TEXAS FORMS OF ORGANIZATION Baker Botts L.L.P.

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1 Last Updated: January 2010 TEXAS FORMS OF ORGANIZATION Baker Botts L.L.P. Table of Contents 1. Nonprofit Corporations 2. For-Profit Corporations 3. Limited Liability Companies 4. Low Profit Limited Liability Companies 5. Joint Ventures 6. Unincorporated Associations 7. Partnerships and Limited Partnerships 8. Sole Proprietorships 9. New Forms of Hybrid Organizations The most common legal form of organization utilized by the social sector is the nonprofit corporation although for-profit corporations, limited liability companies (LLCs), joint ventures and various kinds of partnerships, including limited partnerships, are increasingly being used typically to accommodate plans to earn revenues or access capital markets. Each of these forms of organization has advantages and disadvantages and sometimes, with the help of experienced counsel, they are used in combination to maximize strengths and minimize weaknesses of a particular form. The following chart provides a high-level overview of various organizational forms that can be used in the social sector. More detailed descriptions of each form follow in the subsequent text. 1

2 Nonprofit 501(c)(3) Corporation For-Profit Corporation B Corp (a forprofit corporation with a social mission that is licensed to use the trade name B Corporation ) Formation File articles or certificate of incorporation (containing specific info required by IRS) with state and pay filing fee. File application on Form 1023 for tax-exempt status unless below gross receipts threshold. Recruit directors, draft bylaws and hold organizational meeting. Take steps to comply with license, tax and employment law/regs. File articles or certificate of incorporation with state and pay filing fee. Decide on board of directors, draft bylaws, hold organizational meeting and issue stock. Take steps to comply with license, tax and employment laws/regs. See for-profit corporation Management and Control Liability Tax Factors Capital and Loans Managed by directors Members, directors, who appoint officers officers and employees to run day-to-day are generally not liable operations as specifiedfor debts and in bylaws. Some obligations of the nonprofit corporationscorporation, including have members (like shareholders) who elect directors. Managed by directors that are elected by shareholders. Directors appoint officers to run dayto-day operations as specified in bylaws. See for-profit corporation. The B Corp license requires the corporation to incorporate specific socially beneficial performance standards into its governing documents and operating principles. for unlawful acts of others involved in the affairs of the corporation. They can be held liable for injuries due to their own misconduct but some states provide limited immunity to such persons and also to volunteers. Shareholders are generally not liable for debts and obligations of the corporation, including for unlawful acts of others involved in the business. Unless indemnified by the corporation, directors, officers and employees can be held liable for injuries caused by their own acts or failures to act. See for-profit corporation. Generally exempt from federal and state taxes if receive 501(c)(3) exemption. Liable for tax on unrelated business income, and other taxes such as property and sales (unless local and state exemptions apply). Donors can deduct contributions A C Corporation is subject to corporate tax on net income. If net income is paid to shareholders as dividends, the individual shareholders are taxed. If a corporation elects to be a S corporation and meets several criteria, it can receive pass through taxation. See for-profit corporation. Can accept charitable donations and grants. Eligible for program related investments (PRIs) by foundations. Can borrow money and issue debt instruments but cannot raise capital by issuing stock. Can raise capital by issuing stock (equity) and by borrowing money through loans or other debt instruments. Corporation may be able to accept PRIs from foundations in the form of loans or equity. See for-profit corporation. A B Corp should be in a better position to attract PRIs from foundations in the form of loans or equity. 2

3 LLC L3C (low-profit LLC) Partnership Formation File articles of organization or certificate of formation with state and pay filing fee. Negotiate and execute operating agreement. Take steps to comply with license, tax and employment law/regs. Similar to LLC but must be formed for a charitable or educational purpose. Only permitted in certain states (e.g., VT, IL, MI,UT,ME,WY) No filing requirements unless limited partnership (LP) or limited liability partnership (LLP), but partners should sign partnership agreement. Take steps to comply with name, license, tax and employment law/regs. Sole Proprietor No filing requirements. Has no legal existence apart from owner. Take steps to comply with d/b/a name, license, tax and employment law/regs. Management and Control Liability Tax Factors Capital and Loans Flexible structure Can raise capital like a partnership through contributions with management by member/owner. responsibilities Otherwise, same as forprofit specified in corporation. operating agreement (usually management committee or single manager). Same as a corporation. Usually not taxed as an entity because most LLCs choose pass through treatment whereby the member/owners report profits and losses on personal tax returns. Tax-exempt member/owners treat their share of income as exempt or subject to unrelated business taxable income, depending on the character of the income. See LLC Same as a corporation See LLC. Same as for-profit corporation except L3C enabling legislation is written to comply with PRI regs and is thus intended to attract equity or debt investments by foundations. Partners have equal, full control unless otherwise specified in partnership agreement. Owner has full control. Partners are personally liable for the debts and obligations of the partnership, including for unlawful acts of other partners and employees. Risk can be limited by creating an LP or LLP. Owner is liable for all debts and obligations, including for unlawful acts of employees. Generally not taxed as an entity. Partners report profits and losses on personal tax returns. Not taxed as an entity. Owner reports business profits and losses on personal tax return. Can raise capital through contributions by partners and by borrowing money through loans or other debt instruments. Owner provides funds for capital investment and owner can borrow money through loans or other debt instruments. 3

