Business Formations

Business Entities

Anytime one engages in business there will be a business entity, or form, which will be used to run the business, whether formally chosen or by default.  The following are some examples of business entities in North Carolina with characteristics and explanations of each.

Sole Proprietorships

The Sole Proprietorship is the simplest form of business entity and is the easiest to form and maintain.  The individual owner conducts business and holds assets in his or her own personal name.  The individual owner is also personally liable for the debts and obligations of the business.  It is possible to conduct the business under a trade name by complying with certain provisions of the North Carolina General Statutes, requiring an assumed name certificate to be filed locally.

A Sole Proprietorship may have only one owner, hence the term “sole.”  If another owner comes on board, absent any formal action to form another type of entity, a General Partnership will be formed.  Forming the Sole Proprietorship does not require the filing of any documents under state law (other than perhaps an assumed name certificate).  The individual owner enters into contracts, hires employees and conducts such other business as may be appropriate.  This type of business entity is also one of the cheapest to maintain because of the lack of filing fees and maintenance fees necessary to maintain the business.

The principal drawback to the Sole Proprietorship is that liability is unlimited for the individual owner.  This is because the Sole Proprietorship does not have an independent legal existence from its owner, unlike a Corporation or LLC.  As a general rule, the individual owner is liable for all claims against the Sole Proprietorship, including claims against employees which arose out of actions taken by employees within the scope of their employment.  This is the main reason many business owners do not use this business entity.  Liability can be managed to an extent by purchasing insurance, however, the coverage will be limited by exclusions and policy limits, of course.

As a general rule, the owner of a Sole Proprietorship can freely transfer his or her ownership interest in the business.  Because there can only be one owner, no contractual relationships or corporate formalities hinder this transferability.  On the negative side, there is no continuity of business.  Typically, when the owner faces bankruptcy, dies, becomes incompetent, or withdraws from the business the business will be liquidated.  This is because the existence of the business is dependent upon the continued legal capacity of the owner.

Finally, a Sole Proprietorship can be converted to another form of business fairly easily.  It is quite common for a Sole Proprietorship to convert to a Limited Liability Company or Corporation.  This conversion is accomplished by forming the new entity and then transferring the assets and liabilities to the new entity.

General Partnerships

A General Partnership, in North Carolina, is an association of two or more people to carry on a business as co-owners for a profit.  No written partnership agreement needs to exist for a General Partnership to legally exist.  As can be imagined, General Partnerships can be created intentionally or even inadvertently, which, in the latter case can lead to unintended and very detrimental consequences. 

The “Partners” in a General Partnership need not be individuals.  They can be Corporations, LLCs, or other partnerships or associations.  It is important to remember that General Partnerships are different from Limited Liability Partnerships, although both of these entities have lost some popularity with the advent of the Limited Liability Company.  See Limited Liability Partnerships below.

Requirements of forming and maintaining a General Partnership can vary depending on the business, number of partners, and specific needs of the Partnership.  It is always a good idea to have a detailed and comprehensive partnership agreement drafted for a General Partnership, a Limited Partnership, or a Limited Liability Partnership.  Absent a partnership agreement between the partners, default statutory rules will govern the relationship between the partners and each other, and between the partners and the partnership itself.

The most detrimental characteristic of a General Partnership is the unlimited liability of each partner for the obligations of the partnership and unlimited liability for the wrongful acts of other partners.  This is the primary reason why few General Partnerships are intentionally formed.  In North Carolina, all partners are jointly and severally liable for the acts of the General Partnership.  Another interesting rule is that a partner admitted to an existing General Partnership will be liable for all partnership obligations, whether or not the obligation arose before the partner was admitted as a partner. 

A General Partnership can be sued in state and federal court on any of its obligations.  The general partners will usually be added to the lawsuit so that both the General Partnership and the individual partners are “on the hook” for any liability.  Here, again, is why most businesses do not intentionally form a General Partnership.  There is usually a better option.

