Understanding how to form an entity is not second nature for most people, much less many attorneys. Tune in as Michael and Brad share a story about a first-time entrepreneur, who unfortunately trusted his friend to form his business. We bet you can guess what happens next. In part two, ByrdAdatto attorney Robert Fisher joins us to walk through the process of properly forming a business.
Listen to the full episode using the player below, or by visiting one of the links. Below is the episode’s transcript which has been edited for readability. If you have any questions or would like to learn more, email us at firstname.lastname@example.org.
Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues, simplified through real client stories and real world experiences. Creating simplicity in three, two, one.
Brad: Welcome back to another episode of Legal 123s with ByrdAdatto I’m your host, Brad Adatto with my cohost Michael Byrd.
Michael: Thanks Brad. As a business and healthcare law firm, a client call is usually a request for help, but sometimes clients don’t recognize they even need help. Instead, it is often too late when they finally make the call. Today’s story is one of those examples where the client trusted one of his business partners, best friend growing up and just didn’t think he needed to call anyone for help.
Brad: Yeah, often, Michael, we call this the 5/50 rule. We’ve discussed this in other episodes, but if you’re not familiar with the 5/50 rule, the concept is, when you’re starting [00:01:00] something out, sometimes you need help. Either you’re going to pay someone $5 up front to do it right or $50 in the back end of the fix it. But Michael, I want to shift a little bit here. I would like to know, do you trust me?
Brad: That was not an A or B question. The question is, do you trust me or a stranger?
Michael: Oh, okay. Yeah, of course I trust you. You’re one of my closest friends and we’ve been partners for 15 plus years. Why are you asking?
Brad: All right. So going back with the concept, do you trust me over a stranger because the whole stranger danger thing. Right? So for our listeners that have worked with us or met us in person, they know us, but for everyone else, we’re just some voice in their head hopefully saying nice things to them. And so for our audience that doesn’t know this, I thought today we could share some more personal facts for our audience so they can have more of a trust factor with us. I know that in season one, we had our premiere where we talked a lot about who we are and why we started the podcast but today I thought we could just have [00:02:00] some fun facts. So, Michael, what is your favorite one hit wonder song from the nineties and why?
Michael: Well, I don’t know how this builds trust. In fact, it may do the opposite, but it will definitely reveal my poor taste when I was in my twenties. The first song that popped to my mind is What’s Up by the 4 Non Blondes. I remember listening to this song during the angsty season of life, called my twenties plus law school. What about you?
Brad: I’m hoping that our audience is not tuned out when they hear that one, but mine’s probably not much better. Um, there’s a band called Chumbawamba Tubthumping, but most people know it as I get knocked down and that song was on one day when I was driving back from studying all day for the Louisiana bar and it kind of kicked me to the next gear to keep studying. And it became my rally song throughout that process when I was studying. So let’s have a one more question. What’s your favorite pizza?
Michael: Okay. I can kind of regain some credibility here. New York style pepperoni.
Brad: [00:03:00] All right well, my favorite is basically any kind of pizza, but if I’m going to go with my very, very favorite, my cousin makes homemade pizza and he puts bacon potatoes, onions, green chives, and cheese on it. It’s amazing. The pizza dough and the sauce is all homemade. It is some good eating.
Michael: I’m one of those people that will inadvertently start oversharing so before we go there, are there any other personal questions?
Brad: No, not today. We’re not going to have any more questions, but you know, speaking of pizza, kids do love it and at my children’s school, every Friday fathers could volunteer to serve pizza for lunch. Yes, this is pre COVID world. And so we would get to show up and hand out cheese and pepperoni pizza and we were the rock stars of the school, but one of these random pizza Fridays is the genesis of today’s story.
Michael: Well jump in, I want to hear it.
Brad: So in this story [00:04:00] I was heading to hand out pizza at the school with a couple other fathers. After the kids headed back to their classrooms we started cleaning up and we started having that typical small talk, you know as to who does what kind of thing. And one of the dads noticed I was wearing a suit and said, well, what type of profession? What do I do? After I gave him the quick elevator speech about being a business and healthcare attorney, he kind of stops me and says, can I ask you a quick question?
Michael: Famous last words. Anyone who’s practiced as long enough knows that there’s no such thing as a quick question in those circumstances.
Brad: No there never is and that’s exactly what happened here. So over the next 45 minutes, he shared this story with me. And so for today, we’re going to call him Mr. Workhorse.
Michael: Okay explain Mr. Workhorse.
