Introduction
Many entrepreneurs become confused when considering which business
organization form to use for a business. There are potentially as
many as nine business forms available under current Missouri law.
Several of them are simply variations on basic forms. Some of the
business organization forms available today are the result of recent
changes in Missouri law. Not all lawyers or accountants may be familiar
with what is available, or the advantages and disadvantages of each.
In addition, there are federal income tax choices that may affect
which form is chosen. You, yourself, should learn as much as possible
about the different business forms and the tax treatment of each
in order to be able to judge better the quality of advice you are
receiving. Do not hesitate to ask an advisor why a particular form
is being recommended, what other options are available, and why
the advisor recommends the one over others. A good advisor should
be able to explain these things to you in terms you can understand.
Be prepared to pay for such advice. Most professionals in this area—attorneys,
accountants and business consultants—will provide a short,
free consultation. If you then become a client, charges are generally
based on the amount of time required or may be a flat fee for certain
services.
| |
Sole Proprietorship
|
Partnership/ Registered Limited Liability
Partnership
|
Limited Liability Company
|
S Corporation
|
C Corporation
|
|
Legal Liability
|
Unlimited |
Unlimited for general partnership,
limited for RLLP |
Limited, same as RLLP or corporation
|
Limited |
Limited |
| Continuity of the Entity |
Limited to life of proprietor |
Limited, unless provided for in
partnership contract |
Dissolve date |
Perpetual Life |
Perpetual Life |
| Acquisition of Capital |
Limited to only what the proprietor
can secure |
Generally limited to what partners
collectively can raise |
Generally limited to what members
collectively can raise |
Maximum of 75 stockholders, but
capital generally not raised by selling stock |
Unlimited number of stockholders,
but capital generally not raised by selling stock |
| Transfer of Interest |
Easy because all assets owned by
individual proprietor |
Right to distributions easy to
transfer; interest in assets and right to management cannot
be transferred without consent of other partners |
Economic rights are transferable,
management rights transferable with consent of other members
|
Stock easy to transfer unless restricted
by agreement, by articles of incorporation or by being statutory
close corporation |
Stock easy to transfer unless restricted
by agreement, by articles of incorporation or by being statutory
close corporation |
| Management |
All management decisions by proprietor |
Usually all general partners will
be actively involved in management activities |
Usually managed by members, but
can have separate managers with duties as outlined by the operating
agreement |
Managed by directors, who are elected
by shareholders unless statutory close corporation has chosen
to eliminate directors |
Managed by directors, who are elected
by shareholders unless statutory close corporation has chosen
to eliminate directors |
| Taxation of Income and Expenses |
All income and expenses reported
on proprietor's individual tax return |
Divided among partners in accordance
with investment or partnership agreement and reported on partners=
individual returns |
Divided among members in accordance
with investment or operating agreement and reported on members=
individual returns |
Passed directly through to the
shareholders according to the amount of stock held. Generally
no income tax paid by corporation |
Taxed separately at the corporate
level, again at the shareholder level if distributed as a dividend
|
| Liquidation of Entity |
At the discretion of the proprietor,
treated as sale of individual assets |
Required upon withdrawal of a partner
unless partnership agreement permits business continuation |
Same as partnership |
Normally a two-thirds vote of shareholders
is required |
Normally a two-thirds vote of shareholders
is required |
| Major Advantages |
Independence, flexibility, minimum
of legal requirements |
Additional management input and
operational responsibilities shared, additional capital and
equity available, flexibility, shared overhead means increased
profits, limited liability with RLLP |
Same as partnership plus limited
liability without having to file annual document, can be treated
as any business form for income tax purposes |
Limited liability, profits taxed
once, direct pass through of income and expenses to shareholder
|
Limited liability, can offer fringe
benefits to owners and deduct them for income tax purposes |
| Major Disadvantages |
Unlimited liability, limited life,
limited management ability, limited investment potential |
Unlimited liability unless RLLP,
annual renewal filing to keep RLLP, limited life, relations
among partners can cause problems, changes of partners or partnership
agreement may be difficult |
Relations among members can cause
problems, changes of members or operating agreement may be difficult
|
Not every corporation can qualify,
cannot deduct fringe benefits for owners or their families,
relations among shareholders or directors can cause problems
|
Difficult to get assets out or
to sell business without double tax, relations among shareholders
or directors can cause problems |
Basic Nature of the Form
Section 1.1 Sole Proprietorship—Overview
A sole proprietorship is nothing more than an individual who uses
personally owned assets in a commercial transaction with another
person. The assets may consist of something the proprietor has created,
has purchased for resale or may be a service. A sole proprietorship
is considered to be the simplest form of business organization because
it requires no legal formality in order to come into existence.
All that is necessary is that an individual engage in a commercial
activity with some individually owned asset. The fact that it may
be necessary to obtain some sort of license in order to engage in
business in a particular place has nothing to do with whether the
individual conducting the business is or is not a sole proprietor.
Because a sole proprietorship is nothing more than an individual
using personally owned assets in a business, everything that happens
with respect to the business is treated as having been done by the
proprietor. This means, therefore, that the proprietor is treated
as being the owner, manager and worker in the business. If anything
goes wrong, the proprietor is considered to be the one responsible
and has unlimited personal liability as a result. This is true even
if the proprietor has employees, as an employer is always responsible
for the wrongdoings of employees when they are acting as employees
of the proprietor.
Section 2.1 Sole Proprietorship—Liability
Protection
A sole proprietor has full, unlimited liability for whatever happens
in the business. This means the sole proprietor is liable for what
the proprietor personally does wrong, whether in tort or contract,
and is also responsible for any imputed liability that may arise
because of things employees of the business do. Because of this
unlimited liability, the personal assets of the sole proprietor
are exposed to the risks of the business.
