Case Study – XYZ Enterprises

Many factors go into entity selection and XYZ Enterprises has a few unique issues related to its business type. The main value in XYZ Enterprises is its copyrights. Copyrights are protected, in the United States, for 70 years after the death of the last surviving author (United States Copyright Office, 2006). This applies to any works created after December 31, 1977.  If XYZ bought rights to any material created before January 1, 1978, the period would be shorter but still long enough to outlive most authors.

Another important concern regarding copyright is the liability the owner(s) may face. Copyright holders get sued all the time and although many of these suits are nuisance lawsuits, protection of the assets is paramount. For example, if a litigant successfully sues for copyright infringement, all assets in the company are at risk. This includes all other copyrights in the catalog as well as the physical products and any sub-licensing deals. Thus, it is important to shield assets appropriately even at the expense of a more complicated entity structure.

Corporations

When people think of a business entity they are generally thinking of a corporation. This is the traditional structure of most large businesses. The unique aspect of corporations is in the recognition of corporations as separate legal entities. This means corporations exist separate from the people who own, control, or manage it. Corporations, unlike sole proprietorships and some partnerships, don’t cease to exist when the owners change or die. Corporations are also allowed to enter into contracts, incur debt, and pay taxes separate from its owners. From an asset protection aspect, corporations are not liable for its owner’s debts and vice-versa.

“C” and “S” Corporations

Two common types of corporations exist; C and S. Which type of corporation to form is based on tax planning and if the corporation will go public. Both C and S corporations allow for limited liability, but several significant differences need to be considered. Both types of corporations have tax benefits which other entities may not.

S corporations can be thought of as a corporate partnership. They allow for limited liability of the owners, but still have profits pass through to the individual shareholders. S corporations run on a calendar year which may be a detriment to certain businesses. S corporations also have limits on the number of shareholders and can not have, in Nevada, any alien, non-Nevada resident, shareholders. Privacy is not assured as there is full disclosure of all corporate owners.  S corporations have lost favor in most typical business situations since the Limited Liability Company has emerged.

C corporations have the maximum amount of benefit and the most flexibility of any entity type. C corporations have absolute privacy in Nevada; there is no disclosure of corporate owners. C corporations are allowed to use a fiscal year which can be strategically created for tax advantage.

Profits can be kept as retained earnings but are taxed at corporate rates on an 1120 form. This can be used to advantage in a multi-entity tax strategy. For instance, assume a musician has income from either an LLC or sole proprietor which places them in the 38% tax bracket. By creating a C corporation and paying a salary, the musician can keep (retain) up to $50,000 and those retained earnings will only be taxed at the corporate tax rate of 15%, a significant tax advantage.

Limited Liability Company

Limited Liability Companies (LLC) are the new kid on the block. Created in Wyoming in 1977, LLC’s were modeled after similar entities in South America and Germany. LLC’s became mainstream after the 1998 ruling by the IRS which taxed LLC’s as partnerships. All states allow LLC’s as legal business entities. One common misconception people have  is confusing an LLC with a corporation. An LLC acts more like a partnership, but shares similarities with limited partnerships, S corporations, and Trusts, mainly in liability protections.

The LLC takes care of some of the shortcomings of an S corporation. LLC’s are not limited in the number of shareholders, which are called members. Nevada, and several other states, allow for single member ownership of an LLC. Like a corporation, an LLC provides liability protection for its members and can hold property and transact any type of business.

A major advantage of the LLC is simplicity. An LLC does not require the formal procedures such as minutes, bylaws, and other administrative detail needed by a corporation. Because of this, almost no one going into business should even think about a sole proprietorship or partnership with the advent of the LLC. There are very few benefits and many drawbacks and the cost of an LLC is trivial in the State of Nevada.

Taxation of an LLC

As stated above the IRS has determined that, personal liability notwithstanding, an LLC will be taxed as a partnership. LLC’s can also elect to be taxed as a corporation and even as an S corporation. An LLC is never directly taxed since all profit flows through to the partners (unless the corporate taxation election is made). A sole owner is considered a disregarded entity by the IRS and therefore, the member simply reports profit and loss on a standard schedule C.

