Business Law

Section 1: Corporations vs Limited Liability Companies

INCORPORATIONS

 Incorporation – It is the legal process of forming a corporation. With incorporation, a

business has many benefits over being a sole proprietor or partnership, including limited
liability, property ownership and contractual capacity.
 2 types of incorporation: (1) Corporation (2) Limited Liability Company (LLC) – which
is a mixture of a partnership and a corporation
 Corporation – A legal entity that is separate and distinct from its owners. Corporations
are owned by their shareholders who share in profits and losses generated through the
firm’s operations and have three distinct characteristics:
(1) Legal existence – The firm can buy, sell, own and enter into a contract, sue other
persons and firms and be sued by them.
(2) Limited liability – A firm and its owners are limited in their liability to their
creditors and other obligors only up to the resources of the firm, unless the owners
give personal-guaranties.
(3) Continuity of existence – A firm can live beyond the life spans and capacity of its
owners.
 How corporations can be created (4 ways):
1. By grant of royal charter
2. By special Act of Parliament – Such bodies are known as statutory corporations.
3. By registration under the Companies Acts
4. By registration under the Limited Liability Partnership Act (LLPA) 2000
 Advantages of Incorporation (Advantages of Incorporation) (meaning the advantages
of being incorporated, i.e., having separate legal personality) (The effects of
incorporation):
1. Separate legal personality (also veil of incorporation):

Since a company is a separate legal entity, it has rights and obligations of its own. The
company property belongs to the company. Also, the members (shareholders) of a company
own and control it, but they are not parties to its legal transactions, nor are they necessarily
agents to the company.
Veil of Incorporation: A company has a separate legal personality. The distinction between a
company and its members is called the ‘veil of incorporation’. It is a protective measure to
protect the personal assets of a director. The principle of the veil was established in the very
important case of Salomon v. Salomon & Co. (1897) in the House of Lords.

Case:

The usual case cited in relation to separate personality is Salomon v Salomon & Co (1897).

For about 30 years, Aron Salomon carried on business as a leather merchant and wholesale
boot manufacturer. In 1892, at the request of his family who wanted a “share” in the business,
he re-organized the sole proprietorship into a limited company. This company was called A.
Salomon & Co Ltd and was registered under the Companies Act 1862.

Once the company was formally incorporated, he then sold his boot-making business to the
company. The company paid for the business through issuing 20,001 shares and a £10,000
debenture to Aron Salomon. The company gave Mr. Salomon security for the debentures by
granting him a floating charge over the company’s stock-in-trade. Shortly after this, the
company suffered heavy losses because of a depression in the boot and shoe trade, along with
other economic factors. It became insolvent and entered into liquidation. The company owed
£7,773 to its unsecured creditors and plus, there were amounts owed to Aron on his
debentures. However, upon realization of the company’s assets, there remained only £1,055
for distribution. As a creditor to the company, Mr. Salomon claimed that he was entitled to
the £1,055 as he held security in consideration for his debentures. Being a security holder, he
would take priority over the company’s unsecured creditors, leaving them with nothing.

The House of Lords stated that the company (Salomon & Co.) was validly formed under the
Companies Act 1862 and on the terms of the Act the company was a different personality
from its members. Its property and debts belonged only to the company and in its activities it
was not the agent of Mr. Salomon, but instead he was the agent of the company.

Thus, this case is the precedent for the “veil of incorporation” between the company and its
owners.

2. Business property is owned by the company

Any of the business’s assets are owned by the company itself, not the shareholders. This is
normally a major advantage, in that the company’s assets are not subject to claims based on
the ownership rights of its members (members cannot claim to be the owner of a company’s
property(s)). However, it can cause unforeseen problems.

Case: Macaura v. Northern Assurance

Macaura owned a timber estate. He later formed a one-man company and transferred the
estate to it. He insured the timber in his own name. The time was later destroyed by a fire.
When the timber was lost, it was held that Macaura could not claim on the insurance, since he
lacked any ‘insurable interest’ in the timber. In other words, he no longer owned the timber
(it belonged to the company), regardless of his “interest” in the company.

As Lord Buckmaster said: “no shareholder has any right to any item of property owned by the
company, for he has no legal or equitable interest therein”.

3. The company has contractual capacity

Contractual capacity is defined as the legal capability to form a binding contract.

