Choice of Entity
This is normally the first substantive issue that must be resolved. Should the business be incorporated? Is a sole proprietorship, partnership, a limited liability company, or some other kind of legal entity more appropriate? Are there federal or state tax considerations that have a bearing on the decision? If an entity is to be formed, what state is the best choice.
If the client is a small enterprise with only one owner, operating in a relatively risk-free environment, a sole proprietorship is perhaps most appropriate. As a general rule, the client’s decision to operate as a sole proprietorship raises at least three major issues for the clinical student. First, is the business name that the client wishes to use available or is it being used by someone else that may have prior legal rights? Second, under state law, is the company name (if it is “assumed” or “fictitious”, i.e., other than the name of the individual business owner) required to be registered or recorded? Third, is the sole proprietorship required to obtain a business license or permit of some kind? For a further discussion of these issues, see the discussions herein regarding “Name Selection" and “Business Licenses”.
A second entity option when there are two or more owners is a general partnership. A partnership is simple to establish and operate. However, this may be a poor choice in some cases because it does not limit the partners’ personal liability, and because any partner can make commitments that bind the business and the other partner. Limited partnerships (LPs) or limited liability partnerships (LLPs) are used from time to time, but most often where there is a complex financing scheme unlikely to be encountered in a law school clinic. Of course, there should be a written agreement between or among the partners. See sample agreements collected as Owners’ Agreements.
The limited liability company (LLC) is the entity of choice for many entrepreneurs. It provides the owners with limits on their personal liability, permits equity to be divided among two or more owners in a variety of ways, is relatively simple to operate, and provides tax advantages not otherwise available. See LLC Articles for samples of the forms that must be filed with the Secretary of State in order to establish an LLC. The major issue that must be faced when preparing LLC Articles of Organization is: by whom is the entity to be managed—by the owners (members) or by a designated manager? Other issues regarding the structure and operation of the entity and the rights and obligations of the owners are normally addressed in a separate operating agreement. For sample forms, see Owners Agreements.
Corporations have traditionally been a popular form of business entity although they have been losing favor to LLCs. The advantages of the corporation are limited liability for the owners, well-developed and understandable legal requirements, an easy way in which to divide ownership, and ownership interests that are relatively easy to transfer. The disadvantages are the possibility that the entity and its shareholders will be subjected to “double taxation” (see the discussions herein of “Tax and Other Entity Choice Considerations”) and the need to observe corporate formalities (board meetings, minutes, etc.) in order to minimize the likelihood that owners of the venture will lose their limited liability protection.
Corporations are formed by filing a certificate of incorporation or articles of incorporation with the Secretary of State. See Cert. of Incorporation for sample forms. The most challenging issues the student must resolve in preparing this basic corporate document relate to the number and type of shares (e.g., common v. preferred), the par value of the shares, and any special limitations or rights attached to the shares (e.g., voting v. non-voting rights or limitations). These decisions are important because they can affect the initial franchise tax and the ongoing relationship among the shareholders.
The certificate of incorporation will ask for the name and address of the “registered agent” and the name and address of the “incorporator”. Any person, including faculty and students, may fill these positions. It is recommended, however, that one of the founders be named rather than taking on the fiduciary responsibilities to which these positions give rise.
Practical information regarding the choice of entity, official filing fees, and required forms can be found on the Web site maintained by the Secretary of State in the jurisdiction of choice.
It is usually appropriate to give the entrepreneur a written summary of the available business forms with the clinic’s recommendation as to which is most appropriate. See the student-drafted Opinion Letters section for samples.