For more information on forming a partnership, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 2.

Limited Liability Companies. To form an LLC , owners must file articles of organization and sign an operating agreement. For more information on forming an LLC , see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 4.

If you will be the sole owner of your LLC, use Form 2F: LLC Operating Agreement for Single- Member LLC .

Corporations. To form a corporation, incorporators must files articles of incorporation— which in some states are called certificates of incorporation, articles of association, or charters. In many states, the secretary of state can give you a printed form for this essential document—or you may find the form online; all you have to do is fill in some blank spaces. In other states, you must start from scratch. Although details vary from state to state, you’ll typically include:

• the corporation’s name
• its purpose
• the name of the "initial agent for service of process" (sometimes called a registered agent or resident agent)
• the number of shares authorized, and
• the names and addresses of the incorporators.

You’ll file the form with secretary of state (or other designated official) and pay an incorporation fee. In addition, your corporation will need to adopt bylaws. For more information on forming a corporation, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 3. When you’re ready, use Form 2C: Preincorporation Agreement, Form 2D: Corporate Bylaws, and Form 2E: Stock Agreement.

S Corporations. If you decide to form an "S" corporation, in addition to the regular corporate paperwork mentioned above you’ll also need to file IRS Form 2553, Election by a Small Business Corporation. For more information on S corporations, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 3.

Find a Business Location

Unless you’ll start out running your business from home (which many sole proprietors do indefinitely), you’ll want to find suitable commercial space.

Identifying Your Needs. When choosing business space, you need to consider the size of the premises, the availability of customer parking, and the status of electrical and communications wiring, among other things. For help on identifying your minimum requirements and the maximum rent you can pay for your business space, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 1.

Finding a Location. One key to choosing a profitable location is determining the factors that will increase customer volume for your business. For more information on looking for a location and using a broker, see Negotiate the Best Lease for Your Business, by Janet Portman and Fred Steingold (Nolo), Chapter 2.

Negotiating Your Lease. With a little effort, you can usually negotiate significant improvements to the landlord’s lease terms. For lots of helpful information on negotiating lease terms, see Negotiate the Best Lease for Your Business, beginning at Chapter 5. To create your own lease, see Chapter 6 of this book for a number of forms you can use.

[Certificate of Assumed Name] omitted for online sample chapter

Home Businesses. Following are a few issues that concern most home businesses—in most cases, a few precautions are all that’s needed to avoid unexpected legal difficulties. For more information, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 14.

• Insurance. Make sure you have adequate liability and property damage insurance—your homeowners’ insurance policy may not cover business use of your home. For example, if a UPS delivery person trips on your porch step while delivering a business package to you or if your dog bites a visiting client, you may not be covered. Similarly, you may find that homeowners’ coverage won’t pay for a business computer that gets stolen. An insurance agent or broker can probably extend your policy to cover your business use for a modest additional premium.
• Lease and Homeowner Restrictions. Be aware that you may not have an unlimited right to do business from your home. If you’re in a rented unit, your lease may prohibit business operations. In a private home, you may be bound by "covenants, conditions, and restrictions"—rules that apply to all owners in a subdivision, condo, or planned unit development.
• Review Zoning Ordinances. Local zoning ordinances may not allow businesses to operate in the district where you live. Learn about the local zoning restrictions—you may be able to abide by them, or at least meet their spirit. Or, you may need to get a "home occupation" permit for your business. Check with your local zoning or planning office. A neighbor or municipal zoning ordinance will probably not stop your business use if you keep a low profile. Limit your signage, keep deliveries to a minimum, and don’t see too many customers or clients at your home. Neighbors are unlikely to complain if you run a quiet, low-traffic business that doesn’t affect them.
• Taxes. Taxes—especially the rules on the home-office deduction and depreciation—are another concern for home-based businesses. You should review IRS Publication 587, Business Use of Your Home. This publication is available from the IRS website at www.irs.gov. For more information on taxes for home businesses, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo), Chapter 13.

File for Licenses and Permits

You will need to complete general business registration requirements. You may have to obtain a business license from your municipality, an employer identification number from the IRS, a seller’s permit from your state, a zoning permit from your local planning board, and other licenses or permits.

Federal Taxpayer Identification Number. If you are forming a partnership or corporation or your business will hire employees, you need to obtain a taxpayer ID from the IRS. You can use IRS Form SS-4, Application for Employer Identification Number, included in this book.

Licenses. In most locations, every business needs a basic business license, or "tax registration" certificate. And in addition to a basic business license, you may need a specialized business license—especially if you sell food, liquor, or firearms, or work with hazardous materials. States also require licensing of people practicing traditional professions, such as lawyers, physicians, pharmacists, and architects, and may require licenses for other occupations such as barbers, auto mechanics, pest control specialists, and insurance agents—the list varies from state to state.

Permits. In addition to a business license, you may need a zoning permit or variance to carry on your intended business. And if you plan to run a regulated business such as a restaurant, bar, taxi service, or waste removal company, you’ll probably need a special permit from state or local authorities. Again, the list varies from location to location so you’ll need to inquire with the appropriate municipal and state offices.

Your state’s Small Business Development Center or other agency may offer a "one-stop shopping" website that advises you on the licenses and permits you need for your particular type of business. To learn more about licenses and permits, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 7. You may also want to see The Small Business Start-Up Kit or The Small Business Start-Up Kit for California, by Peri H. Pakroo (Nolo).

Obtain Insurance

Although business insurance is not generally required, it’s a good idea to purchase enough insurance to cover your company’s assets.

Business Insurance. It’s sensible to carry insurance to replace or repair your property if it’s stolen or damaged by fire, flood, windstorm, earthquake, vandalism, or any of dozens of other hazards. You want the peace of mind of knowing that you have liability coverage in case someone is physically injured on your premises because of your business operations (for example, a truck accident), or if someone’s property is damaged, destroyed, or lost.

Liability Insurance. Be sure there’s adequate liability coverage for your business if an employee driving his or her own car injures someone in an accident while on the job. And if you’ll be manufacturing a product or selling dangerous items, look into product liability insurance so you’re covered if a product you’ve made or sold injures someone.

Other Insurance Coverage. Review your business operations with an experienced insurance agent or broker to learn what other coverage may be appropriate. There’s no substitute for establishing a good working relationship with a knowledgeable insurance agent or broker. For more information on obtaining insurance, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), Chapter 12.

Set Up Tax Reporting and Accounting

Before the end of your first year, you’ll need to learn how to report your income, which may vary depending on how your business is structured. To optimize your tax savings, you should become familiar with how to write off expenses and asset purchases as well as keep good records—before you start to incur start-up costs.

How Your Business Is Taxed. To learn about taxes for sole proprietors, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo), Chapter 6.

To learn about partnership taxation, see Tax Savvy for Small Business, Chapter 9.

To learn about corporate taxation, see Tax Savvy for Small Business, Chapter 7.

To learn about LLC taxation, see Tax Savvy for Small Business, Chapter 10.

Deductions and Depreciation. Just about any necessary and reasonable expense that helps you earn business income is deductible. For information on deducting expenses, see Tax Savvy for Small Business, Chapter 1. Special rules apply to deducting the cost of business equipment and assets, which usually must be depreciated over a number of years. See Tax Savvy for Small Business, Chapter 2, for more information.

IRS Publications. Your checklist alerts you to two IRS publications about federal taxes for small businesses, as well as a helpful tax calendar with important filing dates. You can get these publications from the IRS website (www.irs.gov).

Record Keeping and Accounting. You’ll need to decide on a method of accounting, a tax year, and a method of bookkeeping.

• Cash vs. Accrual Accounting. Most small service businesses use the cash method of accounting, but if your business will stock inventory to sell to the public or use in manufacturing, the IRS requires you to use the accrual accounting method. For information about the difference between cash and accrual accounting, see Tax Savvy for Small Business, Chapter 3.
• Calendar vs. Fiscal Year. Most small businesses use a calendar year (January 1 to December 31). To choose another tax period, you must have a good reason and get permission from the IRS. For information about choosing a calendar or fiscal year, see Tax Savvy for Small Business, Chapter 3. To choose a tax period other than the calendar year, use IRS Form 8716, Election to Have a Tax Year Other Than a Required Tax Year.
• Bookkeeper vs. Software. Depending on the volume and complexity of your business finances, you may benefit from hiring a part-time bookkeeper or consulting an accountant who can show you how to set up a simple bookkeeping system. Or, you may find that business accounting software such as Quicken Home and Business ( Intuit) or QuickBooks (Intuit) will be sufficient. For information on bookkeeping, see Tax Savvy for Small Business, Chapter 3.

