Business Formations: Overview
An owner’s choice of business formation—whether as a corporation, limited liability company, or otherwise—will have a profound effect on how that business will operate. Choice of business entity will affect the way in which a firm is taxed, the sources of funding it may utilize, its future growth potential, and countless other critical aspects of business operations. This will be the fundamental basis for how a company will look and function. Thus, it is imperative for an owner to consult a skilled attorney well versed in entity formation before making a decision; doing so early on will certainly help to avoid hardships (and personal liability) moving forward.
At Neek Law Firm, we specialize in the formation of a variety of business types (see below). Please also find a list of Considerations for Business Formation, which is designed to help owners to begin thinking about the relevant issues that will ultimately dictate which businesses form is best.
- Considerations for Business Formation
- Types of Business Formations, including:
- Sole Proprietorship
- General Partnership
- Limited Partnership
- Limited Liability Partnership
- Limited Liability Company
- Closed Corporation
- Fiduciary Duties and Considerations
- “Piercing of the Corporate Veil”
Considerations for Formation
- When deciding upon an entity type, there are several important matters to take into consideration, including:
- How do you plan to manage the company? Do you plan to keep it private or do you hope to go public? How much control do you want? Who else is involved?
- What kind of business is this? Is it the sort where you need to be particularly concerned about liability for one reason or another?
- Where are you going to do business? Are you going to target a small town, the Northwestern United States, or the whole world?
- What is your growth plan? What kind of funding are you going to need?
- How do you want to be paid? How do you want to be taxed?
- Do you want vesting and compensation plans for employees?
Neek Law Firm has the expertise needed help to determine what makes the most sense for you and your business.
Importance of the Right Legal Team
Once these matters have been discussed and the owner’s lists of goals has been made clear, Neek Law Firm can help to choose which type of entity is best, and may then proceed to creating a customized formation agreement (usually articles of incorporation, articles of organization, or a partnership agreement). This will form the basic rules for the firm in terms of capital investment, ownership, taxation, owners’ liability, and several other important aspects of the business. For this reason, it is very important to be thorough and precise in drafting this document. A well-written agreement will be the basis for a successful business venture.
Types of Business Formations
Though there are a number of different business forms, varying slightly from state to state, the vast majority of businesses will fall into one of the following categories:
A sole proprietorship is the most basic form of business entity. In a sole proprietorship, the individual running the business (the “sole proprietor”) and the business itself are treated as one in the same for legal purposes. Therefore, the sole proprietor is personally liable for any and all actions of the business. For this reason, we strongly discourage our clients to operate as sole proprietorships; the additional effort and expense required to form a different type of business entity is more than worth the additional liability protection.
One of the oldest and most basic types of business entities, the General Partnership (“GP”) simply involves two or more parties carrying on a business for profit while acting as co-owners. The type of business is not restricted in any way (so long as the activity is legal), and owners may include individuals, corporations, estates, trusts, other partnerships, LPs, LLPs, LLCs, and several others.
The GP is very easy to form, but not necessarily easy to form properly. While there is no need to file a certificate or articles of partnership with the Secretary of State, it may be necessary to file a fictitious business name statement with the county clerk in order to receive a business name. The GP is its own separate entity (apart from the founders); however, it does not require the formalities of some of the more complex forms of businesses.
The primary document dictating how a partnership will operate is known as the Partnership Agreement. This agreement will generally specify ownership terms, the distribution of earnings, managerial responsibilities, mechanisms for future amendments to the agreement, as well as several other critical aspects of the firm. Though there is a large degree of freedom when constructing these documents, the law provides for several “default” rules that, if not properly addressed in the agreement, may adversely affect a client’s interest in the firm in some way.
For this reason it is important to clarify the details of the partnership agreement up front in preparation for any future disputes between partners or between the partnership and a third party. While it costs virtually nothing to form a partnership, the partnership itself offers virtually no liability protection to its members; although individual members may shield themselves by forming an LLC and joining the partnership under that LLC’s name. Taking the time to consult with Neek Law Firm will not only help to protect your personal assets moving forward, it will also help to protect your income from the partnership and property interest in the partnership itself.
A Limited Partnership (“LP”) is an organization comprised of at least one general partner and at least one limited partner. One or more general partners hold actual managerial responsibilities for the firm, and each general partner may be held jointly and severally liable for any wrongdoings on the part of the partnership. However, a limited partner is only liable for the amount of capital he or she contributed to the firm.