4 1. Nonprofit Corporations a. Overview Chapter 22 of the Texas Business Organizations Code (the TBOC ) (Tex. Bus. Orgs. Code Ann governs the formation, operation and dissolution of nonprofit corporations in Texas. Chapter 22, together with Chapter 20 of the TBOC, and the applicable provisions of Title 1 of the TBOC to the extent applicable to nonprofit corporations, are referred to as the Texas Nonprofit Corporation Law. A nonprofit corporation in Texas is managed by its board of directors and operated by its officers and employees, unless management is vested in the nonprofit corporation s members, instead of a board of directors, in the nonprofit corporation s certificate of formation. Instead of shareholders, a Texas nonprofit corporation may have one or more classes of members or may have no members. Nonprofit corporations, of course, are specifically organized to not earn profits. No part of the income or surplus of a Texas nonprofit corporation may be distributed to its members, directors or officers; however, reasonable compensation may be paid for services rendered. A nonprofit corporation has an existence of its own, independent of the terms of office or employment of members, directors or officers. It can sue or be sued in its own name and can own real estate in its own name. The Texas attorney general has the power, under the Texas Ultra Vires Act, to sue nonprofit corporations for acts or transfers outside the stated purpose or purposes of the nonprofit corporation. b. Advantages of Incorporation: pros and cons of nonprofit vs. for-profit The principal advantage of incorporation is that it protects the shareholders or members from personal liability for the obligations and liabilities of the corporation, including unlawful actions of officers, directors and staff acting on its behalf. In addition, incorporation establishes continuity; corporations (both nonprofit and for-profit) are subject to a body of statutes that provide very specific guidance as to their formation and operation; and incorporation brings stature to the organization and implies stability. Where profit is not a goal and the enterprise can be funded without the need for access to capital markets, the nonprofit corporation is the preferred vehicle for pursuing social objectives. Although nonprofit corporations are not prohibited from engaging in commercial activities, the directors of a nonprofit are duty-bound to devote primary attention to the promotion of the social mission of the corporation rather than the production of net income. On the other hand, if access to capital markets is needed, a for-profit corporation (or limited liability company, discussed below) is likely to be the preferred option because 4

5 nonprofit corporations cannot issue capital stock. The directors of a for-profit corporation, however, owe strict duties to the members to maximize profits and value. Therefore, unless the directors and managers can tie the social mission of their for-profit corporation directly to its business purpose, they can be sued for breach of their duties to members and for misuse of corporate assets if they focus too much on the social mission and forego profits. This problem can be avoided where all members agree to pursue a social mission or devote a percentage of revenues to charitable causes but such agreements may be temporary because a change in control or a drop in earnings can lead to amendment or abrogation of member agreements. c. Formation A nonprofit corporation attains its separate legal status through the filing and approval by the Texas Secretary of State of its certificate of formation. This document is in essence a contract between the state and the nonprofit corporation in which Texas grants individual legal status to the corporation in exchange for the corporation s commitment to follow its rules. The TBOC requires that the certificate of formation for all entities in Texas (i.e., nonprofit corporation, for-profit corporation, limited liability company, limited partnership, etc.) include the same general information. In the case of a nonprofit corporation in Texas, this general information includes: the name of the nonprofit corporation, the purpose or purposes for which the nonprofit corporation is being formed (which may be stated to be any lawful purpose of a nonprofit corporation), the period of duration of the nonprofit corporation which unless otherwise provided in the certificate of formation will be assumed to be in perpetuity, the street address of the initial registered office of the nonprofit corporation and the name of the initial registered agent of the nonprofit corporation, and the names and addresses of the organizers of the nonprofit corporation. In addition to the above general provisions required for all entities in Texas, the certificate of formation for a nonprofit corporation must also include: if the nonprofit corporation is to have no members, a statement to that effect; if management of the nonprofit corporation s affairs is to be vested in the nonprofit corporation s members instead of a board of directors, a statement to that effect; if applicable, the number of directors constituting the initial board of directors, including their names and addresses; and if the nonprofit corporation is to be authorized on its winding up to distribute corporation assets for other than tax-exempt purposes, a statement describing the manner of distribution. Generally, the name of a Texas corporation is required to contain one of the following words or an abbreviation thereof: corporation, company, incorporated, or limited; 5