Hire Workers

Chances are you may need to hire employees or independent contractors before long, if not right off the bat.

General Information on Hiring Workers. The Employer’s Legal Handbook, by Fred S. Steingold (Nolo), provides excellent information on wage and hour laws, anti-discrimination statutes, and leave policies. Below you’ll also find a discussion of employment forms included in this book, as well as links to government agencies and important websites.

Independent Contractors. When you’re just starting out, hiring independent contractors can save a lot of time and money. However, you need to be careful not to mistakenly or falsely characterize workers as independent contractors. To qualify as an independent contractor under IRS rules, a worker must control both the outcome of a project and the means of accomplishing it. In close cases, the IRS prefers to see workers treated as employees rather than as independent contractors. For more information on the difference between independent contractors and employees, see The Employer’s Legal Handbook, Chapter 12. If you decide to hire an independent contractor, use Form 9F: Contract With Independent Contractor.

Employer Identification Numbers. If you don’t have an employer identification number already, start by completing IRS Form SS-4, Application for Employer Identification Number, included in this book. Mail or fax the form to the IRS to get a tax number for your business. You’ll need the number when you pay the employer’s and employee’s share of income taxes, Social Security taxes, and Medicare taxes.

Unemployment Tax. You’ll have to make payments to your state’s unemployment compensation fund, which provides short-term relief to workers who are laid off. First, you’ll need to register with your state’s employment department or similar agency. To find the proper agency, go to www.statelocalgov. net.

You’ll also need to file IRS Form 940 to report your federal unemployment tax each year. You must file this form for any year in which:

• you paid wages of $1,500 or more in any quarter, or
• had one or more employees for at least part of a day in any 20 or more different weeks. Count all full-time, part-time, and temporary employees, but don’t count partners if your business is a partnership.

Form 940 is included in this book and on the forms CD-RO M. It’s also available from the IR S website (www.irs.gov).

[Sample SS-4 Form: Application for Employer Identification Number] omitted for online sample chapter

Withholding and Payroll Taxes. Every business with employees must withhold a portion of each employee’s income and deposit it with the IRS, and also make Social Security and Medicare tax payments to the IRS. Have each new employee fill out IRS Form W-4, Employment Withholding Allowance, included in this book. This form does not need to be filed with the IRS, but it tells you how many allowances an employee is claiming for tax purposes, so that you can withhold the correct amount of tax from his or her paycheck. For more information, be sure to get IRS Publication 15, Circular E, Employer’s Tax Guide. You can get this publication from the IRS website (www.irs.gov).

Workers’ Compensation. Look into the workers’ compensation insurance requirements in your state. You’ll need this coverage in case a worker suffers an on-the-job injury, because such injuries aren’t covered by normal liability insurance. In most states, the Division of Workers’ Compensation falls under the Department of Industrial Relations. To find your state agency’s website, go to www. statelocalgov.net. For more information on workers’ compensation laws, see The Employer’s Legal Handbook, Chapter 7.

Compliance With Other Government Regulations. Several federal and state agencies administer other laws in the workplace. Be sure to comply with the laws of each agency:

• OSHA. For information on compliance with Occupational Safety and Health Administration (OSHA ) regulations, including creating an Injury and Illness Prevention Plan, go to the OSHA website (www.osha.gov). For more information on health and safety in the workplace, see The Employer’s Legal Handbook, Chapter 7.
• Department of Labor. For information on posters you must display in your place of business, go to the Department of Labor website (www .dol.gov). Use their online "Poster Advisor" to determine which posters you must display in your workplace. (The advisor will ask you a series of questions, such as the number of employees and annual dollar volume, and then provide a list of posters you must display and an opportunity to print them.) In addition, you must comply with your state department of labor’s poster requirements. For a list of state departments of labor, go to www.dol/gov/dol/ location.htm.
• New Hire Reporting Agency. For information on the new hire reporting program, which requires employers to report information on employees for the purpose of locating parents who owe child support, go to the Administration for Children & Families website at www.acf.hhs .gov/programs/cse. This website provides state-by-state reporting information including the name and address of your state’s new hire reporting agency. This agency may or may not be your state’s employment department.
• U.S. Citizenship and Immigration Services. The U.S. Citizenship and Immigration Services (USCI S) was formerly known as the Immigration and Naturalization Service (INS). You must have each new employee complete USCIS Form I-9, Employment Eligibility Verification, to verify the employee’s eligibility to work in the United States. The form need not be filed with the USCIS, but it must be kept in your files for three years and made available for inspection by officials of the USCIS. This form is included in this book.

Employment Applications. Form 9A: Employment Application requests information on the applicant’s educational background, training, skills, and achievements.

Employee Handbook. If you have more than a few employees, you may want to create a handbook that explains your employment policies. This way your employees will know what is expected of them and what they can expect from you. Your handbook should include policies on:

• at-will employment
• pay and benefits
• workdays, hours, and time off
• discrimination and harassment
• performance evaluations
• complaints and investigations
• substance abuse
• privacy in the workplace, and
• discipline.

For guidance on the legal and practical considerations as well as a CD-RO M that includes policies on each of the above topics, see Create Your Own Employee Handbook: A Legal & Practical Guide, by Lisa Guerin and Amy DelPo (Nolo).

Form 2B: Partnership Agreement

If you are creating a partnership, you should make a written partnership agreement. A partnership agreement spells out your rights and responsibilities and allows you to structure your relationship with your partners in a way that suits your business. Although the law recognizes partnerships without written agreements, there are huge benefits to putting yours in writing. For one, the process of creating a written agreement forces you and your partners to confront and talk through many important decisions, such as how much money each partner will invest in the business, how profits and losses will be allocated, how the partnership will be managed, and what happens if a partner withdraws from the business. What’s more, a written partnership agreement can provide an invaluable framework to handle later misunderstandings and disagreements, which of course are likely to be part—hopefully a small part—of any business.

Another benefit of creating a formal agreement is that it allows the partners to adjust the operating rules of the partnership to suit their needs instead of being bound by the "default" rules that state law imposes in the absence of an agreement. For example, suppose you and another partner get into a dispute about the business and one of you sues the other. If you don’t have a written partnership agreement, the judge will decide the case based on your state’s partnership law—which may be different from what you and the other partner would like to happen. By contrast, if you have provided your own way of handling things in a written agreement, it will normally control and determine the judge’s decision.

Example: Al, Barbara, and Carl start a partnership business. Since they’re old friends and don’t like paperwork, they never actually agree on the formula for allocating profits, let alone put it in writing. Because Al will be working full-time in the business and Barbara and Carl will be working only part-time, their joint assumption seems to be that Al will get 50% of the profits and Barbara and Carl will each get 25%. However, a year later, after a bitter falling out among the partners followed by a lawsuit, a judge is forced to consider this issue. Because there’s no written agreement and the oral evidence is inconclusive, the judge must follow state law and rule that each partner is entitled to one-third of the profits.

Resource: For more on partnerships, see Chapter 2 of the Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo), and Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner (Nolo).

Instructions for Form 2B: Partnership Agreement

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CD-ROM. As you read the instructions for Form 2B, you may want to either tear out the form or open the form’s file on the CD-ROM so you can follow along. (For more information on using the forms CD-ROM, see Appendix A, "How to Use the CD-ROM.") Before you use the tear-out form, be sure to photocopy the agreement so you’ll have a clean copy to use later.

1. Partners

Insert the names of all partners.

2. Partnership Name

One of the first things you need to do is settle on a name for your partnership. There are two basic ways to choose your name:

• you can combine your own last names, such as "Johnson, Holmes, & Sanchez" as your official partnership name, or
• you can make up the name under which you’ll do business, such as "Three Guys Contractors," which is called a "fictitious" or "assumed" business name.

Before settling on a partnership name, it’s wise to conduct a name search to avoid a possible conflict with a business that is already using the same name or a similar one. Typically, if your partnership is a small local business, you can feel reasonably secure if you’ve searched for name conflicts at the state and local level. Check the records of the state, county, or local offices where assumed or fictitious business names are filed and the state office where corporations and LLC s are registered. Also check the phone books and city directories covering your area.

If you plan to do business regionally or nationally and will use your business name to identify a product or service, you should consider doing a national trademark search and look into registering your trademark or service mark at both the federal and state levels. For more in-depth information on trademark searches and registration, see Trademark: Legal Care for Your Business & Product Name, by Stephen Elias (Nolo).

If you decide to use a name that doesn’t include the last names of all of the partners, you’ll need to register your partnership’s name as a fictitious or assumed business name—generally by filing a form at a designated county office. You may also need to publish your partnership name in a local newspaper. Many counties and municipalities have websites that provide more information about registering a fictitious business name and publishing required notices. See www.statelocalgov. net for a comprehensive list of state and local government sites on the Internet.