Here, a company has contractual capacity in its own right and can sue and be sued in its own
name, since law states that the company really does exist (has corporate personality)
(therefore if legal matters occur in the company, the owners themselves will not be sued and
be liable, it will be the company). In other words, a company is able to employ one of its
members under a contract of service, including its principle shareholder.

Case: Lee v. Lee Air Farming

Lee was the sole owner of a company whose business was aerial crop spraying in New
Zealand. He was managed the business and acted as a chief pilot, receiving a wage for that
work. Lee was killed in an air crash while working for the company. Lee, as he was an
employee when the accident occurred, the company thus was liable to his wife for
compensation under the Statutory Workers Compensation Act. The insurers however denied
liability on the ground that Mr. Lee could not be an employee because he was a director of
the company. However, it was held that Mr. Lee was a worker and his position as principal
shareholder and managing director did not stop him from making a contract of employment
on behalf of the company between himself and the company.

Other advantages include:

4. Litigation
The general principal which was established in the case of Foss v. Harbottle, is that no one
other than the company may sue or be sued to enforce its rights or obligations. Individual
shareholders cannot sue for wrongs done to a company or complain of any internal
irregularities.

Case: Foss v. Harbottle

Two shareholders commenced legal action against the promoters and directors of the
company alleging that they had misapplied the company assets and had improperly
mortgaged the company property. The Court rejected the two shareholders’ claim and held
that a breach of duty by the directors of the company was a wrong done to the company for
which it alone could sue. In other words, the proper plaintiff in that case was the company
and not the two individual shareholders.

5. Limited liability

Members (shareholders) are not responsible for the debts of the company. The shareholder’s
liability is limited to the amount remaining unpaid on the lowest value of the shares held.

6. Perpetual succession

Changes in membership have no effect on the Company’s existence, so that members will
come and go but the company will continue to exist.

Because the company is separate from its owners, it does not dissolve when one owner
leaves. For instance, if a shareholder dies, the company may transfer their shares, and the
corporation is not negatively affected. Thus, this allows for a shareholder to disconnect from
the corporation by selling all his shares without ending the corporation.

 Lifting the Veil of Incorporation - Disadvantage

There are certain situations where the courts may be willing to ‘lift the veil of incorporation’
and set aside the separate legal personality of the company holding directors or members
liable for the debts of the company. As a result, the members are revealed and made
responsible for the actions of the company. Such situations arise in the following
circumstances:

1. Company identity used to evade obligations – Here, the Courts have been more than
prepared to pierce the corporate veil when it believes that fraud is or could have been
 performed behind the veil and where the company is merely used as a sham or puppet of
another. The Courts will not allow the Salomon principal to be used as an engine of fraud.
Case: Jones v. Lipman
Here, Mr. Lipman agreed to sell his property to Jones, but then changed his mind. He then
formed his own company and made himself the director and owner. He then transferred
the land, which he agreed to sell to Jones, to this sham company in order to avoid his
legal obligation to complete performance. Jones then applied for specific performance to
be carried out against Lipman and his company. Specific performance was granted
against both. It was said by the judge the company was a sham.
2. Agency/groups “exists” (Where company acts as an agent):

Here, the activities of a subsidiary must be so closely controlled and directed by the
parent company, that the former can be regarded as merely an agent conducting business
of the parent company. It has lost its individuality and shall be identified with its
members.

Case: Smith, Stone & Knight v. Birmingham Corporation

Smith, Stone and Knight Ltd (SSK) owned some land, as a subsidiary company of
Birmingham Waste Co Ltd (BWC). Birmingham Corporation (BC) issued a compulsory
purchase order on this land. Any company that owned the land would be paid for it, and
would reasonably compensate any owner for the business they ran on the land. However,
since the subsidiary company SSK of BWC did not possess the land, BC claimed that
SSK was entitled no compensation.
The Courts held that the subsidiary company was an agent of BC and must pay
compensation.
In this case, 6 points were deemed relevant for determining whether a subsidiary is
carrying on business as an agent of the holding company:
- Were the profits treated as profits of the parent?
- Were persons conducting business appointed by the parent?
- Was the parent the head and brain of the adventure?
- Did the parent govern the adventure?
- Did the parent company make profits by its skill and direction?
- Was the parent company in effectual and constant control?
All these questions were answered in the affirmative, and so the business belonged to the
parent company.

