Business Organizations: Partnerships, Corporations, and Limited Liability Companies
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Those who engage in economic activity with another (or many people) face numerous questions during the relationship, all of which may lead to conflict, both internally (between owners) and externally (with vendors and the public). Such business relationships entities are organized under state law as distinct entities, with policy and measures in place to provide that clarity and protect both owners and the public. An understanding of forms of business organization is also helpful for those who have received by bequest, inheritance or gift an interest in an entity – such as a membership interest in a limited liability company (LLC) – or are considering using an entity to manage land or other assets. A number of landowning families have found use of an entity an effective way to manage land interests otherwise held in co-tenancy.
Some business entities exist by default, or by operation of law based on the circumstances of the endeavor. Others must be created by a filing with the North Carolina Secretary of State (NCSOS), and then managed according to either the law authorizing the entity, or a more specific contract between the owners. Below is a discussion on the various types of entities, ranging generally from the simplest to the more complex. In reality, with the advent in popularity of the limited liability company (LLC), some of the entities below have become less favored except under very specific circumstances, but their features are nonetheless instructive.
This narrative provides a cursory overview on closely-held, non-publicly traded entities exempt from securities registration.
The Sole Proprietorship
The sole proprietorship is not really considered an “entity,” it is just one individual person trying to earn a profit in your business activity. Though no NCSOS filing is required to conduct business as an individual, there may be a requirement in some cities and counties to apply for a business license. The owner of a sole proprietorship has the widest possible latitude to operate the business, and may do anything that is not prohibited by law. However, the sole proprietor retains unlimited personal liability, meaning all assets owned by the sole proprietor, even those not considered part of the “business”, are subject to the claims of others, including holders of legal judgements.
While a sole proprietorship may operate under the owner’s name, doing business under another name requires the filing of an assumed name certificate with the county register of deeds.1
A partnership is an association of two or more persons to conduct a business for profit. The relationship is consensual and often contractual. Like many other states, North Carolina has adopted the Uniform Partnership Act (UPA).2 Under the UPA, the partners must have equal management authority and share equally in profits and losses, and have an equal obligation to contribute their time, energy and skill without compensation to the partnership business.3 Each partner has unlimited personal liability to the creditors of the partnership, and all partners are liable for wrongful acts and breaches of trust by any partner.4 In other words, one partner’s personal assets are liable to claims that arise from the actions of the other partner(s), even if that partner has not contributed property to the partnership.
General partnerships do not require a written agreement, and are simply two or more individuals operating a business as co-owners for profit.5 Furthermore, two individual sole proprietors cooperating their assets and efforts in a business can be considered a partnership by default, and therefore subject to UPA. In other words, courts can impose a partnership relationship upon parties given sufficient facts. The UPA is specific, however, that certain relationships do not constitute a partnership, such as co-ownership of property.6
A partnership files a federal information tax return (Form 1065) annually.7 However, all income flows through the partnership and is taxed to the individual partners.8 Each individual partner’s share of income is shown on a Schedule K-1 issued by the partnership. Each partnership interest is personal to the partner.
Under UPA, partnerships are dissolved by the death of a partner or by the sale of a partnership share.9 However, most provisions of the UPA can be modified in a written partnership agreement. Such items that are typically modified include acknowledgment of differing capital contributions, different management responsibilities, unequal sharing of profits and losses, rights and obligations, and the terms of property ownership, termination and dissolution. Many such agreements contain a buy/sell agreement to address the situation when a partner wants to exit the partnership (such option elements are the same as those discussed in LLC Operating Agreements: Concepts and Clauses).
Partnerships are still widely used in large-acreage commodity operations because – unlike LLCs and corporations – they are considered “disregarded entities” under federal commodity and conservation programs. Thus, each partner counts as an individual entity for receipt of payment (known popularly as a “payment limitation” and creative use of the partnership form can increase payments for a single operation (which can include family members who are “actively engaged in farming”).10 Partners may limit their personal liability by individually organizing as a single-owner corporation or LLC.
A limited partnership is a partnership whereby certain partners enjoy limited liability. Such entities are authorized by the NC Revised Uniform Limited Partnership Act (RULPA).11 It is not uncommon to see limited partnerships own land, particularly those created some decades ago. This form of entity has been used when some partners want neither management responsibility nor the unlimited liability for actions of the other partners. Unlike general parnterships, limited partnerships require a certificate filing with the NCSOS.12 Under RULPA, a limited partnership is formed with general partners and limited partners. The general partner(s) typically manages the partnership and has full personal liability for the debts of the partnership.13 The limited partner (or partners) contributes cash or other property only. The limited partner’s liability for partnership debts is limited to the amount of his or her investment in the partnership.14 Limited partners do not participate in the management of the partnership. A limited partnership also files an information tax return, but income is taxed to the individual partners. A limited partnership is required to file an annual report for continued recognition under North Carolina law.15
A corporation is a legal entity of potentially perpetual duration that has rights and liabilities separate from its owners, which are called shareholders, and the entity itself has powers of an individual.16 A shareholder’s liability for the debts of the corporation are limited to their investment in the corporation, at any given time measured by the value of the share, based on market valuation of the business (assets and other factors). Corporations formed in North Carolina are done so per the North Carolina Business Corporation Act (“NCBCA”).17
The basic premise of corporate formation is a limitation on liability by the owners for debts of the corporation, while potentially sharing in distributions of income from the corporation, called dividends. The share of stock represents a fractional value of the corporation, and the number of shares owned by an individual determines that person’s indirect voting power in the affairs of the entity, and the amount of any dividend. The shareholders (the owners) elect a board of directors who will manage the entity, and who will draw up management documents for the corporation upon organization, including bylaws and stock purchase agreements. The directors manage the corporation, and have the power to declare dividends. The directors will name officers, such as president, vice-president, secretary, etc, who manage daily operations. In a closely-held corporation, a few shareholders also serve as directors and officers, at least initially.