Section 3.1 Sole Proprietorship—Formation
No formal requirements must be followed in order to create a sole
proprietorship. Nothing must be filed with the Secretary of State
or anywhere else. All that is necessary is for an individual to
engage in business alone. It may be necessary to file certain documents
in order to comply with other laws, such as the filing of a fictitious
name registration or getting a local business license, but these
documents have nothing to do with whether you are a sole proprietor.
You become a sole proprietor merely by acting like one.
Section 4. 1 Sole Proprietor—Operation
In a sole proprietorship, the proprietor performs all three functions
of the business as a single person: ownership of the business assets,
management, and work (even though the proprietor may hire others
to do part or all of the work or management). The proprietor is
not accountable to any other owners of the business for what is
done in the business. As a result, operation of the business is
relatively simple and informal, with little or no record keeping
outside of the records normally associated with the running of a
business. Taxes are relatively simple, too, because all income and
expenses of the business are reported on the individual income tax
return of the sole proprietor.
Section 5.1 Sole Proprietorship—Taxation
There are no special tax issues involved in starting a business
as a sole proprietor. That is because you are considered to be the
business for income tax purposes. The business is not considered
to be a separate tax entity, as with a corporation. Nor are there
other owners in the business, as there would be with a partnership
or a limited liability company. All you are required to do is to
keep proper tax records of the operations of the business.
All of the income and expenses of a sole proprietorship are reported
on the individual income tax return of the proprietor. This is done
by attaching a schedule C, Profit or Loss From Business, to the
proprietor's individual income tax return. An agricultural business
would use schedule F, Profit or Loss From Farming. Whatever profit
or loss there is from the business will be reported directly on
the proprietor's individual return and the income tax, if any, will
be paid on that return.
Section 6.1 Sole Proprietor—Business Termination
A sole proprietor owns personally the assets used in the business.
If the proprietor stops running the business and simply continues
to own the assets, there may be some income tax consequences, depending
upon what the assets are and what kinds of deductions the proprietor
may have taken before ceasing the business. If the assets are sold
to someone else, the proprietor will be treated as selling each
asset individually and will have to calculate gain or loss on each
asset. (There is no such thing as selling the "business" if you
are a sole proprietor. Because you are selling your own assets,
each asset is treated as a separate sale.)
Section 1.2 General Partnership and Limited Liability Partnership
- Overview
The easiest way to understand a partnership is to think of it simply
as two or more sole proprietors who have decided to pool their resources
in a common business activity. It is, in essence, a "collective
sole proprietorship." As a result, both Missouri state law and federal
income tax law treat the partnership as being made up of this collection
of sole proprietors. What makes this concept complicated is that
there are two sets of relationships that have to be dealt with:
(1) the relationship of the business activity to the rest of the
world (the external relationship) and (2) the relationship of the
individual partners to each other within that business activity
(the internal relationship). With a sole proprietor there was only
one relationship, that of the proprietor to the rest of the world.
With respect to the external relationship, Missouri partnership
law generally treats all partners as having full, unlimited liability
for anything that occurs in connection with the partnership's business.
This is the same result that would occur if each partner had, in
fact, been a sole proprietor. Missouri partnership law also sets
up the rules that govern the internal relationship of the partners
to each other, but permits these rules to be changed through a written
partnership agreement. To say that partners in a partnership have
full, unlimited liability for anything the partnership does is not
entirely true today. That is because Missouri has adopted a law
permitting a form of partnership known as a "registered limited
liability partnership" (RLLP). This is discussed in more detail
under the topic of limited liability partnership.
Because a general partnership is nothing more than a collection
of sole proprietors, there are no legal formalities required in
order to bring it into existence. Instead, all that is necessary
is for two or more people to pool their resources in the conduct
of the business. Becoming an RLLP, however, does require certain
legal formalities.
The main reason why people form partnerships is a matter of economics.
A sole proprietor will be able to produce a certain amount of income
and will have a certain overhead cost. By adding another person
as a partner, the income should theoretically double, while the
overhead will increase at a smaller rate. Therefore, there will
be more net income to divide between the two partners than either
one would have been able to earn as a sole proprietor. In addition,
they will be able, by pooling their resources, to give the business
a stronger economic base.
Section 2.2 General Partnership—Liability
Protection
Partners in a general partnership have full, unlimited personal
liability for anything that happens in the partnership business,
the same as sole proprietors. This means, first, that each partner
is responsible for whatever that partner individually does wrong.
It also means, however, that each partner has liability for what
any other partner or any employee of the partnership does wrong
in connection with the partnership's business. This is known as
Aimputed@ liability because it is a result of what someone else
has done wrong, not what you personally have done. As a general
partner, therefore, you may be exposed to liability with respect
to the actions of someone over whom you have no control.
In a general partnership, each partner is treated as acting on
behalf of the partnership and of all the other partners whenever
the partner is acting in the apparent conduct of the partnership's
business. Thus, if there is a provision in the partnership agreement
saying that a partner cannot do a certain thing without the consent
of the other partners, such as borrow money, that provision will
not prevent you as a partner from being liable to someone, even
if a partner violates the partnership agreement, unless the non-partner
actually knew about the limitation in the partnership agreement.
A common misconception is that each partner is responsible for
any liability of any other partner. For example, if the teenage
child of a partner causes an accident and the partner is sued, can
the other partners be made to pay? Not if the accident had nothing
to do with the partnership business. Partners have liability only
for things that relate to the partnership business.
If a partner does something wrong that has nothing to do with the
partnership business, none of the other partners has any liability
for that. If the partnership has liability for something, that liability
can be settled from the partnership assets or from the individual
assets of any or all of the partners. It is not necessary for the
injured party to go after only the partner responsible for the damage
or to collect from the different partners in proportion to their
liability under the partnership agreement.