Insert the name of the partnership.

3. Partnership Duration

Insert the date the partnership began or when it is to begin. Your partnership will begin on whatever date you decide. This can be either a date in the future that you select now, or it can be the same day you sign your partnership agreement.

Next, check one of the boxes to indicate when the partnership will end. Most partnerships last indefinitely—as long as the partners want them to last. However, you can choose a date when your partnership will end. If you are setting up your partnership to complete a specific project, such as developing a particular piece of real estate, you might want the partnership to end on a date that you specify here. If you check the second box, insert a date for the end of the partnership.

4. Partnership Office

Insert the address where partnership records will be kept. Usually this will be the partnership’s main business location. If the partnership’s mailing address is the same as the partnership office, check the first box. If you have a separate mailing address— a post office box, for example—check the second box and fill in the mailing address.

5. Partnership Purpose

Insert the purpose of the partnership.

SAMPLES

• to operate one or more retail stores for the sale of computer software.
• to manufacture and distribute equipment for the preparation of espresso, cappuccino, and other coffee-based beverages.
• to design websites for computer users and companies.
• to cater banquets, picnics, and other social and business functions requiring food service, and to rent equipment to be used in connection with such catering services.

6. Capital Contributions

Each partner must contribute some property to the partnership in exchange for an ownership interest. The partner can contribute cash, property, or both.

Depending on how readily available the partners’ contributions are, this can be anywhere from a few days to a few weeks or even months after your partnership starts. The important thing to keep in mind is that your business needs to have enough money to operate until the partners make their contributions. In the first blank, enter the date by which the partners will hand over their contributions.

1. If partners will be contributing cash, fill in their names and the amount each will contribute.
2. If partners will contribute property, insert the partners’ names. Then describe the property and what value it will be given on the partnership’s books.

Often, partners’ initial contributions are equal, but not always. Unequal contributions are accounted for by granting the partners unequal rights to the partnership’s profits and losses. For example, one partner contributes $6,000 and the other puts in $4,000. Future profits and losses of the partnership are allocated 60% / 40%.

7. Capital Accounts

You don’t need to insert anything here. A capital account is a bookkeeping technique for keeping track of how much of the partnership assets each partner owns. When a partner contributes cash or property to the partnership, the partner’s capital account is credited with the cash amount or fair market value of the property contributed. The partnership will regularly add each partner’s share of partnership profits to the capital accounts. Each partner’s share of any losses and distributions will be deducted. In addition, if the partnership takes out a loan, the capital accounts should reflect each partner’s share of the debt.

See An Expert: Get help setting up your books. If you’re unfamiliar with business bookkeeping, see an accountant to help you get started and to explain how capital accounts work. The accountant can also brief you on how to meet your federal and state business tax obligations. But first, you might want to consult Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner (Nolo), which explains the basics.

8. Profits and Losses

Nothing needs to be inserted here. Generally, a partner’s reward for doing work for the partnership is a share of the partnership profits. For this reason, this partnership agreement does not provide for partners’ salaries. Instead, it gives partners a share of the partnership’s profits and losses.

Our partnership agreement splits profits and losses according to the partners’ capital contributions. This is the easiest and most common method for making such allocations. For example, suppose one partner puts in $20,000 and two other partners put in $10,000 each. The profits and losses will be allocated 50% / 25% / 25%.

If you’d like to split up profits and losses in a way that is not proportionate to the partners’ capital contributions, it’s called a "special allocation," and you must carefully follow IRS rules. For example, suppose John and Anna set up a partnership to operate their consulting business. John and Anna put up equal amounts of cash, but they decide that John will be allocated 65% of the partnership’s profits and losses for the first two years, and Anna will be allocated 35% of the partnership’s profits and losses.

If you want to set up a special allocation, you’ll need an accountant or tax lawyer to add special language to your partnership agreement to ensure that it will pass muster with the IRS. If the IRS refuses to accept your special allocation, it will deem the profits and losses to be distributed in the same percentage as the partner’s capital contributions.

9. Salaries

You don’t need to insert anything here.

10. Interest

You don’t need to insert anything here. If you would like a partner to receive interest, it’s better to have the person lend money to the partnership. Be sure to document the loan with a promissory note. (See Chapter 4.)

11. Management

For a small partnership to succeed, the partners need to have both shared goals and confidence in one another’s judgment. If those elements don’t exist, pages of rules as to how decisions should be made won’t help. When it comes to important decisions, it’s smart to talk over the matter with all the partners and respect each other’s opinions. But requiring unanimity on all decisions may be as unnecessary as it is hard to achieve—making it impractical to select the first option (agreement of all partners on all partnership decisions).

Choosing the second option allows you more flexibility by requiring unanimous agreement on just the major business decisions that you specify, such as renting, buying, or selling real estate, or taking out a business loan. Let’s briefly look at the potential consequences of each type of decision to help you figure out whether you want to require unanimity for a particular decision.

Borrowing or Lending Money. When the partnership borrows money, each partner in a general partnership is personally responsible for repaying that money if the partnership doesn’t. With such serious consequences, it’s understandable that all partners would want to control the borrowing of money. Similarly, partners should always agree on lending money to outsiders before writing the check.

Signing a Lease. Especially if the partnership is leasing its first commercial space, all of the partners will probably all want a say in the location, price, and lease terms. Even if it’s not the first business space, it’s likely that each partner will want to be involved in the decision because each partner is personally liable for the lease payments.

Signing a Contract to Buy or Sell Real Estate. Selling real estate, especially if it is one of the partnership’s main assets, is another matter that the partners will want to agree on. Likewise, buying real estate will probably require a large commitment of the partnership’s capital, so the partners will probably want to unanimously approve that decision as well.

Signing a Security Agreement or Mortgage. Your partnership may have to sign a security agreement or mortgage when taking out a loan. A security agreement or mortgage will place a lien on partnership property; in other words, the partnership property will act as collateral for the loan. If the partnership defaults on the arrangement, usually by failing to make payments on a loan, the lender or creditor can take the property and sell it to pay the debt. Because this can have serious consequences for the business, it’s advisable for partners to agree before pledging property as collateral.

Selling Partnership Assets. If the partnership wants to sell some or all of its assets, all of the partners should discuss the matter and agree. This will help to avoid confusion, arguments, and monetary losses to the business.

Other Decisions. There may be some other decisions for which you want to require unanimity that we haven’t listed here. If that’s the case, describe the action or decision in the space provided.

Sample: Releasing any partnership claim, except upon payment in full.

12. Partnership Funds

Insert the name of the financial institution where you’ll keep the partnership funds.

Then check a box to indicate who will be able to sign partnership checks. Many partnerships require the signature of only one partner on business checks, but others require two or more. If you check the last box, insert the number of partners who must sign. In a three-person partnership, for example, you may want to require that checks be signed by two partners.

The financial institution where you have the account will have a form of its own for you to fill out.

13. Agreement to End Partnership

You don’t need to insert anything here. This paragraph makes it clear that the partnership can be ended if all the partners agree.

14. Partner’s Withdrawal

Under the laws of most states, if one partner withdraws from the partnership, the partnership will automatically end: the partnership assets will be liquidated, bills will be paid, and the partners will be cashed out. Check the first box if this scenario is what you want.

You can, however, create a different outcome. Check the second box if you want to give the remaining partners the chance to keep the partnership alive by buying out the interest of the withdrawing partner. The partners will have 30 days to decide whether to continue or end the partnership. All remaining partners must agree to continue at that time. Technically, if the remaining partners choose to continue, they will form a new partnership with each other, but the business will continue as if there was no change.

15. Partner’s Death

As with a partner’s withdrawal, a partner’s death will end the partnership—unless you agree to another outcome. Check the first box if you want the partnership assets to be liquidated and the deceased partner’s share of the assets to be paid to that partner’s estate.

Check the second box if you want to give the remaining partners the chance to keep the partnership alive by buying out the interest of the deceased partner. The partners will have 30 days to decide whether to continue or end the partnership. All remaining partners must agree to continue it at that time. Technically, if the remaining partners choose to continue, they will form a new partnership with each other, but the business will continue as if there was no change.

16. Buyout

Complete this optional paragraph only if you’ve provided for a buyout of a withdrawing partner’s interest (Paragraph 14) or a deceased partner’s interest (Paragraph 15). If you haven’t provided for a buyout in Paragraph 14 or 15, either cross out this paragraph (in which case, all partners should initial the deletion) or insert the words, "Not Applicable." (CD-RO M users can just delete it and renumber the paragraphs that follow.)

