FINANCIAL PLANNING

VOLUME I

TABLE OF CONTENTS

This section of the book is for those persons who are or will be engaged in business. Obviously, one of the best ways to make money is to earn it. There are, in practice, only three legal ways to earn money: working for others, working for yourself or winning a lottery. Only the first two methods are dependable and, as to them, there are benefits and drawbacks with each.

As an employee, a person has the stability of knowing that fixed paycheck will be coming in each week. The drawback is that the employee does not share in the profits of the business and does not have the time to form his business. In contrast, a person in business for himself shapes his own destiny. No money is earned unless the person earns it himself. When no client comes into the office for advice or services, the lawyer does not earn any money. At that point, five degrees do not earn the money that a hamburger flipper with McDonald's makes. A self-employed business, however, has the opportunity to make more money annually than a salaried employee doing the same work. In addition, a self-employed person can set the hours, goals and objectives because he owns the business. A person who decides to go into business for himself or with others is to be congratulated.

Two or more people who are not married to each other and wish to conduct a business together have only two options available in structuring the business. They may incorporate and operate as a corporation or they may operate as a partnership. Corporations are discussed in the next chapter.

Partnerships are used because they are simple. A partnership is not required to be in writing to be legal; although it makes a great deal of sense to have it in writing. Partnerships are usually created between family members or close friends. There are two types of partnerships: general partnerships, which are discussed in this chapter, and limited partnerships, which are discussed in Chapter 10.

While general partnerships are simple to form and operate, that does not mean they are unregulated. On the contrary, a complete body of partnership law has been developed both by case law and statutory law. The rights and obligations of partners and those persons dealing with partnerships are covered by a state's general partnership law in the absence of written agreement of the partners to the contrary.

This chapter is intended to educate the reader about the differences between partnerships and corporations, but, most importantly, it is intended to raise the awareness of what is legally required of persons doing business in the form of apartnership. It is important that anyone considering the possibility of forming a partnership possess a good understanding of the rights and obligations that arise from a partnership arrangement.

The National Conference of Commissioners on Uniform State Laws wrote the Uniform Partnership Act (UPA). The Act has been adopted by every state except Louisiana. The UPA provides the rules on how a partnership is to operate when the partnership agreement does not have sufficient detail: the UPA fills in the blanks in a partnership agreement. The partners can agree not to use the UPA provisions. They can write their own replacement provisions if they elect to do so.

A partnership is two or more persons or entities working together as co-owners to run a business for profit. The Internal Revenue Code defines a partnership in Section 761(a) as:

"a syndicate, pool, joint venture or other unincorporated organization through which...any business is carried on...and is not a corporation, trust or an estate (meaning sole proprietorship)."

A partnership may be formed by a written agreement, or it may be formed by an oral agreement of the parties. The factors that determine if a partnership exists are:

1.Whether the parties intend to form a partnership, and

2.Whether they intend to make a profit from the activities.

Once the foundational elements of a partnership are met, the partnership is formed and governed either by the terms of the written agreement or the UPA or (in the case of Louisiana) its own state partnership law.

A joint venture is a partnership that was created to accomplish a narrow purpose. Most partnerships exist to make a profit while engaging in a particular type of business. A joint venture seeks to make a profit usually on a one-time basis. The joint venture automatically terminates when the purpose of the partnership is completed. An example of a regular partnership is where two persons form a cement- paving company. An example of a joint venture is where two persons agree to work together to pave just one job. A joint venture, as with a regular partnership, is governed by the partnership law of the state where it is formed. Like any partnership, the agreement should be in writing or else its provisions will be set by the state. Except for the limited purpose of the joint venture, it has the same issues, problems and elements of a regular partnership.

Partnerships are treated for federal tax purposes as "pass-through" vehicles. All profits and losses of the partnership pass through the partnership and are attributed to the partners. The effect of this pass through of profits and losses is that the partnership itself is not taxed. Partnership income is not subject to double taxation as is the income of a regular C corporation. To achieve this same tax benefit for small corporations, Congresscreated the S Corporation.

The partnership does not pay any taxes on the income from the partnership. All partnership profit and loss is passed through to the partners. The partnership files its Form 1165 partnership return and its K-1 to inform the IRS how the profit and loss is being allocated to each partner. Each partner is treated for tax purposes as a self-employed individual. Each partner is required to estimate his share of the partnership income and make estimated quarterly payments to the IRS.

Under the 1986 Tax Reform Act, profits and losses passing through to partners retain the same character they had in the partnership. A passive profit or loss to the partnership remains a passive profit or loss to the partner. The same treatment exists for an active profit or loss. A partner who materially participates in the partnership business will receive his portion of the attributed profits and losses and declare them "active" for tax purposes. A partner who does not actively participate in the partnership business will likewise receive all of his share of the profits and losses and will declare them "passive."

Generally a joint venture is treated the same as a partnership for tax purposes. There are certain Internal Revenue Code differences or elections, however, that pertain only to joint ventures:

1.The joint venture, like a partnership, must file an informational return except for certain real estate joint ventures.

2.The joint venture makes tax elections for computation of its taxable income.

3.The joint venture can adopt its own tax year but it must have I.R.S. permission to use a tax year different from any principal partner.

4.A joint venturer, one of the partners in the joint venture, may enter a business transaction with the joint venture and be treated as an outsider for tax purposes.

5.The members of the joint venture may elect to be excluded from some or all of subchapter K of the Internal Revenue Code (which defines how partnerships are taxed) if the joint venture is basically a passive investment .

The above tax aspects of joint ventures give them a better degree of flexibility than general purpose partnerships.

The main drawback to any general partnership is the fact that the partners are personally liable for the debts of the partnership. By forming a partnership the partners have agreed to guarantee payment of any debts or judgments taken against the partnership. Partners are not liable for the personal non-partnership related debts of the other partners.

Under the Uniform Partnership Act the partnership (and thus the partners) are liable for "any wrongful act or omission of any partner in the ordinary course of the business of the partnership. Where loss or injury is caused to any person by the partnership, the partners are individually liable for payment of the damages.In addition, the partners are liable for money damages that arise from the actions of any partnership employee or the other partners during the course of their work for the partnership. Example: A partner is involved in a car accident and kills two people while engaging in partnership work. All of the other partners will be liable to pay the damage award that the heirs of victims receive in wrongful death action against the partnership. If the award is $1,000,000 and the partnership only has assets of $200,000, a personal judgment will be taken against each partner for $800,000.

This is the main drawback of the partnership. The general rule of thumb is if a partnership is formed and it has employees, the partners should either carry a great deal of insurance or incorporate. Either of these entities will carry their individual personal liability for the partnership's debts.

By law each partner is an agent of the partnership. Each partner owes fiduciary duty to the partnership and to the other partners to act in their best interests. Some of the most important things that partners cannot do are:

1.A partner may not usurp a partnership benefit. This means that a partner must give the partnership the right of first refusal on any business opportunity he discovers that may benefit the partnership. Example: The partnership is in the paving business, and a partner finds that a school is intending to repave its parking lot. The partner cannot bid on the job for himselfwithout first informing the partnership of the job and giving the partnership the option of bidding.

2.A partner may not divert partnership assets for his own personal use. Such conduct is a breach of trust and may even expose the partner to criminal liability.

3.The partner must fully disclose all material facts affecting the partnership and its affairs to the other partners.

A partner who breaches any of these duties may be sued by the other partners for their lost profits or other damages suffered as a result of the partner's misconduct. If a partner usurps a partnership benefit, he may be ordered to pay all of the profits realized from the transaction to the partnership on the theory that the partnership should have received it.

In a general partnership each partner has full authority to act on the partnership's behalf in the normal course of its business. Each partner can bind both the partnership and the other partners to contracts that the other partners never authorized or approved. This unlimited power on the part of one partner to bind the partnership and the other partners is the biggest concern of most investors. The partners may agree to limit their authority to bind or act on behalf of the partnership.

People dealing with a partnership are entitled to assume that any partner has the right and power to act for the partnership inthe normal course of its business. Even though a partner may actually have limited authority to act for the partnership, the apparent authority of the partner may nevertheless bind the partnership to contracts with third parties. Contracts entered with people who did not actually know the partner lacked authority are binding on the partnership.

Moreover, there are some acts that a partner can never do unless the authority is specifically granted in a partnership agreement. Anyone dealing with a partner is presumed to know that he cannot execute a valid contract in these special areas unless the partnership agreement gives him the specific authority to act.

The Uniform Partnership Act states the following acts are invalid and not binding on the partnership unless the partnership agreement expressly states that a partner has the authority:

1. Transfer of a partner's interest to another.

2. Conveyance of partnership property.

3. Mortgaging of partnership property.

4. Confession of a judgment against the partnership.

5. Submission of partnership claim to arbitration.

6. Performing any act that would make it impossible to continue the business of the partnership.

Anyone dealing with a partnership should always ask to review the partnership agreement to assure himself the partner executing the contract does indeed have authority.