Partners in a General Partnership have equal rights to share in the management of the partnership unless the partners agree to the contrary.  Also, as a general rule, each partner is an agent who may act to bind the partnership as long as the act is one that is apparently in furtherance of the partnership’s purpose.  This can be extremely hazardous in combination with the rule that General Partners have unlimited personal liability for partnership obligations.  A good partnership agreement can limit or eliminate certain issues with agency problems, but typically using another business entity instead of a General Partnership is an easier answer to navigating the hazards of agency and liability in General Partnership law.

One of the most interesting characteristics of Partnerships is the concept of Fiduciary Duties between Partners.  Each General Partner stands in what is called a “fiduciary relationship” to the other general partners with regard to matters that affect the partnership.  This means that partners must act with good faith, undivided loyalty, and general fairness in their dealings with each other.  Generally, a partner may not usurp a Partnership’s business opportunity unless the transaction is openly disclosed to the other partners and they have approved or at least consented to it.

To discontinue a General Partnership’s existence, the Partners may use a stated term included in their partnership agreement.  Death, retirement, withdrawal from the partnership, incapacity, or bankruptcy of any partner may cause what is known as a dissolution of the partnership.  This dissolution does not automatically terminate the partnership.  The Partnership continues to exist after dissolution solely to allow for winding up of the partnership affairs. 

For taxation purposes, a General Partnership is treated for federal income taxation as a partnership, which is a pass-through entity not taxed at the partnership level.  A Partnership’s tax items are determined at the partnership level while each individual partner includes his share of the partnership income or loss on his individual tax return.  The Partnership Income is taxed to the individual partners even if it is not actually distributed to them.

In summary, General Partnerships subject their owners to unlimited personal liability for the obligations of the partnership.  Each General Partner has the apparent authority to act on behalf of the partnership.  The statutory default rules governing partnerships in North Carolina can be overridden by a good partnership agreement between the partners.  One advantage a Partnership has is pass-through federal income tax treatment for its partners.  Finally, two or more people going into any business arrangement should be very careful about inadvertently forming a General Partnership due to the liability concerns.

 

Registered Limited Liability Partnerships

Registered Limited Liability Partnerships can be formed by filing an application with the Secretary of State’s office in North Carolina.  A partner in a Registered Limited Liability Partnership is not individually liable for debts and obligations of the partnership incurred while it is a Registered Limited Liability Partnership solely by reason of being a partner. The partner also does not become liable by participating in the management or control of the business of the partnership.   Now, General and Limited Liability Partnerships are not formed with as much frequency due to the popularity of Limited Liability Companies.

 

Corporations

The North Carolina Business Corporation Act governs the organization and operation or corporations formed in North Carolina.  Corporations are one of the oldest and most stable business entity forms. 

Strict compliance with the statutes is necessary to properly organize a Corporation in North Carolina. As a general rule, these steps may include preparing and filing the Articles of Incorporation, preparation of bylaws, organizational meeting of directors and shareholders, registering as a foreign corporation in states where necessary, establishing books and records, and issuing stock.

The Corporation officially exists in North Carolina at the time the Articles of Incorporation are filed with the Secretary of State.  Then, at the first organizational meeting of the Board of Directors actions taken will usually include adopting bylaws, electing officers, selecting a corporate seal, choosing the fiscal year and a bank for corporate funds, and authorizing issuance of stock.

A North Carolina Corporation is a separate and distinct entity from any of its shareholders.  It is also subject to certain record keeping requirements. 

Where a Corporation is formed with more than one shareholder, a Shareholders’ Agreement  is typically drafted and enacted for the purposes of confirming the expectations of parties, establishing certain transfer restrictions, if applicable, and determining transferability of shares in the event of a shareholder’s death, retirement, bankruptcy, or dissolution. 

The Corporation will further, want to keep and maintain appropriate records of minutes of meetings of both shareholders and directors to comply with state law.  For smaller Corporations, a significant risk of not complying with corporate formalities is that a creditor may try to assert that the Corporation was not truly operating as a Corporation and should be treated as a general partnership or sole proprietorship with unlimited personal liability for shareholders and even directors.  See Piercing the Corporate Veil below.

One of the main advantages of the corporate form is limited liability of the shareholders for the obligations of the Corporation.  The liability of a shareholder is limited to the amount of that shareholder’s investment in the Corporation, as a general rule.  This is preferable to the unlimited liability of a Sole Proprietor or a General Partner.  However, under certain circumstances, a shareholder may have liability beyond his or her investment in the Corporation.  This is called “piercing the corporate veil” and is a situation which all shareholders will want to avoid.  For a small business, in particular, a veil piercing can be devastating.

