Oftentimes one of the most challenging aspects of starting a commodity futures or forex business is selecting the proper form of legal entity. Routinely we are asked questions like: “How should I structure my commodity trading advisor (“CTA”)?” “What type of entity should a commodity pool operator (“CPO”) use?” “What liability will I have with my Introducing Brokerage (“IB”)?” or “How and why do most CFTC registered and NFA member commodity and forex firms form the way they do?” This article will briefly touch upon some of the most common legal entity forms we have seen used within the commodity and forex industry and highlight some of the possible benefits and disadvantages of each. Please note that the following descriptions do not constitute legal advice and are intended solely for educational or informational purposes. Before making a decision we recommend that you contact a competent industry professional or legal advisor before forming your business.
Limited Liability Companies
A limited liability company (“LLC”) is one of the more recent and most flexible business structures available to commodity and forex firms. An LLC is a separate legal entity having the authority to conduct business, acquire, hold and dispose of property, and sue or be sued in its own name. Management of an LLC may be controlled by the members (as few as one) or by selected managers who may or may not also be members themselves. The relationship among members and the management structure are typically set forth in a written operating agreement executed or accepted by each of the members. An LLC can elect to be taxed as either a partnership, corporation, or as a sole proprietorship depending on the planning decisions made by the company.
· Asset Protection – No member or manager is personally liable for the obligations of an LLC beyond the amount such person has contributed to the LLC (if any)
· Tax Structuring – An LLC can determine its own tax structure (see above)
· Flexible Management – An LLC be member or manager managed
· Established History – The primary disadvantage of an LLC is its “newness” as an entity form, because case law pertaining to LLCs is not uniform (or even necessarily consistent) between the various states
· Shared Authority – Depending on whether the company is member or manager managed, a respective member or manager may act on behalf of or bind an LLC; in other words, certain elements of centralized control may be forfeited
A limited partnership (“LP”) is a common form of arrangement between two or more parties to form a business entity. An LP is a separate legal entity from its partners and it must have both at least one general partner and also at least one limited partner. The general partner must be different from the limited partner. In an LP, the relationship among partners is governed primarily by a partnership agreement. While the agreement may be oral, use of a written agreement is almost always advisable. The principal distinguishing feature of an LP is that the limited partners are not personally liable for the debts and obligations of the partnership. In effect, limited partners are only at risk up to the value of their invested capital. The general partner, on the other hand, remains fully liable for the overall debts and obligations of the company. From a tax perspective, LPs are pass-through entities. This means that any income or expense from the business is passed through to the individual partners and is included on their individual tax returns.
· Asset Protection – Limited partners have no liability beyond their initial contribution
· Tax Structuring – An LP is a pass-through entity (see above description)
· Management Control – The general partner maintains control over the company
· Liability – The primary disadvantage of an LP is that the general partner has personal liability for obligations of the company. As a result it is often recommended to make the general partner a company as opposed to an individual
· Shared Authority – Any general partner (if more than one exists) may bind or obligate the company
· Formalities - There are generally more filings, formalities, and state requirements with LPs than with LLCs
A general partnership is simply an association of two or more persons to own or carry on a business together. No formalities or legal filings are required to create a general partnership, as opposed to an LP. Thus, a general partnership may arise out of the conduct and actions of the parties, or through a simple oral agreement. It is prudent, however, to use a written agreement that specifies the respective rights and duties of each partner. Where no agreement exists, the Revised Uniform Partnership Act provides some rules for the creation, operation, dissolution and termination of a general partnership, but it is not considered a desirable substitute for a written agreement. Lastly, general partnerships are taxed as pass-through entities, meaning that each partner is responsible for their personal tax liabilities.
The distinguishing features of a general partnership are that each partner is an agent for the partnership with the power to legally bind (i.e. speak and act on behalf of) the general partnership. As a result, each partner is personally liable for the debts and obligations of the general partnership as a whole. Most business decisions may be made by a majority of the partners, although some matters, such as admission of a new partner, may require unanimous agreement.
· Easy Set-up – Very easy to form and no legal filing requirements
· Liability – The primary disadvantage of a general partnership is that all partners in the general partnership are personally liable for the company’s actions
· Shared Authority – Any partner to a general partnership may bind or obligate all partners in the partnership
The simplest form of business enterprise is a sole proprietorship. This business is conducted by an individual after obtaining any necessary licenses, permits or other authorizations necessary to commence business. A sole proprietorship does not involve the creation of a legal entity separate from the proprietor. Since there are no organizational or operational formalities involved, a sole proprietorship is very simple to start, operate and terminate. However, if business will be conducted under a trade name, a "fictitious name filing" or “doing business as” may be required. Sole proprietors are personally liable for all debts and obligations of the business and there is no continuity of business in the event of disability or death. The only way to transfer ownership of the business is through a sale of the assets used in the business. Sole proprietorships are taxed at the personal income tax rate of its owner, and they might also be subject to additional self-employment taxes.
· Easy Set-up – Very easy to form and no legal filing requirements
· No Shared Authority – One individual is free to make all of the business decisions for the company
· Liability – The primary disadvantage of a sole proprietorship is that the individual running the business is personally liable for all debts and obligations of the business
· Possible “double taxation” based on an individual’s unique tax filing status
Probably the most common type of business entity, in general, is a corporation. A corporation is a legal entity that is separate and distinct from its owners, and may acquire, hold, and dispose of property, conduct its business, and sue or be sued in its own name. The relative rights and duties of the corporation, its owners, and its management are largely defined by statute and by the corporation's certificate of incorporation and bylaws.
