LEGAL ASPECTS OF HORSE MANAGEMENT
LESSON ONE: HORSE BUSINESS ORGANIZATION
Instructor: Ruth Kochard
For those planning to establish a horse business, the first decision is to determine the form your business will take. Picking your business name and placing an advertisement are just a couple of decisions facing you in getting your business off of the ground.
This lesson examines the legal forms a horse business or operation may take, as well as the advantages and disadvantages of each. A business may take the following forms: sole proprietorship; partnership; limited liability company (“LLC”); subchapter S corporation (“s corp.”); and c corporation. There are also joint ventures involving a joint effort in a specific venture, and syndicates, a form of co-ownership arrangement.
1) Sole Proprietorship
A sole proprietorship is the simplest form of conducting business—but not always the wisest. It is a business formed by one individual where the business has no separate existence apart from the owner. This does not necessarily mean the business is in the name of the owner—a business may transact under another name (a trade name). Examples of a sole proprietorship are:
--Susan is a professional trainer who freelances at local farms and operates under her own name. She has no partners, investors, and no corporate entity.
--Tim has a farm called Windy Stables. He has two employees, but no partners, investors, and the farm is not incorporated. Tim owns the land on which the farm sits.
The advantage of a sole proprietorship is the ease with which it is formed. There is minimal paperwork and government intrusion, and minimal expense; often times all that is necessary is a business license and—depending on the state--registering the name or d/b/a (doing business as). Obtaining a federal tax id number will also be necessary if the business has employees.
The taxation of a sole proprietorship is simple; no corporate tax forms need to be filed. In that there is no separate corporate existence, everything the sole proprietor makes is his/hers and is taxed individually (on a schedule to the personal tax return). The double taxation of a stock corporation (discussed below) does not occur.
Again, everything the sole proprietor makes is his/hers. There are no partners or shareholders to account to or split profits with. Similarly there are no others to consult with, and decisions about the business may be made quickly and without fuss or trouble.
The advantages all hold great appeal to many horse business owners who may not seek a paper-heavy, reporting-intensive business, or having to split profits and decisions with others. But, there are risks!
There are several significant disadvantages to a sole proprietorship; the foremost being a lack of a separate corporate existence to accept liability. If the business has debts, or is subject to any liability, the sole proprietor’s personal assets are vulnerable.
For example, if a person operates a farm as a sole proprietor and starts the operation with $10,000 in the bank and after a year of weak business has debts in excess of $10,000.00—or, worse yet, is sued for $1+ million--the sole proprietor will be personally liable for the amount of the debt. Not only will his/her business be broke, but all personal belongings, assets, home etc. will be subject to this debt. In a horse business this may be particularly problematic in light of the significant risks involved.
Other disadvantages to this business structure include the difficulty such businesses face in raising capital, both from banks, and in the absence of shareholders/partners. While sole proprietorships may appear ideal to a horse businessperson in light of the simplicity and minimal start-up effort, the risks of the horse world, and thus the risk of personal liability of the business owner, often dictate that the business operate in a different form.
A partnership is a business where more than one person conducts business with the intent to make and share in the profits—and liabilities. Unless there is a different agreement, the partners are considered to share equally in profits/liabilities. A partnership is not perpetual (unlike a corporation) and, unless otherwise agreed to, ends if a partner dies.
The most basic (and simple) partnership is a “general partnership.” Examples of a general partnership are:
--John and Jill operate a breeding facility. John owns the property and handles the bookkeeping. Jill manages the barn and trains the babies. They each are 50/50 partners and split the profits (and debts).
--Sue, Larry, and Ted form a business called “Greener Pasture Riding Apparel.” Larry invests 90% of the business capital, Sue is the store manager and invests 5%, and Ted invests 5% and handles purchasing. All three divide the profits (and debts) and have entered a partnership agreement where the profits and losses are divided in the same percentage as their initial investments.