Brad: So Mr. Workhorse was a young self-made individual who had been working for years for a very large company. He was their number one best salesperson, did a ton of travel, and he was their company’s [00:05:00] go-to guy on any of these major projects, but still was not seeing any financial awards for success.
Michael: Okay, I get it. I see why you are calling him Mr. Workhorse.
Brad: So when he learned his wife was pregnant with their first child, he didn’t think he could keep up this pace of these long hours and travel and just the pay was too low. So one night he was hanging out with his best friend who actually happened to be his best man in the wedding. And over a few beers, he started to share his concerns with this current career path.
Michael: Yeah, who has not had that conversation at some point in their life?
Brad: Exactly. And in this conversation, Mr. Workhorse tells his best friend that he has this idea of how to develop a new business based on all this knowledge that he has on hopefully helping himself make more money and putting himself in a better position when his first child was born. So his best friend who we will call Mr. Crawfish, tells him he wants to help start this business.
Michael: Brad, I know you’re from New Orleans, but why Mr. Crawfish?
Brad: Growing up [00:06:00] in New Orleans, we had this saying that if, someone backstabbed you or went around your back, they crawfished you. And yes, that Michael that is different than the term catfishing someone. So we won’t, it’s not a catfish. It’s a crawfish.
Michael: Okay, well, little Cajun flair. Mr. Crawfish works. I hope there’s not a Mr. King cake in the story.
Brad: No, no Mr. King cake in this story, but I think I liked that for another woman. Well, as Mr. Workhorse planned out this new business model and Mr. Crawfish says that maybe they should bring Mr. Crawfish’s brother in on this deal, because he’s good with helping with legal and accounting.
Michael: Crawfish, was he a lawyer or CPA?
Brad: No, but he did work in a very large accounting department for a very large company and apparently knew how to use Legal Zoom.
Michael: So he basically stayed at a Holiday Inn Express last night?
Brad: Exactly. So the brother who we’ll call Mr. Weasel helped form the limited liability company and filed all the paperwork to launch this new company.
Michael: I don’t think [00:07:00] you need to explain why we’re calling him Mr. Weasel.
Brad: No, it’s going to become apparent real quick. So Mr. Workhorse gives notice and leaves his current employer and ventures out to build his own company. For the first few months, he’s actually not taking any income, but he’s betting on the fact that he has this great business idea, great business relationships, and he’s going to build something. So he keeps the same crazy hours, but knows ultimately that at the very end it’s for his own benefit. Mr. Crawfish and Mr. Weasel are helping them kind of, but they both have full-time jobs. So they’re only giving them a few hours put here and there.
Michael: So he’s hard at work building up his company this time.
Brad: Yeah, one would think that is a correct statement. Michael, that’s a good observation so far, but let’s fast forward a few years later. It’s about two years later. Mr. Weasel has been releasing small draws from the company to Mr. Workhorse to help offset the cost of running the business. The company has seen a large number of new clients and Mr. Workhorse feels confident enough that he’s actually going to go try to buy himself a new [00:08:00] house. Obviously with a child on the way and one child already. So while he’s gathering all his information for the new home, the bank starts asking him for all his current employer copies of his tax returns and a list of all his assets.
Michael: Fairly standard stuff.
Brad: Right! Same stuff that everyone would get when they’re giving the bank their underwear drawer moment, right? So Mr. Workhorse notes that he’s the founder of this company and he owns 80% of it. The bank asked him for some additional paperwork and Mr. Workhorse’s taxes note that he’s never received a distribution from the company to date.
Michael: Well, I thought you said he’d been an owner for two years. He didn’t have a K-1 from his company?
Brad: No, he didn’t. In fact, he actually never even asked why he didn’t have one because he was a first time owner and didn’t realize he should be receiving a K-1 for the company. Maybe, Michael, for our audience, we have a vocabulary word of the day. What is a K-1?
Michael: A K-1 is a reference to schedule K-1 on the IRS form 1065 for businesses that [00:09:00] operate as partnerships. It reflects the partner share of the partnership income deductions credits, et cetera.
Brad: So tech stuff.
Brad: So Mr. Workhorse had never been part of any ownership and so he didn’t understand how corporate taxes were paid as an owner and as such, he didn’t even know he should have been receiving a K-1. Additionally, when he asked for proof of ownership from Mr. Weasel, at first, Mr. Weasel was like, oh yeah, I gotta get that from my lawyers. This kind of confused Mr. Workhorse because he just needed the paperwork to give to the bank. So he started calling his good friend, Mr. Crawfish, and finally the draw, the big bomb was dropped. Mr. Weasel had formed the entity, like he said, he would via Legal Zoom and made himself the sole manager and then basically eventually made he and his brother, Mr. Crawfish as the only owners.