6 however, this rule does not apply to Texas nonprofit corporations. A nonprofit corporation is prohibited from having a name that may allude to or imply that the entity is conducting business outside its stated purpose and it may not include the words Lotto or Lottery. The name must also be distinguishable from other entity names. The TBOC provides for specific nonprofit corporation purposes including serving charitable, benevolent, religious, eleemosynary, patriotic, civic, missionary, educational, scientific, social, fraternal, athletic, aesthetic, agricultural, and horticultural purposes; operating or managing a professional, commercial, or trade association or labor union; providing animal husbandry; or operating on a nonprofit cooperative basis for the benefit of its members. If the nonprofit corporation intends to obtain exemption from state taxes, the certificate of formation must conform with applicable statutes and regulations discussed below in section g. The organizer or organizers of the nonprofit corporation must execute, acknowledge and file the certificate of formation. Under the TBOC, only one organizer is required and the TBOC provides that any person, partnership, association or corporation, singly or jointly with others, may incorporate or organize a Texas nonprofit corporation regardless of the organizers residence, domicile or state of incorporation. Furthermore, an organizer of a Texas nonprofit corporation need not be a U.S. citizen. The organizer(s) must sign the certificate and acknowledge it in accordance with Section of the TBOC. The certificate of formation is then filed with the Secretary of State of the State of Texas. The basic filing fee is $25. As referenced earlier, while the TBOC sets general guidelines for the powers of the board of directors of a nonprofit corporation, it also provides a nonprofit corporation with the option of being run by the members that make up the corporation by stating so in the certificate of formation. A nonprofit corporation is considered to have vested the management of the corporation s affairs in the board of directors in the absence of a provision to the contrary in the certificate of formation. In the case of a board of directors-managed nonprofit corporation, the initial board of directors may consist of no fewer than three directors and the number of directors on the initial board of directors, as stated earlier, must be included in the certificate of formation. Thereafter, the number of directors may be increased or decreased by amendment to, or in the manner provided by, the certification of formation or bylaws. A generic form of certificate of formation for a Texas nonprofit corporation may be found by going to d. Management and Control Once the nonprofit corporation has been established, the initial board of directors should hold an organizational meeting to ratify the acts in connection with the initial formation 6

7 of the corporation and adopt bylaws which set forth the rules and procedures governing the decision-making process of the board of directors and the general operation and management of the corporation consistent with the applicable statutes of Texas and the certificate of formation. Typically, the bylaws of a nonprofit corporation contain provisions governing member, director and officer qualifications, powers, and duties; voting; filling of vacancies; meetings; property holding and transfer; indemnification of directors and officers; committees; bank accounts; fiscal year audits and financial reports; conflicts of interest; and amendment and dissolution procedures. A generic form of bylaws for a Texas corporation may be found in the Texas Transaction Guide in Section See Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007). e. Liability of Members, Directors and Officers Under Texas law corporate directors and officers generally owe certain duties to the corporation. Two important duties are the duty of loyalty and the duty of due care. The duty of loyalty dictates that a corporate officer or director must act in good faith and must not allow his or her personal interest to prevail over the interest of the corporation. The duty of loyalty requires an extreme measure of candor, unselfishness, and good faith on the part of the officer or director. The TBOC addresses the duty of loyalty by prohibiting loans from nonprofit corporations to directors and creating liability for all directors that approve or acquiesce in such loans. The TBOC also provides for procedural safeguards in connection with transactions between a nonprofit corporation and a director or officer, providing that such transactions are not void or voidable merely because of the conflict of interest if it is approved by disinterested directors, acting in good faith and with ordinary care, after full disclosure regarding the conflict of interest. Directors and officers are also subject to a duty of care in the management of the corporation. The TBOC addresses this duty codifying what is commonly referred to as the business judgment rule. The rule is as follows: a director is not liable to the corporation or its members if the director acts (1) in good faith; (2) with ordinary care; and (3) in a manner the director reasonably believes to be in the best interest of the corporation. Ordinary care is defined as the care that an ordinarily prudent person in a similar position would exercise under similar circumstances. When making management decisions, directors and officers may rely on the advice of certain professionals including attorneys, accountants and other officers or employees of the corporation. Under the TBOC, members of nonprofit corporations are not liable for the debts, liabilities, or obligations of the corporation.. There seems to be no case law on piercing 7

