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Entity Formation

If you intend to build your business to last, part of its foundation must be a good legal structure. Legal and accounting fees are always less for drafting good documents than they are for fighting over bad ones.

There are several different ways to set up the legal structure of your business, we can help you decide which one is best for you. The three most common structures are a limited liability company, corporation, or partnership.

LIMITED LIABILITY COMPANIES

One of the most common entity types when starting a business is what is known as a limited liability company, or LLC. Like corporations (see below), LLCs are principally governed by the law of the state in which the LLC is formed.

In general terms, an LLC is similar to a corporation for the asset protection provided to its owners. However, unlike a corporation, an LLC may utilize a flexible governance structure and adopt the flow-through tax treatment of a partnership.

Because of the flexibility permitted by the LLC structure, the owners (known as “members”) of most LLCs adopt what is known as an operating agreement or limited liability company agreement to document the “rules” for the company.

If you form an LLC, you need an operating agreement. While not required by law, an operating agreement is usually a good idea.

If your company does not have an operating agreement, then state statutes, regulations, and case law will govern your company to a degree. States have default laws and rules that apply absent agreement among the members of an LLC.

The members of an LLC are generally aligned in at least one goal: they want the company to succeed. But regardless of how the business does, the desires and needs of all the members will never be perfectly aligned. Such differences can be based on risk tolerance, personal wealth, family dynamics, business goals, or any number of other factors. The process of preparing the operating agreement brings these conflicts to light, allows each member to express his or her respective viewpoint and document the collective agreement within the operating agreement. While discussing certain issues may be uncomfortable, failing to do so on the front end may result in significant expenditure of time, money and energy on the back end.

Even if you (and your partners or investors, if you have any) decide that an operating agreement is not needed for your company’s internal purposes, you may nevertheless be required to prepare one for something as simple as opening a bank account, because banks commonly include an operating agreement on their account opening checklists in order to confirm proper authority.

Common Provisions in an LLC Operating Agreement

Since operating agreements are a product of contract, they may address most anything the members of an LLC wish to cover. Depending on your state of formation, however, there are a small number of matters that are dictated by statute and which cannot be changed by agreement of the members.

Operating agreements typically include provisions addressing the following subjects:

  • Business Purpose: The type(s) of business your LLC will be doing in Missouri.

  • Term: How long your LLC in Missouri will be valid, typically until you file for termination.

  • Capital Contributions: The amount of money each member has invested in the LLC.

  • Profits, Losses, and Distributions: How income and debts are allocated among members and methods for distributing funds.

  • Ownership Percentage: How much of the company each member owns.

  • Management and Roles: The managerial structure and decision-making processes, naming who is in charge of certain operations.

  • Compensation: How members/managers are compensated and reimbursed.

  • Bookkeeping: Accounting procedures and member account policies.

  • Tax Treatment: Whether your LLC will be taxed as a Sole Proprietorship, Partnership, S-Corporation, or C-Corporation.

  • Member Additions: The procedure for bringing on new members – how they will be admitted, if they’re entitled to income, any expenses they will owe, their roles, etc.

  • Member Withdrawal: Procedures for the resignation, expulsion, retirement, or death of an existing member.

  • Amendment Procedures: How your LLC will approve changes to the operating agreement. Usually, it’s through a majority vote by the members.

  • Dissolution: What happens when you terminate your LLC. How your members will split up the remaining assets or debts.

A Good Operating Agreement Anticipates Issues

Operating agreements are (and should) usually be drafted to permit the members of the LLC to change it as circumstances change. However, it is best to create an operating agreement that anticipates common scenarios and addresses them in a fair, equitable manner. The good news is that most issues that will arise in your business have already arisen in other businesses, so drafting a flexible operating agreement is not difficult.

CORPORATIONS

A corporation is a business entity that functions as a distinct legal “person,” one that is separate from its owners and offers them protection from personal liability for business debts. There are two different kinds of corporations:

  • A C-corporation is a separate taxpayer.

  • An S-corporation is a “pass-through” tax entity, meaning federal income taxes are not paid at the company level, but rather the profits and losses of the business pass through to its owners, who report them on their personal tax returns.

Corporations are required to keep good records, file a corporate tax return, and, in order to retain limited liability for owners (i.e. shareholders), they must follow corporate formalities involving finances, decision making and record keeping.

To create a corporation, Articles of Incorporation (in some states called a “Certificate of Incorporation”) must be filed (including the filing fee) with the business division of the state government, which is usually, but not always, part of the secretary of state’s office.

In most states, the state has a prescribed form that may be used, which requires a few basic details about the corporation, such as its name, address and contact information for the person who will receive legal papers on its behalf (usually called a “registered agent”). Some states also require a list of the names and addresses of the corporation’s directors and officers. If the corporation will be conducting business in more than one state, then it must also register with the business division in each additional state. Usually, that entails filing a form and paying fees similar to the filing of the original Articles of Incorporation, but the original state of incorporation remains the “home” state.

State statutes also require the adoption of corporate bylaws that address issues of corporate operation and management, such as: how and when to hold regular and special meetings of directors and shareholders, as well as the number of votes that are necessary to approve corporate decisions. It is also a good idea for the shareholders to adopt and follow a shareholders’ agreement, which typically addresses issues of ownership and economics. The bylaws and shareholder agreements are internal company documents that are not filed with the state, but instead maintained in the corporate minute book.

Finally, corporations are required to issue stock to the shareholders of the corporation (which may or may not be certificated), as well as record who owns the ownership interests (i.e., shares or stock) in the business.