Michael: Oh, wow.
Brad: So Mr. Workhorse had no ownership. They had been treating him as a [00:10:00] W2 employee and worse, he later learns through the litigation basically that Mr. Weasel and Mr. Crawfish had been paying themselves a salary and running I’m doing air quotes here, business expenses through the company.
Michael: Wow. That’s a crazy story and yeah, they have full-time jobs. I just can’t imagine what their quote business expenses were. Well, let’s go into a commercial and on the other side, Brad and I will spend some additional time discussing what happened to Mr. Workhorse and we’ll bring in one of our friends and colleagues here from ByrdAdatto to talk through it.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my cohost Michael Byrd. Now Michael, this season, the theme is when should I ask for help. So for the second half of the show, we are joined by our friend and colleague, Robert Fisher to help us break down today’s story, Michael, please introduce Robert.
Michael: Robert is an associate here at ByrdAdatto. He’s from Dallas, married to his wife, Taylor. He is obviously in our Dallas office. His undergrad was at the University of Georgia and usually you can see some evidence of that if you’re around him. He went to law school at SMU in Dallas, two kids and a dog named shocker, [00:12:00] Georgia and he was actually our first law clerk when we started ByrdAdatto and the first associate we hired out of SMU law school. Robert, welcome.
Robert: Yeah, thanks for having me. I got to rep the undergrad however I can.
Brad: Yes. For the audience, just to let you know, before we started Robert and I were having entire conversation about Georgia football. So if you want to see a grown man cry, and Robert’s a big man, it’s just talking about Georgia football, but let’s get in today. Robert, understanding how to form an actual entity is not second nature for most people and much less a lot of attorneys. So in this story, we have this first time entrepreneur who unfortunately trusted his friends and in his case, his best man to form his business. And for those who don’t know the actual process of how you form a business, let’s stick with this today’s story. How do we initially form a limited liability company?
Robert: Sure. I think a big piece of it is that you have got to [00:13:00] understand the terminology that the secretary of state uses and whatnot and you want to make sure that you’re actually filing the document that is doing what you want it to do. I know one of the big things I’ve always heard is that people think that filing a DBA or a doing business as name is forming an entity and it’s not. No, that’s just basically filing an alias or an AKA or a nickname. And so if you haven’t actually gone through the process of registering the entity, forming the entity with the state, then you’re not really protected. So the big thing, and the first step is that you’ve got to file the certificate of formation and that’s what we call it in Texas. You know, you can see it called other things in other States, which I think we’ll get into that a little bit more in a second, but for a Texas LLC, you’re going to file a certificate of formation and that is what, you know, breathes air and life into the lungs of your entity. And you have a [00:14:00] LLC, a separate entity that you can run business out of that provides the liability protection and all the things that you form a business for, to isolate yourself individually from the business. And from there, there’s a series of steps and documents that you need to have that the secretary of state’s concerned about the certificate of formation. And so you of got to get a little bit deeper into the Texas business organizations code or whatever your state’s code is to really find out the documents you need to shore up the border around your entity and make sure it’s doing what it needs to do. Typically, the next step after you actually form it would be to get the EIN from the IRS, which is, we typically try to say, that’s the entities social security number, you can also hear it called a tax ID number. And that number is going to be the permanent number assigned to your [00:15:00] entity at which you need for opening bank accounts and filing your taxes and tracking all of those data points where, just like your social security number goes with you for life, your EIN typically goes with your entity for life and you know, the business side’s social. And then depending on what state you’re in, you’re going to want to prepare consents. And these are documents that aren’t necessarily going to be filed with anybody, but you’re going to want these organizational consents on record and your internal documents that show the paper trail, that the proper people have approved this entity to be formed. And, you know, you started to delegate powers as to who can do what and really start narrowing down the scope of what each person is going to do within the entity, especially when it’s a multi person, entity, like our story. You know, if it’s just yourself, that’s one thing. There’s still some reasons to divide the roles even within yourself, but [00:16:00] when it’s a multi-member though, it’s really important to start telling people, hey, you can do this, and I can do that. And that way you don’t get these situations where somebody has taken ownership for it from you and you don’t even know it. And the big granddaddy document that you’re going to want, especially with a multi-member LLC, is going to be the company agreement, the governing document that outlines from start to finish, who can do what, how tax distributions are going to be made, how we call it succession planning, you know, if somebody was to die or somebody was to commit fraud, all of those kinds of worst case scenario situations. And you get it in writing so that you have your plans laid out and everybody’s on the same footing and you know what the plan is moving forward. The way most States are set up is that there’s a, you know, in Texas we have the Texas business organizations code, which gives the default rules for [00:17:00] how, if you didn’t have something in writing, this is what you would follow. Similar to, if you died without a will, there’s the default rules of what would happen to the entity. If you don’t have a company agreement in place, you go to the TVOC or whatever your state’s code is. And those rules aren’t always going to be what you want, and the beauty of an LLC or any entity is that you can create it in the vast majority of situations, you can create it to do and function however you want. And so it’s just really important to spend the time and the company agreements can be long and tedious and people don’t want to get into the nitty-gritty details, but it’s just really, really important to get everything set up on the front end. Just like your five 50 Deal, like you were talking about Brad, where if you don’t spend the time doing this on the front end, it’s going to cost you on the back end because it’s a lot harder to fix things after they’ve gone wrong then [00:18:00] putting the rules in place ahead of time.
