Chapter 7: Business Organizations

Choosing a business entity

- formation - liability - capitalization - taxation - management and operation

Common Forms of Business Entities

- sole proprietorship - partnerships: general limited - limited liability partnership - limited liability company - corporation

tax in a sole proprietorship

-A sole proprietorship is not a distinct legal entity; it is considered one and the same with its owner. -A sole proprietorship business is not subject to corporate income taxation and no tax return is filed on behalf of the business. -Owner files Schedule C (report your business revenue and subtract your business expenses) with your individual federal tax return (Form 1040). •If joint return: business losses can offset other income received by owner and spouse.

Once publicly-held

-Subject to additional state and federal regulations •Securities law •Corporate governance statutes e.g. (Federal) Sarbanes-Oxley Act of 2002 - "Public Company Accounting Reform and Investor Protection Act" -Enacted after Enron and Worldcom scandals -responsibilities of a public corporation's board of directors, criminal penalties for certain misconduct, and new SEC regulations

Differences of business organization

Advantages and disadvantages

Corporation: Dissolution

Although corporations have an unlimited life under state law, the directors of a corporation may vote to dissolve the corporation. •Typically, a resolution of dissolution is prepared and a plan of dissolution is developed. -The plan is executed during a period referred to as the "winding up period." •During the winding up period, creditors are paid, federal and state filings are made, and shareholders receive a liquidating dividend of the remaining assets.

Piercing the Veil

Because LLCs and corporations provide limited liability for owners (members or shareholders), creditors will often try to pierce the veil of an LLC or a corporation to gain access to the personal assets of members/shareholders. •To be successful, creditors must show that -Members/shareholders exercised some form of pervasive control over the activities of the LLC or the corporation, and -There were some fraudulent or injurious consequences as a result of the pervasive control. •In determining whether these two requirements have been met, courts consider a variety of factors, including those listed on the following slide.

Formation of a General Partnership

Fundamentally, a general partnership is: 1.an association of two or more people/entities, 2.who are co-owners/co-managers, and 3.share in the profits of an ongoing business operation. These partnerships typically use the designation GP at the end of their business name to signify •Partnerships at will -partnerships where the partners have not agreed to remain partners until the expiration of a definite term or event •Joint venture -the parties wish to have only a limited-in-time relationship instead of an ongoing business entity -governed by the same legal principles as a general partnership

•Each partner receives an equal share of the partnership profit payments regardless of the partner's involvement in the success of the business. •The same rule applies to losses. •General partners have the general power to bind the partnership to a contractual obligation. * (* all unless agreed otherwise!)

Operation of management of the partnership

Fiduciary Obligations

RUPA (Revised Uniform Partnership Act) sets out these duties as threefold: 1.loyalty, 2.care, and 3.good faith.

Breach of Fiduciary Duty Lawsuits by Shareholders

Shareholders enforce their rights and fiduciary duties through the use of a lawsuit in the form of: •Shareholder's derivative action, or -(on behalf of the company) •Shareholder's direct action. -(on behalf of shareholder)

Business Judgment Rule

The Business Judgment Rule protects directors and officers of a corporation against the risk of personal liability for making business decisions that shareholders might find imprudent or unwise—as long as the directors and officers acted on an informed basis, in good faith, and within the scope of their authority. •Self-dealing, abuse of discretion, or an absence of good faith often are cited by shareholders when challenging the decision of directors and officers.

Corporate Veil

The personal liability shield; the corporate protection that entitles shareholders, directors, and officers to limited liability; can be pierced for improper conduct of business or fraud.

Corporation: Taxation

Unlike pass-through entities, corporations are taxpayers. •They are required to file annual income tax returns and to pay taxes on the amount of taxable income earned by the corporation. •Under certain circumstances, corporations may make an "S election" and chose to be taxed like a pass-through entity. •Double taxation occurs because the corporation and the shareholders each pay a tax on the same income. -The corporation pays a tax on its taxable income annually. -Shareholders pay a tax upon the distribution of earnings (dividend income).

Corpotation

a company or group of people authorized to act as a single entity (legally a person) and recognized as such in law.