First, insert the number of days the partnership has to pay the withdrawing partner or the deceased partner’s estate for that partner’s interest. Keep in mind that the remaining partners already have 30 days to decide whether they want to purchase the interest and continue the business, so the number of days you select for payment of the buyout price should include this amount of time. For example, if you insert 60 days, the remaining partners will have 30 days to decide whether to buy out the interest and 30 more days to pay for it. The number of days should account for any time the partners will need to determine the value of the partner’s interest, but it should not make the withdrawing partner or the deceased partner’s estate to wait too long after the buyout decision is made.

Next you must choose a way to value the interest of a partner being bought out. Here are the alternatives:

Capital Account. A partner’s capital account is the amount of the partner’s contributions, plus any unpaid allocations of profit, less any distributions already made to the partner. It should also reflect the partner’s share of any partnership debts. This is the simplest way to value a partner’s ownership interest: using the dollar value of the partner’s capital account. However, this may not include the value of the business’s assets, its yearly revenues, and profits and intangibles such as goodwill.

Appraisal Value. Another way to value a partner’s ownership interest is to have your partnership’s accountant determine the fair market value of the partner’s interest. This may or may not be appropriate, depending on how knowledgeable the accountant is about your industry and how expensive it would be to have the accountant conduct an appraisal. (Most will charge an hourly or flat fee for this service.)

Other Valuation Methods. There are several other methods of valuing a partner’s interest that use your company’s financial statements from one or more years. These include the "book value," "multiple of book value," and "capitalization of earnings" methods. These methods are explained in more detail in Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo). Depending on your business, one of these methods may be more appropriate than using a partner’s capital account or an accountant’s appraisal.

Check one of the first two boxes if it contains an acceptable formula for fixing the buyout price. If not, check the third box and fill in the method of setting the buyout amount. If you’re not sure which method you want to use, you may want to consult your legal and accounting advisers and talk with other business owners in your field about how they would go about valuing their business.

Resource For a more thorough discussion of the subject and a comprehensive agreement with different options, see Business Buyout Agreements: A Step-by-Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo). For instance, you may decide that you need a more customized agreement that covers more contingencies, such as what happens in the case of a partner’s divorce or bankruptcy. Or you may want to include other payment options for purchasing a partner’s interest, such as an installment plan or payments of interest only for a period of time. If you do decide to create a separate, more comprehensive "buy-sell" agreement, you would remove from this partnership agreement the provisions dealing with buyouts in the case of a partner’s death or withdrawal.

Standard Clauses

The remainder of the agreement contains the standard clauses we discussed in Chapter 1. The only thing you’ll need to fill in here is the name of the state whose law will apply to the contract in the paragraph called "Governing Law."

Date and Signatures

Fill in the date the agreement is signed. Each partner must sign his or her name, and their respective names and addresses should be typed in.

Form 2C: Preincorporation Agreement

A preincorporation agreement sets out the financial and organizational structure of a corporation being formed. Although not legally required, a preincorporation agreement can be a very useful aid to starting a new corporation. The process of drawing up an agreement allows you and other owners to focus on key business issues. Sometimes doing this may even cause you to abandon the idea of starting the business. If so, this should be seen as a positive development. It’s much better to confront tough management issues early rather than after everyone has invested money, time, and energy in a business enterprise.

This form is designed for people who plan to incorporate a small business owned by a handful of shareholders, each of whom will actively take part in the day-to-day operations of the business. You may not need to create a preincorporation agreement if you fall into one of the following categories:

• you will be the sole owner of your corporation
• you are incorporating an existing business with your co-owners
• you’ve previously done business with those who will co-own your corporation, or
• the owners of your corporation will be family members.

However, it can never hurt to create a quick preincorporation agreement, and it can help avoid financial and management spats later.

Tip: A preincorporation agreement is just the first step you take in starting a corporation. Among the other important things you must do are:

• prepare and file the articles of incorporation (known in some states by other names—see instructions, below, for Paragraph 2)
• select a board of directors
• adopt bylaws
• issue stock, and
• decide whether or not you want to elect S corporation tax status.

Instructions for Form 2C: Preincorporation Agreement

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CDRO M. As you read the instructions for Form 2C, you may want to either tear out the form or open the form’s file on the CD-RO M so you can follow along. (For more information on using the forms CD-RO M, see Appendix A, "How to Use the CDRO M.") Before you use the tear-out form, be sure to photocopy the agreement so you’ll have a clean copy to use later.

1. Shareholders’ Names

Insert the names of all shareholders.

2. Incorporation

Insert the state in which you plan to incorporate. Corporations are created under state law rather than federal law, and each state has its own rules for how to start a corporation.

The best place to form your corporation is in the state where you and your co-owners live. Incorporating in another state, such as Delaware, does not make sense for most small corporations. Though incorporation fees may be lower in another state, a corporation always has to register in the state where it actually does business. Registering in two states takes as much time and costs as much money as filing in just one state—so we recommend filing in the state where you live.

Usually, a state office—such as the Secretary of State—can provide a form for the articles of incorporation. Many Secretary of State offices provide incorporation forms and a list of filing fees on their website. Check www.statelocalgov.net for a list of state government agencies on the Web.

Tip: Legal jargon differs from state to state. Most states use the term "articles of incorporation" to refer to the basic document that creates a corporation, but some states (including Connecticut, Delaware, New York, and Oklahoma) use the term "certificate of incorporation." Washington calls the document a "certificate of formation," and Tennessee calls it a "charter."

For single-owner corporations, the sole owner usually prepares, signs, and files the articles of incorporation himself. For co-owned corporations, all of the owners may sign the articles, or they can appoint just one person to sign them. Whoever signs the articles is called the "incorporator." Select the option that fits your choice.

3. Corporate Name

You need to make sure the business name you want to use is available. Your state’s corporate filing office will not let you use a name that is identical or very similar to the name of another corporation in your state. Contact your state’s corporate filing office to see if the name you want to use is available, and if it is, ask whether you can reserve it. You can usually reserve a name for a month or two (the exact period of time depends on your state’s law) for a nominal fee.

Be sure the name you choose complies with the corporation laws of your state. For example, you may be required to include one of the following words or its abbreviation in the name of the corporation: Corporation, Incorporated, or Limited.

In addition to checking name availability with your state’s corporate filing office, you will need to make sure your proposed name does not violate another business’s existing trademark. If you will use your business name to identify a product or service, you should also look into registering your trademark or service mark at the state or federal level. For more information on naming your business and products, see Trademark: Legal Care for Your Business & Product Name, by Stephen Elias (Nolo).

If your corporation will do business under a name other than the name that will appear on your articles of incorporation, you’ll need to register that name as a fictitious or assumed business name. For example, Apollo Furniture, Inc., is considering doing business as either Apollo—a shortened form of its official name—or as Contemporary Studio— a name completely different from its official name. Whichever name it chooses, the company must register it as a fictitious or assumed business name with the county or counties where it does business. You can register a fictitious or assumed business name by filling out and filing a printed form at a designated county office, usually for a small fee. You may also need to publish the fictitious or assumed name in a local newspaper. Many counties and municipalities have websites that provide more information about registering fictitious business names and publishing required notices. See www. statelocalgov.net for a comprehensive list of state and local government sites on the Internet.

Fill in the name of the new corporation. Also, check the box if you’re planning to use an assumed or fictitious name that’s different from the official corporate name. Then fill in the name.

Samples:

• Apollo Furniture Inc. wants to do business as Apollo—a shortened form of its official name. It inserts the name Apollo in the space.
• Apollo Furniture wants to do business as Contemporary Studio—a name completely different from its official name. It inserts the name Contemporary Studio in the space.

Tip: You’ll need to make your trade name a matter of public record. State law will probably require you to file an assumed name certificate with a state or county office. And in some states, you’ll need to publish a notice in the newspaper informing the public of your fictitious name. This will let the public know that the business called Contemporary Studio, for example, is another name for Apollo Furniture Inc.

4. Corporate Purpose

Insert the purpose of the corporation. Use simple language and describe the purpose broadly enough to cover all your intended and possible activities.

Samples:

• to operate one or more retail stores for the sale of computer software.
• to manufacture and distribute equipment for the preparation of espresso, cappuccino, and other coffee-based beverages.
• to design Web sites for computer users and companies.
• to cater banquets, picnics, and other functions requiring food service, and to rent equipment to be used in connection with these catering services.

5. Corporate Stock

Issuing shares of stock to the initial owners formally divides up ownership interests in the corporation and supplies the corporation with start-up capital. The initial owners provide money or other property to the corporation in exchange for shares of stock. Insert the total number of shares the corporation will be issuing to the shareholders signing the agreement.

