Entity Documents Overview
Understanding Entity Documents: A Comprehensive Guide
By definition, entity documents are the pivotal historic, actual or operative documents formed or utilized in entities for purposes of operations, governance or existence of an entity under principles of law. Entity documents establish and form the legal structure, capacity and powers of an entity that also dictate its rules, regulations and government.
In the business world, there are many forms of organization as it relates to a business that use entity documents. These include, but are not necessarily limited to, corporations, limited liability companies, limited partnerships, professional limited liability companies, limited liability partnerships, general partnerships, limited liability limited partnerships, and finite risk insurance companies. All of these different business forms are created under the laws of a specific state or other jurisdiction in order to separate the legal liability of the business from that of its owners with respect to creditors, lenders, guarantors, investors and potential litigants. These entity documents could include articles of incorporation, bylaws, statutes, certificates of formation, articles of organization, operating agreements, certificates of limited partnership, limited liability partnership agreements and other documents. The relevant statutes and/or regulations in any given state or other jurisdiction also dictate many of the substantive minimum requirements for creating and forming an entity and its basic rules and regulations , which require the use of various forms of entity documents.
In the legal realm, there exists and is also used the similar concept of whether a corporation, for example, or some particular legal structure, is in good standing in order to conduct business in the given state or jurisdiction. For example, in Texas, upon the creation of an entity, the person or entity forming it must have a certificate of formation on file with the proper secretary of state. This document sets forth the actual characteristics, rules and regulations for that entity. It is used in conjunction with other filings to establish the entity under principles of law. Once an entity is created and formed, it cannot exist in perpetuity but must be maintained in good standing with the state or other applicable jurisdiction, typically by the filing of annual reports, payment of franchise taxes and the like. The entity also must conduct itself according to the rules, regulations and laws of the state or primary jurisdiction. All of these legal principles exist at both the federal and state levels. These documents are arguably profound in the law and business world because once formed, they can last forever as long as the person or entity obligated to comply with them has the ability and resources to do so, and a litany of strategic options are available to an entity only if the legal rules, regulations and laws are complied with successfully. Entity documents could be also used in a controversial manner if entity shielding is used properly but then might appear as being abused or misused if the laws are not properly followed.
Types of Entity Documents
At the heart of any business entity are its documents. The terms of the relationship between owners, officers and directors (if any) are often found within those documents. Each type of entity has a different type of foundational document, which may also be referred to as the "operating agreement," "bylaws," or "[governing statute] agreement."
General Partnership. The default type of entity is the general partnership ("GP"). A GP does not need to file any documentation with the Secretary of State to be validly formed, but it is wise to enter into a partnership agreement to avoid uncertainties which inevitably arise if an issue were to arise during the life of the partnership. Important highlights to include in a partnership agreement are: terms of admission of new partners, sharing of profits/losses and records of capital contributions. A good partnership agreement will also have a buy-sell agreement which provides a mechanism for the redemption of partnership interest in the event of death or other triggering events.
Limited Partnership. A limited partnership ("LP") is a special type of GP whereby it has a GP and a limited partner ("LP"). The LP has no liability but limited to her investment in the LP. A LP is governed by a LP agreement, required to be filed with the Secretary of State. An example of a LP would be a private equity fund. A LP generally has a buy-sell agreement which provides a mechanism for the redemption of LP interests in the event of death or other triggering events.
Corporation. A corporation is formed via filing of Articles of Incorporation with the Secretary of State. The owners are shareholders and the shareholders are typically entitled to dividends as determined by the Board of Directors. The Board of Directors is a separate party from the shareholders and is responsible for the long-term strategy and oversight of the corporation. A corporation is governed by Bylaws which set forth the powers, duties and obligations of the corporation. Examples of the various provisions set forth in the Bylaws include: how often to hold director/shareholder meetings, how to hold special meetings, voting requirements and procedure, designation of committees, indemnification, approval of transactions and compensation of officers. A corporation generally has a buy-sell agreement which provides a mechanism for the redemption of corporate stock in the event of death or other triggering events.
Limited Liability Company ("LLC"). LLCs are probably the most common form of entity today. LLCs can either be member-managed or manager-managed, with the distinguishing factor being the delegation of authority to make decisions on behalf of the LLC. A LLC must file Articles of Organization with the Secretary of State and in addition the members should enter into an Operating Agreement which sets forth the powers, duties and obligations of the LLC. Some example provisions of an Operating Agreement include; each member’s rights to distribution, management rights, indemnification, election of officers, tax treatment and transfer of membership interests. With respect to the transfer of membership interest provisions in an Operating Agreement, a common clause will provide that the other members have the first right of refusal to purchase the transferred interest. Also, LLCs generally have a buy-sell agreement which provides a mechanism for the redemption of membership interests in the event of death or other triggering events.
