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Biz Legal Bytes—Understanding Certain Massachusetts Business Law Issues

As you increase your understanding of Massachusetts business law to protect and promote your business, consider these common questions and answers to guide you.

• What Should I know About Starting a Business in Massachusetts?
• Choice of Entity - What should I consider in the start-up, purchase or sale of my business?
• Should I incorporate my business and, if so, how do I maintain its protections?
• What are the advantages and disadvantages of a Limited Liability Company (LLC)?
• What duties do officers and shareholders owe each other in a closely held corporation?
• What Protections Are Available for Officers, Directors, and Shareholders in a Closely Held Corporation?
• What is a Buy-Sell Agreement, and how does it work in the event of death or disability of a company owner?
• When do I need to have my business valued and what is involved?

What Should I know About Starting a Business in Massachusetts?

You need the advice of an attorney and certified public accountant about how to set up a business to meet your needs and to protect you and your family and your / their assets. There are many good books available with basic advice about all of the many steps that you may need to take. Since starting a business can involve the purchase or rental of equipment, licensing and insurance issues, trade name and/ or trade mark and trade secret protection, rental of office or other commercial space and lease negotiations and innumerable other legal and practical steps, check lists and advice from the state and from the Small Business Administration and SCORE will make the process easier. We can help with a number of these decisions and there are many on-line sources of advice and help, including state, local, university, and local library resources.

In the start-up or sale of a business, what does “the choice of entity” mean and what factors should I consider with my attorney?

“The choice of entity” is what lawyers label the decision regarding the which kind of business type. Determining “the choice of entity” is when you make the choice to set-up your business as a separate legal entity or person. At Lawrence B. Morse & Associates, we advise clients about which choice is best for your situation. While the choice is often simple, it can also become quite complicated.

The primary options for “the choice of entity” and their liability status include:

• Sole Proprietorship--a single individual – unlimited personal liability
• Partnership—two or more people join together in business, generally unlimited personal liability
• Corporation—business incorporated as one or more people or entities, protection against personal liability
• Limited Liability Company— one or more people or entities set up as a “ LLC,” a relatively new form of business combining the benefits of a corporation and a partnership, including protection against personal liability.

Other less common options for “the choice of entity” include hybrids. We work with you to consider all important factors concerning the decision, such as your specific business goals, the industry, the risks of being sued not covered by insurance, tax issues, and the costs of setting up and maintaining an entity. Sometimes one entity needs to be converted to another under new circumstances.

A person starting a business alone is a sole proprietor and no specific filing is required in regards to this entity choice. However, choosing to be a sole proprietor or entering into a partnership comes with the risk of personal liability and having all or most of one’s personal assets at risk if sued. There are exceptions and they need to be reviewed.

Should I Incorporate My Business and, If So, How Do I Maintain Its Protections to Avoid or Decrease Personal Liability?

• Why incorporate your business - to avoid or lessen personal liability? If you are a sole proprietorship or general partnership, then all of your personal assets, including your house, car, savings accounts, etc. (subject to certain exemptions and certain protections for your home if in place) are at risk, if you should be sued.
• How does personal liability for claims occurring at your business arise? For example, if you or one of your employees, in the course of employment, injures another person, that person may seek money damages in a court action against you. Other examples include someone slipping and falling in an entrance way, a customer who feels that you may have committed some negligent act, e.g. a violation of privacy that gives him or her a right to money damages. Some of these risks can be covered by liability insurance, but it may not be adequate for the amount claimed or may be subject to exclusions. Both sole proprietors and partnerships are liable for the acts, including the negligence, of their employees. Likewise, partners are liable for the negligent acts of other partners.
• How does incorporating your Massachusetts business avoid or decrease personal liability? When you properly incorporate in the Commonwealth of Massachusetts, you have created a new legal person or entity completely separate, if done correctly, from your own person and your own personal assets. A person, seeking to obtain money damages from your business, can reach only assets of the corporation and not your personal assets. In other words, the law recognizes and creates a business entity known as a business corporation that is separate from the individuals who invest in it as shareholders. Those shareholders will only be liable to the extent of their investment paid into the corporation, provided they both properly set up and maintain it. {Link].
• Are there other advantages to incorporating your business? There are a number of other advantages to being an incorporated Massachusetts business. There is flexibility in dividing your business. Corporate stock provides an ease of transfer of interest in the business. You can divide up the business among family members or others. You can give different types of rights with different kinds of stock e.g. preferred or common stock if it is a C corp. In addition, use of the corporation may make estate planning easier in making gifts of stock in the business to family members. The corporate form may make much simpler the sale of the business to others if at some point a sale is contemplated. If the business needs to raise more money, shares of stock may be sold to "Angel investors," venture capital firms, and eventually the public. Corporations are said to have more lasting power since in theory they may have perpetual existence.

What are the Advantages and Disadvantages of a Limited Liability Company (LLC)?

