Nuts and Bolts of Business Formation:
An Overview of Business Entities and Their Formation
Starting out by selecting the proper business entity (or making sure your existing business is operating in the appropriate form) and knowing what is required, even if the business is very small, will not only make the operation of the business much easier, but will also be beneficial in connection with the potential transition for future expansion, restructuring and securing financing.
General Overview
The purpose of this article is to provide a general overview of the characteristics of the basic forms of business entities and the requirements for their formation. It is not intended to provide a review, summary, or analysis of all aspects of a particular entity or applicable federal and state regulations, statutes, requirements, and issues in connection with business entity formation. California requirements and law are referred to for purposes of example. Selection of the form of a business entity is made from a variety considerations, including ownership and management structures, tax and limiting liability. A qualified attorney and accountant should be consulted prior to making a decision on the type of business entity to form or in connection with the conversion or merger of an existing entity.
The Entities
The following is an overview of the basic forms of businesses, including: sole proprietorships, general partnerships, limited partnerships, limited liability companies, joint ventures, corporations and S corporations.
A. Sole Proprietorships
Description and Formation - A sole proprietorship is a for-profit business owned and operated by an individual, acting as the sole owner and decision maker. Sole proprietorships are the basic forms of business organizations, requiring no formal types of government filing to form the business and are not required to follow any type of operating formalities (although the sole proprietorship may need to obtain a business license or file a fictitious business name statement in the city or county in which the business is being conducted).
Tax Aspects - A benefit of a sole proprietorship is the taxability of business income and the deductibility of business losses on the proprietor�s individual tax returns.
Liability - Sole proprietorships offer no protection from personal liability to the individual. The sole proprietor is personally liable for all liabilities and obligations of the business, which liability extends, not only to liabilities in excess of the amounts invested in the business and potentially for excess available insurance coverage, but also to their personal and business assets.
B. General Partnerships
Description and Formation - A general partnership (a �GP�) is an association of two (2) or more persons to carry on a business for profit as co-owners and is characterized by a community of interests in a particular business and a sharing of profits. The term �person� includes individuals, partnerships, corporations, limited liability partnerships and other associations. Generally, GPs are not restricted to engage in any particular type of business. A GP is another type of business entity which is easy to form and is not dependent on a formal written agreement, such as a partnership agreement (However, is it strongly recommended that the partnership have a written partnership agreement to govern the operation of the partnership and the relationship among and between the partners, except to the extent governed by statute).
Compliance Requirements - For California GPs, the filing or recording of any type of formation documents is permissive, but not required. GPs may file with the Secretary of State a Statement of Partnership Authority, which functions as creating record title and giving constructive notice of changes in the partnership. GPs may also record their partnership agreement at the County Recorders Office(s) in which partnership property is located. GPs have no specific records which must be maintained, but must make available information to their partners concerning the business and affairs of the partnership and in connection with the proper exercise of the partner�s rights and duties under the partnership agreement.
Management - In a GP, each partner not only has equal rights in the management and conduct of the business of the partnership, but also is considered an agent of the partnership for business purposes. Generally, an act of a partner binds the GP.
Liability - Because of having personal liability, jointly and severally, for partnership debts, the obligations and liabilities of partners in a GP are similar to those of a sole proprietor. With few exceptions, a general partner�s liability not only extends to that partner�s percentage interest in the partnership, but also to the partner�s other personal assets as well.
Tax Aspects - A GP is a separate tax-reporting entity for income tax purposes and is required to file an informational return detailing income and deductions. However, it is not a separate taxable entity, but serves as conduit through which income and losses and the tax obligations of the partnership pass through to the individual partners.
C. Limited Partnerships
Description and Formation - A limited partnership (an �LP�) is a partnership formed by two (2) or more persons that has one (1) or more general partners and one (1) or more limited partners to carry on, as co-owners, a business for profit. With few exceptions (banking, insurance or trust company), LPs may carry on any business that a GP may conduct.
