Starting a new business can be a daunting and expensive process for any new entrepreneur. For a brick-and-mortar business, this process typically includes all of the usual stopping points between a mere business concept and finally opening the doors to customers. This may include finding a space in which to operate, creating a brand presence through a creative name and specialized product/service, and creating the necessary framework to handle employee and tax obligations. This process can take an entrepreneur from a few weeks, months, and sometimes several years and can require the advice of a multitude of professionals: commercial bankers, real estate agents, business attorneys, and accountants, just to name a few.

 

For an entrepreneur seeking to provide video game related services to potential customers via the internet, however, he or she may begin creating content by streaming on Twitch or YouTube, spreading awareness for their work on social media, or professionally all in a single day with nothing more than a computer. Part of the excitement of platforms like Twitch or YouTube is that someone pursuing video-gaming streaming, a form of artistry, or other content creation as a way to make a living can potentially transform from a complete unknown, to an internet sensation, virtually overnight.

 

Beyond this, a new content creator on Twitch and YouTube is typically much younger than someone who decides to open a new brick-and-mortar business, and the former may be relying on their own parents as their primary source of guidance in getting their venture off the ground. While there is ample evidence throughout Twitch and YouTube to support the fact that youth is surely not a detriment to the potential success of the business, a sixteen, eighteen, or twenty year-old is simply not going to have the same network of professional contacts to assist them with their business venture as a sixty-five year old who has retired and wants to start their own small business.

 

This disconnect between the traditional business creation process for these internet-based service businesses, combined with the ease of entry to the industry (through Twitch, YouTube, and social media), and the relatively lower average age of these entrepreneurs, creates the perfect environment for an inexperienced decision-maker to enter in to contractual arrangements with little to no thought of their future impact. The situation between Tfue and FaZe Clan is a perfect example of how this situation can result in future problems for a successful content creator.

 

TFUE v. FaZe Clan

Although the issue may have arisen far before it reached our ears, the recent legal issue between Turner Tenney (professionally known as “Tfue”) and Faze Clan Inc. (known as “FaZe Clan”), a professional sports organization has shaken the video gaming community over the past week. Tfue is a gamer who primarily plays the popular battle-royale video game Fortnite, both professionally and as a streamer on Twitch. FaZe Clan is a sports entertainment organization, which primarily enters in to contracts with professional gamers to play certain video games on behalf of FaZe Clan, including Fortnite, Player Unknown’s Battlegrounds (“PubG”), and my personal favorite, Counter-Strike: Global Offensive (“CSGO”), among others.

 

Based upon the information available to the public from the Hollywood Reporter article on the subject, the issue between Tfue and FaZe Clan surrounds Tfue’s “Gamer Agreement”, which Tfue and FaZe Clan allegedly signed on April 27, 2018. While we only currently have the Complaint filed in the California Superior Court for the Central District of L.A. County, the basic allegations Tfue’s Complaint regarding his contract can be briefly summarized as follows:

 

 

Counts I & II              Tfue is alleging that the Gamer Agreement is void and invalid as a matter of law, or should be considered so by the court, to be, under both California contract law and California’s “Talent Agency Act” because of the language within the contract and surrounding circumstances, including the following:

 

 

a.    The Gamer Agreement allows FaZe Clan to extract a finder’s fee of “up to eighty percent (80%) of the revenue paid by third-parties for Tfue’s services.

 

b.    The Gamer Agreement restricts Tfue from lawfully pursuing his trade and profession by prohibiting Tfue from providing his services to any other gaming company than FaZe Clan, from appearing in, sponsoring, promoting, endorsing, or otherwise providing services on behalf of companies competitive with the products or services of FaZe Clan.

 

c.    The Gamer Agreement permits FaZe Clan to reject any third-party requests (including from sponsors) for Tfue’s services, the result of which could be a declination of an offer to Tfue from a third-party, which would have otherwise been profitable to Tfue.

