Choice of Organizational Form for the Start-Up Business

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Choice of Organizational Form for the Start-Up Business Choice of Organizational Form for the Start-Up Business

John H. Matheson University of Minnesota Law School, [email protected]

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Choice of Organizational Form for the Start-Up BusinessJOHN H. MATHESON

Individuals embarking on new business ventures must choose alegal form under which to operate. They can form their businessenterprises as sole proprietorships, general or limited partnerships,limited liability partnerships, limited liability companies, orcorporations. State taws set forth the attributes of each organizationalform. These include criteria for limited liability, centralized ordecentralized management, transferability of interests, and duration ofexistence.

Before 1997, the issue of entity choice for the businessperson andlegal counselor was tax-driven, and the determination to obtain pass-through tax treatment depended on the corporate resemblance test ofthe now-discarded Kintner Regulations.1 Under the Kintner Regulations,unincorporated businesses were taxed as corporations if they had morecorporate than noncorporate characteristics.

On January 1 of 1997, the law of business organizations changeddramatically, when the United States Treasury Department'sSimplification of Entity Classification Rules became effective. Thecurrent system, sometimes referred to as the "check-the-boxregulations," ended decades of manipulation of business organizationforms to fit the requirements of the Kintner Regulations and obtain pass-through tax treatment. Only corporations and publicly tradedorganizations are taxed as separate entities. All other businessorganization forms have presumptive pass-through federal tax status.Check-the-box regulations reduced the impact of tax issues in thedetermination of the type of legal organization a business chooses touse.

This article introduces the basic business organization forms andsome of the attributes of each that influence the choice of entitydecision for the modern start-up business.

Sole Proprietorships

A sole proprietorship is a business owned by one individual andnot through a separate entity. Creation of the sole proprietorship

John H. Matheson is the Melvin C. Steen and Corporate Donors Professor of Law andCo-Director - Kommerstad Center for Business Law and Entrepreneurship, University ofMinnesota Law School. Of Counsel, Kaplan, Strangis and Kaplan, P.A., Minneapolis,Minnesota.

1 Prior Treas. Reg. § 301.7701-2 (1993).

© 2002 by the Regents of the University of Minnesota

Minnesota Journal of Business Law and Entrepreneurship

requires no organizational formalities and is not subject to anyspecialized statute. The substantive law of contracts, torts, and agencygovern the sole proprietorship, including the personal liability of theowner for the obligations of the business. The proprietor has soleauthority to manage the business that ends with the owner's death ordecision to end the business. Ownership is transferable as any otherpersonal property.

Most business owners wilt choose an organizational form thatlimits personal liability, making the sole proprietorship a less-favoredchoice.

Sole proprietors can make cash or property contributions to thebusiness and can withdraw money or property from the business withouttax consequences.

Sole proprietors report the results of business operations onindividual tax returns by reporting all of the net profit from thebusiness, whether or not the proprietor withdraws the amount orreinvests it in the business. In profitable businesses, overall taxableincome increases and business income is taxed at the proprietor'smarginal tax rate. If the business operates at a loss, the proprietor'soverall taxable income decreases. Subject to certain [imitations, suchlosses can offset the proprietor's income from other sources and resultin tax savings.

Partnerships

General Partnerships

A partnership is an association of two or more persons who are co-owners of a business for profit. Formation of a partnership does notrequire a written partnership agreement setting forth the terms of thepartnership nor even the explicit intent to form a partnership. Thoughcertain exceptions exist, a person receiving a share of the profits of abusiness is presumed to be a partner in that business.

If an explicit partnership agreement exists, it will control therights of the partners. If the agreement fails to address particular areasor there is no explicit partnership agreement, nearly every state has apartnership act that controls.2 Partnership acts contain numerous default

2 Versions of the Uniform Partnership Act are the basis of most state statutes --

http://NNwww.law.upenn.edu/bll/ulc/fnact99/1 990s/upa97fa.htm. Summary andhistory: http://wwA.nccusl.org/nccusl/uniformact summaries/uniformacts-s-upal 994.asp


Choice of Organizational Form for the Start-Up Business

provisions that govern the relationships among the partners, betweenthe partners and the partnership, and between the partnership and thirdparties. To avoid unanticipated outcomes in the operation of thepartnership, parties shoutd approve a written partnership agreementbefore forming the partnership.

For example, if partners do not explicitly specify profit and losssharing ratios, partnership acts provide that partners witt share profitsand losses equally. Partners who want a profit or loss structure differentfrom this defautt provision should set forth an alternative structure inthe partnership agreement.