Corporation: Formation

a, 1) Must submit articles of incorporation 2) State issues a corporate Charter 3) Shares of stock issued 4) Board of directors elected by shareholders 5) Board of directors appoint officers 6. File with state •Like an LLC, promoters initiate the process to form a corporation. •Promoters specify the business purpose, develop a business plan, identify sources of capital and financing, and locate a place to operate the business. •Articles of incorporation are prepared and filed with the appropriate state agency. •Other required documents are filed with state and federal agencies. •A taxpayer identification number must be requested from the IRS and relevant state tax authorities. •Bylaws are prepared to help guide officers and directors in the running of the business. -Like an operating agreement of an LLC, bylaws set forth the corporation's most important policy statements and guidelines and serve as the "terms of reference" for directors, officers, and managers in developing strategic plans and making significant business decisions.

Sole Proprietorships: Popular choice and funding

businesses owned and operated by one individual; the most common form of business organization in the United States •A popular choice for starters: ease of formation and maintenance •Funding? •proprietor's personal resources •private or commercial loan, secured by the proprietor's personal assets.

Taxation of C Corporations and S Corporations

only C corp can make certain deductions like for employee benefits, so you have to look at the bigger picture

Corporation Management

separation of ownership and management prevents owners from having an active role in managing the company

Taxation

•"C" corporations are considered a separate legal, taxable entity from the owners for income tax purposes. •Therefore, corporations pay tax on their earnings and then tax is paid again if corporate earnings are distributed to shareholders in the form of dividends -This system is known as double taxation •Corporations must qualify and make an "S-corp. election" •Pass-through tax treatment, under subchapter S or the IRS code •Subchapter S benefits are numerous: -Use of losses to limit tax liability -Avoids double taxation •Not all Corp. can make election: -Limited classification -Single class of stock -No corporate shareholders -Limited scope of business (Banks and insurance companies cannot be S corp) -Limited number and type of shareholders (not more than 100 shareholders) -Unanimous consent

Formation

•A corporation has the most formal filing and reporting requirements. •The articles of incorporation are filed with state agency: -must state the corporation's name, purpose, number of shares issued, and address of the corporation's headquarters

Shareholder Derivative Action

•A legal claim brought by the shareholders of a corporation against the corporation's directors and officers. -Typically, the claim is that the directors and officers failed to discharge their duties to the benefit of the corporation and its shareholders, and they engaged in fraud, mismanagement, or self-dealing. •Derivative suits are difficult to prove because courts are reluctant to interfere with management's decision-making processes.

operation and management of the partnership

•Absent an agreement by the parties, the RUPA governs certain internal operations of the general partnership. •Partners who provide labor to the partnership are not entitled to any compensation (other than a share of profits) for this work -unless the principals have agreed ahead of time to certain compensation terms.

Limited Liability Company Operating Agreement

•Although generally not required by law, most LLCs prepare an operating agreement. •It is a written document that includes policies, procedures, and operating guidelines. -An operating agreement serves as a kind of "roadmap" for running the business. •It includes information about how new members may join, how members will share profits and losses, what functions will be performed by members, how members may leave, how the value of their interest will be determined, and so on. •Operating agreements help preserve the relationship among members by providing clarity and instructions about the running of the business.

Limited Partnerships

•An entity that exists by a state statute that recognizes one or more principals as general partners managing the business enterprise with unlimited liability •Limited partners normally participate only in terms of contributing capital or property, and have limited liability.