• What is a Limited Liability Company and how is it set up?
  The limited liability company, LLC, is the most recent addition and popular of the choices for a new business entity. As an LLC, your business may have the flexibility of a partnership and the legal protection of a corporation. Because of its dual character of corporation protection against personal liability and partnership tax treatment, the LLC has come to replace general partnerships, limited partnerships, and S corporations as the entity of choice for small businesses. It is not, however, the choice for businesses seeking venture capital or “angel” financing. For them, a C Corp may be best permitting various classes of stock. Additionally, Massachusetts in recent years allows single member LLCs. The LLC may need an operating agreement to define the relationship between its members, similar to a partnership agreement, to control business, financial and tax matters. The operating agreement may be oral, although it should be in writing and signed by all the LLC's members. Management of an LLC may be vested either in the members or in certain designated "manager(s)." Managers do not have to be members of the LLC, and even corporations may serve as managers. A check-the-box form filed with the IRS by your accountant will determine whether the LLC is taxed as a partnership or corporation; but the default provision is a partnership tax treatment if no election is filed.
• What are the primary advantages of an LLC that should be considered when starting a business compared with an S Corp?
  LLC members are protected from personal liability just as are corporate shareholders. Since the LLC will likely be treated as a partnership as to tax treatment: it will be a flow- through entity for which income and losses are reported directly by its members on their tax returns. Unlike an S corporation, special allocations of income, expenses, deductions and losses can be made among its members, and an individual member's losses are not limited by the amount of a member’s investment in the LLC. The LLC differs from a partnership in that management may be by nonmembers. An LLC should be used rather than an S corporation when a business plans to have foreign persons, corporations or trusts as shareholders. The LLC is also a useful entity for estate planning purposes since trusts and estates are eligible shareholders.
• What are the primary disadvantages of an LLC that should be considered when starting a business?
  With the LLC being a newer legal entity, there are fewer legal precedents concerning the law of LLCs. There may be more involved in setting up an LLC, particularly when formulating an operating agreement among multiple members, than in organizing a corporation. In Massachusetts, the fee for filing an LLC with the Secretary of State is higher than the fee for filing a corporation, as is the fee for filing the annual reports. Other cost savings generally offset this disadvantage.
• In what situations, is the Limited Liability Company best suited?
  In summary, an LLC is best used when one or more people are considering a new company. The LLC provides significant advantages over both general partnership and limited partnership structures. Similar to an S corporation, it does not have the “S corp.’s” restrictions. LLCs are available to professionals and may be advisable in place of a Limited Liability Partnership because more states recognize LLCs than LLPs for the protections discussed here. LLCs should not be used when a "C" corporation would be able to utilize the corporate reorganization tax provisions or the ability to have separate classes of stock. C corporations are particularly appropriate for companies expecting to attract “angel investors” or venture capital which often take preferred stock.
  

What Are the Duties that Officers, Directors, and Shareholders in a Closely Held Corporation Owe One Another?

The following are general principles that may be modified by statute, agreements, or case law and do not govern every situation. The relatively new business corporation law, G. L. Ch. 156D, provides considerable flexibility to change the rules governing a corporation.

• What are the duties of the Directors of a Closely Held Corporation?
  Directors of a Massachusetts corporation, including small closely held companies, stand in a fiduciary relationship to the company. As fiduciaries, their primary duty is to the Corporation, and their personal interests are subordinate to that duty. Directors' basic duties comprise both the duty of good faith and care and the duty of loyalty. G.L. Ch.156D, 8.30 provides guidance in a Director’s decision making and allows consideration of the best interests of employees, shareholders, creditors, vendors, the corporation and of other factors.
• What are the duties of the Shareholders of a Closely Held Corporation?
  For stockholders in closely held corporations, the Massachusetts’ highest court, the Supreme Judicial Court, the SJC, in the case of Donahue v. Rodd Electrotype Company of New England, Inc., established a higher standard: Stockholders in a close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another, namely, a duty of the utmost good faith and loyalty. The SJC defined a close corporation as "typified by: (1) a small number of stockholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operations of the corporation." In that context the majority shareholders owe a minority shareholder a duty of utmost fair dealing, disclosure and loyalty. This may be modified under certain circumstances.
• What are the duties of Officers or Employees to a Corporation?
  Massachusetts courts have ordinarily not distinguished the duty of corporate officers from the fiduciary duty of directors. Massachusetts cases state that "employees occupying a position of trust and confidence owe a duty of loyalty to the employer and must protect the interests of the employer." Chelsea Industries, Inc. v. Gaffney, 389 Mass. 1, 11 (1983) Nonetheless, our courts have been vigilant to leave the managers of the Corporation broad discretion in the management of corporate business. Massachusetts courts generally find that corporate officers and directors are not to be held liable for "mere errors of judgment" or "bad business judgment" and the courts will not substitute their business judgment for that of the corporation's management.
• How do Massachusetts Courts apply the strict Donahue fiduciary standard to corporate opportunities?
  “Uncle” Demoulas ran his supermarket chain so as to obtain most of the benefits of the business’s growth for himself, his deceased brother’s family, as shareholders, sued. In 1997, in Demoulas v. Demoulas Super Mkts., the state’s highest court sternly applied the Donahue standard, stating that "the directors of a corporation stand in a fiduciary relationship to the corporation.” It stated that they owe to the corporation both a duty of care and, more significantly for this case, a paramount duty of loyalty. “They are bound to act with absolute fidelity and must place their duties to the corporation above every other financial or business obligation.” Provisions in corporate documents can limit the duties discussed above of controlling shareholders to minority shareholders.

