May/June 1997
Which direction should you take on the road to structuring your scrap recycling business—sole proprietorship, partnership, corporation, or limited liability company? This primer can help you choose the legal entity that’s best for your firm.
By Walter G. Wright Jr., Kala S. Rogers, and Robert S. Jones
Walter G. Wright Jr., Kala S. Rogers, and Robert S. Jones are attorneys with Mitchell, Williams, Selig, Gates & Woodyard P.L.L.C. (Little Rock, Ark.).
A critical component of every business is its legal structure—that is, whether it’s a sole proprietorship, partnership, corporation, or limited liability company.
A firm’s structure addresses critical issues such as governance, ownership, succession, and the events that can trigger the dissolution or sale of the business. In addition, the structure can minimize the owner’s or owners’ tax burden and protect individuals from being held personally responsible for the liabilities of the business.
But such benefits are available only if the correct structure is chosen. And they may, in fact, be lost if the requirements for the creation and maintenance of the organization aren’t properly followed. It’s crucial, therefore, that business owners give careful thought to choosing the best possible legal structure.
Selecting the appropriate configuration is especially important for scrap recycling firms, particularly when it comes to liability issues. As all recyclers know, the acquisition, transportation, handling, storage, processing, brokering, and/or sale of scrap recyclables can pose risks. Recyclers can also be exposed to off-site liabilities related to activities such as transportation spills or Superfund cleanup actions.
Fortunately, scrap recyclers have several options—some old, some new—for structuring their businesses, a few of which can protect their assets from the liabilities of their operations. Here’s a review of the business structures typically used in the scrap industry, including the pros and cons of each.
Going It Alone: Sole Proprietorship
A sole proprietorship is a business entity in which one person is the owner. This type of business is considered the simplest to form and operate. It is, in fact, the “default” form of business entity in that, if no other structure is chosen, a sole proprietorship is presumed. No special formalities or procedures are needed to create it, though the owner may need to make a filing of record for an assumed or fictitious name if the business is being operated under a name other than his or her personal name.
The chief benefit of being a sole proprietor is that the net profits of the business are considered personal income for tax purposes, which means there is no double taxation—defined as taxation of both corporate and personal income—as there is with other types of business entities.
A serious disadvantage is that the sole proprietor is responsible for all debts of the business. Actions of the agents and/or employees of the business can cause the personal assets of the sole proprietor to be subject to creditors’ claims. Also, the sole proprietor is almost always named as the primary party in litigation by or against the business and will be liable for any judgment rendered against the business. The bottom line is this: While the sole proprietor enjoys the benefit of owning all the assets and collecting all the income from the business, he or she also faces unlimited liability for all obligations, expenses, claims, and other liabilities of the business.
In the area of succession, a sole proprietorship is not an indefinite entity with an existence of its own like a corporation. Its existence terminates upon the death of the owner, with its assets and liabilities being processed through whatever form of testamentary disposition the owner has planned. If the business is sold to another individual, it would become a new and distinct sole proprietorship, not an extension of the prior one.
Working Together: Partnership
Some scrap recyclers use a partnership as the entity through which they operate new ventures or contract with other persons or companies.
There are two types of partnerships: general and limited.
General partnership. A general partnership is a business entity in which two or more persons combine their skills, experience, and capital to engage in a business for profit. Such an arrangement requires an agreement between the partners. While this agreement can be oral or simply interpreted from the partners’ actions, the preferred method is to have a written agreement. Aside from the initial formation and licensing requirements, general partnerships aren’t subject to any specific, ongoing recordkeeping requirements.
The income of a general partnership flows through the entity and is regarded as the individual income of the partners, being divided based on the respective ownership of each party. As with a sole proprietorship, a general partnership isn’t subject to double taxation of its income.
A major disadvantage is that each partner has joint and several liability for all the obligations of the business. Their personal assets are at risk to the extent that partnership assets are insufficient to cover the firm’s liabilities.
Additionally, each partner is able to obligate the partnership and other partners to a contract even if those other partners don’t agree. The result is that each partner would be responsible either individually or as part of the group until such obligations are fully satisfied.
