Choice of Legal Entities

Corporation

The Business Corporation Law of 1988 (15 Pa. C.S.A. §101, et. seq.) (the “BCL”) is the statute which governs the formation and operation of corporations organized under Pennsylvania law. Corporations are created upon the filing of Articles of Incorporation with the Bureau of Corporations at the Pennsylvania Department of State.

Corporations must adopt bylaws by holding an organizational meeting. A corporation’s bylaws provide the internal rules by which the corporation operates, and the BCL permits corporations to adopt rules in whatever form desired. Notwithstanding this flexibility, there are certain bylaw provisions that must be consistent with the BCL.

Under the BCL, corporations must have shareholders, directors and officers. Unless otherwise specified in the bylaws, the Pennsylvania corporation is managed under the direction and authority of the board of directors. Directors stand in a fiduciary relationship to the corporation and must perform their duties in good faith, in a manner reasonably believed to be in the best interests of the corporation, and with the inquiry, skill and diligence of a person of ordinary prudence. This standard requires that a director acting in good faith may rely on information, opinions, and reports prepared by those the director reasonably believes has competence in the matters addressed in such documents.

Every corporation must have officers consisting of, at a minimum, a president, treasurer and secretary, or persons who act in such capacities regardless of their title. One individual may serve in each capacity. Additional offices, such as vice‐president, may be established in the bylaws.

Business owners seeking to avoid “double taxation” often choose to make an election under Subchapter “S” of the Internal Revenue Code and analogous Pennsylvania tax law. As an “S” corporation, earnings are not retained by the corporation but are deemed to “pass through” to the owners, and therefore are taxed only once. A corporation that has not made an “S” election is taxed as a separate taxpayer pursuant to Subchapter C of the Code and is referred to as a “C” corporation.

Partnership

Pennsylvania law recognizes several different forms of partnerships. The most common forms of partnerships are the general partnership and the limited partnership.

The Uniform Partnership Act (“UPA”), which nearly every state has adopted, including Pennsylvania, governs the formation and operation general partnerships. The UPA defines a general partnership as “an association of two or more persons to carry on as co‐owners of a business for profit.” Partnerships are based upon contract among the partners that comprise the partnership. The “persons” associated in a partnership may be natural persons, corporations, or any other entity.

A general partnership is formed by agreement of the partners, which need not be in writing. The only requirements are that the agreement include the clear mutual assent of two or more persons, is supported by consideration, provides for a sharing of profits and losses and there is co‐ownership of the business. There is no required filing to be made with Pennsylvania’s Department of State to establish a general partnership under Pennsylvania law.

Unless the partnership provides otherwise, each general partner is entitled to share equally in all aspects of the management of the partnership. In addition, each general partner is considered an agent of the partnership and has the authority to bind the partnership. An individual or an entity may serve as a general partner.

With a general partnership, the owners do not get the advantage of limited liability. Unless the general partnership registers as a limited liability partnership, the partners have no protection from the liabilities of the partnership as each partner is jointly and severally liable for all of the liabilities of the business.

Pennsylvania limited partnerships are governed by the Pennsylvania Revised Uniform Limited Partnership Act. 15 Pa. C.S.A. § 8511. Unlike a general partnership that is a creation of the parties comprising the partnership, limited partnerships are creations of the state and in order to exist require that a certificate of limited partnership be filed with the Department of State.

In contrast to a general partnership, only the general partner of the limited partnership acts as the agent of the limited partnership. As a general rule, limited partners do not have any right to participate in the management of the partnership’s business.

In a limited partnership, only the limited partners have the benefit of limited liability. In many jurisdictions, the liability protection applies only to limited partners who do not actively participate in the management of the business. However, this is not the case in Pennsylvania.

A registered limited liability partnership (or LLP) is a general partnership or limited partnership that registers with Commonwealth of Pennsylvania Department of State as an LLP. LLPs generally are professional partnerships, such as law firms and accounting firms. The required form for the creation of an LLP is referred to as a Statement of Registration, and requires the signature of one general partner. Furthermore, every domestic registered LLP is required to file an annual certificate of registration before April 15 for the preceding calendar year. 15 Pa. C.S.A. § 8221. Also, the name of the LLP must contain the term “company”, “limited” or “limited liability partnership” or an abbreviation of one of those terms. 15 Pa. C.S.A. § 8203(a)(2).

The general partners of an LLP are not personally responsible for the negligent misconduct committed by another partner, but they do remain liable for all other debts of the partnership such as contractual liabilities. 15 Pa. C.S.A. § 8204. This limited protection only from the professional malpractice of your partners is an important consideration when deciding what type of entity to form.