Section 3.2 General Partnership—Formation
Because a partnership is nothing more than a collection of sole
proprietors, a partnership is formed the same way as a sole proprietorship:
if two or more people join together in a common business activity
where they share management responsibilities and profits, they are
a general partnership. Nothing has to be filed with anyone in order
to create a general partnership, although the partnership may be
subject to other filings in the same manner as any other business,
such as a fictitious name registration. (For a general partnership
to become a registered limited liability partnership, however, a
registration certificate must be filed with the Secretary of State
as discussed under the topic on RLLPs.)
Section 4.2 General Partnership—Operation
Because a partnership is a collection of sole proprietors, each
of the partners is an owner, manager and worker (even though some
of them may not actually work in the partnership business). It therefore
becomes necessary to figure out how they are going to run a business
on a collective basis. The first place to look for the rules is
in the partnership agreement. The partners are able in it to say
who will do what and how it will be done. They can set out such
things as voting requirements, provide for how new partners will
be admitted and old ones leave the partnership, how a partner's
interest will be bought out and how the partnership will be terminated.
If the partners fail to adopt a partnership agreement or do not
cover all the statutory items in their agreement, Missouri partnership
law provides default rules for them. Because many partnerships fail
to go through with adopting formal partnership agreements, you should,
if you are going to be in a partnership, familiarize yourself with
the Missouri Uniform Partnership Law (UPL), as it essentially sets
out the "default" partnership rules that apply when partners
have failed to adopt rules themselves.
Most decisions in a partnership are, under the default rules of
the UPL, made on a majority basis with each partner having one vote.
This is not always desirable, especially if one partner has put
in a greater share of the money or other assets. For there to be
a different form of voting, or to require something to be decided
by a number of partners that is different from what is required
by the statute, provision must be made in the partnership agreement.
If a partner stops being a partner, such as through death, withdrawal,
or expulsion, the partner or the partner's estate is required to
be paid the "fair share" of the partner's interest within
a "reasonable period" after the event. The payment must
be in cash. Such a requirement could cause a business to fail because
of the effect it could have on the business' resources. It is therefore
important to cover in a partnership agreement how a partner's interest
will be bought out in the event the partner stops being a member
of the partnership. This can be an interesting problem, though,
because there are two sides that have to be considered: that of
the partner who has left the partnership and that of the remaining
partners. You never know, when you're writing a partnership agreement,
which of those sides you may eventually be on, so be fair in what
you decide!
You should have a good business attorney help you with your partnership
agreement. You can do much of the conceptual work yourselves, however,
and help your attorney, too. You can do this by writing down as
much as you can think of about such things as the kind of business
you plan to run. Include what each partner will be required to do,
who has to contribute what resources, how contributions of additional
resources will be determined, how decisions are to be made, how
disagreements or deadlocks are to be handled, how partners can leave
the partnership, and how partners will be paid off for their interests
if they leave.
There is no difference between a general partnership and a registered
limited liability partnership in how the two operate. That is because
the only difference between the two is what kind of liability partners
have to outsiders, not how the partnership operates internally.
Section 5.2 General Partnership—Taxation
The formation of a partnership involves the various partners each
contributing assets to the partnership in exchange for partnership
interests. This is usually not a taxable event. That may not always
be the case, however. If the partnership assumes a liability of
an individual partner in connection with the transfer by that partner
of an asset to the partnership, the assumption can result in a tax
liability for the partner whose liability is assumed. The receipt
of a partnership interest in exchange for the performance of services
instead of for cash or property is also usually treated as a taxable
event, with the partner having income equal to the fair market value
of the partnership interest received and the remaining partners
receiving a deduction for the same amount. It is therefore important
to have good tax advice from an accountant or other knowledgeable
person concerning the formation of a partnership.
A partnership is not taxed as a separate entity, but is treated
as a collection of sole proprietors engaged in a common business
activity. The problem therefore becomes one of trying to apply sole
proprietorship taxation to a collection of sole proprietors. This
is accomplished by requiring the partnership to file a tax return
on which the partnership accounts for the collective income and
expenses of the partnership's business. The partnership does not
pay any tax on this, however. Instead, the net profit or loss is
divided up among the partners in proportion to their interest in
the partnership. Each partner then reports their own share of any
profit or loss on their own individual returns.
Although a partnership will never pay any income tax as a separate
taxable entity, there are some tax rules that have the effect of
treating the partnership as a separate taxpayer. These rules have
to do with administrative matters, however, and are intended to
insure that tax rules are applied on a consistent basis to partnerships.
It would not do, for example, to have different partners apply different
depreciation methods to the same partnership asset. Tax law insures,
therefore, that there will be consistency among the partners by
requiring most administrative and accounting decisions to be made
by the partners collectively as a partnership rather than individually.
Section 6.2 General Partnership—Business
Termination
You can form a partnership that will end on a definite date or
on a the happening of a certain event. It is more common, however,
to have a partnership with no such termination. This is referred
to as an "at-will" partnership. One of the most important
things to understand about an at-will partnership is that, in the
absence of any restriction in the partnership agreement, any partner
can leave the partnership at any time and for any reason. Whenever
something happens that causes a partner to stop being a partner
in the partnership, the partnership, is said to have "dissolved."
A dissolution does not mean the partnership's business has ended;
it only means that someone who was a partner no longer is. However,
if a partnership dissolves, it is mandatory under the UPL that the
partnership stop running its business, pay off its creditors, and
liquidate, unless the partners have a partnership agreement that
allows the remaining partners to continue the partnership's business
without liquidation. It is very important to provide for this sort
of business continuation, as failure to do so can give any partner
the unilateral ability to force a termination of the partnership
business simply by withdrawing from the partnership.