What Protections Are Available for Officers, Directors, and Shareholders in a Closely Held Corporation?

Insurance for Directors and Officers and indemnification of directors and officers for all but the most serious and willful errors is available.

• Incorporation documents can spell out the extent and conditions for the company to pay back officers and/or directors for any losses to them personally for their action on behalf of the corporation. These conditions must be properly written into the articles of organization and/or by-laws. The “new” incorporation law effective July 1, 2004 has language spelling out the extent of “permissible indemnification,” of directors for their actions representing corporations. Under Section 8.52, a corporation must indemnify any director who is “wholly successful” in defending litigation. This very limited mandatory protection, among others, is good reasons for a corporate “legal audit”, particularly if you have not brought your previously set up corporation in line with the new law.

What is a Buy-Sell Agreement and How Can It Protect the Owner(s) of a Closely Held Corporation and the Business in the Event of Death or Disability?

A buy-sell agreement deals with the death or disability or termination of employment of a key owner or owners of a closely held corporation to provide for the sale of that person’s interest.

• Your business may be the primary asset that provides income and security for you and your family. The owners and shareholders of many closely held corporations understandably find it hard to plan for the risk of the death, disability, or voluntary or involuntary termination of employment of the company owner(s). Buy-sell agreements include provisions governing those situations and legally enforceable restrictions on the transfer of stock. They provide for the “redemption” of stock by the corporation or purchase by one or more of the remaining shareholders. For the selling shareholder, the agreement may assure a buyer for the seller’s stock at a fair price as determined by an agreed-upon formula or process.
• What can a more sophisticated buy-sell agreement provide that simple right of first refusal provisions in the Articles of Organization cannot?
  While buy-sell agreements serve key corporate and individual shareholder’s purposes, the frequently encountered problem is that most closely-held businesses have only the simplest of agreements. They often fail to solve the financial and governance problems that may undermine an orderly transition in the ownership of the business. Many companies are incorporated with only boiler-plate first refusal language in their Articles of Organization. A sophisticated buy-sell agreement will address key tax issues and also determine who is the selling party, the buying entity, and the source of the funds - usually either a promissory note secured by certain provisions for payment from future income or better yet, a corporate split-dollar insurance policy or some combination of the two. Attorney Morse works with the tax and other advisers to provide the necessary advice.
• What are the Three Common Types of Buy-Sell Agreements?
  The question arises as to who is the appropriate buyer of the selling shareholder’s shares. There are three common types of Buy-Sell Agreements: (1) Corporate Redemption Agreement; (2) The Cross-Purchase Agreement; and (3) the Hybrid or "Wait-and-See" Agreement. In the Corporate Redemption Agreement, corporate funds are used to purchase the shares, either directly through current or accumulated earnings, or through the payment of insurance premiums. If insurance is expected to be the funding source, this corporate approach can result in a simpler insurance program than a cross-purchase approach. The Cross-Purchase Agreement provides for one or more of the remaining shareholders to purchase the stock of the departing shareholder. Each shareholder must own insurance on the life of every other shareholder. The Hybrid or “Wait-and-See” Agreement may provide needed flexibility. The corporation might have the first option to redeem shares, and if it chooses not to exercise that option, remaining shareholders would then have the option to purchase the shares. If the shareholders do not do so, then the corporation could be required to purchase the shares.
• What are Other Provisions Commonly Found in Cross-Purchase and Other Agreements to Protect the Company against Unfair Competition Of A Departing Owner / Employee? Anticipating the possible departure of one of the key owners or employees, there arise issues of non-competition, non-solicitation of customers and employees, and confidentiality or nondisclosure of key confidential data or trade secret. Language that deals with these issues should be put in the Buy-Sell Agreement and in employment or separate agreements for key employees and sometimes almost all employees with access to important data. It can spell out the parties’ expectations of their duties to the enterprise. It may contain employment rights and identify expectations as to who the officers and directors will be. These non-competition, non-solicitation and nondisclosure agreements can be rendered ineffective to invalid under some circumstances so advice here is very important.
  

When do I need to have my business valued and what is involved?

• Business valuation is both a goal and a set of procedures employed to estimate the fair market value of a business.
  Business attorneys use company valuation appraisals in a number of contexts. Valuation is used by sellers and buyers to determine the price to offer or to pay in the sale or purchase of a company. The same valuation tools are often used by business appraisers in estate planning, to allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes. For instance, during shareholder disputes, sometimes the value of the company must be determined at a past point in time to determine damages. Often time a conversion of a "C" corporation to an "S" or Sub S corporation is advisable and a valuation of the business could be needed. In two contexts from his practice, Attorney Morse has recent examples of working with business appraisers: 1) in having a minority shareholder stock valued for purposes of negotiating its sale to the corporation and 2) in another matter to determine the value of successful business for its sale.

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