A. Entity Overview of LLCs, LPs And LLPs
- (1) Limited Liability Companies
Limited liability companies (“LLC”) are creatures of statute. They can be formed and exist only if the organizational formalities required by the particular statute have been met. Failure to meticulously follow the formalities imposed by a state LLC statute (even misidentifying the na me of the company) could expose the members of the LLC to personal liability for the debts and obligations of the business.
Once properly formed, the LLC combined certain advantageous elements of corporate and partnership forms of doing business. Under state law, members and managers of a LLC are not personally liable for the debts and obligations of the LLC solely by being members and/or managers. Further, under federal law, LLCs and other business entities that are not corporations will be automatically treated as partnerships for tax purposes if they have two or more owners, or will be disregarded if they have only one member. This combination of the protection for all owners from personal liability for the obligations of the entity, coupled with favorable pass-through federal income tax treatment has spurred the enactment of LLC legislation.
A uniform LLC act currently does not exist. The Uniform Limited Liability Company Act, as drafted by the National Conference of Commissioners on Uniform State Laws, has been approved; however, each state has developed its own LLC statute. A discussion of Iowa’s LLC statute is provided in Section D.
(2) Limited Partnerships
- (a) Generally
A limited partnership is a partnership formed by two or more persons under the limited partnership laws of the state. The partnership must have one or more general partners and one or more limited partners. Limited partnerships formed under state statute are categorized as partnerships for federal income tax purposes. A general partner has unlimited liability for partnership indebtedness. As a consequence, if partnership assets are inadequate to satisfy partnership debts, the partnership’s creditors can collect against the personal assets of the general partners. A person admitted as a general partner into an existing partnership is not personally liable for any partnership obligation arising before the admission as a partner. A limited partner is liable for partnership indebtedness only to the extent of the capital which he or she has contributed or agreed to contribute. If however, the limited partner actually acts as a general partner, this limited liability status may not apply.
In order to form a limited partnership, a state statute must be in effect and must provide for the formation of limited partnerships. When organized to achieve limited partnership status, the partnership must substantially comply with the requirements of the applicable state limited partnership statute. A corporation may be a general partner, however if the corporation is insubstantial, a question may arise as to whether the partnership, for tax purposes, is in effect a corporation.
Most states have enacted the Revised Uniform Limited Partnership Act to allow for the formation of limited partnerships in their respective jurisdictions. The act provides that two or more persons desiring to form a limited partnership shall file in the office of the Secretary of State of the state in which the limited partnership has its main/principal office a signed certificate of limited partnership. The objective of these state laws is to assure that all parties dealing with the limited partnership have adequate notice regarding the nature of liability and nonliability of the entity and its partners (general and limited).
(b) Iowa Limited Partnership Statute
- 1. Introduction. Like general partnerships, Iowa has substantially followed the Uniform Limited Partnership Act of 1976 in terms of the formation and operation of Limited Partnerships (“LPs”). An Iowa LP has two classes of partners, general partners and limited partners. General partners have all of the rights, duties and obligations of partners in a general partnership, and limited partners are very similar to a corporation’s shareholders. The obligation of limited partners is limited to the limited partner’s contribution in the partnership. It should be noted that a LP in Iowa can conduct its business as a partnership without limited partners.1
2. Formation. Iowa law does not require a LP to have an agreement. To form a LP, all that is required is to complete and file with the Secretary of State a Certificate of Limited Partnership.2 However, because the information contained in the Certificate of Limited Partnership is rudimentary in nature, a written Limited Partnership Agreement is recommended.