Caution: There’s a difference between authorized stock and issued stock. Your new corporation will be authorized under state law to issue a certain number of shares of stock. The number is usually established at the time you incorporate and in a few states will be tied to the fees you pay the state for incorporating. Just the same, it’s a good idea to have plenty of stock authorized so that you’ll have some in reserve after you issue shares to the initial shareholders—although if you run out, you can always get authority later for more stock.

This paragraph of the shareholders’ agreement deals only with the shares you’ll be issuing to the initial shareholders and not with the total number of shares authorized.

This paragraph assumes that all your shares will be common stock, meaning that there’s no guarantee that dividends will be paid. Issuing preferred stock (under which owners receive a fixed dividend before dividends are paid to common stock owners) is too complex for most small businesses.

6. Stock Subscriptions

Here, each shareholder makes a commitment to buy a certain number of shares.

Fill in the price per share of the stock. Most new corporations charge $1 per share—a simple and commonsense approach that simplifies bookkeeping. Then, fill in the name of each person signing the agreement, the number of shares each is buying, and the total price each is paying.

The form that we’ve provided for the Preincorporation Agreement assumes that shareholders will pay cash for their shares. While this is normally the case, payment can also be made by contributing tangible assets to the corporation, such as a car or a computer. If this fits your situation, you’ll need to add appropriate language describing the asset that the shareholder will contribute.

After you’ve incorporated and the shareholders have paid for their shares, the corporation will issue a stock certificate to each shareholder making it official that the person named has a designated number of shares in the corporation. It’s usually signed by the corporation’s president and secretary. You can buy blank forms at an office supply store.

In some states you may also have to file a "notice of stock transaction" or similar form with your state corporations office.

7. Tax Status

This agreement states that all shares of stock will be issued under Section 1244 of the Internal Revenue Code. This language is included in your agreement for the benefit of shareholders who may eventually have to sell their stock at a loss. It permits such shareholders to deduct the loss as an "ordinary" loss from their ordinary individual income (such as salaries, dividends, and the like), up to $50,000 per year. Without this statement, any loss from the sale of stock would be treated as a "capital" loss, and could be used to offset only $3,000 of ordinary individual income in any year. For example, suppose a shareholder buys 10,000 shares of stock for $10,000, but sells it at a loss for $3,000 one year later. If the shares were issued under Section 1244, the shareholder can deduct that $7,000 loss from the rest of the shareholder’s ordinary income. This should save the shareholder several thousand dollars in taxes.

If the shareholders want the corporation to elect S corporation status, check the optional box. (If not, CD-RO M users can delete it.) If so, shareholders will be taxed as if they are partners. Each shareholder’s share of the corporation’s profit or loss will be reported on his or her personal tax return. The corporation itself will pay no income tax.

There are two main reasons to choose S Corporation tax status:

• An S corporation allows owners to deduct business losses on their personal income tax returns, using them to offset any income that they (and their spouses, if they’re married) have from other sources. This can be helpful for corporations that anticipate start-up losses.
• When owners sell their S corporation, the taxable gain on the sale of the business can be less than if they operated the business as a regular corporation.

There are additional pros and cons to electing S corporation status. See Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo), for further discussion. After reading up on this subject, you may still want to consult a tax advisor to help you decide whether to form an S corporation.

If you choose to elect S corporation status, all shareholders must sign IRS Form 2553 and you must file it with the IRS. You must file a similar form with the state tax agency. After filing Form 2553, your business will be taxed as a partnership if your corporation has more than one shareholder or as a sole proprietorship if yours is a one-shareholder corporation. Shareholders will be allocated a portion of profits (or losses) of the corporation according to their percentage of stock ownership in the corporation. If you change your mind, your corporation can revoke S corporation status and return to regular corporate tax status, but if it does this, it will not be able to reelect S corporation status for another five years.

Resource: If you like the idea of having the profits and losses of your business pass through to the owners for tax purposes, you should know that this can be accomplished by forming a limited liability company (LLC). LLC owners automatically receive partnership tax treatment unless they elect to be taxed as a corporation. Again, consider talking to a tax advisor if you need help in choosing which way to go. For more information on small business taxation, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).

8. Board of Directors

You don’t need to insert anything here. A corporation’s directors make major policy and financial decisions for the corporation—for instance, they authorize the issuance of stock, approve loans to and from the corporation, and elect the officers. Your corporate bylaws will grant directors these powers. In a small business in which the owners actually run the business, it usually makes sense for all owners to serve on the board of directors.

In many states, the number of required directors is tied to the number of shareholders. For instance, a corporation with one shareholder would need only one director, while a corporation with two shareholders would need at least two directors and a corporation with three or more shareholders would need at least three directors. However, no state requires a board to have more than three directors. Your preincorporation agreement will make all of the initial shareholders directors of the corporation. If you want to name different directors, you can do so at a later time.

9. Officers

Insert the names of the officers. You should name at least a president, a secretary, and a treasurer. In most states, however, one person can hold all of the required offices. Check with your state’s corporate filing office if you want one person to hold all of the required positions or if you don’t want to appoint a president, secretary, or treasurer.

Officers are responsible for the day-to-day operation and management of the corporation. Officers do not have to be shareholders, but in small corporations, they usually are. The president is usually the chief operating officer (CO) of the corporation. The secretary is responsible for the corporate records. The treasurer—sometimes called a chief financial officer (CFO)—is responsible for the corporate finances, although it’s common to delegate everyday financial duties to a bookkeeper or accounting department.

10. Place of Business

Insert the address of your main location. This is the address where the records of the corporation will be kept and where official notices will be sent.

11. Bylaws

Form 2D, the next form in this chapter, can be the basis for your bylaws.

Standard Clauses

The remainder of the agreement contains the standard clauses we discussed in Chapter 1. The only thing you’ll need to fill in here is the name of the state whose law will apply to the contract in the paragraph called "Governing Law."

Signatures

Each shareholder must sign his or her name, and their addresses should be typed in.

Form 2D: Corporate Bylaws

A corporation’s bylaws are the internal rules that govern the company’s day-to-day operations, such as how many directors will serve on the board and when and where the corporation will hold directors’ and shareholders’ meetings. You should prepare and follow bylaws for two reasons:

First, every corporation needs an orderly way to handle the legalities of corporate life. You need rules, for example, on how to elect the board of directors and corporate officers, how to hold meetings, and the number of votes required for shareholders and directors to take action. Bylaws deal with these and related issues.

Second, as you know, one big reason to do business as a corporation is to limit your personal liability. But to maintain limited liability status, you need to act like a real corporate entity—which means creating a paper trail that demonstrates your corporation is following the necessary business formalities. Doing this not only means adopting bylaws when your corporation is established but also keeping ongoing corporate records such as minutes of regular and special shareholders’ and directors’ meetings. (See Chapter 3.) In short, good corporate record keeping will help protect you if the IRS or a creditor insists that your corporation is just a sham and tries to go after your house, car, bank accounts, and other property that you personally own.

The bylaws in this chapter are designed for a small corporation—one in which a handful of people own all the stock and are actively involved in the day-to-day operations of the business. At first these bylaws may look complicated and even a little overwhelming. True, there are a lot of details, but these bylaws are sensible, written in clear language, and easy to put into practice.

See An Expert: You may need more customized bylaws. Our bylaws give you a reasonable measure of flexibility, but you may have other ideas about running your business that don’t easily fit into this mold. Chances are your creative ideas will affect only one or two areas of corporate management. If so you can use these bylaws for most provisions, but see a lawyer for help with appropriate wording to cover the troublesome areas.

Incorporators should formally adopt bylaws as soon as the incorporation papers have been signed and filed with the required state office. But the ideal time to prepare bylaws is when the incorporators are putting together a preincorporation agreement (Form 2C). This helps all shareholders learn whether they have really achieved a meeting of the minds on many of the key aspects of starting and running the corporation.

Instructions for Form 2D: Corporate Bylaws

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CD-RO M. As you read the instructions for Form 2D, you may want to either tear out the form or open the form’s file on the CD-RO M so you can follow along. (For more information on using the forms CD-RO M, see Appendix A, "How to Use the CD-RO M.") Before you use the tear-out form, be sure to photocopy it so you’ll have a clean copy to use later.

Heading

In the first blank, insert the name of your corporation. In the second blank, fill in the state in which you filed your incorporation papers.

Article I: Meetings of Shareholders

Article I covers the procedures for annual and special meetings of shareholders.