Alt partners have an equal right to participate in the managementof the partnership, unless they alter its management structure. Theymay choose to vest management rights in only a few partners andmaintain a centralized management structure. Unless the desiredmanagement structure is clearly set forth in an agreement, the equal-authority default will apply.

High standards of behavior apply to partners, which includemaking full disclosure to fellow partners under appropriatecircumstances and acting primarily for the benefit of the firm whenacting in the partnership's usual course of business. While the enterprisecontinues, partners owe one another strict loyalty. Many actionspermitted by those acting at arm's length are prohibited in a fiduciaryrelationship.

Fiduciary duties commence at the formation of the partnershipand continue until partnership affairs are wound up and the partnershipmakes final distributions.

A partnership is a smalt group of business owners who activetyparticipate in the business. Though a partnership is an entity separateand distinct from its partners, alt partners in a general partnership arejointly and severalty liable for the debts of the partnership - there is noinsulation from personal liability. The partners are liable not only forclaims involving their own misconduct, but also for the debts,obligations, and liabilities incurred by the partnership, and for actions ofother partners in the conduct of the partnership business.

A partner admitted into an existing partnership is jointly andseveralty liable only for those claims arising subsequent to admission tothe partnership.

Partners should consider exit strategies when forming apartnership and drafting a partnership agreement, because partnershipinterests are not transferabte without the consent of att the other



partners. The partnership agreement could make the transfer of aninterest contingent on receiving approval from a certain percentage ofthe partners. Or, the partnership agreement could eliminate all approvalrequirements, making the partnership interests freety transferable.

A partnership does not have a perpetuat existence. In apartnership at wilt, a partner can dissotve the partnership at any time.

A court may dissolve a partnership. Upon apptication by a partner,the court may find that the economic purpose of the partnership is liketyto be unreasonabty frustrated, another partner has engaged in conductwith respect to the partnership that makes it not practicable to carry onthe business in partnership with that partner, or it is not practicabte tocarry on the partnership business as outlined in the current partnershipagreement.

Dissolution does not necessarily mean the partnership terminatesimmediately. The partnership continues after dissolution to wind up itsbusiness and terminates when the winding up of the business iscompleted. During this phase, the partnership completes its business,marshals its assets, pays its liabilities, and distributes its interests. Anagreement between partners cannot prevent dissolution but can managethe consequences of dissolution. The partners also may agree tocontinue the partnership after dissotution rather than entering thewinding up phase.

Two fundamentat differences exist between the taxation ofpartnerships (and other non-corporate business entities) andcorporations. First, a partnership is a flow-through entity, not a separatetaxabte entity. Corporations are subject to an entity-level tax, whitepartnerships are not. Second, partners are tiabte for tax on thepartnership's income, even though there may be no distribution of theincome. Shareholders in a corporation are liabte for tax onty upon thereceipt of a distribution from the corporation. A partnership avoids thedouble tax effect because only the partners, not the partnership, havetax liabilities.

An illustration of the advantageous effect of the single tax:

Smith and Jones form a partnership as equal partners. Thepartnership earns $1 million of taxable income for the taxableyear. Smith and Jones each report $500,000 gross income fromthe partnership. The $1 million is subject to the maximumindividual tax rate of 38.6%, creating a tax liability of $386,000.

Assume instead that Smith and Jones formed Smith and Jones,Inc., as equal shareholders. The corporation earns $1 million oftaxable income for the taxable year. Since the corporation is a



separately taxed legal person, the corporation pays $340,000 intax, at the current corporate tax rate of 34%. Then, if thecorporation distributes the $660,000 after-tax earnings to Smithand Jones as a dividend, in cash, Smith and Jones must pay taxon the dividends. Assuming a 38.6% individual tax rate, Smithand Jones wilt pay almost $255,000 in tax.

The combined corporate and shareholder tax on thecorporation's $1 million of table income is $595,000, comparedto $386,000 if the organization operated as a partnership.

Although the partnership does not pay taxes, it files aninformation tax return, Form 1065.

The partnership nets its ordinary income and expense itemsresulting from trade or business activities to produce a single income orloss amount. The partnership files a Schedule K, on which it lists allitems that must be reported separately to the partners. These itemsmust be listed separately because they may affect individual partners'tax liabilities differently. Examples of separately stated items includecharitable contributions, net short-term capita[ gains and tosses, netlong-term capital gains and losses, dividends eligible for a dividends-received deduction, and tax-exempt interest. Every partner receives ashare of the partnership's income, gains, losses, deductions, and creditson his schedule K-i.

