The limited liability company permits flexibility for special allocations and distributions of cash and other assets to the owners in a manner similar to that of a limited partnership.

Do you need a formal operating agreement to form a LLC?

While a formal document, called the Articles of Organization, must be filed with the Colorado Secretary of State to form a limited liability company, the internal operations of the limited liability company are generally governed by an operating agreement. An operating agreement can be a verbal agreement or a written agreement, but just like a partnership agreement, a written agreement is always advisable. An operating agreement can also specify how new owners will be admitted to the company. For example, although an existing member can transfer his or her interest in the profits of the company to a new person, the new person is generally not admitted to the company as a full member unless the remaining members vote to admit the new person. If the new person is not admitted to the company as a member, the new person has no right to participate in the management of the business and affairs of the limited liability company.

How do you form and maintain a LLC?

A limited liability company is formed by filing Articles of Organization with the Secretary of State. If the Articles of Organization are filed in a paper format, the filing fee is $50.00. If the Articles of Organization are filed electronically, the filing fee is currently $0.99.

A limited liability company must file an annual report with the Colorado Secretary of State in order to remain in good standing and to retain its authority to engage in business in the state. The annual report consists of the name and street address of the company’s registered agent, the address of the company’s principal office, and the name and address of the individual completing the report. The report is due on or before the last day of the month during which the company filed its Articles of Organization (the anniversary month) each year, and the filing fee for a report submitted on paper is $25.00. A limited liability company may file its annual report electronically beginning two months prior to its anniversary month, and the fee for electronic filing is currently only $0.99.

What are the rights and responsibilities of an LLC’s owners?

The owners of a limited liability company are called members. Members have certain voting rights that are provided by the Colorado statutes, and these generally include the right to vote on the managers of the company, the right to approve transfers of ownership interests by the other members, and the right to vote whether to continue the company’s existence upon the withdrawal of a member. A member of a limited liability company may resign at any time by giving written notice to the other members, unless resignation is prohibited in the Operating Agreement. If the member violates the Operating Agreement by resigning, the limited liability company may recover damages from the resigning member for breach of the Operating Agreement, and may offset the damages against amounts otherwise distributable to the member.

Who is responsible for running an LLC?

A limited liability company is managed by one or more managers. A manager can be a natural person or another entity. The manager can be an owner or can be a non-member. The owners elect the managers each year. The managers have complete authority to act for the limited liability company unless their authority is limited in the Articles of Organization or in the operating agreement. A limited liability company may also appoint officers and other agents that have the authority given to them by the owners. Therefore, a limited liability company may have both a “manager” and a “president.”

How do members contribute to an LLC? Are members liable for company debts?

The members of a limited liability company may contribute cash, property, services rendered, or a promissory note or other binding obligation to contribute cash or property or to perform services. The members and managers of a limited liability company are not personally liable for the debts or obligations of the company. However, a member of a limited liability company is personally liable to the company to perform any enforceable promise to contribute cash or property or to perform services for the limited liability company, unless the obligation to make such contributions is waived by consent of all of the members or unless the Operating Agreement provides otherwise. If the members waive the obligation to make additional contributions, the member’s obligation may be enforced by a creditor who has extended credit to the limited liability company in reliance on the member’s obligation to make the contribution. A member is also liable to restore distributions made to that member while the limited liability company’s liabilities exceeded its assets, and this liability extends for six years after a prohibited distribution is made.

How is an LLC taxed?

A limited liability company may elect to be taxed as a partnership or as a corporation.

How is an LLC dissolved?

A limited liability company may be dissolved as a result of the passage of a stated amount of time or the happening of a stated event specified in the Articles of Organization or in the Operating Agreement. The owners of the company may agree to dissolve the company at any time. The business of a limited liability company may be continued under the provisions for continuation of business stated in the Operating Agreement.

An “earn-out” provision is a method of measuring part of the purchase price for a business based on its financial performance after the closing date. Earn-out provisions are common where the seller continues to be involved in the business after closing, and they provide an efficient way for the seller and the buyer to share post-closing operating risk by aligning the seller and the buyer’s post-closing incentive for the business to continue to succeed.