 

Count III                     FaZe Clan’s use of the Gamer Agreement as described above constitutes unfair and unlawful business practices in violation of California law, and to the detriment and damage of Tfue.

 

Count IV, V, & VI          FaZe Clan recieved funds from third-party sponsorships for Tfue's services that were not distributed to Tfue as required. These separate counts each provide different    legal theories which allegedly support why Tfue is entitled to money damages based on this alleged conduct by FaZe Clan.

 

Count VII                   FaZe Clan acted against Tfue’s interest by preventing Tfue from moving forward with a sponsorship deal with HyperX (a company that is, in my opinion, most notable for its gaming headsets, but also a manufacturer of keyboards, mice, and other PC accessories) despite the fact that the rejection of this deal was detrimental to Tfue. Tfue also alleges that FaZe Clan rejected this deal because of a clear conflict of interest as a result of FaZe Clan’s relationship with another sponsor (although the identity of this sponsor is not in the Complaint, it seems to me that they are likely referring to SteelSeries, a direct competitor of HyperX in the PC accessory industry).

 

The Gamer Agreement

It is evident from the above that Tfue signed an Agreement with FaZe Clan that he now wishes he hadn’t signed. Based upon the limited provisions that are included in Tfue’s Complaint, it is clear that the Gamer Agreement is both comprehensive and restrictive. If the financial implications are true, it also creates a massive windfall to FaZe Clan for Tfue’s success and puts him in a position where he has little decision-making power in terms of which sponsors he deals with and whom he provides services to. Below are my thoughts on Tfue’s position, and the lessons that can be gleaned from his situation:

 

Tfue

Based on the above, and the timing of the signing of the Gamer Agreement, it is likely that Tfue signed the Gamer Agreement when he was relatively unknown, and while he likely always possessed the gaming skill he does today, his circumstances were not such to monetize his skills in the manner he is today. Think Eminem before Dr. Dre, or Drake before Lil’ Wayne.

 

A review of Tfue’s alleged historical Twitch subscriber data shows a drastic increase in subscribers to his Twitch account from 2,886 in April of 2018 (when he signed with FaZe Clan), to a whopping 65,633 in January of 2019. While this does not necessarily mean cause and effect, it is hard to ignore the timing and infer a correlation. Further, I doubt that as a twenty-year-old, excited to be signing an agreement with a major gaming organization, Tfue considered the impact the Gamer Agreement may have if he went from making several thousand dollars to making millions.

 

As a result, a restrictive contractual agreement with FaZe Clan which may have helped him, at least in part, to make such a meteoric rise is now (according to Tfue’s Complaint) restricting his freedom to perform services, curtailing his ability to make his own decisions regarding his own career, and potentially directing large amounts of money away from Tfue to FaZe Clan. I am assuming that the Gamer Agreement is of a lengthy duration as well, as it appears that Tfue’s attempt to negotiate a new agreement with FaZe Clan fell through, leading to the lawsuit. As such, Tfue’s only options were to 1) suffer the consequence of his decision to sign the Gamer Agreement until it ran its course, or 2) pursue legal action against FaZe Clan to attempt to get out of the Gamer Agreement.

 

The lesson here is simple. Always have an attorney review a contract before you sign it. It doesn’t matter if you have 65,633 Twitch subscribers, or 1,000 YouTube followers, the only time you can be certain to avoid the consequences of a restrictive contract is before you sign it. The terms of this agreement could bind you to something that could ruin your business, your career, and your livelihood. It could also lock you in to a financial arrangement you can’t get out of, and could divert the fruits of your labor to another person or organization. Although legal action is always an option, the results are never guaranteed, and will likely require a hefty amount in attorney’s fees to get your chance to get out of the agreement.