Partnerships

•An entity with more than one principal has a number of additional choices. •The simplest multiple-person business entity is a partnership. •General partnerships < > limited partnerships

Personal Guarantees

•Banks, landlords, and other creditors are fully aware of the limited liability provided by the corporate veil. •Thus, if a corporation is a start-up or has limited assets, these creditors will almost always require that the shareholders give a personal guarantee. •Landlord •Banks

Pre-incorporation Activity: Liability of Promoters

•Before filing articles of incorporation... •Such activities include arranging for necessary capital through a loan, recruiting personnel, leasing property, and arranging to have the business incorporated •The individual who performs these activities is known as a promoter. •If the promoter makes a contract on behalf of a not-yet-formed corporation, she may have some degree of personal liability to perform under the contract. -RISK: if incorporation never occurs -Liability extinguished once corporation is formed

Factors for Piercing the Veil of an LLC or a Corporation

•Common ownership (the LLC or the corporation and its members or shareholders are effectively one unit) •Pervasive control by members/shareholders over the operations of the LLC or the corporation •Commingling of corporate and member/shareholder funds •Thin capitalization of the LLC or corporation •Nonobservance of formalities •Absence of company records •No payment of dividends in the case of a corporation •Siphoning away of business funds by members/shareholders •Personal use of LLC or corporate assets

Corporate Entities

•Corporation -fictitious legal entity that exists as an independent "person" separate from its principals. -Well-established principle of American law •E.g. first Amendment rights

Classification

•Corporations are generally classified as either -Closely held, or -Publicly held (traded) •The most common category is a privately held corporation. •do not sell ownership interests through sales via a broker to the general public or to financial institutions or investors. •Examples: lego, Rolex

Capitalization

•Corporations have the widest range of options when considering how to finance their operations. •They may be funded through debt or through the selling of equity in a variety of forms. -Debt: bonds are often used to finance building of new facility (*bondholders are not shareholders, but creditors) -Equity: selling securities is highly regulated -Turning to venture capitalists

Corporation: Dividends

•Dividends represent a distribution of corporate earnings to shareholders. •Dividends represent a return on the shareholders' investment in a corporation. •The board of directors declares dividends and determine the amount to be paid. -Directors are not required to declare dividends. It is left to their discretion. •Dividends are usually paid in cash.

Fiduciary Duties of Officers and Directors

•Duty of care and the duty of loyalty •Breaching these duties may result in personal liability for the officer or director. •Protection in the form of the business judgment rule.

Personal Liability of Principals

•Each general partner in a limited partnership is personally liable for all of the partnership's debts and liabilities. Limited partners do not have the same automatic personal liability of a general partner, it is limited to whatever the limited partner contributed to the partnership

Limited Liability Company (LLC)Formation

•Forming an LLC is relatively easy and inexpensive. •Promoters (owners) prepare a legal document called Articles of Organization and file the document with the appropriate state agency. -Some states refer to this document as a Certificate of Organization. •Unlike a corporation, which has an unlimited life, LLCs generally have a limited life. •Promoters usually make a contribution of property to get the business started. -However, a contribution is not required to become a member of an LLC.

Limited Partnership (LP)

•Has characteristics of both a corporation and a general partnership. •Has two classes of partners: -1) limited partners and -2) general partners. •Limited partners enjoy the benefit of limited liability and have no responsibility for managing the partnership. •General partners have unlimited liability and are responsible for managing the business. •Unlike a general partnership, state law requires that a written document be prepared and filed with the appropriate state agency to form a limited partnership.

Piercing the Corporate Veil

•Inadequate capitalization •Nature of the claim •Evidence of fraud or wrongdoing •Failing to follow corporate formalities('alter ego' doctrine)

Taxation of Partnership and Principals

•Just as in the case of a sole proprietorship, a partnership is a pass-through entity. •This means that the partnership entity pays no level of corporate tax. Rather, profits are taxed after they pass through the business and are distributed

Key draw back and termination of sole p

•Key drawback: a complete lack of protection of the principal's personal assets for unpaid debts and liabilities of the business. •Termination: -by an express act of the principal or by operation of law in the case of the death or personal bankruptcy of the proprietor.

Limited Liability

•LL for owners, directors and officers is the large appeal of corporations •This liability protection is called the "Corporate veil" •Exception 1: bank may require personal guarantee •Exception 2: the court may discard the corporate veil protection: or "pierce the corporate veil'

LLPs and LLCs: Hybrids

•LLC: Hybrid of advantages and disadvantages of other ownership structures -Sole proprietorship -Corporations •Marriage of -the key benefits of a SP: pass-through taxation (LLC has that option!) -With key benefit corporations: limited legal liability

Limited Liability Company (LLC)Taxation

•Like a partnership, LLCs are pass-through entities, which avoids the possibility of double taxation. •As a pass-through entity, an LLC is a non-tax entity. It files an information return with the IRS to report the amount of profits or losses of its members. -Profits and losses of the LLC are reported on members' individual income tax returns. •The IRS allows LLCs to make an election to be taxed like a corporation.