All property contributed to or purchased by the partnership is considered the property of the partnership, rather than that of an individual partner. The partners have equal rights to such property for partnership purposes, but not for individual purposes. Each partner also has a right to his or her interest in the partnership itself, which is comprised of his or her share of profits.
In a general partnership, each partner has a personal and equal interest to actively participate in the management and control of the partnership. This right cannot be delegated, assigned, or otherwise transferred to any other individual, even upon a partner’s death. If there are three or more partners in the partnership, a simple majority of the partners will settle the decisions of the business, unless the partnership agreement specifically dictates otherwise.
A general partnership dissolves when any partner discontinues his or her association with the business. While this dissolution doesn’t automatically discontinue the operation of the business, it does terminate the authority of the partners to act on one another’s behalf and bind the other partners, except as necessary to complete a “winding-up” process.
Limited partnership. A limited partnership is a variation in which the liability of certain “limited” partners is held to a certain amount. Like a general partnership, a limited partnership is a business entity in which two or more persons engage in a business for profit.
Limited partnerships are governed by state statutes, which set out specific requirements for their formation. A certificate of limited partnership must typically be filed with the office of the secretary of state. And limited partnerships require an agreement between the parties that should address the split of profits, losses, and tax allocations among the partners. Absent a specific provision in the partnership agreement, these items are allocated in proportion to the contribution of the partners to the limited partnership.
Unlike a general partnership, a limited partnership has two categories of owners: general and limited. A limited partnership is operated exclusively through its general partner or partners. Not only are limited partners prevented from participating in the operation of the partnership, but if they do participate, they may lose the limitation of liability granted to them in accordance with their role.
As in a general partnership, general partners in a limited partnership are able to obligate both the partnership and other partners to contracts. Also, except for the limitation on limited partners regarding involvement in management activities, the customs and practices of operating a limited partnership are similar to those of a general partnership regarding distribution of assets and joint and several liability. Further, when properly structured, limited partnerships are taxed just like general partnerships, receiving pass-through treatment with only one level of tax paid by the owners.
While a limited partner generally risks only his or her investment in the partnership for partnership debts and liabilities, there is an exception to the limited liability of a limited partner. That exception is that a limited partner can’t use his or her status as a limited partner to protect themselves from liability for their own acts. If a limited partner guarantees a partnership debt on behalf of the business, for example, the limited partner places his or her personal assets at risk to satisfy that particular partnership debt.
Generally, limited partnerships can be dissolved following the same rules that govern the dissolution of general partnerships.
The Industry Standard: Corporation
Corporations are the predominant form of business entity in the United States. Most scrap recyclers operate their businesses through one or more affiliated corporations. The motivation lies in the opportunity to invest capital in one or more ventures without risking—in most instances—personal assets. The limited liability company is, however, gradually becoming the entity of choice for recyclers because it offers limited liability with arguably fewer burdens and restrictions than the corporation structure.
A corporation differs from a sole proprietorship and a general partnership in many ways, but one distinct difference is that a corporation is a product of state statutes—that is, it can only be formed pursuant to state law. Also, a corporation is a separate legal entity and is considered a “person” in most circumstances.
A corporation is formed by one or more persons who act as co-owners of the business. It is essentially a vehicle to obtain funds from investors, or shareholders, for a common business purpose. These shareholders are the equity owners of the corporation.
The corporation provides a formal internal management structure, with the board of directors elected by the shareholders having the primary responsibility for managing the enterprise. Many of the day-to-day operations are performed by the corporation’s officers, who are appointed by the board of directors. The corporate officers have the responsibility and authority to act on behalf of the corporation and bind it.
Typically, the primary formation requirement for a corporation is the filing of articles of incorporation with the secretary of state. These articles must set out the name of the corporation, which in turn must include the term corporation, incorporated, company, limited, or an abbreviated form of one or more of these terms. The articles of incorporation must also include the name and address of the registered agent and the incorporators, the address of the registered office of the corporation, an explanation of the stock the corporation will be authorized to issue, and a general statement of the corporation’s purpose.
In addition to filing articles of incorporation, a new corporation must prepare bylaws that outline the general parameters of its day-to-day operations. Organizational meetings must also be held to elect directors and appoint officers.