Before forming a partnership, the parties should consider thefollowing issues and decide for themselves how they should be addressed:

These are important considerations. They are not the only ones. Each partnership is different because each is composed of different people with different viewpoints. What must be remembered is that anything not covered in the partnership agreement will be decided in accordance with the state's Uniform Partnership Act. If the partners do not want the UPA to apply on a particular point, they must expressly create their alternative provision.

All partners have certain basic rights in a general partnership. These rights are:

1.To insist on a partnership accounting. Along with this right is the right to have the books examined by an outside accountant.

2.To dissolve the partnership in accordance with the terms of the partnership agreement or the Uniform Partnership Act of the state.

3.To restrain the partnership from performing acts prohibited under the partnership agreement.

4.To bring legal action for breach of the partnership agreement.

These are implied rights in any partnership agreement. Provisions in partnership agreements that waive such rights are usually found to be invalid and against public policy.

One of the most important issues in any partnership is how profits and losses are divided. After all, the partners formed the partnership in order to conduct a business to make money. Therefore, it is important to know the manner of accounting and distributing partnership profits and losses.

Under the Uniform Partnership Act all profits and losses of a partnership are divided equally among the partners. The equal division of profits and losses occurs even if the partners own unequal interests in the partnership or have contributed unequalamounts of work or property to it. The partners can agree to an unequal division of profits and losses. Unequal divisions are usually based on partnership ownership interests or contributions. Any agreement for an unequal division of profits and losses should be detailed with particular clarity in order to make clear that the UPA does not apply.

Under the Uniform Partnership Act property which is titled in the partnership name is owned by the partnership. A partner who contributes property to a partnership gives up ownership in the property. Likewise, property purchased with partnership funds is owned by the partnership.

The property held by a partnership can be legally sold, transferred or conveyed only by the partnership. Since partnership property is owned by the partnership, it cannot be directly attached to satisfy any court judgment against a partner. A partner's ownership interest in a partnership can be attached and sold by a creditor, but not the underlying property in the partnership.

The Uniform Partnership Act requires unanimous consent of all partners before the admission of new partners. Unless the partnership agreement has a clause to the contrary, the UPA requirement controls, and the admission of new partners requires unanimous consent. Requiring unanimous consent makes sense. If unanimous consent is not required, new partners can be added overthe objections of existing partners who would not be in the partnership had they known the identity of the new partners. The personal liability of each partner being at risk, it is essential that each retain the right to select whom he will share this responsibility.

Under the Uniform Partnership Act a new partner is liable for the partnership debts incurred before becoming a partner only to the extent of the amount of his contribution to the partnership. The partner is liable, as any partner, for all of the partnership debts incurred after becoming a partner. Example: George joins an existing partnership which owes $200,000 in debts. George contributes $50,000. After he joins, the partnership adds another $100,000 to its debt. George is liable for $150,000 of the total partnership debt: $50,000 of the pre-existing debt plus $100,000 debt after joining. The other partners are liable for the whole $300,000.

A tax consideration that all persons forming a partnership should bear in mind is the tax consequence of contributing services for an equity interest in the partnership. Under federal tax law a partner has to recognize as income the value of partnership interest purchased by services rendered or to be rendered. A person cannot acquire a partnership tax free by bartering services. Example: George agrees to become a partner by providing services. The partnership interest acquired will be worth $10,000. George will have to report the $10,000 as income on his tax return.

The tax consequence of purchasing a partnership interest with services may result in the transaction not being financially worthwhile personally. Often those who contributed services and perhaps some money resent the partner who contributed only money. In a successful partnership it is common for the partner who contributes most of the work to feel slighted when a partner who does less but who contributed the start-up capital receives a bigger share of the partnership by virtue of that capitalization.

Generally, a partner may freely sell or convey his interest in the partnership unless the partnership agreement says otherwise. If the other partners do not approve of the transfer, they can usually dissolve the partnership. The remaining partners do not have to dissolve the partnership if they object to the transfer. The Uniform Partnership Act protects the remaining partners by authorizing them to restrict the new partner. The remaining partners may continue partnership operation as before but not accord the new partner all of the rights of a full partner. Example: The new partner could have the right to receive the selling partner's share of profits but be prohibited from demanding an accounting or inspecting corporate books or participating in management of the business.

Partnerships which have a large number of partners sometimes have a provision in the partnership agreement which permits the expulsion of a partner without the dissolution of the partnership.Expulsion clauses in partnership agreements are valid if they exist to protect the partnership from harm caused as a result of the expelled partner's breach of the partnership agreement or fiduciary duties.

The procedure for the expulsion must be in the partnership agreement. An expulsion is obviously against the wishes of the expelled partner. Therefore, the courts will narrowly construe an expulsion clause to determine if it violates state law or is otherwise against public policy.

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A partnership is subject to its own peculiar tax treatment under federal tax law. Most unincorporated associations and trusts that conduct business are taxed as though they were corporations. Partnerships, however, are treated differently. In a partnership the income is attributed to the partners according to their percentage of partnership interest. The partnership pays no income tax itself on the federal level. Example: A partnership earns $1,000,000. It will pay no taxes. Each partner will include his pro rata share of the $1,000,000 on his personal tax returns. Assuming a 28% federal tax rate, the partners will pay a total of $280,000, not the total $519,200 that a C corporation and its shareholders must pay.

An S corporation is a corporation that is allowed to pass its income to the shareholders. In that respect, it resembles a partnership. The major differences between a partnership and anS Corporation are:

1.Partnerships may admit anyone as a partner and may have any number of partners; whereas S corporations are limited to 35 members of special status.

2.Partnerships can divide profits and losses in a manner not related to the partners' ownership interests. By contrast S corporations must divide profits and losses among the shareholders according to their percentage of stock ownership. In most cases these differences are not important because the S corporation usually does not want additional shareholders and does want profit and losses allocated according to shareholder investment.

3.Partnerships thrust personal liability onto each partner. The most important difference between S corporations and partnerships is that there is no personal liability on the part of the shareholders for the corporation's debts. By comparison, the general partners (but not limited partners) have personal liability for the partnership debts.

Persons considering doing business as a partnership should weigh the relative merits of both a partnership and an S corporation and elect the one that best suits their type of business.

Most states require a partnership to file a fictitious business name if they are doing business with the public. Allstates require a partnership doing business under a name other than its own to file a fictitious business name statement. The purpose of a fictitious name statement is to give notice to the world concerning who actually is running the business. Usually the filing is in the county clerk's office where the business is run under the fictitious name. If the partnership does business under a fictitious name in several counties, the filing must be in every county where it does business.

Any employer is familiar with the federal identification number (FIN). All employers are required to have one. A sole proprietor who has no employees is not required to have an identification number because his social security number is used instead. Once a partnership is formed, it needs an identification number because the partnership is also an employer.

A federal identification number is obtained by filing Form SS-4 with the IRS. It should be filed as soon as possible after the partnership is formed. A sole proprietor who joined a new partnership will need a new identification number. The old number used by the sole proprietor in the previous business will not transfer to the new partnership.

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The most important change in partnership law since the creation of the limited partnership is occurring now. A few formof partnership has been enacted by some states called the REGISTERED LIMITED LIABILITY PARTNERSHIP or just the LIMITED LIABILITY PARTNERSHIP (LLP). The limited liability partnership is a cross between the two existing types of partnerships: the general partnership and the limited partnership. On the whole, a LLP is the treated the same as a general partnership except for the fact that the LLP provides a degree of protection to the partners for the liabilities of the partnership. A LLP must, the same as any other type of partnership, be composed of two or more persons, trusts, or companies who have joined together to engage in a business for profit.

The driving force behind the enactment of LLP Acts is that professionals are permitted to practice their profession through the use of the LLP. As discussed in the chapter, LIMITED LIABILITY COMPANIES some states, most notably California, does not permit professionals to do business through the use of a limited liability company, LLC. In such states, professionals are limited to doing business in a corporate form, as either a regular corporation or subchapter S to limit their liability for the debts of the business. In order to provide professionals to get together and conduct their profession with some degree of limited liability for professionals working together, some states have enacted limited liability partnership acts. California is a state that does not permit professionals to operate through a LLC and instead adopted in October 1995, one year after the enactment of its LLC Act, a LLP Act. Other states which permit LLP's are Delaware, Minnesota, NewYork, New Mexico, Texas along with the District of Columbia. More states may be adopt such acts in the future. As of January 1996, 46 states along with the District of Columbia have enactment limited liability company acts. A LIMITED LIABILITY COMPANY OFFERS THE OWNERS (MEMBERS) THE SAME DEGREE OF FREEDOM AND OPERATION AS AN LLP ALONG WITH EVEN GREATER PROTECTION FOR LIABILITY FOR THE BUSINESS'S DEBTS. Usually, if a person can do business in either the LLC or the LLP form, the LLC form is better. As stated above, however, not all states permit their professionals to do business in the LLC business form. Therefore, in such states, the LLP is the only alternative to a forming a corporation if it is available in the person's state

The LLP is for most purposes the same as a general partnership. All of the discussions previously,in this books, regarding a general partnership except for the personal liability of the partners applies to the LLP. A partner of a LLP is a general partner not a limited partner. One of the major differences between the LLP and a general partnership is that the LLP is governed and managed by a written partnership agreement whereas the general partnership is not required to have a written partnership agreement.

