"A friend and I recently set up a small business as a subchapter S corporation. The two of us are 50/50 owners of all shares in the corporation. We know we need a Shareholders' Agreement, and the attorney who set up our corporation sent us a form for that document, but it's all Greek to us. But when we ask the attorney for help, he just tells us it's a standard form and that we shouldn't negotiate it. That doesn't sound right to us. What are some of the things that should be covered in a shareholders agreement, so we can make sense of the attorney's document?"

I feel your pain here. Many attorneys who set up small businesses use only one form of shareholders' agreement, which is a bad idea because this is one situation in which "one size" clearly doesn't fit all clients. What the attorney should do is set up a questionnaire for people like you who are setting up small business corporations, walk through the questionnaire with you at your initial meeting, and then prepare a shareholders' agreement that is "custom tailored" to your individual situation.

Here are 12 questions I routinely ask people in your situation.

(1) Management of the Company. You are 50/50 shareholders of the corporation, but will the management responsibilities also be 50/50, or will one of you be doing all of the work? If the former, I would include a provision that the management of the corporation's business will be conducted equally, so that if one of you "slacks off," the other one can buy him out or reduce his ownership of the company. If the latter, I would want you to consider an Employment Agreement between the corporation and the "working" shareholder, so that he can be compensated for his labor out of the business' income before the "passive" shareholders receives any dividends or other distributions.

(2) Capital Contributions. Will your contributions to the capital of the corporation be 50/50, or will one of you be putting in most of the money? If the latter, I might recommend that the "excess investment" (the amount by which the rich shareholder's contribution exceeds the poor shareholder's contribution) be treated as a loan to the corporation, to be paid back by the corporation when there's available cash to do so.

(3) "Tie-Breaking" Voting Provisions. Since you are 50/50 shareholders, how will you handle disagreements? If one of you will be doing the bulk of the work and will be responsible for the day-to-day operation of the business, I would ask you to consider a provision giving the working shareholder an extra vote if a disagreement occurs (solely for the purpose of breaking the tie on that one issue, not as a general matter).

(4) "Gross Up" Provisions.

Since in a subchapter S corporation all income, losses and other tax benefits flow through to your personal tax returns, how will you handle "phantom income"? Any money you decide to keep in the corporation's checking account at year-end will be considered "phantom income" — you will have to pay taxes on it even though the corporation didn't pay it out to you. If that's a problem for either of you, consider a clause in the shareholders' agreement allowing the corporation to reimburse you (or "gross you up") for the tax liability you incurred on any "phantom income."

(5) A Mediation Clause. How will you handle disputes that go beyond the "informal discussion" stage? Arbitration clauses are nice but, in my experience, too cumbersome in practice. Consider a simple mediation clause appointing an individual you trust — such as the corporation's accountant or lawyer — to mediate any dispute between you. He or she will not decide the dispute for you, but will attempt to broker an agreement between you (or, in plain English, "bang your bloody heads together until you see clearly") so the corporation can move forward.

(6) An Agreement to Preserve Your Subchapter "S" Status. How will you prevent the corporation from accidentally losing its favorable subchapter "S" tax status? There are a number of situations where this could happen. For example, if a shareholder dies without a will and some of his shares end up in the hands of relatives who are not U.S. citizens or "green card" holders, the corporation would lose its subchapter "S" status. There are two provisions you need here. One is a provision by which all shareholders agree not to take any action involving the issuance or transfer of the corporation's shares without getting the approval of the corporation's tax attorney or accountant. The other is a "buyout" clause requiring the two of you (or the survivor) to repurchase immediately the shares of any person who receives shares in the corporation if that person is not qualified to hold shares in a subchapter S corporation.

More next week . . .

Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and former host of the PBS television series 'Money Hunt'. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

COPYRIGHT 2008 CLIFFORD R. ENNICO.

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