Regarding the election to be taxed as a corporation, an LLC which does not hold real or intellectual property (i.e. most traditional businesses), may find tax benefits by electing to be taxed as a corporation and electing S corporation status. This would only apply if the LLC is going to make over $50,000 in profit, but allows the company to retain earnings.

Series LLC

One advantage of Nevada is the series LLC. In other states proper risk planning would require a forming a separate LLC for each asset. This can get extremely costly and is fraught with administrative headaches. The series LLC allows for compartmentalization of dangerous assets. In the case of XYZ Enterprises, each individual copyright (song, etc.) can be placed in a “separate” compartment inside the main LLC.

Nevada statue NRS 86.161(e) provides this protection. Each copyright can be held inside a separate cell effectively isolating it from all the other copyrights.  In case copyright A is sued, the plaintiff can not go after any other copyrights owned by XYZ Enterprises.

C Corporation

A C corporation will be created for the day to day operations of the company. The C corporation will own the products created from copyrights. This separates the intellectual property from the actual physical, salable product.

The C corporation will buy the distribution rights from the LLC and conduct business as a separate concern. The C corporation will also be responsible for packaging and hiring, either independent contractors or employees. The C corporation will also be responsible for marketing and content creation.

Family Limited Partnership (FLP)

An essential part of asset control is the separation of risk. FLP’s are a special form of limited partnership. Like a normal limited partnership, an FLP consists of one or more general and one or more limited partners. The limited partner can also be a general partner as long as at least two people are in the partnership. This does not need to be started until the LLC has significant value. A Family Savings Trust (FST) is also setup as a passive entity with ownership of dangerous assets and shielding differing asset types from judgments.

The FLP is an advanced strategy of asset protection whereby liability is extremely compartmentalized from inside and out. The way this is done is by transferring the ownership of the C corporation and LLC from the owners, into the FST.

The FST is a passive business and generally can not generate any liability. The following scenario illustrates the point. If owner A is in a car accident and gets sued, the shares of stock or member shares could be transferred in case of a judgment. While the LLC or C Corporation is not liable, effectively the creditor could control the company and force liquidation of assets. If the FST is the owner, no shares are owned directly by the owner to attach. The creditor is effectively blocked from recovering any damages from the debtors’ business interests.

Own nothing and control everything is the rule of asset protection.

The Family Savings Trust will own 100% of the LLC and 98% of the FLP. The principals will be 1% general partners in the FLP. The trust will contain language to protect the LLC and FLP from a charging order and provide estate planning needs.

DISCLAIMER

I am not a lawyer, and you would be served best by getting appropriate advice for your specific situation. That said, this article should point you in the right direction and help you understand what your professional is talking about.

Resources

United States Copyright Office (2006, July). Copyright office basics. Retrieved March 25, 2008, from http://www.copyright.gov/circs/circ1.html

The four day musicians strike on Broadway in 2003 has been estimated to cost $4.8 million in box-office receipts and $7 million to the city of New York (Taylor, 2003). This strike was quickly negotiated by all parties through the use of one form of alternative dispute resolution, arbitration. Alternative dispute resolution is an attractive option for all litigants in most business lawsuits.

Arbitration

Many contracts, including union contracts, require arbitration clauses specifying arbitration as the first means of dispute resolution. Arbitration uses a neutral third party, usually a member of the American Arbitration Association (AAA), to hear the complaints and make a decision (Cheeseman, 2004, p.41). Arbitration can be either binding or non-binding, depending on the contract language, and can be requested through the use of a submission agreement if no arbitration clause exists in the contract.