Earn-out provisions also give the seller an incentive to provide the buyer with all available information, both good and bad, about upcoming events. Earn-out provisions also encourage the seller to help with the transition of the business to the buyer, especially the transition of customer relationships. Finally, earn-out provisions discourage the seller from “puffing up” the business’ past financial performance, since the earn-out will usually be tied to the performance measures that the seller provides.

Since earn-out provisions are usually are based on projected revenue or profits, the seller and the buyer, and especially their attorneys, should be careful to clearly define the revenue and expense accounts that will be counted toward the earn-out benchmarks. Not only will the revenue and expense accounts require attention, but the timing of when revenue is earned and when expenses are deducted must also be addressed. These definitions and procedures can become even more difficult if the buyer intends to operate the business that it is buying as a part of a larger enterprise.

Since an earn-out will mean that a buyer will pay more for a business if it performs well, a seller may blame the buyer for running the business poorly if the earn-out targets are not met. A seller may also say that the buyer didn’t invest enough time or money in the business for the business to meet its potential. To avoid this problem, the earn-out agreement should address whether the buyer is obligated to operate and support the business in a manner consistent with its history or at a certain level.

What are “Caps” and “Baskets”?

“Caps” and “baskets” describe concepts that are used to simplify the administration of the liability and indemnification sections in a purchase agreement after the sale has closed and the buyer is operating the business. “Baskets” are designed to have the parties avoid petty squabbles over minor disputes after the closing. A “basket” agreement will usually say, for example, that a buyer cannot sue the seller for damages for a breach of any term, warranty, or representation in the sales agreement until the total damages exceeds a minimum threshold such as 1 percent of the purchase price.

A “cap” limits the amount that the buyer can seek to recover from the seller for a breach of the terms, warranties, or representations of the sales agreement, such as 10 to 25 percent of the purchase price. A cap helps the seller limit the uncertainty about whether they will have to refund the purchase price. A cap also encourages the buyer to perform thorough due diligence because the buyer will not be entitled to a full refund if the business fails to meet expectations, unless the seller committed fraud.

Who is Giving the Indemnification?

If the seller is a corporation that will distribute the sales price from selling its business assets to its stockholders, the corporation may have few assets left after the sale for the buyer to go after if the business assets fail to perform as expected. If the buyer’s only indemnification rights are against the selling corporation, the buyer may be chasing a bankrupt entity.

If the buyer is purchasing stock from numerous individual stockholders and the purchase agreement provides that the individual stockholders will be severally liable instead of jointly liable for indemnification obligations, the buyer may find itself chasing many individuals who have already spent the money they received from the sale.

When an individual stockholder is wealthy enough to reassure the buyer of its ability to indemnify the buyer, the purchase agreement may provide that the buyer can sue the wealthy stockholder individually for all breaches of representations and warranties. In this case, the wealthy stockholder may enter into a side agreement with the other stockholders whereby they each agree to remain liable to reimburse the wealthy stockholder for their individual share of any indemnification obligation.

Under Colorado law, a merger is generally treated like a sale of stock. In the merger the buyer, called an “acquirer,” assumes all of the corporation’s assets and liabilities by operation of law and without the need for any other agreement or transaction. Under Colorado law, mergers generally take one of the following forms, and the form chosen will always depend on the business, tax, and practical reasons for the merger:

• Forward Merger: The Seller merges into the Acquirer, with the Acquirer surviving the merger.
• Forward Triangular Merger: The Seller merges into a wholly-owned subsidiary of the Acquirer, with the subsidiary of the Acquirer surviving the merger.
• Reverse Triangular Merger: A subsidiary formed by the Acquirer for the sole purpose of effecting the merger merges into the Seller, with the Seller surviving as a wholly-owned subsidiary of the Acquirer.