The mere co-ownership of a horse does not make the owners “partners” under partnership law. However, there may be a partnership that involves co-ownership of a horse. For instance, if two individuals agree to purchase show prospects, train and resell them and split the profits this would be a partnership since it involves more than mere ownership—it involves sharing of gross profits.
Partnerships do not need a written agreement, but may arise by oral agreement as well. In addition (in that the key to finding a partnership is the intent of more than one person to operate a business for profit) a partnership may be implied by the parties’ actions. This may, in the eyes of the law, create a partnership whether the parties intend to or not. An example:
--Sarah and Karen have a horse training/sales business as a partnership. They ask Mark, a non-partner, if they can use his farm to sell and market their horses. Mark has a nice farm, (“Miranda Farm”) and a grand prix ring. Sarah and Karen use Mark’s farm name in marketing their business, calling their operation S & K and Miranda Farm and use this in obtaining a loan. If the business suffers losses, and the loan is defaulted on, Mark could potentially be liable as a partner by estoppel, since the loan was based on the presumption that he was a partner in Sarah and Karen’s business.
There are advantages to a general partnership. Similar to a sole proprietorship it is easy to form, requiring mere compliance with business license and registration laws. And although it is strongly recommended that it be done, a partnership does not require any written agreement. For example, the above partnerships would have been formed simply by virtue of the relationship and the intent to form a partnership. Also, there is no double taxation, and the profits of a general partnership are taxed directly to the partners in the proportion of their partnership interest. (Note: Unlike a sole proprietorship, a partnership, while taxed individually to the partners, must nonetheless file a partnership tax return.)
An additional advantage with a partnership is that there is more than one person to invest money/assets, thereby giving the business greater ability to grow. Also, while partners are directly liable for the debts of the business, this risk is shared between the partners. Finally, a partnership also offers the advantage of the greater expertise and support provided by the additional partners.
The foremost disadvantage to a general partnership—and one that is significant--is liability. The individual partners’ personal assets are liable for the debts and liabilities of the partnership. As stated, concerning sole proprietorship, this risk exposure is significant in light of the frequent accidents encountered in the horse world. In addition, a partner, unlike a sole proprietor, is liable for the acts of his/her partners acting within the course of partnership business. An example:
--Tracy and Sue have a partnership where they purchase horses off the track for retraining and resale as show horses. Sue enters a contract to purchase a horse she loves. Unfortunately Tracy does not, after discovering the horse is a lame cryptorchid who is severely barn sour. Tracy is stuck with the contract to purchase the horse.
Other disadvantages of a general partnership include the fact that profits must be split or divided, and decision-making may not be unilateral. Partners may not always agree, and this may affect the business bottom line.
An additional problem may arise in the case of a partnership that is operating without a formal agreement. Contracts are interpreted under general contract law, however all states (except Louisiana) have adopted the Uniform General Partnership Act or Revised Uniform Partnership Act. This Act provides the legal principles that are to govern general partnerships, particularly in the case where there is not an agreement explicitly governing the arrangement. Partners need to adequately memorialize the specific terms of their agreement so that unwanted effects of the partnership act will not apply. Although oral agreements are (too) frequently the basis for a horse business, it is strongly advised that any business or partnership agreement is written, and fully addresses all issues that may or will arise between the partners. A “handshake” agreement may be easy, and frequently done, but is not usually smart.
Many in the horse world enter partnerships because it is simple to do. One person asks another if they want to buy a few horses, train and promote them, and sell them and divide the profits. It may be as simple as that with no writing and nothing other than the intent to share a business and its profits and debts. However the significant risk of personal liability to partners—particularly in the risk intensive horse world--should make future partners take note and possibly consider an alternative means of operating.
3). Limited Partnership
A “limited partnership” is an unincorporated business association that is a partnership with two classes of partners: general partners, and limited partners. It attempts to offer greater liability protection and tax benefits than the traditional partnership or corporation.
