A business operating in the State of Ohio may take one of several forms of organization. The most common forms of organization (not necessarily in the order of their popularity) are sole proprietorship, general partnership, limited partnership, limited liability company, and corporation. This article will provide a brief outline of those forms of organization. If contemplating the formation of a business in Ohio, the reader should consult with an Ohio business/tax attorney to determine the appropriate form of organization for the business, given the number of owners, the type of business, the desired tax treatment of the business, and other considerations.
The simplest form of business is the sole proprietorship, which is owned by a single individual. Under a sole proprietorship, the owner has no partners and has no organizational documents. Typical sole proprietors include babysitters, handymen, and landscapers
A sole proprietor is not required to register his or her business with the Ohio Secretary of State, although the business may be subject to registration with the Ohio Bureau of Workers Compensation and other state and local governmental agencies. The owner may wish to obtain a trade name, or a fictitious name, registration, if the owner operates the business under a name other than his or her own; for example, Joseph Smith operates a business known as “Quality Bait Shop” and registers “Quality Bait Shop” as his fictitious name with the Ohio Secretary of State. A trade name or a fictitious name is sometimes referred to as a “dba,” hence, Joseph Smith dba Quality Bait Shop.
A sole proprietor is personally liable for the debts and liabilities of his or her business, and, therefore a sole proprietorship is a riskier form of ownership than a corporation. A sole proprietor includes the business income and business expenses on his or her personal income tax return, but may obtain a separate employer identification number (an “EIN”) if the sole proprietor has hired one or more employees for the business.
If two or more persons (whether individuals or entities) own the business, the owners can operate the business in several forms, including a general partnership or a limited partnership. In a general partnership, all of the owners are general partners, and no other person has any ownership interest in the business. In a limited partnership, on the other hand, at least one of the partners is a general partner and at least one of the partners is a limited partner. Although, since the mid-1990’s, the limited liability company form of ownership has largely supplanted the partnership form of ownership, some real estate firms, and professional firms of doctors or attorneys, have retained their partnership form of organization.
A general partnership is usually governed by a general partnership agreement signed by all of the general partners. Under the general partnership agreement, each general partner contributes capital and/or other consideration (for example, the partner’s real estate or management skills) to the general partnership. The general partnership agreement also indicates the percentage of ownership of each general partner, and what authority each general partner is given to bind the partnership. Like a sole proprietorship, each general partner is personally liable for the debts and liabilities of the general partnership, just by the fact that he or she is a general partner.
Lenders can and should obtain certain organization documents from a potential borrower, including a general partnership, as part of the lender’s due diligence activities before the execution of the loan documents. Formerly, unless the name of an Ohio general partnership included the names of all general partners, the partnership was required to file a list of the names and addresses of its partners with the Recorder of the County where the general partnership’s principal place of business was located.
Although the law in Ohio is now somewhat unclear as to what filing or registration is required for a general partnership, a lender making a loan to an Ohio general partnership should require the general partnership to provide a “statement of authority” that has been filed with the Ohio Secretary of State. The statement of authority indicates what person or persons (whether a general partner or an authorized agent) has been granted authority by the general partnership to act for the general partnership. The statement of authority is particularly useful if a person dealing with a general partnership has not been able to obtain a copy of the general partnership agreement, and must enter into a contractual relationship with the general partnership.
A lender should also require the general partners to provide a copy of the general partnership agreement, including all amendments, a current certificate of good standing issued by the Ohio Secretary of State, and a certificate of authority, signed by the general partners, authorizing the loan transaction and other transactions between the lender and the general partnership. The certificate of authority should include a sample signature of each general partner, or authorized representative, who is authorized by the general partners to execute the loan documents and transact other business on behalf of the general partnership. If the lender is making a loan secured by real property, the title insurance agency issuing the lender title policy may require that a copy of the statement of authority, certified by the Ohio Secretary of State, be recorded with the Recorder of the County where the real property is located.
A general partnership usually files an information return, rather than a federal income tax return, with the Internal Revenue Service. The gains and losses attributable to a general partnership “flow through” to the general partners. Therefore, those gains and losses are usually reported on the federal income tax return of each general partner based on the respective general partner’s percentage of ownership in the general partnership. If the general partnership has employees, the general partners should obtain a federal employer identification number for the general partnership.
