Choice of Entity

What are Business Entities?

Why is it important to choose the right entity when forming your business?

A business entity describes the legal structure under which a business operates. If you wish to start a cooperative business, it is important to choose the right entity for a number of reasons, including the application of employment law, liability, and taxation. This chapter includes a very broad overview of such issues. For additional discussion, please refer to the other relevant chapters in this manual.

What if I start doing business before forming an entity?

If you start doing business before officially forming an entity, the law presumes that you are either a sole proprietorship (if there is one business owner), a general partnership (if there are multiple owners of the business) or, in certain cases, an unincorporated association. Sole proprietors, general partnerships and unincorporated associations are UNLIMITED liability entities. These entities pose a risk to their owner(s) because someone who sues an unlimited liability entity can reach not only the assets of the business, but also the personal assets of the owners, such as their car, bank account, or home.

When thinking about whether you need a limited liability entity, think about the activities your business will engage in and the risks these activities may create. For example, will you be serving food to people? Will they be walking into your store? Will you be doing work on someone else’s property? Will you have employees? Think about what could possibly go wrong in all of these scenarios, and then prepare yourself for the chance that you or your business may get sued.

How do I protect my personal assets?

Form an entity that is protected by the limited liability shield!  The most common limited liability entities are limited liability companies (LLCs) and corporations. In most cases, if you form your business as a limited liability entity and maintain its entity status, you can protect your personal assets.

In order to maintain the entity’s status, the entity must do things such as: observe corporate formalities, avoid mixing personal assets with company assets, and provide adequate funding for the business to operate.

Corporate formalities include filing the correct papers with state and local governments, maintaining separate bank accounts and financial records and contracting in the entity’s name, not your own name.

Beware though–limited liability entities usually cost money! In California, for example, they are generally subject to a minimum annual franchise tax of $800.

Do I need insurance?

Even if you have a limited liability entity, you should still get insurance. This is because, while the entity protects your personal assets, it will still cost you money to defend yourself or your business if you get sued. A good insurance policy will cover those legal expenses. The main type of insurance you should consider is general liability insurance, which covers bodily injuries, property damage and other losses that could occur as a result of the operation of your business. You should also probably carry workers’ compensation insurance if you have employees (see the employment law section of this handbook), product liability insurance, and commercial automobile insurance if your business uses vehicles.

Cooperatives that are not Cooperatives

When helping a client to start a cooperative, the first thing an attorney should do is review the cooperative statutes in the relevant state.  This is always an interesting exercise because state laws governing cooperatives vary so much.  You may find there is no cooperative statute at all, or you may find there are three or four different cooperative statutes for various purposes.  For various reasons, you may end up deciding that your client would be better off forming under a non-cooperative statute.

For example, let’s say a group of people approach you and they want to form a cooperative to develop software.  They will be working on software for a while before they will have any real income.  Let’s say there is a cooperative statute in your state and, like most cooperative statutes, it defines cooperatives as corporations.  As someone who is familiar with employment law, you know that if a group of people form a corporation and work for the corporation, there might be a presumption that these people are employees. (However, this presumption may have recently been weakened by the U.S. Supreme Court, in the ruling Clackamas Gastroenterology Associates, PC v. Wells, 538 U.S. 440 (2003). See the section on Employment Law.)  This means that the members of the cooperative would have to be paid at least minimum wage from day one, and all other employment law requirements would apply, such as the need to do payroll tax deductions, purchase workers compensation insurance, pay overtime, and so on.  In this case you may suggest that your clients form an LLC structured like a cooperative.  LLC owners are not generally considered employees and therefore there would have more flexibility with respect to minimum wage, withholding, workers compensation, etc.  Of course it would be essential to read Chapter 7 of this book and research these issues in your state before making a recommendation.

