Business Organizations: An Overview

Background

The practice of forming organizations for the purpose of doing business began centuries ago, but the twentieth century witnessed an explosion in both the number and types of business organizations. From the simplest sole proprietorship to the most complex multinational corporation, various business structures have evolved to meet the needs of society. There are a variety of business structures to choose from, so every business can select the structure that best fits their particular needs. Informal arrangements become sole proprietorships and partnerships, providing structure to business ventures as they grow. More formal arrangements are created at the state or national level, such as limited liability companies and corporations. These business organizations provide stability and protection to investors and officers while establishing guidelines within the organization.

Over the past century, numerous states have changed their laws to create new business structures and modify old structures in an effort to encourage businesses to locate within their borders. Delaware, for example, has fashioned its statutes to create an almost ideal environment for businesses. As states strive to entice business organizations, laws affecting businesses, including those related to taxes and liability as well as the composition of the business itself, are changing rapidly.

Business organization laws govern almost every type of business, including agricultural businesses. For this reason, it is important to know the consequences, both positive and negative, of creating a business entity. The creation of a formal business entity can trigger consequences like liability issues, tax implications, payment limitation issues, corporate farming statutes, bankruptcy, and more. The specific consequences are primarily determined by the type of business organization selected. The most common business structures are a sole proprietorship, general partnership, limited liability partnership, limited liability company, or a corporation (whether C or S).

Important Issues

Liability Issues

One of the most common reasons to create a business entity is to protect owners and investors from the legal liability of actions performed on behalf of the business. To achieve this, legislators created certain business entity statutes which provide a “veil” of protection for the owners and investors. The level of protection differs however, depending on the type of business structure and the actions of the parties and organization.

At the end of the spectrum with the least protection, sole proprietorships and general partnerships provide no liability protection to the owners. General partnerships will often expose all partners to joint and several liability as a result of the actions of a single partner. In the middle of the spectrum lies the limited partnership (LP), which provides partial protection to the partners. Typically, these ventures have at least one general partner who is personally liable for the actions and debts of the partnership and one or more limited partners that are protected by the limited partnership so long as they remain passive in the running of the business. On the most protective end of the spectrum are organizations such as limited liability companies (LLCs) and corporations that shield all shareholders and officers from the actions and debts of the business so long as certain boundaries are respected.

Asset protection is a very important aspect for many farming and agribusiness operations. As a result, arranging the ownership of assets through business entities has become a frequently used method to limit exposure to events such as civil liability from lawsuits and financial liability from unpaid or delinquent loans. For more information, see the Reading Rooms on Landowner Liability, Commercial Transactions, Finance and Credit, and Secured Transactions.

Tax Implications

Changes in business organization statutes in all fifty states have had direct consequences on income taxes and indirect consequences on estate taxes. Earlier in the twentieth century, before the establishment of many of the limited liability organizations, businesses were taxed according to which structure under which they operated. Sole proprietorships and general partnerships were not (and are still not) taxed directly. Instead, the income is imputed to the owner/partners who then have to pay taxes on that income. This tax system is sometimes referred to as “flow-through status.” Corporations were subject to the so-called “double taxation” rule in which the corporation itself was taxed on its earned income, and the dividends paid out to the shareholders were also subject to taxation. For a time, the Internal Revenue Service (IRS) tried to determine whether new business entities that were being created across the country should be classified as a form of corporation; however, this approach has been abandoned. In its place, the IRS uses the “check the box” rule under which a business may elect to use the “flow-through status” of a partnership even though the business may more closely resemble a corporation. The IRS has used this policy since 1997 and it has greatly enhanced the popularity and flexibility of the newer generation of business entities because limiting the taxes paid by the business is no longer of great concern.

Business structures are also useful tools for the purposes of estate planning in the form of discounts. A business owner who is concerned about paying estate taxes may create one or more business entities to hold assets while gifting shares of those business entities to the heirs. As long as the business is structured correctly, after the owner passes away, the business is valued at a discount of up to 40% as a result of the lack of marketability or control. This strategy has begun to feature prominently into many estate plans because of the ability to discount the value of the business. For more information, see the Reading Room on Estate Planning and Taxation.