 

For Tfue, based upon Tfue’s Complaint and the limited portions of the Gamer Agreement therein modification of the agreement as follows could have prevented his situation: a contract with 1) a shorter duration; 2) less restrictive language; and/or 3) more control/direction by Tfue based on financial performance may have solved his issues before they began.

 

1)         If the contract were of a shorter duration, Tfue could simply weather the storm that is the Gamer Agreement and part ways with FaZe Clan when the Agreement expired. While he would still lose out in the short term, knowledge that his long-term career is not at risk would be the more important victory.

 

2)         If there had been thorough examination of the Gamer Agreement prior to its signature, the provisions cited within the same jump off the page as both comprehensive and restrictive. Often in reviewing contracts for my clients, my final advice to them is that it is okay to come to the conclusion that you are simply not willing to sign the contract with certain provisions left in. If the other party refuses to change the contract, it is almost always better to not sign the contract, rather than to agree to something you can’t do (either literally, figuratively, or morally).

 

3)         It makes perfectly good business sense that FaZe Clan would expect to “recoup their investment” in Tfue at the time of signing the Gamer Agreement. Rather than arguing against these provisions at the time of singing, perhaps Tfue could have asked for a provision that required the Gamer Agreement to be renegotiated or to terminate after certain financial performance. While FaZe Clan may not have been willing to budge on some of these provisions, it is unlikely their attorneys would have been absolutely unwilling to agree to any reasonable modifications to the Gamer Agreement. If they were, see #2 above.

 

FaZe Clan

The biggest takeaway from FaZe Clan’s side of the current situation is that regardless of the result of the dispute or of who is “right” or “wrong”, it is a publicity nightmare for FaZe Clan. While it appears that the Gamer Agreement does have some confidentiality language in it, in terms of what Tfue can disclose to third-parties regarding the Gamer Agreement, this language did not stop the disagreement between them from reaching the public. Only time will tell what kind of damage the fallout will do to FaZe Clan’s business and reputation.

 

Here are some tools FaZe Clan (by and through their attorneys) could have implemented in their Gamer Agreement to avoid this publicity nightmare:

 

1) Confidential Pre-litigation Mediation Clause – This clause requires any dispute between the parties to the agreement to submit to facilitated mediation as a condition precedent to filing a lawsuit or submitting a claim for arbitration. Mediation is a form of facilitated negotiation, where an impartial third-party attempts to find a resolution to the issue(s) that are agreeable to all parties. In short, it requires the parties to attempt to work things out before proceeding to litigation or arbitration. Most courts will enforce these clauses as a good faith attempt to avoid formal court action and promote settlement.

 

On the one hand, this lets an uninterested third-party mediator (typically a practicing attorney in that area of law or an alternative dispute resolution attorney) review each party’s claims, and try to find a resolution that is agreeable for both parties. On the other, this process not only often results in settlement, but it also gives the parties a better idea of what the other party’s interests in the dispute are beyond their legal claims. If the mediation is unsuccessful, the parties could still make their claims in the appropriate court or via arbitration if the contract contains an arbitration clause.

 

The kicker here is that this entire proceeding is confidential (assuming the contract drafter utilizes the proper language). None of this process would be public, and would have allowed FaZe Clan a chance, by and though their attorneys, to approach Tfue (and his attorneys) to attempt to reach an amicable resolution.

 

2) Arbitration Clause – Similar to the Confidential Pre-litigation Mediation Clause, an arbitration clause drafted with proper language would have further served to privatize the dispute if it were to move beyond negotiation or mediation. Arbitration is an alternative to litigation that can be selected by parties to a contract, which is typically less formal than litigation. This could also have aided FaZe Clan in avoiding the publicity headache that FaZe Clan now faces, and the potential backlash from their and Tfue’s fans.

 

Final Thoughts

Before you sign any contract, including a contract in the video game streaming, e-sports, and other online content creation industries, it is extremely important that you hire an experienced business attorney to review the document and represent you in contract negotiations.