 2 types of incorporations: (1) Corporations (2) LLC

 Corporations:
Statutory Corporation: Is an autonomous corporate body created by a Special Act of
Parliament or state legislature with defined functions, powers, duties etc. The State helps
these corporations by subscribing full capital and it is fully owned by the state. The
Government nominates the Board of Directors and they manage and operate these
corporations. It enjoys financial independence is answerable only to the legislation that
creates it.
 Limited Liability Company (LLC):
The LLC is a creation of statute and merges the benefits of a partnership alongside those
of a corporation. It is a popular business structure which provides benefits of pass-through
taxation associated with the partnership and the protection of limited liability of a
corporation.
How LLC operates: Ownership, management, sharing profits, limited liability, taxation.
 Termination/Dissolution of Incorporation
1. Voluntary dissolution – This is when the shareholders, incorporators or members
decide to dissolve a company. It can occur because the purpose of the company has
been fulfilled, it has stopped being economically viable, internal problems between
members so they all agree to dissolution (such as in LLC).
2. Bankruptcy – Here, all the entity’s debts come to an immediate end. The court will
not force the company to pay more than the company is worth. This happens when the
company is unable to pay their debts. Thus, there may be liquidation where the assets
are sold to pay off the creditors.
3. Order of the court or forced winding up – This is involuntary dissolution where the
court forces sale of ownership from one to another, or by forcing sale of the entire
business. They may occur due to many factors, for instance, disputes between
shareholders, not paying taxes, seriously offending any provisions of the state
corporate law, or even abuse of power. This method is done when all other resolution
methods have failed.

Differences between LLC and Corporation:

 1. Ownership structure:
- Ownership: The owners of an LLC are members, while the owners of a corporation are its
shareholders.
Expand:
Corporations: Corporations issue shares or stock to their owners who are called
shareholders. Shares are easy to transfer from one owner to another. Also, a
corporation is a good choice for an entity seeking to attract external investors or to
make a public stock offering.
LLC: Owners of an LLC are called members and each member owns a designated
percentage of the entity, which is known as a membership interest. Here, membership
is more difficult to transfer and an operating LLC agreement will specifically state if
and how membership interest can be transferred.
2. Taxation:
Corporations: Corporations are double taxed. Corporations are taxed as a legal entity
as laid down in accordance with legislation (company tax) and also, shareholders
must pay taxes on dividends (personal level). Thus, as the amounts are taxed at both
the corporate and personal level, this is often referred to as double taxation.
LLC: With the LLC there is one tax, which is reflected in the income tax. The LLC is
more flexible. Where there is one member, the LLC is taxed as a sole proprietor.
Where there is multi members, it is taxed as a limited partnership. The members must
report and pay tax on business income as part of their personal tax returns. This is
called “pass-through taxation”.
3. Management (activity of management, role):
- Corporations: Corporations have a rigid management structure. All corporations have a
board of directors who have set out the company’s policies and oversees the operations
and maintenance of the entity. The day to day operations is managed by its officers and
shareholders are less likely to be involved in the daily running of the business. The rights
and responsibilities of the directors, officers and shareholders are spelled out in the
corporations bylaws.
- LLC: Are more flexible in the way they are managed. They can be managed by its
members or by a group of managers. The owners are heavily involved in the running of
the business. When an LLC is member-managed, this means that all members jointly run
the business and share responsibility for the day to day running of the business. With
 manager-managed, one or more members are designated to be managers or even one or
more outside managers are hired. There could be a combination of members and outside
managers. Also, the LLC generally has fewer and less formal requirements for the way
that they are to conduct business.

Characteristics of Corporation and LLC (in case scenario):

TABLE BELOW
N.B: LLCs are ideal for small businesses that need liability protections, don’t need to raise a
lot of money from investors, and want flexibility in how the business is managed and taxed.

Benefits of LLC over Corporation:

1. LLCs are government more informally than corporations. Corporation laws require a
board of directors, meetings, quorums, minute keeping and other management
“formalities” that LLC laws don’t require. Also, LLCs don’t require a lot of paper work.
2. LLCs have greater flexibility in deciding how to split their financial interests. An LLC
can distribute its income to each member equally, based on their capital contributions, or
in many other ways. Profits and losses can be allocated disproportionately among owners.
A corporation distributes its income to shareholders on a per share basis. It is strictly
based on ownership percentage.
3. LLCs are not double taxed. They are a pass-through entity without the restrictions
imposed on corporations.