The general partner in a limited partnership is one or more individuals who have all the similar rights, obligations, and duties of a general partnership. The general partner personally absorbs the risks and liabilities of the partnership, shares the profits in predetermined proportion, and controls and operates the management of the partnership. The general partner also has actual authority to act as agent for the partnership and bind the partnership in contracts with third parties to the extent such is in the ordinary course of the partnership’s business. (Note: General agency principles are addressed in Lesson 3.)
Unlike the general partners, the limited partners have limited liability. As such, they are only liable for the amount of their investment; if the debts of the partnership exceed the amounts of the partners’ investments, only the general partners will be personally liable for the excess. Also the limited partners have no management authority or control. (Note: if a limited partner engages in the management of the partnership limited liability may be jeopardized). An example of a limited partnership:
--Jeff and Barbara are race-horse trainers. Jeff is experienced in selecting and starting colts; Barbara is experienced in getting them racing and winning. They want to purchase one or more colts, and are able to find a few wealthy investors to invest a certain amount for a limited partnership interest. Jeff and Barbara are solely involved in the selection, training, and management of the horses’ careers. They are also personally liable for any and all debts of the partnership. To the extent the partnership makes a profit, the investors (limited partners) are paid a dividend. If the business is a failure, or otherwise has a debt, the limited partners may only lose their investment—no more. (Note: There is a variation of the limited partnership—a limited liability partnership (LLC) where all partners have limited liability.)
As you can see, the limited partnership has the advantages and disadvantages of a general partnership, with the additional advantage that investors (limited partners) bring added capital to the business. This can be advantageous in a horse business, where the initial capital outlays (particularly in areas such as racing) can be extreme.
However, there is still personal liability for the general partners. To limit or avoid this negative effect a limited partnership is sometimes formed with a corporate general partner, since, in such a case the corporation, not the individual, would be ultimately liable.
Also, unlike general partnerships where partners’ acts may result in the finding of a partnership, a limited partnership is a creation of state law, and such laws must be followed to create one.
As with a general partnership, a limited partnership should be detailed in a written agreement. The terms of the agreement will determine its legal effect. In addition, all states, except Louisiana, have adopted variations of the Uniform Limited Partnership Act, which sets forth provisions that govern a limited partnership and details the terms of the partnership in the absence of an express agreement.
As a final note, limited partnerships also may enjoy the pass through taxation of a general partnership, though in order to do so certain limitations apply. A limited partnership must meet certain criteria in order to avoid being treated as a corporation for purposes of taxation.
(4). C Corporation
A “c corporation” is a business entity created under state law, and has a separate existence apart from its shareholders. The owners of the corporation, are the individual shareholders, but since a corporation is a separate legal “person”, it may enter a contract, obtain a loan, file a lawsuit or be sued. In the case of a corporation, liability, is directed to the corporation and not to the shareholders’ personal assets. An example of a corporation:
--Susan and Fred have a great idea: they are going to acquire a stable and offer horse rentals and organized trail rides to the general public. Because of their need for capital, and the substantial liability risk created by such a business, they decide to form a corporation. They file articles of incorporation for Echoing Wind Farm, a board of directors is appointed, corporate officers named, and stock issued. If the stable gets sued, the stockholders will not be personally liable.
C corporations may be public or private. A publicly traded corporation is one where the stock is traded on a public exchange. A closely-held corporation is one where the stock is not traded on a market. Most (but not all) horse businesses are closely-held; publicly traded corporations have greater access to capital, but are subject to the markets and have significantly greater administrative expenses including, but not limited to, the added reporting requirements of the securities laws. Typically only very large businesses are publicly traded.
A corporation is perpetual, meaning that it does not lapse upon the death of a shareholder. The formation of a corporation requires filing articles of incorporation with the state Secretary of State. The incorporator then names a board of directors who issue shares of stock and appoint the officers. The board of directors run the business in a broad sense; the officers (president, vice-president; secretary; treasurer) run the day-to-day affairs.