Michael: Yeah, and, you know, it becomes obviously even more important, the more owners you have because your risk sky rockets, if you don’t have that all worked out. And in many States for those that are not in Texas, the company agreement is also called the operating agreement. But that begs the question, Robert, does it make a difference as to where you form the LLC?
Robert: I think it does, absolutely. And it’s kind of a multi-factor test. Not necessarily a test, but different factors that you want to take in to consideration, you know, first off being, where is your company going to be operating? Where are your employees? Where are you doing business from? Because a lot of people hear Delaware is the flag bear, or it’s got this great corporate code and as CPAs, and especially if you’re a big pub company that wants to go public, the international world loves Delaware law, but [00:19:00] if you’re kind of running just you’re your own little entity in your world, Delaware may not make sense for you because I have yet to meet somebody who lives in Delaware, but I’m sure there are people out there.
Brad: It’s on the map. We know that much, right?
Robert: It is there.
So I think that’s what people forget is that you form in Delaware, but if you’re in Texas, and all your employees are in Texas, then you have got to register as a foreign entity in Texas. You’re going to be a Delaware, LLC, doing business in Texas. And you know, the little extra money you’re spending on filing fees and having to do tax filings in multiple States, it may not work out for you. So it’s just a consideration there. And then, the individual States taxes, franchise taxes and how one state handles it better than others, or it might have a little bit more advantageous tax structuring is a consideration. And it’s important also when you’re [00:20:00] doing your documents, that you understand what state you’re in, because each state uses a little bit different terminology. I kind of mentioned it a second ago, we call it a certificate of formation, and California calls it the articles of incorporation. You might have the articles of organization, the certificate of form of organization or incorporating it it’s these interchangeable terms and so you want to make sure that your documents reflect the exact terminology that your state, that you formed your entity in and whose law you’re following, it all needs to line up. And that’s where just pulling documents off the internet, these formation documents are not one size fits all. That’s for sure.
Brad: That’s a great point and you’re using. And so now that our audience knows that there’s a whole bunch of steps that you go through to form it, understanding that they’re different terms depending on your state. So in the story, I use a couple of terms and I want to get back to it. So Mr. Weasel was the sole manager and [00:21:00] he and his brother were the sole members. And for the audience, maybe you can at least distinguish in Texas and other States, what does that term mean? Manager and member of an LLC?
Robert: Absolutely. A member is going to be the owner. That would be the shareholder in a corporation. So in an LLC, we call it the members and those are the owners. Those are the people that are going to be receiving distributions, the profits of the company and have the ownership stake. A manager is a person more like the board of directors in a corporation. The managers are running the day-to-day operations. They can be a member or they could just be somebody you bring in to be the manager. And that’s where that operating agreement company agreement that I’ve been talking about. That’s going to be the document that distinguishes the power between those two positions. And it’s important, even if you’re a single member, LLC that you have those roles [00:22:00] divided. If you’re going to be a manager managed LLC, which we typically recommend is that there is that wall that divides those. So even though you’re the same person, it’s important to remember that you’re going to be wearing a different hat when you’re making decisions as a member, as opposed to making decisions as a manager. And there’s different, your fiduciary duties, who you are representing and the consequences of those actions. It does matter from a technical legal standpoint as to which hat you’re wearing when you make those.