Compliance Requirements - The formation and operation of a LP requires a little more formality than a GP; however the formation requirements are minimal. In California, a LP is formed by the filing of a Certificate of Limited Partnership with the Secretary of State, together with payment of the required filing fees. The LP must also have an oral or written partnership agreement which governs its affairs and the conduct of the partnership business. Like GPs, LPs are also recommended to have a written partnership agreement to establish the relationship between the partners and to govern the operation of the business. The partnership agreement may provide for the creation of classes of general or limited partners and, if so, must define the rights, powers and duties of those classes. LPs are required to maintain an office in the state where records are kept, an agent for service of process and specific record keeping, including the name and address of the partners, a copy of the Certificate and other formation documents, tax and financial statements, and books and records as they relate to the internal affairs of the LP.
Management - A general partner has exclusive management authority of the LP, except as provided by statute or the partnership agreement. The general partner in a LP has similar rights and powers as a partner in a GP. However, a single general partner in a LP may have more freedom and control than a partner in a GP because the limited partners do not share in the decision-making process.
Liability - The general partner�s liability is also basically the same as a partner in GP, wherein personal liability, with few exceptions, is extended to all partnership debts, obligations and liabilities. The LP allows a limited partners to avoid subjecting their personal assets, outside of their investment in the partnership, to creditor claims. A limited partner�s liability is ordinarily limited to the assets contributed to the partnership and any obligations for subsequent contributions. The key aspect of a LP is that a limited partner is granted limited liability as long as the partner does not participate in control of the partnership business.
Tax Aspects - For federal and state income tax purposes, a LP, like a GP, is a separate tax reporting entity and is required to file an informational return. With the exception of paying a tax for the privilege of doing business in California (and other states may follow California), the LP is not a separate taxable entity, as partnership income flows through to the individual partners in proportion to their interest in the partnership. LPs may elect to be taxed as a corporation or partnership.
D. Limited Liability Companies
Description and Formation - A limited liability company (an �LLC�) is a relatively new type of entity that is essentially a hybrid of a corporation and a partnership. An LLC is an entity having one (1) or more members, organized under a particular state LLC statute and, with the exception of banking, insurance and trusts companies, may engage in any lawful business activity (subject to its Articles of Organization (the �Articles�) and compliance with applicable laws). Although LLCs are recognized in all 50 states, not all states recognize single member LLCs (California, Nevada and Delaware are examples of states which do). LLCs have all the powers of natural people, including to: transact business, sue or be sued, make contracts, own and transfer real estate and personal property, issue stock and many others, subject to any limitations contained in its Articles and all other applicable laws. Unless there are statutory restrictions, individuals, trusts and all types of business entities, including foreign individuals and entities can be the owners of an LLC.
Compliance Requirements - Although LLCs require more formality in formation and operation similar to a corporation, the formation and operation of an LLC is relatively simple. In order to form an LLC, two requirements must be met: (1) Articles are filed with the Secretary of State (other states refer to the Articles as a Certificate of Formation); and (2) the LLC must have a written or oral operating agreement to govern the affairs of the LLC and the conduct of its business. For reasons similar to partnerships, it is highly recommended that the operating agreement for the LLC be written to specifically provide for all the necessary terms and provisions in connection with the operation of its business and to address the rights, duties and obligations of its members and managers. California LLCs are required to file an annual Statement of Information for both domestic and foreign LLCs (which have qualified to transact business in the state). LLCs also have similar requirements to that of a limited partnership for maintaining an office, an agent for service of process and record keeping.
Management - The LLC may be managed by all of its members or by one (1) or more managers. The managers may be some or all of the members, but need not be members or natural persons. The Articles or operating agreement may restrict or enlarge the management rights or duties of any member or class of members. The operating agreement may also provide for the appointment of officers with such powers and duties as specified in the Articles or operating agreement or as determined by the members or managers.
Liability - Generally, LLCs provide its members, managers and officers limited liability similar to that enjoyed by corporate shareholders. They are not personally liable for any debt, liability or obligation of the LLC arising in �contract, tort or otherwise� solely by being a member, manager or officer. However, members and managers may be liable for their own tortious conduct. Members or managers may agree to be personally obligated for any or all of the LLC�s debts, obligations and liabilities, as long as the state�s statutory requirements are followed. Members also have similar exposure to liability as that of a shareholder under the common law theory of �alter ego liability�, which is the disregarding of the existence of the entity and holding the individuals members responsible for acts knowingly and intentionally done in the name of the entity (this is also known as piercing the corporate veil in a corporate context).
