Chapter 7 Business Organizations

Sunday, September 17, 2017 7:41 PM

Chapter Objectives
1. To know the primary types of legal structures used by business organizations
2. To understand the advantages and disadvantages of each type of legal structure
3. To understand the business, legal, and tax reasons for selecting one legal structure over another
4. To know the circumstances under which creditors may pierce the veil of a corporation or a limited
liability company
5. To understand the nature and purpose of the business judgment rule, the rights of minority
shareholders in a closely held corporation, and the rights of shareholders to initiate derivative
lawsuits
Sole Proprietorship
• A proprietor is someone who has legal title to property (such as a business)
• Sole proprietorship is a business structure where one person owns "property" in the form of a
business enterprise
○ Simple and cheapest way to start a business
○ The business does not have a legal identity separate from the person
○ The person is the owner, manager, and enjoys profit or loss
• Advantages: not required to file a tax return for business (same identity as owner), no need to
worry about expenses relating to business funds
• Disadvantage: owner is personally liable for the debts of the business
• Allowed to use a business or trade name different from the name of the owner
• Operating a sole proprietorship does not require the preparation of a written document or any
other kind of organizational formalities
General Partnership
• A general partnership provides the simplest organization structure for starting a business when
two or more individuals decide to associate for the purpose of owning and operating a business
○ More expensive than a sole proprietorship
○ Administrative costs (prepare tax return, prepare internal system of control)
○ Managerial need for a written partnership agreement (roadmap for directing the
affairs and operations of the partnership)
□ Components of a partnership agreement: ownership interest, sharing of profits
and losses, managerial decision making, partnership valuation, partnership
dissolution
○ The business is not legally separate from its owners
○ Partners are personally reliable for the business
• Share common attributes with sole proprietorship
○ Difference is in the amount of people owning and operating the business
• Does not require preparation of written documents
○ Can exist when people with common goals join forces
• A pass-through entity is a partnership that is a nontaxable entity
○ Profits and losses are reported on the partners' individual tax returns
○ However, partnerships are required to file a tax return which discloses the revenue earned
by the partnership and reports the various deductible expenses
○ Partnership tax does not calculate a tax liability
Limited Partnership
• Limited partnerships provide a legal structure that has characteristics of both a corporation and a
general partnership
• Two classes of partners comprise a limited partnership:
1. The general partners have unlimited liability and responsibility for managing the business

Class Notes Page 1

 1. The general partners have unlimited liability and responsibility for managing the business
2. The limited partners have limited liability and no responsibility for managing the
partnership
i. Their financial exposure is restricted to their capital investment
• Most states require the preparation of a written partnership agreement for a limited partnership
• Unpopular due to the cost of complying with state and federal laws
Limited Liability Partnership (LLP)
• A limited liability partnership operates like a general partnership except statutes provide that
non-negligent partners are not liable for the negligent conduct of another partner
○ A partner is not liable for the negligent conduct of an employee of the firm, unless the
employee is under the direct supervision of a partner
 The assets of non-negligent partners are insulated from the party injured by a
negligent partner
Limited Liability Company (LLC)
• State statues authorize the formation of a limited liability company to operate as unincorporated
entities with legal identities separate and distinct from their members
• Characteristics
○ Possess characteristics of both partnerships and corporations
 Partnership: an LLC is a pass-through entity for tax purposes
 Corporation: LLCs' members enjoy limited liability as do the shareholders of a
corporation
□ Corporation's shareholders = LLC's members
 LLC's members may include individuals, corporations, and other limited
liability companies
• Formation
○ Easy and cheap
○ To form, 1 or more of the promoters must prepare and file an LLC's articles of organization
(certificate of organization) with the appropriate state agency
○ LLC comes into legal existence at the time of the filing of the articles of organization with the
appropriate state agency
 Once formed, an LLC continues as a separate legal entity until an authorized
member(s) officially terminate the LLC by canceling its articles of organization
○ Has limited life
○ Members usually make contribution to an LLC through investing
• Management
○ Small LLCs rely on member management, in which individual members participate equally in
the management of the company
○ Big LLCs form a management team which comprise of active members (members involved
in day-to-day operations), while the remaining members assume a more passive role as
holders of an ownership interest
 As an alternate model, some LLCs will designate 1 member to serve as the manager
○ LLC must maintain the following types of records as part of its management policies and
procedure:
 A current membership list: full name and last known address of each member
 A copy of the LLC's articles of organization
 A copy of the LLC's operating agreement, assuming that a separate operating
agreement has been prepared
 Copies of the LLC's federal, state, and local income tax returns and other official
reports for the 3 most recent years
 Copies of LLC's financial statements for the 3 most recent years
• Operating Agreement
○ An operating agreement is typically a written document regarding the management of the
company and the conduct of its business
 Provide guidelines about the LLC's operating policies, practices, procedures