8 the corporate veil in the Texas nonprofit corporation context, however, for a discussion of piercing the corporate veil see subsection d. under the For-profit corporations section. The TBOC provides directors both mandatory and permissive indemnification. A corporation must indemnify the director if the director is wholly successful, on the merits or otherwise, in the defense of any proceeding brought against them in their capacity as director of the corporation. By complying with Sections through of the TBOC, a corporation may choose to indemnify the directors of the corporation. A corporation may also choose to limit the liability of the directors in the certificate of formation. However, any provision limiting liability will not be effective to protect a director for liability arising from certain occurrences including intentional acts made not in good faith, breaches of the director s duty of loyalty, self interested transactions, or acts which subject the director to personal liability under any other statute. f. Mergers, Acquisitions and Dissolution The TBOC has several provisions that are specifically applicable to nonprofit corporations. A domestic nonprofit corporation may not merge into another entity if it would, because of the merger, lose or impair its charitable status. A domestic nonprofit corporation may merge with another entity if the domestic nonprofit corporation is the surviving entity. Sections and provide for the merger of a nonprofit corporation with another business entity. If the corporation that is a party to the merger has members with voting rights the board of directors must adopt a resolution both approving the plan of merger and directing the plan to be submitted to a vote at an annual or special meeting of the members. The members must approve the plan of merger by a two thirds vote unless the certificate of formation requires higher voting requirements. If the corporation has no members or has no members with voting rights, the plan of merger must be approved by at least a two thirds vote of the board of directors. Nonprofit corporations appear to be capable of conducting short-form mergers as the code refers to parent and subsidiary organizations and organizations are defined to include nonprofit corporations. It also appears that nonprofit corporations can merge with partnerships or limited liability companies as the merger sections of the code refer to entities, both foreign and domestic, and nonprofit corporations, partnerships, and limited liability companies are all entities under the code. Dissolution of a nonprofit corporation is effected under Sections and of the TBOC. Section provides that the governing body of a nonprofit corporation shall perform all acts necessary for dissolution as required by Chapter 11 of the TBOC. If the members of the nonprofit corporation are entitled to vote on dissolution, they are 8

9 given notice and the opportunity to vote. If the members are not entitled to vote, the dissolution may be effected by a vote of the members of the governing body of the nonprofit corporation. Once the dissolution is properly authorized, the certificate of termination is filed with the Secretary of State of the State of Texas. g. Recordkeeping, State Reports and State Taxes All nonprofit corporations incorporated in the State of Texas are required to file an annual report with the Secretary of State for the State of Texas and maintain current and accurate financial records. Texas has no state income tax. However, there are several taxes which a nonprofit corporation may be subject to under the Texas Tax Code (the Tax Code ) including the property tax and the franchise tax. All personal and real property within the State of Texas is taxable unless exempt by law. Charitable organizations are exempt from the property tax if it meets the requirements of Section All corporations are also subject to the State of Texas franchise tax unless specifically exempted by the code. Specific exemptions from the franchise tax include nonprofit corporations organized for religious, charitable, agricultural or educational purposes. The Tax Code has several other taxes which may affect nonprofit corporations depending on the corporation s activities. h. Insurance Nearly every type of activity by a nonprofit corporation can become the target of some kind of a claim by a firm or an individual that alleges damage or injury by the corporation or individuals responsible for it (i.e., directors, officers or employees). Even if the claim is without merit, the costs of defending against the claim can be very substantial. To encourage qualified individuals to accept positions as directors and officers, many nonprofit corporations purchase insurance to cover director and officer (D&O) liability. In addition, most responsible nonprofit corporations purchase a basic comprehensive general liability policy that covers liability for accidents in the corporation s offices, at sponsored meetings and the like. Section of the TBOC specifically allows a Texas corporation to purchase liability insurance on behalf of its governing body members and to insure against potential liability of such members regardless of whether the corporation has the power to indemnify the particular litigant. Thus, Section theoretically permits the corporation to insure its governing body members against judgments or amounts paid in settlement of derivative suits and against expenses incurred by a member even in 9

10 circumstances in which a member has been found to have acted unlawfully or in bad faith. Liability insurance for nonprofit corporations is often a very complicated matter. Consultation with an experienced and knowledgeable agent or consultant is essential in order to obtain the right coverage at the lowest premium. i. Resources Oleck and Stewart, Nonprofit Corporations, Organizations & Associations (Prentice- Hall, 1994, Cum. Supp. 2002) Jacobs, Jerald A., Association Law Handbook (ASAE & The Center for Association Leadership 4 th ed., 2007) Nonprofit Governance and Management (American Bar Association and American Society of Corporate Secretaries, 2002) Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley (American Bar Association Section of Business Law, 2005) Guidebook for Directors of Nonprofit Corporations (American Bar Association Section of Business Law 2d ed., 2002) Takagi, Gene. Nonprofit Bylaws - Common Issues Nonprofit Law Blog Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007) 2. For-profit Corporations a. Using For-profit Corporations to Pursue Social Objectives The for-profit form of organization can and frequently is used as a vehicle for conducting a business that also has a social mission or objective. Although for-profit corporations are usually formed for the purpose of making money and distributing it to managers and shareholders, there is no reason why a for-profit corporation cannot include a social mission in the purposes clause of its certificate of formation. While such a provision would authorize the corporation to pursue social objectives, it would not require the corporation to do so only the shareholder/owners have this power. And unless all shareholders agree to pursue social aims, dissenters could sue the corporation s directors and managers for failing to operate the corporation in the best economic interests of the shareholders. 10

