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 the number and types of business organizations. From the simplest sole proprietorship to a 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 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 to encourage businesses to locate within their borders. Delaware, for example, has fashioned its statutes to create an ideal environment for businesses to be domiciled. As states strive to entice business organizations, laws affecting businesses, including those related to taxes, owner and investor liability, and the composition of the business, are rapidly changing.

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 liability issues, tax implications, payment limitations, 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 a C-corporation or S-corporation).

Important Issues

Liability Issues

One of the most common considerations in creating a business entity involves protecting owners and investors from legal liability of actions performed on behalf of the business. To achieve this, legislators created certain business entity statutes which provides a “veil” of protection for the owners and investors. The level of protection differs depending on the type of business structure and the actions of the parties and organization.

With the least protection, sole proprietorships and general partnerships provide no liability protection for their owners. General partnerships will often expose all partners to joint and several liability as a result of the actions of a single partner. In contrast, a limited partnership (“LP”) provides partial liability protection to the partners. Typically, these LPs 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 running the business.  The most protective business entities are 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. 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, income generated by the business is imputed to the owner/partners who 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 while 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 closely resemble a corporation. The IRS has used this policy since 1997, which has greatly enhanced the popularity and flexibility of the newer generation of business entities. Limiting the taxes paid by a business is no longer of great concern through choosing a certain business entity.

Business structures can also be useful tools for estate planning purposes. 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. If the business is structured correctly, after the owner passes away, the business is valued at a discount of up to 45% as a result of the lack of marketability or control. This strategy features 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

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. 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, business associations from the three-entity rule era still exist, and ownership and control issues must still be addressed. For more information, see the Reading Room on Commodity Programs.

Corporate Farming Statutes

Corporate farming statutes have been passed in several states. All these statutes, to some extent, restrict the ability of corporations to engage in farming or to own agricultural land. Several courts have heard challenges to corporate farming statutes on that basis that they violate the U.S. Constitution. Courts have consistently upheld the constitutionality of these statutes. 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, 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 can 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.

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 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.

Corporate Transparency Act

Beginning January 1, 2024, the Corporate Transparency Act (“CTA”) requires entities, in particular small businesses to disclose certain information on their ownership structure to the United States Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”). The CTA was designed to help prevent and combat money laundering, terrorist financing, corruption, tax fraud and other illicit activity while minimizing the burden on entities doing business in the United States.

Most corporations, limited liability companies, limited partnerships, and trusts established through a filing document with a state authority qualify as a reporting company under the CTA. Foreign entities are generally reporting companies when their activities or business requires authorization from the state authority. All reporting companies must disclose beneficial owners, that is individuals who, directly or indirectly, own or control 25% or more of the business or exercise substantial control over the company.

While the CTA is currently undergoing legal challenges, all companies should note if they qualify as a reporting business and, if so, comply with necessary FinCEN reporting requirements. For more information regarding the CTA, please click here.

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 does not require any filed documents 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. 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, the partners must file legal documents with the state in which it is 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 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 at the corporate level and then on the individual level via taxes on the dividends collected by shareholders.

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 one of the most popular for farms and other agricultural businesses, is the limited liability company. 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, 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 with an LLC structure is the inconsistency of the vocabulary that describes members’ duties. This can lead to confusion and 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 all reasons driving various agricultural operations to create formal business structures. This trend will likely continue into the foreseeable future.