Choosing the Best Form for Your Colorado Business Entity
In recent years, the number of business entity forms available under Colorado law has doubled, adding limited liability companies (“LLC’s”), limited liability partnerships (“LLP’s”) and limited liability limited partnerships (“LLLP’s”), to the basic group consisting of general partnerships, limited partnerships and corporations.
The factors which have most frequently been used to differentiate between these various types of business entities are: (1) the extent to which the entity shields its owners from personal liability for the debts or obligations of the entity; (2) the management structure of the organization and the extent to which management may be centralized among a group consisting of less than all the owners; and (3) the income tax treatment of the organization and whether or not its profits or losses may be passed through to the owners without first being subject to tax at the entity level. However, as a result of changes in the statutes governing certain of these entities adding flexibility to their structure, and as a result of the elimination of certain tax rules which often had a major impact on choice of entity decisions, business planners now consider many of the forms of business organization to be interchangeable.
Corporations are the most formal type of business entity. They provide a liability shield for their shareholders, have a centralized management group consisting of a board of directors elected by the shareholders and they have perpetual existence. Corporations are the preferred form of business entity for organizations which have a large and diverse ownership group and for organizations which intend to make a public offering of their securities.
One feature which often distinguishes the corporate form of organization from all of the other forms of organization mentioned above, is its tax treatment. Unless a corporation and its shareholders make an affirmative election under Subchapter S of the Internal Revenue Code, the corporate entity is separated from its owners for tax purposes and is responsible for payment of its own income tax. All of the other forms of business organization mentioned above are generally intended to be pass-through entities for tax purposes, meaning that the entity itself does not pay income tax. Instead, the owners are responsible for payment of income taxes on their proportionate share of the entities income.
In the past, a significant issue in forming a non-corporate entity, was to avoid structuring it in such a way that it would be considered to have too many corporate characteristics (such as limited liability, centralized management, free transferability of interests and continuity of life). Any entity considered to have too many corporate characteristics would lose its status as a pass-through entity for tax purposes. However, in January, 1997, the IRS adopted new regulations (which are often referred to as the “check the box” regulations) which allow non-corporate business organizations, including LLC’s and all types of partnerships, to simply elect whether to be treated as partnerships (i.e. pass-through entities) or corporations (i.e.. non pass-through entities) for tax purposes. The adoption of these regulations has caused business planners to begin to view many of the available forms of business organization as interchangeable because there is no longer any need to consider whether a non-corporate entity might inadvertently lose its status as a pass-through entity for tax purposes.
Following adoption of the IRS “check the box” regulations, changes have been made to the Colorado statutes on formation of business entities which have also had the effect of making the available forms of business organization more interchangeable.
General Partnership. The classic definition of a partnership is “an association of two or more persons to carry on, as co-owners, a business for profit,” and the most basic form of partnership is a general partnership. No formal action or formal agreement is needed to form a general partnership, and as a result, any business enterprise involving two or more owners will be a general partnership unless the participants make a different agreement.
The most significant characteristics of a typical general partnership include the fact that (i) each partner has an equal right to participate in management, (ii) each partner has the authority to make commitments or enter into binding agreements on behalf of the partnership, (iii) the death or withdrawal of one of the partners results in the dissolution of the partnership, and (iv) a general partnership does not provide a liability shield for its partners, because each partner has complete joint and several liability for all debts and obligations of the partnership.
As a result of recent changes in the Colorado Uniform Partnership Act, it is now possible to have a general partnership in which the first three characteristics described above are eliminated and are replaced with the corporate characteristics of centralized management and continuity of life. In other words it is possible to have a general partnership in which certain partners do not have the ability to participate in management decisions relating to the business of the partnership or to enter into binding agreements on behalf of the partnership. It is also possible to structure a general partnership in such a way that the death or withdrawal of one of the partners does not cause the partnership to be dissolved.
The most significant disadvantage of a general partnership is that it does not provide a liability shield, which means that the individual partners have joint and several personal liability for partnership debts and obligations. However, that problem can now be addressed through the formation of a limited liability partnership.
Limited Liability Partnership. A limited liability partnership (LLP) is a general partnership which registers with the secretary of state as an LLP. The effect of registration is to limit the vicarious liability of each of the partners. In other words, partners in an LLP are not personally liable for the debts or obligations of the partnership which arise in the ordinary course of its business or as a result of the negligence, wrongful acts, or improper conduct of another partner. Partners in an LLP, however, continue to be liable for debts or obligations of the organization which arise as a result of their own negligence, wrongful acts, or improper conduct.
All currently existing general partnerships should consider whether registration as an LLP is appropriate because the process of registration is quite simple. The form to be filed is a simple one-page form, and the partnership must change its name to include the words “Limited Liability Partnership” or the abbreviation “LLP.” At the time of registration, consideration should also be given to possible modification of any provisions of the written partnership agreement dealing with indemnification and with the obligations of partners to make additional contributions to the partnership to make those provisions consistent with the concept of limited liability.
