So you're ready to start a business. Which entity type is right for your goals? Many types of business entities depend on how many partners hold equity, what kind of tax protections are important, and how long the business venture is intended to last. This article will discuss several entity types, the filings required with the state, and their internal operating documents.
Please note that there are additional, more complex entities that this article does not discuss but still stand as options for incorporation. Further, each state's definitions and specifications differ for properly forming business entities. Therefore, be sure to check your state's requirements.
When do I need to file Articles of Organization or Articles of Incorporation?
The Model Business Corporation Act, adopted in 36 U.S. jurisdictions, also sets forth requirements for filing Articles of Organization or Incorporation. Among these requirements are the following:
-the corporate entity's name,
-the number of shares the corporation is authorized to issue,
-the address of the corporation's registered office,
-the name of the corporation's registered agent, and
-the name and address of the incorporator.
Let's begin our examination of corporate entities with General Partnerships ("GPs"). GPs are formed when a Partnership Agreement is executed between two or more partners intending to last indefinitely, and then the agreement is filed with the state. Partnership Agreements define the roles and expectations of the partners.
The most important provisions to include in a Partnership Agreement will describe contribution requirements, management roles, the authority of each partner, division of profits, and disputes. The number one structural difference between GPs and other corporate entities is that the dissociation of a partner could lead to dissolution. Thus, describe in detail what would become of the GP if a partner passed away, was incarcerated, wanted to dissociate, or wanted to sell their share.
Additionally, the Uniform Partnership Act of 1997, a model statute adopted in every state except Louisiana, creates a default rule of equal sharing of profits and losses under §401. This means that unless the agreement states otherwise, each partner is responsible for an equal share of all profits and losses. This is the case despite any differences in contributions to the partnership.
General Partner vs. Limited Partner
Understanding a few terms of art before examining individual corporate forms is pertinent. First, a "general partner" is someone who:
-has a responsibility for the actions of a business,
-has the authority to bind the business legally, and
-is personally liable for all the business's debts and obligations.
A "limited partner" is someone who receives limited profits from a business in exchange for being protected from the incurrence of the business's debts beyond the extent of its investment. Limited partners need more decision-making ability due to their limited liability status.
Limited Liability Companies (LLCs)
Now, we move to Limited Liability Companies (“LLCs”). LLCs require a formal filing with the state of Articles of Organization (the document's name may vary by state). LLCs are very similar to GPs, but partners are called “members” or “shareholders” and have limited liability for the LLC's debts.
The appeal of an LLC is this limitation on liability – it allows members to invest in companies without risking their personal assets. LLCs can be managed by the investing members or managers hired at the members' discretion through the Operating Agreement.
What is an Operating Agreement?
Operating Agreements are internal agreements that can only be amended through a unanimous vote of all members (unless the agreement specifies a lower threshold for amendment). The default method of profit and loss sharing is equal, but this can be amended in the Operating Agreement.
The way to maintain flexibility in an LLC is to delineate rights and responsibilities in the Operating Agreement with specificity. For example, LLC members can require the following:
-the election of a Board of Directors in their Operating Agreements
-the method of voting
-allocation of votes between members, and
-what to do in case of a stalemate.
Limited Partnerships ("LPs") also require a formal filing of Articles of Organization. LPs are distinct in that some partners are limited partners, and others are general partners. The general partners manage the operation of the LP, and the limited partners simply contribute to the assets of the LP.
What is a Limited Partnership Agreement?
The daily operations of the LP are outlined in the Limited Partnership Agreement, an internal document that requires unanimous consent to amend unless otherwise defined. It is important to note that limited partners in an LP cannot participate in the business's day-to-day functions without putting their limited liability status at risk.
LPs are often established for short-term business ventures to protect investors from liability. Additionally (and this varies by state), the dissociation of a partner in an LP could trigger the automatic dissolution of the LP in its entirety. Therefore, be sure to define and specify the consequences of dissociation in your Limited Partnership Agreement to avoid surprises.
Outlining measures to protect limited partners from exposure in the Limited Partnership Agreement can set expectations and limitations for the limited partners without risking personal assets.
The last entity type we will discuss is the Corporation. Corporations require filing Articles of Incorporation (name varies) with the state. The two main differences between other types of entities and a Corporation are the method of taxation and the transference of ownership. Corporations can be taxed as C-Corps or S-Corps.