The primary advantage of a corporation is that it’s responsible for its liabilities and obligations to the full extent of its assets. The assets of the individual shareholders generally aren’t at risk for the liabilities of the corporation.
It should be noted, however, that a shareholder may risk his or her personal assets to the corporation’s obligations if the obligation arises out of the shareholder’s own actions, the shareholder personally obligates himself or herself for a debt of the corporation, a creditor convinces the court to disregard the limited liability protection for public policy purposes, or federal and state environmental statutes have been interpreted to impose individual liability.
One disadvantage of corporations is that they are subject to extensive and mandatory administrative and recordkeeping requirements. These procedures entail considerable work and may be a deterrent to choosing the corporate form of business entity.
Another primary disadvantage of certain corporate entities is the potential for double taxation of income. This income tax treatment depends on whether the corporation is either a C-corporation or an S-corporation, so-called based on the controlling section of the Internal Revenue Code.
In contrast to partnerships, a corporation’s existence can be perpetual. The death, disability, or termination of a shareholder will not cause the corporation to dissolve or otherwise terminate its existence as an entity.
C-corporations. Corporations controlled by Subchapter C of the Internal Revenue Code are separate taxable entities. While shareholders don’t have any personal income tax liability arising from the taxes generated by a C-corporation, there are substantial potential income tax implications arising from transactions between a C-corporation and its shareholders.
In essence, there are generally two levels of taxation in a C-corporation. If the corporation has net taxable income, the corporation pays taxes on that income. Additionally, any distribution to the shareholders will generally be considered dividend income upon which shareholders must pay income taxes. Accordingly, income from the corporation is subject to both corporate and individual taxation. Such double taxation is the main disadvantage of a C-corporation.
S-corporations. S-corporations, in contrast, are not separate taxable entities and have traits more comparable to partnerships for tax purposes. The net income of the corporation is allocated among the shareholders based on their respective ownership interest. The S-corporation, as an entity, isn’t required to pay taxes on the income. Accordingly, there is only one level of tax at the shareholder level, which is the primary attraction of an S-corporation.
A New Option: Limited Liability Company
A limited liability company, or L.L.C., is a new form of business entity created by statute and now authorized in all 50 states. It has become the favored entity of many scrap recyclers because it blends aspects of corporations and partnerships to create a unique organization with opportunities not available in any other form of entity.
An L.L.C. may have one or more owners or “members” and is formed by filing articles of organization with the secretary of state. These articles are the equivalent of articles of incorporation or a limited partnership certificate. The operation of the company is governed by a written operating agreement among the members.
There are two basic options for management of the firm: member- or manager-managed.
With a member-managed company, each member has equal rights to manage and conduct the business of the company similar to the partners of a general partnership. With a manager-managed company, the members elect or appoint a person or persons to manage the company.
As the name suggests, one important benefit of an L.L.C. is that it offers its members liability protection. A member is not liable for the debts or obligations of the company merely due to his or her status as a member and, unlike limited partnerships, there is no individual who must bear unlimited liability. The personal assets of the member generally aren’t subject to creditors’ claims. The investment of the member in the L.L.C. is the only asset at risk for the company’s obligations. This protection is available to members even if they’re involved in the day-to-day operation and management of the company.
Thus, L.L.C. members receive the same limited liability protection available to limited partners and corporate shareholders, but without any constraint on participation in the operation or control of the business. As with other types of limited liability entities, however, an L.L.C. member can’t be protected from liability arising from his or her personal actions.
Another advantage of an L.L.C. is that, unlike a C-corporation, it doesn’t subject its members to double taxation when properly structured. Also, L.L.C.s aren’t burdened with the onerous meeting and recordkeeping requirements of corporations.
Similar to general and limited partnerships, L.L.C.s are dissolved upon the occurrence of certain events to its members, such as death or bankruptcy. Dissolution isn’t mandatory, however. The business can be continued if all members consent or if it is so stated in the written operating agreement.
The Conversion Question
One question for recyclers who already have an operating business is whether they should switch to a different form of entity. In making such a choice, it’s essential to weigh several factors, including liability protection, management structure, tax consequences, and the cost of conversion.