11 A shareholders agreement is probably the best way to address this problem. Such an agreement, entered into by all shareholders and the corporation, would require the corporation to be managed and operated so as to pursue specified social objectives thereby overriding fiduciary duties and similar legal principles that govern normal behavior of for-profit corporations. But even the most skillfully drafted shareholders agreement is not a perfect solution because agreements can always be abrogated and amended and the owners of the shares can change via sale, gift or inheritance. Moreover, a tightly drafted shareholders agreement which makes it difficult to respond to business changes over time would tend to render the for-profit corporation much less attractive to investors (potential new shareholders). b. Formation The TBOC governs the formation, operation and dissolution of for-profit corporations in Texas. Any legal entity with the capacity to contract is authorized to organize or incorporate by filing a certificate of formation with the Secretary of State. The certificate of formation must set forth: (1) the name of the corporation; (2) the type of entity being formed; (3) the purpose or purposes for which the corporation is formed; (4) the period of duration, if the corporation is not formed to exist perpetually; (5) the street address of the initial registered office of the corporation and the name of the initial registered agent of the filing entity at the office; (6) the names and addresses of the organizers of the corporation; (7) the aggregate number of shares the corporation is authorized to issue; (8) if the corporation is authorized to issue one class of shares only, the par value of each share or a statement that each share is without par value; (9) the number of directors constituting the initial board of directors and their names and addresses; (10) if the corporation is to be managed pursuant to a shareholders agreement in a manner other than by a board of directors, the name and address of each person who will perform the functions required by the TBOC to be performed by the initial board of directors. The certificate of formation must be executed, signed and filed by the organizer or organizers in accordance with Section of the TBOC. The cost of filing a certificate of formation with the Secretary of State is $300. A generic form certificate of formation may be found in the Texas Transaction Guide as Form 201. See Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007). 11

12 c. Management and Control The business and affairs of a Texas corporation are managed by or under the direction of a board of directors. The board of directors shall consist of one or more members. The TBOC does not specify qualifications for directors. Each director holds office until his or her successor is elected and qualified or until such director s earlier resignation or removal. Generally, directors are elected each year at the annual meeting of stockholders, but their terms may be staggered so that only a portion of the directors are elected each year. The board of directors is permitted to delegate managerial duties to officers of the corporation, except to the extent that the corporation's certificate of formation or bylaws limit or prohibit such a delegation. The board of directors must elect a president and a secretary at the time and in the manner prescribed by the corporation s bylaws. The TBOC permits the bylaws or the board of directors to determine the titles, duties and number of corporate officers. Officers of a Texas corporation are chosen in the manner, and hold their offices for a term, prescribed by the governing documents or determined by the board of directors. The powers and duties of the officers are fixed by the governing documents or by resolution of the board of directors. After filing the certificate of formation, the organizer or organizers, or the board of directors if the initial directors were named in the certificate of formation, should hold an organizational meeting to adopt bylaws, elect directors (if the meeting is of organizers) to serve or hold office until the first annual meeting of stockholders, elect officers (if the meeting is of directors), do any other acts to perfect the organization of the corporation and transact such other business as may come before the meeting. Alternatively, in lieu of an organizational meeting, the organizers or the directors, as the case may be, may execute a written consent setting forth the actions so taken. Section (b) of the TBOC provides that the bylaws of a corporation may include any provision, that is not inconsistent with law or with the certificate of formation relating to the regulation and management of the affairs of the corporation. In general, the bylaws of a typical for-profit corporation contain provisions governing stockholder meetings, the board of directors and committees thereof, officers and the indemnification of directors and officers. A generic form of bylaws for a Texas corporation may be found in Texas Transaction Guide in Section 3A.201. See Kendrick, John J., Texas Transaction Guide 3A.201 (Matthew Bender & Company, Inc., 2007). While Texas corporations are managed by and under the direction of a board of directors, the TBOC requires a stockholder vote on major corporate events including the election of directors, certain mergers, a sale of all or substantially all of the corporation's assets, and a voluntary dissolution of the corporation. 12

