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228 Planning and Forecasting pre scribed fee. The members then enter into an operating agreement setting forth their respective rights and obligations with respect to the business. Most states that have adopted the LLC have also authorized the limited liability partnership, which allows general partnerships to obtain limited liability for their partners by filing their intention to do so with the state. This form of business entity is normally used by professional associations that previously op- erated as general partnerships, such as law and accounting firms. COMPARISON FACTORS The usefulness of the five basic business forms could be compared on a virtu- ally unlimited number of measures, but the most effective comparisons will likely result from employing the following eight: 1. Complexity and cost of formation. What steps must be taken before your business can exist in each of these forms? 2. Barriers to operation across state lines. What steps must be taken to move your business to other states? What additional cost may be involved? 3. Recognition as a legal entity. Who does the law recognize as the operative entity? Who owns the assets of the business? Who can sue and be sued? 4. Continuity of life. Does the legal entity outlive the owner? This may be especially important if the business wishes to attract investors or if the goal is an eventual sale of the business. 5. Transferability of interest. How does one go about selling or otherwise transferring one’s ownership of the business? 6. Control. Who makes the decisions regarding the operation, financing, and eventual disposition of the business? 7. Liability. Who is responsible for the debts of the business? If the com- pany cannot pay its creditors, must the owners satisfy these debts from their personal assets? 8. Taxation. How does the choice of business form determine the tax payable on the profits of the business and the income of its owners? FORMATION OF SOLE PROPRIETORSHIPS Reflecting its status as the default form for the individual entrepreneur, the sole proprietorship requires no affirmative act for its formation. One operates a sole proprietorship because one has not chosen to operate in any of the other forms. The only exception to this rule arises in certain states when the owner chooses to use a name other than his own as the name of his business. In such event, he may be required to file a so-called d/b/a certificate with the local authorities, stating that he is “doing business as” someone other than himself. Choosing a Business Form 229 This allows creditors and those otherwise injured by the operation of the busi- ness to determine who is legally responsible. FORMATION OF PARTNERSHIPS Similarly, a general partnership requires no special act for its formation other than a d/b/a certificate if a name other than that of the partners will be used. If two or more people act in a way which fits the definition set forth in the Uniform Act, they will find themselves involved in a partnership. However, it is strongly recommended that prospective partners consciously enter an agree- ment (preferably in writing) setting forth their understandings on the many issues which will arise in such an arrangement. Principal among these are the investments each will make in the business, the allocation and distribution of profits (and losses), the method of decision making (i.e., majority or unanimous vote), any obligations to perform services for the business, the relative com- pensation of the partners, and so on. Regardless of the agreements that may exist among the partners, however, the partnership will be bound by the ac- tions and agreements of each partner—as long as these actions are reasonably related to the partnership business, and even if they were not properly autho- rized by the other partners pursuant to the agreement. After all, third parties have no idea what the partners’ internal agreement says and are in no way bound by it. CORPORATIONS In order to form a corporation, in contrast, one must pay the appropriate fee and must complete and file with the state a corporate charter (otherwise known as a Certificate of Incorporation, Articles of Incorporation, or similar name in the various states). The fee is payable both at the outset and annually thereafter (often approximately $200). A promoter may form a corporation under the laws of whichever state she wishes; she is not required to form the corporation under the laws of the state in which she intends to conduct most of her business. This partially explains the popularity of the Delaware corpo- ration. Delaware spent most of the last century competing with other states for corporation filing fees by repeatedly amending its corporate law to make it increasingly favorable to management. By now, the Delaware corporation has taken on an aura of sophistication, so that many promoters form their com- panies in Delaware just to appear to know what they are doing! In addition, it is often less expensive under Delaware law to authorize large numbers of shares for future issuance than it would be in other states. Nevertheless, the statutory advantages of Delaware apply mostly to corporations with many stockholders (such as those which are publicly traded) and will rarely be sig- nificant to a small business such as those described at the beginning of this 230 Planning and Forecasting chapter. Also, formation in Delaware (or any state other than the site of the corporation’s principal place of business) will subject the corporation to