 

While it is best to find a business attorney who has experience representing clients in your particular industry, if you are grasping at straws to find a qualified and trustworthy business attorney, here a couple suggestions on tracking one down:

·         Ask family and friends who own a small business for a referral;

·         Connect with other business professionals (financial advisors, CPAs, etc.) that you currently use for other services for a recommendation of someone they work with.

 

While many landowners, when asked to consider what their land consists of, would only think of the visible surface, this only encompasses one-third of their actual ownership. Through a concept known as cujus est solum, ejus est usque ad coelum et ad inferos (roughly, whoever owns the soil, owns all the way to the heavens and down to hell), ownership of the surface also gives ownership of the space below and above. While this doctrine has been impeded over time, most notably with the introduction of airplanes, it is still, in large part, intact.

Because of this doctrine, property owners are able to sell off portions of their land which still allow them to otherwise inhabit the surface, namely their mineral and airspace rights. Mineral rights have long been, and continue to be, a major concern for property owners, particularly where, as in Michigan, there is an abundance of oil and gas beneath the surface. But oil and gas are not the only things lurking beneath the surface.

The Backstory:

In 2005, Jerry and Robert Severson sold their ranch to the Murray family, but retained for themselves two-thirds of “all right title and interest in and to all of the oil, gas, hydrocarbons, and minerals in, on and under, and that may be produced from the [Ranch],” meaning that while both had the rights to the minerals, two-thirds of any profits would belong to the Seversons. However, what was found in 2006 was neither oil, nor gas, but instead several of the rarest, and most valuable dinosaur fossils ever found, including the unique “Dueling Dinosaurs” fossil, as well as one of only twelve completely intact Tyrannosaurus Rex fossils ever found (learn more about the fossils HERE). The Murrays were able to sell several of the fossils, with the T-Rex alone being sold for “several million dollars,” and the Dueling Dinosaurs being appraised between seven and nine million dollars. The Seversons, however, disputed the Murrays’ ownership, stating that the fossils qualified as “minerals” and, per the terms of the sale, they were entitled to two-thirds of the proceeds of the sale. When the Murrays were unwilling to part with the disputed monies, the Seversons filed suit. What followed was a case of Jurassic proportions.

The Science:

During the initial hearing at the United States District Court for the District of Montana, both the Murrays and the Seversons produced experts to testify as to the composition of the fossils. The Seversons’ expert testified that, while the bones of living vertebrates contain the mineral hydroxylapatite, during the fossilization process, that mineral would recrystallize into another mineral, francolite. Following tests on the fossils, the Seversons’ expert concluded that this recrystallization had occurred in these fossils, and because of this they qualified as “minerals.” Unsurprisingly, the Murray’s expert disagreed, stating that no recrystallization had occurred, and that the bones found in the soil were no different than a modern bison bone. The District Court, weighing both the scientific evidence, as well as what the District Court believed to be the definition of “mineral,” agreed with the Murrays.

The Legal:

The Seversons, disagreeing with the District Court’s decision, filed an appeal with the United States Court of Appeals for the Ninth Circuit, arguing that the plain definition of “minerals” included the fossils. In the Ninth Circuit, just as in Michigan, the Court noted that “words in a contract are interpreted ‘in their ordinary and popular sense unless the parties use the words in a technical sense or unless the parties give a special meaning to them by usage.” Here, to find the “plain meaning” of the word, the Court looked first to dictionary definitions of minerals, but found not only that dictionary definitions varied, but also that the interpretation of those definitions varied. While the Murrays argued that minerals only included items which were valuable because of their ability to be refined and used commercially, such as gold, diamonds, oil and gas, the Seversons argued that the fossils could also be used commercially, as evidenced by the Murray’s sale, and as such fell squarely within the Murray’s definition.  The Court, after weighing each of these arguments, along with several arguments specifically focused on Montana law, decided that dinosaur fossils fell inside the definition of “mineral,” and ordered the District Court to enter an order conforming with such a decision (Read the full decision HERE)