There are advantages to incorporating, particularly in a horse business. The limitation of liability is the primary advantage. Unless there are facts that show the corporate entity is a sham (undercapitalized, lack of formalities), the shareholders are protected from personal liability. In the risk-dominated business of horses, this can be a significant advantage. An additional benefit of a corporation is the ability to raise capital.
The two prime disadvantages to a c corporation are the double taxation imposed on corporations, and the increased administrative and start-up costs. An example of “double taxation”:
--Tim’s breeding business is a corporation, and it has $10,000 in taxable income. The breeding business files a corporate tax return and pays corporate tax on this amount. The distribution of any after-tax dividends or profits to shareholders are also taxed to such individuals on their individual tax return; hence, the “double” taxation.
Since the prime advantage to being a corporation is limited liability, it is critical that all corporate formalities and administrative requirements be followed. It is also critical that the corporation is adequately capitalized. Sloppy bookkeeping and ignoring the administrative side of the business can result in the corporate form being disregarded for purposes of personal liability. This is commonly referred to as “piercing the corporate veil.”
An incorporated horse business needs to pay attention to corporate details to enjoy the limited liability that is the purpose of incorporating. An example:
--Tim’s been very busy with his breeding farm, and the foaling, training, and sales. He’s been so busy that he’d forgotten the need for corporate meetings, minutes, had undercapitalized and underinsured the business, and had begun paying farm bills from his personal account. A mare that is being bred on his farm breaks a leg and is put down; Tim loses not only the stud fee, but is sued by the mare’s owners, who recovers a judgment against Tim for $1.5 million. The insurance paid $500,000 and, the plaintiffs seek to recover the remainder against Tim individually since: the farm itself had no assets, and, Tim’s failure to follow corporate formalities made him personally liable for the corporate debts. One all too common horse disaster, and Tim has not only lost his business, but possibly everything he owns.
As the example demonstrates, a corporation offers needed liability protection to a risky business involving horses since the corporation is a separate “person” that can be sued and is responsible itself for corporate debts. However, there are formalities that must be followed, and a person selecting this business entity must play by the corporate rules to achieve this advantage.
(5). Limited Liability Company (LLC)
A limited liability company is a relatively new corporate entity that combines both partnership and corporate traits. It is also a business form that is popular both in horse and other businesses.
An LLC is managed by “managers,” and the shareholders of the corporation are referred to as its “members.” The manager may or may not be a member. The agreement that details how the LLC will operate is called an “operating agreement.”
As a corporation, an LLC offers the advantage of shielding the members from personal liability. However, a corporation that is a sham, or not properly run, could potentially expose members to personal liability—the so-called “piercing the corporate veil.” It is important to note that corporate formalities must be followed by the members in order to receive the benefit of limited liability.
An additional benefit that an LLC offers—and one that a “c corporation” does not—is that of pass-through taxation, similar to the way a partnership is taxed. The profits that are made by the LLC are passed directly through to the members; there is no additional (or double) tax due directly by the LLC.
Example of an LLC:
--Todd wants to start a business as a horse farm consultant. He will manage and operate the business, and he has Jeff and Terry who are investing money as members. He files the necessary state forms to establish the business as an LLC. Todd, Jeff, and Terry will not be subject to personal liability when the consulting business loses money. (Note: in this example, there is more than one member. Certain states permit LLC’s where there is only one member.)
The formation of an LLC is relatively simple, and the bookkeeping and corporate formalities are minimal (compared to a c corp). Nonetheless, there is legal paperwork to be filed with the state; all states have laws addressing LLC’s, and organizational documents will need to be filed. The LLC laws also provide certain default provisions in case there is no express written agreement. Typically an LLC is formed with a detailed operating agreement that addresses how the business will operate. Unlike the uniform acts governing partnerships, the states vary widely on their LLC laws. While the above could possibly be handled by a business/legal savvy horseperson, it is generally advisable to retain an attorney to set up the structure of the operation so that it best addresses the organizer’s and members’ business interests.