addi- tional, unnecessary expense. It is thus usually advisable to incorporate in the company’s home state. The charter sets forth the corporation’s name (which cannot be confus- ingly similar to the name of any other corporation operating in the state) as well as its principal address. The names of the initial directors and officers of the corporation are often listed. Most states also require a statement of corpo- rate purpose. Years ago this purpose defined the permitted scope of the cor- poration’s activities. A corporation which ventured beyond its purposes risked operating “ultra vires,” resulting in liability of its directors and officers to its stockholders and creditors. Today virtually all states allow a corporation to de- fine its purposes extremely broadly (e.g., “any activities which may be lawfully undertaken by a corporation in this state”), so that operation ultra vires is gen- erally impossible. Still directors are occasionally plagued by lawsuits brought by stockholders asserting that the diversion of corporate profits to charitable or community activities runs afoul of the dominant corporate purpose, which is to generate profits for its stockholders. The debate over the responsibility of directors to so-called corporate “stakeholders” (employees, suppliers, cus- tomers, neighbors, and so forth) currently rages in many forms but is normally not a concern of the beginning entrepreneur. Corporate charters also normally set forth the number and classes of eq- uity securities that the corporation is authorized to issue. Here an analysis of a bit of jargon may be appropriate. The number of shares set forth in the charter is the number of shares authorized, that is, the number of shares that the di- rectors may issue to stockholders at the directors’ discretion. The number of shares issued is the number that the directors have in fact issued and is obvi- ously either the same or smaller than the number authorized. In some cases, a corporation may have repurchased some of the shares previously issued by the directors. In that case, only the shares which remain in the hands of sharehold- ers are outstanding (a number obviously either the same or lower than the number issued). Only the shares outstanding have voting rights, rights to receive dividends, and rights to receive distributions upon full or partial liqui- dation of the corporation. Normally, we would expect an entrepreneur to au- thorize the maximum number of shares allowable under the state’s minimum incorporation fee (e.g., 200,000 shares for $200 in Massachusetts) and then issue only 10,000 or so, leaving the rest on the shelf for future financings, em- ployee incentives, and so forth. The charter also sets forth the par value of the authorized shares, another antiquated concept of interest mainly to accountants. The law requires only that the corporation not issue shares for less than the par value, but it can, and usually does, issue the shares for more. Thus, typical par values are $0.01 per share or even “no par value.” Shares issued for less than par are watered stock, subjecting both the directors and holders of such stock to liability to other stockholders and creditors of the corporation. Choosing a Business Form 231 Corporations also adopt bylaws, which are not filed with the state but are available for inspection by stockholders. These are usually fairly standard docu- ments describing the internal governance of the corporation and setting forth such items as the officers’ powers and notice periods for stockholders’ meetings. LIMITED PARTNERSHIPS As you might expect, given the limited partnership’s hybrid nature, the law re- quires both a written agreement among the various general and limited part- ners and a Certificate of Limited Partnership to be filed with the state, along with the appropriate initial and annual fees. The agreement sets forth the part- ners’ understanding of the items discussed earlier regarding general partner- ships. The certificate sets forth the name and address of the partnership, its purposes, and the names and addresses of its general partners. In states where the Revised Uniform Limited Partnership Act has been adopted, it is no longer necessary to reveal the names of the limited partners, just as the names of cor- porate stockholders do not appear on a corporation’s incorporation documents. LIMITED LIABILITY COMPANIES The LLC is formed by filing a charter (e.g., a Certificate of Organization) with the state government and paying a fee (usually similar to that charged for the formation of a corporation). The charter normally sets forth the entity’s name and address, its business purpose, and the names and addresses of its managers (or persons authorized to act for the entity vis-à-vis the state if no managers are appointed). The same broad description of the entity’s business which is allowable for modern corporations is acceptable for LLCs. The members of the LLC are also required to enter into an operating agreement that sets forth their rights and obligations with regard to the business. These agreements are generally modeled after the agreements signed by the partners in a general or limited partnership. OUT OF STATE OPERATION OF SOLE PROPRIETORSHIPS AND PARTNERSHIPS Partly as a result of both the Commerce clause and Privileges and Immunities clause of the U.S. Constitution, states may not place limits or restrictions on the operations of out-of-state sole proprietors or general partnerships that are different from those placed on domestic businesses. Thus, a state cannot force registration of a general partnership simply because its principal office is lo- cated elsewhere, but it can require an out-of-state doctor to undergo the same licensing procedures it requires of its own residents. 