3. Name. The name of each LP as set forth in the certificate filed with the Secretary of State shall contain the words “limited partnership” or the abbreviation “L.P.”3 However, the certificate cannot contain the name of a limited partner unless that name is also the name of a general partner or the corporate name of a corporate general partner or the business of the LP had been carried on under that name before admission of that limited partner.4
4. Commencement of Business/Certificate Requirements. The LP begins when there has been substantial compliance with the requirements of executing and filing a Certificate of Limited Partnership. A Certificate must contain the following:5
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(i) the name of the limited partnership;
(ii) The general character of its business;
(iii) The address of the office and the address of the agent for service of process and the address of its principal place of business;
(iv) The name and the business address of each partner, specifying separately the general partners and the limited partners;
(v) The amount of cash and a description of the statement of the agreed value of the other property of services contributed by each partner and which each partner has agreed to contribute in the future;
(vi) The time at which or events on the happening of which any additional contributions agreed to be made by each partner are to be made;
(vii) A power of a limited partner to an assignee of any part of the partner’s partnership interest and the terms and conditions of the power;
(viii) If agreed upon, the time at which or the events on the happening of which a partner may withdraw from the limited partnership and the amount of, or the method of determining the amount of, the distribution to which the partner may be entitled respecting the partnership interest and the terms and conditions of the termination and distribution;
(ix) A right of a partner to receive distributions of property, including cash from the limited partnership;
(x) A right of a partner to receive, or a general partner to make, distributions to a partner which include a return of all or any part of the partner’s contribution;
(xi) A time at which, or an event upon the happening of which, the limited partnership is to be dissolved and its affairs wound up;
(xii) A right of the remaining general partners to continue the business on the happening of an event of withdrawal of a general partner; and
(xiii) Other matters the partners determine to include in the Certificate.
5. Amending the Certificate. A Limited Partnership Certificate frequently needs to be amended. The certificate of amendment shall set forth (1) the name of the limited partnership, and (2) the amendment to the certificate.6 An amendment to the Limited Partnership Certificate must be filed within thirty (30) days when (1) a new general partner is admitted, (2) a general partner withdraws, and (3) when the business of the limited partnership is continued after an event of withdrawal of a general partner.7
6. Limited Partner Obligations. A limited partner is not liable for the obligations of a LP unless the limited partner is also a general partner or, in addition to the exercise of the limited partner’s rights and powers as a limited partner, the limited partner participates in the control of the business. 8 However, if the limited partner participates in the control of the business, the limited partner is liable only to persons who transact business with the LP reasonably believing, based on the limited partner’s conduct, that the limited partner is a general partner.9
7. Becoming a Limited Partner. A person becomes a limited partner at either (1) the time the LP is formed, or (2) at any later time specified in the records of the LP for becoming a limited partner.10 After the filing of a limited partnership’s original certificate, a person may be admitted as a limited partner if done in accordance with the Partnership Agreement or, if the partnership agreement does not so provide, upon the written consent of all partners, or in the case of an assignee of a partnership interest of a partner who has the power, upon the exercise of that power and compliance with any conditions limiting the grant or exercise of that power.11
8. Voting Activities of Limited Partner. The partnership agreement may grant all or a specified group of the limited partners the right to vote on a per capita basis upon any matter.12 A question may arise, however, concerning the power exercised by the limited partner in voting on partnership matters. Generally, a limited partner who participates in the control of the business of the LP may lose his limited liability status and be treated as personally liable for the partnership’s obligations and liabilities.13 However, Iowa law provides that a limited partner may vote on any one or more of the following without being treated as participating in the business:14
(i) The dissolution and winding up of the limited partnership;
(ii) The sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all the assets of the limited partnership;
(iii) The incurrence of indebtedness by the limited partnership by the limited partnership other than in the ordinary course of business;
(iv) A change in the nature of the business;
(v) The admission or removal of a general partner;
(vi) The admission or removal of a limited partner;
(vii) A transaction involving an actual or potential conflict of interest between a general partner and the limited partnership or the limited partners;
(viii) An amendment to the partnership agreement or certificate of limited partnership; and
(ix) Matters relating to the business of the limited partnership not otherwise enumerated above, which the partnership agreement states in writing may be subject to the approval or disapproval of limited partners.
