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Business Law

Helping Businesses Get Started:
In Praise of an Unsung Legal Specialty

John M. Cunningham

Every year about one million new businesses are established in this country. Maybe a third of them are started with the help of a lawyer. The ease with which businesses can be formed and the frequency of their formation are among the distinguishing features of the American economy.

The ceaseless creation of new enterprises in America speaks volumes about American culture itself—about the high value we attach to individual enterprise and achievement, about our admiration and support for innovation and risk-taking, about our ability constantly to generate new ideas and our willingness to risk everything to realize them.

However, while entrepreneurs are accorded special stature in American business culture, business start-up lawyers generally are not. One searches in vain in the literature of business law for descriptions of the unique role and capabilities of these lawyers. Indeed, among entrepreneurs, among the nonlegal professionals who assist them, and, for that matter, even among business lawyers themselves, business start-up practice is rarely thought of as a distinct legal specialization. Rather, it is simply something lawyers do.

But, as a few minutes’ reflection will make clear, in order to handle business start-ups competently, business lawyers must master a clearly defined and extensive body of law and a wide range of skills.

Your friend Bill Jones is an engineer. Together with three colleagues, he’s developed new technology in his spare time. He and his colleagues are about to quit their current jobs to form a new company to exploit it. Bill gives you a call and says he’d like your help in starting the company. What areas of legal knowledge must you have mastered in order to give Bill the service he requires?

The list is long. First of all, Bill is unlikely to know in advance the business organization form he should adopt. Your initial task will be to advise him on choice of entity. In virtually all jurisdictions today, choice of entity normally requires consideration of three main business organization forms: sole proprietorships, business corporations, and limited liability companies (LLCs). Every choice among these forms involves three principal steps.

• First, you must determine which of the three relevant business organization forms is best for your client from a nontax viewpoint—meaning, normally, from the viewpoint of statutory and nonstatutory business organization law.

• Second, you must evaluate the impact that use of each of these forms will have on your client from the viewpoint of federal and state tax.

• Finally, if nontax factors favor one business organization form and tax factors another, you must decide which set of factors predominates.

In order to apply nontax choice-of-entity factors, you must have a thorough understanding of the common-law rules that make up sole proprietorship law. You must also have a detailed knowledge of all rules relevant to business start-up planning under your state’s business corporation and LLC statutes.

Moreover, possessing an adequate mastery of business corporation law means, in most cases, thoroughly understanding not only the corporate law you learned in law school but also the specialized body of law—generally called "close corporation law"—that governs nonpublic corporations. Close corporations comprise perhaps 97 percent of all American corporations and virtually 100 percent of business start-ups. Regrettably, in most law schools close corporation law is largely ignored. Thus, business lawyers must learn it largely on their own.

Finally, with regard to every significant business organization law issue, you must be able to compare the rules in these various areas of law systematically and comprehensively as they affect your client.

A quick illustration: In Bill’s business, will it matter that in Hawaii, Massachusetts, and Vermont (the three states in which LLCs are not yet recognized), the limited liability of Bill and his colleagues for claims against their business may not be recognized if they conduct their business as an LLC? If they’re merely selling software, perhaps not. If they’re selling aerospace equipment, whose malfunctioning could result in a catastrophic tort claim anywhere in the United States, probably yes.

In order to apply tax factors in choice of entity, you must have a systematic knowledge of your own state’s tax system and at least a general knowledge of tax rules in other relevant states. But the real challenge in making a tax-based choice of entity is the Internal Revenue Code.

A few years ago it was enough if, in making tax choices of entity, you brought to the task a systematic understanding of the general principles of federal taxation and of two specific code subchapters—namely, Subchapter S, which contains the rules for S corporations, and Subchapter C, which contains the rules for C corporations (and, except as otherwise provided in Subchapter S, for S corporations as well).

Today, however, with the advent of LLCs, the tax challenge for business lawyers is vastly more difficult. Properly organized LLCs are treated for federal income tax purposes as partnerships under code Subchapter K. The principal reason why businesspeople choose the LLC form is to obtain the unique benefits of this subchapter.

However, the guiding principles from which Subchapter K rules have evolved are very different than those of Subchapters C and S, and to a person familiar with only these latter subchapters, the Sub-chapter K rules may appear not only difficult but even bizarre.

But the tax challenge doesn’t even end there. Assume that by applying your knowledge of Subchapters C, S, and K, you decide that Bill Jones’s business, while requiring corporation-like limited liability, also needs partnership taxation and thus must be formed as an LLC.

As already noted, Bill’s business can’t obtain partnership tax benefits unless it is properly structured—that is, unless it generally resembles a classic partnership under the "default" rules of partnership statutory law (i.e., the statutory rules that will automatically apply unless the partners alter them by written or oral agreement).

This means that in order to determine whether Bill’s business can be structured to qualify for partnership tax treatment, you must have a thorough knowledge of federal tax classification law as applicable to C and S corporations (for which the criteria are primarily statutory) and as applicable to partnerships (for which the criteria consist primarily of IRS administrative guidelines).

It would be nice if start-up lawyers could focus on just one or two of the three main areas of law—business organization law, substantive tax, and tax classification law—normally essential to start-up practice, and leave the rest to others. Unfortunately, this isn’t an option. In any given start-up process, all three areas interact in complex ways. The start-up lawyer has to simultaneously control all three.

The list of laws that you must have at least a basic grasp of in order to assist Bill isn’t finished yet. You must also understand a broad range of nonbusiness organization laws and nontax laws that are likely to be relevant for a start-up. These laws fall into seven categories:

• Securities laws

• Employment law

• Real estate and environmental law

• Intellectual property law

• Contract and commercial law

• Estate planning

• Laws specific to particular lines of business

John M. Cunningham is of counsel to Ransmeier & Spellman, P.C., in Concord, New Hampshire.

This article is an abridged and edited version of one that originally appeared in Business Law Today, Nov./Dec. 1995 (5:2) .

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