            Piercing the Corporate Veil

A Corporation’s veil can be pierced when it acts as a “mere instrumentality” for another person (individual or business entity).  The following three elements, when present, will support an attack on the corporate veil:

·         Complete domination and control over a Corporate transaction such that the Corporation has no separate mind, will, or existence of its own;

·         Use of that control to perpetrate some fraud or wrong; and

·         What is known as “Proximate Causation” of harm or injury because of such control.

 The following factors are typically considered when determining whether to pierce the corporate veil:

·         Inadequate Capitalization;

·         Noncompliance with Corporate Formalities;

·         Complete domination and control over the Corporation so that it has no independent identity;

·         Additionally, another factor which can lead to a veil piercing is when the business has been Excessively Fragmented into separate businesses beyond any reasonable justification or purpose.

 

As far as management is concerned, typically the shareholders will elect directors to run the Corporation.  The directors, in turn, appoint officers to run the actual day to day affairs of the Corporation.  A shareholder may also serve as a director and/or officer.  There are also other ways to give the shareholders more direct control like voting trusts and shareholder’s agreements. 

Like in partnerships, the players in Corporations owe certain Fiduciary Duties to the shareholders.  These duties apply to officers, directors, and sometimes to shareholders owning majority interests.  In North Carolina, the general Fiduciary Duties are:

·         The duty to act in good faith, requiring the discharging of duties in honestly and with undivided loyalty to the Corporation;

·         The duty to act in the best interest of all of the shareholders and not for a particular shareholder or group of them;

·         The duty to act with the care of an ordinary prudent person in a like position would exercise in similar circumstances.

Generally, shares of a Corporation may be transferred so long as the transfer complies with State and Federal securities laws.  Sometimes, shareholders may wish to include reasonable transfer restrictions on the transfer of shares.  These are usually included in a Shareholder’s Agreement, which can also include other provisions relating to management, taxation or any other appropriate provisions.  Where a Corporation is private and has more than one shareholder, but still a relatively small number, having transfer restrictions is usually desirable.

Defining C-Corporations and S-Corporations

There are only two types of Corporations under North Carolina law; for-profit Corporations and nonprofit Corporations.  Whether a Corporation is classified as a “C” or “S” Corporation only refers to the method of taxation under the federal taxation scheme.  In proper terms, there is no such legal entity as a “C Corp” or an “S Corp” even though these terms are commonly used.  There are only for-profit Corporations under state corporate law, which select to be taxed under subchapter S of the Internal Revenue Code or for-profit Corporations under state corporate law, which default to being taxed under subchapter C of the Internal Revenue Code. 

C-Corporations (C-Corps)

The main characteristic of C-Corp taxation is that the Corporation is subject to taxation separately from its owners.  Then, profits distributed to the shareholders are taxed again.  This is what is commonly referred to as “double-taxation” and is a major concern of corporate owners.  C-Corps are usually larger public Corporations because of the taxation issues.

S-Corporations (S-Corps)

If a Corporation qualifies under the restrictions of subchapter S of the Internal Revenue Code, it may elect to be taxed under this subchapter and not pay income tax at the corporate level, but have the earnings “pass-through” to the shareholders regardless of whether earnings are actually distributed to them.  This is referred to as “pass-through” taxation in the corporate context. 

There are limits on the number of shareholders an S-Corporation may have.  There are also restrictions on who may own shares of an S-Corp.  Further, there are restrictions on the class of shares that the Corporation may issue. To make sure that a Corporation can be taxed under subchapter S, always check with a business law attorney.

Maintaining compliance with the requirements of Subchapter-S requires diligence on the part of the owners and operators.  Particular care need be paid to the election and to maintaining requirements with subchapter S.  A Shareholder’s Agreement should be used in the case of an S-Corp to ensure that no act can be done which would disqualify the Corporation from subchapter S compliance.

