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The Legal and Ethical Environment of Business - Version 2.0 Terence Lau and Lisa Johnson

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Business Organizations Chapter 11

Introduction Part - 11.0

Introduction

• Legal entity chartered by the state, with a separate and distinct existence from its owners

Corporation

• Commercial enterprise, organized for profit of its owners, and involving the provision of goods or services to a customer

Business

• Persons or entities to whom money is owed Creditors

• Persons or entities granted a franchise to market or sell a the franchisor’s goods or services, usually under a franchise agreement

Franchisees

• Investment where the investor’s maximum possible losses is the amount invested

Limited liability

Sole Proprietorships Part - 11.1

Learning Objectives

• Understand the importance of sole proprietorships in our economy

• Explore the advantages presented by doing business as a sole proprietorship

• Assess the disadvantages and dangers of doing business as a sole proprietorship

Sole Proprietorships

• Type of business where there is no legal distinction between the business and its owner – Most common form of doing business in the United States

• Entrepreneur: Person who organizes a business and carries the risk of loss and reward of profit with it – Obtains permits or licenses, depending on the business, before

they can begin operating

– Utilizes venture capital • Venture capital: Money invested in an unproven or new start-up business

Advantages and Disadvantages of Sole Proprietorship

Advantages

• Creation is easy

• No creation time or cost • Autonomy • Total ownership of the

business’s finances

Disadvantages • Impossible to bring in others

to the business and pass ownership of business

• Raising working capital is difficult

• Tax planning is challenging

• Unlimited liability: Undesirable situation where if the debts of the business exceed its ability to pay, creditors may reach the personal assets of the business owner

Venture Capital Firms

• Combine funds from institutional investors and angel investors to identify promising start-ups and fund them in a private placement – Angel investors: Affluent individuals who provide capital to

start-up and early-stage businesses

– Private placement: Nonpublic offering in which a business sells securities to a few chosen and qualified investors to raise capital

• Seek an exit strategy, by offering sale of the business to the public in an initial public offering – Initial public offering (IPO): First time a corporation sells

its shares to members of the public

Partnerships Part - 11.2

Learning Objectives

• Learn about how general and limited partnerships are formed

• Explore the major differences between general and limited partnerships

• Understand major advantages and disadvantages to doing business as general or limited partnerships

Partnerships

• Allow multiple individuals to conduct business together

• General partnership: Association of two or more persons in an unincorporated entity to do business and share profits and losses – Articles of partnership: Voluntary contract (typically written)

in which two or more persons decide to conduct business together and share profits and losses

• Known as partnership agreement

General Partnerships

• Do not involve the state as there is no separation from the business and the partners

• End on termination of agreement to share profits and losses • Those with more than two persons, the remaining partners

can reconstitute partnership without the old partner – Buy/Sell agreement: Agreement between partners to value

and sell a partner’s portion of the business in the event the partner withdraws or dies

• Considered as a disregarded entity for tax purposes – Disregarded entity: For tax purposes, an entity that does

not need to file its own tax return or pay taxes

General Partnerships

• File information return – Information return: Tax return that provides information

only to the taxing authority

• Every partner is jointly and severally liable for the partnership’s debts and obligations – Joint and several liability: Creditors or other claimants can

pursue their entire claim against one, several, or all possible defendants, leaving defendants to sort out their respective proportions of liability and payment

Limited Partnerships

• Formed in compliance with state law that provides limited liability to certain limited partners who agree to refrain from management of the business

• Limited partners are prohibited from participating in day-to- day management of the business

Corporations Part - 11.3

Learning Objectives

• Learn about the advantages and disadvantages of corporations

• Study roles and duties of shareholders, directors, and officers in corporations

• Explore issues surrounding corporate governance • Understand how corporations are taxed

Corporations

• Form of business organization that provides limited liability to owners and is also flexible and easy to manage

• Possess continuity regardless of its owners • Can be created for a limited duration, or it can have

perpetual existence

Corporations

• Stock: Capital raised by a corporation through issuance of shares entitling owners to an ownership interest

• Securities: Any negotiable instruments representing financial value, such as a bond or stock

• Formed in compliance with corporate law – Corporate law is state law, and corporations are incorporated

by the states

• Initial public offering (IPO): First time a corporation sells its shares to members of the public

Formation of a Corporation

• Articles of Incorporation are filed by the founders of the corporation with the state agency charged with managing business entities – Articles of incorporation: Legal document that creates a

corporation when filed and approved by the relevant state authority

• Founders must state: – Name of the company which is to be unique and distinctive