When a partner determines gross income for federal income taxpurposes, it must include the partner's distributive share of income froma partnership.

The major disadvantage of a general partnership is that partnersare personally liable for the obligations of the partnership. This leavesthe personal assets of the partners unprotected and subject toattachment by creditors.

Another drawback is uncertainty under the partnership laws. Theyare not as detailed as most corporate statutes and they are not clear asto how various disputes or concerns will be resolved. Fewer courtdecisions interpret partnership statutes than corporate statutes, and thisabsence of judicial interpretation contributes to the uncertainty.

Limited Liability Partnerships

The limited liability partnership (LLP) is a new type ofpartnership, nonexistent before 1990, governed by special provisions ofa state partnership statute.

Most of the attributes of general partnerships also apply to LLPs,



including the discussion of management structure, period of existence,transferability of interests, fiduciary duties and taxation. As the namesuggests, regarding liability of the partners, LLPs have a distinctadvantage over a general partnership.

LLP status appeals to members of professional partnershipsbecause they can continue to function as general partnerships whilelimiting partners' vicarious liability for any malpractice committed byother partners. The LLP does not require the creation and administrationof an entirely new type of business entity. Instead, it enables membersto continue to hold themselves out as partners. Although LLPs initiallywere tailored to the needs of professional service practices, they haveflourished outside the professional domain.

To create an LLP, partners file a statement of qualification with adesignated state agency, usually the secretary of state. Existingpartnerships, to achieve LLP status, must vote to amend the partnershipagreement and file a statement of qualification.

This statement must include the name of the partnership, theaddress of the partnership's chief executive office and, if different, ofan office in the state where the LLP statement of qualification is filed, astatement that the partnership elects to be an LLP, and a date ofcommencement. LLP status is effective on the later of the filing of thestatement or a date specified in the statement. The name of the LLPmust include "Registered Limited Liability Partnership," "LimitedLiability Partnership," "R.L.L.P.," "L. L.P.," "RLLP," or "LLP."

LLP status is in effect initially through the end of the calendaryear after the year of formation. To maintain LLP status, the LLP mustfile an annual registration.

Under many LLP statutes, the formation of an LLP protectspartners against vicarious liability from both tort and contract claimsarising during the partnership's registration as an LLP. The liabilityshield does not protect a partner from liability for claims based on his orher own wrongful acts, negligence, or misconduct.

Under certain circumstances, the partners in an LLP could losethe limited liability shield and be personally liable for partnershipobligations.

Not all states have adopted similar limited liability provisions, andLLPs should not assume that other states automatically would defer tothese provisions. So far, it is unclear whether other states wilt applytheir own law or the foreign state's law to claims regarding an LLPformed under the foreign law.



In states with these provisions, the statutes govern all internalaffairs of the limited liability partnership, including the liabilities ofpartners for the debts and obligations of the LLP.

It is a risk to operate as a generat partnership, with no chance ofprotection from personal liability. Alt partnerships that formerlyoperated as general partnerships should become limited liabilitypartnerships.

Limited Partnerships

A limited partnership is a creature of statute. It has one or moregeneral partners and one or more limited partners. In a limitedpartnership, the general partners are in the same position as partners ina generat partnership - jointly and severally tiabte for the debts of thepartnership. Limited partners are distinct from the partnership and areusually liable only to the extent of their capital contributions.

Limited partners cannot participate in the management of thelimited partnership without risking their limited liability status. If theyparticipate in the control of a business, they can lose their limitedliability and become personalty liable. This prevents a limited partnerfrom possessing ultimate decision-making responsibility. Individual statestatutes may provide a great deal of protection for limited partners withregard to the activities in which they can participate.

Limited partnership interests are freely transferable. Unlikegeneral partnerships, the transfer of an interest in a limited partnershipdoes not require unanimous approval by the other partners. The sate orissuance of a limited partnership interest is treated as a sate or issuanceof a security and the entity must comply with the relevant federal andstate securities taws.

Limited partnerships do not enjoy perpetual existence. Dissolutionoccurs at the earliest of (a) the date specified in the limited partnershipcertificate; (b) the occurrence of events specified in the partnershipagreement; (c) the written consent of all partners; (d) the withdrawal ofa general partner, unless another general partner continues the businessin accordance with the partnership agreement or with the consent of theparties; or (e) judicial dissolution. The limited partnership can agree toavoid a winding up and continue its existence.