1. First, insert the day of the month and the month when annual meetings will take place.

   Sample:
   The annual meeting of shareholders will be held on the first Wednesday in September.

   Second, insert the time when annual meetings will start.
2. Insert the number of people who will serve on the board of directors. Typically in a small corporation, all of the shareholders will want to serve on the board of directors. While most states permit a corporation to have just one director regardless of the number of owners, a few states require that a corporation must have at least three directors, except that a corporation with only two owners can have two directors and a corporation with only one owner can have just one director. If you would like your corporation to have only one or two directors but you have more than one or two shareholders, check with your state’s corporate filing office to see if this is allowed.
3. A special meeting of shareholders is one called and held between the scheduled annual meetings.
   
   Check a box to indicate whether the president or a number of shareholders or directors can call a special meeting of shareholders. If you check the second or third box, insert the number of shareholders or directors required to call a special meeting.
4. You don’t need to fill in anything here. This section sets out the notice requirements for annual and special meetings.
   
   Cross Reference: For a notice form, see Form 3A: Notice of Shareholders’ Meeting.
   
   
5. You don’t need to fill in anything here. This section provides the minimum number of shareholders that must be present for a meeting to be valid. In order to take action at a meeting, a "quorum" of shareholders must be present— either in person or by proxy. Your bylaws provide that a quorum of shareholders at any shareholders’ meeting consists of the owners of a majority of the shares outstanding.
6. You don’t need to fill in anything here. Each share of stock constitutes one vote. In other words, each shareholder will have as many votes as he or she owns shares of stock.
7. You don’t need to fill in anything here. Shareholders may authorize someone else to vote their shares at a meeting using a shareholder proxy. Your bylaws require all proxies to be in writing.
   
   Cross Reference: For a proxy form, see Form 3C: Shareholder Proxy.
   
   
8. For shareholders to take action, the action must usually be supported by a majority of the shares the corporation has issued. There are two exceptions. First, although it’s rare, state law occasionally mandates a two-thirds or even three-fourths vote (called a supermajority) on some issues, such as a corporate merger or a dissolution of the corporation. Consult the corporation laws in your state to learn if any actions require more than a majority vote. Second, and far more commonly, shareholders themselves may use their bylaws to require a supermajority vote for certain significant actions such as purchasing or selling real estate, borrowing significant sums of money, or selling all or nearly all of the corporation’s assets.
   
   If you wish to require a supermajority for some actions, check the box marked "Exception." Insert the type of action requiring a supermajority in the first blank and the percentages of votes required to pass the action in the second blank.
   
   

   Sample: Approval of the sale or purchase of real estate by the corporation requires the assent of two-thirds of the corporate shares that have been issued.

9. You don’t need to fill in anything here. This section allows shareholders to take action by signing written consent—written approval of corporate actions—instead of holding formal meetings. A meeting, documented in formal minutes, is still the best way to deal with controversial issues, but for routine matters or actions that all shareholders agree on, written consents are a convenient way to proceed.

Article II: Stock

1–4. Nothing needs to be filled in here. These sections discuss who must sign stock certificates, and the requirements for keeping track of and transferring shares of stock. Skim these requirements before you continue preparing your bylaws.

• Each stock certificate must be signed by the president and the secretary of the corporation.
• The corporation must keep records of which stock certificates have been issued to which shareholders, and the number of shares each certificate represents.
• If a shareholder sells or transfers his stock, the corporation will cancel the original certificate and issue a new stock certificate to the new owner.
• If a shareholder sells or transfers his stock, the transfer isn’t complete until the secretary makes the transfer in the corporation’s books.

Article III: Board of Directors

1. This makes it clear that the board of directors will run the corporation. But because the shareholders and directors are often the same in a small corporation, the shareholders aren’t typically delegating management to others. Insert the name of the state in which you filed your incorporation papers.
2. You don’t need to fill in anything here. This section sets out a procedure for filling vacancies on the board of directors. Generally, a director vacancy is filled by calling a special meeting of shareholders to vote on a new director.
3. Check a box to indicate who can call a special meeting of the directors—the president, any director, or several directors. If you check the last box, insert the number of directors required to call a special meeting. Then, insert the number of days required for a notice of a meeting of the directors. The notice must be sent by first-class mail and must state the time, place, and purpose of the meeting.
4. Insert the number of directors required for a quorum at directors’ meetings. A quorum is the minimum number of directors who must be present for the meeting to be valid. A one director corporation should provide for a one director quorum. Most other corporations provide that a quorum is a majority of the directors. For instance, if your corporation has three directors, two of the directors would have to be present at a meeting to make a quorum. Alternatively, you can choose the exact number of directors that will make a quorum. In many states, the minimum number of directors for a quorum is two directors or one-third of the directors, whichever is larger. For instance, a four-director corporation may provide for a quorum of two, but the minimum quorum for a nine-director corporation would be three.
5. Check one box to indicate the type of vote required for actions to be taken by the board of directors. If you check the last box, insert the minimum number of directors’ votes required. The number of director votes needed to approve an action or make a decision is different from the quorum requirement. For example, suppose a four-director corporation requires a majority quorum (that’s three directors) and a meeting is held at which three directors are present. If the bylaws require a majority of director votes to take action at a meeting, action can be taken only by the affirmative vote of two or more directors at the meeting.
6. You don’t need to fill in anything here. Typically, directors of a small corporation aren’t paid for those duties but, of course, may get paid for the other work they do for the corporation. Suppose, for example, that you, Joe, and Alice each own one-third of the shares of a corporation and you each work in the business each day. The corporation will pay you each a salary for your work and may pay you each a bonus as well—but won’t pay you something additional for the time you spend serving on the board of directors.
7. You don’t need to fill in anything here. Your bylaws allow directors to take actions in writing (in legal jargon, "by written consent") so they don’t have to hold formal meetings to make a decision. Written consent requires the signatures of the same number of directors that would be necessary to take action at a face-to-face meeting.
8. You don’t need to fill in anything here. Holding a meeting by conference call can be a great convenience.

Article IV: Officers

The officers of a corporation are responsible for running the business on a day-to-day basis. Many state laws require that a corporation have at least a president, a secretary, and a treasurer, although some states do not require corporations to have any officers. In most states one person can hold all of the required offices. Check with your state’s corporate filing office if you want one person to hold all of the positions, or if you don’t want to elect a president, secretary, or treasurer.

1. Check a box for each officer your corporation will have. You can check more than one box. (CD-ROM users should delete the unused officer choices.)
2. You don’t need to fill in anything here. This section provides for the president to preside at directors’ meetings.
3. Check a box to indicate whether the vice president or the secretary takes over if the president can’t act. The vice president is the appropriate officer if there is one, but not every corporation has a vice president.
4. –5. You don’t need to fill in anything here. This section defines the roles of the secretary and treasurer.
5. You don’t need to fill in anything here. This section gives the board of directors the authority to set salaries for the corporation’s officers.

Article V: Fiscal

1. Check whether the corporate books will be kept on a cash basis or accrual basis. Most small corporations use the cash basis. Keeping your books on a cash basis means you take expenses into account when you actually pay for them (not when you incur them) and put income on your books when you actually receive it (not when you’ve just earned the right to receive it). Accrual accounting works a bit differently. With accrual accounting, you take expenses into account when you incur them and put income on your books when you earn the right to receive it. Some types of corporations are required to use the accrual accounting method. Consult an accountant or do some of your own research to decide which method is better for your business.

   Sample 1: You purchase a new phone system on credit in January and pay $1,000 for it in March, two months later. Using cash-method accounting, you would record a $1,000 payment for the month of March, the month when the money is actually paid. But under the accrual method, the $1,000 payment would be recorded in January, when you take the phone system and become obligated to pay for it.

   Sample 2: Your computer installation business finishes a job on November 30, 2007 and doesn’t get paid until January 10, 2008. If you use the cash method, you’d record the payment in January 2008. Under the accrual method the income would be recorded in your books in November of 2007.

   Resource: For more information about the difference between cash and accrual accounting, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).
2. You don’t need to fill in anything here. This section requires the treasurer to give financial statements to the shareholders annually.

Article VI: Amendments

You don’t need to fill in anything here. Only the shareholders can change (amend) the bylaws. Your bylaws specify that a vote of the owners of a majority of the shares outstanding is required to change the corporation’s bylaws. Changes may be made at an annual meeting or at a special meeting called for the purpose of amending the bylaws.

Resource: For in-depth help in calling and holding special meetings and adopting corporate resolutions, see The Corporate Records Handbook: Meetings, Minutes & Resolutions, by Anthony Mancuso (Nolo). Also see Chapter 3 of this book for several additional useful forms.

