Articles Posted in Small Businesses

This is the final installment in a series of articles dealing with Indiana’s new benefit corporation statute in general and its applicability to small businesses in particular, and we now arrive at the ultimate question:  Is it a good idea for a small businesses to incorporate as (or to convert to) a benefit corporation?

In our opinion, the best choice of entity for most small businesses is a limited liability company, not a corporation, and the new benefit corporation statute does not change that opinion. Although we think the benefit corporation statute is an excellent addition to Indiana corporate and business law, we believe the Indiana LLC statute already has enough flexibility to permit LLCs to adopt the same governing principles, policies, and procedures that are pre-packaged in the benefit corporation statute without giving up the other advantages that LLCs have over corporations in general.

First, the Indiana Business Flexibility Act allows LLCs to be organized for “any business, personal, or nonprofit purpose,” which certainly seems broad enough to include the combination of business and public benefit purposes for which benefit corporations are created. Second, all of the governance, transparency, and accountability provisions of the benefit corporation statute can be incorporated into a limited liability company’s operating agreement. Finally, certification as a B-Corp is not restricted to benefit corporations – essentially any form of business entity is eligible to be certified as a B-Corp, including LLCs.

Here are the links to the other articles in this series:

Benefit Corporations and Small Businesses — Part I
Benefit Corporations and Small Businesses — Part II
Benefit Corporations and Small Businesses — Part III
Benefit Corporations and Small Businesses — Part IV

[This article is written by Rep. Casey Cox (R-Fort Wayne), the author of Indiana’s new benefit corporation statute and an attorney in the Fort Wayne office of Beers Mallers Backs & Salin, LLP, where he practices in the areas of business and corporate matters, real estate, and local government law. As we developed this series, Rep. Cox was very generous with his time and his insights into the new statute.  For that and for this article, we are grateful, and we thank him. — MS]

The last few decades have seen a dramatic increase in the number of investors who not only seek a financial return but also want to invest their money is socially and economically responsible businesses, as well as an increase in the number of consumers who want to purchase goods and services from those businesses. Many of them are frustrated by the number of companies who claim to be good corporate citizens but do not provide the transparency for investors and consumers to prove it.

The Potential Drawback to Transparency

That does not necessarily mean the claims of those companies are false.  Some companies that are every bit as responsible as they say they are may be reluctant to provide transparency out of a concern of inviting shareholder lawsuits when their efforts to be socially and environmentally responsible arguably result in lower profits.  The benefit corporation statute addresses that concern in part by requiring directors to take into account the interests of constituencies other than shareholders, as well as local and global environmental impacts and the short and long term interests of the company.  Part III of this series raised the question of whether requiring (rather than just permitting) directors to consider those factors shifts the risk of lawsuits from those brought by shareholders who are disappointed with the company’s financial performance to those who are disappointed with the company’s social or environmental performance.

Encouraging, Not Punishing, Good Intentions

I discussed this point with B Lab and with the author of the Model Benefit Corporation Act. Their view was that the requirement to consider the factors listed in the code of conduct certainly does not require the board to act on the consideration. I do think it would be advisable in Board meetings to make reference to the factors to consider.  I also think the scope of which a particular Board would undertake those considerations may vary widely.  Also, while a benefit enforcement proceeding could be levied for failure to consider such factors, I think the failure would have to be pretty significant to merit bringing a benefit enforcement proceeding.  In addition, the remedy, I think, would be to simply force the Board to consider it, but not necessarily act or not act on the consideration.  I view the standard of conduct as a reminder to the Board of their purposes and the benefit report and the market itself as the prime enforcement of these standards.

In addition, a benefit enforcement proceeding brought by shareholders is also a derivative proceeding subject to the procedures of chapter 32 of the Indiana Business Corporation Law. (A derivative proceeding is one brought by a shareholder against a director or other person based on a lawsuit that the corporation could bring in its own name, but hasn’t.)  That chapter permits the board to appoint a committee of independent directors to decide whether the corporation should file its own lawsuit to pursue a claim raised in a derivative proceeding.  If the committee decides that it is not in the best interest of the corporation to do so, the derivative lawsuit will be generally be dismissed.

Finally, according to B Lab, there are about 2200 incorporated or converted benefit corporations in the country.  When I asked in January 2015 how prevalent the benefit enforcement proceeding was, they told me they were not yet aware of a single case in which it had been brought.