(i) Being a contractor for an agent or employee of the limited partnership;
(ii) Being a contractor for an agent, employee, manager, member, director, officer, or shareholder of or a limited partner of a general partner, or a partner in a limited liability partnership that is a general partner;
(iii) Consulting with and advising a general partner with respect to the business of the limited partnership;
(iv) Acting as surety for the limited partnership or guaranteeing or assuming one or more specific obligations of the limited partnership;
(v) Taking any action required or permitted by law to bring or pursue a derivative action in the right of the limited partnership;
(vi) Requesting or attending a meeting of the limited partnership;
(vii) Winding up the limited partnership; and
(viii) Exercising any right or power permitted to limited partners under Chapter 487 but not enumerated above.
After the filing of a limited partnership’s original Certificate of Limited Partnership, additional general partners may be admitted as provided in writing in the partnership agreement or, if the partnership agreement does not provide for the admission of general partners, with the written consent of all the partners.17
- (a) Generally
The unlimited liability faced by general partners in a limited partnership form of doing business encouraged states to enact limited liability partnership (“LLP”) provisions to facilitate another form of conducting business. The LLP follows the basic structure of a general partnership but has unique features which allow partners to benefit from partial limited liability. In an LLP, partners often remain personally liable for their own wrongful acts and the acts of those whom they directly supervise, but their personal assets are protected from claims involving the wrongful acts of another partner.
Generally, the LLP is simple and user-friendly, both procedurally and structurally. The transition from general partnership to LLP status is easy and can be accomplished with minimal amount of paperwork and expense.
(b) Iowa Limited Liability Partnership Statute
- 1. Formation. The terms and conditions on which a partnership becomes a limited liability partnership must be approved by the vote necessary to amend the partnership agreement except, in the case of a partnership agreement that expressly considers obligations to contribute to the partnership, by the vote necessary to amend those provisions.18
2. Statement of Qualification. After approval, a partnership may become a limited liability partnership by filing a statement of qualification. 19 The statement must contain all of the following:20
(i) The name of the partnership;
(ii) The street address of the partnership’s chief executive office and, if different, the street address of an office in this state, if any;
(iii) The address of a registered office and the name and address of a registered agent for service of process in this state, which the partnership is required to maintain;
(iv) A statement that the partnership elects to be a limited liability partnership; and
(v) A deferred effective date, if any.
The statement shall be executed by one or more partners authorized to execute the statement on behalf of the partnership.21 The status of a partnership as a limited liability partnership is effective on the later of the filing of the statement or a date specified in the statement.22 The status remains effective, regardless of changes in the partnership, until the statement is canceled.23 The filing of a statement of qualification establishes that a partnership has satisfied all conditions precedent to the qualification of the partnership as a limited liability partnership.24
B. Comparison with Corporations
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(1) Non-Tax Issues
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(a) Limited Liability
An owner of an entity desires limited personal liability for the debts, obligations and liabilities of the entity. This objective can be achieved easily through ownership of stock in a corporation, whether an S or a C corporation, or a membership interest in an LLC. Regardless of the form of entity, however, an individual is personally liable for the individual’s own torts, including any damages caused by his or her own acts or omissions, as well as for any contractual liabilities he or she has personally guaranteed.
(b) Retention of Control
Parents often desire to transfer the future appreciation in assets to younger family members for estate planning purposes while retaining control over the business. This objective is achievable in every type of business entity, even after transfer of a majority of interests. Further, in both a corporation and an LLC, parents can retain all the voting rights in the entity while transferring nonvoting ownership rights to younger family members. However, voting interests may receive valuations significantly more that a pro rata equity interest. However, an LLC offers the ability through mangers to separate voting and control from value because manager status is not conveyed at death.