Date and Signatures

Fill in the date the bylaws are adopted. Each of the shareholders must sign his or her name, and their respective names and addresses should be typed in.

Form 2E: Stock Agreement

A stock agreement, also known as a "buy-sell agreement" or "shareholders’ agreement," controls who can own shares of stock in your corporation and when a shareholder can be bought out by the corporation or the other shareholders. Every corporation with more than one owner should have this type of agreement so that the owners can maintain some control over who can become fellow shareholders.

This stock agreement automatically restricts the right of shareholders to sell their stock by giving the corporation or other shareholders the first option to buy a selling shareholder’s shares (this is called a "right of first refusal"). The basic idea is that before an outsider can come aboard as a shareholder, the corporation will first have a chance to buy the shares. If the corporation itself doesn’t purchase the shares, the other shareholders then have the opportunity to buy the shares. This agreement also gives you the option of requiring the corporation to buy the shares of any shareholder who dies.

Instructions for Form 2E: Stock Agreement

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CD-RO M. As you read the instructions for Form 2E, you may want to either tear out the form or open the form’s file on the CD-RO M so you can follow along. (For more information on using the forms CD-RO M, see Appendix A, "How to Use the CD-RO M.") Before you use the tear-out form, be sure to photocopy the agreement so you’ll have a clean copy to use later.

1. Names

In the first set of blanks, insert the names of the shareholders. Then fill in the corporation’s name.

2. Restrictions on Sale of Stock

Again, insert the name of the corporation.

3. Offer to Corporation

You don’t need to insert anything here. This section says if a shareholder receives a good faith offer to purchase his or her shares, the corporation gets first crack at purchasing them at that price. A good faith offer is one that’s freely negotiated and not rigged to artificially boost the price. If it’s not a good faith offer, the corporation doesn’t have to buy the stock, and the shareholder will not be permitted to sell it. After learning of the offer, the corporation has ten days to decide whether to buy the shares. If it decides to do so, it must purchase the shares from the selling shareholder at the same price and on the same terms as the original offer.

4. Offer to Shareholders

You don’t need to insert anything here. This section lets the other shareholders buy the stock at the good faith offer price if the corporation declines to buy some or all of the shares. The shareholders can buy the shares pro rata (each shareholder purchases the same percentage of shares he or she already owns in the corporation) or the shareholders can agree to divide up the shares in a different way.

5. Remaining Shares

This paragraph says that if any of the selling shareholder’s shares are not bought by the corporation or the other shareholders, the selling shareholder may, within 30 days, sell those shares to the person who made the original offer to purchase them, as long as the sale is on the same terms and conditions as in the original offer.

6. Continuing Effect

The terms and restrictions imposed by your stock agreement will last until the agreement is amended (changed) or until it is replaced by another stock agreement signed by all of the shareholders. The agreement’s terms and restrictions apply to all shares in the corporation, whether or not they have been issued on the date this agreement is signed. Anyone who becomes a shareholder in the corporation at a later time is bound by the terms of this agreement in the same way as the initial shareholders.

7. Death of Shareholder

When a shareholder dies, there’s a possibility that the shareholder’s shares will be inherited by someone with whom the other shareholders don’t want to share ownership of the company. To avoid this possibility, this stock agreement gives you the opportunity to require the corporation to purchase a deceased shareholder’s shares from the shareholder’s estate. To pay for the shares, the corporation is required to purchase life insurance policies on the life of each shareholder in an amount sufficient to pay for the shares of a shareholder who dies.

Although many business owners do not like paying up front for a benefit that may be years away, insurance policies are cheaper than either saving or borrowing money. (You’d have to save much more money than the amount of your insurance premiums to achieve the same payout an insurance policy will give you, and this money wouldn’t be available to help you expand your business.) An insurance policy also guarantees that cash will be available to purchase the shares of a shareholder who dies unexpectedly.

Check the box to the left of the paragraph heading if you wish to require the corporation to buy a deceased shareholder’s shares. In addition, you must either choose to have the corporation’s accountant value the shareholder’s shares by checking the first box, or enter a different valuation method by checking the second box. If you check the first box, your accountant will conduct an appraisal of the business, which will take into account the value of the business’s assets, its yearly revenues and profits, and intangibles such as goodwill. However, it is often difficult for an accountant to subjectively but fairly value a private company’s shares because the shares are not traded on a public exchange. Moreover, unless an accountant has expertise in valuing businesses in a particular industry, he or she may not be able to provide an accurate assessment of the business’s value.

You may want to enter your own valuation method, which can be less expensive than an appraisal. There are several methods of valuing your company’s shares that use your company’s financial statements from one or more years. These include the "book value," the "multiple of book value," and the "capitalization of earnings" methods. These methods are explained in more detail in Business Buyout Agreements: A Step-by-Step Guide for Co- Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo). Depending on your business, one of these methods may be more appropriate than an appraisal.

If you choose to enter your own valuation method, check the second box and describe the method in detail. Here are some examples of how to describe various valuation methods:

Sample: Agreeing on a fixed price in advance
The agreed value of the company shall be $500,000, or such amount specified in a written statement signed by each Shareholder of the company after the signing of this agreement. The value of the deceased Shareholder’s shares shall be the entire value for the company, multiplied by the Shareholder’s percentage of ownership.

Sample: Book Value
The value of the company shall be its book value (its assets minus its liabilities as shown on the balance sheet of the company as of the end of the most recent fiscal year prior to the Shareholder’s death). The value of the deceased Shareholder’s shares shall be the entire value for the company, multiplied by the Shareholder’s percentage of ownership.

Sample: Multiple of Book Value
The value of the company shall be two times its book value (its assets minus its liabilities as shown on the balance sheet of the company as of the end of the most recent fiscal year prior to the Shareholder’s death). The value of the deceased Shareholder’s shares shall be the entire value for the company, multiplied by the Shareholder’s percentage of ownership.

Sample: Capitalization of Earnings
The value of the company shall be determined on the basis of three times the average net earnings (annual gross revenues of the company minus annual expenses and any annual federal, state, and local income taxes payable by the company) for the three fiscal years prior to the Shareholder’s death. The value of the deceased Shareholder’s shares shall be the entire value for the company, multiplied by the Shareholder’s percentage of ownership.

If you’re not sure which method you want to use, you may want to consult your legal and accounting advisers and talk with other business owners in your field about how they would go about valuing their business.

While a mandatory buyout provision is common in small business stock agreements, it often results in the owner who remains alive the longest ending up with the whole business. This may be a reasonable outcome because the last owner to die will have managed or worked for the company for the longest amount of time. Nevertheless, since it forces a shareholder’s estate to sell the shareholder’s shares, it can work against the shareholder’s survivors in some circumstances. You might want to explore more flexible buyout options for your stock agreement than we can provide here. For more information, see Business Buyout Agreements: A Step-by-Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo).

See An Expert: Jointly owned shares need further attention. This book assumes the usual situation in which a stockholder owns shares in his or her own name only, meaning that the shares will become part of the shareholder’s estate when the shareholder dies. Rarely in a small incorporated business will a shareholder own shares jointly with his or her spouse. If this does occur, the shares of the first spouse to die will belong to the surviving spouse rather than the estate of the spouse who has died. This paragraph won’t work for jointly owned shares unless it’s substantially modified—a task that will probably require a lawyer’s assistance.

Standard Clauses

The remainder of the agreement contains the standard clauses we discussed in Chapter 1. The only thing you’ll need to fill in here is the name of the state whose law will apply to the contract in the paragraph called "Governing Law."

Signatures

All shareholders must sign their names and fill in their respective names and addresses. In addition, even though all shareholders sign the document (as individuals), a representative of the corporation must also sign the agreement on the corporation’s behalf to bind the corporation to the terms of the agreement.

A corporate officer, probably the president or chief executive officer, should sign the agreement on the corporation’s behalf. However, your corporate bylaws may specify that more than one officer must sign contracts in order to bind the corporation. In that case, you’ll need two officers to sign the agreement.

Resource: Do you need a more detailed agreement? This stock agreement provides a limited number of ways to control the ownership of your company. It establishes fixed rules that govern the sale of corporate stock and it allows you to indicate whether the corporation will repurchase the shares of a shareholder who dies. However, you may want your agreement to cover other matters. For instance, you may want it to establish terms for buying out the interest of a retiring shareholder. You may also want to include more complex valuation formulas and payment plans in your agreement. For a stock agreement form that offers more alternatives, see Business Buyout Agreements: A Step-by-Step Guide for Co- Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo).

Form 2F: LLC Operating Agreement for Single-Member LLC

The operating agreement for an LLC (limited liability company) is similar to the bylaws of a corporation. The agreement defines the internal rules that govern the company’s day-to-day operations.