The Effect:

                While the Murrays may still appeal this decision to the Supreme Court, until such a time that they do so, and until the Supreme Court overrules the Ninth Circuit’s decision, the effect on landowners, both in Montana and around the country, is clear. Even though Ninth Circuit decisions are not binding upon cases in Michigan, as Michigan falls under the Sixth Circuit, as this is the only case which deals with fossils in the context of a mineral estate case, it would almost certainly be looked to for guidance. So, if you, or a friend, neighbor or family member, are looking to purchase or sell mineral rights, be sure to discuss whether or not fossils fall within the definition of “mineral,” so you don’t wake up with a pain in the neck big enough to bring down a brontosaurus.

Starting a new business can be a daunting and an expensive process for new entrepreneurs. Quite often, the sole focus of a new business owner is establishing the physical framework of the business, which may include essential building blocks such as finding a space in which to operate, creating a brand presence through a creative name and specialized product/service, and handling necessary employee and tax obligations. Often first-time business owners establish relationships with suppliers, marketing professionals, and accountants out of necessity to assist in the start-up process, but forego contacting a business attorney until after the first few years of their business venture.

 

By contrast, entrepreneurs who have past experience creating and running small businesses will contact an attorney prior to starting a new venture. There are several reasons why the knowledge and expertise of a business attorney will pay significant dividends to the business owner from the outset and will likely save the business significant legal costs in the long run.

 

Defining a Brand through Sale of a Product, Service, or Combination

 

Most new business ventures start due to some form of creative thought on the part of the entrepreneur. The business owner may have an idea for a new product, service, or a way to better provide an existing product or service to its target market. This new idea is at the forefront of business planning and represents the most significant “value add” to the fledgling business. Creating a brand or trade name for the new service or product is one of the most effective ways to garner notoriety for this new venture.

 

One of the most significant pitfalls for the entrepreneur who foregoes consulting a business attorney during this early process is failing to recognize that the legal rights to this branding concept may already belong to an existing business, or legally conflict with the name, slogan, or logo of another business or product line. Such a conflict can result in the new business owner realizing they are legally precluded from using their brand, but only after sinking significant funds in to its development.

 

Contacting an experienced business attorney at the outset of this process allows the business owner to ensure that state and/or federal rights to a trade name, logo, domain name, business name, or other brand identification (intellectual property) are available for the business and aligned with one another.  If the brand name is available for use, it can be adequately protected from use by competitors through state or federal registration.

 

 

 

Creating a Proper Entity

 

Whether it is through an accountant or from doing legal research through the internet, many new business owners properly identify the need to create a formal business entity out of which to run the business. The basic benefit of forming a small business entity such as a limited liability company (LLC) or an S corporation is two-fold. First, the business entity choice should protect the personal assets of the business owner from lawsuits or claims by creditors against the business. Second, the business entity choice should provide some level of tax benefit at an operational level to the business owner.

 

Despite these perceived benefits, if a business owner fails to consult a business attorney during this important step, these benefits may be diminished in value relative to another entity choice, or even fail to be present at all if the business owner fails to set up the entity properly pursuant to Michigan law.

 

First, in order to ensure a business entity will protect the personal assets of the business owner, the business owner must do a few things beyond simply forming the entity by filing the Articles at the state level. This includes creating proper entity documents as required by state law and maintaining proper separation between personal and business activities. If the creation of entity documents is attempted without the assistance of a seasoned business attorney, documents are very frequently drafted incorrectly or incompletely, resulting in additional cost to re-draft these documents properly. Similarly, pre-paid internet legal services that provide these documents often fail to address important state law, tax considerations, or provide documents that truly fit the scope and character of the new business.