Documentation And Filing Requirements

To make a merger effective under Colorado law, the acquirer must file a Statement of Merger with the Colorado Secretary of State. The statutes that govern the filing of the Statement of Merger set forth certain information that must be set forth in the Statement, and the statute restricts the other information that may be included in the Statement of Merger. Each of the entities that are parties to the merger must comply with the statutes organizing documents and agreements under which it was formed and operates. For example, if a party to the merger is a corporation the corporation’s board of directors will adopt a plan of merger that will be approved by the corporation’s stockholders. The approval and adoption of the plan of merger may be accomplished after notice to the directors and stockholders of the meetings and of the votes to be held, all as provided in the statutes and organizing documents and agreements that govern the operation of the corporation.

Dissenters’ Rights in Mergers

If a corporation’s stockholders vote against a plan of merger and comply with the procedures set forth in the Colorado law, they may receive either: (1) cash equal to the fair value of their shares immediately before the effective date of the merger; and (2) interest accruing from the effective date of the merger, all in lieu of the consideration set forth in the plan of merger. If the stockholder believes that the fair value of the shares determined by the corporation is too low, the stockholder may demand that the corporation pay the stockholder the amount that the stockholder estimates to be the fair value of the shares. The corporation must then either file a lawsuit to have a court determine the fair value of the shares or pay the amount demanded by the stockholder.

Legal Effects of Mergers

After a merger, all of the assets and liabilities of the merged corporations become vested in the surviving corporation by operation of law. This transfer of assets and liabilities is not an assignment, and therefore does not require the consent by third parties.

Short Form Parent-Subsidiary Mergers

If one corporation owns at least 90 percent of each class of the stock of another corporation, a simplified form of merger allows the owner, the parent, to merge with the corporation whose stock it owns, the subsidiary. No votes of the subsidiary’s stockholders is required. No action is required of the subsidiary’s board of directors. The parent simply mails a written summary of the plan of merger to all stockholders at least ten days before the effective date of the merger. If the parent is the surviving corporation and the plan of merger does not change the parent’s articles of incorporation, the parent’s stockholders will not change and their stockholdings will not change, and if the parent will not issue more than twenty percent of its outstanding shares in connection with the merger, no vote of the parent’s shareholders is required.

When a company sells its assets, the seller typically enters into an asset purchase and sales agreement with a buyer. The typical asset purchase agreement contains representations, warranties, covenants, and indemnifications. Like most legal documents, there is no “one-size-fits-all” form asset purchase agreement.

At a minimum, the written asset purchase agreement should identify the specific assets that are being sold, the amount and form of consideration to be paid, and the time when the assets and the consideration are to be exchanged. The asset purchase agreement should also address how the seller and the buyer intend to pay the liabilities, debts, and obligations associated with the assets being transferred.

Successor Liability in Asset Sales

In general, when a person or company buys the assets of a business, the purchaser is not liable for the pre-existing debts and liabilities of the seller. However, the buyer may be liable for the seller’s debts if any of the following circumstances exist: (1) the buyer expressly or impliedly assumes the seller’s liabilities; (2) the buyer merges or consolidates with the seller; (3) the buyer is a “mere continuation” of the seller; (4) the buyer engages in fraud; (5) the buyer or the seller fail to warn the seller’s creditors; or (6) the seller or the buyer distribute products out of state. There are also specific statutes in tax, bankruptcy, or environmental laws that impose liability for the seller’s debts on the buyer unless specific steps are taken.

Express or Implied Assumption of Seller’s Liabilities

If the asset purchase agreement states that the buyer will assume or will be responsible for the seller’s debts, this is called an express assumption of liabilities.

If the agreement is ambiguous or is silent about the seller’s debts, or if there is no written asset purchase agreement, a court will look at the parties’ conduct to measure whether the buyer “impliedly” agreed to assume the seller’s debts. The court’s conclusion will depend on the buyer’s intent. No Colorado case has directly addressed this issue, but the courts in other states have relied on the following facts to determine the buyer’s intent: (1) discounted purchase price; (2) lack of consideration; (3) assumption of most of the seller’s debts by the buyer; and (4) the buyer’s payment of the insurance premiums for liabilities from the seller’s products that were made before the date of sale.