A North Carolina corporation is formed by the filing of articles of incorporation with the NCSOS.18 The articles identify key information about the entity, including the name of a registered agent and the number of shares authorized for the entity.19 The agent is primarily required for service of process, so the public (e.g. customers and vendors) know upon whom to serve legal process in the event of litigation. The articles also require a maximum number of shares that can be issued for the corporation, also as a matter of public disclosure. The person(s) filing the articles is called the incorporator, all of whom must be listed (with addresses) on the filed articles.20 The initial directors may be listed as well.21
In a closely-held corporation, the incorporators are usually the founder owners (initial shareholders), who convene upon filing the articles of incorporation to draw up governing parameters of the corporation, known as bylaws.22 This document contains provisions for managing the company and regulating the affairs of the company that are legal and consistent with the articles of incorporation. The bylaws are the continuing set of governing rules under which the corporation, its officers, directors and shareholders exercise management powers, hold meetings and all other activities related to the corporate business objective. The bylaws can be amended from time to time by the directors.23
While the bylaws define the governance of the corporation, the rights of shareholders are protected by the NCBCA. For example, the bylaws may outline the timing and details of shareholder meetings for voting on matters for which they are authorized to vote by the bylaws.24 However, certain procedural requirements and substantive rights are required by the NCBCA, such as the requirement to notice meetings (§55-7-05), preparing a list of shareholders entitled to vote at the meeting (§55-7-20), the right to vote ones shares at a meeting (§55-7-21), the right to vote by proxy (§55-7-22) and hold at least an annual meeting (§55-7-01). Additionally, if a corporation (by the directors) proposes to liquidate all or substantially all of the corporation’s assets, the shareholders must approve.25 Shareholders are also guaranteed a right to have their shares appraised and purchased in the event the directors take certain actions including amending the articles of incorporation to change the form of business or merge with another entity.26
As noted above, the maximum number of shares authorized for issuance is declared in the articles of incorporation. The directors then decide how many of the shares to actually issue, normally less than that authorized. Generally, at founding the quantity of shares actually issued equivalent to the initial shareholder(s) total investment of founding capital or other resources. For example, a corporation may be authorized to issue 1000 shares, yet chooses to issue 100 to its founding incorporators:
Gordon, Andy and Stewart form a corporation to sell license plate recognition cameras to the police. Gordon and Andy each contribute $25,000, and Stewart contributes $10,000, for a total capitalization of $60,000 to start. The three issue a total of 100 shares: 16 shares to Stewart, and 42 each to Gordon and Andy. The directors have a remaining 900 shares they are authorized to issue to new shareholders to raise capital.
Shares may be classified into different classes, each with different rights of distribution and vote participation, as defined by the Articles or the bylaws.27 At least one class must have unlimited voting rights.28 It is important to note that authorization of more than one class of stock disqualifies an entity from seeking Subchapter S “pass through” taxation (see below), which most small corporations choose for taxation of corporate income.
Though shares of stock are freely transferable by the stockholder, smaller close-held corporations often place limits on their transfer. One type of restriction would be a stock purchase agreement between a stockholder and the corporation or other stockholders requiring the selling stockholder to offer his stock first to the other party to the agreement. The agreement could set a price to be paid for the shares or a method by which they are to be valued, considering the shares were not publicly traded (A stock purchase agreement is analogous to a limited liability company operating agreement. Such transfer restrictions and option principles are discussed in LLC Operating Agreements: Key Concepts and Clauses).