 

Second, entity choice can play a significant role in the operational and long-term tax treatment of the business. Limited liability companies (which are taxed as partnerships by default) and S corporations (taxed under Subchapter S of the Federal Tax Code) provide unique business and tax planning opportunities to a business depending on a large number of different factors. These different tax treatments also create significant differences in the long-term tax treatment of the business, affecting choice in succession planning and the manner in which initial owners may form the business without incurring adverse tax consequences. As such, forming the proper entity for the specific product or service being provided at the outset is key in avoiding costly merger or conversion processes that may be utilized to alter initial entity choice after the business has already been formed.

 

Finding a Space

 

Unless a business owner is operating out of their residence, finding a space to purchase or lease is a necessity in starting a new business. Many business owners will choose to purchase or lease a space because of the physical layout or industry specific equipment present in a particular location. In entering into a purchase agreement or commercial lease, new business owners frequently gloss over significant obligations they are taking on in a rush to get their business open.

 

Unfortunately, many commercial leases and purchase agreements take advantage of restrictive and burdensome provisions that are not legally permissible in a purchase agreement or lease for residential property. This frequently includes requiring the new business owner to move in to the space accepting its current condition, without an inspection, no matter what potential structural flaws may exist. In the case of commercial leases, the agreement also often requires the tenant to pay for all necessary future repairs to the interior, and the obligation to replace all major equipment in the building, including any industry specific equipment, heating and cooling units, and utility related fixtures.  They also often state that any fixtures placed on the property become the property of the landlord.  Leases also often seek to take advantage of the excited, eager entrepreneur by asking the entrepreneur to individually sign a personal guaranty under the Lease, leaving their personal assets vulnerable.

 

It is also commonplace for the business owner to become aware of these obligations only after purchasing the building or becoming locked in to a lengthy lease. Contacting a business attorney prior to signing the document will allow a business owner to anticipate any potential issues with the space, be aware of their potential obligations for repair and maintenance, and allow the business owner an opportunity to negotiate these terms or simply find a different space if these obligations prove too daunting.

 

Creating Adequate Purchase, Employee, and Customer Agreements

 

The primary reason for delaying or altogether avoiding having a formal contract or agreement drafted by a business attorney is cost. Most frequently, the alternative is for the business owner to utilize a search engine to find a contract that appears to fit their industry. In other situations, business owners will skip the formalities and leave their business dealings to an oral agreement between themselves and the customer.

 

Despite the appearance of initial cost savings by repurposing an agreement from the internet or foregoing one entirely, a customer agreement that is not tailored to the product or service being provided to the public can create a catastrophic financial loss when a misunderstanding occurs with a customer. This can come from legal fees incurred through litigation and/or the judgment entered against the business in a lawsuit brought by a customer, or lost profits associated with a customer failing to pay and a business owner being unable to enforce its legal rights in collection. Frequently, these disputes arise because there is a difference in expectation between the business owner and the customer as to what was to be provided to the customer and when.

 

A well-drafted agreement will lay out all the material terms between the parties, and ideally leave no “grey area” for misunderstanding, or for the parties to dispute. In addition, in the event of a lawsuit against the business, provisions would be included in the agreement to benefit the business owner to the maximum extent possible under state law. In addition, any state or federal laws that enable the business to take industry specific collection efforts against a customer delinquent on payment would be in place to avoid loss of important cash flows.

 

At the end of the day, a well-drafted agreement will grant a business owner the maximum potential to negotiate a resolution without going to court, potentially saving the business thousands of dollars over and above the cost of drafting the agreement in the first place. Similarly, if litigation is inevitable, a well-drafted agreement gives the business solid footing on which to stand, rather than the shaky ground provided by an ambiguous, poorly drafted or incomplete contract. Unfortunately, once a dispute arises, there is no way to turn back the clock and draft an adequate agreement to avoid the dispute or aid in winning the resulting litigation.

