Forms of Organizations
Sole Proprietorship
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This is the simplest and also the most prevalent form of business in the United States.
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As the name implies, in a sole proprietorship, one individual owns all the assets and is
responsible for all liabilities–debt, contracts, and tort liabilities.
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The proprietor is the business. The business is not different from the proprietor.
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If the business has to be conducted in a name other than that of the proprietor, the name
must be registered with the appropriate state authority.
A sole proprietorship ceases to exist when the proprietor decides to wind up the business, or on the death
of the proprietor–whichever is earlier.
Advantages:
1. Easy and simple to set up.
2. One person is in control.
3. Only one level of income tax–proprietor reports income and loss on personal returns.
4. Proprietor receives all the profits and other benefits.
Limitations:
1. Proprietor is personally liable for business obligations. The risk is high.
2. Difficult to raise capital. The proprietor can borrow from relatives and friends and from
institutions as an individual.
General Partnership
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Two or more persons agree to invest their money, time, and skills in a business, and to share
the profits/losses. Essentially, a GP is sole proprietorship with multiple proprietors.
Thus, the partners are personally liable for all partnership obligations.
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The partnership agreement may be explicit or implied, but sharing of profit/loss must be real. In
other words, partners cannot merely receive wages or salaries.
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Unless specified otherwise, each partner has some authority and a corresponding responsibility.
A partnership exists as an entity by itself and separate from its partners. CAN acquire property.
Advantages:
1. Allows for a range of possibilities in ownership and sharing.
2. One partner may invest money, another may provide space, and a third may provide expertise.
Yet, they may be equal partners.
3. Subject to only one level of tax–that of the individuals who are partners.
4. From a tax perspective, a partnership is a pass-through entity.
5. Does not necessarily terminate on the death, resignation, and even bankruptcy of a partner. Other
partners can decide to continue.
Limitations:
1. Individual partners are personally liable, just as in a proprietorship.
2. When the partnership cannot repay its debts, honor its contracts, or fulfill its tort liabilities,
aggrieved parties can proceed against the partners in their individual capacity.
3. A partnership, too, faces difficulty in raising capital.
4. Thus, the opportunities for growth may be limited by the ability of the partners to invest.
Joint Venture
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A one-time partnership between two or more persons for a specific purpose.
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The parties to the joint venture should have a common interest; have the right to govern; share in
the venture’s profits/losses; and be willing to contribute money, time, and/or skill for the success
of the venture.
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Not a continuing relationship. Ends when the purpose has been accomplished.
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Authority of any one member to bind the venture with third parties is limited.
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The venture’s legal status must be included in all communications and forms.
Limited Liability Partnership (LLP)
Designed primarily for grps of professionals s.a. consultants, lawyers, and accountants.
● LLP can be created by filing the appropriate forms with a central state authority.
● LLP retains the pass-through treatment of taxes.
● Partners of an LLP have unlimited liability for their malpractice.
● Many states protect LLP partners from commercial liability.
● Some states offer wider protections that blur the distinction between an LLP and a limited
liability company (LLC).
Advantages:
1. Protects partnership from vicarious liability arising out of malpractice or negligence of one
partner.
2. Limited personal liability–A judgment against a partnership for damages cannot be recovered
through the individual partners.
Limited Partnership (LP)
Has general partners and limited partners.
1. General partners have the same rights and responsibilities as in a general partnership and
operate the business day-to-day.
2. Limited partners’ liability is limited to the amount of capital invested by them. Limited
partners do not participate in the management of the business.
Advantages:
1. Useful for raising capital. Since limited partners’ liability is limited to their investment, a limited
partnership has greater potential to raise capital than a general partnership.
Limitations:
1. More difficult to create than a general partnership. Comes into existence only when a certificate
of limited partnership has been filed with the appropriate state authority.
2. Unless all provisions have been met, courts tend to treat these as general partnerships.
Limited Liability Companies (LLC)
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LLC combines the advantage of a pass-through entity (from a tax perspective) with the
limited liability concept of a corporation.
● An LLC can be formed by filing a charter document with the designated authority (usually the
office of the Secretary of State).
○ The LLC charter is called articles of organization or certificate of formation.
● The owners of an LLC are referred to as members. The rights and obligations of members are
outlined in the operating agreement.
● All the owners of an LLC can fully participate in the management of the business (member-
managed). Or, the members may choose to appoint or hire a manager (manager-managed). This
designation is typically required to be stated in the articles of organization.
● Similar to a partnership, an LLC can allocate profits/losses in a flexible manner.
● Investors in an LLC can include
○ Partnerships, corporations, and even foreign entities.