232 Planning and Forecasting OUT OF STATE OPERATION OF CORPORATIONS, LIMITED PARTNERSHIPS, AND LIMITED LIABILITY COMPANIES Things are different, however, with corporations, limited partnerships, and LLCs. As creations of the individual states, they are not automatically entitled to recognition elsewhere. All states require (and routinely grant) qualification as a foreign corporation, limited partnership, or LLC to nondomestic entities doing business within their borders. This procedure normally requires the completion of a form very similar to a corporate charter, limited partnership certificate, or LLC charter, and the payment of an initial and annual fee simi- lar in amount to the fees paid by domestic entities. This requirement, inciden- tally, is one reason not to form a corporation in Delaware if it will operate principally outside that state. Much litigation has occurred over what consti- tutes “doing business” within a state for the purpose of requiring qualification. Similar issues arise over the obligation to pay income tax, collect sales tax, or accept personal jurisdiction in the courts of a state. Generally these cases turn on the individualized facts of the particular situation, but courts generally look for offices or warehouses, company employees, widespread advertising, or negotiation and execution of contracts within the state. Perhaps more interesting may be the penalty for failure to qualify. Most states will impose liability for back fees, taxes, interest, and penalties. More important, many states will bar a nonqualified foreign entity from access to its courts and, thus, from the ability to enforce obligations against its residents. In most of these cases, the entity can regain access to the courts merely by pay- ing the state the back fees and penalties it owes, but in a few states access will then be granted only to enforce obligations incurred after qualification was achieved, leaving all prior obligations unenforceable. RECOGNITION OF SOLE PROPRIETORSHIPS AS A LEGAL ENTITY By now it probably goes without saying that the law does not recognize a sole proprietorship as a legal entity separate from its owner. If Phil, our computer entrepreneur, were to choose this form, he would own all the company’s assets; he would be the plaintiff in any suits it brought, and he would be the defendant in any suits brought against it. There would be no difference between Phil, the individual, and Phil, the business. RECOGNITION OF PARTNERSHIPS AS A LEGAL ENTITY A general partnership raises more difficult issues. Although most states allow partnerships to bring suit, be sued, and own property in the partnership name, this does not mean that the partnership exists for most purposes separately from Choosing a Business Form 233 its partners. As will be seen, especially in the areas of liability and taxation, part- nerships are very much collections of individuals, not separate entities. Ownership of partnership property is a particularly problematic area. All partners own an interest in the partnership, which entitles them to distributions of profit, much like stock in a corporation. This interest is the separate property of each partner and is attachable by the individual creditors of a partner in the form of a “charging order.” Each partner also owns the assets of the partnership jointly with his other partners. This form of ownership (similar to joint ownership of a family home by two spouses) is called tenancy in partnership. Each partner may use partnership assets only for the benefit of the partnership’s business; such assets are exempt from attachment by the creditors of an individual partner, although not from the creditors of the partnership. Tenancy in partnership also implies that, in most cases of dissolution of a partnership, the ownership of partnership assets de- volves to the remaining partners, to the exclusion of the partner who leaves in vio- lation of the partnership agreement or dies. The former partner is left only with the right to a dissolution distribution in respect of her partnership interest. RECOGNITION OF CORPORATIONS AND LIMITED LIABILITY COMPANIES AS LEGAL ENTITIES The corporation and LLC are our first full-fledged separate legal entities. Ownership of business assets is vested solely in the corporation or LLC as a separate legal entity. The corporation or LLC itself is plaintiff or defendant in suits and is the legally contracting party in all its transactions. Stockholders and members own only their stock or membership interests and have no direct ownership rights in the business’s assets. RECOGNITION OF LIMITED PARTNERSHIPS AS A LEGAL ENTITY The limited partnership, as a hybrid, is a little of both partnership and corpo- ration. The general partners own the partnership’s property as tenants in part- nership operating in the same manner as partners in a general partnership. The limited partners, however, have only their partnership interests and no direct ownership of the partnership’s property. This is logically consistent with their roles as silent investors. If they directly owned partnership property, they would have to be consulted with regard to its use. CONTINUITY OF LIFE The issue of continuity of life is one which should concern most entrepreneurs, because it can affect their ability to sell the business as a unit when it comes 234 Planning and Forecasting time to cash in on