(c) Continuity of Life
Owners usually do not want other members to have the power to dissolve the entity. This power is no longer a factor leading to corporate tax status. Continuity of life, a basic corporate characteristic, is no longer relevant for income tax classification. It is rapidly becoming the default rule for limited liability companies due to change in state statutes. Under Iowa law, the Articles of Organization must set forth the period of the LLC’s duration, which may be perpetual.26
(d) Transferability of Interests
- 1. Corporations. Free transferability of ownership interests is an essential corporate characteristic. However, with S corporations, a restriction on transferability of ownership interests is important to prevent the termination of an entity’s status as an S corporation because of a transfer to an ineligible shareholder.
2. Limited Liability Companies. Whether a membership interest in an LLC may be assigned depends on the provisions of LLC statutes, as well as the provisions of the operating agreement where the LLC statute permits such flexibility. Under Iowa law, unless otherwise provided in the articles of organization or the operating agreement, a membership interest in an LLC is assignable in whole or in part.27 Further, an assignment of an interest in a limited liability company does not dissolve the limited liability company, and, except as provided in the articles of organization or an operating agreement, an assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member.28
- 1. C Corporations. There are no restrictions on the number or kinds of entities that can own stock in a C Corporation.
2. S Corporations. Federal law imposes limitations on both the number and types of shareholders. In general, there may be no more than 75 shareholders. All shareholders must be individuals except for certain estates of decedents, certain voting trusts, certain grantor trusts, certain trusts for limited periods of time following the death of a decedent, qualified subchapter S trusts, electing small business trusts, and certain charitable and pension organizations. S corporations can have no more than one class of stock.
3. Limited Liability Companies. There are no restrictions on ownership or type of entities.
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1. Corporations. A corporation has centralized management in the corporation’s board of directors. Although the directors are elected by the shareholders, once elected, which seemingly gives the shareholders control of corporate management, the directors are free to act as long as their actions are in the best interest of the corporation
2. Limited Liability Companies. LLCs offer great flexibility in terms of management structure. LLCs can be managed like a general partnership, with every member having management authority, or like a corporation with centralized management by a board of directors.
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1. Generally. Every issuance of securities must comply with the federal securities laws and the securities laws of the state in which the securities are offered, issued or sold. Under federal securities law, every offer or sale of securities must be either registered under Section 5 of the Securities Act of 1933. Most private placements in new ventures will be made pursuant to Regulation D, the private exemptive rule adopted by the SEC in 1982. Under Iowa law, there are numerous transactions which are exempt from state registration requirements.29
2. Corporations. Stock in corporation (whether S or C) is a security for purposes of federal law30 and state law.31
3. Limited Liability Companies.
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(i) Federal Law.
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a. Howey Test. The term “security” includes an investment contract.32 The term “investment contract” is somewhat of a “catch all” category for purposes of federal securities law. The U.S. Supreme Court defined the parameters of an investment contract in the case of S.E.C. v. W.J. Howey Co..33 The Court stated that an investment contract for purposes of the Securities Act means requires (1) an investment of money, (2) in a common enterprise, (3) with profits to come solely from the efforts of others. The third prong subsequently was modified and currently, an investment contract is a security if it evidences:34
i. An investment of funds,
ii. in a common enterprise,
iii. with a reasonable expectation of profits,
iv. to be derived from the entrepreneurial or managerial efforts of others.
In Keith v. Black Diamond Advisors, Inc., the court held that the plaintiff retained substantial control over the LLC such that he did not have an expectation of profits solely from the efforts of others.35 The plaintiff in Keith had a 25% interest in an LLC while a joint venture capital firm maintained a 50% interest. The plaintiff alleged that the firm used its majority position to strip him of control of the LLC.