In order to form an LP, the partners must file a certificate of limited partnership with the Secretary of State, and have and maintain a partnership agreement that sets forth the purpose and operating standards of the limited partnership. In addition to the concerns associated with a GP’s version of the document, the partnership agreement of an LP needs to take into account the balance of control and fund distribution between general and limited partners. Because the general partners must maintain management of the firm, but also owe a fiduciary duty to the limited partners; a poorly constructed partnership agreement could lead to potential liability for the general partners. Or, conversely, it could result in insufficient protection for the limited partners in case of poor performance by the general partners. This is precisely why we strongly advise engaging the Neek Law Firm to structure such documents. Whether our client is a general or a limited partner, we can help protect his or her personal and business interests moving forward.
Why choose LP? There are very few requirements for the operation of a Limited Partnership, particularly regarding who may own the business. Thus, the LP remains the predominant business form in certain industries in which there are several limited partners investing (but not participating) in an organization run by one or few general partners. In many instances, the general partners of the firm can organize and operate as an LLC, thereby precluding personal liability for the actual individual functioning as a general partner.
Most investment funds function in this manner—individual investors join as limited partners, with one or more individuals doing the actual investing as general partners, but under an LLC name instead of a personal name. This form offers protection both to the investors (limited partners), who are only liable for the amount they have invested, as well as the fund managers (general partners) who have the limited liability protection of the LLC.
Limited Liability Partnership
The Limited Liability Partnership, or LLP, is a modified version of the general partnership designed to grant limited vicarious liability to certain types of professional organizations. An LLP or individual members of an LLP may not be held liable for the wrongdoing of another individual member. However, the “wrongdoer” may be held personally liable for his or her actions.
LLPs may engage in the business of accountancy, law, architecture, engineering, land surveying, and certain consulting services. There must be two or more partners in order to make an LLP election. However, the form offers a large degree of freedom as to who can participate in ownership (including individuals, partnerships, LLCs, and corporations), and maintains the pass-through taxation applied to general partnerships. Thus, certain service professionals may organize as a partnership (avoiding governance under LLC legislation) while also avoiding a degree of personal liability for the owners.
Like the LP and GP, the fundamental document in forming an LLP is the Partnership Agreement. In many ways, the partnership agreement for an LLP is similar to those for the other forms of partnerships. However, the LLP is unique in that each individual partner may be held personally liable for his or her acts, but the other partners and the firm itself generally cannot be held liable for those same acts. This may not always be the case, though, particularly if the partnership agreement is vague on the matter. Thus, clients choosing the LLP form need to take particular care to make sure that the document is structured such that they do not over-expose themselves to liability in any way.
Moreover, there is a large amount of variation between each of the five professions allowed to file as LLPs. In addition to the rules regarding organization, an LLP must also comply with the specific regulations of the industry in which that firm operates. For example, a law firm must both conform to the rules of LLP filing as well as any applicable American Bar Association standards.
This process can become very complicated as the needs and desires of the business owners must be balanced with various requirements across multiple government agencies. We at Neek Law Firm have the expertise to carry out this process comprehensively and in a cost-effective manner.
Limited Liability Company
The Limited Liability Company, or LLC, has rapidly grown to become one of the most popular business forms. It allows for a great deal of flexibility in terms of ownership, income distribution, liability shielding, and management structure. The LLC was initially designed to allow firms the limited liability available to corporations along with the pass-through taxation and high degree of customization available to general partnerships and sole proprietors. State laws generally recognize a great deal of freedom to contract within the LLC business form. Thus, an LLC can be structured in many different ways; this can be highly advantageous for an owner of a firm.
In order to form an LLC under the law, owners must submit a relatively simple document (known as a certificate of formation or articles of organization) to the Secretary of State. This filing will specify the name of the LLC, the lifespan of the firm (if applicable), and can include names of owners.
However, it is the firm’s operating agreement which actually details the business’s day-to-day operations. This document is both more detailed and easier to modify than a certificate of formation, and may specify matters such as ownership rights, distribution, management terms, merger and sale terms, dissolution, indemnification and insurance, procedures for amending relevant agreements, and applicable fiduciary duties and responsibilities for members or managers.