their efforts as founders and promoters. The survival of the business as a whole in the form of a separate entity must be distinguished from the survival of the business’s individual assets and liabilities. Sole Proprietorships Although a sole proprietorship does not survive the death of its owner, its indi- vidual assets and liabilities do. In Phil’s case, for example, to the extent that these assets consist of the computer program, filing cabinets, and the like, they would all be inherited by Phil’s heirs, who could then choose to continue the business or liquidate the assets as they pleased. Should they decide to continue the business, they would then have the same choices of business form which confront any entrepreneur. However, if Phil’s major asset were a government license, qualification as an approved government supplier, or a contract with a software publisher, the ability of the heirs to carry on the business might be entirely dependent upon the assignability of these items. If the publishing con- tract is not assignable, Phil’s death may terminate the business’s major asset. If the business had operated as a corporation, Phil’s death would likely have been irrelevant (other than to him); the corporation, not Phil, would have been party to the contract. Partnerships Consistent with the general partnership’s status as a collection of individuals, not an entity separate from its owners, a partnership is deemed dissolved upon the death, incapacity, bankruptcy, resignation, or expulsion of a partner. This is true even if a partner’s resignation violates the express terms of the partner- ship agreement. Those assets of the partnership that may be assigned devolve to those partners who are entitled to ownership, pursuant to the rules of ten- ancy in partnership. These rules favor the remaining partners if the former partner has died, become incapacitated or bankrupt, been expelled, or re- signed in violation of the partnership agreement. If the ex-partner resigned without violating the underlying agreement, she or he retains ownership rights under tenancy in partnership. Those who thus retain ownership may continue the business as a new partnership, corporation, or LLC with the same or new partners and investors or may liquidate the assets at their discretion. The sole right of any partner who has forfeited direct ownership rights is to be paid a dissolution distribution after the partnership’s liabilities have been paid or provided for. Corporations Corporations, in contrast, normally enjoy perpetual life. Unless the charter contains a stated dissolution date (extremely rare), and as long as the corpora- tion pays its annual fees to the state, it will go on until and unless it is voted out Choosing a Business Form 235 of existence by its stockholders. The death, incapacity, bankruptcy, resigna- tion, or expulsion of any stockholder is entirely irrelevant to the corporation’s existence. Such a stockholder’s stock continues to be held by the stockholder, is inherited by his heirs, or is auctioned by creditors as the circumstances de- mand, with no direct effect on the corporation. Limited Partnerships As you may have guessed, the hybrid nature of the limited partnership dictates that the death, incapacity, bankruptcy, resignation, or expulsion of a limited partner will have no effect on the existence of the limited partnership. The limited partner’s partnership interest is passed in the same way as that of a stockholder’s. However, the death, incapacity, bankruptcy, resignation, or ex- pulsion of a general partner does automatically dissolve the partnership in the same way as it would in the case of a general partnership. This automatic disso- lution can be extremely inconvenient if the limited partnership is conducting a far-flung enterprise with many limited partners. Thus, in most cases the part- ners agree in advance in their limited partnership agreement that upon such a dissolution the limited partnership will continue under the management of a substitute general partner chosen by those general partners who remain. In such a case, the entity continues until it is voted out of existence by its part- ners, in accordance with their agreement, or until the arrival of a termination date specified in its certificate. Limited Liability Companies The laws of the several states generally impose dissolution on an LLC upon the occurrence of a list of events similar to those which result in the dissolution of a limited partnership. However, these laws usually allow the remaining mem- bers to vote to continue the LLC’s existence notwithstanding an event of dis- solution. Under such laws, the LLC may effectively have perpetual life in the same manner as corporations. TRANSFERABILITY OF INTEREST To a large extent, transferability of an owner’s interest in the business is simi- lar to the continuity of life issue. Sole Proprietorships A sole proprietor has no interest to transfer because he and the business are one and the same, and thus he must be content to transfer each of the assets of the business individually—an administrative nightmare at best and possibly 236 Planning and Forecasting impractical in the case of nonassignable contracts, licenses, and government approvals. Partnerships To discuss transferability in the context of a general partnership, one must keep in mind the difference between ownership of partnership assets as ten- ants in partnership and ownership of an individual’s partnership interest. A partner has no right to transfer partnership assets except as may be authorized by vote in accordance