Entity Formation Basics: The Cooperative

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company (LLC), partnership, non-profit, or some other type of business entity.

This post is about one useful form of business entity that is frequently overlooked by business advisors and attorneys – the cooperative!

A cooperative or “co-op” is a type of legal entity that is distinguishable from standard, for-profit corporations, LLCs, and partnerships.  Co-ops offer a flexible business model that can be used by any group of people who are interested in creating a democratic decision-making company that benefits all members.  In other words, co-ops strive to be patron- or member-oriented, rather than investor-oriented like traditional corporations or LLCs.

At their core, co-ops are formed by a group of people who either work or shop there (a brewery co-op or a food co-op), use its services (a credit union or health insurance co-op), or product goods and items for it (a food producers co-op).  Co-op members are not to be held liable for any debt, obligation or liability of the co-op.

The International Cooperative Alliance, a global membership association of co-ops and co-op support organizations, has established Seven Cooperative Principles including Democratic Member Control and Concern for Community, among others.

The “common purpose” of individuals wishing to form a co-op can include a number of things, including employee-ownership, group marketing, or group purchasing.  Some of the most nationally well-known co-ops include Ace Hardware and REI, as well as dozens of successful agricultural co-ops such as Land-O-Lakes, Sunkist, and Ocean Spray.

Today, artist and freelancer co-ops are becoming more common due to the rise of the “sharing economy” and the realization of individual artists, photographers, software developers and other freelancers there can be great benefits to pooling resources, infrastructure or ideas.

Colorado Cooperatives

Colorado cooperative law has developed cumulatively over more than five decades.

Today, a standard co-op should be formed under Article 56 of Title 7 of the Colorado Revised Statutes.  Article 58 contains the “Colorado Uniform Limited Cooperative Association Act”, recently enacted in 2011.  Also, Article 33.5 of Title 38 is a special Colorado code section for housing co-ops.

Interestingly, Colorado law explicitly prohibits the ability to use the word “cooperative” or any abbreviation or derivation of as part of your business name, trade name, trademark or brand unless you are actually formed as a co-op under these statutes, so be careful if you are loosely using the term “co-op” or “cooperative” in your business!

Under Colorado law, co-op members and those on a co-op’s Board of Directors are protected from personal liability from the activities of the company, similar to corporations and LLCs.  Co-ops are also allowed to limit membership only to persons engaged in a particular business, persons who will use the goods or services of the co-op, and other membership conditions stated in the co-op’s Articles of Incorporation or Bylaws.  Because they are so member-oriented, Colorado law requires a co-op to keep detailed membership lists with contact info.

Limited Cooperatives

Under the newer Limited Cooperative Association Act, a co-op can have investor members who do not participate as much in the common purposes of the company.  This kind of co-op would have “patron members” who fully own and participate in the co-op and “investor members” who participate in the co-op on a more limited, financial basis.

Because the Article 58 was designed with maximum flexibility in mind, a co-op’s Bylaws and Membership Agreements can set forth all kinds of rules and arrangements for the patron members and investor members as far as how the company is run, how patron member votes versus investor member votes are counted towards certain decisions, and how allocation and distributions are made to these different kinds of members.

Cooperatives and Securities Laws

Both Articles 56 and 58 state that any unit or evidence of a membership interest in a co-op is exempt from the Colorado Securities Act or our state’s “Blue Sky” laws.  This means a co-op can offer and sell its membership interests without needing to registered as a broker-dealer, unlike the ownership in a corporation or an LLC.  This takes a lot of legal headache and expense away from co-ops who are looking to have dozens or even hundreds of members.

Nevertheless, if your co-op needs to raise a lot of capital and wants to do so by securing many membership fees or contributions, we strongly recommend this is done through a Regulation D private placement offering under the federal Securities and Exchange Commission’s (SEC) rules.

Worker Cooperatives

Worker co-ops (i.e., employee-owned companies) are gaining traction like never before as the socially-conscious business movement and sharing economy continue to gather momentum.

The common purpose of the worker co-op is each member’s livelihood – their job and income – as it relates to the success and sustainability of the company as a whole.  In a worker co-op, the employees democratically control the management and operations of the company, with each employee-owner having an equal vote.