A limited partnership is composed of at least one general partner (an individual or an entity) and at least one limited partner (an individual or an entity). The general partner or partners in a limited partnership exercise the day-to-day management of a limited partnership, while the limited partners are akin to capital investors in the business. It follows that the general partner or partners of a limited partnership are personally liable for the debts and liabilities of the limited partnership, while each limited partner is only liable to the extent of the limited partner’s capital contribution to the limited partnership.
Persons desiring to organize as an Ohio limited partnership usually execute a written limited partnership agreement that governs the operations of the limited partnership. The limited partnership agreement usually indicates the percentage of ownership in the limited partnership of each limited partner and each general partner. The organizing partners must file a certificate of limited partnership with the Ohio Secretary of State, which indicates the names of all general partners and the location of the limited partnership’s principal place of business in Ohio.
A lender making a loan to an Ohio limited partnership should require the limited partnership to provide copies of the limited partnership agreement, including all amendments, the certificate of limited partnership filed with the Ohio Secretary of State, and a current certificate of good standing issued by the Ohio Secretary of State. The limited partnership should also provide the lender with a certificate of authority, signed by all of the general partners, indicating the name and address of each general partner, or authorized representative, who is authorized or required to execute the loan documents for the limited partnership. The certificate of authority should also include a sample signature of each such general partner or authorized representative.
The gains and losses attributable to a limited partnership also “flow through” to the general partners and the limited partners, in accordance with the limited partnership agreement. Therefore, those gains and losses are usually reported on the federal income tax return of each partner, based on the respective partner’s percentage of ownership in the limited partnership. If the limited partnership has employees, however, the general partner or partners should obtain a federal employer identification number for the limited partnership.
Limited Liability Company
The use of the limited liability company form of ownership in Ohio has become increasingly popular in the last 15-20 years, especially for businesses with few or no employees, and has largely supplanted the use of the general partnership and limited partnership forms of organization. Consultants, professionals, technology firms, and many other types of businesses are organized as limited liability companies.
A limited liability company is owned by its member or members. Similar to a limited partner in a limited partnership, a member of a limited liability company is not personally liable for the debts of the limited liability company, unless the member signs the debt instrument in his or her personal capacity, or signs a personal guaranty, which is often the case. Unlike a limited partnership, a limited liability company has no “general partners” who are liable for the company’s debts merely because they are members of the company. Also unlike partnerships, a limited liability company can have one member, or more than one member.
To form a limited liability company under Ohio law, the organizer files articles of organization with the Ohio Secretary of State, on a form provided by the Ohio Secretary of State. Although not required by law, the members of a limited liability company usually sign an operating agreement that governs the affairs of the company. The operating agreement usually indicates the capital contribution (and, therefore, the percentage of ownership) of each member. The operating agreement may also include provisions describing the scope of authority of the chief executive officer of the company, who is usually designated as the “manager” or the “managing member,” and what matters are left to a vote of the members. The members of the company may also designate other offices for the company, for example, a president, a vice president, and a secretary/treasurer.
A lender making a loan to an Ohio limited liability company should require the company to provide the lender with copies of the company’s articles of organization, the company’s operating agreement, including all amendments, and a current certificate of good standing for the company, issued by the Ohio Secretary of State. The lender should also require the company to provide a certificate of authority, or similar document, signed by all of the members of the Company, authorizing the managing member, or other authorized representative of the company, to execute loan documents, and transact other business, on behalf of the company. The certificate of authority should include a sample signature of the managing member or other authorized representative, as applicable.
The operating agreement of a limited liability company will usually indicate whether the members desire to have the company treated as a partnership, or a corporation, for income tax purposes. If the members elect to have the company treated as a partnership, the company itself will not file a tax return, and the gains and losses attributable to the company will “flow through” to the members, as in a partnership. If the members elect to have the company treated as a corporation for income tax purposes, the company will file an income tax return and pay taxes, if applicable, as an entity separate from its members. Like other forms of business organization, if the company has elected to be treated as a partnership for income tax purposes but has employees, the company must obtain an employer identification number.