While it is not mandatory in many states, we strongly advise our clients with an LLC to maintain an operating agreement. Because it clearly specifies goals, limitations, and responsibilities, it can be a valuable source of liability protection in the case of conflict with another LLC member in the future. Moreover, the operating agreement is much more easily modified than is the articles of formation; thus, it can adapt to business changes much more easily. Technically speaking, once the certificate of formation is filed with the Secretary of State, the LLC officially comes into existence. It is the operating agreement, though, that defines a firm’s structure, management, and distribution rules moving forward.
A primary issue to be discussed in structuring both the certificate of formation and the operating agreement is the relationship between the owners of an LLC and its managers. When it comes to this relationship, there are two fundamental structures used in LLCs: member/owner-managed and manager-managed.
A member/owner-managed LLC, is exactly what it sounds like: the owners known as member of the LLC also carry out the day-to-day management of the firm. Most LLCs, particularly those that have no intention of ever going public, will form as member-managed entities. Owner-managed LLCs allow owners the freedom to conduct their businesses exactly as they like, without the additional complexity and cost associated with having a hired manager run the firm.
Perhaps more importantly, because management and owners are one in the same their motivations are perfectly in-line. Conversely, in corporations and manager-managed LLCs, owners and managers may actually have different incentives and priorities. At Neek Law Firm, we assist our clients to carefully balance their desire to be involved in the new LLC with the benefits and costs of hiring a manager, focusing on the impact each will have on the business. Having taken these factors into consideration, many clients find the member-managed LLC to be the best way to form a new business.
In a manager-managed LLC, the members have elected to hand-off managerial duties to a representative manager, who will take control of the daily operations of the firm but will still report to the owners. This manager (or managers) will often be a member of the LLC itself (often with the largest stake), although some firms will choose to hire third-party managers. In this form of LLC, the owners act more as passive investors than as business operators. Generally, an LLC is required to specify whether it will elect to form as a manager-managed LLC in its operating agreement and will often do so in its certificate of formation.
There are several benefits to the manager-managed LLC format, particularly where members intend to participate (invest) in several LLCs at once. Because a manager frees owners from having to handle the day-to-day operations of the business, manager-managed LLC owners may invest in several businesses or investments simultaneously. An LLC may also choose to bring in a manager in the case that the owners are not particularly knowledgeable in regards to a certain industry or business practice, or simply to avoid disagreement between owners.
However, there are drawbacks to the manager-managed LLC as well. Unlike the owner-managed LLC, owners of manager-managed firms face the challenge of properly motivating managers in order to align the goals and priorities of management with those of ownership. For example, if a manager’s annual bonus is based on a given percentage growth in sales since the previous year, that manager may take actions to reach that target in the short-term without considering the long-term well-being of the firm.
Furthermore, at least to some degree, owners put their own well-being in the hands of management. In some cases, if a manager is found to have done something sufficiently egregious that a court decides to “pierce” the firm’s “corporate veil,” owners may be found personally liable for the negative actions of the owner.
At Neek Law Firm, we take the time to sit down and work through each of these benefits and drawbacks, and can help to carefully craft the proper documentation and operating agreement in order to emphasize the benefits while minimizing the drawbacks. We have the business understanding and experience necessary to provide our clients with innovative, high-value service, whether assisting a client in forming an owner-manager LLC, manager-managed LLC, or a hybrid of the two.
A corporation is the most complex entity, requiring a large number formalities and governmental reporting. More often than not, a corporation is subject to “double taxation.” However, it also allows for much greater access to funding, more growth potential, and a higher degree of liability protection than any other form of business entity. It is for this reason that most of the world’s largest firms are corporations; while it is pricy, the opportunities lost by not incorporating are often pricier.
When forming a corporation, a firm must file Articles of Incorporation with the Secretary of State, which are then reviewed for compliance with relevant state law before being approved. The most comprehensive and scrutinized of the various documents required to form a business, the Articles of Incorporation dictate everything from a firm’s purpose and capital structure (including issuance of shares) to owners’ voting rights to liquidation preferences and anti-dilution provisions. This document has the power to eliminate certain additional types of liability on the part of directors, can dictate how and when each party is paid, and can even serve to ward off unwanted future sales, mergers, or takeovers of the firm.