13 d. Liability of Shareholders, Directors and Officers Under Texas law, corporate directors and officers generally owe certain duties to the corporation. Two important duties are the duty of loyalty and the duty of due care. The duty of loyalty dictates that a corporate officer or director must act in good faith and must not allow his or her personal interest to prevail over the interest of the corporation. The duty of loyalty requires an extreme measure of candor, unselfishness, and good faith on the part of the officer or director. The TBOC addresses the duty of loyalty by prohibiting loans from nonprofit corporations to directors and creating liability for all directors that approve or acquiesce in such loans. The TBOC also provides procedural safeguards in connection with transactions between a nonprofit corporation and a director or officer. The code provides that such transactions are not void or voidable merely because of the conflict of interest if the transaction is approved by disinterested directors, acting in good faith and with ordinary care, after full disclosure regarding the conflict of interest. Directors and officers are also subject to a duty of care in the management of the corporation. The TBOC addresses this duty codifying what is commonly referred to as the business judgment rule. The rule is as follows: a director is not liable to the corporation or its members if the director acts (1) in good faith; (2) with ordinary care; and (3) in a manner the director reasonably believes to be in the best interest of the corporation. Ordinary care is defined as the care that an ordinarily prudent person in a similar position would exercise under similar circumstances. When making management decisions directors and officers may rely on the advice of certain professionals including attorneys, accountants and other officers or employees of the corporation. Under the TBOC, shareholders of corporations are not liable for the debts, liabilities, or obligations of the corporation. Shareholders may be held liable, however, if for some reason the court deems it appropriate to disregard the fiction of the corporation under a legal theory commonly referred to as piercing the corporate veil. Courts will not disregard the corporat[e] fiction and hold individual officers, directors or stockholders liable on the obligations of a corporation except where it appears that the individuals are using the corporate entity as a sham to perpetrate a fraud, to avoid personal liability, avoid the effect of a statute, or in a few other exceptional situations. The TBOC provides directors both mandatory and permissive indemnification. A corporation must indemnify the director if the director is wholly successful, on the merits or otherwise, in the defense of any proceeding brought against them in their capacity as director of the corporation. By complying with Sections through of the TBOC a corporation may choose to indemnify the directors of the corporation. A corporation may also choose to limit the liability of the directors in the certificate of formation. However, any provision limiting liability will not be effective to protect a 13

14 director for liability arising from certain occurrences including intentional acts made not in good faith, breaches of the director s duty of loyalty, self interested transactions, or acts which subject the director to personal liability under any other statute. e. Raising Capital For-profit corporations offer a great deal of flexibility in raising capital, ranging from various kinds of equity (e.g., common stock, preferred stock, options, warrants) to numerous types of debt instruments (e.g., convertible notes, subordinated notes, bonds, commercial paper). f. Recordkeeping and State Reports All corporations incorporated in the State of Texas are required to file an Annual Report with the Comptroller of the State of Texas in conjunction with paying annual franchise taxes. The "Taxation" section below discusses the computation of a Texas corporation's annual franchise taxes. The Annual Report and franchise taxes are to be received no later than May 16th of each year. g. Taxation Corporations incorporated in the State of Texas are subject to several taxes including the Texas franchise and property taxes and the federal income tax. The franchise tax is computed as a percentage of the corporation s taxable margin as determined by Section of the Tax Code. The franchise tax is to be received no later than May 16th of each year. Corporations may also be subject to the property tax as all personal and real property within the State of Texas and owned by the corporation is taxable unless exempt by law. The property tax bill is sent by the local tax assessor for the geographical taxing unit and is due no later than February 1st of each year. There is no state income tax in Texas. However, income earned by Texas for-profit corporations doing business in the state is subject to the federal income tax and may be subject to double taxation. That is, the corporation pays federal taxes on the income it earns and the stockholders are taxed at their personal income tax rate on any profits that are distributed to them by the corporation as dividends. A corporation may, however, elect to be governed by Subchapter S of the Internal Revenue Code to avoid double taxation. Subchapter S corporations are not taxed at the corporation level. Rather, the income and losses of a Subchapter S corporation are passed through to the stockholders in relation to their ownership interests. To be eligible for this tax treatment, S corporations must meet certain requirements including, but not limited to, having only one class of stock and no more than 100 stockholders. A Tax Attorney or Accountant should be consulted as the Texas Tax Code has multiple other taxes to which a corporation could be subjected. 14

15 h. Resources Texas Corporations Section Secretary of State P.O. Box Austin, TX Phone - (512) Texas Office of the Comptroller IRS publication discussing general tax laws that apply to ordinary domestic corporations IRS publication discussing Subchapter S corporations Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007). 3. Limited Liability Companies (LLCs) a. Using LLCs to Pursue Social Change Combining certain characteristics of both partnerships and corporations, LLCs are legal entities that can be formed for the purpose of earning profits, pursuing a social mission, or both, although some states require an LLC to be formed only for a business purpose. LLCs differ from for-profit corporations because they are formed and owned by members rather than shareholders; however, like S corporations and partnerships, LLCs are eligible for pass-through income tax treatment. This means that income and expenses are reported as though the members incurred them directly, and profits or losses are taxed at the ownership (member) level, rather than the entity (company) level. Members of LLCs can be individual investors as well as for-profit corporations and taxexempt nonprofit corporations or other legal entities. For this reason and also because of pass-through taxation which eliminates double taxation (the effect of taxing income at the corporate level and again when it is included in the owner s income), LLCs are preferred over for-profit corporations as vehicles for social enterprise, especially for joint ventures between a tax-exempt nonprofit with a social change mission and a for-profit business. LLCs are akin to partnerships because the members have broad discretion to allocate profit and loss and management powers among themselves in a limited liability company 15