Another example: a group of parents come to you wanting to create a cooperative school for their children.  It is very important to them that they control the school and they also want to be able to apply for grant funding because the parents don’t think they will charge enough tuition to cover costs.  In this case, you may advise your client to form a membership nonprofit and apply for 501(c)(3) tax exemption.  The parents would be entitled to elect the board on a one-member-one-vote basis just as they would in a cooperative, but the organization would be eligible to receive tax deductible donations and grants that a cooperative would not be.

Some “cooperatives” can also form as nonprofit mutual benefit corporations. This type of entity is used by some cooperative housing groups, cooperative groceries, credit unions, and other consumer cooperatives.  The important point is that a group of people that want to form an organization that follows cooperative principles may or may not end up forming an actual statutory cooperative.

Choosing an Entity for a Worker-Owned Business

A worker-owned business should probably form as some type of limited liability entity. The business has many choices in entity formation, including forming as an LLC, a domestic stock corporation, a cooperative corporation, a flexible purpose corporation or a benefit corporation. However, the most commonly used entities for worker-owned businesses are the cooperative corporation and the LLC.

Cooperative Corporation or LLC?

What are some important benefits and considerations of the LLC and the cooperative corporation?

The choice between the limited liability company and the cooperative corporation depends on each cooperative’s specific circumstances. The following are some main differences between the LLC and the cooperative corporation.

Naming the business

In California, in order to use the word “cooperative” in its business name, a cooperative must be incorporated under the California Consumer Cooperative Corporation Law. Therefore, if you want to include the word “cooperative” in your business name, you should incorporate as a cooperative corporation. An LLC may not use the word “cooperative” in its name, but may use related words, like “collective” or “collaborative.”

Employment status

Sometimes, the people who form a cooperative corporation and work for that cooperative corporation are presumed to be employees. The question of whether cooperative corporation members are employees is a complicated legal issue discussed in the employment law section of this handbook. If the members are indeed considered employees, then members would have to be paid at least minimum wage. You would also have to comply with other employment requirements, including payroll tax deductions, issuance of W-2s, purchase workers’ compensation insurance, pay overtime, etc.

In contrast, LLC owners are not generally considered employees. Therefore, a worker cooperative that is formed as an LLC may have more flexibility with respect to minimum wage and overtime, withholding, workers’ compensation insurance, etc.

Governance structure

The LLC also tends to be a more flexible type of organization. The rules governing the operation of an LLC are contained in the Operating Agreement, which is agreed to by the worker-members of the company. The cooperative principles of “one member, one vote” can be written into the Operating Agreement. However, because the Operating Agreement is so flexible, there is a risk that future worker-owners could change and remove the cooperative provisions, unless the Operating Agreement is structured carefully to avoid such possibilities. Conversely, the cooperative corporation has the ideals of “one member, one vote” embedded in its DNA. This ensures that worker-owners continue to own and control the business. Also, a cooperative corporation must have a board of directors. A limited liability company may or may not have a board of directors.

Profit-sharing and taxes

Both the LLC and the cooperative corporation allow for worker-owners to share in the profits of the business. Members of a worker cooperative share in the profits based on “patronage”, which most worker cooperatives measure based on the number of hours each member works. The more “patronage” you have (for example, the more hours you work), the greater the profit-share to which you are entitled. Either an LLC or a cooperative corporation could also include other factors such as “job creation” or a “founder’s multiplier” to vary profit distribution based on what is perceived to have been the value of the worker-owner’s contribution for the year.

LLCs and cooperative corporations both have tax advantages when compared to other corporate entities, because they are able to avoid double taxation. Typical corporations have to pay taxes once on their profits at the corporate level, and shareholders must pay taxes again when they receive dividends, hence the term double taxation. However, if it meets the requirements of Subchapter T of the Internal Revenue Code (discussed later in this manual), the cooperative corporation would avoid double taxation. The cooperative corporation could avoid double-tax on some of its profits if they are derived from members’ labor, paid out to the members as patronage refunds/patronage dividends, and the cooperative complies with other requirements of Subchapter T. In comparison, a limited liability company is generally considered a “pass-through” entity, where profits and losses are not allocated at the entity level, but directly accounted to the members. There are some other tax differences between LLCs and cooperative corporations, so it’s a good idea to check with an accountant to find out if one will serve your business better than the other.

