Formation
A. Types
B. Selection
C. Requirements
D. Tax Consequences on Formation

Organization and Operation
A. Owners
B. Ownership Interest
C. Management
D. Liability
E. Income Tax Consequences

Purchase and Sale of Business Entity

Dissolution
A. Methods of Terminating Business Entity
B. Tax Consequences of Dissolution/Liquidation


FORMATION, ORGANIZATION AND DISSOLUTION
OF BUSINESS ENTITIES

This summary involves sophisticated legal concepts. Before applying anything in it to your personal situation, you should contact your professional advisor. The general information in this document may or may not be appropriate to you, and your advisor will be able to advise you in the context of your specific circumstances.

FORMATION

A. WHAT ARE MY CHOICES FOR FORMING A BUSINESS?

Sole Proprietorship

A business owned personally by one owner or a married couple is a Sole Proprietorship. A sole proprietor has total control over and responsibility for the business. A Sole Proprietorship is easily formed and allows important decisions to be made quickly. It also enjoys fewer legal controls than other types of business entities. The Sole Proprietorship must file an Application of an Assumed Business name with the Montana Secretary of State if the sole owner does business under another name.

Partnership

A Partnership is an association of two or more people acting as co-owners of a business for profit. A Partnership can be created by an oral or written agreement between the partners.

General Partnership

All partners in a General Partnership are jointly and severally liable for partnership debts and obligations. Generally, all partners have equal rights to manage and conduct the business, and profits and losses are shared by the partners, according to their ownership interest, even though their capital contributions may vary. The partners may modify the management and profit-sharing arrangements through a partnership agreement. A Partnership may, but is not required to, file a Partnership Agreement with the Office of the Secretary of State.

Limited Partnership

A Limited Partnership is more closely regulated than a General Partnership. It consists of one or more general partners and one or more limited partners. A Limited Partnership permits investors to become limited partners without assuming unlimited liability for partnership debts and obligations. There must be at least one general partner who manages the business and has unlimited liability for partnership debts and obligations, and one or more limited partners, whose liability is limited to the extent of their investment. Limited Partnerships must file a Certificate of Limited Partnership with the Montana Secretary of State.

Limited Liability Partnership

A Limited Liability Partnership operates much like a general partnership, except that as a general rule, none of the partners of a Limited Liability Partnership are personally liable for debts or obligations of the partnership or claims against the partnership arising out of the errors or negligent acts of other partners or employees of the Limited Liability Partnership. Partners in a Limited Liability Partnership remain personally liable for the partner’s own negligence, wrongful act, or misconduct, including misconduct of any person under the partner’s direct supervision and control. To become a Limited Liability Partnership, a partnership must file an Application for Registration of a Limited Liability Partnership with the Secretary of State and make reference to this status in the business name.

Corporations

A corporation is a more complex form of business organization. A corporation exists apart from its owners or shareholders and is a legal entity in its own right. The corporation is a "person" in the eyes of the law. As a separate entity, it has its own rights, privileges and liabilities apart from the individuals who form it.

A corporation has shareholders who invest money in the business and therefore own it. The shareholders elect at their annual meeting a board of directors who make the policy decisions for the company. The board of directors in turn select the corporate officers who manage the daily affairs. Generally, a corporation affords limited liability to its shareholders.

For tax purposes, a corporation can be taxed as a C Corporation or an S Corporation.

C Corporations

A C Corporation is a separate taxable entity. The income of the C Corporation is computed and taxed independently from its shareholders. Therefore, a C Corporation is subject to “double taxation” to the extent that it pays dividends to shareholders. The C Corporation is first taxed on its income at the corporate level. Then, when a dividend is paid to the shareholder, the dividend is not deductible to the corporation, but is income taxable to the shareholder. While existing C Corporations can convert to S Corporations, there are __________. See a tax attorney.

S Corporations

Unlike a C Corporation, an S corporation is not a separate taxpaying entity. Instead, income and losses of the corporation are passed through to the shareholders and reported on the individual tax returns of the shareholders. In order to be treated as an S Corporation for tax purposes, the corporation must file an election with the Internal Revenue Service (IRS). An S Corporation cannot have more than 75 shareholders and as a general rule, only individuals and certain trusts and estates can be a shareholder of an S Corporation.