16 or operating agreement (an LLC agreement ). On the other hand, as with the shareholders of corporations, the members of an LLC can be divided into classes, each with its own economic rights, and members have limited personal liability (discussed below). The TBOC governs the formation, operation and dissolution of LLCs in Texas. Two states, Tennessee and Kentucky, specifically authorize the formation of nonprofit limited liability companies (nonprofit LLCs). The statutes of numerous states, including California, have language that permits nonprofit LLCs to exist. Assuming state laws permit formation of nonprofit LLCs, the IRS will recognize such an LLC as exempt under Section 501(c)(3) if it elects to be treated as a separate legal entity for tax purposes and its operating agreement includes the language mandated by the organizational test (purposes, distribution of assets upon dissolution, etc.) and it meets numerous requirements largely designed to guard against inurement and private benefit. These conditions will be discussed in the Nonprofit Taxation section. b. Formation To form and organize an LLC under the TBOC, a certificate of formation must be filed with the Secretary of State of the State of Texas and an LLC agreement must be entered into by the member or members. The certificate of formation must set forth: (1) the name of the LLC which must include the phrase limited liability company", "limited company" or an abbreviation of one of those phrases; (2) the type of entity being formed; (3) the purpose or purposes for which the filing entity is formed; (4) the period of duration, if the entity is not formed to exist perpetually; (5) the street address of the initial registered office of the LLC and the name of the initial registered agent of the LLC at the office; (6) the names and addresses of the organizers of the LLC; (7) whether the LLC will or will not have managers; (8) if the LLC will have managers, the name and address of each initial manager; and (9) if the LLC will not have managers, the name and address of each initial member of the LLC. The certificate of formation must be executed, signed and filed by the organizer or organizers in accordance with Section of the TBOC. The cost of filing a certificate of formation with the Secretary of State is $300. Any legal entity with the capacity to contract is authorized to organize or incorporate by filing a certificate of formation with the Secretary of State. The certificate of formation must be signed by an authorized officer, manager, or member of the limited liability company. An LLC may engage in any type of lawful business, purpose or activity whether or not for profit. An LLC shall possess and exercise all of the powers and privileges granted by the TBOC or by an other law or by its LLC agreement, together with any powers incidental thereto, including such powers and privileges as are necessary or convenient to the conduct, promotion or attainment of the business, purposes or activities of the LLC. 16

17 The purposes and powers of an LLC may be restricted by provisions in the LLC agreement if desired. A generic form of certificate of formation may be found in Texas Transaction Guide in Section See Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007). c. Management and Control Typically, an LLC agreement among the members governs the management of an LLC. The LLC agreement which is like the articles of incorporation, bylaws and a shareholder agreement all in a single document may contain provisions requiring adherence to a social purpose and such purpose and the values it embodies may be interwoven throughout the LLC agreement. The TBOC states that an LLC agreement governs the relations among members, managers, and officers of the company, assignees of membership interests in the company, the company itself and other internal affairs of the company. The TBOC permits the formation of LLCs that have only one member. The TBOC was drafted in a way which provides flexibility in establishing the management and structure of an LLC. In most cases, the rules set forth in the TBOC are default rules that may be modified in the LLC agreement and are otherwise only applicable when the LLC agreement is silent on the issue. Virtually any natural person, legal entity, association, government or representative may be a member of an LLC. In connection with the formation of an LLC, a person is admitted as a member of the LLC upon the later to occur of (i) the formation of the LLC or (ii) the time provided in and upon compliance with the LLC agreement, or if the LLC agreement does not so provide, when the person's admission is reflected in the records of the LLC. Once an LLC has been formed, a person may be admitted as a member after a vote of the current members or pursuant to the terms of the LLC agreement. A person may be admitted as a member of an LLC without making a contribution to the LLC or being obligated to make a contribution to the LLC. An LLC may have an LLC agreement that provides for classes or groups of members having such relative rights, powers and duties as such LLC agreement may provide. The LLC agreement may grant to all or certain identified members or classes or groups of members the right to vote, separately or with all or any other class or group of the members or managers, on any matter. The LLC agreement may also provide for the taking of any action without the vote or approval of any member or class or group of members. 17

