Legal Forms of Business

Legal Forms of Business

Business entities are an integral part of business practice and economic productivity. An effective business practitioner must understand the characteristics of the major types of business entities, as these attributes can dramatically affect the nature of the business's relationships. Before beginning to conduct business, one should always weigh the benefits and burdens of the different types of business entities and make a conscious decision about which type of entity to form to conduct one's business.

Depending on the type of business, the people involved, and the goals of the business, some entities may be more appropriate than others for a particular business. To make the decision about the appropriate type of entity to form, one should consider factors including the following:

· creation and maintenance—the effort associated with forming and maintaining the entity

· continuity—the continuity or stability of the organization upon given occurrences

· ownership and control—the ownership rights and control of those involved with the business

· personal liability—the potential for personal liability of those involved with the business

· compensation—the compensation and division of profits among business owners

· taxation—the taxation of the organization's earnings and its distributions of profits to the owners

Weighing these and related factors, which vary in consequence depending on the entity, informs the choice of the type of business entity best suited to one's business. Examination of these characteristics will make obvious the effect of these attributes on stakeholders of the business entity. The decision of which entity is right for a particular business impacts many facets of a business's operation, including accounting, management, and finance.

Business Entities

Business entities are legal organizations that exist by virtue of state law. One way to view a business entity is as a separate person. The business entity carries on business activity on its own behalf. The owners of the business entity are representatives of the entity. Business entities benefit society by allowing individuals to aggregate their resources and efforts in furtherance of a business activity. The legal entity is essentially a bundle of contracts that provides for the rights and duties of the owners and employees of the business entity. Each individual state passes its own substantive and procedural laws regarding business entities. A business must choose its state of formation or organization. The home state may be the location where the business is headquartered or it may be any other state where the business organizes and establishes a registered agent. If the business wishes to carry on business outside of its home state, it must qualify to do business and register as a foreign entity doing business in the other state. Carrying on business is generally defined pretty broadly to include marketing or sales activity. A business may carry on the majority or all of its business in a state or states where it is registered as a foreign entity. The business entity must comply with the laws of any state in which it does business.

For example, I want to form a business entity in my home state of New York. The rules prescribed by New York will govern the formation process. I want to also carry on business in Pennsylvania. To do so, I will register my business in New York and then register as a foreign entity doing business in Pennsylvania.

Ask Yourself

· Think about major businesses within the United States. Can you identify five major businesses (Fortune 100 Businesses) within the United States and the state in which they are formed? Where is the headquarters located for each of these businesses?

· Martin is from Mississippi. He forms a business entity and begins providing chartered fishing services. He wants to expand his operations to Louisiana. Can you do that given that he is organized in Mississippi? How or why not?

Why Is Studying Business Entities Important?

Owners and managers of a business seek to organize their resources to maximize productivity and opportunities. These individuals must understand the important characteristics of the business entity to take advantage of all of the benefits associated with carrying on a business activity as a legal entity.

Taking advantage of a business entity status means choosing an entity form for your business, operating within your chosen entity form, and undertaking business transactions with various entity types.

Understanding business entity characteristics includes familiarizing oneself with the ownership structure, organizational structure, potential liability, compensation methods, and tax laws applicable to the business entity. Lastly, the owners and managers of a business must comply with the procedural and substantive laws applicable to that business entity. This is generally known as business governance.

Numerous other requirements may exist before a business entity may carry on business in a jurisdiction. For example, she will likely have to obtain a business license from the local government before undertaking business. She will have to do a fictitious name filing if she operates under a name other than her own name. Further, she will need to set up an employer identification number (EIN) if she plans to have employees for her business. All of this is distinct from the nature and characteristics of the business entity.

Ask Yourself

· Try to outline the procedural steps necessary to form a business entity within a state. This will likely require you to go to the Secretary of State's website for your particular state. The process and rules for form any business entity type will be explained there. The process may vary slightly, for each state.