Limited Liability Company

The Pennsylvania Limited Liability Company Law of 1994 governs LLCs in the Commonwealth. 15 Pa. C.S.A. § 8901. LLCs are a popular business form, as owners enjoy the limited liability protection of a corporation together with the pass‐through tax benefits of partnerships.

Owners of LLC interests are referred to as members. LLCs are formed upon filing a Certificate of Organization with the Commonwealth.

LLCs may be managed by the members or one or more appointed managers. The default rule in Pennsylvania is that an LLC is managed by the members. Each member has the authority to bind the LLC because each member is deemed to be a general partner for management purposes. Alternatively, the members of an LLC may choose to appoint one or more managers to operate and control the business of the LLC. Each manager is vested with the authority to bind the LLC because each manager is deemed to be a general partner for management purposes. In order to choose this type of management, the members must explicitly say so in the Certificate of Organization. The manager‐managed structure also can be used to form a management structure that is similar to a corporate structure with the managers acting as directors who appoint officers and the members acting as passive shareholders.

Unlike a limited partnership, there is no requirement that an owner must be responsible for potential liability. Members are not liable for the debts of the LLC solely because they are members. This aspect of LLC is primarily the reason why LLCs have become so popular nationally. However, their popularity in Pennsylvania has been slightly tempered because of the application of the capital stock/foreign franchise tax to LLCs (except for LLCs that also are restricted professional corporations, such as law firms).

Primary Considerations in Choosing a Legal Entity

Liability Protection:

“Inside out liability protection.” Protection of the owners from the risks of the business.

The first line of defense is good liability insurance.

A corporation generally offers complete limited liability for all shareholders. Since 1995, Pennsylvania has also authorized the use of a limited liability company which also offers the same limited liability protection for the owners.

A general partnership exposes the owners to unlimited liability. Consider converting a general partnership to a limited liability company or limited partnership. Can be done without Pennsylvania realty transfer tax consequences.

The general rule is that a limited partner of a limited partnership has limited liability so long as the limited partner does not participate in the control of the business. The general partner of a limited partnership has unlimited liability. However, use of a limited partnership with a corporate or LLC general partner can provide enhanced liability protection for the underlying individual owners of the business. Section 8523(d)(1) of the Pennsylvania Revised Uniform Limited Liability Act specifically provides that a limited partner will maintain limited liability protection if that limited partner participates in the control of the business solely by being an employee of the general partner or being an officer, director or shareholder of the general partner. A limited liability company generally is a simpler and more flexible structure than a limited partnership with a corporation or LLC general partner. Complete liability protection is available for all of the owners of a limited liability company whether or not they participate in the control and operations of the business.

“Outside in liability protection.” Protection of the business from the creditors of an owner. Charging order protection — limited liability companies with more than one member. Zokaites v. Pittsburgh Irish Pubs, LLC, 962 A 2d 1220 (Pennsylvania Superior Court, December 11, 2008) and Section 8924(a) of the Pennsylvania Limited Liability Company Act. Held: Charging order is exclusive remedy against membership interest in a limited liability company. Consider forming an LLC or Limited Partnership in a jurisdiction where charging order protection is spelled out clearly in the LLC statue- e.g. Delaware.

Segregation of assets- Containment of liabilities within separate entities. Valuable assets should be owned in an entity where liability is not likely to arise. An important precept of asset protection planning is to avoid mixing “risky assets” (such as business real estate and vehicles) with “safe assets” (such as undeveloped ground, cash and marketable securities).

A well written business continuation agreement, i.e. shareholders’ agreement, partnership agreement or operating agreement is essential for maximizing liability protection.

Tax Consequences. Click here for more information…

Control of the Business

  • Centralized management
  • Voting and non-voting stock in a corporation
  • General partner of a limited partnership
  • Manager of a limited liability company

Funding for the Business and Distribution of Profits to Owners

  • Different classes ownership with different economic interests

Questions Every Business Must Ask

Q. Has your business recently reviewed its legal structure to determine whether it is set up in the most advantageous manner for legal and tax purposes, considering recent developments and changes in the law?

Q. Do the owners of your business have a current, updated buy-sell agreement which controls how ownership interests in the business are to be transferred in the event of an owner’s death, disability or termination of employment?

Q. Have the owners of your business developed a succession plan to define how ownership and authority will transition upon the death or retirement of the present owners?

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