Management and Operation

•Limited partners remain primarily investors -may not participate in daily management of the business -not engage in management activities such as supervision of employees -no authority to bind the partnership -may engage in consulting and contribute expertise, under the RULPA (Revised Uniform Limited Partnership Act)

Taxation of Partners and Partnership

•Limited partnerships are pass-through entities just like general partnerships. The same rules apply for taxation as in a general partnership.

Duty of Care violated in case of:

•Negligence •Failure to act with diligence •Rubber stamp Doesn't matter if director is not paid or it's a privately held corporation! Duty of Loyalty •Insiders: officers, directors and controlling shareholders •To prevent oppression of minority shareholders •1. Prohibition against CERTAIN self-dealing •2. Corporate opportunity doctrine

Corporation: Officers

•Officers take direction from the directors, execute decisions make by directors, and run the business on a day-to-day basis. •They have the authority to commit the corporation to perform services, sell goods, assume financial obligations, etc. •Officers work directly with external parties, such as auditors and attorneys. •Officers hire managers and other employees.

Limited Liability Company (LLC)

•Operates as an unincorporated entity with a legal identity separate and distinct from its owners. •Possess characteristics of both a partnership and a corporation. -Like a partnership, an LLC is a pass-through entity for tax purposes. -Like a corporation, the owners of an LLC enjoy limited liability. •The owners are called members -Members may include individuals, corporations, and other LLCs. -There is no limit on the number of members, and an LLC may have only one member, called a single-person LLC. •All fifty states have statutes authorizing the formation of LLCs. Wyoming was the first state to authorize them, doing so in 1977.

Limited Liability Partnership (LLP)

•Operates like a general partnership except it protects non-negligent partners from exposure to unlimited liability. •Generally, partners are not liable for the negligent acts of other partners or the negligent acts of employees, unless the employees are under the direct supervision of the partner. •LLPs are often used by professional firms, such as accounting firms or law firms.

Conclusion: Corporations

•Organized under State law (but federal securities law) •Privately held and publicly held •'Going public' -IPO •C corp: Double taxation (<> S corp election) •Limited liability of shareholders, but piercing corporate veil •Fiduciary duties of insiders, but business judgment rule

Components of a Partnership Agreement

•Ownership interest •Sharing of profits and losses •Managerial decision making •Partnership valuation •Partnership dissolution

Corporation: Stock

•Ownership of a corporation is represented by shares of stock. •Corporations may issue more than one class of stock: •Common stock: holders have voting rights, but are generally subordinate to preferred stockholders for claims to corporate assets and dividends. •Preferred stock: holders generally have no voting rights, but have a priority claim to corporate assets and dividends over common stockholders. •In a publicly held corporation, stock is traded over a public exchange. •In a closely held corporation, ownership of stock is often restricted by agreement.

Shareholders

•Power to elect and remove directors •Power to veto fundamental changes to corporation, e.g. sale of all assets, mergers, issuing more capital stock, and issuing bonds •Shareholders also must approve any changes in the structure of the corporation through amending the articles of incorporation or bylaws.

Board of Directors

•Sets strategy and policies of the corporation, including -payment of dividends -high level decisions, such as whether to add a new product line or expand operations into a foreign nation. •Generally, at least 3 (but one person corporation can have one director) •Also has important oversight functions •Most planning initiatives that result in a change to the corporation, such as an acquisition of another corporation's assets or stock, are overseen by the board prior to submitting the plan to shareholders for approval. •Directors operate by the committee in large corporations, such as the audit committee and the compensation committee.