As with a general partnership or limited partnership, the partners are the owners of the partnership in accordance to the terms and conditions set forth in the partnership agreement. As with any partnership, the partners are responsible for themanagement of the partnership either directly or through management which they elect or appoint. The partnership agreement will govern, when stated, those disputes that normally arise during the normal course of business. When the partnership agreement does not cover such instances, the normal business disputes or matters are handled by the majority vote of partners. When the disputes,in questions, are outside the normal course of business, the dispute can only be resolved by the unanimous vote of the partners, RUPA section 401(J).

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A corporation is an artificial entity created in conformity with a particular state's law. As a distinct legal entity, a corporation is considered to be separate and apart from all of the people who own, control or operate it. A corporation holds most of the rights of a legal person. A corporation is able to execute contracts, incur debts, hold title to both real and personal property and pay taxes. The attractiveness of a corporation stems from the very fact that it is held to be a separate legal entity from its owners (the shareholders), which gives it unique advantages over both a sole proprietorship and a partnership as an entity for conducting business.

A corporation is said to have perpetual existence: a corporation will legally exist forever unless it is dissolved or terminated under state law. One of the main grounds for a corporation's existence being terminated is its non-payment of taxes. Usually, as long as a corporation pays it taxes, it will remain in effect.

A corporation's perpetual existence is an important advantage over other forms of business. A partnership terminates upon the death of a partner, and a sole proprietorship also terminates upon the death of the owner. A corporation continues regardless of the death of a shareholder. The perpetual existence of a corporationis one of its most compelling features. The fact that a corporation continues regardless of the death of shareholders gives it stability. Most people are reluctant to invest in a business that is not a corporation and that may terminate upon the sudden death of any partner. Likewise, most lenders will not loan money to a partnership because it could suddenly terminate upon the death of a partner. The stability of a corporation derives from its continuity of existence beyond that of its shareholders.

The main advantage that a corporation has over a sole proprietorship or a partnership is that the shareholder is not personally liable for the debts of the corporation or the actions of the employees. Consider a partnership or sole proprietorship. If a partner or employee does an act in the scope of their employment that injures another person, each of the partners or the owner (of the sole-proprietorship) is personally liable to pay for the resulting damages. On the other hand, the most any shareholder can personally lose if a monetary judgment is taken against the corporation are the assets they contributed to the corporation in payment for their stock.

This limited liability for corporate shareholders is vastly different from a partnership or sole proprietorship where the owners are totally liable for all debts of the business. The creditors of the business can seek and attach every dollar and piece of property that a partner or sole proprietor owns in order to settle a judgment against the partnership or sole proprietorship. Such personal attachment of the assets of ashareholder is not allowed to satisfy corporate debts. The reason most people incorporate is to avoid this unlimited liability for the debts of the business. Few people would ever invest in a business if they would be risking everything they had earned or would earn in the future.

Several years ago, a person who owned a fast food franchise visited a corporate attorney for general tax advice. Since he was not incorporated, the attorney suggested that he incorporate so as not to be personally liable for any of the acts of his employees. The client, however, decided to rely on his insurance policy to protect him from any personal liability. As if on cue, less than three months later, the attorney opened his newspaper to read in the headlines that one of client's employees had hepatitis and passed it to over three hundred patrons. One person had died, another person had irreversible brain damage and the rest had varying degrees of discomfort. Later that day, the client called the attorney and asked what could be done to limit his liability. Unfortunately, the attorney had to explain that if the client's insurance did not cover all the damages that would be awarded, he would have to pay the difference. The upshot was that the client may be forced into bankruptcy simply because he had not incorporated. Had the client incorporated, he would not have had to face the possibility of personal judgments of hundreds of thousands of dollars in damages because of the acts of an employee. The moral of this all too true tale is that whenever a business has employees, the owners must either carry a great deal of insuranceor be incorporated (or if the sate permits being doing business as a limited liability company as discussed in the next chapter) in order to be protected from any judgments obtained as a result of the employees' or other partners' actions. Incorporation acts as a one-time insurance premium.

In addition to limited liability, special tax treatment for small corporations make them as attractive as partnerships. Normally, except for S corporations, the federal government taxes corporate income twice. Corporate income is taxed when the corporation first earns it, and it is taxed again when distributed to the shareholder. The federal corporate tax rate is:

Corporations having income between $100,000 and $335,000 are taxed at a 39% rate.

When after-tax income is distributed to the shareholders as dividends, the shareholders must include it on their tax returns as income. The shareholder has to pay income tax on the income he receives that has already been taxed as corporate income.

One alternative to this double taxation is for a small corporation to pay most of the income as legitimate salaries to the shareholders for work done. A salary is deductible by the corporation whereas a dividend payment is not deductible. Thus if the income can be paid as salaries, corporate taxes are reduced.

The taxing of a regular corporation is regulated by subchapterC of the federal tax code: it is called a "C corporation" and is subject to a different taxing structure than either a partnership or sole proprietorship. A special corporation whose taxing is regulated by subchapter S of the federal tax code is called an "S corporation" and is taxed quite differently from a C corporation.

The income tax of a C Corporation is subject to double taxation. It is taxed first when the corporation files its corporate tax return. The C corporation is taxed again when the corporation pays dividends to its shareholders: the dividends that a shareholder of a C corporation receives are includible in the shareholder's income on his Schedule B of Form 1040. Example: A C Corporation had $1,000,000 in net profit. It will pay approximately $340,000 in taxes. After it distributes the remaining $640,000 to the shareholders, they will have to pay taxes on it again. Assuming the shareholders' tax rate is 28%, the shareholders will pay an additional $179,200 in taxes. The total tax on the corporate income is $519,200 which means that the joint tax exceeds 51%.

Partnerships provide more flexibility than S corporations in a few areas:

Generally, these differences are not important because the S corporation usually does not want additional shareholders and does want profit and loss allocated according to stock ownership.

An individual who incorporates a business is given the opportunity to employ certain tax advantages called fringe benefits. A corporation is allowed to deduct from its pre-tax income the costs of certain fringe benefits that are not deductible by persons in a partnership or sole proprietorship. One of the main areas of tax advantage is in retirement plans. A corporate employer may contribute, tax free, significantly more to the employees' retirement plan than a self-employed person's Keogh plan. In addition, employees of corporate plans may borrow amounts to a maximum of $50,000 of the funds contributed to a plan without penalty which is not the case with Keogh plans. Other fringe benefits that are deductible by a corporation but not by a partnership or sole proprietorship are health, life and disability insurance and a $5,000 death benefit. These benefits are deductible by the corporation and usually are tax free to the corporate employee.

The costs for incorporating a business vary somewhat from state to state. In California the costs for filing the Articles of Incorporation and the minimum franchise tax fee is about $915. In addition, the corporate books, which include the minute book, stock book and the corporate seal, cost between $75 and $125. Attorney fees are normally $800 to $1,000 in California. Most states are not as expensive as California and charge $300 to $500 for an incorporation. In like manner, attorney fees in these states vary from $300 to $1,000. The cost of incorporation should be viewed as a one-time insurance premium. Once the business is incorporated, the shareholders are protected from individual liability caused by the actions of the corporation or its employees. After incorporation, shareholders no longer have everything they own at risk. Peace of mind is an important consideration when deciding to incorporate. After a corporation is formed, the yearly requirements for meetings and record keeping are not much more than required for any non-corporate business.

There is no mystery to forming a corporation nor is it difficult. In its simplest sense, a corporation is merely a license to do business in a particular manner. In that sense, the articles of incorporation are the application for the license, and, when accepted for filing by the secretary of state, become the license. In fact, a corporation is said to be "licensed to do business" once the articles are filed.

The act of incorporating a business is simple. All it entails is the filing of the articles of incorporation and the subsequent issuance of stock. The actual act of incorporating is no more than standing in line before a clerk in the secretary of state's office and having the articles filed and stamped. It can also beaccomplished by mail.

There are many companies that provide corporate kits which include basic articles, minutes and by-laws specifically designed for use in just one state. The usual cost is between $50 and $100. The corporate kit, however, does not address the many issues or provide the information contained in this book. This book, traveling beyond the mere corporate kit, provides guidance and advice on the considerations that arise in forming any corporation. Before filing any articles a person should decide what additional provisions he may want in the articles. In addition, a person should read those provisions in the state's corporation code (available in most public libraries) to assure that the state law has not changed in content.