Payment Limitation Issues

During the last fifty years, many farming operations have created one or more business entities to own and manage the farming operation. There are many reasons for this trend including limiting liability and comparative ease in transferring the operation to the next generation. However, one of the primary reasons behind the sudden increase in the use of business structures within the agricultural community was to take advantage of a loophole in payment limitations on federal farm programs. The so-called “three entity rule” allowed producers who were part of more than one business entity to collect up to two times the amount of the payment limitation. While the three-entity rule was abolished by the 2008 Farm Bill, so there is no longer a benefit to create business entities for this purpose, business associations from the three-entity rule era still exist, and the ownership and control issues they bring must still be addressed. For more information, see the Reading Room on Commodity Programs.

Corporate Farming Statutes

Corporate farming statutes have been passed in nine states at present. All of these statutes, to some extent, restrict the ability of corporations to engage in farming or to own agricultural land. The constitutionality of the statutes has been questioned, and in some states, Nebraska for example, the statutes have been found to be unconstitutional. For more information, see the Reading Room on Corporate Farming Laws.

Bankruptcy

Filing bankruptcy as a business organization can shield vital assets and assist in reorganization. The same “veil” that protects the owners and officers of the business organization from civil liability may also be used to protect them from the debts of the business. For example, consider a farmer who farms as a sole proprietor and falls onto hard times. The creditors of the farmer would be able to pursue everything the farmer owns, except exempt property, in order to satisfy the debt. However, if that same farmer ran the farm as an LLC and goes into bankruptcy, only the assets within the LLC are at risk and the farmer’s personal assets are safe. Putting a “veil” between assets can give the business owner leverage to negotiate with creditors if reorganization or liquidation is necessary. The protection of the veil may be nullified however if there is fraud or a lack of separation between the LLC and the rest of the farmer’s assets. For more information, refer to the Bankruptcy Reading Room.

Fiduciary Duties

Certain business structures create fiduciary duties between parties involved in the business. In a general partnership, there is usually a duty of loyalty, duty of care, and a duty of good faith each partner owes to the joint venture. These duties require a partner to refrain from engaging in business actions that would compete with the partnership and to perform duties for the partnership that are consistent with fair dealing. In many jurisdictions, a partner does not violate their duty of good faith when a partner’s conduct furthers the partner’s own interest. Most of these duties are statutory, but a partnership agreement can include or exclude duties owed by a partner. However, in some states, the permitted modification of a partnership agreement is limited and the fiduciary duty of care or loyalty cannot be unreasonably reduced.

These fiduciary duties also appear in other business structures such as LLCs. Generally, individuals in a member-managed LLC cannot compete with the LLC of which they are a member. Under most state statutes, a member has a duty of good faith to take ordinary care when making decisions for a corporation. On the other hand, an operating agreement dictates how an LLC is managed. Thus, upon becoming a member of a corporation, an LLC’s operating agreement could potentially allow members to enter business ventures that would compete with the corporation. Nevertheless, a member has a duty to make decisions that are in the best interest of the corporation. If a member commits acts against the corporation’s operating agreement, the LLC may not be accountable, but the individual member is liable for any misconduct committed.

Business Structures

Sole Proprietorship

One of the simplest forms of business, the sole proprietorship is effective without any legal filing. Any individual who starts his or her own business or farming operation without further organization and filing is considered to be a sole proprietor and is held personally liable for the actions and debts of the business. For further discussion of this business structure, please click here.

General Partnership

Similar to the sole proprietorship, a general partnership business structure does not require any legal documents to be filed to be created. Evidence of two or more individuals involved in a common enterprise and sharing of the profits is often enough for courts to find that a partnership exists. In a general partnership, the actions of one partner are imputable to the other partners through joint and several liability, which makes this an unpopular option for a business structure. However, the partnership itself is not taxed and the income that flows through the partnership to the individual partners is taxed solely to them. For further discussion of this business structure, please click here.

Limited Partnership

To form a limited partnership (LP), the partners must file legal documents with the state in which it is to be created. There must be at least one general partner that is personally liable for the actions of the partnership and will typically run the business operation. There will also be one or more limited partners that are only liable up to the amount that they have invested in the partnership. These members typically have little or no control over the business operation and remain as passive investors. It is important to note that the more involved a limited partner becomes with the business, the more likely it is that a court will find that partner to be a general partner subject to general liability. For further discussion of this business structure, please click here.