As a general rule, conversion from one form of entity to another can be legally accomplished, but the cost or complications can sometimes be a problem. In most instances, the problem isn’t completing the conversion, but the legal ramifications of it. It’s important to ensure that the conversion from one entity to another isn’t prohibited by agreements to which the recycler is party, such as a major scrap supply contract. Further, the recycler should ensure that the conversion considers any potential impact on previous or future recycling tax credits provided by various state programs.
Going from a sole proprietorship to any other form of entity is a simple process of transferring the assets and liabilities of the business to the new entity. The sole proprietor receives an interest in the new entity in exchange for those assets and liabilities. Significant advantages such as liability protection and continuity of existence can be gained in other entities.
Converting into a general partnership is easily done from a legal standpoint. A person simply needs to find one or more other persons to be partners and agree to form and operate a partnership. A complete conversion to a general partnership would be advisable in normal circumstances only for a sole proprietor who wants to join with others, though other types of entities may be preferred over the general partnership.
Converting from either form of partnership into any other form can also be accomplished. The partners can either transfer their partnership interest to the new entity or they can transfer assets and liabilities to the new entity. Where partnership interests are transferred to the new entity, the previous partnership automatically dissolves. When assets are transferred, the partners must take steps to dissolve the partnership if they want to personally own the interest in the new entity. In most cases, a transfer of partnership interests will be preferable. Separate transfers of each asset aren’t necessary and the transfer of partnership interests isn’t subject to transfer taxes that would apply to a transfer of assets such as real estate.
The L.L.C. is currently the most popular conversion target. Given the L.L.C.’s similar tax treatment and greater liability protection, general and limited partnerships may want to consider converting. In a properly planned and executed conversion, no income tax liability is created and the new L.L.C. is simply considered the continuation of the former partnership. The flexibility in management structure allows recyclers to manage the new business in a manner similar to the former one—member-managed for general partnerships and manager-managed for limited partnerships. An L.L.C. can also offer opportunities to involve passive investors and provide for continuation of the business.
Debt relief is a key consideration when converting to an entity that offers more liability protection than the current one. Generally, transfers to a partnership or corporation aren’t taxable, but this tax-free treatment doesn’t apply when a person is relieved of debt. A relief of debt is treated like a distribution of money and gain is recognized to the extent money is received. Care should be exercised that gain and tax aren’t triggered by debt relief in a conversion.
Corporations offer unique opportunities and problems in the conversion area.
The biggest set of problems lies in the tax treatment of the conversion. The tax cost of the transaction in most cases will be prohibitive.
The tax issues relating to the conversion of a C-corporation vary based on which entity the corporation is converted into. The most likely conversion for a C-corporation is to make an S election. The corporation will then receive the benefit of pass-through income with some limitations. S-corporations that have C-corporation history are subject to built-in tax gains. This means that a corporate-level tax is imposed on the difference between the fair market value and adjusted value of the assets at the time of the election. The tax is triggered if any of these assets are sold in the 10-year period after the election.
The conversion of a C-corporation to any of the other entities in almost all circumstances isn’t an option due to the substantial negative tax consequences. If the corporation owns appreciated assets, the conversion can’t be accomplished without a double tax being imposed.
An S-corporation faces a problem similar to a C-corporation with a conversion to any noncorporate form of entity. While an S-corporation doesn’t face a double tax, a single level of tax will be paid in any transaction that distributes appreciated assets from the corporation.
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As this primer shows, there are significant distinctions between the different legal business structures. Every scrap recycler launching a new operation should recognize the crucial importance of not only selecting the right entity, but also in properly establishing and maintaining it. For the vast majority of recyclers with already-established business structures, it may be beneficial to consider converting to one of the newer entities—such as an L.L.C.—in the future.
But whether keeping an old structure or changing to a new one, the goal is the same—to operate under the legal structure that best suits the business needs of the company and the personal goals of its owners or partners. •
Editor’s note: This article is intended as an introduction to the different legal business structures, not as professional advice. Recyclers are advised to consult an attorney well-versed in business law before making any changes to their corporate structure.
Which direction should you take on the road to structuring your scrap recycling business—sole proprietorship, partnership, corporation, or limited liability company? This primer can help you choose the legal entity that’s best for your firm.