There are many choices that an incorporator faces in forming a corporation. Many of these choices can be difficult given the many options available and the particular concerns of each business. One example of a choice that must be made is whether or not to become a "CLOSE CORPORATION" which requires the shareholders to agree to operate the business pursuant to a shareholder's agreement rather than under the formalized procedures of the state's corporate law. Another choice to be made is whether a Subchapter S tax treatment is desired. If it is, should the election be made at the first directors meeting. Nothing can replace the cold, practical consideration of the person forming the corporation. That person knows the business purpose and how it will be operated. The most any book can do is steer the incorporator tothose provisions and issues of concern and practical use.

There is no set definition of a small business. The definition varies among the states and is different under federal law. Simply, it means a corporation with a limited number of shareholders. When a business qualifies as a small corporation it has the opportunity of availing itself of special advantages. Under federal tax law a small business (less than 35 shareholders) may elect subchapter S tax treatment, which allows the corporation to be treated as a partnership for tax purposes. Many states have similar subchapter S laws for small corporations. Several states also permit small corporations (in Delaware it is 30 shareholders; in Ohio it is unlimited provided there has never been a public offering) to elect to become closely held corporations.

The steps for incorporating a business are simple. They can be summed up as simply filing the articles of incorporation and issuing the stock. In arriving at this result, the corporation will go through these steps:

A corporation must have a name that denotes that it is a corporation and not a partnership or sole proprietorship. The name usually must contain the word "Incorporated", "Corporation" or "Limited." The name must not mislead the public into believing it is an agent of the federal or state government. The name of the corporation must not mention or suggest involvement in a regulated or licensed field unless the corporation has that license. Forexample, selecting the name Dr. Peter Jones Medical Corporation for a corporation would not be valid unless Peter Jones, as the principal shareholder, actually had a medical license.

In practice, the main concern is that the proposed name may be so similar to an existing corporation's name that it misleads the public. No state will permit two corporations to have the same name or one so similar that they are confusing. To avoid the possibility of having the articles rejected because of similarity to the name of an existing corporation, the incorporator should conduct a name search with the secretary of state's office. If the name is not taken, it can be reserved for a period of 60 days or longer. The reservation fee is nominal. The search can be done by mailing a request with the name and a check for the search to the secretary of state. The amount of the check and where to send it can be obtained by telephoning the secretary of state's office. A search through the secretary of state's office will take about 30 days. There are attorney service firms (in the phone book for the state capitol) that will search the name and reserve it within two days for about $30. These firms also usually sell, for under $100, corporate kits for the state,If the corporation will be doing business in other states, it may have to operate under a fictitious name if the corporate name is substantially similar to an existing business in any of those states.

After the corporate name is reserved, the incorporator prepares and files the articles of incorporation. Each state hasit own requirements for the contents of the articles. There are sold in every state, corporate kits that contain the basic articles, stock and filing materials needed to become a corporation under that state's law. Such kits cost between $50 and $100. In addition, there has also been written a companion book to this series on incorporation which contains the Articles, Bylaws, stock certificates and minutes in more detail than any corporate kit and, yet, at a cheaper price. Most attorneys charge between $800 and $2,000 to, in essence, tailor make a set of Articles for filing which usually are not necessary.

After the articles are prepared, they are filed with the secretary of state's office. Most states require the articles to be filed in triplicate originals, all signed by the incorporator. Four or more originals should be filed and a conformed, file-stamped copy requested and received from the secretary of state. Filing can be done by mail. It will take thirty 30 to 60 days to get a return. The alternative is to use an attorney service to file the articles. Such a firm usually takes a week to get the articles returned and charges about $50 for the service. The advantage of the attorney service is that any problem can be corrected faster. When the articles are filed, the incorporator must pay the filing fee and the yearly franchise fee for the corporation. The fees vary from state to state. For example, in California the total fee is $917 ($117 filing and $800 franchise tax). The correct amount of the fees can be obtained by calling the secretary of state's office. If an attorney service is used, theywill know the fees.

After the articles are filed, the corporation exists in a de facto mode which means that it exists on paper. It is not until stock in the corporation is actually issued that it will exist at law (de jure). Outstanding shares in the hands of shareholders is the defining characteristic of a corporation.

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The most recent development in business law is the creation of the Limited Liability Company (LLC). The first LLC was created in the 1970's. For many years LLC's were not popular because the tax laws subjected them to more taxation than either a corporation or a limited partnership. In 1977, the first LLC was created in Wyoming for an oil company. The company was granted a private tax ruling stating that it would be treated as a partnership. In 1980, the U. S. Treasury issued proposed regulations that stated an LLC would be taxed as a corporation because its members did not have a partner's liability for the company's debts. In 1988, the Internal Revenue Service finally issued Revenue Ruling 88-76, 19882 CB 360, stating that an LLC could be taxed as a partnership. This revenue ruling calmed concerns about forming LLC's. As a result, the number of states permitting LLC's has increased dramatically.

An LLC is a cross between a corporation and a partnership. The characteristics shared with a corporation or a partnership are:

In addition, an LLC may give full management and control to just a few managing members, which is the same treatment that is available in a partnership and similar to that of the board of directors of a corporation.

The following, however, are the major differences between LLC's and corporations or partnerships:

These characteristics are important. If an LLC has any three of them (as discussed below), it will be taxed as a corporation. Such taxation would be detrimental to members so care must be taken in deciding which common characteristics the company should share with a corporation.

The main advantage of an LLC is the limited liability that it provides its owners, who are called members. In an LLC, the most that its members can lose in a lawsuit against the company are the assets they contributed to the LLC. The limitation of liability would naturally not extend to any personal guarantees of company debts by a member. If a member personally guarantees a company loan of $100,000, the member is personally liable for the repayment. The member's liability arises not because the person is a member of the company but because the member guaranteed that he personally would repay the loan. It is immaterial that the money may have gone directly to the company. The limited liability for members is quite different from that of a general partnership where the partners are totally liable for all debts of thebusiness. The creditors of a general partnership can seek and

attach every dollar and piece of property that a partner owns in order to settle a judgement against the partnership. Such personal attachment to satisfy company debts cannot be taken against the assets of a member. People either incorporate or form an LLC to eliminate this unlimited business liability exposure. Few people will invest in a business that risks everything they have or will earn.

LLC's are relatively new and has taken time for them to catch. Even so, 48 states and the District of Columbia now permit them to be formed or recognize them. Only Hawaii and Vermont have as yet to join the majority, although there are bills before their legislatures to enact a LLC Act. It is expected that soon these states will also enact a LLC Act.

The fact that some states have yet not decided to permit the existence of LLC's causes a degree of concern for any foreign LLC that wishes to do business in a state that does not permit the formation of LLC's. Such a state could treat a foreign LLC in one of two ways:

It is commonly felt among corporate and tax attorneys that most of the four states that do not permit their citizens to do business as an LLC will permit foreign citizens to do so. An LLC that is considering doing business in one of these three states should consult with both a corporate and a tax attorney to determine how that state would treat the company. It may well be that by the time the company wishes to do business in Hawaii or Vermont, the state may have, by then, adopted a LLC Act which settles the issue.

An LLC is considered to be separate and apart from all of the people who own, control and operate it. An LLC holds most of the rights of a legal person. An LLC is able to validly execute contracts, incur debts, hold title to both real and personal property and pay taxes. The attractiveness of LLC's is that they are held to be separate legal entities from owners, the members, which gives them unique advantages over both corporations and partnerships.

An LLC is a statutory creation. It can only be formed by strict compliance with the state law under which it is being created. An LLC just as with a corporation or a limited partnership requires a public filing of its formation documents. The filing of the articles of organization is required:

Most states require an LLC to have more than one owner. This is a different requirement than imposed on corporations, which are permitted to legally have only one shareholder. Several states which include Arizona, Colorado, Delaware, Illinois, Iowa, Kansas, Louisiana, Maryland, Minnesota, and Virginia permit only one person to form an LLC, but the company is not given legal effect until it has more than one member. The states requiring the LLC to have two or more members also usually require that the organizers sign the Articles of Organization or, alternatively, a subscription agreement prior to filing the articles. If a company falls below the minimum number of members for an LLC, it will not only be dissolved but it will lose the limited liability shield for its members to the extent necessary to dissolve the company. A company will be treated harshly if it continues to do business for an undue period after ceasing to have the minimum number of members. Those states that have the two member requirement use it to insure the availability of the partnership classification for tax purposes. A partnership requires, by definition, two or more persons engaged in business.

