Business Organizations: An Overview


Background

The development 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 available.  From the simplest sole proprietorship to the most complex multinational corporation, the various business structures have evolved to meet the needs of society.  The many types of business structures offer the flexibility required to fit the different needs of both business in general and businesses in agriculture specifically.  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 and under the laws of the states in which they do business.

Within the United States over the past century, there have been numerous changes in state laws creating new business structures and modifying old ones in an effort to induce businesses to locate within their borders.  States such as Delaware have fashioned their statutes in such a way as to create an almost ideal environment for businesses, in order to attract both old and new entities into the state.  Competition between the states has arisen to attract business organizations, which in turn has resulted in rapid changes in laws affecting businesses ranging from taxes and liability to the composition of the business itself.

Laws surrounding business organizations concern almost every aspect of business, including those tied directly to agriculture.  Because of this, it is important to know the benefits and consequences of creating a business entity.  These benefits and consequences can include liability issues, tax implications, payment limitation issues, corporate farming statutes and bankruptcy, among others.  The benefits and consequences are primarily determined by the type of business organization that is selected-usually 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 fundamental reasons to create a business entity is to protect owners and investors from the legal liability of actions performed on behalf of the business.  As a result of this need, legislators organized business entity statutes to provide a “veil” of protection, depending on the type of business structure and the actions of the parties and the 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, in fact, 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 provide the most protection to the shareholders and officers of the businesses by shielding all parties 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 frequent method used to help 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 advent of many of the limited liability organizations, businesses were taxed according to which structure they operated under.  Sole proprietorships and general partnerships were not (and still are not) taxed directly.  Instead, the income is imputed to the owner/partners.  Corporations were subject to the so called “double taxation” rule; the corporation itself was held liable for taxes 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.  Instead, since 1997 the IRS has used 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.  This 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.

The use of business structures added a very useful tool for the purposes of estate planning in the form of discounts.  A farmer 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 farmer passes away the businesses are valued at a discount of up to 40% as a result of the lack of marketability or control.  Because of the ability to discount the value of the business, this strategy has begun to feature prominently into many estate plans.  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 has been abolished by the 2008 Farm Bill, and thus the need to create business entities for this purpose is now a thing of the past, business associations created for this purpose 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 power of corporations to engage in farming or to own agricultural land.  The constitutionality of the statutes has been questioned and in some cases (for example, in Nebraska) the statutes have been found to be unconstitutional; however, these statutes may prove to be an obstacle for corporations wanting to own land within these states.  For more information, see the Reading Room on Corporate Farming Laws.


Bankruptcy

Filing bankruptcy as a business organization can function as a shield to protect other vital assets and also as a tool to 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, except exempt property, that the farmer owns in order to satisfy the debt.  However if that same farmer ran the farm as a LLC that goes into bankruptcy, only the assets within the LLC are at risk (as long as there is no fraud and there is separation between the LLC and the rest of the farmers assets).  Putting a “veil” between assets can give the business owner leverage to negotiate with creditors if reorganization or liquidation is necessary.  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; is obligated to perform duties for the partnership that is 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 fiduciary duty of care or loyalty cannot be unreasonably reduced in the partnership agreement.

These fiduciary duties also appear in other business structures, such as limited liability corporations (“LLC”). 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 corporations 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, this form of business structure does not require any legal documents to be filed to create the partnership.  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, however, 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

According to Black’s Law Dictionary, a limited-liability partnership is “a partnership in which a partner is not liable for a negligent act committed by another partner or by an 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.  It was established in order to provide protection from liability.  However, along with the liability protection comes a disadvantageous tax situation known as “double taxation.”  In this situation, the income generated by the corporation is taxed first at the corporate level, then, when it is distributed to shareholders in the form of a dividend, it is taxed again on the individual level.

Traditional corporations with these parameters are now known as “C. Corporations,” and while originally all business organizations were organized in this manner, it is now only the largest (and typically publicly traded) businesses that 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,” this business form provides the limited liability of a C. Corp, but it allows the corporation’s shareholders to elect against double taxation and choose instead to use “flow-through” taxation so that the profits are only taxed on the individual level.  An S. Corp has the same initial formation requirements as a C. Corp, but it requires an additional step.  In order for a business to incorporate as a S. Corp, it must be a domestic corporation or LLC with only one class of stock, it 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 LLCs 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 and file formal paperwork (usually called “articles of organization”) with the state, along with the payment of 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-including flow-through taxation, limited liability, and relaxed corporate formalities-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 because of the evolving nature of this new form 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.  Just as all governments are different, so are the organizations that 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 benefits and problems, 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 that are currently driving agricultural operations of all forms throughout the world into creating a formal business structure, and this trend will undoubtedly continue on into the foreseeable future.