If a partnership stops its business and distributes its assets
to its partners, and if everything is distributed among the partners
in proportion to their interests in the partnership, there is generally
no tax as a result. If not, there may be a tax liability. If the
partnership sells off its assets to someone else, gain or loss will
be calculated on each individual asset sold by the partnership,
just as with a sole proprietor. The gain or loss on each asset will
then be divided among the partners in proportion to their interests
and reported on their own individual tax returns as if they had
sold the assets separately.
Unlike a sole proprietor, however, because there are other owners
involved, a partner can sell the partner's interest in the business,
so that the business does not stop being run if only one of the
owners stops being involved. This is a sale of a partnership interest
rather than a sale of partnership assets. If a partner's partnership
interest is sold, the partner will have to calculate any gain or
loss by subtracting the partner's basis in the partnership interest
from what is paid for the interest.
Section 2.2.1 Registered Limited Liability Partnership (RLLP)
An RLLP is a general partnership that has filed a registration
certificate with the Missouri Secretary of State in order to become
an RLLP. The filing of the certificate does not cause the RLLP actually
to come into existence, as the filing of articles of organization
does a limited liability company. Instead, an existing general partnership
changes to an RLLP by filing the certificate. The only difference
between a general partnership and an RLLP has to do with the liability
exposure the partners have. Otherwise, general partnerships and
RLLPs are treated exactly the same under Missouri law and for federal
tax purposes. This section therefore describes only the liability
differences. A fee must be paid with the filing of the certificate.
When a general partnership files a certificate of registration
as an RLLP, the general partners no longer have automatic liability
to them from what other partners or employees do wrong in the business.
Instead, each partner is liable only for what that partner individually
does wrong. This protection only goes into effect as of the date
and time the registration is filed with the Secretary of State.
Until then all partners have unlimited liability. It is therefore
very important that the certificate be filed as soon as possible
after the partnership is formed.
Although an RLLP may seem like a good idea, it has one serious
disadvantage. Each year a renewal certificate must be filed no later
than the anniversary date of the filing of the original registration
certificate. If the renewal certificate is not filed by that date,
the partnership is no longer an RLLP, but becomes a general partnership
again. The partners will thereafter have unlimited liability until
a new registration certificate is filed. The filing of a new registration
certificate after one has expired will not provide retroactive protection
for any period during which no certificate was in force. There is
a fee for the annual renewal of the certificate.
It is not uncommon for small business owners to fail to pay close
attention to the details involved in the business organization form
they have chosen. With an RLLP, this can be dangerous, because liability
protection depends entirely upon a critical event: the filing of
an annual document by a certain date. If that is not done, everyone
in the partnership is exposed—perhaps unknowingly—to unlimited
liability. It does not matter why the renewal certificate is not
filed by the due date, whether the responsible person forgot or
it was lost by the Postal Service. This should be contrasted with
limited liability companies, where, at the time these materials
were prepared, the filing of the articles of organization generally
meant permanent liability protection without the need to file annual
documents.
If a partner in an RLLP commits a tort, that partner can always
be sued personally. The partnership can also be sued, of course.
The partner generally cannot be sued personally if the RLLP breaches
a contract, however, because only the RLLP is liable for damages
on breach of contract unless a partner has personally guaranteed
the contract. If an RLLP is liable for damages, therefore, only
the assets of the RLLP (and of the responsible partner, if any)
can be used to settle those damages.
Section 1.3 Limited Liability Company—Overview
A limited liability company ("LLC") is a relatively new form of
business organization. It generally provides the same degree of
liability protection one would have with a corporation or RLLP,
while providing nearly as much flexibility as a partnership. In
fact, the LLC is considered to be the most flexible form of business
organization because it can be set up in ways that allow it to be
treated as a sole proprietorship, a partnership or a corporation
for federal income tax purposes without having to do anything special
under Missouri law in order to have limited liability protection.
As with any business organization that offers limited liability
protection, the formation of an LLC requires the filing of a document
with the Secretary of State.
Section 2.3 Limited Liability Company—Liability
Protection
An LLC offers virtually the same liability protection as a corporation
or an RLLP with one major difference. As noted in the discussion
of RLLPs, there is no need (under the law in effect when these materials
were prepared) to file any annual or other documents in order to
keep the liability protection offered by an LLC. This is important
because it makes it highly unlikely that there might be an accidental
loss of liability protection such as could occur with an RLLP. Corporations
are also required to file annual reports or they may be terminated
by the Secretary of State.
Section 3.3 Limited Liability Company—Formation
An LLC is formed by filing articles of organization with the Secretary
of State. The LLC does not exist until the articles of organization
are filed. The person who forms the LLC is known as the "organizer."
One person can be the organizer, and the organizer does not have
to be a member of the LLC. At the time these materials were prepared,
however, Missouri law required that there be two or more members
of the LLC in order to have a valid LLC. It is expected that this
law will be changed to allow one-member LLCs. If you call yourself
an LLC and you have not properly filed articles of organization
with the Secretary of State, you will be treated as a sole proprietor
(if there is just one person) or as a general partnership (if there
are two or more) and will therefore have personal liability exposure
for anything that happens in the business. There is a filing fee
of $105 that must be paid when the articles of organization are
filed.
Section 4.3 Limited Liability Company—Operation
An LLC generally operates in the same manner as a partnership.
Instead of a partnership agreement, however, an LLC uses a document
called an "operating agreement" to set out the internal rules. In
addition, the owners of the LLC are known as "members" rather than
partners. The reason that LLCs and partnerships are so similar is
that many of the rules set out in the statute for how LLCs are to
operate have been borrowed from partnership law. Drafting an operating
agreement is therefore not much different from drafting a partnership
agreement. In fact, if a partnership wants to convert to an LLC
(which it easily can do), changing the partnership agreement to
an operating agreement requires little more than changing terminology.