"Closely Held" and "Publicly Held" Companies

Business entities are often categorized as either closely held or publicly held. These designations are not separate types of business entity; rather, they are classifications or defining characteristics of a given business. Generally, the distinction between the two classifications concerns the number of business owners and whether the equity ownership is sold on a public exchange.

A  closely held business, as the name implies, is held by a smaller or more closely related group of individuals. It is often thought of as a smaller business, such as a mom- and-pop or family business. In truth, however, the closely held status has little to do with the size or revenue of the business; rather, it simply means that the business is not widely owned by numerous, unrelated people. Another characteristic of the closely  held entity is that it is not traded on a public market,

For example, my wife, three friends, and I own a business that specializes in dog training and boarding. We are a closely held business because all of the ownership is held by a small group of closely connect individuals.

A  publicly traded business is any business that is traded on a public exchange. This means that the company has gone through an initial public offering in which its shares were registered with the Securities and Exchange Commission and subsequently listed for sale to the public at large. A publicly held or publicly traded company is generally held, or capable of being held, by a large number of unrelated people.

For example, Elton's business is growing rapidly. He needs to bring in additional capital to expand operations. He decides to undertake a public offering and list shares of his company for sale on a public exchange. Once listed for sale to the public, Elton's business is now a publicly traded company.

A closely held business is a private business. It is unlikely that a business could or would undertake a public offering and remain closely held. The inverse, however, is not necessarily true. Private business entities are not necessarily closely held. Some private businesses are widely held by a large number of shareholders.

Ask Yourself

· Some companies choose to remain closely held instead of seeking a large and diverse set of owners. Other companies prefer to be widely held and often undertake a public offering as part of that effort. Can you think of reasons why a company would prefer to remain a closely held private company versus a widely held public company?

· Can you identify a very large closely held company that does business across the United States? Can you identify why the company is considered, "closely held."

Main Types of Business Entities

The main types of business entity discussed here are as follows:

· sole proprietorships—The sole proprietorship is not considered a separate business entity, but it is the basis from which business entities are defined.

· general partnerships—The general partnership is the most basic type of business entity. While the general partnership is commonly understood to be a legal business entity, some legal theorists do not regard the partnership as a formal legal entity.

· limited partnerships—This is a hybrid form of partnership that allows for a class of partner known as a "limited partner."

· limited liability limited partnership—This is a hybrid form of partnership that allows professional practitioners to organize as partners with limited personal liability.

· limited liability companies—This is the most common form of business entity in the United States. The reason for this fact is based upon the blend of informal and protective characteristics of the LLC.

· corporations—The corporations is the oldest form of business entity. The corporation is generally divided based upon its tax status as C-Corporation, S-Corporation, and non-profit Corporation.

Some of the less-common types of business entity are the limited liability limited partnership (LLLP) and the professional corporation (PC). The LLLP is a special purpose entity generally used as part of special project, such as a real estate project. A professional corporation is a corporate form for small practitioner firms that is rarely used because of the unfavorable 25 percent flat corporate tax rate.

Characteristics of Business Entities

There are numerous characteristics that make a business entity unique. The major characteristics of a business entity are as follows:

· creation and maintenance—The effort associated with forming and maintaining the entity;

· continuity—The continuity or stability of the organization upon given occurrences;

· ownership and control—The ownership rights and control of those involved with the business;

· personal liability—The potential for personal liability of those involved with the business;

· compensation—The compensation and division of profits among business owners; and

· taxation—The taxation of the organization's earnings and its distributions of profits to the owners.

This list is certainly not exhaustive; however, these primary characteristics provide a great deal of necessary insight for understanding and choosing a business entity.

Ask Yourself

· Why do you think these are the primary characteristics of a business entity? Can you think of any other characteristics of the business entity that would be important to understand when selecting and forming a business entity.