General partners owe fiduciary duties to limited partners. Alimited partner has the right to bring an action in the name of thelimited partnership to recover if: 1) the general partners who haveauthority to do so refused to bring an action or 2) an effort to force thegeneral partners to bring an action is unlikely to succeed. The plaintiff



must be a partner when he or she brings the action and when thetransaction complained of occurred. This action is similar to a derivativesuit in the corporate context.

Limited partnerships are rare outside of investment fund andfamily contexts. Their odd management structure, with both general andlimited partners, penalizes limited partners for being active in thebusiness. Limited liability partnerships and limited liability companiesoffer advantages similar to the limited partnership without this structureand its accompanying restrictions.

Limited Liability Companies

A limited liability company (LLC) is an unincorporated statutoryentity that provides presumptive limited liability for all of its owners -its "members." I Under the typical LLC statute, because of the check-the-box regulations, an entity can be created with flow-through taxtreatment, limited liability for its owners, perpetual existence, freetransferability of interests, and a choice of management structures.These developments make the LLC the most appealing non-corporateentity for business organization purposes, making the LLC the entity ofchoice for closely held businesses in the United States

LLC statutes vary significantly from state to state and may bebased on a partnership model, a corporate model, or some hybrid of thetwo.

Typically, one or more organizers can create an LLC. Most statesallow an LLC to have only one member and do not limit the number ofmembers allowed. Members may be corporations, partnerships, trusts,or individuals. Professional organizations, such as accounting and lawfirms, may organize as LLCs.

To achieve LLC status, "Articles of Organization" must be filedwith the secretary of state or other designated office and LLC statuscommences on the date of filing. Articles of organization must includethe LLC's name, its address, the names and addresses of each organizer,and the period of existence if limited. The LLC's name must contain thewords "limited liability company" or the abbreviation "LLC."

To maintain LLC status, the LLC must register annually. An LLC

3 National Conference of Commissioners on Uniform State Laws, Uniform LimitedLiability Company Act: Limited Liability Companies, a Kind of Business Organization,http://www.nccust.or /nccust/uniformact summaries/uniformacts-s- utItca.asp.Summary and history:http://www.nccust.org/nccus/uniformact summaries/ uniformacts-s-Upt97attupa1994.as .



that fails to file its annual registration may terminate administratively.Loss of LLC status may cause the LLC's members to lose the limitedliability shield, leaving members personally liable for any debts incurredafter the termination of LLC status.

LLC status provides an organization with flexibility in determiningits management structure. Statutes usually allow either a manager-managed governance structure or a member-managed structure.Through contractual agreements, an LLC can limit the managementrights of some members. Members may adopt operating agreementsspecifying the relationship of its members and the manner in which theLLC will operate. The operating agreement is the principal governingdocument of the organization.

The transferability of the members' LLC interests depends on thetype of rights involved. The interests in an LLC usually are divided intofinancial rights and governance rights. A financial right in an LLC often isfreely transferable, while a governance right presumptively is not.Transfer of governance rights to a nonmember typically requires theunanimous consent of all other LLC members.

An LLC is liable for all company obligations, including liabilityresulting from the wrongful acts of its members or employees. LLCmembers are liable only to the extent of their capital contributions. Thislimited liability status remains in full force even in the event of adissolution, winding up, and termination of the LLC. This protection willbe lost only if a complaining party successfully pierces the LLC's limitedliability shield.

The presumed duration of an LLC varies among LLC statutes. Somestates provide partnership-like dissolution provisions, while others allowa stated of existence or presume a corporate-like perpetual duration.

Corporations

Historically, one advantage of doing business in the corporateform was the ability of the shareholders, as the owners of the business,to limit their personal liability for the business's debts and obligations.This liability shield protects the shareholders' personal assets from anytoss incurred by the corporation, because a corporation is a distinct legalentity separate from its owners. Creditors must took to the corporation'sassets to satisfy their claims.

Business parties who intend to use the corporate form must followthe proper corporate formalities or risk losing limited liabilityprotection. Corporate law requires that all corporations have agovernance group called the board of directors. Responsible for a



corporation's management, shareholders must elect the board ofdirectors through regularly scheduled annual elections or specialelections. Shareholders typically do not participate in the managementof the corporation.

Centralized management is important in large, publicly tradedcorporations. With thousands of passive shareholders scatteredthroughout the globe, a shareholder is not likely to seek or be able toactively participate in the management of the typical multinationalcorporation. In smaller business entities, centralized management is adisadvantage, because their owners want to manage and their managerswant to own.

Directors are fiduciaries to the corporation and have duties ofobedience, care, and loyalty. Shareholders do not owe the corporationor each other any fiduciary duties.