As noted, the shareholders elect the board of directors to delegate the power of management. The board is responsible for all of the business affairs of the corporation, such as issuing shares of stock and the rights of the shares issued, the sale of corporate assets, mortgaging corporate assets, declaring dividends, and the election of corporate officers. The senior manager of the company, often known as the Chief Executive Officer (CEO) and others that may comprise a senior management team are responsible for the day-to-day operations of the corporation. Their authority and duties are prescribed by the bylaws and the votes of directors, which are also governed by the bylaws. The NCBCA requires directors to act in good faith in the best interest of the corporation.29
A business corporation can be dissolved in one of two ways: voluntary dissolution30 and involuntary dissolution.31 For a corporation that has not issued any authorized stock, the directors may voluntarily dissolve a corporation by passing a resolution of dissolution and filing articles of dissolution with the Secretary of State. If shares of stock have been issued, a shareholder vote is required.32 Alternatively, a corporation can be dissolved without its consent by court action or administrative action of the Secretary of State. Such “administrative dissolution” can occur if – for example – the corporation neglects to file the required annual report, fails to pay any associated fee NCSOS, or fails to notify of change in principal place of business or agent.33 Also, if the directors are not acting in the best interest of the company, any shareholder may petition for judicial dissolution.34
Tax Matters: C Corporations and S Corporations
A corporation can elect to be taxed in one of two ways under federal law. The corporation can elect to pay a corporate tax as an entity on its profits, with the shareholders paying a tax on their dividends. This is the famous “double taxation” we often hear about. Such a corporation is known as a “C Corporation” has has elected to be taxed under Subchapter C of the Internal Revenue Code (IRC).35 Such election is not popular with small closely-held corporations.
A corporation formed under Subchapter S of the IRC is a close corporation that has elected to be taxed like a partnership.36 Thus, instead of being taxed at the corporation level, the income is deemed to “pass through” to the shareholders and is only taxed once, at the individual level (whether the profits are distributed or not). Subchapter S corporations may have no more than 100 shareholders (who must all be individuals or special trust37), one class of stock, and no non-US resident shareholders.38
Special note: There are corporations serving as land-holding entities that were established prior the advent of the LLC, and one should not add land to an existing corporation, or choose the entity form as the landholding entity. Reason: under the Internal Revenue Code, land (and other assets) receive a step up in basis upon the death of the owner.39 and though share values get a step up (based on appreciation in the land asset), the underlying land asset does not! Therefore, appreciation does not step up and when the corporation liquidates the land, the capital gain will be calculated on the full gain of the land, and not decreased by any step otherwise available to deceased shareholders. However, land in partnerships and LLCs may be stepped up at the election of partners of members.40
The Limited Liability Company (LLC)
The Limited Liability Company has become in North Carolina and elsewhere a common entity of choice for many if not most closely-held business and land interests. The LLC is a distinct entity that is a hybrid of a partnership and a corporation. An LLC is very similar to a limited partnership, only without the general partner thus no member is required to accept unlimited liability (providing all members with liability protection). LLCs are authorized by the North Carolina Limited Liability Act (“LLC Act”).41 LLCs can be used both for management of farm operations and as land-holding entities. Land interests transferred to the ownership of an LLC lose certain attributes of real property under state law, and are treated as personal property interests.
Owners of an LLC are referred to as “members.” Those with management and decision-making authority are referred to as “managers.” Like a corporation, the members have limited liability for debts of the LLC. Ownership in the LLC is considered a percentage interest rather than distinct shares, although many people authorize a number of units to represent the percentage interests. These units can operate much like shares in a corporation, having different rights and responsibilities as designed by the owners.
Ownership and management of an LLC is governed by the LLC Act or by an Operating Agreement executed between the members. The operating agreement can address any number of issues, such as division of profits between members, the limits of management authority without a vote of the members, and restrictions on who can become members as well as restrictions on transfers of ownership. LLCs are often used in operating and land asset transfer planning for a number of reasons. They can be an efficient way to manage and transfer assets over time to the next generation as a valued percentage of the entity as opposed to re-titling of individual assets.
The Operating Agreement can also restrict ownership of the entity to lineal family members, an often critical issue in farm and forest transfer. A key component given this restriction is a buy-sell agreement embedded in the operating agreement. (For more detail on LLCs, see The LLC: Steps and Formation and LLC Operating Agreements: Key Concepts and Clauses)
1 N.C.G.S. §66-71.4(a)
2 N.C.G.S. §59-31 et seq.
4 N.C.G.S. §59-45
5 N.C.G.S. §59-36
6 N.C.G.S. §59-37
7 26 U.S. Code § 6031 and 26 CFR § 1.6031(a)-1
8 26 U.S. Code § 704 and 26 CFR § 1.704-1
9 N.C.G.S. § 59-61
10 See generally 7 CFR Part 1400, available at https://www.fsa.usda.gov/Internet/FSA_Federal_Notices/activelyengaged.pdf
11 N.C.G.S. §59-101 et seq.
12 N.C.G.S. §59-201
13 N.C.G.S. §59-403(b)
15 N.C.G.S. §59-102
16 N.C.G.S. §55-3-02
17 N.C.G.S. §55-1-01 et seq.
18 N.C.G.S. §55-1-20
19 N.C.G.S. §55-2-02
20 N.C.G.S. §55-2-02(a)(4)
21 N.C.G.S. §55-2-02(b)(1))
24 See N.C.G.S. §55-7-01 through §55-7-07
35 26 U.S.C. §§301 et seq.
36 26 U.S. Code §1361(b)(1)(d)
3726 U.S. Code §1361(c)(2)
38 26 U.S. Code §1361(b)(1)
39 26 U.S. Code §1014
40 See 26 U.S. Code §754 and 26 CFR §1.743-1
41 N.C.G.S. §57D-1-01 et seq.
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