The Significance of Precise Entity Documents
The law requires registered entities to maintain detailed corporate records or risk being deemed non-compliant with state, federal, and local rules and regulations. Each file, document, and record should be reviewed, edited, and revised as necessary to ensure that the acceptable Standards of Conduct are being maintained. Disorganization may result in penalties, fines, and even dissolution from the Secretary of State’s office. The following is a general list of documents that should be maintained for a business entity:
One of the unfortunate circumstances that can arise from failing to maintain active and updated entity documents is the triggering of a forced dissolution in state court. An involuntary dissolution is initiated, usually by a creditor, through a court proceeding. If a business is not actively conducting business and has no contributions, members, or shareholders, this proceeding will often succeed. This means the business may be forced to dissolve even though its owners would prefer to keep it in existence.
The structure of your business is crucial to the protection of your assets. Overall, maintaining accurate, complete, and consistent documentation and records will enforce the rules, regulations, and bylaws of your organization.
Techniques for Drafting & Maintaining Entity Documents
The process of creating entity documents begins with a detailed overview of the business and personal objectives of the business owners. In that regard, the formation of the business should involuntarily trigger a strategic and informed decision regarding which legal entity is most suited for the intended business activity. The entity can be formed in multiple states, so it is imperative to determine which state is the best choice for both the entities governance and operations.
Once the entity is formed, there is a series of documents which govern the entity and its manner of operations. For LLC’s, these documents include an Operating Agreement, a Certificate of Formation and a listing of Members of the LLC. The Operating Agreement will govern how the Member(s) will operate the LLC, how profits and losses will be allocated and how new Members can join the LLC. Once the Operating Agreement is drafted, the Certificate of Formation is filed with the Secretary of State of the state that the entity is formed. An LLC will also need to obtain an EIN for its operations which is secured through the Internal Revenue Service.
As these documents are created, one of the duties of the Members is to ensure that all entity documents are kept organized and accessible in a manner which makes them available if called upon during the course of business or during the short life of an LLC. As such, all documents should be kept together in an organized and logical manner. These terms of organization cannot be overlooked as they are essential to the operation of any entity. There are many companies which offer online access to corporate records and other entity information as well as offers of "know your rights" type of services or offers to provide documents (with no reference to services or individual advice) in return for a fee. As a result, a business should take an active role in the organization and preservation of its documents rather than put its hands in the air and simply pay a fee for document delivery.
Another important note is that any time a Member elects to make a capital investment or loan into a business, the Member would be wise to place its own interests in writing, as no one can predict the future of either the entity itself or its Member(s). To that end, securing the name of a local attorney who can advise on these matters and assist with drafting the appropriate documents is strongly encouraged. Also, if there is one Member who makes the bulk of the investments, the other Members should not make the decision on their own to continue with the business if it appears that the main investor is pulling back from its investment in the entity. This may signal an associated withdrawal of its interest thus effectuating a dissolution whereby the remaining Members may receive little to no financial compensation for their investment in the entity’s enterprise. In summary, the key to creating documents for an entity is to 1) carefully consider which documents are needed, 2) understand the types of terms which must be established between and Membe, 3) understand the importance of keeping all corporate records organized, and 4) listen to updates from its Members as to the future of the company’s operations.
Frequent Issues with Entity Documents
Common challenges with entity documents lie in the areas of too old of documents or filings, not having all of the required filings, the documents do not match between states or jurisdictions, incomplete filings, or in a worst case scenario the entities have been completely abandoned and have fallen out of existence.
The issues mentioned above all lead to problems because they will lead to a longer than needed (or necessary) time period to separate the owners from the business and can create additional issues when doing the separation. For an example in a merger the acquisition entity will need an unqualified opinion letter from the target entity’s counsel if the required filings are not available in order to close. The quality of a bankruptcy filing can depend on the required documents with some courts requiring sufficient documentation although most courts will allow for complete turnaround at least once. Obtaining new documents can be very time consuming depending on the state or jurisdiction because most states are behind in processing filings.