18 The TBOC is drafted in a way to permit members to have broad discretion in determining the internal governance of the LLC in the LLC agreement. The certificate of formation specifies whether management is vested in managers or the members of the company. The governing body manages in accordance with any management provisions in the LLC agreement. Under the TBOC, an interest in an LLC is freely assignable, in whole or in part, except as otherwise provided by the LLC agreement. An assignee of an interest in an LLC shall not be admitted as a member or have any right to participate in the management of the business and affairs of the LLC except upon either the approval of all members of the LLC other than the assignor or the compliance with any procedure provided for in the LLC agreement. Unless an LLC agreement provides otherwise, a member may not resign from an LLC prior to the dissolution and winding up of the LLC. The TBOC provides certain default rules regarding allocations of profits and losses and distributions of assets, but members are free to contract with respect to such economic rights in the LLC agreement. Absent a provision in the LLC agreement, the profits and losses of an LLC shall be allocated and distributions of cash or assets shall be made on the basis of the agreed value (as stated in the records of the LLC) of the contributions made by each member to the extent they have been received by the LLC and have not been returned. Generic forms of LLC agreements for Texas LLCs may be found in Sections through of the Texas Transaction Guide. See Kendrick, John J., Texas Transaction Guide (Matthew Bender & Company, Inc., 2007). d. Limited Liability of Members and Managers Under the TBOC, the general rule is that a member or manager is not liable for the debts, obligations or liabilities of the LLC solely by reason of being a member or manager of the LLC. Notwithstanding this limitation on liability, a member or manager may be obligated for their own tortious or wrongful acts or conduct. A member is also liable to make its contributions to the LLC and other payment obligations that are provided in an LLC agreement and, under certain limited circumstances, a member may be required to return distributions wrongfully distributed to it. Section of the TBOC provides that an LLC may indemnify and hold harmless any member or manager against any and all claims. e. Merger, Dissolution and Term of Existence The TBOC permits any entity or organization to merge or consolidate with any other entity or organization. Organization and entity are defined to include a corporation, 18

19 limited or general partnership, limited liability company, business trust, real estate investment trust, joint venture, joint stock company, cooperative, association, bank, insurance company, credit union, savings and loan association, or other organization, regardless of whether the organization is for-profit, nonprofit, domestic, or foreign. To merge an LLC must enter into a plan of merger. Unless the LLC agreement requires a different vote or consent, such merger or consolidation must be approved by a majority of members or by the members of each class or group, as appropriate. The TBOC provides that an LLC will have perpetual existence unless a time is otherwise specified in the certificate of formation or the LLC agreement. The TBOC further provides that an LLC will dissolve (1) upon the happening of events specified in the LLC agreement, (2) unless otherwise provided in the LLC agreement, upon the affirmative vote or written consent of the members of the LLC, or if there is more than one class or group of members, in either case, by members who own more than one half of the then current percentage or other interest in the LLC or by the members in each class or group, as appropriate, (3) at any time there are no members, provided however that the LLC is not dissolved and is not required to be wound up if a new member is admitted and the LLC is continued in accordance with the provisions of Section (a)(1) or (2) of the TBOC, or (4) upon decree of court requiring the winding up and dissolution of the LLC. Upon dissolution, the affairs of the LLC shall be wound up by the governing body, the members or a person approved by the court. Upon the winding up of an LLC, Section of the TBOC provides that the assets of the LLC shall first be distributed to creditors of the LLC, whether by payment or the making of reasonable provision for payment thereof, and then, unless otherwise provided in the LLC agreement, to members in satisfaction of liabilities for distributions, for return of their contributions and with respect to their interests in the LLC in the proportions in which the members share in distributions. f. Raising Capital An LLC offers the same flexibility in raising capital as a for-profit corporation. g. Recordkeeping and State Reports Members of an LLC should set forth in the LLC agreement how to keep and maintain the required books and records of the LLC. Members of LLCs have the right, subject to reasonable standards set forth in the LLC agreement or otherwise established by the manager or members of the LLC, to obtain from the LLC upon reasonable demand for any purpose reasonably related to the member's interest as a member of the LLC, certain information regarding the affairs of the LLC, as enumerated in Section of the TBOC. It is therefore advisable that, at a minimum, an LLC keep records of such information. An LLC may maintain its records in a form other than written form, 19

20 provided such form is capable of conversion into written form within a reasonable time frame. h. Taxation For Federal income tax purposes, LLCs may be classified as a partnership if they have more than one member or disregarded as a separate entity if they have only a single member. Federal treasury regulations permit LLCs to elect their desired U.S. federal tax classification as a partnership or a corporation. Under these regulations, an LLC will be classified as a partnership for federal tax purposes absent an affirmative election to the contrary. If the LLC has only one member, the LLC will be classified as a sole proprietorship, branch or division of the member so that may be ignored for federal tax purposes absent an affirmative election to the contrary. LLCs in the State of Texas are subject to several taxes including the Texas franchise and property taxes. The franchise tax is computed as a percentage of the LLC s taxable margin as determined by Section of the Tax Code. The franchise tax is to be received no later than May 16th of each year. LLCs may also be subject to the property tax as all personal and real property within the State of Texas and owned by the LLC is taxable unless exempt by law. The property tax bill is sent by the local tax assessor for the geographical taxing unit and is due no later than February 1st of each year. i. Resources Secretary of State P.O. Box13697 Austin, TX Phone - (512) Texas Office of the Comptroller, Transactional Lawyer's Deskbook: Advising Business Entities (Arthur Norman Field & Morton Moskin eds.) Humphreys, Thomas, Limited Liability Companies and Limited Liability Partnerships (Incisive Media, 2009) 4. Low-profit Limited Liability Companies (L3Cs) a. Overview The L3C, or Low-Profit Limited Liability Company, is a new type of corporate entity that is a cross between a nonprofit and a for-profit corporation. L3Cs are not eligible for tax- 20