It is important for a buyer to clearly state in the asset purchase agreement that the seller will continue to be responsible for all of its liabilities, whether accrued, prospective, actual, or potential, unless the buyer specifically agrees to treat a specific debt differently. The agreement should list the seller’s debts and liabilities as precisely as possible and, for those liabilities that are undetermined (or undeterminable) at the time of sale, the agreement should provide clear guidance for allocating responsibility between the buyer and the seller.

Merger and Consolidation

An buyer may be held liable for a seller’s debts if a court concludes that the sale is a merger or consolidation between the parties. A court may conclude that a sale is a merger or consolidation even if the buyer and the seller believe that a sale really did take place. In order to avoid having a court treat a sale as a merger or as a consolidation, the buyer should deal with the seller in an arm’s length relationship, especially after the seller has transferred the assets to the buyer.

A buyer wishing to protect itself from being deemed to have merged or consolidated with the seller may wish to ask the seller to wait for a specified period of time after the sale before dissolving its business entity. The buyer should also avoid making insurance payments on or otherwise assuming existing contractual obligations with respect to the assets.

Buyer as “Mere Continuation” of Seller

The gravamen of the “mere continuation” theory imposing liability on the buyer for the seller’s debts is the continuation of the entity rather than continuation of the business operation. To avoid bearing the burden of the seller’s debts, the buyer should ensure that it and the seller maintain independent and separate corporate identities and existence before, during, and after the sale.

Fraud

A buyer will be liable for a seller’s debts if a court determines that the parties fraudulently arranged the sale so that the seller could escape its debts. To avoid even a hint that a sale was fraudulently arranged, the consideration given for the assets should bear a reasonable relationship to their fair market value.

Failure to Warn

In some situations, a buyer has a duty to warn consumers of the seller’s products about defects in the products that come to the attention of the buyer after the sale. In the case where the seller was a manufacturer, the buyer should include in the asset purchase agreement some appropriate representations, warranties, and indemnifications by the seller with regard to the quality of the products that the seller manufactured.

Distribution of Products Outside Colorado

In some states simply continuing the seller’s business, even though the buyer purchased only assets from the seller, is enough for the buyer to be held liable for the seller’s debts. In some states the buyer is liable for the seller’s debts if the buyer purchased the manufacturing assets of a “product line” and continues to produce the line. If the seller’s business involves manufacturing products, the buyer pay special attention to the states where the seller distributes the products.

Dissenters’ Rights in Asset Sales

Under Colorado law, shareholders who believe that they will not receive “fair value” for their shareholder interest in a sale of all or substantially all of a corporation’s assets may exercise dissenters’ rights. The substantive and procedural requirements for exercising these dissenters’ rights are essentially the same as those for minority shareholders exercising dissenters’ rights in a merger transaction.

The choice of the best type of entity for any particular business involves an analysis of many business and legal considerations. Among the most important factors are:

• the cost and formality of organization
• transferability of ownership interests
• expected life of the enterprise
• who will manage and control the enterprise
• the need to obtain capital and credit
• method of participation in profits
• vulnerability to liability, and
• the manner and extent to which the enterprise is taxed

For a small business, the available forms of business enterprise include the individual or sole proprietorship, the general partnership (including the limited liability partnership), the limited partnership (including the limited liability limited partnership), the limited liability company, and the business corporation. Each of these forms of business enterprise is adaptable to the small business venture.

What is a corporation?

A corporation is an artificial legal entity that must be created under the specific laws of a state or of the United States. A corporation may, with some exceptions, be owned by one or more people, by other legal entities, or by people and legal entities. Once created, a corporation is considered to have an existence separate and distinct from that of its owners or its employees. A corporation can buy, own, and sell property. In a legal sense, a corporation can do everything that a person can do.

What are shareholders?

The corporation’s owners are called shareholders. Their rights are set forth in the laws under which the corporation is formed and in a document called the Articles of Incorporation. While the shareholders own the corporation, they do not act for it unless they are also officers or employees of the corporation.