● Courts have repeatedly ruled that the operating agreement is the one that defines the scope of the
business, the rights and responsibilities of members, and the personality of LLCs.
***LLCs DO NOT have a limit on the number of members.***
Corporations
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An organization that is a legal entity distinct from its owners.
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A corporation has a name and a purpose set out in its charter called the articles of
incorporation or certificate of incorporation.
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A corporation is owned by shareholders (or stockholders). Their ownership stake in the
business is in the form of shares (or stock or equity).
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The liability of the shareholders is limited to their investments.
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Shareholders elect a board of directors to manage the corporation.
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The board, in turn, appoints executives to carry out the day-to-day operations.
Advantages:
1. Liability of shareholders is limited to their investment.
2. Corporations can raise large amounts through a public issue of shares.
3. Cap on liability encourages risk-taking.
4. Corporations have perpetual life. The “going concern” concept is one of the foundations of
corporations. The basis of this concept is the assumption that the business entity (in this case a
corporation) will stay in business for the foreseeable future.
Limitations:
1. Subject to dual taxation–The corporation has to pay a tax on the profits earned; shareholders
have to pay a tax on those earnings when they are distributed as dividends.
2. Unless otherwise stated, corporations are called C-Corporations since they are
governed by the rules outlined in Subchapter C of the Internal Revenue Code.
S-Corporations
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Closely held corporations can ****avoid double taxation**** by electing to be treated as S
Corporation under Subchapter S of the Internal Revenue Code.
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An S Corporation is treated as a pass-through entity.
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Not taxed on its income. Shareholders pay tax on their prorated share of the income.
Requirements to qualify as an S Corporation:
1. Must have no more than 100 shareholders (U.S. Citizens, Resident Aliens, Trusts, or Estates).
2. Must have only one class of stock.
3. May not own 80% or more of any other corporation.
4. Must file in a timely manner to be treated as an S Corporation.
Otherwise, will automatically be treated as a C Corporation.
Close Corporations
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****A close corporation is one that has a small number of shareholders, typically no more
than thirty;**** is treated more like a partnership; and is able to avoid some of the more
cumbersome formalities of traditional large corporations.
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To be treated as a close corporation, the corporation must meet its state’s close
corporation laws of incorporation. This typically includes electing close corporation
status in its charter. If the state’s incorporation laws are not met, irrespective of the
number of shareholders, it will not be treated as a close corporation.
Individual state close corporation laws provide significant flexibility to close corporations.
Because close corporations have fewer shareholders, and those shareholders are treated like partners,
shareholders can choose to manage the close corporation themselves, instead of delegating to a board of
directors. For this, a certain percentage of shareholders must agree in writing.
Closely Held Corporations
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A closely held corporation may have any number of shareholders.
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Its important characteristic is that its shares are not traded on the stock market.
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Because of this characteristic, courts tend to impose a greater sense of loyalty and care on
the corporation’s directors and major shareholders.
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The impositions are not codified and exist in common law, precedent, and contemporary
business practices.
Examples: Dell (2013), H J Heinz (2013) and Hilton (2007).
Incorporation
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Incorporation refers to the process through which a corporation is formed.
● Each state stipulates the steps to be taken for incorporation.
● A corporation is not limited in its business by the state where it is incorporated. It can transact
business in other states as a foreign corporation by filing the appropriate documents with the
designated authority.
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The state in which a corporation is incorporated is called the corporate domicile.
● Factors affecting incorporation in a state are the costs of incorporation and the advantages and
disadvantages of a state’s corporate laws.
● Corporate laws of states may favor either the management or the shareholders. For example,
California laws are considered pro-shareholder. Delaware and Nevada laws are considered pro-
management.
50% of the companies listed on the New York and NASDAQ exchanges are incorporated in Delaware.
Two-thirds of the Fortune 500 companies are incorporated in Delaware.
Thus, Delaware corporate law is considered to be the standard not only in the USA
but also in many parts of the world.
● Delaware law allows (but does not require) cumulative voting that affords a greater opportunity
to a minority shareholder to elect a person to the board.
● Delaware law also allows a staggered or classified board. That is, directors serve a three-year
term, with only a fraction of the directors coming up for re-election at any one time.
○ A classified board makes it difficult to change the entire board at once.
○ Delaware law prohibits the removal of a director on a classified board without cause.
California Vs Deleware
● Delaware law permits broader limitations on directors’ personal liability than California
● California law requires cumulative voting and prohibits a staggered board.
De Jure and De Facto Corporations
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If an incorporation is done correctly, a de jure corporation is formed.
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The entity becomes a corporation by right and cannot be challenged.
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Most states will accept de jure status if a corporation has substantially met the
requirements.