Another relevant area , although not the one that most people think of when discussing issues with entity documents, is whether or not the entity has entered bankruptcy. If the entity is in bankruptcy this should lead to planning other than simply having a closing occur through an asset purchase agreement where the entities trade their assets and liabilities.
All of the issues above lead to far greater costs than most people understand because of the need to go back and re-file documents, obtain opinions of counsel, or in the worst case scenario, to abandon the failed entity and start a new entity.
Legal Risks of Erroneous Entity Documents
The risks of incorrect or incomplete entity documents are not just procedural. They can result in substantive legal issues such as liability, tax status, or even the legal standing of the entity.
Liability
One risk inherent in improper entity documents is the risk to a member’s or partner’s liability shield. In some cases, the improper documentation will serve as a piercing of the corporate veil (see the United States v. Fritz & Holzer GMBH case discussed above) and allow the creditor to collect from the individual either instead of or including the corporation or other entity. An individual member may also find an asset of the member itself at risk in other circumstances, especially in a single member entity. Again in the Fritz & Holzer case discussed above, under circumstances that included improper recordkeeping and informal distributions, a German GmbH (a limited liability company) was found to have been a sham and the assets of the LLC attached.
Tax Status
The risk to the tax standing of an entity may also be a substantial risk. The IRS has several specific requirements that must be met for an entity to achieve its desired taxation treatment. For example, in order to qualify as a subchapter S corporation, the corporation must meet several requirements, including those relating to the number of owners and the type of stock. One of the requirements is that the subchapter S corporation must only have one class of stock. If you have a corporation with more than one class of stock, or convertible preferred stock, then the corporation fails to qualify under subchapter S.
Another example is the purpose of the entity. If an entity was formed to achieve a tax benefit under the tax code, the LLC must actually operate in such a manner as to achieve the purpose of that classification. Missouri law does not give a member random latitude to apply any tax classification that member arbitrarily wishes. In an April 2000 ruling, an Administrative Law Judge struck a tax classification on various transactions of the Thomas Blueberry Farms and Blueberry Fields, LLC asserting that the LLC was a sham entity created for tax benefits, not for a legitimate and active business interest. The case, WHC, Inc. v. Department of Revenue, 40 Missouri Tax LEXIS 105.
Entity Documents: An Eye to the Future
As we look toward the future and consider the trajectories of business formation such as LLCs and corporations, we can expect both continuity and change. The fundamental reasons for forming and maintaining these entities will not change; individuals and businesses want protection from liability, potential tax advantages, and the ability to carry on business more broadly. New forms and structures will likely not emerge, but we may see different ways of documenting and maintaining our understandings of these newer forms.
Inside the Four Corners
In the future, companies will continue to look at how they document their compliance with both legal and regulatory requirements – and will evaluate the pros and cons of an internal working system focused on the "Four Corners" of the document as compared with a digital database or a repository backed by technology where we can easily access the information we need about our entities with as little effort as possible.
Ultimately, the future of entity documentation will be driven by changing legal requirements, which continue to evolve in a world in which the desire to shield individuals and investments from liability is paramount. In the realm of LLCs, states are increasingly moving toward more uniformity. And you will see legal requirements move in that direction as well.
Beyond some notion of the Four Corners of a document (which are the BYLAWS of a corporation and the OPERATING AGREEMENT of an LLC), we will have to contend with how regulators interpret these documents . To be sure, the process will be driven by emerging regulations and technological changes that will be demanded by sophisticated parties who want to document their legal relationships: how will companies capture, comply, and avoid liability in a regulated world? How will individuals impact that world, and what role will technology play?
As we move toward a regulated world, there will be a renewed tension between individual rights and concerns about centralized government practices (such as the Privacy Bill in the EU). Just how to incorporate those ever-evolving tensions into the Four Corners is something on which we as outsiders aren’t ready to opine yet.
The Future of Documenting Formations
What does it mean to document a formation? Does it mean copying and pasting once and then filing old documents as new? Does it mean redrafting and re-executing documents each time there is a change? Does it mean filing a formation in a digital world – or just filing a piece of paper? When states went online a dozen years ago, the states began to digitize the information on the formation filings and on the annual returns.
But these documents are not going to become automatons (even if we digitize them). They are just documents. What they create is the relationships among people and the relationships – both internal and external – that those legal documents create. In the future, those documents will just be the proxies that we use to create those relationships; the core function of those documents will not change.
From a practical perspective, the way that we document our understanding of relationships among individuals and entities is also evolving. As we move toward the future, those documents and processes will likely begin to look very different than they do right now.