Brad: Yeah that’s a good point. I want to jump on that real quick for audience understanding is that you could have a hat on as a member, right? As Robert just said, which means you’re an owner and you could also have a hat on as the manager. So it’s just different hats and you wear them at different times.
Michael: Yeah. I just want to say too, we mentioned earlier, Robert, that the company was taxed as a partnership in the story. Now none of us are tax attorneys so I think we can [00:23:00] do kind of a real quick summary, but can you kind of give an explanation on what the choices are when you’re an LLC on how it can be taxed?
Robert: LLCs are another benefit of the LLC that it’s very flexible, allows you to be taxed in several different ways. And the first step is just how many members you have. If you’re a single member, LLC, then your options are to be a disregarded entity, or you could elect, which is the default the IRS assigned to you, or you could elect to be taxed as an escort. A partnership is going to be the default for a multi-member LLC and you could also elect to be taxed as a different as an S Corp or C Corp if you wanted to. A partnership is just kind of that default tax setting for a multi-member LLC. And so while the LLC itself is not a partnership [00:24:00] in the sense of the structure of it. It can be taxed as a partnership in the eyes of the IRS so you’d follow that partnership tax law, which brings up the K-1 and everything that we discussed in the story.
Brad: That’s a great point. A lot of times, as you’re explaining, there is a difference from a tax perspective in an LLC. And so for our audience, Robert, we get this question a lot. Maybe the audience is like, I’m trying to remember what I am. Am I an LLC or an S Corp? Well, what’s the difference between an LLC and an S Corp?
Robert: An LLC is going to be the legal structure that you have filed as in your state. So I have formed a limited liability company. S Corp is a tax status. People might throw S Corp around which you’ve elected to with the IRS. People want to throw the S Corp around if you’re a corporation that is taxed as an S Corp, that’s one thing. An LLC that is taxed as an escort is a different. So for sure, don’t just say that you’re an S Corp. You are an [00:25:00] LLC that is taxed as an S Corp.
Michael: Wow. Okay. We could probably do an entire episode with one of our tax buddies to start breaking that down, but we would have zero listeners at the end. So Brad, what happened to Mr. Workhorse?
Brad: Well, unfortunately he had to hire litigation counsel and quickly learned that he was in a tough spot. He had no documents to prove that he was the owner. The LLC had had two years of tax returns, which did not list him as an owner and he didn’t have any significant documentation, except for the fact that he was listed as a W2 employee tax term, a W2 employee. So he was just treated just as any other employee of the entity. And unfortunately, after spending some good money, trying to chase this with this litigation counsel, he realized he really didn’t have any options but to either go back to his old employer, find a new employer, or start all over again. [00:26:00]
Michael: Man that sounds awful.
Brad: Yeah, it was terrible. After he told me this story, I gave him some additional thoughts and we kind of strategize a few other things, but eventually he headed back to work. We walked off and were walking down the corridor together and he was holding his cold pizza in his hand and it was just awful. He had tears going down his eyes as he was leaving, I felt horrible for him. I wish he had spoken with an attorney when this all started. And Michael, this is why we started this podcast. Going back to the theme, when should I ask for help?
Michael: Well, the answer always tends to be the same, on the front end. I mean Mr. Workhorse should have called an attorney when he was getting this set up to make sure that it was as he thought it was. Not just because he should have suspected his best friend would screw him over, but just to get the business set up correctly. And [00:27:00] what comes to mind when I hear this story and we connect it to the 5/50 rule is, a lot of times, the only option you have if you’re on the 50 side of things is litigation. For a small business, litigation’s not very viable. When we were doing our show prep, all of us got so mad just talking about the story again because you’re just thinking about how this guy got completely screwed and he had no access to justice. He couldn’t afford to fight the fight in a civil court context. And so he got pushed basically to killing his dream and going back into the workforce, so to speak.
Brad: Yep. Well on that positive note, join us next Wednesday when we have a special guest, the founder of Synergy MedAesthetics, Nicole Chiaramonte.
Outro: Thanks again for joining us today. And remember, [00:28:00] if you liked this episode, please subscribe. Make sure to give us a five-star rating and share with your friends. You can also sign up for the ByrdAdatto newsletter by going to our website at byrdadatto.com. ByrdAdatto is providing this podcast as a public service. This podcast is for educational purposes only. This podcast does not constitute legal advice, nor does it establish an attorney-client relationship. Reference to any specific product or entity does not constitute an endorsement or recommendation by ByrdAdatto. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Please consult with an attorney on your legal issues.