As with a partnership, if you fail to have an operating agreement
for your LLC, the default rules of Missouri law apply and effectively
become your operating agreement. Although an operating agreement
can be either written or verbal, a verbal operating agreement is
nearly worthless because no two people will ever agree on what was
decided, especially if they are arguing over an issue.
When drafting articles of organization for an LLC, one of the choices
that must be made is whether the LLC will be run by its members
or by managers. The default approach is that an LLC is run by its
members, in the same fashion that a general partnership is run by
all the partners. If it is decided that the LLC is to be run by
managers instead, then the members have no rights, as members, to
participate in most aspects of the running of the LLC. They become
more like passive investors, similar to limited partners in a limited
partnership or shareholders in a corporation. How the managers are
chosen and what their powers actually are relative to the members
must be set out in the operating agreement.
The ability to have managers is one of the features that gives
LLCs so much flexibility, especially when an LLC is used for estate
planning purposes or as a means of attracting passive investors.
Using a manager-managed LLC may not be a good idea for a standard
business arrangement, however, because in most closely held businesses,
all of the owners want to be able to participate in the management
and running of the business. A manager-managed LLC is intended more
as a control device that will keep some of the owners of the business
from actually having any ability to control the business.
Section 5.3 Limited Liability Company—Taxation
An LLC with two or more members is, by default, treated as a partnership
for federal income tax purposes unless the members of the LLC file
an election with the IRS to have the LLC taxed as a corporation.
If an LLC is treated as a partnership for federal income tax purposes,
there is no difference between general partnerships, registered
limited liability partnerships and LLCs as far as income taxes are
concerned. If an election is filed to have the LLC classified as
a corporation for federal tax purposes, it will be treated as a
C corporation, unless an additional election is filed to have it
treated as an S corporation. (Remember that an election to have
an LLC treated as a corporation for income tax purposes does not
change it to a corporation as far as its form under Missouri law—it's
still an LLC.) A one-member LLC is taxed as a sole proprietor unless
the member elects to be taxed as a corporation. Please refer to
the materials on partnerships, corporations and sole proprietorships
for the discussions of taxation. For Missouri income tax purposes,
an LLC will be treated the same as it is for federal income tax
purposes.
Section 6.3 Limited Liability Company—Business
Termination
How the termination of an LLC's business will be handled for income
tax purposes depends on how the LLC is classified for federal tax
purposes. Please refer to the materials on partnerships, corporations
and sole proprietorships for the discussions of terminations. For
non-tax purposes, the termination of an LLC's business is generally
the same as the termination of a partnership's business.
Section 1.4 Corporation—overview
Unlike other business organization forms, a corporation is considered
to be a separate legal person from its owners. This means it is
the corporation that owns the business, not the shareholders or
anyone else. The corporation uses agents to carry on the business
because it has no physical existence itself that would allow it
actually to do anything. The management decisions are made by the
board of directors and the day-to-day activities are carried out
by the officers and other employees. Because the corporation is
a completely separate legal person from the shareholders, it is
the corporation which has the primary responsibility for what happens
in the business and which therefore has primary liability if something
goes wrong. That is why corporations have traditionally been used
for purposes of liability protection, although this is no longer
necessary because of RLLPs and LLCs. Corporations are the most formal
business entity, generally requiring more paperwork than any of
the others, although this can minimized with proper planning and
understanding of what really is required and how that can be done.
The corporation is also generally treated as a separate taxpayer
for tax purposes, meaning that any shareholders who work in the
corporation's business will be considered employees of the corporation.
Only corporations allow an employer-employee relationship between
the business entity and its owners, which can result in certain
tax benefits, such as paying for health insurance as a business
expense.
Section 2.4 Corporation—Liability Protection
A corporation has no physical existence. It is therefore impossible
for a corporation actually to do anything itself, even though it
is treated as a separate legal "person" under Missouri
law. In order for the corporation to do anything, therefore, it
has to have human agents who will do things for it. Because we have
to assign functions to agents, we can split the functions up. We
do this by assigning the ownership function to the shareholders,
the management function to the directors and the work function to
the officer-employees (hereafter referred to as "officers").
Shareholders do not own the business or the assets that are used
in the business. These are owned by the corporation. Nor are shareholders
permitted by virtue of their stock ownership to participate in the
conduct of the corporation's business. They are just passive investors
who own shares of stock which gives them the right to receive dividends,
distribution of the corporation's assets if the corporation liquidates,
and the right to vote for directors. Because they are not allowed
to participate in the corporation's business and, therefore, they
cannot have participated in the wrongdoing, shareholders cannot
have any personal liability for anything the corporation does wrong.
This is the source of the so-called limited liability protection
offered by corporations.
In a small business, however, the shareholders will also be the
directors and the officers. The directors generally have no liability
for decisions they make as directors as long as they make their
decisions in good faith. Officers are responsible for carrying out
the directions of the directors and for the day-to-day running of
the corporation. It is here that you can get into trouble.
If you are an officer or any other employee of a corporation and
you commit a tort, you are personally liable for any damages because
you are the one who did it. It really does not matter, therefore,
that you cannot be sued as a shareholder. Where you do receive protection,
however, is from imputed liability. For example, if a partner in
a two-partner general partnership commits a tort, the other partner
has automatic imputed liability, even though that partner had nothing
to do with the tort. If the two were shareholders and officers in
a corporation, there would be no imputed liability. Instead, only
the one who actually committed the tort would have liability. Thus,
corporations, like RLLPs and LLCs, offer you protection from what
others do wrong, not from what you, yourself, do wrong. In addition,
of course, the corporation, as the employer and owner of the business,
will always have automatic liability for what its employees do wrong
when acting for the corporation.