 

Limited Liability Companies (LLCs)

Limited Liability Companies (LLCs) have become an extremely popular business entity recently.  LLCs are a sort of hybrid entity combining characteristics of Corporations and Partnerships to form an incredibly versatile form of business entity.  In North Carolina, LLCs are governed under the North Carolina Limited Liability Company Act, contained in Chapter 57D of the NC General Statutes. 

Formation of an LLC in North Carolina requires the filing of Articles of Organization with the North Carolina Secretary of State and paying the applicable formation fee.  The person who drafts and sends in the Articles of Organization is usually called the Organizer, although a Member can do this as well. 

The owners of an LLC are called the Members.  Those who run the operations of the LLC are called the Managers.  An LLC can be managed by its members or may have non-member managers.  There is no limit on the number of Members an LLC may have.  In fact, an LLC may have only one member.  This is called a Single-Member LLC or SMLLC.

The organizational documents will typically include the Articles of Organization and an Operating Agreement.  While it is legally allowable to have an oral Operating Agreement, wisdom suggests that it be put in writing.  Having a good written Operating Agreement can save the owners from many possible disputes about what the agreement actually says.  As the old saying goes – Put it in writing!

All of the Members of the LLC are protected against personal liability from the obligations of the LLC, as a general rule.  A Member’s liability for debts and claims against the LLC is limited to the Members capital contribution to the LLC.  This limited liability protection will not be affected by a Member participating in the management and control of the business.  However, a Member will always be liable for his own actions.  These rules provide significant advantages to LLCs over Limited Partnerships and General Partnerships.

From a management perspective, there are two possibilities for LLC management.  The first is where all Members by virtue of their status as Members, are Managers (Member-Managed).  The second is where Members by virtue of being Members do not have to be Managers (Manager-Managed).  If the Articles of Organization designate that not all Members by virtue of the fact they are Members are also Managers, then the LLC is Manager-Managed.  Typically, LLCs are formed as Manager-Managed to provide more flexibility in management.  Each Manager has equal rights to participate in the management of the LLC and management decisions require a majority of managers unless otherwise provided in an Operating Agreement.

Managers of an LLC have Fiduciary Duties similar to that of Partners in a Partnership.  The Manager must act in good faith with the care of an ordinarily prudent person and in the manner the Manager reasonably believes is in the best interest of the LLC.  A Manager also has a fiduciary duty of loyalty comparable to that of Partnership duties.

Transferring an interest in an LLC is possible by assignment of an LLC interest to a third party, unless the Articles of Organization or Operating Agreement provides differently.   An assignment does not make the assignee a Member.  The third party to whom the interest was assigned (the assignee) can become a Member as provided in the Articles or Operating Agreement. If nothing is said in either the Articles or the Operating Agreement, then the assignee may become a Member by the unanimous consent of all other Members, either in writing or as evidenced by a vote taken at a Members meeting.

Typically, most Operating Agreements for small business LLCs will have some transfer restrictions and buy-sell provisions to ensure orderly maintenance of the business and that no one will be receiving a member they didn’t originally bargain for. 

LLCs are generally easy to convert into other entities.  LLCs can even merge into other business entities although these transactions can be extremely complicated and will require the assistance of a business law attorney.

A Multi-Member LLC is typically taxed as a partnership under the federal tax scheme.  Although, if the LLC qualifies, it can elect S-Corp taxation.  A Single-Member LLC can be taxed as a Sole Proprietor (pass-through) or as an S-Corporation, provided it qualifies.

LLCs have really become the preferred entity for many businesses, particularly small businesses.  However, there are extremely difficult and technical choices which must be made in given situations when deciding between various entities, i.e. a Corporation taxed as an S-Corp, an LLC taxed as a partnership, or even an LLC taxed as an S-Corp.  The varying factors to be weighed and examined in making a determination like this for a given business are not only complicated, but extremely important, and can have lasting consequences.  When choosing which business entity for your North Carolina business Contact a North Carolina Attorney.

 

SUMMARY

The information here is just a brief summary of the characteristics of these various types of business entities in North Carolina.  When starting a business and selecting a business entity it is important to consider all of the advantages and disadvantages of each type of entity.  Choosing the right form can save money and headaches down the road.  The Mitchell Law Firm  stands ready to help you in forming your business entity and building your business.