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Module 3: Business Law Basics

Module 3: Business Law Basics. Part 1: Different Business Entities. Types of Legal Entities. Sole proprietorship- 1 person in business to make money; unlimited authority; does not survive death; Associations- 2 or more people in business to make money

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Module 3: Business Law Basics

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  1. Module 3: Business Law Basics Part 1: Different Business Entities

  2. Types of Legal Entities • Sole proprietorship- 1 person in business to make money; unlimited authority; does not survive death; • Associations- 2 or more people in business to make money • Partnership- General & Limited, Limited Liability • Limited Liability Company-hybrid corp/pship • Manager or member managed • Corporations- Requires intent, formality and agreement • Closely-held---small bus., family, few people; • public--min. # of people, $ assets • Professional corporation-licensed professionals

  3. Critical Factors • Limited Liability • Management • Tax-free conversion • Eligibility • Transferability of Interest • Dissolution • Taxation

  4. Module 3: Business Basics Part 2: Understanding the Deal

  5. Financing a Business 1. Debt vs. equity- Reflects the characterization of the contribution of an investor. Affects priority in getting return, i.e. debt-repaid before return contribution or distribute profits but limited to amount owed plus interest; or equity-return on contribution plus a pro rata share of profits. 2. Retaining control vs. maximizing return via Preferences (priority in distribution), and Preemptive- right of first refusal. Preferences give the investor priority in distribution or first in line, e.g preferred shares. Preemptions allow the investor to restrict rights of other and protect against dilution. E.g. right of first refusal. 3. Leverage- use of other people’s money to purchase or invest. Cost of borrowing must be lower than interest earned in investing. 4. Marginal (tax rate from chart) vs. Effective tax (actual rate applied)

  6. Contribution of Capital • Partnerships: Any or no consideration is required • LLC: Owners can contribute $, property, services rendered or binding obligation to contribute these so future services with a contract is OK. • Closely corporation: Capital for a corp can be $, property, past services, debt securities. In Calif. no future services or promissory notes. There must be some consideration. Calif Corp. 409(a) • -Under MBCA 6.21(b) allows bd to authorize shares for cash, promissory note, services performed, contracts for future services. -Bd. Assigns reasonable value to the noncash contribution.

  7. Characterization of Contribution • Co. has interests different from individual owners: -Company usu. prefers more capital and less debt no obligation to repay so don’t spend your money on debt service; easier to leverage ‘cause it is not encumbered; better financial condition for lenders. • Individual owners: -Based upon risk tolerance, need to get money back, tax treatment, so may want more debt than capital ‘cause greater assurance for repayment, but low upside.

  8. Module 3: Business Basics Part 3: Tax Planning

  9. Tax Terms-Basis 1) Basis: The cost or purchase price of an asset. Example: If Harry buys a car for $20,000, the basis in the car is $20,000. 2) Adjusted basis: Basis + improvements - deductions from depreciation of certain improvements. Example: If Harry buys a house for $100,000 and puts an additional $25,000 in improvements and upgrades to the house, then the adjusted basis equals $125,000. Some upgrades, such as a furnace or boiler is amortized or depreciated over a period of time, meaning that a portion of the cost is deducted over the useful life of the building. 3) Stepped-up basis: Equals the fair market value of property at the death of a person that becomes the basis of the beneficiary. This means when someone dies and the beneficiaries receive property as part of a bequest, the basis in the property for tax purposes will be the current value of the property, not the original purchase price to the decedent. Example: Harry buys some stock in 1980 for $10,000 and holds it until his death and bequeaths the stock to Joe. The current value of the stock is $50,000. At the time of Harry's death, Joe's stepped up basis in the stock is $50,000.