Articles of organization is an application by a group ofindividuals or entities for a license to do business as an LLC. Once the articles are accepted and filed, the LLC is thereafter formed. Each state sets its own requirements for the contents of the articles, however, they all require:

The requirement for listing both the resident agent and the registered office is also imposed upon a company which is incorporating. Listing of registered agent ensures that someone is authorized to receive legal process against the company. The resident agent is the person who is served any legal notices or summons and complaint on behalf of the company. A company maintains a resident agent in the state, or by default agrees to let the secretary of state serve as the resident agent. The registered office is the location where the company's authority is kept in the state. The registered office's address gives notice to the world where any complaint against the company can be served.

Several states also require additional provisions to be included in the articles, such as:

The states of Colorado, Florida, Minnesota, Nevada, West Virginia and Wyoming require the articles to state if the company will continue in effect upon the death, bankruptcy or withdrawal of a member.

This book attempts to provide a general set of articles sufficient for most states and has provided specific articles when necessary. The reader should, nonetheless, familiarize himself with the particular LLC law of the state where the LLC will be formed. There are possibly current changes not reflected in this text. The provisions contained in the articles of organization for an LLC can only be altered or changed by the filing of an amendment to the articles. Members frequently place important management provisions in the articles because it is difficult to amend them. The articles contained in this book are all that are needed to meet minimum requirements under state law. In practice, the entire operating agreement or any of its provisions can be included in the articles. Remember, once something is listed in the articles, it can only be changed by filing an amendment.

Before the articles are filed they must be approved and adopted. The person who will file the articles calls a meeting of potential members where they decide what provisions will be contained in the articles. They also decide another important detail: whether all the members or a centralized panel of selected managers will manage the business. Once the articles are adopted,they must be signed either by all the selected managing members, or

by all of the members (if no managing members are selected. Usually, the operating agreement for the company is also created and adopted at this meeting.

After the LLC files its articles, it exists on paper; it does not exist at law (de jure) until membership certificates are actually issued. It is the fact that the company has outstanding membership certificates in the hands of members that is the defining characteristic behind the existence of an LLC. Similarly, a corporation is not deemed to be in effect until it has sold and issued stock. Following the filing of the articles, the potential members of the LLC meet to purchase their membership certificates and adopt the operating agreement for the business. After the membership certificates have been issued, the company is fully formed.

Operating agreements are the rules for the general day-to-day management and operation of the LLC. Contained in the operating agreement are the terms of the company concerning:

The operating agreement is adopted by the members and thereafter can be amended only by a majority vote of the members. An operating agreement is an attempt to resolve the many areas of potential conflict within an LLC and to delegate duties and assign responsibilities. A proposed form for a basic operating agreement for use in the 48 entities that permit LLC's is in the company book for Limited Liability Companies of this series.

Operating agreements can be general in nature or tailored to the needs and desires of the members. Most operating agreements contain or mention most of the issues covered in the Operating Agreements chapter. A few states do not require the operating agreement to be in writing. Only if the agreement is in writing can the actual intent of the members be ascertained with confidence.

Operating agreements are not set in concrete and, in fact, quite flexible. Members can change the operating agreements by simple amendments. The purpose of operating agreements is to establish procedures for daily administration and management of the company. As the company develops the operating agreement must be amended to meet new requirements.

As can be seen from the foregoing discussions, the steps for forming a business as an LLC are simple:

Once these steps have been accomplished the LLC is formed and cancommence operations. An LLC is easier and less expensive to create than a corporation or a limited partnership provided ordinary caution and care are undertaken.

Members are the owners of the LLC. Usually an LLC must have two or more members. Texas alone permits a company to have only one member. Members own the membership certificates of the LLC and have the right to vote in the election of managing members. The extent of ownership interest a member has in the company is usually based either:

Members are not personally liable for the debts of the LLC beyond the extent of their investment in the LLC. Exception: A member is personally liable for a company debt or obligation if he personally guarantees repayment.

Members may agree for all members to manage the company or agree to elect a few members to manage, who will be called "managing members." In addition to electing any managing members, the members are required to vote on the following:

The term "managing member" refers to all of the managing members. Managing members must be elected if the operating agreement does not reserve the management to all of the members. If managing members are elected, they alone are responsible for running the day-to-day business of the LLC. When the LLC is taxed as a corporation, the managing members are permitted reasonable compensation for their services. In small LLC's, the managing members usually serve for free to protect their investments. Caveat: The decision to have the LLC managed by elected managing members is an element of corporate existence. If the company also has free transferability of its shares or continuity of life, it will be taxed as a corporation and not as a partnership.

Most operating agreements for an LLC require an annual members' meeting to review business affairs and conduct. The members also will elect or re-elect the managing members for another year. Members are usually given votes proportional to their percentage of ownership in the company. A majority of those membership interests voting is needed to carry a resolution or any other matter brought to the floor.

A member has a duty of loyalty to the LLC. A member cannot usurp a company benefit that could go to the LLC. A member owes the LLC the right of first refusal on any business opportunity hediscovers that could affect the company. For example, if the company is in the paving business, a member could not form a competing paving business and solicit business from the LLC's existing clients. When a member has a personal interest on a matter before the board, the member is only allowed to vote on it when:

A member cannot be sued by other members for losses incurred as a result of the member's actions or decisions provided they were reasonable and prudent. As agents of the LLC, members have the authority to bind the company by their actions. Members can execute contracts for the company and can subject the company to liability for damages arising from negligent or intentional acts they may commit on behalf of the company.

All of the states which permit LLC's hold that an assignment of a member's interest only passes financial right unless the operating agreement states otherwise. The assignee (person who acquired a member's interest in the company) only acquires the right to participate in the management of the company through a majority vote of the other members. Usually, a consensus is required.

This is important enough to repeat. The non-assigning members must agree to let the new member participate in the management unless the operating agreement states otherwise. This lack of fulltransferability of interest means interests do not have "free transferability." As a result, the value of the company is lessened and the company is assisted in obtaining tax treatment as a partnership.

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A membership interest in an LLC is a security just like stock in a corporation or interest in a limited partnership. Thus a membership certificate cannot be sold unless it is either registered or exempt from registration under both federal and state law. Registration for sale of a security under federal law costs thousands of dollars and takes months. Fortunately, there are several specific exemptions that a qualified LLC can use to avoid the federal registration requirement. Most small LLC's have at least one exemption available to avoid registration. The exemptions are:

Once the requirements for claiming an exemption have been satisfied, then the LLC can issue its membership certificates without fear of violating federal security laws.

In addition to the federal registration requirement, all states have registration requirements for securities sold in their jurisdictions. Just as there are exemptions from the federal registration requirement, the 48 states that permit LLC's have exemptions. Usually, an LLC of less than 15 members can simply sell membership certificates and notify the secretary of state of the sale. An LLC using this exemption is generally not required to identify the members who purchased.

If a membership certificate is sold without complying with both federal and state exemption procedure, the sale is voidable at any time by the purchaser. If the company fails, the members could use the fact that no exemption was ever obtained to sue the organizer for their money. A California case provides an actual example of how security laws are applied. A limited partnership was sold to fund the drilling of an oil and gas well. At the time the legal exemption was for a maximum of five persons (it has since been increased to 35). The interests were sold to nine members. The well was drilled and was dry. Two of the investors sued to get their money claiming the sale was not exempt because more than five persons bought interests. The general partner faced criminal charges for selling an unlicensed security and had to refund the full investment money to all of the investors. If the sale hadbeen to only five persons, there would not have been a problem. The lesson to borne in mind is that it is not only necessary but critical to open both the state and federal security laws.

How an LLC will be taxed is the second most important concern, the first being the limited liability of members. Because an LLC has elements of both a corporation and partnership, it can, depending on the facts, be treated for tax purposes as either a corporation or a partnership. When the LLC is taxed as a partnership, its income is passed to its members and double taxation is avoided. On the other hand, when an LLC is taxed as a corporation, its income is taxed twice, first upon being earned and second when distributed to its members as dividends. It is almost always better for an LLC to be taxed as a partnership so as to avoid the double taxation.

Regardless of how a LLC is treated for tax purposes, be it as a partnership or as a corporation, the members of the LLC will not have personal liability for the debts of the company.

The IRS has developed a four-prong test for determining whether an LLC will be taxed as a corporation or a partnership. If an LLC possesses any three of the four following corporate characteristics, it will be taxed as a corporation and not as a partnership:

When three of the four characteristics listed above are present,the LLC will be taxed as though it is a corporation. It does not make good sense to do business as an LLC unless the company will be treated as a partnership for federal tax purposes.

Another tax concern of an LLC is how its property will be treated for tax purposes. Property which is titled in the LLC name is owned by the LLC, not the individual members. The same is true for property contributed to a corporation or a partnership. A member who contributes property to an LLC relinquishes ownership in the property, and property purchased with LLC funds is owned by the LLC. This company ownership of the property means that creditors of members cannot attach the property. They are limited to attaching the member's interest in the LLC. The property held by an LLC can be legally sold, transferred or conveyed only by the company. The LLC's basis in the contributed property is the basis that the member had before it was contributed.