Arbitrators themselves can also be looked at in two different ways. First, the arbitrator can be seen as a private judge who simply looks for facts and applys the rule of law. Second, an arbitrator can be thought of as a “contract reader,” serving as the parties’ agent and focusing on the relationships and interests of the parties as opposed to facts and rules of law (Kirgis, 2007). The former definition of an arbitrator has been in use for the longest time, but has lost favor in the United States in the 20th century. The contract reader definition is more modern and is preferred by most businesses as contract arbitration takes cultural and mutual interests into account. Since arbitrators simply clarify agreements, no way to overturn the arbitration exists. The only review this type of arbitration has is to ensure the arbitrator was neutral and interpreted the agreement (Kirgis, 2007).

Arbitration was codified by the Federal Arbitration Act (FAA) in 1925 as a means to counter judicial hostility towards arbitration clauses existing in English common law as well as American courts (Cheeseman, 2004, p. 42). Courts have always considered labor arbitration as distinct from individual employment contracts, but paradoxically since the 1980s courts now see no fundamental differences between them (Gould, 2006). Since around 1960 labor arbitration has held a contract view as opposed to the earlier quasi-judicial interpretation.

Besides labor and employment contracts, arbitration clauses are present in many consumer contracts including banking relationships such as credit cards and loans. Many consumer advocates question the use of arbitration clauses, especially in consumer contracts. The Federal Reserve Board is actively investigating arbitration clauses in consumer credit agreements such as automobile loans and mortgages (Fahmy, 2006). Fahmy (2006) goes on to suggest consumers who do business with companies requiring mandatory arbitration will lose their right to sue. Fahmy (2006) also points out this trend towards arbitration clauses is unlikely to change as the price to file for arbitration is much higher than filing a lawsuit and many arbitration clauses include fee recovery for the winning party. This further discourages challenging of non-negotiated arbitration clauses in contracts.

Other Forms of Alternate Dispute Resolution

Mediation is another popular form of dispute resolution. Mediation, unlike arbitration, does not involve a decision. The mediator simply guides the parties in reaching an amicable settlement. Mediators generally meet separately with all the interested parties and relay any pertinent information to the other parties (Cheeseman, 2004, p. 43). Conciliation occurs when an interested third party is involved, instead of a neutral party. Neither mediation nor conciliation has any legal standing, and the third party has no authority to gather any evidence or witnesses.

Judicial referee, minitrials, and fact-finding are also used as alternative dispute resolutions. A judicial referee can be appointed by a judge with the consent of all parties. The judicial referee has legal standing and the decision can be appealed by the losing side. Minitrials, are similar to judicial referees, but have no legal standing. Arguments are presented and a negotiated settlement is the desired outcome. Minitrials have the advantage of gently forcing settlement talks as both sides can see weaknesses and strengths in the case. Finally, fact-finders are neutral parties who investigate a dispute, report on the findings, and sometimes make settlement recommendations.

Conclusion

The quick resolution of the musicians strike could not have been possible without the use of arbitration. Both parties would have been tied up in lengthy litigation. Commerce would have been directly and indirectly affected. The public relations fallout may well have proven disastrous for either or both sides, possibly closing theaters and causing layoffs due to lack of revenues. Arbitration, besides being called for in the union contract, is the most expedient way of settling labor differences. Both sides saved money and time, and prevented a possible public relations fiasco with the ancillary businesses which were affected.

References

Cheeseman, H. R. (2004). Business law: Legal, e-commerce, ethical and international environments (5th ed.). New York: Prentice-Hall.

Fahmy, H. (2006). Arbitration – wiping out consumer’s rights, State Bar of Texas. Retrieved February 28, 2008, from http://www.texasbar.com/customsource/wrapper/globals/tbj/2001/oct01/fahmy.asp.

Gould IV, W. B. (2006). Kissing cousins?: the federal arbitration act and modern labor arbitration., Emory Law Journal, 55(4), 609-689. doi: Article.

Kirgis, P. F. (2007). Judicial review and the limits of arbitral authority: lessons from the law of contract., St. John’s Law Review, 81(1), 99-121. doi: Article.

Taylor, C. (2003). Four-day musician strike costs ny dearly., Billboard, 115(12), 8. doi: Article.