 

Contacting an Attorney

 

Family and friends who own a small business, and other business professionals (financial advisors, CPAs, etc.) can be a great place to start for a referral to a local attorney who specializes in assisting start-ups and new business owners. Finding an attorney in this manner can be very valuable, as the referral is coming from someone who can either personally vouch for the expertise of the business attorney, or from another business professional who trusts the knowledge and integrity of the business attorney with their own clients.

When people ask me what type of law I practice, I tell them that we handle mostly business law, estate planning, and probate.  Because “business law” is so broad, I will often extrapolate on that and talk about how we assist entrepreneurs with everything from the start of the business to the end of the business and everything in between.  That includes entity selection and formation, corporate document drafting and review, contracts, intellectual property, and succession planning.  I was at my daughter’s friend’s birthday party and explained this to the hostess.  When I said “succession planning”, she said, “Oh, so you help businesses be successful?”  My initial reaction was to say no, that is not what that means.  But, actually, it kind of does mean that in a way.  It really got me thinking that a lot of people may not know what succession planning means.

 

The ideal time for us to meet entrepreneurs is at the inception of the business.  We can help them determine which entity structure is best for them from an operating, liability and tax perspective, and ensure they have the proper company documents in place, such as Articles, By-Laws or an Operating Agreement, Consent Resolutions, ownership interest certificates, etc.  We will research the proposed name for the business to ensure that it is not infringing on another business’s name or intellectual property.  Oftentimes, I will ask the entrepreneur what their goal is for the business and what will happen to the business if the principal becomes disabled or passes away, or what will happen when it is time for the principal to retire.  People are frequently taken aback by this line of questioning.  Why do we need to talk about the end of the business that is just getting started? 

 

It’s a fair question.  This discussion is important for several reasons.  Bad things happen and when a business relies solely on one person, the business can be destroyed quickly if something happens to that one person.  Is there someone that can step in and run the business?  The answer to this question is extremely important to the business owner(s), the business owner’s family members, employees, and perhaps most pressing, to the customers or clients of the business.  Additionally, we see too often a business owner in their seventies that is ready to retire but has no qualified retirement plan in place.  Most of the time, when this situation occurs, the business owner views their business as their retirement plan, but has no way to cash out of the business to sustain their lifestyle.  This can be catastrophic.  The business could be worth very little to an outside purchaser, or, even worse, there may be no one that wants to purchase the business.  As such, it is imperative that the business owner have a plan in place well before he or she is ready to retire.  This includes setting aside money for retirement and also having a business succession plan in place.

 

So, what is a succession plan?  A succession plan is just that – a plan for the future of the business beyond the career of the initial owner(s).  That means, it takes time to develop it and it needs to be in place prior to when it is needed.  It is a plan to address what will happen in the case of certain events.  If the principal becomes disabled or dies, there needs to be a plan in place for what will happen to the business.  There either needs to be someone who can run the business indefinitely unless and until the principal can return (in the case of disability), or there needs to be a plan to either sell the business or wind up the business and close down.  A succession plan needs to be developed to ensure continuity of the business if the principal is no longer in the picture due to disability, death, or retirement.  It is important to plan ahead so that the transition can be as seamless as possible.  Often, the plan includes family members who are involved in the business or trusted key employees that are well-versed in running the business.  This will make everything easier on the business owner, their family, the employees, and the customers or clients of the business.

 

Another key step in creating the succession plan is ensuring that the initial owner(s) can be sufficiently compensated for their ownership interest when the plan is put in to action. In the case of a sale to other existing owner(s) or to key employees of the business, if the sale is pre-planned, significant cost and tax savings can also be achieved. To accomplish this requires weighing and considering complex legal, financial, and tax factors surrounding the plan. Creating a team consisting of an experienced business attorney and business financial planner is the best way to ensure that all of these factors are accounted for so that the proper framework is put in to motion in enough time before the plan must be executed.