Creation of a Business Entity

Creation of a business entity is the legal or procedural steps that one must undertake to bring the business entity into existence. There is a general dichotomy in the process or steps required to form a business entity.

Default Entity Status 

Some business entities may arise by default without any formal procedural undertaking by the founder. That is, the business entity may arise simply by the parties undertaking some business activity with the intention of generating revenue or making a profit.

To form a general partnership, the only requirement beyond the physical activity of the founders is the subjective intent of the partners with regard to the responsibilities of each party and the allocation of proceeds (or losses) as they arise. Generally, in the event of dispute, a court will be charged with determining whether individuals carrying on commercial activity are a default general partnership. Notably, the sharing of losses is the greatest indicator of co- ownership of a business, as opposed to an employer-employee or contractor relationship.

In some cases, a court may determine that a business entity exists pursuant to the conduct or actions of the parties. Further, a court may recognize a partnership to avoid an inequitable result if an entity does not exist. This is known as "estoppel."

Filing for Entity Status 

Some business entities require a formal filing process through the state secretary of state's office. This requires the filing of documents of organization in accordance with the procedural rules adopted by the state of organization. The amount of information and type of documents required will vary between states and depend on the type of entity. The general requirements for each business entity type are discussed along with that business entity.

For example, Eric wants to form an LLC. He goes to the website for the Nebraska Secretary of State's Office and downloads the necessary forms. He files the information sheet and articles of organization and pays the applicable fee. Seven days later he receives a Nebraska state certificate of organization for his LLC.

Ask Yourself

· Most people do not realize the commercial activity by two or more individuals defaults to a business entity status under certain conditions. Can you think of any consequences that this may have for the partners and business activity? Hint: think about the characteristics of a business entity discussed above. These will help give you an idea of the potential consequences of being deemed a legal business entity.

· Eric is thinking about forming a business entity for his personal consulting practice. He has been consulting for several months and is bringing in Audrey, also a consultant, as a co-owner of the business activity. He and Audrey begin operating their consulting practice before filing the applicable business organization documents. What should Eric and Audrey known about their current business entity status?

Maintenance Requirements for a Business Entity

Maintenance of a business entity is summarized as the administrative steps associated with starting and carrying on business as a given entity form. It entails the process of filing documents, holding meetings, maintaining records, observing formalities, and reporting necessary information to regulators. The requirements for starting a business vary considerably between entity types. Businesses entities that require formal procedures to organize also require formalized maintenance procedures. At the most basic level, these entities require the owners to file statements each year (along with annual fees) with the Secretary of State's office, to hold business meetings, to maintain records, and to report information to regulatory authorities. The state may require that an entity maintain certain records, such as meeting minutes and resolutions, ownership logs, capital accounts, financial statements, etc. The federal government may require that business entities file specific information related to taxation or securities issuances. State and federal reporting requirements can also be industry specific or based upon the company's size or status as privately or publicly held.

For example, A group of friends and I form a corporation. We all vote and elect each of us as directors. We then appoint me as CEO. Our creation and maintenance requirements mean following the state-required duties for filing annual information and paying fees to the state. This could include voting as directors to approve our corporate documents. As CEO, I will be charged will filing those documents with the state.

Generally, default business entities require little or no maintenance to continue on as a business entity. These businesses arise simply through the conduct of those involved and do not involve the formalized procedure for maintaining their operating status. While there are few formal maintenance requirements for default entities, there are still numerous tax formalities to follow. The lack of formal maintenance requirements associated with default entities often causes the owners to fail to follow other business formalities.

Ask Yourself

· Why do you think the government requires business entities to undertake these maintenance formalities? Why do you think it is important internally for businesses undertake formal maintenance? Which state and federal agencies do you think the care about business maintenance? Hint: Think about taxation and securities law.

· Visit your state's secretary of state's website. Can you locate the information and filing required to form and maintain each type of business entity recognized by your state? How do these requirements vary between each type of business entity?