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An LLC is a legal entity, but because it is an artificial entity, it needs an individual to file any lawsuit on its behalf. When the company is managed by all the members, a suit can be brought by a member only after a majority vote of approval by the members. An exception to the majority vote approval requirement for filing a suit may exist where there is a conflict of interest among the members or members are breaching their fiduciary duties. The non-agreeing members would be excluded from the voting, and only the votes of the disinterested members would be considered. If thesuit is commenced, and it is later found that the members whose votes were ignored were not in violation of their fiduciary duties and had no conflict of interest, the persons bringing the suit might be held personally responsible for any damages caused by virtue of the suit.

When a suit is brought by virtue of a majority vote of approval by all members, no member will be personally liable for any damages that might result to the company. When the company is being managed by managing members, it is the managing members who have the authority to file suit on behalf of the company. A manager is bound by the fiduciary standard of care of a reasonable and prudent manager in making a decision about commencement of a lawsuit.

Liability attaches to a member who brings unauthorized or improvident suit that violates the fiduciary standard of care. Should a member act without the approval of the other members to file suit, the company would nonetheless be bound by the decision or settlement. The company may sue a member for any damages which the company suffered by virtue of the member bringing an unauthorized suit or settling one improperly.

As part of the legal series, a book on limited liability companies has also been written.

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The North American Free Trade agreement (NAFTA) is the most important and expansive trade agreement ever created. The signatories of NAFTA are Canada, Mexico and The United States. Several Central American countries have expressed interest in joining NAFTA as well. NAFTA is the largest free trade zone in the world. NAFTA creates a single $6.5 trillion market with 370 million persons. The primary aspect of NAFTA is its tariff elimination feature. Prior to the enactment of NAFTA Mexican import tariffs were 2.5 times greater on American and Canadian goods than the import tariffs charged by the U.S. or Canada on Mexican goods. Nearly all tariffs on Canadian, Mexican, and American goods are scheduled to be slowly eliminated within 10 years.

NAFTA is in many ways a continuation of the 1988 Canada-United States Free Trade Agreement (CFTA). As a result of the enactment of the CFTA, trade between Canada and the United States experienced unprecedented growth. Both Canada and the United States prospered as a result of the increased trade to an extent that exceeded expectations. Canadian trade in 1992 accounted for 1.5 million U.S. jobs. It was the success of CFTA that prompted Canada and the United States to approach Mexico with the idea of creating asimilar program for all of North America.

Mexico, after decades of isolationism, was receptive to the idea of a North American free trade zone. Until 1986 Mexico's markets had essentially been closed to foreigners. As a result, the Mexican economy had stagnated. In 1986, Mexico had eased some of its restrictions to foreign investment and opened many of its markets. The result was an immediate success. The year Mexico opened its markets (1986) U.S. trade with Mexico was $17.8 billion. In 1992, U.S. trade to Mexico had increased to $40.6 billion, an increase of 228%. Mexico is the U.S.'s second largest market for manufactured goods, much larger than Japan. U.S. trade to Mexico in 1986 supported nearly 700,000 jobs scattered throughout the United States. NAFTA is projected to create another 200,000 U.S. jobs in its first year. Mexico was the third largest trading partner of the United States even before NAFTA. The per capita income for the average Mexican is relatively low compared to a U.S. citizen, but there are over 90 million Mexicans. The purchasing power is impressive.

NAFTA coverage will extend to products and goods originating in North America (Canada, America or Mexico) or goods and products that contain nonregional materials that have been transformed to such an extent by the manufacturing process that they are now considered as originating in North America. There is a de minimis rule for many products that permits as much as 7% of a product to contain non-North American materials without substantial modification.

Special treatment under NAFTA is afforded automotive goods. Tariffs on passenger cars, light trucks and other vehicles and parts are to be slowly eliminated, usually in five years but not more than 10. Cars and trucks must have at least 62.5% North American content (be composed of North American originating materials). Other vehicles and parts must have a 60% content. Mexico has agreed to end its Auto and Auto-Transportation decrees that impose production and sales restrictions by 2004. In 2009 Mexico will begin a 10-year elimination of its imports of North American used vehicles. Estimates for the U.S. automobile industry predict that for the first year NAFTA sales will rise from less than 2,000 vehicles to over 60,000 vehicles.

Most tariffs on textiles and apparel were eliminated immediately upon enactment of NAFTA with the remainder to disappear by 2004. Most U.S. quotas on Mexican textiles and apparel were eliminated on those goods that meet NAFTA's rules of origin (met the required percentage of North American origin).

Broadly speaking, a free trade zone in North America will remove or gradually reduce barriers to trade and permit a more profitable growth of trade between all of the members. Established economic policies of free trade increase efficiency in trade and lead to increased trade and overall improvement in economic well-being. Most economists have predicted that NAFTA will generate a discernible increase in U.S. jobs. The Institute for International Economics predicts a net gain of 170,000 jobs by 1995 with 316,000 new jobs against a loss of 145,000 jobs.

The average Mexican purchases more U.S. imports than the average person in the European community or Japan. Seventy cents of every dollar a Mexican spends on foreign products is spent for a U.S. product. In 1992, the average Mexican spent $450 on U.S. produced products. In contrast, the average Japanese individual only spent $385 on U.S. products. Mexico is the second largest market for U.S. tele-communications exports in the world, which increased 20% between 1991 and 1992.

NAFTA will have both its good points and its bad points. Personal feeling on NAFTA will depend on how it affects the individual on a personal basis. The International Trade Commission has estimated that the U.S.'s horticultural, tuna, apparel, construction and household glassware industries are to be the most adversely affected by NAFTA. In contrast, the greatest gains are estimated in U.S. agricultural and capital goods. Capital goods are goods used in the production of other goods: industrial buildings, machinery, equipment, highways, office buildings, government installations. These goods form a nation's productive capacity.

Capital goods have been the slowest increasing export category of U.S. exports between 1988 and 1993. Capital goods remain the largest single export item to Mexico but the percentage has been dropping. In 1987, the percentage of total U.S. capital goods exported to Mexico was 40%. In 1992, this percentage reduced to 33%. The percentage is misleading to an extent because overall trade with Mexico during this period increased by 228%. So the netcash value of capital exports to Mexico was nearly twice what it had been in 1987. Capital goods account for 40% of all U.S. exports to developing countries and 39% of all U.S. exports in total. The exports of capital goods to Mexico support major employment in high paying U.S. jobs and will continue to do so for many years to come.

Prior to NAFTA, Canada had little trade with Mexico. Canada's reason for joining NAFTA was to assure that it did not lose benefits from its existing free trade agreement with the United States. Canada also recognized the possible advantage that might accrue from having the sizeable Mexican market opened to it. Generally, the tariff reduction schedule established under CFTA remains in force for trade between the U.S. and Canada at lower rates than most of the NAFTA schedules. The result is that most goods traded between Canada and the U.S. are very nearly tariff free whereas goods traded to and from Mexico will still in many cases be subject to tariffs for the next five or 10 years. Canada and the U.S. still have a slight incentive over the next few years to trade between themselves rather than with Mexico until all tariffs are eliminated.

It has been asserted that NAFTA is the best prospect for reducing illegal immigration from Mexico to the United States. A study on the economic impact of illegal immigration was performed in 1991 by Robinson and Hinojosa-Ojeda of the University of California. The report concluded that free trade coupled with internal reforms could reduce immigration (both legal and illegal)by 260,000 to 1.1 million people by the year 2000. Another study by William Spriggs of the Economic Policy Institute (an opponent to NAFTA) concluded that NAFTA would result in 1.4 million fewer Mexicans migrating to the U.S. by the year 2000. It has also been concluded that a reduction of illegal migration to the U.S. will result in the real wages of U.S. residents increasing as much as 6%. NAFTA does not interfere with a member's right to set its own environmental, health or safety standards. Nonetheless, NAFTA requires each country to make laws and set standards compatible with the other two. Supplemental agreements on environmental issues require that each country actively enforce its environmental laws equally and without discrimination against persons or entities from the other NAFTA members.

Commissions are to be established to settle disputes when a government does not enforce its laws with the result that investors, persons or businesses from the other NAFTA countries are placed in a competitive disadvantage. If for a period of time the nonenforcement of the law continues, trade sanctions may be imposed under NAFTA against the offending country. The United States reserves the right to enforce its own trade laws, and if NAFTA is not operating for the benefit of U.S. workers and businesses, the U.S. may withdraw from NAFTA at any time after six months notice.