  10. Profits & Losses 4) Amount realized, Gain or Profit: The cash received-adjusted basis upon sale or disposition of property; otherwise considered what is taxable as gain or profit. Example: In our previous example, if Harry has an adjusted basis in a house for $125,000 and later sells it for $200,000, then the amount realized from the transaction is $75,000, or the difference between the adjusted basis and the sale price. 5) Loss: The amount lost if the sale price of property is less than the purchase price or adjusted basis. Losses are sometimes deductible, or can offset similar types of gains. Example: In our previous example, if Harry has an adjusted basis in a house for $125,000 and later sells it for $75,000, then Harry will recognize a loss of $50,000 or the difference between the adjusted basis and the sale price.

  11. Treatment of Assets/Income 6) Capital asset: An asset held for use in a business for more than 1 year, depending upon income, the maximum tax is 15%. Example: Harry buys some equipment and holds it for 1 year. He actively uses the equipment in his business. If he sells it after 1 year, it will be considered a capital asset. 7) Passive income: Income earned from investments that are held for more than 1 year. Taxed at a maximum rate of 15%. Does not apply to income earned from an asset or activity in which the taxpayer is actively engaged in the business. Example: Harry owns some stock worth $10,000 in a company in which he is not actively engaged. If he holds the stock for more than 1 year and then sells it for $15,000, the gain from the sale of the stock, or $15,000 will be taxed at a maximum rate of 15%.

  12. Tax Treatment 8) Passive Loss: Income lost from investments that are held for more than 1 year. You can offset passive income from passive losses to determine net passive income. Example: Harry owns some stock worth $10,000 in a company in which he is not actively engaged. If he holds the stock for more than 1 year and then sells it for $7,500, the loss can be offset against other passive income he has realized. 9) Capital gains: Gain realized from profits earned from disposition of passive income. Passive income can be offset from passive losses. The current capital gains rate is a maximum rate of 15%. Example: Harry owns some stock worth $10,000 in a company in which he is not actively engaged. If he holds the stock for more than 1 year and then sells it for $15,000, the gain from the sale of the stock, or $15,000 will be taxed at a maximum rate of 15%. 10) Short term gain: Income earned from investments held or activity engaged in for less than 1 year. Taxed as ordinary income. Example: Harry earns $50,000 in profit from a business in which he is actively engaged. This is taxable income and will be taxed under the applicable tax rate.

  13. Tax Plan Questions 1) Goal: What is the tax liability to the individual? What is the tax liability of company? Must compute separately by running the numbers to determine projected. 2) Objective: What are all sources of income? What are deductible expenses and how will they be deductible, e.g. ordinary or capitalized over term? Any carry forward of deductions? 3) Result: At what rate will the investor be taxed? Marginal (schedule rate on income) vs effective rate (based upon computation of actual tax). 4) Impact: How should contribution of capital be characterized? Equity vs. Debt What is the optimal return on capital and how should it be characterized? Tax interest as ordinary income vs dividends taxed as capital gain.

  14. Taxation Rules • Individual taxation: Taxed on income less allowable deductions; Based upon Marginal rate or formula (See chart) • Partnership taxation: Partners taxed on pro rata share of earnings (profits); Partnership does not pay separate tax; Allocate according to Partnership agreement re percent of interest; not what actually distributed; • Corporation: Taxed as entity and then salary and distributions taxed to individual. Since individual is a shareholder and employee, same pot of money is taxed twice, although the corporation can take a deduction as a expense for the salary.

  15. For Each of the Following: • Who will likely drive the terms of the deal? • Who would be most interested in long term goals of the company? • What type of entity should be created?

  16. Module 3 Problems

  17. What type of entity should be created? 1) Prescription Drug Is a manufacturer of PMS and menopause-related treatment. The industry is subject to heavy government regulation by the FDA, including extensive trial tests, documentation and consumer information, and strict liability for negligence in handling or dispensing the drug. Company has 4 departments and a heavy investment in research and development. Investors include individual chemists and scientists who are leading experts in this field of research, university and institutional investors pharmaceutical companies. 2) Group of 5 lawyers who have a varied corporate law practice in related and complementary fields. They propose to divide profits and losses in accordance with valuations assigned to client lists, cash investments. Their practice requires that they issue opinion letters on the feasibility of deals. They will have 4 associates on an independent contract basis based upon billable hours and an hourly rate of $75.00, and 2 salaried secretaries and 1 office manager. .