Capitalization - Capital contributions may be in the form of money, property or service by its members, or an obligation to contribute money, property or to render services. In addition, loans secured by property of the LLC or the personal guarantees of members are often used to satisfy the capital requirements of the LLC. LLCs can be attractive to capital investors because liability can be limited to the amount of the investment and the availability of different classes of members can provide flexibility among investors.
Tax Aspects - An LLC with two (2) or more members may elect to be taxed either as a corporation or as a partnership. An LLC with a single owner may elect to be taxed as a corporation or to be disregarded as an entity separate from its owner. The taxation of LLCs at the state level is particular to each state. In California, LLCs are subject not only to an annual minimum franchise tax, but also to a graduated entity level fee based on total income.
E. Joint Ventures
Description - A joint venture (a �JV�) is similar to a partnership wherein the joint venturers are co-owners of the business enterprise, sharing profits and losses. The distinction lies in that a joint venture is usually formed for a single transaction or a series of transactions. Thus, a JV is limited in scope and duration, while a partnership usually is a continuing business for an indefinite or fixed period of time.
Formation - A JV is formed under state law by an agreement between the parties, which may be oral or written; however, as with other entities, having a written agreement is usually recommended.
Tax Aspects - A JV is taxed as a partnership by both federal and state taxing authorities. However, a JV is defined for tax purposes as a joint transaction of two or more persons for the purpose of making a profit, without any corporate or partnership designation.
F. Corporations
Description - Corporations are by far the most common and well known form of business entities. All corporations are governed by the state of incorporation and, to some extent, by other states in which the corporation has registered to transact its business. A corporation is treated as a separate and distinct legal entity, existing apart and recognized separately from its owners and shareholders, with all the rights to own property, make contracts, and sue in its own name. A corporation may be formed to engage in any business activity, subject to compliance with all applicable laws. Unless otherwise provided in its Articles, the existence of the corporation is perpetual. The perpetual existence of a corporation provides an advantage over other types of business entities because the death, disability, retirement or termination of either a shareholder, director or officer will not terminate the corporate existence.
Formation - A corporation is formed by the filing of Articles of Incorporation (the �Articles�) with the Secretary of State (some states refer to Articles as Certificates of Incorporation). Owners of the corporation are usually issued certificates representing the shares of stock issued by the corporation. Like an LLC, a corporation may have a sole owner and the types of entities which may own a corporation is not restricted. Bylaws, which typically set forth the rules and procedures that govern the management of its business and conduct of its affairs, may be adopted by the corporation.
Compliance Requirements - Corporations must follow strict statutory compliance in connection with meeting and record keeping. Annual shareholder meetings are required, and, although it is not required, board of director meetings are customarily held after the annual shareholder meetings. California corporations are required to maintain adequate and correct books and records of account, written minutes of all shareholder, board of director and committee meetings, records of share transactions, record of shareholders and bylaws. Certain foreign corporations (organized in another state or country and qualified to transact business in California) are also subject to California�s record keeping and reporting requirements. In California, corporations must also file an annual Statement of Information by Domestic Stock Corporation with the Secretary of State. Foreign corporations qualified to transact business in California are also required to file a similar statement. California corporations are also required to maintain its records at its principal place of business (which may be either within or outside of California) and an agent for service of process. Generally, corporations must maintain an office within the state of formation (the office address may not be a P.O. Box, but must be a physical street address).
Management - Generally, a corporation�s business, affairs and powers are managed and exercised by, or under the direction of, a Board of Directors (the �Board�). The initial directors may be set forth in the Articles, bylaws or elected by the incorporator(s). Thereafter, directors are elected by the shareholders of the corporation at the annual shareholders meeting. Day-to-day management of the corporation is usually placed in the officers of the corporation. Officers are chosen by the Board, which also has the power to establish committees, having authority to act on behalf of the entire Board. The position of director and of all required officer positions in a corporation may be held by a single individual.