Structure, Management and Operation : allocation of powers between SH, D and O

•Shareholders -owners of the corporation and act principally through electing and removing directors and approving or withholding approval of major corporate decisions. •Directors -responsible for oversight and management of the corporation's course of direction. •Officers -carry out the directors' set course of direction through management of the day-to-day operations of the business.

Corporation: Shareholders

•Shareholders are the owners of a corporation. •Some are the original promoters of the corporation. •They provide initial and subsequent capital investments. •They may be active shareholders by also working for the corporation, or they may be passive investors. Shareholders elect the corporation's board of directors

Choice of State of Incorporation

•Some (publicly held) corporations choose the state of Delawareas the state of incorporation because of the advantages of that state's permissive rules on the flexibility of how a corporation's managers operate the business. •Strong protections for officers and directors in case of shareholder lawsuits! •Ample case law=reliability in corporate planning •However, most (privately held) corporations are better served by incorporating in the state where they are headquartered.

Officers

•The corporation's officers are appointed by, and may be removed by, the board of directors. •The officers carry out the day-to-day operations of the corporation and execute the strategy and mandates set out by the board of directors.

Corporation Characteristics

•The law recognizes corporations as having legal characteristics similar to those of a person. For example, corporations may: -Own property in its own name -Enter into contracts with third parties -Be the subject of a civil lawsuit or initiate a lawsuit in its own name -Be subject to criminal prosecution However: -A corporation has an unlimited life (but can be dissolved).

Sole Proprietorship

•The simplest and least expensive way of starting a business. •It has a legal existence only in the identity of the sole proprietor (owner): -The owner and the business are one and the same; a sole proprietorship does not have a separate legal existence. •Typically, one person (the owner) is responsible for the affairs of the business and enjoys the profits of the business and bears the burden of losses. •The owner has unlimited liability; thus, creditors of the business have access to the owner's personal assets. •The owner reports the financial affairs of the business on his/her personal tax return. •A sole proprietorship may use a business or trade name different from the name of the owner.

More of general partnership

•The simplest structure for starting a business when two or more individuals decide to own and operate a business. •Like a sole proprietorship, a general partnership does not have a legal identity separate and distinct from its owners. •The partners have unlimited liability; thus, creditors of the business have access to the partner's personal assets. •A written document is not necessary to form a general partnership; however, best practices recommend the preparation and use of a written document, often referred to as a partnership agreement. •A partnership is a pass-through entity for tax purposes: -The profits and losses of the partnership are reported on the partners' individual income tax returns. -However, unlike a sole proprietorship, a partnership is required to file an "information" tax return. The return reports information about the partnership to the Internal Revenue Service (IRS), such as the amount of profits and losses to be reported on the partners' individual tax returns.

Formation of LP

•To form a limited partnership, the general partner files a certificate of limited partnership with the state government authority (usually in the secretary of state's office). -Cost to Form an LP: The state of Rhode Island charges a filing fee of $_______ to form a limited partnership. Processing Time: 3-4 business days for the Secretary of State to process your formation upon receiving the completed Certificate of Limited Partnership. •Draft and sign LP agreement -details the rights, obligations, and relationships between partners -At least cover: The term (in years) of your partnership - Identities and roles of general and limited partners - Initial capitalization and ongoing capital contributions - Allocation of profits/losses - Management structure - Voting rights and meeting plans - Accounting and record-keeping practices -Conditions for transfer and dissolution

General Partnerships

•Unlike most business entities, general partnerships are not created by filing a form with a government agency. •Instead, the law recognizes two or more principals as being a general partnership if they have demonstrated an intent to carry on as co-owners of a business for profit.

IPO (initial public offering)

•When a privately held corporation wishes to fund capitalization through the sale of ownership interest to the general public and commercial investors, the principals -pursue an Initial Public Offering (IPO) and -then continue their corporate existence as a publicly held corporation.

•In a member-managed LLC, the

•management structure of the entity is similar to that of a general partnership, with all the members having the authority to bind the business.

•In a manager-managed LLC, a named manager generally has

•the day-to-day operational responsibilities, while the non-managing members are typically investors with little input on the course of business taken by the entity except for major decisions