The discussion thus far has focused on tort liability, which generally
means liability for causing personal injury to someone else. That
is because an officer of a corporation generally has no personal
liability for contracts entered into on behalf of the corporation.
If, for example, you sign a contract on behalf of your corporation
as its president, you are not signing the contract for yourself
as your contract. It is, instead, a contract you are signing on
behalf of the corporation as its contract, and you are acting merely
as the agent of the corporation. If you are acting as an agent,
it is the one for whom you are acting, known as the "principal,"
who is considered as having entered into the contract, not you.
Thus, if the corporation breaches its contract and causes damages,
it is the corporation, as the principal, not you, as the agent,
who will be liable, even if you were the one who caused the corporation
to breach the contract. This is true also for RLLPs and LLCs.
Section 3.4 Corporation—Formation
A corporation is formed by filing articles of incorporation with
the Missouri Secretary of State. The corporation does not exist
until the articles are filed. The person who files the articles
of incorporation is known as the "incorporator," and can
be any individual. A corporation can have any number of shareholders.
The filing fee for articles of incorporation varies, depending on
the value of the shares of stock the corporation is authorized to
issue. The minimum filing fee is $58. Except in very unusual circumstances,
there should be no reason to pay more than the minimum filing fee.
When you form a corporation, it can be a traditional corporation
or what is referred to as a "statutory close corporation," commonly
called a "close corporation." A traditional corporation is governed
by the usual laws that cover all corporations, from the largest
publicly held corporation to the smallest closely held corporation.
These laws are based on traditional notions of what corporations
are and how they should be run and have been criticized as not meeting
the special needs of closely held corporations. (A "closely held
corporation" has no special definition, but is one whose stock is
not publicly traded and which usually has only a few shareholders.)
As a result, Missouri enacted special provisions under which closely
held corporations receive special treatment. A corporation formed
under or adopting these provisions is called a close corporation.
There are a number of benefits that result from being a close corporation.
These are not discussed in detail in these materials but can be
summarized as follows:
A newly formed corporation becomes a statutory close corporation
by including in its articles of incorporation a statement that it
is a statutory close corporation and other special provisions that
are required of close corporations. An existing corporation with fifty
or fewer shareholders can become a statutory close corporation by
amending its articles of incorporation to include such a statement.
Stock certificates of a close corporation are required to have a special
statement included on them in order for the statutory restrictions
on transfer to be effective.
If there is any question about whether your corporation should be
a traditional corporation or a close corporation, the answer is that
it should be a close corporation because there are really no disadvantages,
only benefits.
A corporation is run on a day-to-day basis by its officers, who are
employees of the corporation. They are elected by and subject to the
control of the board of directors, which makes all of the important
management decisions for the corporation. The role of the shareholders
in a traditional corporation is limited to electing the directors.
The corporation may also have other employees, who are subject to
the direction and control of the officers.
If you form a corporation, you will undoubtedly serve all three functions
of officer, director and shareholder. This makes it easier to get
things done, since you usually do not have to worry about getting
other people together for meetings or about whether the directors
might disagree with the officers. It also creates a problem for small
businesses because it makes it easy to ignore some of the administrative
things, such as maintaining corporate records, that should be taken
care of. This is especially important if there is more than one person
involved in the corporation because, if there is ever any disagreement
among the owners of the business, courts will look at what the corporation's
records say in making their decision. If there are not proper records
authorizing what was done, there may be a problem.
A corporation is governed first by the rules set out in its articles
of incorporation. This is the document filed with the Secretary of
State and can be changed only by filing an amendment and paying the
appropriate filing fee. The corporation also is required to adopt
bylaws that set out the internal rules for running the corporation,
such as what officers there will be, when and how meetings will be
conducted, what voting requirements there are to be, and similar matters.
The bylaws are not filed with the Secretary of State. If the corporation
fails to adopt bylaws, there are default rules set out under Missouri
corporation law that say what must be done.
Another document for a corporation to have is a shareholder agreement.
This is not required by law, but is probably the most important document
you can have if there is more than one shareholder in the corporation.
The shareholder agreement can be used to control to whom shares of
stock can be transferred, how a shareholder's shares will be bought
back if the shareholder wants out of the corporation or dies, the
price at which shares are to be bought, how a shareholder can be removed
from the business if necessary, and how disagreements among shareholders
are to be resolved. A good shareholder agreement will, in short, anticipate
problems you might have in running your corporation and will try to
provide solutions in advance.
Corporations are the most formal business organization. There are
bylaws, shareholder agreements, directors, officers, minutes, resolutions,
stock certificates, corporate seals, annual reports, and separate
tax returns. All of this may be overwhelming, causing you to not do
it or pay someone else—a lawyer or an accountant—to do it
for you. If you have a good planner helping you set up your business,
are willing to do some self-education and a little work, this can
be made much simpler for you. See the next page for some things to
consider in forming a corporation.
Corporations are required by law to have a president and a secretary.
They can be the same person, which they would be in a one-person corporation.
The president is usually required to sign documents, such as contracts
or loans, on behalf of the corporation as its official agent. About
the only thing the secretary really has to do is keep minutes, "attest"
the president's signature and certify that copies of the corporation's
resolutions or minutes are true copies. A corporation can have whatever
other officers are authorized by its bylaws, with the duties of such
other officers being whatever is set out in the bylaws or by resolution
of the directors. You might consider a provision in the bylaws authorizing
the directors to appoint one or more vice presidents and assistant
secretaries. This could allow you to appoint any of the shareholders
who work in the business as an appropriate officer. For example, making
sure everyone is both a vice president and an assistant secretary
could make it easier to sign documents because any one person could
then sign. There is no need to have a treasurer, although you could,
or you could have the secretaries also serve as treasurers.