The ownership of a corporation is usually evidenced by stock certificates. Unless restricted in the corporation’s Articles of Incorporation, in the corporation’s Bylaws, or in a separate agreement such as a buy-sell agreement, a stockholder can sell or give away his or her stock without notice to or approval from the corporation or the other stockholders. A stockholder can also, without notice or prior approval, pledge his or her stock as security for a loan or other obligation. If the corporation or its stockholders wish to control the ownership or transfer of the corporation’s stock, this can easily be solved with a buy-sell agreement or with a stockholders’ agreement.

What are incorporators?

During start-up, the incorporators control the corporation. The incorporators elect and appoint the initial Board of Directors, who control the corporation during their initial term and are primarily responsible for all management decisions. The initial Board of Directors also oversees the issuance of the corporation’s stock to its initial shareholders. The statutes that govern corporations require the Board of Directors to consult the shareholders on major corporate changes. The corporation’s officers are appointed by the Board of Directors and perform the duties delegated to them by the Directors. The officers are responsible for the day-to-day operation of the corporation’s business.

How do I create a corporation?

The Colorado Secretary of State accepts and files the Articles of Incorporation for new corporations formed in Colorado. The fee for filing the Articles of Incorporation is $50.00. The Secretary of State will soon offer electronic filing for Articles of Incorporation, but as of August 31, 2004 Articles of Incorporation must be filed in paper format.

A corporation must file an annual report with the Colorado Secretary of State in order to remain in good standing and to retain its authority to engage in business in the state. The annual report consists of the name and street address of the corporation’s registered agent, the address of the corporation’s principal office, and the name and address of the individual completing the report. The report is due on or before the last day of the month during which the corporation filed its Articles of Incorporation (the anniversary month) each year, and the filing fee for a report submitted on paper is $25.00. A corporation may file its annual report electronically beginning two months prior to its anniversary month, and the fee for electronic filing is currently only $0.99.

How long can a corporation exist?

The corporation’s Articles of Incorporation can provide for perpetual existence. If this is the case, the corporation continues to exist even if the stockholders, directors, or officers and employees die, quit, or withdraw. If a stockholder dies, the corporation is not divided among stockholder’s heirs. The shares of stock are transferred to the deceased stockholder’s heirs and the corporation continues in existence as if the original stockholder were still alive. If the corporation or the stockholders wish to end the corporation’s life, the corporation may be dissolved by agreement of the stockholders.

Why should I consider incorporating my business?

Probably the most attractive feature of a corporation is the limit on the personal liability of the stockholders. A properly formed corporation that observes the statutory corporate formalities and is properly capitalized will shield all of its stockholders from personal responsibility for the corporation’s obligations. However, in some situations where a corporation is newly formed and has not established a credit and business record, a bank, lender, landlord, or vendor may require the main stockholders to personally guarantee the corporation’s debts.

How is a corporation taxed? How can I minimize taxes?

In general, a corporation must pay federal and state taxes in its own right, separate from the taxes that its shareholders, officers, directors, and employees pay.

Unless a corporation elects to be taxed as a “flow-thru” entity, the corporation’s income is taxed according to the corporate tax rates. The highest corporate rate currently in effect is 35%. The profits left after taxes are available to be distributed as dividends, which are subject to tax again on the stockholder’s personal income tax return.

This double taxation is recognized as a distinct disadvantage of the corporate form, as compared with other forms of business enterprise. Larger corporations with many shareholders simply accept the disadvantage, but in smaller, closely held corporations double taxation must be minimized. There are several ways to accomplish this, including:

1. Salaries. Whenever shareholders are officers or employees of a corporation, as is frequently the case in smaller organizations, they may be paid salaries that are deductible as a corporate expense. By taking salaries, the stockholder-officers are compensated in a manner other than through dividend distributions.
2. Loans. The small corporation may be structured so that a significant portion of its capital comes from loans to the business rather than from shareholder investments. Having established sufficient equity capital, the remaining funds needed for the business may be raised through interest-bearing loans. The interest is deductible to the corporation as an expense. Interest paid to the stockholder-lender is individual income to him, but it substitutes for dividends and is not subject to double taxation.
3. Subchapter S Election. The small business corporation may elect not to be taxed at the corporate level, but may have its income (whether distributed or not) passed through and taxed pro rata to its shareholders. This choice of taxation, called a “flow-thru entity, generally causes the corporation to be taxed as a sole proprietorship or a partnership. It also takes advantage of potential losses in the early stages of the business. All shareholders must consent to the election by signing a separate statement of consent, which is submitted with the application electing taxation under Subchapter S. The following requirements must also be met for a corporation to qualify for the Subchapter S election:
   • There may be no more than seventy-five (75) shareholders.
   • Shareholders must be natural persons, and cannot be another corporation or partnership, although estates and certain trusts may own shares.
   • The corporation has limitations on different classes of stock (they may vary only with respect to voting rights), and may not be a member of an affiliated group.
   • The corporation cannot have a non-resident alien as a shareholder.
   • The corporation’s foreign income and passive investment income may not exceed certain limitations.
4. Employee Benefit Plans. The corporate structure permits the corporation to offer certain benefit plans to its employees. Qualified stock option plans, qualified pension and profit-sharing plans, and life, health, and accident insurance plans are all available as corporate benefits.Qualified profit-sharing plans permit a corporate deduction for profits accumulated for employees under the plan, and the employees are not taxed until they receive payment. Qualified pension plans are treated similarly for tax purposes.Insurance plans may provide a direct economic benefit to employees, who may also be shareholders. The corporation may deduct the expense of paying insurance premiums as an ordinary business expense. Hospital, accident, health, and disability insurance plans may be maintained by the corporation with very few limitations. Group life insurance, with a maximum limitation of $50,000 per employee, may be maintained by the corporation with the premiums treated as an expense to the corporation but not taxable to the employee.

What other tax disadvantages exist?

There are certain tax disadvantages and pitfalls in utilizing a corporate form:

(1) If the character of the income of a partnership or a sole proprietorship is tax exempt, such income retains its tax-exempt status in the returns of the partners or the individual proprietor. However, if the corporation form is used, such income does not preserve its tax-exempt status when paid out in the form of salaries or dividends to the shareholders, although that income is exempted from the corporation’s taxable income. Similarly, a dividend traceable to the capital gain income of a corporation is, nevertheless, ordinary income to the shareholders (except in the case of a Subchapter S corporation).

(2) The liquidation of a corporation is normally a taxable event, unlike a similar situation in a partnership or a proprietorship. Moreover, a sale of stock or a liquidation at a loss may only give the shareholder a capital loss, whereas there is an ordinary loss upon the abandonment of a sole proprietorship or a partnership. The same is true if stock becomes worthless before it is sold. This disadvantage can be avoided in the small business by utilizing Section 1244 of the Internal Revenue Code.

(3) The Internal Revenue Code places a penalty tax on a corporation’s earnings accumulated beyond the reasonable needs of the corporation. This tax, called the accumulated earnings tax, is on earnings accumulated for the purpose of avoiding income taxes on the shareholders. The tax is aimed at forcing corporations to pay out taxable dividends. However, for the small corporation that is not a professional services corporation it may well not be a problem, as a surplus of $250,000 can be accumulated without incurring this tax.

(4) Salaries are only deductible by the corporation if they are reasonable in amount. Consequently, the excessive portion of a salary paid to a shareholder-employee will be disallowed as a deduction by the corporation, while the shareholder-employee will be taxed on the full amount received as either salary or dividend income.

(5) A corporation, in some circumstances, may be taxed as a personal holding company. Generally speaking, when a large portion of the income of a corporation is derived from passive or non-operating sources, such as dividends, interest, annuities, amounts received from personal service contracts, rents, and royalties, the corporation may be subject to a 50 percent tax on its undistributed income. Such corporations are not subject to the accumulated earnings tax. Speaking broadly, a corporation will be treated as a personal holding company if more than 50 percent of the value of its outstanding stock is owned by fewer than six individuals and if at least 60 percent of its ordinary gross income is from passive or non-operating sources. The provisions of the Internal Revenue Code and regulations must be examined carefully if the income of the business is likely to be of this passive nature.