LEGAL ASPECTS OF HORSE MANAGEMENT
LESSON ONE: HORSE BUSINESS ORGANIZATION
Instructor:
Lisa Smith
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.
2).
Partnership
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.
(8).
SYNDICATION
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.
CONCLUSION
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.