An argument against NAFTA often heard is that U.S. companies will abandon the U.S. and relocate in Mexico. While this will undoubtedly occur in some glaring instances, it will not be the rule. Even before NAFTA, Mexico permitted regulated foreigninvestment. In addition, there is the maquiladora program that permits American companies to open plants directly across the border and have the finished products shipped to the U.S. tariff free. Despite this fact, only a few foreign companies have opened plants in Mexico and the U.S. is not being overcome with imports from such plants. In fact, the opposite has occurred: U.S. exports from highly paid U.S. workers have flooded Mexico. The economic message is that low wages alone do not guarantee success. Quality of the work and high productivity are more important than low wages alone.

The text of NAFTA may be obtained by calling the U.S. Printing Office at (202) 783-3238 or by fax at (202) 512-2250. Payment for the order may be made by credit card using VISA or Mastercard. Documents can also be ordered by mail sent to:

The prices for the NAFTA publications are:

TEXT OF NAFTA (volumes 1 and 2) 041-001-00376-2 $41.00

TARIFF SCHEDULES (ANNEX 302.2):

UNITED STATES 041-001-00377-1 $34.00

MEXICO 041-001-00391-6 $34.00

CANADA 041-001-00390-8 $30.00

SUPPLEMENTAL AGREEMENTS 041-001-00411-4 $ 6.50

The tariff schedules are the most important NAFTA books. These schedules list the tariff rate that each party imposes on the imported goods from each of the other members and the tariff elimination schedules.

The greatest practical impediment to trade between countries is the paperwork which exporters must prepare in order to sell their product. The cumbersome nature of the paperwork and long delays in delivery that result from any small technical mistake has caused manufacturers to decide not to export their product. The main reason behind the paperwork is so that the importing country can collect tariffs. As tariffs are eliminated, the need for such paperwork is, itself, gradually eliminated. Towards this end, NAFTA has up customs procedures to reflect the gradually reducing tariffs and thus less paperwork as well.

NAFTA concerns increasing trade between Canada, Mexico and the United States. For that reason, it is important for a procedure to be adopted to determine what is the country of origin for products exported between the countries. Without a viable system to determine truth of origin, non-NAFTA countries can ship their product through one NAFTA country to another in order to avoid import duties.

NAFTA adopted the origin rule of the 1988 Canada-U.S. Free Trade Agreement (CFTA) as its standard. To be covered by NAFTA, exported goods must have undergone processing in North America. Many foreign corporations have significant investments in NAFTA countries. It is hoped these foreign corporations will increase their operations in Canada, Mexico and the United States to qualify for the NAFTA tariff reductions.

NAFTA creates a uniform certificate of origin for use by NAFTA countries. The Certificate of Origin can be obtained from many stationary stores and from the U.S. Custom Service. The exporter of a product seeking NAFTA tariff reduction must state in the certificate of origin that the product qualifies as an "originating good." An originating good is one that qualifies under NAFTA as a product possessing the required North American content. NAFTA does not require certificates of origin when the value of the exported good does not exceed $1,000. Importers who seek to claim tariff reductions on imported goods under NAFTA must declare the imports qualify as originating goods. The importer's declaration must be based on the exporter's certificate of origin. An importer has one year to seek refund for any excess tariff that was erroneously paid on qualified original goods. For example, assume that a product qualifies for a 10% reduction in tariffs, but the importer mistakenly pays full tariff. The importer can seek a refund for the 10% overpayment within one year of the overpayment.

False statements on a certificate of origin will subject the exporter to the same civil and criminal penalties as an importer who makes false statements to avoid tariff duties. An exporter who voluntarily corrects a false certificate will not be subject topenalties for the false statement.

NAFTA imposes upon both exporters and importers the burden of having to maintain records for five years on products that were issued certificates of origin and received reduced tariffs. NAFTA requires that the parties keep records on:

The purpose of requiring the maintenance of these records is to assure that goods for which tariff reductions were given did, in fact, qualify for the reductions. The documentation requirement imposes a greater burden on smaller companies than larger companies. Small companies do not usually maintain such detailed records. Revamping their records policy to maintain such comprehensive records will be difficult. When the tariff savings involved are relatively low, the expense in maintaining these records may exceed the amount actually saved. In such an event, the importer may simply decide to pay the full tariff rather than be bound by unprofitable record keeping.

NAFTA Article 401 determines what exports are covered byNAFTA. Article 401 states:

A good shall originate in the territory of a party where:

Goods exported from a NAFTA country to another NAFTA country will be covered by the tariff elimination schedule of NAFTA if:

Annex 401.1 describes the tariff changes required to grant North American origin to goods containing non-NAFTA components. Annex 401.1 tariff category listings also state what the manufacturer must do to meet the NAFTA tariff elimination requirement. NAFTA differs from previous tariff treaties in that it does not require a specific percentage of the product value to be derived from the country claiming the tariff reduction. Under the Generalized System of Preference (GSP), 35% of the value of the product must be derived from work or materials provided by the GSP country seeking the tariff reduction.

Article 402 of NAFTA establishes two methods for determining the North American content of the finished products exported between NAFTA countries. Article 402 reads in pertinent part:

1. Each party shall provide that an exporter or producer may calculate the regional value content of a good on the basis of the following transaction value method:

Under the transaction value test, the North American content of exported goods between NAFTA countries is determined by subtracting the price paid for non-NAFTA materials used in the products construction from the price of the finished product.

Under the net cost test, the price paid for the non-NAFTA materials used in the product are subtracted from the net cost of manufacturer of the product. The manufacturer is entitled to use either of the above tests in determining whether the product meets the North American origin standard. If the product passes either test, it qualifies for coverage under NAFTA.

The importance of the automobile industry to the economies of Canada, Mexico and the United States has resulted in special rules for automotive products. NAFTA Section 403 establishes special origin requirements. Under Article 403, the net cost test is used to determine if the North American origin requirement is satisfied. NAFTA requires that automobiles, light trucks and engines must have new cost basis of 56% starting in 1998 that increases to 62.5% in 2002. For other vehicles and automotive parts the percentages are 55% and 60% respectively. The percentage of North American content is higher than the percentage under CFTA. Under CFTA, the local content was only 50%. The higher limits under NAFTA will nowcontrol automotive imports between Canada and the U.S.

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To provide assistance to exporters, the government of Mexico, the United States Department of Commerce and the United States Customs Service have instituted several phone services for the dispersement of information. These phone numbers are:

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From the moment a person in business decides to hire employees, life will never the same. The social engineers have succeeded in passing employment laws that impose onerous and often ridiculous hiring restrictions. The result is that employers can find themselves totally at the mercy of unscrupulous employees or prospective job applicants who file frivolous employment complaints. In addition, the regulatory agencies almost always side with the employees or prospective employees regarding such complaints.

A national television news show devoted an entire program to an example of this plight during the 1992 Presidential campaign. A small employer in Illinois with about 50 employees was charged by the federal government's Equal Employment Opportunity Commission with discrimination against a black woman because she had not been hired. The employer's business was located in a primarily Hispanic part of town. All of the employees were minorities. The only Caucasian was the boss. The number of employees had varied in the past. Many employees would come and go. The employer had other black employees. The Equal Employment Opportunity Commission concluded that, given the demographics of the area, the employer should have had more black employees and ordered him to pay a fine of nearly $100,000. There was no proof of discrimination: only the imposition of the demographic study that the agency claimed was nota quota requirement. The show interviewed former black employees who all stated that they had never in any way felt discrimination or been treated unfairly. The employer offered the woman a job, but she refused, choosing instead to receive the agency's award of lost pay for not being hired. The case is on appeal. Regardless of the outcome, this highlights the concern that an employer should have when hiring employees.

In our society a terminated employee or an unsuccessful job applicant has nothing to lose by filing a false complaint alleging discrimination. Most complaints are not required to be verified. Outlandish claims can be made. In fact, there are some people who deliberately apply for a job with the hope of being rejected so they can file a discrimination suit. After the suit is filed, the person offers to settle for an amount considerably less than the employer would have to spend defending himself against the worthless complaint.

Employment law is not and has never been settled. Each state and the federal government has its own laws regulating employment relations. A corporation operating plants in several states will have unique problems. Such corporations must be careful to obey all state laws. They must be careful not to give unequal treatment to their employees in the different states because of differing state laws.

The penalties for violating labor laws can be astounding. In a case involving sex discrimination, an insurance carrier recently paid more than $250,000,000 in settlements. Given the fact thatcourts can go back years and make awards for hundreds of people regarding past conduct, it becomes absolutely imperative that an employer know, understand and follow the law. Ignorance and good faith mistakes are just not sufficient defenses to violations of employment laws.

This chapter is designed to instruct an individual in how best to hire competent, professional and decent employees without violating state or federal law. This chapter touches upon the major considerations of employment law. An employer should have, at the least, cursory knowledge of them.

An employer has the right to establish job-related requirements and to seek the most qualified person for a job. The employer is permitted to ask questions and obtain certain personal information to be used in making the employment selection and the job assignment decisions. The tests for the appropriateness of a certain question are whether they will result in the disproportionate elimination of members of a protected group, or are they a valid predictor of successful job performance.