Casey B. Cox

[Part V concludes this series — MS]

Part I of this series briefly discussed Indiana’s new benefit corporation statute as well as certification of a company as a B Corp by B Lab and some of the their possible advantages.  Part II began a closer look at the details of the benefit corporation statute, including the question of whether the benefit corporation is a good choice for small businesses.

The “Benefit” Part of a Benefit Corporation

As we’ve mentioned before, a benefit corporation is one with purposes in addition to making money for its shareholders. All benefit corporations share the purpose of creating a general public benefit, defined as having an overall material positive impact on society and the environment.  In addition, benefit corporations may also establish for themselves the purpose of creating a specific public benefit that serves one or more public welfare, religious, charitable, scientific, literary, or educational purpose or another purpose that goes beyond the strict interests of the shareholders.

Transparency and Accountability

The benefit corporation statute also includes provisions intended to provide transparency to investors, customers, and the public.  For example, the corporation must prepare and file with the Secretary of State an annual benefit report that includes, among other things, a description of the ways in which the corporation pursued the general public benefit and its specific public benefit, the ways in which those benefits were achieved, and an assessment of the corporation’s performance measured against a standard created by an independent third party.

The statute also includes provisions that assure a degree of accountability for pursuing the general public benefit and its specific public benefit. Among those provisions are standards of conduct that require the directors to take into account the effects of any corporate action or inaction on:

  • The corporation’s shareholders
  • The workforces of the corporation, of its subsidiaries, and of its suppliers;
  • The corporation’s customers as beneficiaries of the corporation’s public benefits
  • The communities in which the corporation’s facilities, subsidiaries, and suppliers are located
  • The local and global environment
  • The short-term and long-term interests of the company

In addition, the statute gives the corporation, shareholders, and directors the right to initiate a benefit enforcement proceeding against the corporation or its directors or officers for the failure to pursue or create a general public benefit or the corporation’s specific public benefit or to comply any duty, obligation, or standard of conduct created by the statute.

The Concern that No Good Deed Goes Unpunished

A concern of the boards of some business corporations who would like to take into account factors other than maximizing corporate profit is that, by doing so, they may expose themselves to shareholder lawsuits for a breach of their fiduciary duties.  One of the reasons for the standards of conduct described above is to address that concern for the boards of benefit corporations.  However, taking into account every factor listed above for every corporate action or inaction appears to be a tall order, raising the question of whether the benefit corporation statute shifts the directors’ exposure to shareholder lawsuits from those based on the failure to maximize profit to those based on the failure to pursue the public benefit.  That question is addressed in Part IV.

Part I of this series briefly discussed Indiana’s new benefit corporation statute as well as certification of a company as a “B Corp” by B Lab and some of the possible advantages of certification and of incorporation under the new statute.  Part II begins to look more closely at the details of the new law and to consider whether it makes sense for small businesses to incorporate under the new statute.

From a corporate law perspective, benefit corporations are, first and foremost, corporations subject to the Indiana Business Corporation Law, just like any other Indiana for-profit corporation.  In our view, a corporation is not the best choice of the form of entity for most small businesses.  For a number of reasons, including the tax alternatives available to LLCs, the “pick-your-partner” and charging order provisions of the Indiana LLC statute, and the fact that LLCs have fewer corporate formalities that must be observed (which decreases the possibility that the liability shield that protects the assets of owners from the creditors of the business will be disregarded through so-called veil-piercing), we believe that a limited liability company is a better choice than a corporation for most small businesses.

The above advantages of LLCs over corporations are the same – or even greater – for benefit corporations.  For example, partnership taxation is not an option for benefit corporations; if that is important enough, a benefit corporation is not a viable alternative.  In addition, the benefit corporation adds more required corporate formalities on top of those already imposed by the Indiana Business Corporation law, increasing the administrative burden and the possibility of weakening the liability shield protecting the assets of owners from the company’s creditors.  In other words, for most small businesses, a benefit corporation will not be the best choice of entity for most small businesses, unless the advantages of incorporating as a benefit corporation outweigh the advantages of organizing as a limited liability company.

As we discussed in Part I, the advantages of a benefit corporation appear to fall into two categories:

  • The business advantages that may be achieved by demonstrating to customers and investors the company’s commitment to social and environmental responsibility and to creating specific social benefits.
  • Protecting the directors from lawsuits based on allegations of breach of fiduciary duties for basing decisions on social benefits instead of maximizing corporate profits.