Continuity of a Business Entity

The continuity of the business entity concerns the effect on the business of a major change in the ownership and organization structure. More specifically, this question addresses what types of conduct by business owners can cause the business to dissolve. Owners of a business entity must understand the stability and durability of the organization if or when an owner leaves the business. Managers are concerned with the stability of customers and suppliers and should make certain that changes in ownership or structure do not have unintended consequences on the business operations. The primary change affecting the status of a business entity is the death or dissociation of an owner. In some instances this occurrence may be grounds for the dissolution of the business. Another dissolution event may arise through a limitation on the transfer of ownership by any individual in the business. Such a scenario may effectively dissolve the business if one individual wishes to liquidate her interest.

For example, Mary, Bob, and I start carrying on business as a general partnership. We do not have a partnership agreement. When Mary decides to leave the partnership, the default rule is that the partnership dissolves.

Ask Yourself

· Can you think of any situations where a business has faced serious turmoil when a co-owner leaves the company? Passes away? Declares personal bankruptcy? What were the primary issues and what was the result?

· Mike and Bryan are partners in a business venture. They have a partnership agreement. Bryan passes away and his will leaves his interest in the business to his wife, Jane. What information do you need to know to determine the status of the business entity? Why?

Ownership Structure

Ownership structure concerns the internal organization of a business entity and the rights and duties of the individuals holding a legal or equitable interest in that business. As owner of the business entity, it is important to understand how the ownership structure of a particular business entity is organized and what that means for the owner's rights.

A shareholder, as owner of a corporation, for example, has certain rights. These rights are distinct from those of members of a limited liability company. Further, within the corporation, a holder of preferred stock may have different rights than the holder of common stock.

Ask Yourself

· Why do you think different types of business entity allow for unique ownership structures? Why do you think ownership structure is so important for business owners?

· Can you think of any situation where ownership of the business entity became an issue between the founders or co-owners of the businesses? What was the basis of the dispute and what was the outcome?

Control over a Business Entity

This questions concerns who has control over operations or authority to act on behalf of the business. Each business entity type has a default control structure and level of authority vested in individuals in those roles. In many cases the owners and managers of the business are the same people. This relationship becomes convoluted when there are owners who act as managers of the business and others who do not. The issue of overlapping ownership and control becomes increasingly important in closely held business entities. Third parties dealing with a business entity want to be certain about the level of authority of the individual with whom they are dealing. Further, the business entity is concerned about its agents undertaking transactions that obligate the entity, such as taking out loans or entering into purchaser or sales contracts.

The level of authority of individuals acting on behalf of a business entity affects the potential liability of the business for the acts of those agents. Business owners may undertake procedures to outline the role and authority of each member of the business. This is normally done within the business's organizational documents. The title attributable to any owner affects the level of control and authority that she has. Failure to follow procedures to document the authority and control within the business can result in a default level of control or authority in a member of the business that is undesirable to the other owners. Further, a lack of formalized organizational structure can cause internal disputes that affect the operational efficiency of the business.

Owners of an LLC are known as members. I am a member of an LLC. If I am a member- manager of the LLC, I have the authority to carry on all operations and act on behalf of the LLC. If I am a not a manager of a member-managed LLC, I do not have the authority to act on behalf of the business.

Ask Yourself

· Why do you think structure of control is an important characteristic of a business entity? Should business owners be able to change or modify a business's control structure? Why or why not?

· Can you find a situation where an employee or agent acted on behalf of a business without authority? Can you identify a situation where the business was contractually bound by the actions of the employee that were not authorized?

Potential Personal Liability

Generally, individuals are responsible for their own conduct. The rules of agency may make an individual vicariously responsible for the acts of an agent, if that agent is acting with authority or within the scope of her employment. Some business entities limit the liability of business owners for the actions of agents of the business. This means that the owner is protected from being held personally liable for the debts (contracts) or tortious conduct of the business's employees or other owners. That is, the business owner does not risk losing her personal assets for debts created or tortious activity committed by the business or its owners. This business entity characteristic is a strong motivation for individuals to form a business entity to carry on their business activities.