Bylaws: in addition to the Articles of Incorporation, a corporation must have a set of Bylaws that lay out the internal governance and day-to-day operations of the firm. The bylaws must be kept at the firm’s headquarters at all times and be available to all shareholders. This document may include anything not in conflict with the Articles or applicable law, and is much easier to alter than the Articles. Thus, this document is often much more fluid, and may often be adjusted in order to adapt to changing market conditions. In many ways, the corporate bylaws serve as a contract between owners and managers of a corporation; once adopted and approved under the rules set forth in the Articles, a corporation’s bylaws are binding on the participating parties. Managers may find themselves in a very difficult situation in the case that they believe they need to do something outside of the bounds of the bylaws, but doing so may leave them personally liable. Thus, it is important to have a well-structured set of bylaws that allow managers the freedom to adequately perform their roles while still reasonably limiting their actions according to the desires of shareholders.
Minutes: finally, a corporation must maintain a set of minutes from all corporate director or shareholder meetings, which must also be be maintained at the firm’s principal place of business. Though the law does not designate exactly what must be included in a firm’s minutes, they generally contain the time and place of a meeting, the parties present or shares being represented by the parties present, the matters being discussed, and decisions or resolutions that were reached. Taking care to design a detailed system for maintaining minutes, while seemingly simple, can be a major source of protection from liability moving forward. When there is a clear record of how and why business actions were taken, it is substantially easier to justify those actions in the case of any future dispute.
There are two fundamental forms of corporations. The predominant type of corporation is known as a “C-Corp,” indicating that the firm is subject to what is commonly known as “double taxation.” In other words, the firm is taxed at the corporate level, and then the income paid out to ownership (whether that be in the form of capital gains or otherwise) is taxed at the personal income level. While this may be a negative consequence of choosing to elect as a C-Corp, only C-Corps allow for an ownership structure conducive to a wide-scale public offering.
The other common corporate form is the S-Corp. An S-Corp. is a firm that is initially formed as a C-Corp., but elects to file under its taxes under Subchapter S of the federal tax code. By doing so, the corporation is not taxed at the corporate level. Rather, the firm’s profits and losses will be passed-through to the individual owners, who will then be taxed and can take advantage of loss carry-forwards at a personal level. While this may sound advantageous, there are certain limitations on the number and type of ownership that can participate in an S-Corp. Thus the S-Corp. is most often better suited to smaller firms that are relatively closely held.
Known by a variety of names (close corporation, closely held corporation, closed corporation, etc), the close corporation is similar to the other forms of corporation in that it generally requires the same fundamental documents, has shareholders, offers limited liability to all participants, and has an indefinite lifespan. However, the close corporation is most often comprised of a smaller number of shareholders (35 or less in California) who also serve as directors or managers of the firm. Essentially, it is owned and operated by a small number of individuals who, usually, actively participate in the business. The benefit of the close corporation is that it allows for a more informal operating structure than a “standard” corporation. However, as each owner is usually also a participant in the business, they may be held to a higher standard of duty than would the directors of a standard corporation, even if the firm has not officially elected to be registered as a “close corporation” under applicable state law.
Pros and Cons for Corporations:
One advantage of the corporation is that it has an almost indefinite lifespan. Unless it is otherwise desired by the owners or required by law, a corporation will often continue on long past the lifespan of its founder. This is one reason why the corporation is the dominant business form among public firms—its longevity makes it more reliable as an investment source.
If a firm does decide to go public, or believes it will do so in the future, it will almost certainly need to incorporate. Even before an initial public offering, venture capitalists and private equity will be hesitant to invest in an unincorporated firm in anticipation of going public in the future. Likewise, a large investment bank is unlikely to underwrite the initial public offering of an unincorporated firm.
Due to the complexity involved in incorporating, many firms will initially organize as a different business form, such as an LLC or general partnership. However, these firms often find themselves scrambling to convert to a corporation at the last minute in anticipation of capital investment, only increasing the complexity and cost of incorporating. Even if a firm may decide not to incorporate initially, it is important to keep in mind the possible need to do so in the future. At Neek Law Firm, we understand the balance between the financial strains of incorporating with the need to be prepared for future growth. This understanding allows our lawyers to draft tailored articles of incorporation and related agreements that will take into account a business’s needs and goals moving forward, whether that firm is initially organizing or converting to a corporation.
Fiduciary Duties and “Piercing of the Corporate Veil”
Regardless of what business type an owner chooses to form, one very important factor to take into consideration at all times is exactly how “limited” his or her limited liability actually is. As a general rule, parties that maintain “limited liability”–including limited partners in an LP and virtually all owners in LLCs and Corporations–are only liable for the extent of their contribution to the firm. However, this protection only extends so far. If a director or manager operates outside the scope of certain “fiduciary duties,” which are essentially certain rules that the law has decided inherently apply to all business entities, or otherwise is deemed to have behaved unfairly by a court, his or her limited liability may be stripped. In this case the other shareholders (or a third party) may be able to access that person’s private assets.
