Choosing The Correct Business Entity

By October 10, 2017 Articles, Business

Societies have conceived new business structures since time immemorial. Fundamentally, joining together with business partners spreads the demands of capital and limits risk.

Italians made family firms, compagnia, where fathers, brothers, and sons would pool their labor and capital. Fittingly, the name compagnia derives from the Latin phrase for the act of sharing bread, cum panis. Then, companies granted by royal charter arrived, like the East India Company, an import-export business who received special privilege from the Crown to pursue a monopoly on trade between London and Asia, with offerings varying from pepper to textiles to tea. The East India Company, the mother of the modern multinational corporation, pioneered the joint stock mechanism. That innovation allowed for separation of investors and managers, broadening the pool of capital; it also spread risk and provided limited liability, and it allowed the enterprise to trade on its own account, rather than in the names of the individual owners.

Now, with a few clicks and an electronic signature, anyone can form a business entity, securing the same limited liability separation between an entity and its owners as employed by corporate giants across America.

But which form of entity is right for your business?

For many business owners, the choice-of-entity decision is driven purely by tax considerations. But the two most prevalent forms, the corporation and the limited liability company (LLC), also offer sought-after advantages of: (i) limited personal liability, (ii) easy transfer of ownership, and (iii) management separation from ownership.

Certainly, the tax benefits are relevant, like the incentive to avoid double taxation or the substantial restrictions on entities under subchapter S of the tax code — but don’t miss the legal distinctions and historical context. The LLC is structurally different than a corporation. Today, many owners form LLCs, almost by default, without considering their unique attributes, such as: (1) the primacy of the operating agreement, and (2) the application of fiduciary duties.

First, owners should consider that the LLC is as much a creature of contract as of statute. As a result, once an LLC comes into existence and has a member, the LLC necessarily has an operating agreement, whether written, oral, or implied by law. The operating agreement plays a vital role, as it establishes the fundamental rules for the relationships between the LLC, its members, and any manager.

Even so, many business owners select the LLC form but never draft an operating agreement — or perhaps worse, draft one, but neglect to sign it.

On the other hand, a corporation is not driven by private contract between individuals. Rather, there is a body of statutory and common law that, in some ways, cannot be displaced. A corporation has been judicially defined as “an artificial being, existing only in contemplation of the law; a legal entity, a fictitious person, vested by law with the capacity of taking and granting property and transacting business as an individual. It is composed of a number of individuals, authorized to act as if they were one person. The individual stockholders are the constituents or component parts, through whose intelligence, judgment, and discretion the corporation acts.”

Second, the owners should consider the obligations they intend to impress on themselves and management; for example, owners should consider whether they can limit their fiduciary duties to simultaneously pursue other ventures.

Granted, the topic of fiduciary duties raises many of the most complex questions in the law of business organizations.

For the LLC, the primary issue is to what extent the members can privately agree in the operating agreement to vary or eliminate those duties. Although a contract cannot completely transform an inherently fiduciary relationship into a merely arm’s length association, the operating agreement has substantial power to “reshape, limit, and eliminate fiduciary and other managerial duties.” For example, the classic fiduciary “duty of loyalty” means: (i) not “usurping” company opportunities or otherwise wrongly benefiting from the company’s operations or property; (ii) avoiding conflict of interests in dealing with the company (whether directly or on behalf of another); and (iii) refraining from competing with the company. Members can agree, however, to tailor those limitations and allow a member or manager to engage in other business or compete with the company. On the other hand, corporate directors and officers are not free to contract out of their duties to shareholders.

The law of business organizations has continually modernized, providing us with accessible tools to limit personal liability. But, whether your company is in real estate or technology, simply holds investments or engages in long-distance trade voyages around the Cape of Good Hope, building upon the right legal structure is critical to its long-term success. If you or someone you know has questions about how to structure their business or investments, please call our office today to schedule a consultation with Andy Anderson.

Andy Anderson is an Attorney with Provident Law®. He serves businesses and individuals, counseling them as they form, operate, and protect their companies. He is a member of the State Bar of Arizona Subcommittee tasked with revising the Arizona Limited Liability Company Act. He also serves on the Board of Directors of the Christian Legal Society and he is a graduate of the James E. Rogers College of Law at the University of Arizona and the W.P. Carey School of Business at Arizona State University. Andy can be reached at andy@newnewprovidentlawyers.mystagingwebsite.com or 480-388-3343.

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