Contractor’s license issues

In 2010, California passed a law that allows LLC’s to obtain a contractor’s license. However, if you are considering forming a business that requires a contractor’s license, the cooperative corporation may be a better choicebecause an LLC must pay higher insurance and bond postings than a corporation.

Graphic Guides to Choosing a Legal Entity

A worker cooperative may incorporate as a cooperative corporation, if one exists under state law, but there are other options as well. Below are factors to consider about various entity types. The first chart address the cooperative corporation and LLC entity choice in California, as well as the most common tax status options.

The content below is courtesy of Democracy at Work Institute.

Steps to Forming A Cooperative Corporation  

Choice of Business Entity

Choosing an appropriate legal entity to carry out your anticipated activities is one of the most important first steps in establishing your cooperative business. The ultimate decision about which legal form to use will depend on specific facts and circumstances about your business andr long-term business goals. Here we are assuming you are forming a cooperative corporation. Next we will consider an LLC.

Steps Before Incorporation

1. Choose a business name (which includes “Cooperative” and an abbreviation that indicates that the co-op is a corporation, such as “Incorporated” or “Inc.”) check for availability of that name with the California Secretary of State.
2. Identify initial members and/or board of directors
3. Decide whether and how to issue membership shares
4. Prepare bylaws (See Appendix for Sample Bylaws)
5. Develop membership agreement (“disclosure document”) and receipt. Given to individuals before they are accepted as members; see Appendix for Sample Disclosure Document.)
6. Determine which (if any) licenses, permits, and insurance must be procured
7. Prepare and file the Articles of Incorporation with the Secretary of State. The filing fee is $30.
8. File a Statement of Information with the Secretary of State within 90 days of filing the initial Articles of Incorporation. The filing fee is $20.

Steps After Incorporation

1. Hold the first directors meeting –adopt bylaws, appoint officers, and discuss other business plans (Members may jointly govern the business by making every cooperative member a director.)
2. Obtain employment identification number (EIN) with IRS and employer account number with the state
3. Open bank account for the cooperative
4. Obtain licenses, permits, insurance
5. Hire or retain accountant or bookkeeper to manage finances
6. Maintain up-to-date membership records (names & addresses)
7. Implement an operational and management structure (designating committees or managers for the operation of the business)

Steps to Forming an LLC

The legal steps to form an LLC in California are as follows:

• Choose a business name (which includes an LLC designator, such as “Limited Liability Company” or “Limited Company” or an abbreviation of one of these phrases, such as “LLC,” “L.L.C.” or “Ltd. Liability Co.”) and check for availability of that name with the California Secretary of State.
• Prepare and file the Articles of Organization with the Secretary of State using Form LLC-1. The filing fee is $70.
• Negotiate and agree to an Operating Agreement with your fellow worker-owners, which sets the rules for how the LLC will operate.
• File a Statement of Information with the Secretary of State within 90 days of filing the initial Articles of Organization using Form LLC-12. The filing fee is $20.

A number of steps are critical to successfully launching any new business enterprise. Here, we outline some key legal steps to starting a worker-owned business. For a detailed outline of the business steps to start a worker cooperative, we recommend the Steps to Starting a Worker Co-op Manual, published by the Center for Cooperatives at the University of California, Davis and the Northwest Cooperative Federation, available below in English y en Español:

Converting from an LLC to a Corporation or from a Corporation to an LLC

Yes. There is a small fee ($150) for conversion and some accounting hurdles. We advise our clients to choose one entity type and plan to remain as that entity type. There may be negative tax consequences for conversion from one entity to another because certain assets that are transferred may be subject to capital gains tax.