with the partnership agreement and in furtherance of the partnership business. However, a partner may transfer her partnership in- terest, and it may be attached by individual creditors pursuant to a charging order. This transfer does not make the transferee a partner in the business, be- cause partnerships can be created only by agreement of all parties. Rather, it sets up the rather awkward situation in which the original partner remains, but his or her economic interest is, at least temporarily, in the hands of another. In such cases, the Uniform Partnership Act gives the remaining partners the right to dissolve the partnership by expelling the transferor partner. Corporations No such complications attend the transfer of one’s interest in a corporation. Stockholders simply sell or transfer their shares. Since stockholders (solely as stockholders) have no day-to-day involvement in the operation of the business, the transferee becomes a full-fledged stockholder upon the transfer. This means that if Bruce, Erika, and Michael decide to operate as a corporation, each risks waking up one day to find that he or she has a new “partner” if one of the three has sold his or her shares. To protect themselves against this even- tuality, most closely-held corporations include restrictions on stock transfer in their charter, their bylaws, or in stockholder agreements. These restrictions set forth some variation of a right of first refusal either for the corporation or the other stockholders whenever a transfer is proposed. In addition, corporate stock, as well as most limited partnership interests and LLC membership inter- ests, is a security under the federal and state securities laws, and because the securities of these entities will not initially be registered under any of these laws, their transfer is closely restricted. Limited Partnerships Just as with general partnerships, the partners of limited partnerships may transfer their partnership interests. The rules regarding the transfer of the in- terests of the general partners are similar to those governing general partner- ships described earlier. Limited partners may usually transfer their interests (subject to securities laws restrictions) without fear of dissolution, but transfer- ees normally do not become substituted limited partners without the consent of the general partners. Choosing a Business Form 237 Limited Liability Companies As previously mentioned, although a membership interest in an LLC may be freely transferable under applicable state law, most LLCs require the affirma- tive vote of at least a majority of the members or managers before a member’s interest may be transferred. Furthermore, membership interests in an LLC will usually qualify as securities under relevant securities laws and will there- fore be subject to the restrictions on transfer imposed by such laws. CONTROL Simply put, control in the context of a business entity means the power to make decisions regarding all aspects of its operations. But the implications of control extend to many levels. These include control of the equity or value of the busi- ness, control over distribution of profits, control over day-to-day and long-term policy making, and control over distribution of cash flow. Each of these is different from the others, and control over each can be allocated differently among the owners and other principals of the entity. This can be seen either as complexity or flexibility, depending upon one’s perspective. Sole Proprietorships No such debate over allocation exists for the sole proprietorship. In that busi- ness form, control over all these factors belongs exclusively to the sole propri- etor. Nothing could be simpler or more straightforward. Partnerships Things are not so simple in the context of general partnerships. It is essential to appreciate the difference between the partners’ relationships with each other (internal relationships) and the partnership’s relations with third parties (exter- nal relationships). Internally, the partnership agreement governs the decision-making pro- cess and sets forth the agreed division of equity, profits, and cash flows. Deci- sions made in the ordinary course of business are normally made by a majority vote of the partners, whereas major decisions, such as changing the character of the partnership’s business, may require a unanimous vote. Some partner- ships may weight the voting in proportion to each partner’s partnership inter- est, while others delegate much of the decision-making power to an executive committee or a managing partner. In the absence of an agreement, the Uni- form Partnership Act prescribes a vote of the majority of partners for most issues and unanimity for certain major decisions. External relationships are largely governed by the law of agency; that is, each partner is treated as an agent of the partnership and, derivatively, of the other partners. Any action that a partner appears to have authority to take will . limited partnership, as a hybrid, is a little of both partnership and corpo- ration. The general partners own the partnership’s property as tenants in part- nership operating in the same manner as partners. tenancy in partnership. Each partner may use partnership assets only for the benefit of the partnership’s business; such assets are exempt from attachment by the creditors of an individual partner,. creditors of the partnership. Tenancy in partnership also implies that, in most cases of dissolution of a partnership, the ownership of partnership assets de- volves to the remaining partners, to