Close Corporations

Close Corporations are a special type of a regular business corporation that elects to operate under special articles like a partnership. Close Corporations are not required to follow all of the normal corporate formalities. For example, a Close Corporation can elect to operate without a Board of Directors, without by-laws, and without having an annual meeting of shareholders and directors. Two-thirds of the shareholders must agree to become a Close Corporation. Close Corporations have limitations on transfers of the corporation's shares. The transfer of a shareholder's interest must meet the approval of the other shareholders. A Close Corporation may be either a C Corporation or an S Corporation for tax purposes.

Professional Corporations

Professional Corporations allow individuals who are licensed in certain professions to form a corporation which provides them with the benefits of the corporate form for the business aspects of their practices, while preserving the personal relationship between the professionals and those they serve. A Professional Corporation may be either a C Corporation or an S Corporation for tax purposes. Montana law also allows professionals to form Professional Limited Liability Companies and Professional Limited Liability Partnerships if a non-corporate entity is desired.

Limited Liability Company

A Limited Liability Company provides the benefits of limited liability of corporations and the favorable tax treatment of partnerships. Limited Liability Companies are low maintenance organizations. They are not required to hold annual meetings, but must file Articles of Organization and annual reports with the Secretary of State. A Limited Liability Company may be managed by its owners (who are called members) or by a manager elected by the members. Depending on the structure, members can be either active or passive participants in the organization. The liability of each member of a Limited Liability Company is generally limited to the amount of his or her investment.

B. WHAT DO I NEED TO CONSIDER IN SELECTING AN ENTITY FORM?

There are a number of considerations in selecting a business entity form, including the following:

1. The type of business to be conducted;
2. The degree of control desired by the owner(s), members or parties involved in the business;
3. The desired degree of formality of the organization;
4. The degree of concern for protection against liability for actions of the business and fellow owners;
5. The desired ability to attract investors; and
6. The tax considerations of the owners, members, individuals involved and the investors.

The primary factors that drive entity selection for small businesses in Montana are liability concerns, formality requirements and tax considerations. The importance of each consideration is relevant to the situation and should be discussed with an attorney. Following is a comparison of various attributes of Sole Proprietorships, General, Limited, and Limited Liability Partnerships, S corporations, C corporations and Limited Liability Companies.

C. IS A WRITTEN DOCUMENT REQUIRED TO FORM THE BUSINESS?

• Proprietorship: No

• Partnership: Not for a general partnership, but a written partnership agreement which sets forth the rights and obligations of the partners is recommended. A partnership may be created unintentionally where two or more individuals carry on a business for profit. For a Limited Partnership, A Certificate of Limited Partnership must be filed with the Secretary of State.

• Limited Liability Partnership: An Application for Registration of a Limited Liability Partnership must be filed with the Secretary of State.

• C Corporation: Articles of Incorporation must be filed with the Secretary of State. The corporation should also have written by-laws which govern the internal operation of the corporation.

• S Corporation: Articles of Incorporation must be filed with the Secretary of State, and an election to be taxed as an S Corporation must be filed with the IRS. The corporation should also have written by-laws which govern the internal operation of the corporation.

• Limited Liability Company: Articles of Organization must be filed with the Secretary of State. The Limited Liability Company should also have a written operating agreement which governs the internal operation of the company and the rights and obligations of the members.

D. ARE THERE TAX CONSEQUENCES TO FORMATION?

• Proprietorship: No.

• Partnership: Generally, no tax is incurred upon a contribution of property to the partnership in exchange for a partnership interest.

• Limited Liability Partnership: Same as partnership.

• C Corporation: Generally, no tax is incurred upon formation, if property is contributed to the corporation solely in exchange for shares of stock and the transferors own 80% of the stock in the corporation immediately after formation (unless the contributed property is encumbered by debt in excess of basis.)

• S Corporation: Same as C corporation.

• Limited Liability Company: Generally no tax is incurred upon a contribution of property to the Limited Liability Company in exchange for a membership interest.

II. ORGANIZATION AND OPERATION

A. WHO CAN INVEST IN THE BUSINESS?

• Proprietorship: Any individual.