C-Corps vs. S-Corps
C-Corps pay corporate taxes, and shareholders must pay taxes on their distributions (this is often referred to as double taxation). S-Corps do not pay corporate income taxes, but Corporations must prove that they have fewer than 100 shareholders, that they are a domestic corporation, and only have one class of stock to qualify.
Certain types of entities are prohibited from qualifying as an S-Corp despite meeting the previously listed qualifications, such as insurance companies. Corporations are limited liability entities, so the shareholders are not personally liable for the business's debts.
What are Corporate Bylaws?
Corporations have bylaws that corporate officers and employees must follow. Bylaws dictate the expectations and requirements for the Board of Directors. While it varies by state, the bylaws typically must contain the minimum and maximum number of directors, how shareholder meetings can be called, and if special meetings can be called. Often, state statutes offer their requirements and optional provisions for corporate bylaws. Virginia's §13.1-624 demonstrates this in practice.
Common Issues After Formation
Typically, four categories of internal disputes occur after incorporation and during the operation of the business. The disputes discussed below are considered internal because they do not include third-party actions against corporate entities.
Equity disputes occur when partners disagree on their ownership interest in the corporate entity – typically, equity disputes go hand in hand with distribution disputes. Most often, the disagreement rests on the input of what is called "sweat equity.”
Imagine three partners starting a business, each contributing $33,333. Partner A works a full-time job as an accountant, Partner B lives in another state and is a serial investor, and Partner C runs the business's day-to-day operations, making calls, hauling products, etc. Partner C is inputting sweat equity and will most likely be entitled to a larger share of the equity in the business overall despite their equal monetary contribution. It is pertinent to describe how your entity will handle sweat equity and financial contributions regarding ownership in your operating agreement.
Distribution disputes often occur when entities make unequal distributions to partners or no distributions. Operating agreements often offer schedules of distributions and a formula for calculating distribution. For example, the formula can be based on stock ownership or services rendered to the business. Entities need to consider the expectations and fair treatment of minority shareholders, so outlining these methods in advance can eliminate future appearances of impropriety.
Partnership disputes occur when partners disagree on the fundamentals of the business and either want to dissolve the business relationship or dissociate from the enterprise. While this varies by state, different entities have automatic standards set for dissolution and dissociation.
For example, under the UPA, dissociation by an act of will from a partnership automatically triggers the entity's dissolution and gives the remaining partners 90 days to unanimously agree to continue without the dissociating partner.
Also, under the UPA, the partnership automatically continues unless the managing agreement states otherwise when a partner dissociates without fault (e.g., a partner passes away). Further, departing partners still have a duty of loyalty and the right to manage the partnership until the partnership formally ends under UPA §603. Be sure to examine the de facto provisions of your entity's dissociation provisions to ensure your entity can or cannot continue after the dissociation of a partner.
Disputes Regarding Alternative Dispute Resolutions
Last, alternative dispute resolution ("ADR") is an overarching issue many partners face at the end of their involvement with an entity. Any good partnership agreement sets out the choice of law and venue clause, usually to minimize travel expenses, filing expenses, and unfavorable opinions in other jurisdictions.
Further, it is acceptable to mandate ADR before filing suit; for example, certain corporations may require partners to file a complaint with a specific mediation company. A lawsuit can be filed if a resolution cannot be reached after a certain period.
Roles and Responsibilities of Members/Partners
Partnership roles within specific entity types were discussed above, but there are duties that all partners and members owe a corporate entity despite their general or limited liability status. Every partner and member owes their corporate entity a duty of loyalty and a duty of care.
This means that partners cannot sabotage business deals, self-deal to benefit other corporate entities they may be involved with or themselves, and cannot enter agreements on the entity's behalf without doing their due diligence. Further, boards of directors have a duty to monitor the entity as a whole to prevent illegality.
It is vital to note that states vary on whether or not exculpations of duty are allowed. For example, in Delaware, shareholders can eliminate liability for the duty of care in their operating agreements if they wish. In any state, it is impossible to eliminate liability for intentional criminal acts or improper distributions.
Long Story Short
Consulting an attorney and an accountant before forming a business entity is critical in protecting your personal assets, maximizing profits, and preventing partnership disputes.
Be sure to read your state's corporate statutes to ensure proper filing and to keep yourself and your partners abreast of any de facto statutory provisions affecting your business.
If you have any questions on how to best protect your rights and your business in your internal documents, contact our experienced corporate attorneys today for a free consultation.