 

The hostess at the child’s birthday party wasn’t wrong.  Succession planning is helping to make a business successful - whether that be the retirement of the principal, a partial change in ownership, winding up the affairs of the business and closing down, passing the business to family members and/or key employees, or selling the business to a third party.  It is never too early to have a plan in place.

One common mistake made by business owners in either new or well-established businesses is that their company is set up as a limited liability company (LLC) with the State of Michigan and elects to be treated as an S corporation for Federal Income Tax purposes.  The result of this structure, or, for all intents and purposes, lack of structure, is that the entity is an LLC for state law purposes and a corporation in the eyes of the IRS.  We typically do not recommend this set up as there are pros and cons to each type of entity and it is important to maintain entity consistency on the Michigan and Federal Level.

In most situations, we do not favor LLCs for active, operating businesses. We do, however, recommend LLCs for rental and commercial real estate, and ownership and operation of capital equipment.

Why does State and Federal consistency matter?

The main purpose and benefit of setting up a business entity is to separate the liabilities of a business from the business owner’s personal assets.  In order for a business entity to properly protect the owner’s assets from liabilities of the business, the entity must be set up and operate as a valid business entity both on a State and Federal level.  The entity must also hold itself out to be a separate, valid, and lawful entity to customers and the public at large.  If a Michigan LLC is created but the company elects to be treated as an S Corporation with the IRS, an inherent disconnect between the operation, the tax filings, and the State corporate filings occurs.  If the business were to be sued, a plaintiff’s attorney may attempt to reach through the entity and assign liability to the business owner personally. This is particularly true for single-member LLCs, as historically they were not treated with the same liability protection as multi-member LLCs in some other states. Furthermore, the annual business activity of a single-member LLC is reported on the member’s personal tax return as a sole proprietorship. This is not a position that the business owner would ever want to be in when faced with a potential lawsuit.

In addition, there are certain tax-favored benefits afforded to the business owner in the operation, sale and merger of an S corporation that are not afforded to LLCs.  For example, if all of the shares of an S corporation are sold back to the company when a new owner buys in, the S corporation owner is afforded substantial tax benefits in the transaction.  These tax benefits do not exist for LLCs because the Federal Tax Code treats LLCs like partnerships. Rather than leaving the tax treatment of a sale or redemption of shares to be determined by the IRS on audit, it is far better to structure the entity as an S Corporation both on a State and Federal level from the inception, or at the very least, prior to the sale of the company. 

We also do not recommend that an LLC owning rental or commercial real estate or capital equipment elect to be taxed as an S corporation, as this election removes the tax benefits afforded to these types of LLCs under partnership taxation rules at the Federal level.

What do I do if my business is an LLC that elected to be treated as an S Corporation?

As indicated, this is a fairly common circumstance in the State of Michigan.  If a business has elected to be treated as an S corporation but is registered with the State of Michigan as an LLC, it signals to us that the entity is likely not set up properly with all of the required documents in place and therefore is not a valid LLC in Michigan.  Furthermore, even if it is a valid LLC, we highly recommend conversion to a corporation on the State level. 

If you have questions regarding the process for converting an LLC into an S corporation in the State of Michigan, please give us a call so that we can explain and assist with the process.

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About Us

The Firm, deeply rooted in Livingston County, has its origins in 1994 when it was founded by Tim Williams.  After having practiced predominantly in tax law for many years with larger firms, Tim decided to start a new firm that centered around working with people rather than with only highly complex tax issues. The Firm is centered in working with entrepreneurs and individuals with a personal touch.  The goal of the Firm has always been to create a relationship-driven rapport with its clients to establish long-lasting, personal relationships.  From the time it was founded, the Firm has specialized in business law and estate planning and probate practice.  Many of the Firm’s clients rely upon its attorneys for business guidance as well as legal counselling. The Firm has always made it a priority to devote time to giving back to the Livingston County community and its residents by working with and giving to charitable and service organizations.  The firm plans to continue to grow its client base in Livingston County and the surrounding areas.

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