• Partnership: Any individual, corporation, trust, estate, partnership, limited liability company or any other sort of entity. A large number of investors may cause federal and state securities regulations to apply.

• Limited Liability Partnership: Same as partnership. A large number of investors may cause federal and state securities regulations to apply.

• C Corporation: Same as partnership. A large number of investors may cause federal and state securities regulations to apply.

• S Corporation: Limited to 75 individuals (who must be U.S. citizens or residents) and certain trusts and estates; no corporations, partnerships, or nonresident alien individuals.

• Limited Liability Company: Any individual, trust, estate, partnership, limited liability company or any other sort of entity. A large number of investors may cause federal and state securities regulations to apply.

B. WHAT SORT OF INTEREST CAN BE ACQUIRED?

• Proprietorship: Direct ownership of 100% of assets.

• Partnership: In a general partnership, different general partners can have different percentage interests. In a limited partnership, there can be different classes of limited partners.

• Limited Liability Partnership: Same as General Partnership.

• C Corporation: No restrictions on classes of stock; can have, for example, voting common, non-voting common, voting preferred, non-voting preferred, different classes among common and preferred, and options to convert. Different classes can have different rights with respect to sharing income, liquidation rights, redemption and other matters.

• S Corporation: Only one class of stock is permitted. However, there is some provision for different voting rights.

• Limited Liability Company: Different members can have different percentage interests.

C. WHO MANAGES THE BUSINESS?

• Proprietorship: The sole proprietor.

• Partnership: Each general partner has equal authority to manage the business, unless a written agreement specifies a managing general partner. In a limited partnership, only a general partner has management authority, not limited partners. If limited partners get involved in management, they may risk losing limited liability.

• Limited Liability Partnership: Same as General Partnership.

• C Corporation: The shareholders elect a board of directors who are responsible for the overall direction and management of the corporation. The directors elect officers who are responsible for day-to-day operations. A shareholder can be a director and an officer.

• S Corporation: Same as C corporation.

• Limited Liability Company: Each member has equal authority to manage unless the Articles of Organization vest management of the Limited Liability Company in a manager or managers. The right to manage between members can be expanded or restricted by agreement.

D. WHO IS LIABLE FOR THE DEBTS AND OBLIGATIONS OF THE BUSINESS?

• Proprietorship: The proprietor. Creditors can reach non-business assets of the proprietor to satisfy their claims.

• Partnership: Each general partner is jointly and severally liable for the debts and obligations of the partnership if the partnership is unable to pay. That means that each partner is liable for the actions of the other partners and employees taken in the course and scope of the partnership business. In a Limited Partnership, limited partners are not personally liable for the debts and obligations of the partnership, unless they participate in management.

• Limited Liability Partnership: Partners in a Limited Liability Partnership are not liable for the debts and obligations of the Limited Liability Partnership, whether arising in tort, contract, or otherwise, or for the acts of any other partner, agent, or employee if the obligation arises while the Limited Liability Partnership is registered. Partners in a Limited Liability Partnership remain personally liable for the partner’s own negligence, wrongful act, or misconduct, including misconduct of any person under the partner’s direct supervision and control.

• C Corporation: Shareholders, directors and officers are generally not liable for corporate debts and obligations. Creditor’s claims are limited to corporate assets. Exceptions exist where the shareholders of the corporation ignore corporate formalities, where the corporation is not adequately capitalized or there exists some equitable basis for disregard of the corporate form.

• S Corporation: Same as C corporation.

• Limited Liability Company: Generally, members and managers are not liable for Limited Liability Company debts and obligations; subject, however, to similar exceptions discussed above for Limited Liability Partnerships.

E. HOW IS INCOME OF THE BUSINESS ALLOCATED FOR TAX PURPOSES?

• Proprietorship: All of the income and expenses of the business are allocated to the proprietor. The proprietor reports all of the income, gain, expenses and losses on his or her individual tax return.

• Partnership: Income and losses of the partnership are passed through to the partners in accordance with their interests in the partnership, and are reported on the partners’ individual income tax returns. The partnership files an income tax return, but pays no tax.

• Limited Liability Partnership: Same as partnership.