The law says the board of directors will adopt the form of the stock
certificates. A stock certificate is merely a contract between a shareholder
and the corporation that sets out the terms of the shareholder's investment
in the corporation. The certificates can therefore be printed on any
kind of paper you want, as long as they contain the appropriate language.
They do not have to have the corporation's name preprinted on them
or be preprinted forms at all. You can sometimes buy blank forms in
stationery supply stores or even type your own certificates on plain
paper.
Missouri law says the board of directors "may" authorize a corporate
seal. If you have one, you must use it. If you decide not to have
one, all that must be done is to type or write "No Seal" in the space
where a seal would go.
A corporation is required to have at least an annual meeting of its
shareholders to elect directors and an annual meeting of its directors
to elect officers. It may also need to have other meetings, usually
of directors, for things such as authorizing the borrowing of money,
large purchases, or the signing of leases or other significant contracts.
Most of the time small corporations do not, in fact, ever have these
formal meetings, especially one-person corporations. An easy way to
handle minutes, therefore, is to use written consent minutes. The
law says anything that can be done at a meeting of the shareholders
or of the directors can, instead, be done by them on written consent,
if everyone who is a shareholder or director signs the minutes. If
they do this, whatever is authorized in the written consent minutes
is legally considered to be the same as if they had actually had a
meeting and everyone had voted in favor of the action. For example,
written consent minutes could be used instead of actually having (or
pretending to have) an annual meeting of shareholders and directors.
You can buy minutes books that come complete with the corporation's
name printed on the cover and special paper on which to type minutes.
An easier and cheaper way to keep minutes is on regular typing paper
in a three-ring binder.
While forming a corporation may be tax-free,
liquidating the corporation is always a taxable event.
If the business of a corporation is to be sold, one way to avoid
the double tax with a C corporation is to sell the stock instead
of the assets. That way there is no need to get the money out of
the corporation because it will all have been received by the shareholders,
instead. Although this is good strategy for a seller, it is bad
for a buyer because the buyer will not be able to deduct any of
the costs of buying the business if stock is bought instead of the
assets themselves. The buyer may therefore insist on purchasing
assets instead of stock, creating a potential for real conflict
between seller and buyer.
Additional Considerations Regarding Liability Protection
The Nature of Liability
There are two kinds of liability exposure you can have in a business:
tort liability and contract liability. "Tort" is a general
term that covers any kind of injury that might be caused to another
person, such as injuries due to negligent driving, resulting from
a defective product or someone's slipping and falling in a store.
Tort liability is usually sudden, unexpected and beyond your control.
Contractual liability is liability you may incur as a result of
entering into a contract with someone else and then breaching the
contract (failing to carry out its terms). In either case, if you
are responsible for injuring someone else through committing a tort
or breaching a contract, you may be required to pay them for any
damages you cause. This, as you know, can be expensive. It is therefore
natural to want to avoid liability exposure as much as possible.
This can be done in part through the kind of business entity you
choose.
Before we discuss additional factors dealing with liability, however,
you must understand one important rule: You cannot avoid liability
for what you, yourself, have done wrong, no matter what kind of
business entity you choose. What you are trying to do, therefore,
is to avoid liability for what someone else, such as a partner or
an employee, may do. This is referred to in these materials as "imputed
liability." If you are the only one involved in the business,
however, it may be very difficult to avoid liability exposure.
Guarantees
Although you usually have no liability exposure for breaches of
contract by a corporation, RLLP or LLC, you may be liable if you
have guaranteed the contract. This will almost always happen if
the business needs to borrow money. It may also happen if the business
needs to rent business space. You may be asked as a shareholder,
partner or member to sign a guarantee that, if the entity fails
to make repayment of the loan or goes into default under the lease,
you personally will pay the entity's obligation. If you sign such
a guarantee, you will have personal liability. Although you certainly
can refuse to sign a guarantee, you may find yourself unable to
get the loan or rental you want. If the other person also wants
your spouse to sign the guarantee, even if your spouse is not involved
in the business, be very careful. Although a lender can require
your spouse to execute documents that will permit the lender to
secure the guarantee with jointly owned assets as collateral, it
generally cannot require your spouse to assume joint liability as
a condition of advancing credit to you. On the other hand, you may
have to do a joint application if you cannot qualify alone on the
basis of your separate credit and income. If both you and your spouse
sign the guarantee, it will result in your having joint liability
exposure, which could affect your ability to protect assets through
tenancy by the entirety as discussed under "Other Means of Protection,"
below.
Piercing the Veil
It is possible for shareholders of a corporation to be held personally
liable for what the corporation does wrong, even if they would not
be under the normal rules. This is known as "piercing the corporate
veil." It is done by the courts in order to prevent someone from
using a corporation in order to commit some form of fraud or injustice
and then hiding behind the corporation. This happens more often
in contract than in tort cases. There are no rules that will tell
you when a court will allow the veil to be pierced and when it will
not. Because it is based on misconduct, about the best that can
be said is that if you act too outrageously and unfairly in your
business dealings, you may have personal liability even if you have
a limited liability entity. Although it is known as piercing the
"corporate" veil, the same principle will be equally applicable
to LLCs, RLLPs and any other form of limited liability entity.
It is often thought that failure to use "Inc." or "LLC" or some
other term showing you are doing business through a limited liability
entity will allow others to pierce the veil and hold you personally
responsible. This is, in fact, not generally the case in Missouri.
If others do not know when they sign a contract with you that you
represent a corporation, LLC or RLLP, however, you may be personally
liable for the contract under a doctrine known as "undisclosed principal."