  18. What type of entity should be created? 3) A group of four college roommates decide to develop three lots: one for commercial and two residential multi-family dwellings. Only two of the four roommates have any experience in real estate development, one as a marketing agent and the other working for an engineering firm. The other two have experience in banking, and retail sales and $10,000 each. They do not have enough money to develop all of the lots at the same time, so they will develop and finance them in stages. They propose to sell units to up to 90 passive investors total (30 investors per lot) who are looking to take the initial losses and profits from the business. Some investors want to invest in the commercial, but not the residential development. They are looking for an income stream. Banks will require personal guarantees of all of the roommates. Some of the investors may be foreign aliens. As part of closing, title insurance will be obtained and they intend to use bonded contractors.

  19. What allocation of interest? • What is the level of risk for A and B in each of the following hypotheticals, assuming A is contributing $100,000, no additional contributions, veto power, no salary; and B is contributing $10,000 plus sweat equity, salary of $5000/mo., no cash contribution, interest for cash, past and future services.

  20. Risk and Interest? • a). ALT 1: A is a retired military who is a widower. His contribution is his nest egg. He relies on social security and disability payments, owns 2 apartment buildings. He is 60 years of age and in fair health.

  21. AssumptionsA is contributing $100,000, no additional contributions, veto power, no salaryB is contributing $10,000 plus sweat equity, salary of $5000/mo., no cash contribution, interest for cash, past and future services. Question:  A is a retired military who is a widower. His contribution is his nest egg. He relies on social security and disability payments, owns 2 apartment buildings. He is 60 years of age and in fair health. Answer: • Level of risk- • Low-moderate • Fixed income; no money to “play with” • Age: old, less time to wait around for profits • Proportion of debt and equity- • More debt than equity? • Debt has less risk, greater assurance of repayment • A will want to make a conservative investment • A is retired, probably does not want involvement in business operations

  22. Risk and Interest? b) ALT 2: A is a real estate attorney, with a profitable practice from which he receives a salary of $120,000. He has other investments that bring in $10,000 a year, is 32 years of age, and is looking to retire by the time he is 40 years of age.

  23. Assumptions: A is contributing $100,000, no additional contributions, veto power, no salaryB is contributing $10,000 plus sweat equity, salary of $5000/mo., no cash contribution, interest for cash, past and future services. Question: A is a real estate attorney, with a profitable practice from which he receives a salary of $120,000. He has other investments that bring in $10,000 a year, is 32 years of age, and is looking to retire by the time he is 40 years of age. Answer: • Level of risk- • High • Income is NOT fixed; financially secure (can afford to risk the money) • Age: middle aged, has time to wait for profits • Proportion of debt and equity • More equity than debt? • Equity has a greater risk, but potential to make much more money • B is an aggressive investor who wants to retire early, wants a greater return on investment • Stock is freely transferable w/ market interest

  24. Risk and Interest? c) ALT 3: B is a recent college graduate with $60,000 in school loans. He is single and wants to use the business to create a chain and eventually franchise the store. He receives $2,000/month from a trust.

  25. Assumptions:A is contributing $100,000, no additional contributions, veto power, no salary.B is contributing $10,000 plus sweat equity, salary of $5000/mo., no cash contribution, interest for cash, past and future services. Question: B is a recent college graduate with $60,000 in school loans. He is single and wants to use the business to create a chain and eventually franchise the store.  He receives $2,000/month from a trust. Answer: • Level of risk- • Medium- High • Low income, but wants to grow big via franchise • Age: young and energy to work hard • Proportion of debt and equity • Equal proportion of debt and equity • B wants to participate in the operation and control of the company, but is not in the position to take a great financial risk

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