Generally, this means that all employees, no matter their salary, job title, or years of employment, are entitled to one vote per person on all matters brought before the membership of the company.  However, this does not mean all employees have to be involved in every company decision.  A worker co-op should still have a Board of Directors, and can also have other officers (for example, a President or a CEO) to set policies, manage day-to-day operations of the company, and determine when important decisions should be put to the members.  Of course, the members vote for who is on the Board and can also vote for who the President or CEO is to be.

Taxation of Cooperatives

Co-ops have unique income tax structures governed by Subchapter T of the Internal Revenue Code.  This tax structure is similar to partnership taxation, but with some different terminology.  Profits of a co-op are called “net margins”.   The members of a co-op are deemed “patrons”.

Under Subchapter T, net margins are not taxed a the co-op level, but are instead allocated to the patrons on an annual basis similar to a partnership distribution.  Unlike a partnership distribution however, co-op allocations are based on a patrons use of the co-op rather than their investment.  For example, in an agricultural co-op, if Farmer A uses 3,000 acres of the co-op’s land and Farmer B uses 10,000 acres, Farmer B had more “patronage” of the co-op and should expect a larger allocation.

Subchapter T states at least 20% of the allocation to a co-op’s patrons must be in cash.  The remaining 80% can also be distributed in cash, or in can be retained on the books of the co-op as “patronage equity”, to be redeemed sometime in the future.  Consequently, patronage equity allows a member of a worker co-op to build personal assets and net worth by having an equity account that can be redeemed when he or she retires or leaves the company.

Each patron should receive a Form 1099-PATR from the co-op every year reporting the allocation (both cash and non-cash).  Then, each patron is responsible for paying his or her own income taxes based on the reported allocation.

If you would like to form a co-op or have a question related to an existing co-op, contact our offices today!







Should I Form My Company in Delaware?

Many savvy startups have heard they should form their corporation in Delaware.  Indeed, more than half of public and Fortune 500 companies are incorporated in this state.

Delaware advertises its General Corporation Law as one of the most advanced and flexible in the country for business entities.  In reality however, nearly all states have now modeled their own corporate laws to mimic the provisions of Delaware’s in order to provide the much-touted “business friendly” legal landscape for companies.

There are still some benefits for incorporating in Delaware.  First, if you have to go to court to settle a dispute, Delaware has a special Court of Chancery that focuses solely on business law, and decisions there are rendered by judges instead of juries.  This means your company’s legal fate will be in the hands of a well-trained business law expert instead of laypeople who might struggle to understand complex legal concepts.  Second, since Delaware’s corporate law is one of the oldest, there is a vast amount of case law that your company can rely on. Thus, most Delaware corporations do not end up litigating disputes because their professional advisers examine this case law and can construct deals to avoid lawsuits.

Despite these benefits, by no means should a startup believe forming is Delaware is the “default” rule.  More often than not, for administrative ease, forming your corporation in the state where you will reside and, at least initially, carry out most of your business activities is probably the state in which you should incorporate.  It lessens the risk of having to travel out of court for legal disputes.  Nevertheless, the fact that so many large, public companies choose Delaware should indicate that large, public companies tend to benefit the most from incorporating in Delaware.

Finally, one may argue if you incorporate in Delaware, you send a message: “This is a national company.”  You send a signal to investors that you understand their preferences and are serious about receiving investments.  From a marketing perspective, this may be important for customers and vendors as well.

Note:  Even if you incorporate in a foreign state like Delaware, your company may still be subject to registration as a “foreign entity” and compliance with the laws of states you transact business in.

If you’re considering starting a business or revisiting a current one, contact us today.

Entity Formation Basics: The S Corporation

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about a very common form of entity for smaller companies – the “S corporation.”

A corporation is defined as an independent legal entity that is owned by shareholders.  A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders.  Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.

While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.).  If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President.  Understandably, this may get confusing!  However, it is important to realize each role carries its own duties and responsibilities under the law.  As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.

Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here.  If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).