As for the first category, we note that being a benefit corporation can help demonstrate a commitment to creating benefits to society but a benefit corporation probably has no more ability to produce those benefits than a regular business corporation or a limited liability company. For example, the Indiana Business Corporation Law already permits directors to take into account the impact of their decisions on constituencies other than their shareholders and concerns other than maximizing profit, and the Indiana Business Flexibility Act permits the organization of LLCs for any business, personal, or non-profit purpose, which seems broad enough to cover anything that might be accomplished by a benefit corporation. We will discuss that topic in more detail in Part III of this series.  The degree to which directors of a benefit corporation are exposed to lawsuits by shareholders for pursuing purposes other than the pecuniary interests of shareholders will be addressed briefly in Part III and more thoroughly by a guest blogger in Part IV.

On January 1, 2016, Indiana will join nearly 30 other states with statutes authorizing a relatively new form of for-profit corporations known as a benefit corporation.  The Indiana statute was created by House Enrolled Act 1015, which was authored by Rep. Casey Cox (R-Fort Wayne), and will be codified at Ind. Code 23‑1‑1.3.

Indiana’s benefit corporation statute, like most (maybe all) others, is based on a model statute developed by B Lab, a nonprofit organization that certifies businesses that meet certain standards for social and environmental performance, accountability, and transparency.  There are currently 1287 businesses certified by B Lab, including some companies that were well known for their social responsibility long before they were certified, such as Ben & Jerry’s.

Sorting out the terminology

Incorporation as a benefit corporation and certification by B Lab are two different things, but, unfortunately, both benefit corporations and certified businesses are often called “B Corps.” Another source of misunderstanding is that, although benefit corporations may serve purposes similar to the purposes served by nonprofit corporations, including those that are tax exempt under Section 501(c)(3) of the Internal Revenue Code, benefit corporations are neither nonprofit nor tax exempt.  Finally, despite the similar terms, a B Corp (by either definition) is not an alternative to an S-corp or a C-corp.  The latter two terms refer to the part of the Internal Revenue Code that applies to a particular corporation, not to the state statute that governs the corporation or to any sort of certification.  In fact, if things are not already confusing enough, every B Corp is also either an S-corp or a C-corp.

What is a benefit corporation?

A benefit corporation is a business corporation (i.e., a corporation governed by the Indiana Business Corporation Law or IBCL, Ind. Code 23-1-1), that opts in to the benefit corporation statute.  In essence, the benefit corporation statute serves as an overlay to the IBCL.  (Indiana’s professional corporation statute works more or less the same way, as an overlay to the IBCL.) Both existing corporations and new corporations may elect to be covered by the benefit corporation statute.

Once a company has elected to be a benefit corporation, it is subject to several additional requirements.  Among them are:

  • It must have a corporate purpose of generating a general public benefit, and it may have a purpose of generating a specific public benefit, including public welfare, religious, charitable, scientific, literary, or educational purposes.
  • In making decisions, its directors and its officers must take into account not only the interests of the shareholders but also the interests of other specified constituencies and concerns.
  • It must have a “benefit director,” and it may have a “benefit officer,” who have specific responsibilities and duties.
  • It must prepare and deliver to shareholders an annual benefit report including, among other things, an assessment of the company’s social and environmental performance measured against standards established by an independent third party (such as these).

Why elect treatment as a benefit corporation?

The advantages of the benefit corporation statute probably fall into two categories:  to enhance the company’s reputation as a socially and environmentally responsible company and to give its officers and directors more “cover” for making decisions that serve a public benefit at the expense of lower corporate earnings.

Companies have good reasons to enhance their reputations for social and environmental responsibility. For example, the company’s goods and services may be more attractive to certain groups of customers; its stock may be more attractive to certain groups of investors; and it may help with the company’s recruitment of employees.  The relative values of B-Corp certification and opting into a benefit corporation statute are a bit speculative.  It seems likely that B-Corp certification will be most effective in reaching out to customers and prospective customers because B Lab provides publicity to certified companies, but investors who are interested in corporate governance might attribute value to incorporation under a benefit corporation statute, either alone or in combination with certification.