This is a rule that says if you are acting as the agent for someone
else, who is the principal, you are required to disclose this fact.
If you do, then it is the principal who is bound by the contract,
not you. But if you fail to disclose that you are the agent of someone
else, then the person with whom you are signing the contract would
naturally assume the contract is with you. If there is a breach
of the contract and you then try to say you were acting on behalf
of your business entity, you may have personal liability because
you mislead the other person. In addition, the business will have
liability. It is therefore important that all contracts with other
people always be signed by you as an officer, member, or partner,
depending upon the business form being used.
Other Means of Protection
One of the best forms of liability protection is adequate liability
insurance. There are two good reasons for having liability insurance:
(1) if you are sued, the insurance company will generally defend
you, possibly saving you significant legal fees; and, (2) if you
lose, the insurance company will pay damages up to the policy limits.
This is not something that keeps you from having liability in the
first place. It is intended to protect you from losing your business
and personal assets if someone successfully takes a judgment against
you. Both you and the business should have liability insurance in
order to protect both the business and the personal assets.
There is another form of asset protection available in Missouri
to married couples. Missouri law presumes that any assets titled
in the names of two people who are legally married are owned by
them in a form of ownership known as "tenants by the entirety"
unless they expressly state a different form of ownership. One of
the things that happens as a result of owning property as tenants
by the entirety is that no individual creditor of either spouse
can take any of the entirety property for the liability of just
the one spouse. There must be joint liability of the two spouses
and a judgment against both of them before a creditor can take the
entirety property. So long as a married couple can prevent a creditor
from asserting joint liability against them, they should be able
to protect the entirety assets, such as a personal residence, from
being taken. It is very important, therefore, that spouses who are
in business together structure the business in a way that, as much
as possible, will prevent their having joint liability. They should
never, for example, be in business together as a general partnership,
but should choose instead a limited liability entity such as an
LLC or a corporation. If you are not certain whether property you
own with a spouse is held as tenants by the entirety, you should
check with your attorney. It is important to understand, too, that
tenancy by the entirety may conflict with estate planning needs
and is not a form of ownership that is recognized in all states.
Business Name
A sole proprietor or general partnership can use any name it wants
as long as the name chosen does not violate someone else's rights,
such as a trademarked name. Any business form that requires you
to file a document with the Secretary of State in order to have
limited liability protection, however, will also mean you will have
to have a name that is different from the name of any other limited
liability business already on file with the Secretary of State's
office. You should therefore always check to make sure the name
you want is available. If you have a lawyer helping you, the lawyer
may do this.
Name Availability Desk
You can check yourself; however, by calling the name availability
desk at (573) 751-3317, and asking whether the name you want is
available. If it is, you will be told it is "conditionally
available," meaning it is yours if you file your organizational
documents with that name before someone else does. If it is not
available, you will have to modify the name until it is acceptable
or will have to use a different name. You can reserve a name for
a period of time, but this costs money and requires the filing of
a name reservation document. It is usually just as easy instead
to go ahead and file the necessary document to create the entity.
If you use a name other than your true legal name, you will be
required to file a fictitious name registration with the Secretary
of State. (This is also sometimes referred to as "d/b/a" or "doing
business as.") For example, if you are a sole proprietor and decide
to call yourself "AAA Services" in order to be listed first in the
telephone book, you will have to file a fictitious name registration
because that is not your true legal name. Partnerships commonly
should file fictitious name registrations because they usually do
not do business in the names of all the partners. The reason for
fictitious name registrations is to allow someone who wants to sue
the business to find out who it really is that they need to find
in order to file the lawsuit. If you are doing business through
a corporation or an LLC, you do not need to file a fictitious name
registration because it is the name of the entity that counts, not
yours. But if the corporation or the LLC uses a name other than
the one under which it was formed, it will have to file. It is a
misdemeanor not to file a fictitious name registration, and there
have been people prosecuted for this. A form for fictitious name
registration is available from the Secretary of State Corporations
Division, and there is a nominal filing fee.
Forms to Complete and Return
The Missouri Secretary of State has forms available that can be
used for filing registration certificates for RLLPs, articles of
organization for LLCs and articles of incorporation for corporations.
The forms must be filed in duplicate and must be accompanied by
the proper filing fee. In fact, it is not uncommon for lawyers to
use the forms provided by the Secretary of State. If that is the
case, why not get the forms and fill them out and file them yourself?
The main reason not to is that you are unlikely to know how to fill
them out in order to meet your particular needs. There are a number
of decisions you must make in designing a business entity to meet
your needs, and making the wrong choices could cause you problems
later and possibly cost you a great deal of money. It is therefore
worth the expense of having the advice of a good business lawyer.
Other Tax Matters
Additional Information
The IRS has a number of free publications you can get that will
be helpful to you. The most comprehensive of these is Publication
334, Small Business Tax Guide. This publication covers tax matters
applicable to all the different forms of business. It also contains
a listing of other specialized publications that are available and
which may be of help to you, such as business use of your home and
auto. These publications are available by calling the IRS forms
number at 800-829-3676 (800-TAX-FORM). You may also download copies
of the publications from the IRS website, www.irs.gov.
Benefits
One of the nice things about being in business is the ability to
deduct the cost of paying for certain employee benefits, such as
health insurance and child care, with the employees not having to
pay tax on the value of the benefits paid for by the employer. These
kinds of benefits will be referred to in these materials as "fringe
benefits." Business owners may also set up pension plans that can
be used to help provide for their own and their employees' retirement.
These will be referred to as "retirement plans." This means that
only a C corporation will allow you to pay for fringe benefits for
yourself, deduct them as business expenses and not have to report
the payments as income.