Forming an S Corporation

A corporation is formed under the laws of the particular state in which it is registered.  To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office.  The individual who actually files these formation documents is usually called the “Incorporator”.

Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors.  Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).

After the corporation, the IRS by default will treat it as a C corporation unless or until you file Form 2553 with the IRS.   In other words, an S corporation is really just a special type of corporation created through an IRS tax election.

“Pass Through” Taxation

 Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types.  (For a discussion of C corporations, click here.)

Traditional C corporations are separately taxable entities who pay taxes at the corporate level, and then shareholders who receive dividends pay taxes again at the individual level.

In contrast, S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level.  Instead, the profits and losses of the business are “passed-through” to the owners to be reported on their personal tax returns.  Any tax due from company profits are thus paid at the individual level by the owners, not the company.

If you are a small business owner contemplating receiving regular payments from your corporation’s net profits, ensuring your Form 2553 is filed right away is crucial.

Ownership Restrictions

An S corporation can have only one class of stock.  Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights, which is a strategy that might be desired if you are looking to have investor shareholders with less management and dividend rights than the company’s founders.  Additionally, the one-class-of-stock restriction also means an S corporation cannot easily allocate losses or income to specific shareholders, as is allowed in a partnership or LLC.

With some limited exceptions, a shareholder in an S corporation cannot be another entity; a shareholder can only be an individual.  Also, there cannot be more than 100 shareholders.  For this reason, startups who are seeking to fundraise through equity financing or going public might find they quickly hit the 100 shareholder limit.

Finally, foreign ownership of an S corporation is prohibited.  Every shareholder in an S corporation has to be a U.S. citizen.

Accounting Issues

 Bookkeeping and accounting issues for an S corporation may be more complex than other entity types.

 Money distributed to a S corporation shareholder can be in the form of distributions or a salary (assuming the shareholder is also running the company as an officer).  There are more burdens with taking a salary (higher tax rate, employer tax obligations, preparing a W-2 form, etc.), so the savvy S corporation owner may try to take as much of his or her income from the S corporation as distributions.  Of course, this ultimately means less tax money for the IRS, and so this is a hot button issue for them!  The IRS scrutinizes the payments an S corporation makes to its shareholders to make sure the characterization conforms to reality.   If the IRS targets your business, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid.  Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

 Also, as discussed above, the allocation to shareholders of an S corporation’s income and loss is governed by stock ownership, and there are complex rules for how this is to be done.  As such, maintaining an S corporation’s books properly can be cumbersome.  Having a good accountant to assist with this aspect of your business is absolutely essential!

If you’re considering starting a business or revisiting a current one, contact us today.


Entity Formation Basics: The Limited Liability Company

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about one of the most popular entities for closely-held businesses – the limited liability company or “LLC”.

In 1977, Wyoming passed legislation allowing for an entirely new type of company called a “limited liability company” to very little notice or fanfare.  Today however, over two-thirds of all new companies formed are LLCs!

An LLC is a hybrid business entity having certain characteristics of corporations and certain characteristics of partnerships (or sole proprietorships, if there is only one owner).  An owner of an LLC is called a “member” and LLCs can have just one member or hundreds of members.

Like a corporation, LLCs offer limited liability to the company’s owners and have certain rules and requirements for management and maintenance set forth under state law.  Like a partnership, how an LLC is governed and how its owners get paid for their participation and/or investment depends on the bargained-for contract between the owners, i.e., the Operating Agreement.

Have a Good Operating Agreement!

Because LLCs are “creatures of contract,” there is a great deal of flexibility in how you can organize and run an LLC, but failing to set forth this information in a well-written Operating Agreement (your contract with the LLC and all your fellow members) is a recipe for disaster.  While a single member LLC’s operating agreement can be fairly simple and straightforward, multiple-member LLCs usually have more complex operating agreements to handle many things, including management responsibilities, the allocation of profits and losses, capital accounts, vesting provisions, dispute resolution, etc.

Even if you go into business with your very best friend and each of you is in perfect agreement at the onset, human nature is such that there will inevitably be a disagreement at some point down the road, especially if your business becomes very valuable.  If you do not have a comprehensive Operating Agreement to reference, you (or your lawyers) will be forced to cobble together scraps of evidence that reflected your prior decisions or understandings about the LLC.  A neutral third party, such as a judge or arbitrator, might not interpret this piecemeal information the way you hoped, and the process can be very expensive.