• Words like incorporated, company, corporation or limited are included

Formation of a Corporation

– Whether it is for profit or nonprofit

– Their identity

– Duration of the company’s existence

– Purpose of formation

– Number of shares that will be issued initially, and their par value

• Par value: Face vale of a security as determined by the corporation

Types of Corporations

• Operated in the state in which it was incorporated

Domestic corporation

• Incorporated in a state other than where it is seeking to operate

Foreign corporation

Reasons for Existence of Corporation

• Reward owners of shareholders • According to Chicago school economists, corporations act

legally to maximize shareholder value – Chicago school: Neoclassical theory of economics most

closely associated with influential economics faculty from the University of Chicago

• Corporate social responsibility (CSR): Deliberate inclusion of the public interest into decision making

Shareholders

• Owners of a corporation – Closely held corporation: Stock is held by only a small

number of shareholders

• Value of a share is determined by the laws of supply and demand

• Own share or stock in the company but have no legal right to the company’s assets – Have limited liability

Parent Company

• Owns all the stock of another corporation

• Affiliate: Commercial enterprise with some sort of contractual or equity relationship with another commercial enterprise

• Subsidiary: Company wholly owned or controlled by another company – Formed to hold real property so that premises liability is

limited to that real estate subsidiary only • Shields parent company and its assets from lawsuits

• Premises liability: Liability of landowners and leaseholders for torts that occur on their real property

Legal Implications

• Sophisticated liability and tax planning make corporate form attractive for larger business in the United States

• Many sole proprietors incorporate their businesses to gain limited liability

• Failure to respect legal corporation by sole proprietors, with an arm’s-length transaction, leads creditors to ask a court to pierce the corporate veil – Arm’s-length transaction: Made by parties as if they were

unrelated, in a free market system, each acting in its own best interest

Legal Implications

– Pierce the corporate veil: Equitable doctrine allowing creditors to petition a court to not permit limited liability to a corporate shareholder

• If a court agrees then: – Limited liability disappears

– Creditors can reach shareholder’s personal assets • Creditors argue that corporate form is a sham to create

limited liability • Shareholders and corporation are indistinguishable from

each other

Shareholders

• U.S. corporate law allows for creation of different types of shareholders

• Shareholders of different classes may be given preferential treatment when it comes to corporate actions – Examples - Paying dividends or voting at shareholder meetings

• Dilution: Result when a corporation issues additional shares, resulting in a reduction of percentage of the corporation owned by shareholders

Rights of Shareholders

• Preemptive right: Given to existing shareholders in a corporation to purchase any newly issued stock to maintain same proportion of their existing holdings

• Outlined in a company’s articles of incorporation or bylaws • Right to obtain a dividend

– Sanctioned only if the board of directors approves

• Right to vote in annually held shareholder meetings – Incase some shareholders are not available, proxy is used

• Shareholder derivative lawsuit: Brought by a shareholder on behalf of a corporation against a third party

Board of Directors

• Group of persons elected by shareholders of company to set high-level strategy for the company

• Elected by shareholders • Drawn internally and externally from the company

– Chief executive officer (CEO) of the company does not serve as chair of the board of directors

– Some corporations seat a representative for shareholders and large force of labor

Duties of the Members of Board

• Declare and pay corporate dividends to shareholders • Authorize entry into a new foreign market • Appoint and remove corporate officers • Determine employee compensation

• Issue new shares and corporate bonds – Corporate bonds: Debt obligation issued by corporations to

raise money without selling stock

Duties of the Members of Board

• Fiduciary duty to the corporation and its shareholders – Business judgment rule: Legal assumption that prevents

courts or juries from second-guessing decisions made by directors, unless they are proven to act with bad faith or corrupt motive

• Appoint corporate officers – Officers: Senior management, often C-Level or Chief Level,

appointed by the board of directors of a corporation to execute strategy and manage day-to-day matters for the corporation

Types of Fiduciary Duties

• Includes duty not to take corporate opportunities for their own purposes and a duty not to self-deal

Duty of loyalty

• Involves making decisions that reflect an attentive relationship to the corporation

Duty of care

Double Taxation

• Imposition of two or more separate taxes on the same pool of money – Employer Identification Number (EIN): Unique nine-digit

number issued by the IRS to business entities for purposes of identification

– Dividend tax: Income tax on dividend payments to shareholders

S Corporation

• Corporation that, after meeting certain eligibility criteria, can elect to be treated like a partnership for tax purposes, thus avoiding paying corporate income tax

• To avoid the double taxation feature, corporations elect to be treated as an S corporation – Provide limited liability feature of corporations but the single-

level taxation benefits of sole proprietorships by not paying any corporate taxes.