Liability - Under the corporation�s limited liability protection, a shareholder�s personal liability is limited to the amount of the shareholder�s investment in the corporation. In addition, corporate shareholders, directors and officers are not liable for the debts and other obligations of the corporation or for the torts or criminal acts of one another. Generally, shareholders, directors and officers may be liable for the following matters: (1) the personal guarantees of corporate debt; (2) the receipt of improper distributions; (3) the common law theory of �alter ego liability�; or (4) the breach of a duty owed to other shareholders or the corporation.
Capitalization - A corporation may raise capital through equity capital contributions by its shareholders, unsecured loans, loans based on the credit or personal guarantees of its officers, directors or shareholders or secured by the assets of the business. Funds may be invested as equity (through the sale of ownership interests in the corporation), debt or in convertible or hybrid securities, including, among other things, promissory notes, stock, warrants, and options.
Tax Aspects - A regular or general corporation (also referred to as a �C� corporation�) is a separate tax paying entity for federal and state tax purposes, as distinguished from sole proprietorships, general and limited partnerships, most LLCs and Subchapter S corporations (discussed below), which are not. A corporation is also subject to state income tax regulation, which generally conforms to federal taxation. Corporations are also subject to double taxation, as follows: a corporation�s profit is taxed once to the corporation and again when after-tax profit is distributed to the shareholders as dividend income, unless the shareholder is a corporation and eligible for the dividends-received deduction.
G. Subchapter S Corporations
Description - A Subchapter �S�corporation, commonly known as an �S corporation�, is a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code and is treated as a partnership for most tax purposes. Thus, the income, losses, deductions and credits of the S corporation are proportionately passed through to its shareholders, who report and pay taxes which may be due on their individual tax returns. Other than the different tax treatment by a Subchapter S election, the S corporation operates identically to that of a C corporation.
Qualification - Along with obtaining the consent of all the shareholders, a corporation may qualify as an S corporation if the following requirements are met: (1) have no more than seventy five (75) shareholders; (2) shareholders must be individuals (excluding resident aliens), estates, certain types of trusts, qualified Subchapter S subsidiaries and certain exempt organizations; (3) must be a domestic (U.S.) corporation; (4) may not be a financial institution that uses the reserve method of accounting for bad debts, an insurance company, a corporation that has elected special tax treatment and operates in Puerto Rico or other U.S. territorial possessions, or is a current or former Domestic International Sales Corporation; and (5) may not have issued more than one class of stock.
Miscellaneous Issues
A. State of Formation
The decision to organize the entity in another state should be made only after careful consideration and weighing of the advantages and disadvantages (the entity may not have such a choice if required by a lender or investor). However, organizing in a state which is not where the entity conducts its principal business is not always recommended. For example, if your business is principally operating in California, it will still be subject to payment of California taxes and the entity will be required to qualify as a foreign entity in order to formally transact business in the state. Thus, any tax benefits gained by forming in another state may be eliminated. A business entity organized in another state, but operating in California will incur the additional expense of having to maintain an office and a registered agent in the state of formation. Further, the entities security laws compliance may also increase due to the selling or offering of securities outside the state of formation.
B. Qualifying to transact Business as a Foreign Entity
Entities transacting business in a state other than which it was formed may be required to qualify to transact business in that state. The key in determining whether the Foreign Entity is conducting business is to review the statutory requirement of each state. If required, an entity may qualify to transact business in the state which it is transacting business by filing the appropriate form with the Secretary of State.
C. Securities Regulation
Federal and state securities regulations (the �Securities Laws�) are applicable to the issuance and transfer of shares of stock, membership interests and limited partnership interests (with some exceptions, general partnership interests are ordinarily not considered a security). If it is determined that such issuance or transfer of the security falls within the definition of an offer and sale as prescribed by the Securities Laws, the securities must either be registered (a very costly and time consuming process) or an applicable federal and state exemption must be found. In addition, if the securities are being offered and sold outside the state in which the entity (referred to as the issuer) is located, the securities laws of the state in which the investor resides must be reviewed to determine the applicability of that state�s securities laws.