Fiduciary Duties of Officers
The basic fiduciary duties owed by managers and directors to a firm’s shareholders are the duty of loyalty, duty of care, and the implied covenant of good faith and fair dealing.
The duty of loyalty, simply states that managers and directors must remain loyal to the best interest of the shareholders at all times, and may not take advantage of economic opportunities that will benefit one or a few managers to the detriment of the firm and shareholders at large. This duty is usually breached when a director takes an action that he or she has a personal interest in in order to better his or her own financial situation (a “self-interested” transaction). Or, it may happen when a manager identifies a business opportunity in his or her capacity as manager, but then takes advantage of the opportunity privately and at the expense of the corporation/shareholders.
The duty of care, states that all corporate representatives of stockholders must act in the same way that a reasonably prudent person would when making a given business decision on behalf of those shareholders. This duty is in place to ensure that corporate managers do not take actions that will adversely affect the shareholders in order to achieve some other personal goal.
The implied covenant of good faith and fair dealing, as the name suggests, is an assumed responsibility for all parties in all business operations (usually). This covenant states that all parties have a duty to one another to behave with fairness, honesty, and good faith in all business transactions, and that one party will not intentionally deceive the other or in any way hinder the other party’s ability to enjoy the benefits of the contract.
To complicate matters further, the degree to which each of these fiduciary duties apply (and the degree to which one can contract around them) varies greatly from state-to-state and across the various business entities. Some states, such as Delaware, have placed an emphasis on freedom to contract, and basically allow firms to contract away any and all fiduciary duties in their Articles of Incorporation or bylaws. There, the manager’s fiduciary duties are limited to those specifically delineated in the relevant documents, and management may even be contractually indemnified “from and against any and all claims and demands whatsoever.” [Del. Code, Ann. tit. 6, § 18-108 (6 Del.C. § 18-108)]. In California, however, courts tend to be less willing to allow managers to contract around implied fiduciary duties. Rather, they often hold managers accountable for fiduciary violations, even where the articles of incorporation waived such liability for the managers.
Corporate Formalities & the “Piercing of the Corporate Veil”
When a court decides to “pierce” a firm’s “corporate veil,” it has decided to strip that firm or the individual(s) at that firm of the limited liability protection normally granted to the legal entity. This will occur where the court has determined that, for example, the individual in question has breached a fiduciary duty to which he was bound, or was otherwise acting to the detriment of the shareholders. There are several specific factors that a court may look to in deciding whether to pierce the corporate veil, including:
- Ignoring necessary corporate formalities
- Absent or incomplete corporate record keeping
- Commingling of the business’s assets with an individual’s assets
- A major shareholder draining corporate funds
- Manipulation of assets or liabilities in the interest of one or few individuals
- The use of the corporation’s assets as an individual’s private assets
- Failure to maintain an arm’s length relationship with other relevant parties
- The corporation appears to be a “facade” for the individual to operate with limited liability
- The corporation has failed to maintain sufficient funds to pay off liabilities in a timely fashion
Fundamentally, these factors can be reduced to a few key questions: did the individual in question behave in such a way that gave him or her an unfair advantage in business dealings? Was there no real separation between the business and the individual? Was there any attempt to defraud either the shareholders or any other relevant parties? And finally, were any third parties (creditors) left unjustly under-compensated?
If the answer to any of the above is yes, the court may pierce a firm’s veil. The effect of piercing the corporate veil is basically that the personal assets of the violating party are treated like assets of the firm itself, meaning that shareholders or other third parties could then recover directly from the offending individual.
For obvious reasons, matters regarding fiduciary duties and the corporate veil are of utmost importance to our clients. One of the chief concerns when incorporating a new firm is to ensure that the owners and managers will not be found unreasonably liable for their actions, and that those who are found to have acted wrongfully can be punished adequately. When considered in conjunction with the large degree of variation among jurisdictions, the relatively vague definitions of the fiduciary duties, and the ability to contract around certain duties in certain situations, it becomes absolutely necessary to have the experience of Neek Law Firm at your side. Working with our skilled legal team, our clients are able to position themselves to minimize liability and maximize income when structuring any sort of business entity.