LLCs and the IRS

In the eyes of the IRS, an LLC is not a separate taxable entity like a corporation is.  This means there is no separate “limited liability company” tax return form or code section for LLCs.  Instead, the IRS refers to LLCs as “pass-through entities,” which simply means that the tax liabilities of the company “pass through” to the LLC’s members’ personal income tax.

If you are the only member of your LLC, the IRS will automatically classify your company as a sole proprietorship (and you will report the activity of your LLC on a Schedule C submitted with your Form 1040 income tax return).  If you have several members in your LLC, the IRS will treat it as a partnership (and you will file the Form 1065, U.S. Return of Partnership Income) and each member should receive a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., every year.

Some LLCs choose to be taxed as corporations.  To do this, you must file Form 8832, Entity Classification Election.

Why would an LLC make this choice?  The most common reason is if your business wants to keep a substantial amount of its profits as “retained earnings”.  Retained earnings for a corporation are generally taxed at a lower rate than they would be when “passed through” to a personal Form 1040 tax return.

Once you elect corporate taxation for your LLC, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences.  In other words, you should treat the decision to elect corporate taxation for your LLC very seriously, and with guidance from legal and tax experts and a solid understanding of how cash is going to be needed to operate your business.

Corporation or LLC?

The reason LLCs have surpassed corporations as far as choice of entity for closely-held businesses is because they are more flexible and generally easier to manage and maintain than a corporation.

If you are wondering if an LLC is right for you, however, be advised that anyone starting a new business should consult with his or her legal and tax advisors before making the big “choice of entity” decision.  There are many subjective considerations and factors which will weigh in favor or against any particular choice.

For example, if you are planning to seek venture capital or go public, forming a C corporation rather than an LLC is the better choice.  Venture capital firms don’t care for the unpredictable and unique management of LLCs, and prefer the familiar structure and management of a conventional corporation.

Morever, VCs generally cannot invest in an LLC.  If you set yourself up as an LLC, and then seek VC funding, you will have to spend a lot of money changing from an LLC to a C corporation, if your particular state’s law even allows this.  Further, the LLC ownership structure simply isn’t a good fit for a publicly-traded company.

If you’re considering starting a business or revisiting a current one, contact us today. 



B Corps vs. Benefit Corporations: What Are They & What’s the Difference?

As socially conscious entrepreneurship becomes more visible and viable, you may keep hearing the terms “B Corp” and “Benefit Corporation” or “Public Benefit Corporation.”  What do these terms mean and how are they relevant to a Colorado small business owner?

Many use the terms “B Corp” and “Benefit Corporation” interchangeably, but they are in fact very different things!

B Corps

A B Corp is a for-profit entity that has obtained a voluntarily certification from a certain nonprofit organization headquartered in Wayne, Pennsylvania, called B Lab.

As of the date of this posting, there are 1,925 certified B Corps in 50 different countries spanning 130 different industries.  Some nationally-recognized Colorado B Corps include New Belgium Brewing Co. and Bhakti Chai.

Obtaining a B Corp certification requires passing the B Lab Impact Assessment, which analyzes a company’s operations and provides a score based on meeting higher standards of transparency, accountability, performance and impact on the community.  Passing the assessment test requires a score of at least 80 out of 200 points.  There are many workshops and boot camps available in the Front Range area for business owners looking to hit the Impact Assessment’s various benchmarks.  After passing the assessment, B Corps must pay a membership fee based on annual revenues.

Obtaining B Corp certification allows a business to join a community dedicated to creating a more just and conscious economy yet still driven by profit motives.  B Corps organize various gatherings around the world, including an annual retreat, and such events provide opportunities to network and support other like-minded business owners.

Benefit Corporations

A Benefit Corporation is a type of business entity (i.e., a special kind of corporation) that is authorized by state law.  As of the date of this posting, 31 states  – including, as of April 4, 2014, Colorado – have recently enacted legislation to allow for these entities.   This legislation allows socially conscious entrepreneurs another entity option when starting a business.