It is important to remember that a business entity offering personal liability protection to its owners may forfeit that protection if the Secretary of State's office or the court disregards the business entity. The Secretary of State may dissolve a business entity for failing to follow entity maintenance requirements. More commonly, a plaintiff who is suing the business may attack the business entity status in an attempt to "pierce the veil."

For example, the owner of an LLC has two employees who deliver goods to customers. One of the employees accidentally crashes the company vehicle into a pedestrian. The pedestrian can sue the negligent driver and the LLC for damages. The driver may be personally liable for his negligent driving. The LLC may be vicariously liable for the employee's tortious act, since it was committed when the employee was acting in furtherance of the business's operations. The owner's personal assets, however, may be protected from the reach of the plaintiff.

Ask Yourself

· Can you identify any situations where the owner of a business has been held personally liable (either in contract or tort) for the actions of the employees of a business? Why was the business owner held personally liable despite the limited liability protections of the business entity?

· Bert is a member of an LLC. The LLC is managed by Victoria, who is also a member of the LLC. Victoria accidentally rear-ends Gayle while driving to meet a business client. If the plaintiff decides to sue for the negligent act, will Bert or Victoria potentially be personally liable?

How Is an Owner of a Business Compensated?

The owners of a corporation may be compensated in two primary manners. The acceptable method of compensation depends upon the type of business entity and the role that the owner plays in the business. Some business entities allow business profits to pass through the business directly to its owners. These owners receive either a percentage of the profits based upon their ownership percentage or a percentage based upon a special allocation of business profits that differs from their ownership percentage. Other business entities (specifically corporations) compensate owners by distributing dividends from business profits. Unlike flow-through profits, payment of dividends is generally a decision by the board of directors and does not represent all profits of the corporation. That is, the corporation determines the amount of any dividends paid to shareholders and may retain any percentage of profits within the corporation.

A corporate employee who is also a business owner must receive a reasonable salary for her services to the corporation. Otherwise, a portion of any share of corporate profits distributed as dividends will be treated as salary. This makes a difference in how the funds are taxed to the individual. An owner of any other type of business entity does not receive a salary and is compensated by receiving a distribution of profits.

For example, say I am a shareholder and CEO of ABC Corp. I will receive a salary for my services as as CEO, and I will receive a dividend if any are paid to shareholders. Corporate business entities (or business entities taxed as corporations) require that an owner who also serves as an employee of the business to draw a salary from the business. The salary is separate from any distribution of dividends.

Ask Yourself

· Is it common for owners of a business to also serve as employees of the business? Are most owners of a business in the US employees of the business? Please explain.

· Frank and Judy are members of an LLC. Both Frank and Judy work in the LLC and each is a 50 percent owner. What other information do we need to know to determine how Frank and Judy are compensated?

How Business Entities are Taxed

Understanding basic taxation concepts as they apply to each entity type will give you sufficient background to understand the important tax considerations in a transaction by a given business entity. To understand taxation of business entities, it is important to understand personal taxation as well as business taxation.

Individual Taxation: Income 

Individuals pay federal and state taxes on a percentage of their adjusted gross income (AGI) in a given tax year. AGI is calculated as an individual's gross income, minus all deductions (either the standard deduction or itemized deductions) and the individual's personal exemption. A person's gross income is comprised of wages or other income, dividends, and investment interest, gains, dividends, rents, royalties, etc. Deductions are numerous categories of expenses that the state and federal government exempts from taxation. A person can either claim individual deductions, known as "itemizing deductions" or claiming a "standard deduction."

The standard deduction in 2016 was $6,300 for single individuals. This changes for individuals filing jointly or as head of household. Each taxpay

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