An interest in a corporation is readily transferable, unlessrestricted by the owners. Free transferability of ownership interests is adefinite advantage of the corporation, particularly a large one.Typically, only small, closely held corporations restrict the transfer ofownership interests.

Another advantage of the corporation is that it has a presumptiveperpetual existence. Unlike a partnership, a corporation does notdissolve upon the occurrence of certain events or the passage of acertain period of time. Corporations need not be concerned that anunwanted dissolution or winding up may occur. The board of directorsand the shareholders can determine when a corporation terminates itsexistence.

Shareholders in a corporation are presumed to be liable only tothe extent of their contributions. They may be personally liable,however, under the equitable doctrine of piercing the corporate veil. Topierce the corporate veil, a complaining party must show that theshareholders employed the corporation as an "alter ego" and that use ofthe corporation was unfair or inequitable.

When third parties seek to pierce the insulation of the corporateform, it usually is in cases involving closely held corporations. Courtsmay perceive less of a justification for the protection of shareholders ofclosely held corporations from personal liability. Operating a corporationlike a sole proprietorship can justify a court's removal of the limitedliability veil.

Corporations are separate taxpaying entities, distinct from theirshareholders. They are taxed annually on earnings. When the



corporation distributes its income in the form of dividends, thecorporation's shareholders must report this income as well. The effect isdouble taxation - a major disadvantage of operating as a corporation.Because the corporation is a separate entity, many ongoing transactionsbetween it and its shareholders are taxable events. When thecorporation liquidates, any previously unrealized income, such asappreciation of corporate assets, is taxed at the entity level.

S Corporations

Recognizing these problems, Congress and the Internal RevenueService created tax provisions that allowed small businesses to not belimited or guided solely by tax considerations when choosing an entityform. The result was the creation of S Corporations, governed bySubchapter S of the Internal Revenue Code. 4

Subchapter S status combines the non-tax legal environment ofregular corporations with taxation similar to that of partnerships. SCorporations enjoy many of the corporation's non-tax benefits whileavoiding double taxation.

S Corporations are small business corporations that have made anelection under section 1362 to become S Corporations. A corporationfiles Form 2553 - Election by Small Business Corporation to TaxCorporation Income Directly to Shareholders - to make the election. 5The Code specifies six requirements that corporations must satisfy inorder to be an S Corporation:

1. It must be a domestic corporation.

2. It may have no more than 75 shareholders.

3. Shareholders must be individuals, estates, and certain types oftrusts or certain tax-exempt organizations.

4. Shareholders cannot be nonresident aliens.

5. The corporation must not be an ineligible corporation, as aresome insurance companies and financial institutions.

6. It may only have one class of stock.

4 I.R.C. §§ 1361-1363,http: //www. access. po.gov/ uscode/titte26/subtittea chapterl subchapters parti .htmI5 I.R.S. Form 2553: Election by a Small Business Corporation,httD: l /www.irs.0ov/ Dub /irs-Ddf/f2553.Ddf



Each of these criteria must be satisfied and all of the SCorporation's shareholders must consent to the election in writing. Theelection remains in effect unless the corporation voluntarily revokes theelection or fails to satisfy any of the six small business corporation tests.

S Corporations are flow-through entities and are like partnershipsfor tax purposes. S Corporations report an ordinary income or tossamount as well as the corporation's separately stated items. Theseparately stated items are identical to those of partnerships. Eachshareholder receives a pro rata share of the ordinary income or lossamount and of each of the separately stated items. The pro rataallocation method assigns an equal portion of each item to each day ofthe taxable year and then allocates that portion among the sharesoutstanding on that day.

Although the S Corporation is not subject to corporate incometax, it must file Form 1120S - U.S. Income Tax Return for an SCorporation - if it existed at any time during the tax year. Also, the SCorporation must give pertinent information to its shareholders and theshareholder's return must be consistent with the corporate return.

Conclusion

The LLP and the LLC are the newest and most popular types ofbusiness entities. All fifty states and the District of Columbia haveenacted such statutes. The primary drawback of LLP or LLC status is thatsome uncertainty surrounds the manner in which LLP and LLC laws willbe interpreted because of their short periods of legal existence.

Notwithstanding this uncertainty, it is difficult to conceive of anyreason why knowledgeable and well-represented entrepreneurs wouldorganize a firm as anything other than an LLP or LLC or a corporationthat has made an S corporation election. Only in special circumstancesshould an entrepreneur use the traditional sole proprietorship, generalpartnership, or limited partnership.


Choice of Organizational Form for the Start-Up Business 19

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Choice of Organizational Form for the Start-Up Business