– Cannot have more than one hundred shareholders and cannot be members of an affiliated group of companies

Limited Liability Entities

Part - 11.4

Limited Liability Entities

• Learn about the development of limited liability entities

• Explore how limited liability entities are created • Understand why limited liability entities are now heavily

favored

Limited Liability Company (LLC)

• Hybrid form of business that provides limited liability to owners while being treated as a partnership for tax purposes

• Members: Owners of limited liability companies – Possible to create an LLC with only one member

– Can be real persons or they can be other corporations, or partnerships

– Participate in day-today management of the business

• Taxation is flexible

Formation of LLCs

• Articles of organization are filed with the state agency charged with chartering business entities – Typically the Secretary of State

• Require only the name and contact information of the LLC and its legal agent – Can be done by any competent business professional without

any legal assistance, for minimal time and cost

Formation of LLCs

• LLCs are not required to: – Issue stock certificates

– Maintain annual filings

– Elect a board of directors

– Hold shareholder meetings

– Appoint officers

– Engage in any regular maintenance of the entity

• Members enter into a written LLC operating agreement

Operating Agreement

• Agreement (usually written) among LLC members governing the LLC’s management, rights, and duties – Absence of an operating agreement makes it difficult to

resolve disputes among members

– Sets forth how the business will be managed and operated

– Contains a buy/sell agreement

– Allows members to operate in their own accord, but it can also be a trap for the unwary

Disadvantages of LLCs

• Members have to be careful while interacting with LLCs due to the risk of piercing the veil

• Fundraising can be difficult as, it is for a sole proprietorship in the early stages of an LLC’s business operations

• LLCs are not the right form for taking a company public and selling stock

Limited Liability Partnership(LLP)

• Entity related to LLC – Designed for professionals who do business as partners

– Allow partnership to pass through income for tax purposes, but retain limited liability for all partners

Bankruptcy Part - 11.4

Learning Objectives

• Learn about chapter 7, chapter 13, and chapter 11 bankruptcy

• Understand why businesses must be aware of bankruptcy laws

Bankruptcy Protection

• Debtors file for bankruptcy protection to seek protection of the federal court – Once bankruptcy petition is filed, the automatic stay goes into

effect

• Automatic stay: Judicial order that halts all collection activities for pre-petition debts

• Pre-petition debt: Debts that a debtor owes to creditors prior to filing the bankruptcy petition

• Debtors find automatic stay advantageous as they can: – Have their assets liquidated to satisfy creditors

– Reorganize debts in a manner that satisfies federal law and the creditors

Parties Involved in Bankruptcy

• Businesses can be either debtors, creditors or both – If a business is a debtor that chooses to file for bankruptcy,

the business needs to know the consequences of its actions

• Sole proprietor has no consequence on the business if bankruptcy is filed for

Legal Implications Associated with Bankruptcy

• When a corporation files for bankruptcy, a chapter 7 bankruptcy should never be used – Unless the corporation is itself terminating

• Discharge order: Order entered by the bankruptcy judge to discharge all dischargeable debts of the debtors

• Failure to cease collection activities in violation of the automatic stay has legal consequences

Table 11.2

Classification of Creditors

• Possess a properly perfected security interest on a particular piece of collateral • Paid before the other types of creditors

Secured creditor

• Do not have secured collateral, but there is an important public policy reason to ensure that they are paid

Priority creditor

• Extend debt that is not secured or priority

Unsecured creditor

The Legal and Ethical Environment of Business - Version 2.0
Slide Number 2
Business Organizations�
Introduction
Introduction
Sole Proprietorships
Learning Objectives
Sole Proprietorships
Advantages and Disadvantages of Sole Proprietorship
Venture Capital Firms
Partnerships
Learning Objectives
Partnerships
General Partnerships
General Partnerships
Limited Partnerships
Corporations
Learning Objectives
Corporations
Corporations
Formation of a Corporation
Formation of a Corporation
Types of Corporations
Reasons for Existence of Corporation
Shareholders
Parent Company
Legal Implications
Legal Implications
Shareholders
Rights of Shareholders
Board of Directors
Duties of the Members of Board
Duties of the Members of Board
Types of Fiduciary Duties
Double Taxation
S Corporation
Limited Liability Entities
Limited Liability Entities
Limited Liability Company (LLC)
Formation of LLCs
Formation of LLCs
Operating Agreement
Disadvantages of LLCs
Limited Liability Partnership(LLP)
Bankruptcy
Learning Objectives
Bankruptcy Protection
Parties Involved in Bankruptcy
Legal Implications Associated with Bankruptcy
Table 11.2
Classification of Creditors