Benefits of corporation over LLC:

1. Raising capital: It is easier for corporations to raise capital as they can issue stocks. It
is easier for corporations to obtain outside financing from venture capitalists and
private equity funds and to have an initial public offering. Investors and banks prefer
to invest in corporations than LLCs. LLCs cannot sell stock and can only sell interests
of their company (which is harder to sell than stock).
2. Ease of transfer: Ease of transfer is prevalent in corporations as stocks are freely
transferable from one owner to another. In an LLC, membership interest is difficult to
transfer and must be stated in operating LLC agreement. In an LLC, the other
members have to approve of this.

Disadvantages of LLC:

1. Raising capital
2. Ease of transfer

Disadvantages of Corporation:

1. Double taxation
 2. Paper work and other formalities
3. No flexibility in splitting financial interests
4. Government regulation – Corporations face government oversight and must keep
detailed records of business activities.

Disadvantages of incorporation (of incorporating a business):

1. Lifting the veil: Sham companies can be formed that facilitate fraud.
2. Expensive: There are higher startup expenses. When compared to a sole
proprietorship or partnership, it is a far more complex legal structure, and is therefore
more costly and complicated to set up.
3. Time consuming: Due to the complex legal structure, there is also a lot of paperwork
that is needed to start up the company. Even after starting up, there is a lot of
paperwork required for example reports, tax return files, bank account records and
audit books.
4. If corporation, there is double taxation.

Scenarios from tutorial:

1. Corporation:
- Nature of the business: There are many individuals (4 departments). The four
departments also show that there is a rigid structure.
- This business has heavy government regulation. Because they are selling a drug, which
can have many side effects and can impact people’s health and risk their lives, there must
be government regulation in order to protect people (Bureau) to ensure that certain
standards for drugs are set before they are placed on the market and endanger people’s
lives.
- Investors – Investors are characteristic of a corporation. From the scenario, it can be seen
that there are many. Investors prefer corporations because it is easier to transfer
ownership (by trading shares), shareholders’ interests are protected as there are
safeguards through how shares are issued (for instance, the shares have to be approved
and there also has to be a stock plan, bylaws and the stock transfer agreement).
- The fact that they have 4 departments means that they will need to seek outside
financing to pay the researchers etc. Corporations are the best form to do this as they can
sell stock and have an initial public offering to get investors and money to pay.
- Because drugs can have serious side effects, it is important to ensure that the owners’
personal assets are protected and separated from the entity’s assets. Salomon vs.
Salomon. Corporations has a result of this veil have limited liability.
2. Limited liability company:
- All four roommates have expertise and all will be involved in the decision making of
the business. Therefore, an LLC would be the best option unlike in a corporation where
only the board of directors make the major decisions. These roommates have already
decided that they want one commercial and 2 residential. Also, the four of them have
expertise in different areas, and so can all be involved.
- Here, there is no evidence of government regulation. This is unlike a corporation where
they have to keep records of all business activities, record meetings (minutes). Also, there
are no corporation fees.
- Income stream – They are looking for an income stream and an LLC is supposed to
provide a higher degree of financial security and so more investors and creditors will me
willing to get involved in the entity and invest.
Investors are attracted to LLCs because they avoid “double taxation”. Because they
avoid corporate taxes, more profit is available to pass through the members.
- Small in size – It is just four roommates, which is characteristic of an LLC. Corporations
are usually for larger entities with many individuals and a rigid management structure.
Here, they are small, so they do not need this rigid management structure, Board of
Directors etc. Also, the LLC will allow for more flexibility in structure, avoid double
taxation so more profits. Also, avoid filing articles of incorporation, appointing directors,
hold regular meetings with directors and shareholders, pay fees and other structural
requirements. They don’t need all this, they are just four roommates.
- Limited liability – Salomon vs. Salomon. There is reasonable liability protection with
minimal amount of paperwork and regulatory burden. The investors want to be protected,
and they will get this with an LLC.
- Continuity – They want to develop the lots overtime, and so continuity of an LLC will
also support this venture of partial and future development. Thus, in a few years time,
they can completely develop.