Corporations have a multi-tier management structure. The top tier of management, known as the board of directors, are elected by the shareholders, and are responsible for making big picture decisions on behalf of the corporation. Those decisions might include such actions as taking on investors, starting a new product line or entering into a multi-year lease. The directors in turn elect the corporate officers—think CEO, CFO, president, etc.—who are tasked with running the day-to-day affairs of the corporation. These types of activities would include sales, operations, employment decisions and such other tasks necessary for successfully running a business.

Once the corporation has been formed, most states require annual franchise tax filings, which essentially amounts to a tax for the privilege of being registered in that state. Corporations are required to hold annual meetings of its shareholders and directors, or to prepare annual consents that formally approve the actions of management over the prior year.

Corporations and their shareholders must observe certain formalities to retain the corporation’s status as a separate entity. Specifically, corporations must:

  • Hold annual shareholders’ and directors’ meetings

  • Keep minutes of shareholders’ and directors’ major decisions

  • Make sure that corporate officers and directors sign documents in the name of the corporation

  • Maintain separate bank accounts from their owners

  • Keep detailed financial records

  • File a separate corporate income tax return

That last exception could lead to what is known as “piercing the corporate veil,” where the shareholders may in fact become personally liable for business debts notwithstanding the corporation’s separate legal existence. In order to prevent that from happening, it is essential that the following happen:

  • Adequate capital is invested in the corporation.

  • Personal activities and funds are not mixed with business activities and funds.

  • Certain formalities are observed, including stock being issued to the shareholders and regular meetings of the shareholders and directors being held.

In addition, business funds should be treated separate from personal funds (e.g. personal expenses should not be paid out of business accounts), and the corporation should create, file and maintain proper documentation of its existence and operation (e.g. make sure that all federal and state forms have been filed).

Finally, while not required under statute, obtaining a comprehensive business insurance policy should help to protect personal and business assets. Such a policy will cover most business activities where they occur in the course of the business’s performance.

The tax advantages of a corporation depend on the type of filing: C-corp or S-corp.

A C-corporation pays taxes on whatever profits are left in the business after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return through Form 1120 with the IRS, and pays taxes at a special corporate tax rate. The Tax Cuts and Job Act established a new single flat tax rate of 21% for corporations, which replaces corporate tax rates ranging from 15% to 35% under prior law.

Alternatively, the corporation can elect what’s called “S-corporation” status by filing Form 2553 with the IRS. Upon making this election, the corporation will be treated like a partnership for tax purposes, with business profits and losses “passing-through” the corporation to be reported on the owners’ individual tax returns. While there are tax benefits to making the S-corporation election (namely the payment of a single layer of tax rather than multiple layers of tax), S-Corporations have several limitations that are not applicable to C-Corporations. These include the types and amounts of shareholders, and it may only issue a single class of stock to shareholders (although there is a limited exception that permits separate classes for voting and non-voting stock).

PARTNERSHIPS

A business partnership is a legal relationship that is most often formed by a written agreement between two or more individuals or companies. The partners invest their money in the business, and each partner benefits from any profits and sustains part of any losses.

The partnership as a business often must register with all states where it does business. Each state may have several different kinds of partnerships that you can form, so it's important to know the possibilities before you register.

Some partnerships include individuals who work in the business, while other partnerships may include partners who have limited participation and also limited liability for the business's debts and any lawsuits filed against it.

A partnership, as opposed to a corporation, is not a separate entity from the individual owners. A partnership is similar to a sole proprietor or independent contractor business because with both of those types of businesses, the business isn't separate from the owners for liability purposes.

Income tax is not paid by the partnership itself. After profits or losses are divided among the partners, each partner pays income tax on their individual tax return.

Before you start a partnership, you will need to decide what type of partnership you want. There are three different kinds that are commonly set up.

  • A general partnership (GP) consists of partners who participate in the day-to-day operations of the partnership and who have liability as owners for debts and lawsuits.

  • A limited partnership (LP) has one or more general partners who manage the business and retain liability for its decisions and one or more limited partners who don't participate in the operations of the business and who don't have liability.

  • A limited liability partnership (LLP) extends legal protection from liability to all partners, including general partners. An LLP is often formed by partners in the same professional category, such as accountants, architects, and lawyers. The partnership protects partners from liability from the actions of other partners.

Depending on the type of partnership and the levels of partnership hierarchy, a partnership can have different types of partners. Partners may be individuals, groups of individuals, companies, and corporations.

General partners and limited partners: General partners participate in managing the partnership and often have liability for partnership debts and obligations. Limited partners invest but do not participate in management.

Different levels of partners: For example, there may be junior and senior partners. These partnership types may have different duties, responsibilities, and levels of input and investment requirements.

A limited liability company (LLC) with two or more members (owners) is treated as a partnership for income tax purposes. The main difference between an LLC and a partnership is that in an LLC, members are generally shielded from personal liability for the company. In many partnerships, only limited partners are protected from personal liability for the company.

Partnerships use a partnership agreement to clarify the relationship between the partners; what contributions, including cash, they will make to the partnership; the roles and responsibilities of the partners; and each partner's distributive share in profits and losses. This agreement is often just between the partners; it's not generally registered with a state.

A strong partnership agreement addresses how decision-making power will be allocated and how disputes will be resolved. It should answer all the "what if" questions about what happens in a number of typical situations. For example, it should spell out what happens when a partner wants to leave the partnership. State law will apply if there is nothing in the partnership agreement that lays out how to handle the separation—or any other issue that arises.