Most corporations are organized as stock corporations and issue one or more classes of stock to evidence ownership. Under certain circumstances, a corporation may be formed as a non-stock, membership corporation. Stockholders in small corporations often choose to enter into a stockholders' agreement to regulate the voting and transfer of stock in order to better protect their investment.
As a separate legal entity, a corporation is liable for its debts and other obligations. Except under unusual circumstances, stockholders, directors and officers of a corporation are not personally liable for the corporation's obligations.
Management of a corporation generally rests with its board of directors, who are elected by the stockholders. Other than the right to elect directors and approve certain transactions, such as mergers, sale of all assets, and dissolution, stockholders generally have no role in managing a corporation.
· Asset Protection – The owners of a corporation cannot be held personally liable for the obligations of the business
· Tax Structuring – C-corporations must file their own separate tax form. An S-corporation is a pass-through entity, however to be considered an S-Corporation specific IRS filings are required and certain restrictions may apply
· Centralized Ownership – A corporation is owned by its shareholders
· Burdensome Formalities – Corporations are legally required to observe a vast array of corporate formalities. Such formalities include holding and documentation of company meetings, formal approval of major corporate decisions, and the approval of the board of directors and shareholders. Failure to meet such requirements may jeopardize the Corporation’s tax deductions and the asset protection attributes of a corporation.
While the above descriptions generally refer to U.S. based companies, companies can also be formed offshore. Companies are often set up offshore to allow for different groups of investors. For instance, a company that anticipates having most of its investors outside of the U.S. and/or have U.S. tax-exempt investors might want to consider forming a company offshore. Other times an offshore company is selected in an attempt to afford privacy to investors. In cases where investor confidentiality and privacy are necessary, an offshore company should generally not accept U.S. investors.
As an additional entity formation consideration, oftentimes new trading companies are confused by the use of onshore and offshore funds in a master/feeder structure. A master/feeder structure simply allows a fund manager to manage money for a broad spectrum of investors. The master fund, structured as an offshore corporation (but treated as a partnership for U.S. tax purposes via a “check-the-box” election), engages in all trading activity. The fund manager will pool money and “feed” it in to a master fund and allocate trading gains and losses back to the onshore and offshore feeder funds based on the percentage assets under management in each feeder fund. A master/feeder structure typically includes (in addition to the master fund company) a U.S. limited partnership or limited liability company as the feeder fund for U.S. taxable investors and a foreign corporation as the offshore feeder for foreign investors and U.S. tax-exempt investors, but it is also possible using this arrangement to have multiple domestic and offshore feeder funds flow into the master fund.
Piercing the Veil
Although one of the primary motivations for creating a separate legal entity is to shield personal assets from liabilities associated with the business, there are certain circumstances under which courts will “pierce the veil” and allow creditors of a company to pursue claims against the owners personally. For example, limited liability generally depends among other things on an entity’s adherence to the formalities required by applicable law, e.g. segregation of company funds from personal funds and maintenance of appropriate corporate books and records for the company. Liability may also extend to personal assets if:
- An owner of the company personally and directly injures someone;
- An owner personally guarantees a bank loan or business debt on which the company defaults;
- An owner engages in fraudulent activity in connection with the company’s business activities; or
- An owner treats the company as an extension of his/her personal affairs, rather than a separate legal entity.
Seek Guidance Now
As you can see from the descriptions above, determining how to properly structure your commodity futures or forex business can be complex. In order to properly evaluate your options, it would be prudent to contact a regulatory professional like Turnkey Trading Partners (“TTP”) as soon as possible. TTP has the business acumen, as well as important relationships with legal professionals, such as Henderson & Lyman of Chicago, to provide you with the tools you need to get your fund or trading advisory business up and running.
-James Bibbings and Nicole Kuchera
James Bibbings is the President and CEO of Turnkey Trading Partners (“TTP”), a firm that supports all commodity and forex specific regulatory and business needs. Prior to founding TTP, Bibbings worked with the National Futures Association (“NFA”) as a supervising auditor. During his time with NFA he was involved in approximately 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations. Since departing from NFA, Bibbings has owned and operated an independent introducing brokerage and participated in international forums on proposed CFTC regulatory requirements. He has also provided financial markets content for MSN, Yahoo, Financial Times, FinAlternatives, Wiki-Investments, Safe Haven, Financial Sense, The Wall Street Journal’s Market Watch, Forex Journal, FX Street, Forex Factory, Commodity News Center and many other highly acclaimed investment publications. Two highly sought after informational pamphlets regarding futures and forex registration authored by Bibbings are currently available for free upon request through his company website. If you have any questions or comments for Bibbings he can be reached directly by email at firstname.lastname@example.org and would love to hear from you.
Nicole Kuchera, JD, LLM is an Associate in Henderson & Lyman's Financial Services Practice Group. She concentrates her practice on transactional and litigation support for securities, futures, forex, and derivatives industry clients. Presently Ms. Kuchera counsels clients regarding a wide range of compliance and regulatory matters involving rules and regulations of SEC and CFTC, as well as self-regulatory organizations and exchanges. She also represents financial services industry clients in a wide range of litigation matters in various forums, including state and federal courts and in industry arbitrations and mediations. Ms. Kuchera is also a member of the Chicago Bar Association’s Securities, Financial & Investment Services, and Futures & Derivatives Law Committees.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.