Additionally, the court in Great Lakes Chemical Corp. v. Monsanto Co. held that LLC members’ ability to remove any manager with or without cause, and to dissolve the company gave the members power to direct the profits it received from others, and thus their LLC interests were not securities for purposes of federal law.36 The court found the LLC interests were not securities even though the members had no authority to directly manage the LLC’s business and affairs.37
However, in S.E.C. v. Parkersburg, the court held that LLC interests were securities for purposes of federal securities law where the investors had little, if any, input into the company and thus their profits were to come solely from the efforts of others.38
This statute essentially codifies the third and fourth element of the Howey test because assuming all members are actively engaged in the management of the limited liability company, profits would not be derived from the managerial efforts of others. If all members are not actively engaged in the management of the limited liability company, it is assumed that Iowa courts would that the LLC membership interest would be a security and thus subject to all state laws concerning the issuance of securities.
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1. Corporations.
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(i) Introduction. Perhaps the most attractive feature of operating in corporate form is that the shareholders of a corporation are not liable for the debts and obligations of the corporation. The effect of limited liability is to protect the shareholder from a loss greater than that of what was invested, and shift a substantial portion of the risk of business failure to creditors and away from shareholders This limited liability principle is stringently upheld under state law.
However, there are instances when the corporate “shell” providing limited liability to its shareholders will be disregarded enabling third parties to impose personal liability upon the shareholders, directors, or officers of the corporation attempting to use the corporate entity as an intermediary to perpetrate fraud or promote injustice.
(ii) General Law. State courts generally employ a two-pronged test when deciding whether to pierce the corporate veil. The first prong requires such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. The second prong seeks to decide whether the acts are treated as those of the corporation alone, for then an inequitable result will follow. Some courts also require that retaining the corporate fiction will work an injustice on the injured party, but this third prong seems to be inherently answered under the second prong of the test, and thus may be superfluous.
This power to pierce the corporate veil, though, is to be exercised reluctantly, and cautiously, with the burden of corporate fiction resting on the party asserting such claim.
One significant factor, which is significant in the inquiry, and particularly in the cases of one-man or closely-held corporations, is whether the corporation is grossly undercapitalized for the purposes of the corporate. The obligation to provide adequate capital begins with incorporation and is a continuing obligation thereafter during the corporation''s operations. The other factors that are emphasized in the application of the doctrine are:
a. failure to observe corporate formalities,
b. non-payment of dividends,
c. insolvency of the debtor corporation at the time,
d. siphoning off funds of the corporation by the dominant stockholder,
e. non-functioning of other officers or directors,
f. absence of corporate records,
g. and the fact that the corporation is merely a facade for the operations of the dominant stockholder or stockholders.
(iii) Iowa Case Law. Iowa substantially follows the analysis given above. Specifically, Iowa courts look at the following factors in deciding whether in deciding whether the corporate veil should be pierced:42
a. undercapitalization of the corporation;
b. lack of separate books for the corporation;
c. corporate finances are not kept separate from individual finances, or individual obligations are paid by the corporation;
d. the corporation is used to promote fraud or illegality;
e. corporate formalities are not followed; and
f. the corporation is a mere sham.
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(i) Introduction. Limited liability companies are distinct from corporations in many ways. For example, the Revised Model Business Corporation Act requires a corporation to file articles of incorporation, adopt bylaws, maintain a registered office and agent, issue shares, hold meetings for the board of directors and shareholders, and file reports.
LLC requirements are less formal. For example, the Wyoming Limited Liability Act, only requires an LLC to file articles of organization, maintain a registered office and appoint managers if the LLC is not to be managed by members. In light of the relatively minimal LLC requirements, courts are not likely to pierce LLCs merely for a failure to follow "corporate" formalities.
However, similarities do exist between corporations and LLCs regarding liability. Member limited liability, like shareholder limited liability in corporations, is perhaps the most valuable feature of an LLC. All state statutes forming LLCs expressly provide such protection. However, most states include a number of exceptions to the general rule that members are not personally liable One exception allows third parties, to whom an LLC is liable, to reach individual members for payment of the LLC''s obligations under a liability theory which is the same as the common law corporate veil-piercing doctrine
(ii) Case Law. Despite the similarities discussed above, there is still uncertainty as to the circumstances under which a court will engage in pierc