The LLC has become very popular because it enables a small business that might otherwise be a partnership to have the limited liability of a corporation, yet without the double taxation and onerous bookkeeping of a c corporation. They also offer greater flexibility than c corporations in how they are structured. For a horseperson starting a farm or other horse-related business this “best of both worlds” can be ideal.
(6). Subchapter S Corporation
A “subchapter S corporation” (“s corp.”) is a corporation where the profits pass through to the shareholders in the same manner as a partnership. Thus, as with an LLC, it provides for limited liability and pass through partnership taxation.
There are qualifications for an S corp. The corporation must: have no more than 75 shareholders, all of whom are individuals, estates, or qualifying trusts; have only one class of stock; be formed in this country; and may not be a bank, insurance company, or Domestic International Sales Corporation. Nonresidents may not hold shares in this type of corporation. In addition, a subchapter s corporate must elect such status by March 15 of the tax year the election is to apply.
Assuming that all of the above is do-able, why would Tim in the above examples consider an S corporation for his breeding business? The limited liability and potential tax benefits are the attraction. These two factors are particularly favorable for a horse business. However, given the similarities between and LLC and an s corp, and the potential (despite double taxation) for more tax benefits, a horseperson would be wise to consult a tax expert for an opinion on the tax impact of each business form.
In addition, there are disadvantages to this business form that may make it less than attractive. There is no flexibility of the distribution of profits in this type of corporation; profits are allocated in proportion to the ownership interest. Also foreign investors are not permissible:
--Susan has a European Sports Sales business that she seeks to incorporate in the United States. She has 20 potential investors, the largest of which is Swiss. She may not form a subchapter S corp.
As can be seen, the S corporation offers some advantages, but particularly in light of the appearance of LLC’s it would be advisable to consult with a professional to determine if your business needs would be better met with a c corporation or LLC.
(7) JOINT VENTURE
A “joint venture” is similar to a partnership, with the exception that it is conducted for one specific business purpose or objective. It is frequently employed by individuals or companies that seek to combine efforts with another to achieve one particular project. By way of example:
--Lois and Margie want to purchase the quarter horse “Chance of a Lifetime” to compete in cutting events. They intend to combine their money, and efforts, to compete the horse, splitting any winnings and eventually selling the horse and splitting the profits. Since the arrangement just involves one specific horse, this would be a joint venture.
The legal advantages and disadvantages of a joint venture are similar to a partnership. However, there is a distinction between a joint venture and partnership in that a partnership continues after one business objective is accomplished, whereas a joint venture is over when the specific purpose has been achieved.
A syndicate in the horse world is a form of common ownership where individuals purchase an interest in a horse. It is frequently encountered in the breeding and racing fields. For example, in a breeding syndication, persons purchase a fractional interest in a breeding stallion that typically entitles them to one breeding per year. The farm will typically retain multiple interests.
The co-ownership is set forth in a syndication agreement, and may take several forms. The agreement is a detailed statement of the owners’ interests, liabilities and obligations, in the syndication. The agreement also addresses the health and fertility of the stallion, and the breeding rights and restrictions of owners. The agreement clarifies issues concerning the transfer of interests.
Syndicates enable persons to invest or own part of a horse that would otherwise be too costly to own. In addition, if structured properly, a syndicate can provide certain tax benefits.
Syndicates require careful structuring and formation. In addition to the typically extensive syndication agreement, securities laws may need to be complied with depending upon how the syndicate is structured. A syndicate that is not an undivided fractional interest syndicate may be deemed a “security” thus necessitating compliance with securities laws. A horse person seeking to form a syndicate should by all means contact tax and legal professionals to form and structure the venture.
There are several forms a horse business can take. What particular form is best for your business will depend on your interests and needs; often this requires assistance from tax and legal experts.
What is most important is that your business takes some well-thought out intended form. All too often horse business owners pay sole attention to the enjoyable aspects of the business—the horses—and neglect the business details that are necessary to limit personal liability and minimize tax consequences.
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