On the other hand, protecting the directors from allegations of breach of fiduciary duties to the shareholders by making decisions that do not maximize profits is directly related to benefit corporation statute, and probably not at all to certification.  Although, as we will discuss later in this series, the IBCL already authorizes directors to take into account constituencies other than shareholders, some think the benefit corporation statute provides even more protection for officers and directors who pass up opportunities to make more money for the company in favor of serving a public purpose.

The issuance or sale of securities is subject to regulation by the United States Securities Exchange Commission and by authorities in every state, including the Securities Division of the Office of the Indiana Secretary of State.   Depending on the situation, a member’s interest in a limited liability company may or may not be within the definition of a “security” and, therefore, may or may not be subject to federal and state securities laws.  If the securities laws apply, the consequences can be signficant because, as my friend and retired securities lawyer Steven Lund says, “There are three types of securities:  registered, exempt, and illegal.”

Contrary to what you may sometimes hear, there is no exemption for securities that are issued or sold to family members or close friends, and there is no sale of securities that is exempt solely because the value is less than a certain amount.  In addition, certain parts of the securities laws, such as those prohibiting securities fraud, apply to every securities transaction, even if it is exempt from registration requirements.  An illegal sale of securities can have serious ramifications, including civil lawsuits and potentially even criminal charges.  And there can be ramifications even if there is never a lawsuit or governmental enforcement action  For example, a debt incurred through a securities violation cannot be discharged in bankruptcy.  Owners of small businesses who set up new LLCs, or bring new members into existing LLCs, without obtaining the advice of a lawyer with experience in corporate and LLC law expose their businesses and themselves to signficant risk.

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I sometimes run across small business owners who have set up their business as a corporation, and I often ask why they chose a corporation rather than a limited liability company (or LLC).  Sometimes the answer is that the business was incorporated before LLCs existed, or when LLCs were new and the lawyer who advised the owner was not familiar with LLCs or was not comfortable with using them, and that makes sense.  Another relatively common answer is that the owner’s lawyer or, more often, accountant advised the owner that there were advantages to being taxed as a Subchapter S corporation rather than being taxed as an LLC, so the business was organized as a corporation rather than a limited liability company.  That doesn’t make as much sense, at least not since 1997.

Although the history of LLCs can be traced back to earlier statutes in Germany and other European countries, there were no LLCs in the United States until 1977 when Wyoming passed the first LLC statute in the country.  For several years after that, the use of LLCs was suppressed by uncertainty surrounding their status for income tax purposes.

The Internal Revenue Code did not (and still does not) include provisions specifically written for taxing LLCs.  The question was whether they would be taxed as partnerships or as corporations, and the answer was not clear.  In 1995, the IRS issued guidance identifying four specific attributes Continue Reading

iStock_000041719054Small.jpgThe Department of Labor’s Office of Federal Contract Compliance Programs (“OFCCP”) has issued a notice of proposed rulemaking that would require certain government contractors to submit an Equal Pay Report to the government as a supplement to the Employer Information Report (EEO-1) that is already required.

If a final rule is adopted as proposed, the Equal Pay Report will require companies to report the number of workers within each EEO-1 job category, the total W-2 wages of all workers in each job category, and the number of hours worked by all workers in each job category, all broken down by race, ethnicity, and sex. Only aggregate information will be reported; no information regarding individual wages will be required. In addition, the reports will not include any information on worker qualifications or experience that might help explain any differences among the groups within a job category.

Small Businesses Excluded

Small businesses — those with fewer than 100 employees — are excluded from the new reporting requirements. In addition the new reporting requirements apply only to companies that hold a contract, subcontract, or purchase order with the Federal government that, including modifications, covers a period of more than 30 days and is worth at least $50,000.

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iStock_000023649013Small.jpgLast year the Indiana Court of Appeals decided a case that illustrates some of the hazards of operating a business as a general partnership. The case is Curves for Women of Angola vs. Flying Cat, LLC.

In 2001, a married couple, Dan and Lori, purchased a fitness and health franchise known as Curves for Women that they intended to operate in Angola, Indiana. The franchise agreement, which Dan and Lori both signed, contained the following affirmation:

We the undersigned principals of the corporate or partnership franchisee, do as individuals jointly and severally, with the corporation or partnership and amongst ourselves, accept and agree to all of the provisions, covenants and conditions of this agreement[.]

At no time did Dan and Lori form a corporation or limited liability company to own the franchise – not before signing the franchise agreement and not after.

