Forming and Organizing a New Entity

If a decision is made to organize a water fund through the creation of a new entity a number of legal steps need to be taken to form the entity and get it up and running. The following discussion provides an overview of the issues that need to be decided and the steps that generally need to be taken to form a new entity, and the organizational formalities that need to be observed by the entity once formed.

Key Considerations:

  • What are the key issues in determining what form of entity to use?
  • What types of entities are available to create a new legal entity?

What are the key issues in determining what form of entity to use?

Many of the key issues to consider in choosing a legal entity are similar to the issues to consider in determining how to organize a water fund, which were discussed above:

● Liability implications for participants/owners

● Tax treatment

● Cost of formation and ongoing administration

● Ownership and governance flexibility

● Whether employee incentives are necessary

● Whether additional investors/contributors will be sought

What types of entities are available to create a new legal entity?

For-Profit Entities

Within the United States, there are generally three types of legal entities available for the creation of a for-profit fund — limited partnerships, limited liability companies and corporations. Set forth below is a brief description of each type of entity.

  • Limited Partnership

    The contributors to a limited partnership hold their interests as “limited partners.” The persons managing the limited partnership receive their decision making power through “general partner” interests. Limited partners generally enjoy limited liability, but general partners do not have limited liability. Consequently, a general partner is personally liable for the debts and obligations of the partnership (as a result, most partnerships use an LLC as their general partner).
  • Limited Liability Company ("LLC")

    LLCs are owned by their “members” and the day-to-day operations are managed by their “managers.” Both members and managers generally are afforded limited liability. Most LLCs are formed in Delaware because of the flexibility provided by the laws of the state of Delaware. For example, the rights that members have to appoint or remove managers (if any) can generally be specified however the parties desire, and there is no requirement to hold an annual meeting. Like a partnership, profits and losses are passed through to owners, not taxed at the LLC level. However, there is more flexibility in the design, distribution and transfer of equity interests in a corporation than in an LLC. A corporation can issue preferred shares with special rights to early investors. It is also easier to compensate and incentivize employees with ownership interests in a corporation than with ownership or profit interests in an LLC, since the later involves complicated capital account calculations for each of the owners (including new employee owners). It is also easier to transfer ownership interests in a corporation and to conduct a broad public distribution (such as an initial public offering) of ownership interests in a corporation rather than an LLC.
  • Corporation

    Corporations are owned by their shareholders, overseen by their board of directors, and managed by their officers. One of the primary benefits of a corporate structure is the limitation of liability - shareholders, directors, and officers generally are not liable for the debts and other obligations of the corporation. On the other hand, corporations are less tax efficient – the corporation typically has to pay taxes on its income (unless there is an exception making the corporation a pass-through entity, as there is for a Subchapter S corporation under the U.S. Internal Revenue Code) and shareholders of the corporation typically pay taxes on any income they receive from the corporation in the form of dividends or otherwise. Corporations are also more administratively complex. State laws impose more obligations on corporations than on LLCs and partnerships; for example, a corporation is generally required to hold an annual meeting of shareholders and to draft and retain records of the board of directors and shareholders meetings.

Non-Profit Entities

In the United States, non-profit legal entities are chartered at the state level, as are for-profit entities. Most state non-profit entity statutes specify that non-profit entities will take the form of corporations. States use a variety of names for such entities, including non-stock corporation, not-for-profit corporation and non-profit public benefit corporation. Non-profits are typically managed by a board of directors. Directors who are volunteers are typically shielded by statute from liability to third parties for their activities as directors, as long as such activities are within the scope of their duties as directors and do not involve acts that are reckless, wanton, willful or similarly culpable (standards vary by state). Non-profit corporations do not issue stock and do not have stockholders – they do not generate profits to be distributed to anyone.

Non-profit corporations may or may not have “members”, persons with special rights with respect to such non-profit, which may include the right to vote for directors for the board of directors of the non-profit corporation. Most U.S. non-profits do not have voting members. Donors may be referred to as “members”, but their rights are limited to receiving information or minor privileges related to the non-profit’s mission. In such cases, the board of directors is typically self-perpetuating – the current directors elect future directors. Non-profits in which the members vote for directors include the eligibility and other requirements for membership in the bylaws (internal governance rules) of the corporation. Such voting-member non-profits must keep accurate lists of members and hold annual member meetings to vote on directors and conduct other member-directed business.

In order to obtain federal tax-exempt status, U.S. non-profits must satisfy the requirements of one of the sections of the Internal Revenue Code establishing exempt entities. Most U.S. non-profits obtain tax exempt status under Section 501(c)(3) of the Code, which applies to “public charity corporations”, organized and operated exclusively for religious, charitable, scientific, literary or educational purposes.