Limited Liability Partnership

In a limited-liability partnership, one partner is not liable for any negligent acts committed by a different partner or any employee not under the partner’s supervision. This type of business organization is normally used with professionals such as attorneys and accountants who share office space and staff, but do not want to be liable for the actions of other partners. Typically, each partner is liable for only his or her own actions just as in a sole proprietorship. For further discussion of this business structure, please click here.

Corporation

The corporate business structure is one of the oldest options for organized businesses and was established to provide protection from liability. However, along with the liability protection comes a disadvantageous tax situation known as “double taxation.” In double taxation, income generated by the corporation is taxed first at the corporate level and then a second time on the individual level via taxes on the dividends collected by shareholders of the corporation. .

Traditional corporations with these parameters are now known as “C. Corporations,” and while originally all business organizations were organized in this manner, now only the largest (and typically publicly traded) businesses choose to organize in this way. C. Corps must have a board of directors, corporate bylaws, and stock certificates for the initial owners of the corporations. They must also file formal paperwork, or “articles of incorporation,” in the state where they incorporate. Once incorporated, a C. Corp must exercise nominal formalities, such as periodic meetings of the board of directors and record retention. For further discussion of this business structure, please click here.

In the twentieth century, a new form of corporate structure was introduced. Known as an “S. Corporation.” An S. Corp  provides the limited liability of a C. Corp, but allows the corporation’s shareholders to elect against double taxation and choose instead “flow-through” taxation so the S. Corp’s profits are only taxed on the individual level. An S. Corp has the same initial formation requirements as a C. Corp but requires an additional step. In order for a business to incorporate as an S. Corp, the business must be a domestic corporation or LLC with only one class of stock, may not have more than 100 shareholders, all of whom must be U.S. citizens or residents, and profits and losses must be allocated to shareholders proportionately to each one’s interest in the business. If these requirements are met, the corporation may file Form 2553 “Election by a Small Business Corporation” with the IRS to elect flow-through taxation status. This election must be filed by March 15th of the tax year for which the corporation wishes to take the election. For further discussion of this business structure, please click here.

Limited Liability Company

A newer business structure, and currently one of the most popular for farms and other businesses, is the limited liability company (LLC). An LLC is a hybrid structure that offers the limited liability of a corporation with the flow-through taxation of a partnership. It is similar to the S. Corp but without many of the corporate formality requirements.

In an LLC, shareholders are referred to as “members,” and LLCs can be either member-managed or manager-managed. A member-managed LLC may be governed by a single class of members (similar to a partnership) or multiple classes of members (similar to an LP). The LLC’s operating agreement sets out the management structure to be used in the business.

To form an LLC, members must choose a business name that conforms to their state’s LLC rules, file formal paperwork (usually called “articles of organization”) with the state, and pay a filing fee. Many states also require that the name must end with an LLC designator, such as “Limited Liability Company” or “Limited Company,” or an abbreviation of one of these phrases (such as “LLC,” “L.L.C.,” or “Ltd. Liability Co.”). While the benefits that come with forming an LLC are significant, flow-through taxation, limited liability, and relaxed corporate formalities, there are also some drawbacks to organizing in this way. One problem with the LLC structure is caused by its relative newness; the first LLC act was passed in Wyoming in 1977, and all other states have since followed suit. As a result, the law in this area is not fully developed and can cause uncertainty if litigation ensues. Another problem that occurs because of the evolving nature of the LLC structure is the inconsistency of the vocabulary that describes members’ duties. This can lead to confusion and potential problems in determining the individuals with authority to write checks, request credit, or bind the LLC to contracts. For further discussion of this business structure, please click here.

Conclusion

Business organizations are creations of governments, and just as governments are different, so too are the organizations they create. From country to country and from state to state, there exist many forms of business organizations that differ subtly. Each form of organization offers advantages and disadvantages, so it is up to the people organizing the business entity to choose the structure that best meets their needs. As agriculture has become more commercialized, the importance of business organizations has risen dramatically. Taxes, estate planning, and limiting liability are some of the reasons driving agricultural operations of all forms to create formal business structures, and this trend will likely continue into the foreseeable future.