• C Corporation: The corporation pays tax on its income, at federal rates ranging from 15% to 35% (35% for corporate taxable income over $10 million; taxable income of more than $15 million is subject to an additional tax equal to the lesser of 3% of the excess or $100,000). Shareholders do not report any portion of corporate income or losses on their individual returns. If there is sufficient cash on hand, a corporation may declare a dividend to the shareholders, which is included in each shareholder's income. There is no deduction for dividends paid at the corporate level. As a result, dividends are, in effect, subject to double taxation.

• S Corporation: Profits and losses of the corporation are allocated among the shareholders according to the percentage of shares owned. The S corporation files an income tax return, but generally pays no tax. Each shareholder reports his or her share of the S corporation's income and losses on his or her individual tax return, at individual rates.

• Limited Liability Company: “Check-the-Box” rules permit a Limited Liability Company with two or more members to elect to be classified as a corporation or a partnership for federal tax purposes. A Limited Liability Company having a single member may elect to be classified as a corporation or a sole proprietorship. A Limited Liability Company that does not elect a particular classification is classified under the “default” rules. If the default provisions found in the Montana statutes are used, the Limited Liability Company is set up to be taxed the same as a partnership. Certain variations from the Montana statute, however, will cause the Limited Liability Company to be taxed as a corporation.

III. SALE AND PURCHASE OF BUSINESS

A. CAN INTERESTS IN THE BUSINESS BE TRANSFERRED EASILY?

• Proprietorship: The proprietor can sell at will. The sale constitutes a sale of assets, including any goodwill or intangibles developed or owned by the business.

• Partnership: Partnership agreements generally prohibit transfer of partnership interests without unanimous consent of other general partners. Even in the absence of such an agreement, each partner may not transfer more than a profits interest (as opposed to an ownership interest) without consent of the remaining partners.

• Limited Liability Partnership: Same as partnership.

• C Corporation: In a corporation with relatively few shareholders, shareholder agreements generally limit transferability of shares of stock in the corporation. In the absence of such an agreement, shares are freely transferable. The Montana Close Corporation Act has special rules on transfer of shares in a Close corporation.

• S Corporation: Same as C corporation.

• Limited Liability Company: Similar to a Partnership. In the absence of an agreement, a member may assign a profits interest (as opposed to an ownership interest), but an assignee can become a member only upon unanimous consent of the other members. Transferability rights can be expanded or restricted through the Articles of Organization or an operating agreement.

IV. DISSOLUTION

A. HOW CAN THE BUSINESS ENTITY TERMINATE?

• Proprietorship: A Sole Proprietorship is not a separate business entity. Therefore, no formal requirements exist to terminate the business.

• Partnership: Generally, a partnership is dissolved and its business must be wound up when a partner gives notice to the partnership of that partner’s desire to withdraw from the partnership, the expiration of the term or the completion of the undertaking of the partnership, or the agreement of all partners.

• Limited Liability Partnership: Same as Partnership. Additionally, failure to re-register with the Secretary of State every five years will cause the Limited Liability Partnership to lose its liability protection.

• C Corporation: If the corporation has a specified term of existence in the Articles of Incorporation, the corporation will automatically cease to exist unless the corporation files Articles of Amendment to extend its life. If the shareholders want to dissolve a corporation, they must file Articles of Dissolution with the Secretary of State. If the corporation fails to file an Annual Report with the Secretary of State, the Secretary of State may dissolve the corporation.

• S Corporation: Same as C Corporation.

• Limited Liability Company: Same as C Corporation, except Articles of Termination rather than Articles of Dissolution must be filed with the Secretary of State.

B. ARE THERE TAX CONSEQUENCES OF DISSOLUTION/LIQUIDATION?

• Proprietorship: No.

• Partnership: Generally, there will be no gain or loss to partners or partnership upon distribution of property where there is a pro rata distribution of assets.

• Limited Liability Partnership: Same as partnership

• C Corporation: Generally, a corporation must recognize gain upon a distribution of appreciated property to its shareholders. The shareholder may also recognize gain. It is difficult to liquidate a corporation without adverse tax consequences.

• S Corporation: Generally, upon a distribution of appreciated property to its shareholders, the S corporation must realize gain. The shareholder may or may not recognize gain. It is difficult to liquidate an S corporation without adverse tax consequences.

• Limited Liability Company: Generally the same as a partnership.