Class Notes Page 2

  Provide guidelines about the LLC's operating policies, practices, procedures
 Provide guidance for how members will share profits and losses, the percentage of
ownership of each member, and the rights, privileges, duties, and responsibilities of
each member
○ A comprehensive operating agreement:
 Helps to preserve the relationship among the members of the LLC by providing a
clarity and instructions about the running of the business
 Provides information about how new members may join the LLC and how existing
members may leave
• Taxation
○ An LLC is a nontax entity (its profits or losses are reported on its members' individual tax
returns)
 The LLC files an annual tax return to report relevant tax data to the IRS
 The LLC reports each members share of the profits or losses annually on an IRS Form
K-1
○ An LLC is allowed to choose how it will be treated for tax purposes (either a corporation or a
partnership)
• Termination
○ An LLC terminates automatically by operation of law when one member leaves
 If the members want to prevent this automatic dissolution, the operating agreement
must specify the means by which the LLC will continue
□ Thus, the default option is dissolution
○ The most common way to avoid automatic dissolution is to include in the operating
agreement a process referred to as a "buyout" agreement
 A "buyout" agreement addresses future situations involving the possible departure of
a member
Corporations
• A corporation is an organization (often a business) that has a legal existence separate and distinct
from its owners
○ The owners (shareholders) share in the profits and losses (owners can work for the
company)
○ By centralizing the management function of an enterprise, corporations attract capital
investment from passive investors who seek a return on their investment without engaging
in the day-to-day activities of the business
• Characteristics
○ The law recognizes corporations as having legal characteristics similar to a person ( can own
property, enter contracts, etc.)
 Corporations are required to file annual tax returns in their own names
 Corporate shareholders enjoy limited liability
○ A new corporation is referred to as closely held corporations, in which the investors often
serve as corporate officers and help manage the business
○ In publicly traded corporations, the management team operates separately and distinctly
from the shareholders
○ The corporate form of organization encourages the creation of new enterprises by
minimizing the risk of starting and running a business
 By separating the management of a business from the owners, two important
features of corporate law emerge:
1) A legal shield (corporate veil) insulates owners from corporate creditors
2) Managers of the business have duties and responsibilities that differ from those
of the owners
• Starting a Corporation
○ A promoter is commonly used to describe the person or persons who start a business
 Starting a corporation also requires a business purpose, a business plan, a source of
capital and financing, a physical place to house the corporation, a source of customers

Class Notes Page 3

 capital and financing, a physical place to house the corporation, a source of customers
and vendors, and generally a cadre of experience and skilled managers and workers,
an attorney to draft the corporation's articles of incorporations, its bylaws, and other
documents
□ A corporation's articles of incorporation serve as a type of constitution for a
corporation which establish basic terms of the corporation's structure and
operations and define its purpose
□ A corporation's bylaws provide guidance to officers and directors regarding a
corporation's internal affairs and operations and its external relations
 Bylaws set forth a corporation's most important policy statements and
serve as the "terms of reference" for directors, officers, and managers
when developing strategic plans and making significant business decisions
• Where to Incorporate
○ Owners of a corporation usually incorporate their business in the state in which they live
and work
○ Promoters of a corporation may decide to go forum shopping (search for a state that is
business friendly)
 Delaware is viewed as the most "friendly" state to incorporate a business
• Shareholders
○ The shareholders of a corporation are the owners of the corporation
 They provide initial capital and subsequent capital for the business to start and sustain
 Shareholders possess certain powers regarding the corporation (elect e-board
members, etc.)
• Directors
○ Directors set the strategic vision for the corporation (where to expand or reduce, where to
make investments, etc.)
 Hire corporate officers such as CEO, CFO, etc.
 Set the officers' levels of compensation
 Establish corporate policies and strategic goals
 Determine when to declare dividends and decide the amount of dividend distributions
○ Directors operate as a unit, commonly referred as the board of directors
 Comprised of committees (audit committee, nominating committee, compensation
committee)
• Officers
○ Corporate officers take directions from the board of directors and run the corporation on a
day-to-day basis
 Have the authority to commit the corporation to perform services, sell goods, and
assume financial obligations, all within their stated levels of authority as set forth in
the corporation's bylaws
 Allocate the resources of the corporation through a comprehensive budgeting process
and system of internal controls
 Hire managers who report to them, often delegating duties to managers to implement
the goals and objectives established by the officers
• Stock
○ Ownership of a corporation is represented by shares of stock
 A corporation may issue common stock (owners have voting rights, but are usually
subordinate to preferred stockholders regarding dividends and corporate assets)
 A corporation may issue preferred stock (owners have a "preferred" claim to
dividends and assets, but typically have no voting rights)
○ Closely held corporation: shareholder may agree to restrict the ownership of stock through
a separate shareholder agreement
○ Publicly held corporation: the value of a corporation's stock is determined through an open
market as the shares are traded on one of the public exchanges
• Dividends

