Business Entity Types

To start learning about different business legal entities, familiarize yourself with terms related to business structures or business entity types. Each type has distinct legal, financial, and operational characteristics that impact taxation, liability, ownership, and management.

Here’s a quick guide to the basic terminology:

1. Sole Proprietorship - The simplest business form owned and operated by a single person. The owner has complete control but also unlimited personal liability for business debts.

2. Partnership - A business entity where two or more individuals share ownership. Partnerships come in several forms:
   • General Partnership (GP) - All partners share equal responsibility, liability, and profit distribution.
   • Limited Partnership (LP) - Includes both general partners (with full liability) and limited partners (with liability limited to their investment).

3. Limited Liability Company (LLC) - A flexible structure that combines elements of partnerships and corporations. Owners (members) have limited liability, and profits can pass through directly to them without corporate taxes.

4. Corporation - A more complex structure with legal recognition as a separate entity. There are two primary types:
   • S Corporation (S-Corp) - Allows profits to pass through to shareholders to avoid double taxation, but with restrictions on the number and type of shareholders.
   • C Corporation (C-Corp) - A standard corporation where the entity pays corporate taxes, and profits distributed to shareholders are taxed again (double taxation). Offers the most separation of liability for owners.
5. Legal and Tax Terms - To deepen your understanding, explore these as well:
   • Limited Liability - Protection against personal financial liability for business debts and obligations.
   • Pass-Through Taxation - Business income that “passes through” directly to owners’ personal tax returns, avoiding corporate tax.
   • Double Taxation - When income is taxed both at the corporate level and then again when distributed as dividends.
6. Other Relevant Terms:
   • Formation - The legal process of establishing a business entity with the state.
   • Operating Agreement - A document outlining the management and operations structure for LLCs.
   • Articles of Incorporation - The document filed to create a corporation officially.

In the United States, business legal entities are governed by a combination of federal and state laws, which vary depending on the entity type. Here’s a breakdown of the primary legal sources and rules:

1. Federal Laws and Codes

• Internal Revenue Code (IRC): Governs tax rules and regulations for all business entities in the U.S., covering corporate taxation, pass-through taxation, deductions, and more. It’s especially crucial for distinctions between S-Corporations, C-Corporations, and LLCs.
• Securities Act of 1933 and Securities Exchange Act of 1934: Regulates corporations that issue publicly traded securities, especially relevant for large C-Corporations.
• Employment Law (e.g., Fair Labor Standards Act, Family Medical Leave Act): Governs employee rights, wages, and other employment standards, which apply to all business types but vary in specific requirements based on the size and structure of the entity.

2. State-Specific Laws

• State Business Corporation Laws: Each state has its own business corporation code (e.g., Delaware General Corporation Law) that sets rules for forming, operating, and dissolving corporations within that state.
• Uniform Partnership Act (UPA) and Revised Uniform Partnership Act (RUPA): These model laws, adopted with variations by most states, govern partnerships and establish default rules for general and limited partnerships.
• Uniform Limited Liability Company Act (ULLCA): Provides a model for LLC formation and operations, but states often have variations. State-specific LLC acts set rules on limited liability, operating agreements, and member rights.
• State Franchise Tax Laws: Most states impose annual fees or franchise taxes for certain entities (like LLCs and corporations) based on either revenue or a flat fee.

3. Entity-Specific Rules and Requirements

• Sole Proprietorship: Requires minimal regulation but must adhere to state and local licensing requirements, permits, and zoning laws.
• Partnerships: Governed largely by state partnership laws, influenced by UPA and RUPA; limited partnerships require filing with the state.
• Limited Liability Companies (LLCs): Governed by each state’s LLC act, which often derives from the ULLCA. Most states require an operating agreement and annual filings.
• Corporations (C-Corp and S-Corp): Controlled by both state corporation laws and the IRC for federal tax purposes.
  • S-Corp Election: Corporations electing S-Corp status must file IRS Form 2553, which has specific criteria (e.g., limited number of shareholders, restrictions on shareholder types).

4. Regulatory Agencies and Compliance Requirements

• Secretary of State (for each state): Business entities must register and file annual reports or pay annual fees with their state’s Secretary of State or equivalent office.
• IRS: Enforces federal tax laws, including those specific to different business entities. LLCs, S-Corps, and C-Corps all have unique filing requirements, forms, and deadlines.
• Securities and Exchange Commission (SEC): Enforces federal securities laws and governs publicly traded corporations. Public C-Corps must comply with SEC regulations, reporting requirements, and financial disclosures.
• Local and State Regulatory Authorities: Depending on the business type, specific state agencies may impose additional regulations (e.g., environmental, health and safety).