Limited Partnership. A limited partnership is a partnership formed by two or more persons, in which at least one of the partners is a general partner and at least one of the partners is a limited partner. The Colorado statute provides that the general partners in a limited partnership have the same rights and responsibilities as general partners in a general partnership. As a result, the amendments to the Colorado Uniform Partnership Act (which are described above in the discussion regarding general partnerships) also have an impact on Colorado limited partnerships. In other words, it is now possible to have a limited partnership in which certain of the general partners do not have the ability to participate in management decisions relating to the business of the partnership or to enter into binding agreements on behalf of the partnership. It is also possible to structure a limited partnership in such a way that the death or withdrawal of one of the general partners does not cause the partnership to be dissolved.
Under the current Colorado statute, limited partners are protected from liability for the debts and obligations of the partnership as long as they do not participate in control of the business of the partnership. Likewise, under current law limited partners may lose their limited liability protection if they participate in management in a manner which is inconsistent with their limited partner status. However, it is very possible that this aspect of Colorado law will be changed at some point in the future. Although it has not yet been adopted in Colorado, under the Uniform Limited Partnership Act (2001) a limited partner is no longer statutorily constrained from participating in the management of the organization.
Limited partnerships are formed by filing a certificate of limited partnership with the secretary of state. They are typically used for business enterprises, such as real estate syndications, in which one or more of the owners desires to be a passive investor, and one or more of the owners desires to promote and organize the business opportunity and to have exclusive management authority. In addition, family limited partnerships have become a popular vehicle to be used for estate planning and asset protection planning.
The advantage of a limited partnership, from the standpoint of a limited partner, is the limited liability protection which the entity affords. The disadvantage is that in order to obtain the limited liability protection, limited partners must refrain from participating in control of the business. The advantages and disadvantages from the standpoint of the general partner are just the opposite. The general partner has sole responsibility for management of the partnership business, but in order to obtain that management authority, must accept personal liability for partnership debts and obligations. In situations in which a limited partnership seems to be the appropriate form of business organization but the prospective general partner(s) are unwilling to accept personal liability for partnership debts and obligations, the solution may be a limited liability limited partnership.
Limited Liability Limited Partnership. A limited liability limited partnership (LLLP) is a limited partnership which registers with the secretary of state as an LLLP. The effect of registration is to limit the vicarious liability of the general partners in the same fashion that registration as an LLP limits the liability of the general partners of a general partnership.
The process of registration as an LLLP is the same simple process as the process for registration as an LLP. The factors to consider in determining whether registration is appropriate include the impact which registration may have on the perceptions of the limited partners concerning the proper role of the general partners, and in partnerships in which there is more than one general partner, the interrelationship between the general partners with respect to their willingness and ability to contribute additional capital to the partnership when considered necessary for the furtherance of the partnership business.
Limited Liability Company. Colorado first adopted a limited liability company statute in 1990 and was only the third state to have such a statute. Now, LLC’s are the most popular form of organization for new business entities because of the liability protection they provide and because of the flexibility they afford in defining the business relationship between the parties.
An LLC is formed by filing articles of organization with the secretary of state. After filing the articles of organization, the basic business arrangement between the owners of the LLC (who are referred as to “members”) is set forth in a separate agreement called an operating agreement. Operating agreements combine many of the elements of partnership agreements and corporate bylaws in a single document. In addition to provisions which identify and define the ownership interests of the various members, operating agreements also include provisions defining the manner in which the business of the company will be managed. For example, the operating agreement may include provisions specifying whether meetings of members or managers are required, provisions describing the manner in which required or optional meetings are called, provisions describing the manner in which votes are conducted at meetings of the members or managers and provisions restricting or limiting the management authority of members or managers. In other words, in the operating agreement, the parties have may contractually create almost any business relationship they believe is appropriate to their particular situation.
One very popular form of LLC is the single member entity. Although an LLC is generally considered to be similar to a partnership (which by definition requires more than one partner), both the IRS and the state statute authorize the creation of a single member LLC. Such an entity is, in many ways, the equivalent of a sole proprietorship with limited liability protection. No formal meetings or other actions as necessary to maintain the entity (unlike corporations which generally require annual meeting of shareholders and directors) and the individual member may elect to report the income and expenses of the LLC on Schedule C of his or her individual tax return.
Although structural distinctions between the various forms of business entity have been minimized, there are certain situations in which business owners may consider one form of entity to be desirable over another. For example, business owners may wish to transform corporations into LLC’s to obtain flexibility, or to transform an LLC or other form of unincorporated business into a corporation in the expectation of making a public offering of securities. Colorado, and many other states, have now adopted special statutory provisions in order to help to facilitate these type of transformations from one form of business entity to another. Under these provisions entities can easily convert from one form of Colorado entity to another or from one form of Colorado entity to another form of entity organized under the laws of another state. The statute permits these transformations to be completed administratively without the need to wind up the business affairs of the converting entity and pay its obligations or distribute its assets. As a result, the transformation is not deemed to be a dissolution of the converting entity and the entity which results from the transformation is deemed to be the same entity as the converting entity.
Many of the distinctions which previously existing between various forms of business entity have been minimized or eliminated. As a result, many more choices are now available in the process of forming a new business entity, and it has become much more likely that business planners can design entities which accomplish all of the important business objectives of the owners. Likewise, owners of existing business entities have a unique opportunity to review and reconsider the form of business organization under which they are currently operating and to either change the form of organization or make changes to the existing form in order to enhance and improve its functionality.