The Benefit Corporation movement, largely spearheaded by B Lab, was to fix what many saw to be a major limitation in standard corporate law.

As you may know, the business and affairs of any for-profit corporation must be managed by a board of directors.  Traditionally, the individuals on the board of directors have a legal duty to manage the affairs of the corporation in the company’s best interest.  If they do not follow this duty, they could be liable to the corporation’s shareholders for breach of their duties.

So…what does “in the company’s best interest” actually mean?  Some perceived it to mean only the maximization of shareholder value.  This would severely limit the goals and the general ethos of the socially-conscious business/B Corp assessment movement.  If a board of directors was trying to decide between two options, with Option 1 promising high profits but harm to the environment and Option 2 resulting in lower profits but no harm to the environment, the maximization of shareholder value theory would require the board of directors to pick Option 1.

Benefit Corporation legislation has thus been enacted to address this limitation in traditional corporate law.

Beyond corporate doctrine, however, forming a business as a Benefit Corporation may be important for reasons of marketability, relaying a message to current and potential employees and customers, and signaling participation in the socially-conscious business movement.

Colorado Public Benefit Corporations

The Public Benefit Corporation Act of Colorado (“PBCA”)[1] contains the relevant provisions for those electing to operate their corporations as a Public Benefit Corporation (a “PBC”).  A Colorado PBC is a for-profit corporation that is “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”[2]

What would be considered a “public benefit”?  The PBCA defines public benefit as “one or more positive effects or reduction of negative effects on one or more categories of persons, entities, communities, or interests other than shareholders in their capacities as shareholders, including effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific, or technological nature.”[3]

A key thing to realize is that PBCs are still subject to the rules and requirements contained in the regular corporate statutes, including the Colorado Business Corporations Act and the Colorado Corporations and Associations Act.  The PBCA merely imposes “additional or different requirements, in which case such additional or different requirements apply.”[4]  The primary differences are:

  • A PBC’s Articles of Incorporation must list one or more public benefit which the company must strive to achieve.[5]
  • A PBC’s name must contain the words “public benefit corporation” or the abbreviation “PBC” or “P.B.C.”[6]
  • A PBC’s board of directors must manage the company to balance (1) the pecuniary interest of the shareholders; (2) the best interest of those affected by the company’s conduct, and (3) the public benefit(s) listed in the Articles of Incorporation.[7]
  • A PBC must prepare an annual benefit report with (1) a description of how the company promoted the benefits listed in the Articles of Incorporation and any obstacles the company faced in promoting those public benefits and (2) an assessment of the overall social and environmental performance of the company against a third-party standard.[8] This annual report must be provided to each shareholder of the PBC and posted on its website.[9]
  • Any share certificates of the PBC must consciously state the company is a public benefit corporation.[10]

A PBC is formed the same was a traditional Colorado corporation would be formed – by filing Articles of Incorporation with the Colorado Secretary of State.  Thereafter, all other documentation used to organize a PBC is extremely similar as what is used to organize a traditional Colorado corporation.

The PBCA specifically protects directors of a PBC from lawsuits by third parties who are interested in the public benefits listed in the Articles of Incorporation and by people who may be affected by the PBC’s conduct.[11]

This section is meant to be a general summary of the PBCA and if you are thinking of creating such an entity or converting your current corporation to a PBC, consulting with an attorney is strongly advised.

[1] Section 7-101-501 et cet., C.R.S. Added by Laws 2013, Ch. 230, § 1, eff. April 1, 2014.

[2] Section 7-101-503(1), C.R.S.

[3] Section 7-101-503(2), C.R.S.

[4] Section 7-101-502, C.R.S.

[5] Section 7-101-503(1)(a)-(b), C.R.S.

[6] Section 7-101-503(4), C.R.S.

[7] Section 7-101-506(1), C.R.S.

[8] Section 7-101-507(1)(a)-(b), C.R.S.

[9] Section 7-101-507(4), C.R.S.

[10] Section 7-101-505, C.R.S.

[11] Section 7-101-506(2), C.R.S.