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iStock_000017700348Small.jpgOwners of Indiana LLCs (and their lawyers) can learn some lessons from a recent case involving an Alabama LLC. The case is L.B. Whitfield, III Family LLC v. Virginia Ann Whitfield, et al.

The Whitfield Case

L.B. Whitfield, III owned half of the voting stock in a business that had been in his family for generations. The other half had belonged to L.B.’s brother, who died and left the stock to a trust for the benefit of his son.

L.B. had four children, his son Louie, and three daughters. After his brother’s death, L.B. became concerned that the 50/50 voting balance might be disturbed if, after he died, his stock were to be divided among his four children. To prevent that from happening, L.B. created a manager-managed Alabama limited liability company to hold his half of the voting stock. L.B. was the sole member, and he and Louie were the two managers. His will provided that his interest in the LLC would pass to his four children in four equal shares.

After L.B. died, Louie continued as manager, and the four children were treated as members of the LLC, with each of them holding 25% of the interest in the LLC. About 10 years later, a dispute arose between Louie and his sisters, and the dispute escalated into litigation. Ultimately, the litigation was resolved on a theory that was not argued in the original pleadings and apparently did not even occur to the parties’ lawyers until several months into the case.

The Alabama Supreme Court noted that L.B. had been the sole member of the LLC and that, after he died, the LLC had no members. Although L.B.’s will gave his children equal shares of his economic rights in the LLC (his “interest”), economic rights in an LLC and membership are two different things, and the will did not make his children members. The Court further noted that, under the Alabama LLC statute, a limited liability company that has no members is dissolved and its affairs must be wound up, a process which includes payment of its debt and distribution of its remaining assets to the holders of interest in the LLC. Accordingly, the Court held that the assets of the LLC should be distributed in four equal shares to Louie and his sisters.

Interestingly, the Alabama statute provides a way that L.B.’s heirs could have become members and avoided the dissolution of the LLC, but they had to do it by mutual written agreement within 90 days of L.B.’s death, and there was no such written agreement.

How does it work in Indiana?

If the Whitfield case had involved an Indiana LLC, the results might well have been the same. Unless other provisions (discussed below) have been made to avoid the result, when the single member of an LLC dies, that member will be dissociated (i.e., will cease to be a member, Ind. Code 23-18-6-5(a)(4)), the LLC will have no members, and, as a result, it will be dissolved, at least if the LLC was formed after June 30, 1999, (Ind. Code 23-18-9-1.1(c)). As a result, the member’s heirs will not receive an ongoing business; instead, they will receive only the rights to receive distributions from the dissolved LLC after all obligations are satisfied — which may be far less valuable than the business would have been as an ongoing concern.

Note that there are other scenarios that can create a similar result. Under Ind. Code 23-18-6-4.1(e) (which applies only to LLC’s formed after June 30, 1999), a member who assigns her entire interest to another person ceases to be a member. If the person making the assignment is the sole member, the person who receives the interest can become a member under Ind. Code 23-18-6-4.1(b), which provides that the person who receives the interest can become a member “in accordance with the terms of an agreement between the assignor and the assignee.” But what if there are no such terms? What if the agreement simply says, “Seller hereby assigns her interest in the LLC to Buyer,” but doesn’t mention membership? In that case (unless the operating agreement already deals with the situation some other way), the LLC will have no members, and it will be dissolved. In other words, the person who thought he bought an ongoing business may well have bought only the rights to receive distributions from a dissolved LLC.

Now, what if there are multiple members and one of them dies? In that case, the LLC is not dissolved, at least not if it was formed after June 30, 1999, but the member’s heirs may not become members. Although they may inherit the deceased member’s interest (i.e., rights to receive distributions), they will become members (and therefore have the right to participate in the management of the company), only if the operating agreement makes them members or the other members unanimously consent.

What should you do?

If you own an LLC, or if you own part of an LLC, and these possibilities make you uncomfortable, you need a business succession plan that includes two different components. First, it should include appropriate estate planning tools to make sure that your economic interest in the LLC goes to the people you want to taken care of after your death. For example, you may want to designate a transfer-on-death beneficiary to inherit your interest in the LLC. Second, the LLC should have an operating agreement with appropriate provisions to ensure that your heirs benefit not only from the right to receive distributions from the LLC but also receive the other rights of membership, including the right to participate in the management of the business. There are different ways to do that; an attorney with experience in business succession planning, particularly with Indiana LLCs, can help you choose the best one for you.
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