Even though you will be the sole owner ("member") of your LLC, it is important to create an operating agreement to separate your LLC from you as an individual. Without the formality of an agreement, the LLC would look a lot like a sole proprietorship (which does not limit your personal liability for business debts). Creating a formal operating agreement helps reduce the chances that courts will refuse to recognize your LLC and hold you personally liable for the debts of your business. Just the existence of a formal written operating agreement, even a simple one, will lend credibility to your LLC’s separate status.

As you’ll see from reading the operating agreement, maintaining an LLC can be simpler and requires less paperwork than running a corporation. And the LLC allows wide latitude in how you structure its management. For example, it can be run by one member, by a member who is selected as a manager, or by an outside manager. Also, an LLC is taxed like a partnership. The business itself pays no federal income tax. Instead, the profits and losses pass through to the members (owners) who report their share on their individual tax returns. Most small business owners prefer this arrangement. You can, however, elect to have your LLC taxed as a corporation. In that case, the business itself would be taxed. To do so, you file IRS Form 8832, Entity Classification Election. Your tax advisor can give you further guidance on this issue.

In every state, you can form an LLC with only one member. Typically, to set up an LLC you must prepare just two basic legal documents: the articles of organization, which is a public document you file with the state, and the operating agreement, which is the internal agreement that defines your rights and responsibilities. While most states use the term "articles of organization" to refer to the basic document that creates an LLC , some states (including Delaware, Mississippi, New Hampshire, New Jersey, and Washington) use the term "certificate of formation" and two other states (Massachusetts and Pennsylvania) call the document a "certificate of organization."

In most states, preparing your articles of organization is surprisingly simple, especially if your LLC is a typical small business consisting of a handful of owners. Most states provide a printed form for the articles of organization—just fill in the blanks, sign the form, and file it with the LLC filing office. For step-by-step instructions on preparing articles of organization and other organizational documents for your LLC , consult Form Your Own Limited Liability Company and LLC Maker, an interactive Windows software program that provides forms and information for setting up an LLC in all 50 states, both by Anthony Mancuso (Nolo). Both of these products can also help you create a multimember operating agreement.

Instructions for Form 2F: LLC Operating Agreement for Single-Member LLC

All the forms in this book are provided as tear-outs in Appendix B and on the accompanying forms CD-RO M. As you read the instructions for Form 2F, you may want to either tear out the form or open the form’s file on the CD-RO M so you can follow along. (For more information on using the forms CD-RO M, see Appendix A, "How to Use the CD-RO M.") Before you use the tear-out form, be sure to photocopy the agreement so you’ll have a clean copy to use later.

1. Names

One of the first things you need to do is settle on a name for your LLC . There are two basic ways to choose your name:

• you can combine your own last names, such as "Johnson, Holmes, & Sanchez" and add LLC at the end, or
• you can make up the name under which you’ll do business, such as "Three Guys Contractors, LLC ."

Before settling on a business name, it’s wise to conduct a name search to avoid a possible conflict with a business that is already using the same name or a similar one. Typically, if your LLC is a small local business, you can feel reasonably secure if you’ve searched for name conflicts at the state and local level. Check the records of the state, county, or local offices where assumed or fictitious business names are filed and the state office where corporations and LLC s are registered. Also check the phone books and city directories covering your area.

If you plan to do business regionally or nationally and will use your business name to identify a product or service, you should consider doing a national trademark search and look into registering your trademark or service mark at both the federal and state levels. For more in-depth information on trademark searches and registration, see Trademark: Legal Care for Your Business & Product Name, by Stephen Elias (Nolo).

Your LLC name will have to include an LLC designator such as "Limited Liability Company," "Limited Company," or "LLC " in the name. Depending on the state in which your business is located, one or more of the following names may be appropriate ways to indicate that your business is an LLC:

Samples:

• Andover Services Limited Liability Company
• Andover Services L.L.C.
• Andover Services LLC
• Andover Services Limited Liability Co.
• Andover Services Ltd. Liability Co.
• Andover Services Limited Company
• Andover Services Ltd. Co.
• Andover Services L.C.
• Andover Services LC.

Insert the name of the LLC in the first blank. Insert the state in the second blank. Insert your name in the third blank.

2. Formation

Each state has its own law covering the creation and operation of a limited liability company. Insert the name of the state in which your LLC is being formed, which will almost always be the state in which you live. Your articles of organization will describe the purpose of your LLC ; you needn’t repeat it here.

3. Offices

Your state law typically will require you to give an address for your registered office—the place where lawsuits and legal notices can be delivered. This usually will be your normal place of business or your home. Insert the address here.

Your state law will also require you to designate a resident agent—the person to whom legal notices can be delivered. Since you are the sole owner of the company, the form assumes that you’ll be the resident agent of your LLC .

4. Management

You will be the sole manager of your LLC . But it’s wise to name a trusted person to watch over your business if you die or become incapacitated and are unable to make business decisions yourself. If you wish to do so, check the box to include the optional paragraph and then insert the name of a trusted friend, relative, or business colleague.

Caution: Do you have a durable power of attorney for finances? Many people make durable powers of attorney for finances—the legal document that names someone to handle your finances if you become incapacitated and unable to handle your own affairs. A durable power of attorney sometimes covers business decisions along with other financial matters. If you have a durable power of attorney for finances, be certain that the power of attorney and your LLC operating agreement work together. If your power of attorney includes authority to make business decisions, you will probably want to name the same person to take care of your LLC that you named in the power of attorney.

5. Capital Contributions

To establish a legitimate ownership interest in your LLC , you must contribute something to the business. It’s best to start with just a token amount, such as $5,000. You can always lend additional funds to the business later, if the need arises. You should open an LLC bank account and put the start-up contribution into that account, along with any other funds you’re lending to the LLC.

However, make sure you put enough money and/or property into your LLC to cover foreseeable short-term debts. If you don’t put very much money in your LLC and you run up a lot of debts, a court might decide your LLC is a sham to prevent creditors from reaching your personal assets and take away your limited personal liability.

You can contribute cash, property, or both. If you’re contributing cash, check the first box and enter the amount. If you’re going to contribute property—such as a computer or real estate— check the second box and describe the property.

Sample:
Sony Vaio computer with monitor and printer HP fax machine

Tip: You’ll need additional paperwork to transfer property to your LLC. You should use a bill of sale to document the transfer of personal property, such as a computer, to your LLC. You can use Form 8C: Bill of Sale for Goods for this purpose. If you are transferring real estate to the LLC, you need to use a deed to document the transfer. To formalize the transfer you must file the deed in the county in which the property is located. Because preparing and filing deeds can be complicated, we recommend getting a lawyer’s help.

6. Taxes

Normally, you’ll want your single-member LLC to be taxed as a sole proprietorship. This means the profits and losses will pass through to you and you’ll report them on Schedule C as part of your annual Form 1040. The LLC will not pay any federal income tax. If you and your tax advisor agree that this is best for you, then check the first box.

An alternative is to have your LLC be taxed as a corporation, in which case the LLC will be taxed on its income and you will be taxed on any distributions you receive from the LLC . If your company is profitable, and if you’re going to hold some profits in reserve for future use by the LLC , this option may reduce your taxes by allowing you to split the LLC ’s income between the LLC and yourself. If you and your tax advisor conclude that this is the better way to go, then check the second box.

Tip: If you choose corporate taxation, you need to file a special IRS form right after you start your LLC. File IRS Form 8832, Entity Classification Election.

7. Funds

Nothing needs to be filled in here. This paragraph simply authorizes you to decide where you’ll deposit LLC funds and provides who can sign checks. You do not have to list any authorized individuals in your operating agreement.

8. Additional Members

Nothing needs to be filled in here. This paragraph allows you to bring in additional members in the future. If you do admit members in the future, you’ll need to amend your operating agreement, and possibly your articles of organization, to reflect the new situation.

9. Distributions

Nothing needs to filled in here. You’ll be the sole judge of when to distribute cash and other LLC assets.

Signature

Date the agreement. Then sign the agreement on behalf of the LLC . For more on signatures, see Chapter 1.

Tip: Document major LLC events. Although most state laws don’t require limited liability companies to keep the same kinds of detailed records as a corporation, it’s often a good idea to get the members’ written consent to certain events anyway. It’s wise to document major events, such as taking out a large loan, selling LLC property, or acknowledging the contribution of property from a member to the LLC. For a comprehensive guide to running a limited liability company and documenting these decisions, see Your Limited Liability Company: An Operating Manual, by Anthony Mancuso (Nolo).