Key Documents and Filings for Business Entities

• Articles of Organization/Articles of Incorporation: Required for LLCs and corporations to establish legal existence in a state.
• Bylaws and Operating Agreements: Governing documents required by many states for LLCs and corporations to outline management structure and operational procedures.
• Annual Report/Franchise Tax: Many states require periodic reporting and franchise taxes to keep business entities in good standing.

By focusing on the applicable federal, state, and local laws relevant to each entity type, you’ll gain a comprehensive understanding of the legal framework surrounding business entities in the U.S.

Delaware General Corporation Law (DGCL)

The Delaware General Corporation Law (DGCL) is the body of law governing corporations in the state of Delaware. It’s widely considered one of the most flexible and business-friendly corporate statutes in the United States, making Delaware the most popular state for corporations, including many Fortune 500 companies. Here’s a closer look at the DGCL and why it’s so influential:

1. Flexibility in Corporate Structure
   • The DGCL provides corporations with significant flexibility in structuring their operations and governance. For example, companies can tailor their bylaws and articles of incorporation to suit specific needs, including board composition, voting rights, and decision-making processes.
   • Delaware law permits a wide range of stock classes, allowing corporations to issue different types of stock with varying voting rights, financial rights, and other attributes.
2. Clear Fiduciary Duty Rules
   • Delaware law provides well-established guidance on the fiduciary duties of directors and officers, including duties of care and loyalty to the corporation and its shareholders.
   • Delaware courts, especially the Delaware Court of Chancery, have developed a large body of case law interpreting fiduciary duties, making legal outcomes more predictable for corporate leaders.
3. Efficient and Experienced Judicial System
   • Delaware’s Court of Chancery is a specialized court that exclusively handles corporate and business disputes. It’s known for its expertise in corporate law and for handling cases without juries, which allows for faster and more predictable rulings.
   • The state’s Supreme Court has also developed a robust body of corporate case law, creating a clear and sophisticated legal framework for corporate governance issues.
4. Attractive Tax and Privacy Benefits
   • Delaware has no corporate income tax for businesses that are incorporated in the state but do not conduct business there, making it a tax-efficient option for many corporations.
   • Delaware law allows a high level of privacy: corporations are not required to disclose the names of their directors and officers publicly, providing an extra layer of anonymity for business owners.
5. Business-Friendly Policies and Protections
   • The DGCL includes indemnification provisions that allow corporations to protect directors, officers, and other employees against certain legal claims, which helps attract top talent to leadership roles.
   • Delaware allows the exculpation of directors from liability for breaches of the duty of care (though not for breaches of the duty of loyalty or acts of intentional misconduct), which limits the personal risk for directors and encourages experienced people to serve on boards.
6. Easy Process for Corporate Transactions
   • Delaware’s corporate law provides streamlined processes for mergers, acquisitions, reorganizations, and dissolutions. For example, the Section 251 merger statute and the Section 271 asset sale statute simplify approval processes, making it easier to complete major transactions.
   • Delaware also allows short-form mergers (mergers without shareholder approval) if one company owns at least 90% of the other, which simplifies intra-group mergers.

Important Sections of the DGCL

Some of the most notable sections of the DGCL include:

• Section 102 – Outlines the requirements for the Certificate of Incorporation and allows for broad flexibility in defining corporate powers and stock rights.
• Section 141 – Governs the composition, powers, and responsibilities of the board of directors.
• Section 211 – Addresses shareholder meetings and voting requirements.
• Section 220 – Allows shareholders to inspect certain corporate records, providing limited transparency for shareholders.
• Section 242 – Governs amendments to the Certificate of Incorporation, allowing changes to key corporate structures or stock provisions.
• Section 262 – Outlines appraisal rights, which allow shareholders to demand a fair valuation of their shares in certain transactions, such as mergers.

Why Companies Incorporate in Delaware

Many companies incorporate in Delaware because the DGCL, combined with the expertise of Delaware’s courts and the state’s business-friendly policies, offers a high degree of predictability, flexibility, and legal protection. Delaware also has a reputation for being innovative, updating its corporate laws to keep up with the needs of modern businesses and maintaining a reputation as the gold standard in corporate governance.