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Where substantial compliance is missing, a court may treat the corporation as de
facto, that is, a corporation in fact although not one in law.
To avoid this, the incorporators need to demonstrate they took adequate measures to incorporate correctly.
Corporation by Estoppel
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Suppose an entity is neither de jure nor de facto.
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It may be a corporation by estoppel.
Example: Consider a third-party transacting business with the entity as if it were a corporation. The third
party is prevented or estopped from treating the entity not as a corporation. In other words, when the third
party has transacted business considering the entity to be a corporation, it would be unfair to subject the
entity’s members to unlimited liability.
Piercing the Corporate Veil
The general principle of a corporation is that of limited liability.
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Piercing the corporate veil: Under certain conditions, courts may override this principle and
hold the shareholders personally liable for claims against the corporation
Courts tend to pierce the corporate veil under two conditions:
1. Alter Ego Theory–when the owners of a corporation have so mixed up the affairs of the
corporation with their own, the corporation may not exist as a distinct entity. Indeed, it may be
treated as an alter ego of the owners.
2. Undercapitalization–suppose a corporation deliberately lacks adequate capital to meet its
obligations. Such undercapitalization may be treated as a fraud on the public or society.
Managing the Corporation
Corporate control is distributed among the shareholders, directors, and officers.
● Shareholders of any widely-held corporation do not manage the corporation. It is unrealistic to
assume that a hundred thousand or a million shareholders can jointly manage any business.
● Shareholders elect a board of directors to govern the corporation.
● Directors can be officers, in which case they are called Internal or Executive directors.
● Directors who are not officers are called External directors.
An increasing trend is the concept of Independent directors.
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Experts from different domains who are expected to protect the interests of shareholders. Many
of the leading companies have as much as 50% of their board composed of independent directors.
The board of directors in turn chooses a chief executive officer and other senior officers such as a
secretary or general counsel and a financial officer. The chief executive officer and senior officers
appoint executives and employees at other levels to manage the day-to-day operations of the corporation.
Fiduciary Duties
● Directors and officers are agents of shareholders.
○ They act on behalf of the shareholders and are expected, at all times, to act in the best
interests of shareholders.
● Being the agents of shareholders, directors have a fiduciary duty to the corporation.
This duty has two primary components–duty of care and duty of loyalty.
1. Duty of care requires directors and officers to arrive at decisions based on accurate
information and sound reasoning. There is no scope for impulsive decisions.
2. Duty of loyalty requires directors and officers to place the best interests of the corporation
ahead of their own. Thus, any act that is selfish in nature would be contrary to the duty of loyalty.
Duty of Care and Business Judgment
As a general rule, courts tend to accept directors’ actions as long as the business judgment rule holds.
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The business judgment rule assumes that the directors acted in good faith and in the
best interest of the corporation when making a decision.
For the business judgment rule to hold, directors should have applied their minds and made informed
decisions.
The business judgment rule will not hold if it turns out that:
1. The directors had a personal interest in the transaction;
2. The directors did not act in good faith;
3. The directors acted in an irrational manner; and/or
4. The directors arrived at a decision through a negligent process.
Duty of Loyalty
Directors and officers must act in the best interests of the corporation and not their own interest.
The foundational principle here is that directors and officers should not use any business opportunity to
further their own interests. This is called the corporate opportunity doctrine.
To test whether an opportunity belongs to the corporation, the line-of-business test is applied.
If a business opportunity is in the corporation’s stated line of business, directors or officers cannot use the
opportunity to serve their own ends.
Duty of Candor
Many of the actions taken by directors and officers are subject to shareholder approval.
The range of such actions is wide–from the issue of dividends to a possible merger or acquisition.
In all such cases, it is incumbent on the directors and officers to place all material facts before
shareholders. This is called the duty of candor.
Any relevant information sought by shareholders should be made available honestly and without window-
dressing. Failure to do so has been interpreted by courts as failure of the duty of care and duty of loyalty.
Mergers and Acquisitions
Directors and officers have additional responsibilities when dealing with mergers and acquisitions.
1. First, the offer price should represent the true intrinsic value of the target. This requires
internal valuation and external validation.
2. Second, the extent to which the negotiations are delegated to officers determines the risk; in
general, the higher the delegation, the higher the risk.
3. Third, directors and officers have a duty to maximize shareholder value.
4. Fourth, due diligence needs to be exercised when relying on officers’ and executives’ reports.
5. Last, any defensive tactics deployed need to be reasonable. These tactics may include so-called
poison pills, which are terms that make the company’s stock more expensive or the purchase of
the company less attractive, in an attempt to protect against uninvited “hostile” takeovers..