Class Notes Page 4

 • Dividends
○ Dividends represent a distribution of the corporation's earnings to the shareholders
 The amounts of dividends received by shareholders depends on the number of shares
owned
• Taxation
○ Federal income tax laws and regulations impose taxes on corporations differently depending
on whether an election has been made to have the corporation taxed as an S corporation
 If a corporation has made an S election, it becomes a flow-through entity for tax
purposes with taxation occurring only at the shareholder level
 If an election has not been made, then the corporation will be taxed as a C
corporation (taxed on its taxable income)
○ When dividends are distributed to shareholders, a possibility exists for double taxation:
1. The corporation pays an income tax on its net income (taxable income)
2. When some or all of that income is distributed to taxpayers in the form of a dividend,
the shareholders also pay an income tax
• Dissolution
○ Dissolution requires the board of directors to prepare and adopt a resolution of dissolution
 The shareholders must then approve the resolution
○ Corporate offices and the directors prepare a plan of dissolution, which is commonly
referred to as a winding-up period, in which the corporation provides employees with
notice of the expected duration of their employment with the corporation
 Creditors are paid to the extent the corporation has liquidity
 All necessary state and federal filings occur including the preparation and filing of
"final" tax returns
○ Then, to the extent that assets remain in the corporation, a final liquidating dividend is
made to the shareholders
• External Influences on Corporate Management Practices
○ The Dodd-Frank Wall Street Reform and Consumer Protection Act affects the corporate
governance of all public companies regarding the disclosure to stockholders of executive
compensation
Business Judgment Rule, Minority Shareholder Rights, and Shareholder Derivative Actions
• 3 major theories affect the decisions and actions of the directors, officers, and shareholders:
1. The business judgment rule
2. Minority shareholder rights
3. Shareholder derivative actions
• Business Judgment Rule
○ The business judgment rule is the standard used in the United States to judge the decisions
of corporate directors and officers
○ The business judgment rule protects directors and officers of a corporation against the risk
of personal liability for making business decisions that others might find imprudent, unwise,
and inappropriate
 Provides immunity for business judgments and decision that corporate directors and
officers make as long as they acted on an informed basis, in good faith, and within the
scope of their authority
 Imposes on directors a duty of care and a duty of loyalty to the corporation and the
shareholders
 Expects directors and officers to act on the belief that their decisions and actions are
in the best interests of the corporation and the shareholders
□ Without this protection, a sense of paralysis would permeate the boardrooms
and corporate offices of nearly every corporation in the United States
○ Directors and officers seek further insulation from personal liability through the use of
directors and officers liability insurance, which provides financial protection from the
consequences of litigation involving wrongful acts on the part of directors and officers
Constituency statutes (stakeholder statutes) allow directors and officers of a corporation to

Class Notes Page 5

 ○ Constituency statutes (stakeholder statutes) allow directors and officers of a corporation to
make non-shareholder-oriented decisions about a company's resources
• Minority Shareholder Rights
• Shareholder Derivative Action
○ A shareholder derivative action is a legal claim brought by the shareholders of a
corporation against the corporation's directors and officers
 The essence of the claim is that the directors and officers failed to discharge their
duties to the benefit of the corporation and its shareholders
○ To be successful in a derivative suit, shareholders generally must prove that the directors
and officers committed fraud, engaged in self-dealing, or otherwise breached a fiduciary
duty owed to the corporation and its shareholders
 In a shareholder derivative action, the shareholders must satisfy a number of legal
requirements
Piercing the Corporate Veil
• What is the Corporate Veil?
○ The corporate veil is a legal assumption that the actions and obligations of a corporation are
separate and distinct from the corporation's principals
 Exists to protect the individuals who manage, direct, or own a corporation
○ The corporate veil affords individuals the opportunity to start a business and assume the
risks associated with a startup business without the fear of jeopardizing personal assets
• Piercing the Corporate Veil
○ Creditors may find it necessary to seek recover by "piercing the corporate veil" when the
assets of a corporation are insufficient to satisfy their rightful and legitimate demand
○ Credits of a corporation may be able to "breach the shield" (the veil) through an equitable
action known as piercing the corporate veil
 Once this happened, the personal assets of the principals fall within the reach of the
corporation's creditors
Global Perspective: Global Business Organizations
• Factors Influencing Decisions to Expand Internationally
○ What product or service is the business planning to export or import?
○ What is the desired level of control over overseas operations?
○ How mature is the business and how much experience does it have working internationally?
○ How much risk is the business willing and able to bear?
○ How much capital is available to invest?
○ How does the international expansion fit with the company's long-term goals and strategy?
• Factors Influencing Geographic Choice
○ Economic ,political, and cultural factors, historic context
• Legal Structures for International Expansion
○ Options are listed in order of increasing presence in the foreign market (from min. to max.
involvement)
 Import/Export
□ Direct import/export sales
□ Sales representatives and sales agents
□ Distributorship
□ Export trading company
□ Branch office
 Licensing and Franchising
□ Licensing (the right to use, manufacture, and/or distribute the licensor's product
in exchange for royalty payments)
□ Franchising (a trademark license)
 Foreign Direct Investment (directly investing in and actively controlling at least a
portion of an ongoing business in another country)
□ Joint ventures (companies contractually agree to work together on a business,
sharing profits and liabilities)

Class Notes Page 6

 sharing profits and liabilities)
□ Subsidiaries (a corporation, the controlling majority of whose stock is owned by
another corporation)

Class Notes Page 7