The corporate form of ownership remains popular in Ohio, especially in the manufacturing sector and in other businesses that require a medium to large workforce, or have a large number of equity owners (although an Ohio corporation can exist with only one shareholder). To form an Ohio corporation for profit, the organizers of the corporation, referred to as “incorporators,” must file articles of incorporation with the Ohio Secretary of State. The articles indicating the name of the corporation, its statutory agent, and the number of shares of stock that the corporation is authorized to issue.
A corporation is owned by its shareholders, and the affairs of an Ohio corporation are governed by its “code of regulations,” which is similar to a set of by-laws. The code of regulations indicates the number of directors of the corporation, usually three, five, or seven, and the officers of the corporation, usually a president, one or more vice presidents, a secretary and a treasurer. Major corporate decisions (for example, acquiring another business, forming a subsidiary, or discontinuing a business line) are made by the Board of Directors.
The code of regulations also lists and describes each corporate office, usually a president, one or more vice presidents, a secretary, and a treasurer. The code of regulations may provide that one person may hold more than one office, for example, one person may hold the offices of secretary and treasurer. The Board of Directors usually appoints each officer and sets each officer’s salary, and may approve an employment contract for the officer. The corporate secretary usually maintains the official records of the corporation, including the share registry.
An Ohio corporation is required to pay to the Ohio Department of Taxation an annual franchise tax, or an annual commercial activity tax (“CAT”), depending on the type of business operated by the corporation. With respect to its federal income tax returns, a corporation may, if it meets certain conditions, elect to be treated as an “S corp,” in which case the corporation need not file a federal income tax return. An S corp is a “flow through” entity, and the income, losses, deductions, and credits attributable to the corporate business are passed down to each shareholder for treatment on the shareholder’s income tax return, similar to the tax treatment of a partnership.
The conditions for classification as an S corp include, among others, that all shareholders must be individuals, certain trusts, or estates, the number of shareholders may not exceed 100, and the corporation may issue only one class of shares. Any for-profit corporation that does not qualify for, and obtain from the IRS, S corp status (sometimes called a “C corp”) must obtain its own tax identification number and file Ohio and federal income tax returns. The dividends paid to the shareholder of a C corp are included on the shareholder’s federal and state income tax returns.
A lender making a loan to an Ohio for-profit corporation, whether an S corp or a C corp, should obtain copies of the articles of organization, and code of regulations, for the corporation, and a current certificate of good standing issued by the Ohio Secretary of State. In addition, the lender should require the corporation to provide a copy of Resolutions, passed by the Board of Directors of the corporation, authorizing the proposed loan and other transactions with the lender, and naming the officers who are authorized to execute the loan documents on behalf of the corporation. The Resolutions should include a sample signature of each officer so authorized, verified as accurate by the Directors (an “incumbency certificate”). The copy of the Resolutions should be certified by the Secretary of the Corporation as being a true and accurate copy of the original.
Other Forms of Business Organization
The statutory law of Ohio, as codified in the Ohio Revised Code, permits the formation of other business entities, including real estate investment trusts (to own but not manage real estate for investment purposes), a business trust, where the chief executive officer is a trustee who operates the business for the benefit of the beneficiaries named in a trust agreement, a limited liability partnership, which is similar to a limited partnership but has no general partners, a legal professional association, which is a corporate form of organization for attorneys, and a limited partnership association, similar to a joint venture, which is a limited partnership that may exist for no more than 20 years.
In Ohio, like many other states, the opportunity to form a business without incurring personal liability, or undertaking the somewhat onerous recordkeeping requirements for a corporation, has expanded opportunities for entrepreneurs to start their own businesses or change their corporate form of ownership.
A lender should be familiar with the various forms of business organizations permitted in Ohio, and the organizational documents appropriate to the borrower’s form of organization. When in doubt as to whether a potential borrower was properly formed under Ohio law, or whether a potential borrower has provided the necessary organizational documents to the lender for the lender to make the loan, the lender should always consult his or her lending manual or the attorneys for the financial institution.
It goes without saying that “entity due diligence” is an essential part of “knowing your borrower.”
Donald E. Miehls, Esq.
Walter & Haverfield, LLP
This overview is intended as general information only. Please note that this information is not legal advice. The reader should consult an attorney with knowledge in this area of the law to determine how the information applies to any specific situation.