D. Merger and Conversion
By statute, most states now permit one (1) or more entities to merge into a single entity or one (1) entity to convert into a different type of entity. Not only is this permitted between entities of the same state, but also entities organized in different states. For example, an existing California LLC can merge into an existing Delaware corporation or the existing California LLC can convert into a Delaware LLC. Partnerships can also merge or convert. Merger or conversion allows entities the flexibility to change to a different type of entity should factors warrant such a change, including the ability to seek new investors and/or changing the management or capital structure of the entity. Generally, the statutory requirements include: the merger or conversion approved by the shareholders and directors, members or partners of the disappearing and surviving entities in a merger or of the entity to be converted; an agreement of merger or plan of conversion; and filing of the required merger or conversion documents with the Secretary of State.
E. Trademark Names
The name of the business entity may be registered as a trademark name by filing a trademark application with the U.S. Patent and Trademark Office (the �USPTO�). The application process can be completed online by the owner of the mark (www.uspto.gov) or through an attorney on behalf of the owner. The time for completion of the application process and registration of the mark is also dependent on whether the application is based on the mark being used in commerce at the time of the application or an intent to use the mark when the application is filed. If the applicant successfully completes the application process, the USPTO will issue the Certificate of Registration for the trademark.
Practical Aspects for Entity Formation
In order to form the business entity and to complete the formation documents, the following information will be required: (a) the business name (which must comply with all applicable statutory requirements); (b) a description of the purpose of the business; (c) the name and physical street address of the agent for service of process; (d) the address for the principal place of business; (e) the name and address of shareholders, members, or partners and percentage ownership interest of each; (f) the name and address of directors and officers, manager(s) and general partner(s); (g) identify the capital contribution of each shareholder, member or partner; (h) identify the fiscal year end of the entity; (i) identify the person(s) authorized to execute documents, checks and open accounts on behalf of the entity; (j) determine whether management will receive a salary (general partners, officers, directors, or managers); (k) identify the name and address of the accountant for the entity; (l) identify the name and address of the bank or financial institution for the entity; (m) identify the tax matters member for the LLC; (n) determine whether a lender is requiring the entity to be a single purpose entity (�SPE�) and identify the SPE provisions required to be incorporated into the articles, operating agreement or partnership agreement; (o) determine whether the corporation will make an S corporation election; (p) determine where the entity will be formed and whether the entity will be transacting business outside of the state of organization; and (q) determine whether the entity will file a fictitious business name statement.
The entity will also need to obtain an Employer Identification Number, which requires the following information: (1) social security number of the principal, officer, manager or member, or partner; (2) date first wages to be paid; (3) highest number of employees next twelve (12) months; (4) If the principal activity of the entity is manufacturing, confirm if raw material will be used; and (5) identify to whom the entities products will be sold (wholesale, retail, other).
Filing fees - each state has its own schedule of fees for filing particular formation or other required document for each specific entity.
Reference Sources
Readers should be aware of the business related sources available through the
IGDA and Gamasutra
websites. For more information, the Secretary of State websites generally have
information on formation of business entities, which includes general
information, forms, fee schedules and applicable statutes. The Secretary of
State may also reference other related government web sites. See also, if
available and applicable, the Department of Corporations, Franchise Tax Board or
related state government tax authority, the Internal Revenue Service, Securities
and Exchange Commission, and United States Trademark and Patent Office. The
local public libraries or law libraries also provide reference material and
transaction guides on business formation and related topics.
Related Resources/Links
- Discuss game business and legal topics in the discussion forum
- IGDA Business & Legal site
- Gamasutra business features
- Book: Game Development Business and Legal Guide by Ashley Salisbury
Author Bio
Aaron Gumbinger is an avid gamer and, for the past three years, has been a regular attendee of the GDC and E3. Since1989, Aaron has been a practicing attorney and, over the past four years, an associate with Haas & Najarian in San Francisco. The emphasis of his current practice is in the area of business formation (of all types of entities) and related business transactional work. Haas & Najarian has represented a third party game developer in all aspects of its business. Aaron can be contacted at [email protected].
The opinions expressed in this article do not necessarily represent the IGDA.