Despite the above, an employer is prohibited from making any non-job related inquiry which may directly or indirectly limit a person's employment opportunities because of race, color, religion, national ancestry, physical handicap, marital status, sex or (for adults) age.

An employer is not permitted to ask a woman her maiden name. Such information is considered irrelevant to job performance andan unnecessary intrusion into her privacy. Asking such questions may tend to stigmatize an unmarried woman or perpetuate stereotypes that a single woman may get married and quit while a married woman is a more stable employee. Appropriate questions that can be asked instead are, "Have you ever used another name?" or "Is any additional information relative to a change of name, use of an assumed name, or nickname necessary to enable a check on your work or educational record? If so, please explain."

The employer is permitted to ask the applicant for his place of residence. Such information is necessary for the ordinary operation of the business. The employer has a legitimate reason for wanting that information so he can contact the individual when necessary. He also needs it to maintain required tax and governmental records.

The employer has no valid business reason for asking whether an applicant owns or rents a home. Such a question may have the effect of discriminating against a job applicant who is a renter because the employer may feel that a person owning a home would be less willing or able to relocate if a better job comes along. An employer may incorrectly view a person owning a home as being more stable and reliable than a renting employee.

There are conflicting laws regarding the questions that an employer may ask a job applicant regarding citizenship and birthplace. It is illegal to discriminate against a person because of citizenship or national origin; yet it is equally illegal to hire an illegal alien. The problems facing an employer hiringaliens and the necessary compliance provisions are such that an employer doing so should be careful to assure the applicant is legally permitted to work in America. An employer should never ask an employee the following questions or ask him to provide proof of the following:

An employer may not require the applicant to provide proof of naturalization, a green card or work permit prior to the decision to offer the person a job. An employer may ask the following question, "Can you, after employment, submit verification of your legal right to work in the U.S.?" An employer may make a statement that proof of the right to work in the United States may be required after a decision is made to hire the applicant.

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An employer must be careful when speaking with a person offered as a reference by an applicant. In questioning the reference, the employer may ask only those questions that could be asked of the applicant. The employer may not ask an applicant's references questions whose answers would elicit prohibited information regarding the applicant's race, color, national origin, ancestry, physical handicap, medical condition, marital condition, age or sex. An employment discrimination complaint can be filed by a job applicant against any employer who asks such improperquestions.

The employer is permitted to ask an applicant the name of the person who referred the applicant for the position. The employer may also request the names of persons willing to provide professional or character references on the applicant. An employer may ask an applicant to furnish the name and address of a person to be notified in the case of an accident or emergency. Such information serves a legitimate business purpose. The employer is not permitted in California to ask the name, address and relationship of a relative to be notified in case of an accident or emergency. From this information may be inferred other information of marital status or national origin that is otherwise improper and irrelevant for job performance. For example, if a parent is listed as the relative to be contacted, the applicant's ethnic background might be determined from that parent's name.

Age discrimination is the firing or hiring of employees based solely upon age. In 1967 Congress passed the American Discrimination in Employment Act (ADEA) to fight age discrimination. Under this Act an employer cannot discriminate in the hiring, firing or promotion of employees between 40 and 65 years of age. In 1978 ADEA was extended to most employees up to 70 years of age with the following exceptions:

There have been significant and well publicized cases in the last few years whereby employees who were discharged because of their age have recovered huge awards in court.

Age discrimination is against both state and federal law. Yet some jobs may legally have age limitations. Examples: Airline pilots who must retire at age 60 or a bartender in a state where the legal age to drink is 21. Age questions that are illegal or dubious and should be avoided are as follows:

Questions that have been held not to promote age discrimination are:

An employer may make a statement that employment is subject to verification that applicant meets legal age requirement. Age discrimination for a job is permitted when the type of job requires exceptionally good health. Where the risk to the public increases as the employee ages, the validity for an age limit for employmentor for mandatory retirement also increases. Federal courts have upheld the mandatory retirement of airline pilots at 60 years of age by recognizing that pilots of that age have more strokes and heart attacks than younger pilots. A pilot having a heart attack may result in a plane crash.

III. EQUAL PAY FOR EQUAL WORK

The Federal Equal Pay Act (FEPA) applies to nearly all employers in the United States (Congress exempted itself). Under this act, employers must pay the same amount to men and women working under similar conditions doing jobs that require similar skill, effort and responsibility. Under FEPA salary differentials based upon non-sex reasons such as seniority or work performance are still permissible. Job titles are not dispositive in determining if the work done by men and women are similar. The actual duties need not be identical but they must be substantially equal in order for FEPA to apply.

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Alcoholism is not considered a handicap under the Federal Rehabilitation Act or in most states. Therefore, in most states it is permissible to fire an alcoholic employee. The reason used for the firing, although work product is not affected, is the anticipated future medical expenses expected to be caused by the alcoholism.

A few states, such as New York, have laws that prevent anemployee from being fired for alcoholism unless the employee is unable to safely and properly perform his duties. A person fired or adversely treated by an employer because of alcoholism can get information about his rights from the National Council of Alcoholism at 733 Third Avenue, New York, New York 10017.

The Equal Employment Opportunity Commission states that sexual harassment pertains to either physical or verbal conduct and exists when:

If an employer is informed of sexual harassment and does not take sufficient corrective action, he can be sued in federal court or a complaint can be filed with the EEOC. The employer is responsible for the elimination of sexual harassment of employees at work under both state and federal law.

A woman or man can sexually harass, and the harassment does not require overt contact. There are many lawsuits in which women have sued other women for creating a hostile work environment. Women have claimed that the harassing women have caused them severe emotional distress by explicit sexual or profane language. TheNinth Circuit Court of Appeals (West Coast, U.S.A.) has held that the test to determine if conduct is harassment is the "reasonable woman" standard: if a "reasonable woman" would be offended, it is harassment even if the average reasonable man would not consider it harassment.

Workers' Compensation is a state-sponsored program involving employer participation (usually mandatory) that ensures all employees against injuries on the job. The program provides cash benefits and medical care for workers who become disabled through injury or sickness related to their job. If death results from the job related injury, benefits are paid to the surviving spouse and dependents. The program has a "down side": injured employees are barred from suing their employers for the injuries suffered on the job. An injured worker is not precluded from suing third parties, only from suing the employer.

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The Civil Rights Act of 1991 pertains to discrimination in employment. The key provisions of the act permit:

Under the Civil Rights Act of 1991 the Rehabilitation Act and the American with Disabilities Act were amended to permit victims of intentional discrimination on the basis of sex, disability or religion to sue for compensatory or punitive damages. Victims of racial discrimination were already permitted to sue for such damages under Title 42 U.S.C. Section 1981. Recovery of damages is not permitted in cases of unintentional discrimination caused by the impact of neutral employment practices.

Plaintiffs may recover both compensatory and punitive damages for violations of the Civil Rights Act of 1991. Punitive damages, however, are not recoverable from a government agency or political subdivision. It must be proven that the employer acted with malice or reckless disregard of the employee's civil rights to win punitive damages. Recovery for both compensatory (future pecuniary losses, pain and suffering, etc.) and punitive damages is limited by the size of the employer:

There is no limit on compensatory damages for past pecuniary losses, nor are damages suffered as a result of racialdiscrimination limited under Title 42 U.S.C. 1981.

As strange as it seems, prior to the Civil Rights Act of 1991, while it was unlawful to discriminate on the basis of race in hiring and promotions, it was not unlawful to harass an employee based on race. The United States Supreme Court had held that previous civil rights laws did not protect workers from racial discrimination on the job.

The 1991 Civil Rights Act now permits claims for racial discrimination in preparation, performance, modification and termination of employment contracts as well as discrimination in the enjoyment of all benefits, privileges, terms and conditions of the contractual relationship. In short, an employer is no longer permitted to harass employees because of their race.

The 1991 Civil Rights Act makes it easier for an employee to maintain a legal action for an alleged civil rights violation in employment. Once an employee demonstrates that a particular practice by an employer causes a disparate impact on minorities and women, the burden of proof shifts to the employer to justify the practice. The employer is required to show that the challenged practice is job related for the position in question and consistent with business necessity. The employee may also prove unlawful disparate impact by showing that a less discriminatory alternative is available and the employer refuses to adopt it.

Prior to the 1991 Civil Rights Act, many employers, specifically governmental agencies, routinely adjusted upward theemployment test scores for minorities. This procedure was called gender or race norming. Supposedly these practices were intended to adjust for the fact that women and minorities were not exposed to the educational system to the extent of white males. Had they been, according to the theory, they would have actually achieved these higher scores. The Civil Rights Act now prohibits race and gender norming. In December 1991 the federal government prohibited state employment agencies from increasing the scores of minority applicants on federally sanctioned aptitude tests.