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Chapter 11
Business Organizations
L E A R N I N G O B J E C T I V E S
Businesses must be organized in order to effectively conduct their operations. This organization can run
from simple to complex and depends greatly on the needs of the business owners to structure their
liability and taxes. In this chapter, you’ll learn about the factors that go into organizing a business.
Specifically, you should be able to answer the following questions:
1. What are the available entity choices when conducting business?
2. What are the factors that determine entity selection?
3. What are the traditional entity choices, and how are they different from each other?
Figure 11.1 Apple’s Headquarters in Cupertino, California
Source: Photo courtesy of kalleboo,http://www.flickr.com/photos/kalleboo/3614939469/sizes/o.
Many of you may be reading this chapter on a laptop or desktop designed and manufactured by
Apple Inc. You may own a phone from Apple, or perhaps a portable music device. The company’s
Chapter 11 from The Legal and Ethical Environment of Business was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0
license without attribution as requested by the work’s original creator or licensee. © 2014, The Saylor Foundation.
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innovation, product development process, marketing capabilities in creating new and unthought-of
markets, and ability to financially reward its owners are well known. While you might enjoy Apple
products as a consumer, have you ever thought about Apple as a corporation? Its corporate
headquarters in Cupertino, California (Figure 11.1 "Apple’s Headquarters in Cupertino, California"),
is the physical embodiment of this entity we call a corporation, but what does that mean? It might
surprise you to learn that this building, or rather the legal concept of the entity that occupies it, is
more like you than you realize. For example, just like you, this entity can own property. This entity
can enter into contracts to buy and sell goods. This entity can hire and fire employees. This entity can
open bank accounts and engage in complex financial transactions. This entity can sue others, and
can be sued in court. This entity even has constitutional rights, just like you. Unlike you, however,
this entity does not breathe, does not bleed, and in fact may be immortal. And most unlike you, this
entity has no independent judgment of its own, no moral compass or conscience to tell it the
difference between right and wrong. In this chapter we’ll explore corporate entities such as Apple
Inc. in detail. We’ll examine why human beings choose to organize into corporate entities in the first
place, and why the law recognizes these entities for public policy purposes. We’ll start by looking at
the factors that go into making a decision about entity choice, and then examine the available choices
in detail.
Try to recall the basic function of a business. At its most fundamental level, a business exists to make
a profit for its owners. In a capitalist market-driven economy, a business that fails to make a profit
ultimately ceases to exist, overtaken by creditors and competitors. The need to make a profit is one
truism that binds all businesses together, but beyond that, it’s hard to draw generalizations about
business operations. The world of business is as varied as human experience itself, ranging from the
neighborhood kids who shovel snow in the winter and sell lemonade in the summer, to the
neighborhood pizza restaurant, to the small tool-and-die factory on the outskirts of town making
machine tools, to the multinational corporation with hundreds of thousands of employees scattered
throughout the globe. Some businesses make things in factories (manufacturers), other businesses
sell things that other businesses make (retailers or franchisees), and still other businesses exist to
help both the makers and sellers make and sell better (business consultants). Some businesses don’t
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make things at all, and instead profit by selling their services (think of an accounting or law firm, a
house painting company, or a hotel) or by lending money at a higher rate of interest than it can
borrow.
With this breadth and diversity, it’s not surprising that there is no “one size fits all” approach to
choosing a business organization. When choosing what form of entity is best, business professionals
must consider several factors. First, they have to consider how much it costs to create the entity and
how hard it is to create. Some entities are easy to create, while others are more complicated and have
ongoing maintenance requirements that are important to consider. Second, they have to consider
how easy it is for the business to continue if the founder dies, decides to retire, or decides to enter a
new business altogether. Third, they have to consider how difficult it might be to raise money to grow
or expand the business. Fourth, they have to consider what sort of managerial control they wish to
keep on the business, and whether they are willing to cede control to outsiders. Fifth, they have to
consider whether or not they wish to eventually expand ownership to members of the public. Sixth,
they must give some thought to tax planning to minimize the taxes paid on earnings and income.
Finally, and most importantly, they have to consider whether or not they wish to protect their
personal assets from claims, a feature known as limited liability.
It’s important to remember that choosing a business organization is different from what kind of
business you run. For example, some businesses are known as franchises because they operate under
a license agreement (contract) whereby they agree to follow certain standards set by the franchisor,
purchase their goods from the franchisor, and maybe share either a royalty fee or percentage of
profits with the franchisor. Franchises are a very common type of business (especially in the food and
services industries), but there is no typical form of business for a franchise. Depending on the needs
of the franchise owners, a franchise could be a sole proprietorship, a limited liability company (LLC),
or a corporation. Similarly, we sometimes refer to “nonprofit organizations” such as universities or
charities as separate legal entities. Although they are nonprofit, some of these enterprises can be very
large, with complex operations that spread across borders (for example, the Red Cross or Doctors
Without Borders). For tax purposes, nonprofits do not have to pay any taxes if they meet strict
qualifications under IRS guidelines to become a “501(c)(3)” organization (named for the section of
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the Internal Revenue Code that grants nonprofit status), but from a legal perspective, these entities
can also take on any number of forms, from sole proprietorships to corporations.
If you are ever in a position to start a new business venture, your focus is typically on growing
revenue and cutting costs so that you can maximize profit. You may not be very concerned with
entity choice at the outset, since so many other considerations are competing for your attention.
Once an entity choice is made, however, it is difficult (but not impossible) to change to another
selection. Since entity choice can have a profound effect on these considerations, it is important to
gain a basic understanding of the available choices so that you, the business professional, can focus
on the business fundamentals rather than legal or accounting details.
Key Takeaways
Business organizations are an important part of a business’s structure. Different organizations provide
different advantages and disadvantages in creation cost and simplicity, ongoing maintenance
requirements, dissolution and continuity, fundraising, managerial control, public ownership, tax
planning, and limited liability. The type of business being conducted (for-profit, nonprofit, franchise) has
little to do with the business organization in which the business is conducted. Many business
organizations take the form of separate legal entities, which the law recognizes as nearly like persons for
purposes of legal rights.
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11.1 Sole Proprietorships
L E A R N I N G O B J E C T I V E S
1. Understand the importance of sole proprietorships in our economy.
2. Explore the advantages presented by doing business as a sole proprietorship.
3. Assess the disadvantages and dangers of doing business as a sole proprietorship.
Lily, a college sophomore, is home for the summer. Unable to find even part-time work in a tough
economy, she begins to help her parents by cleaning up their overgrown garden. After a few days of
this work, Lily discovers that she enjoys doing this and is good at it. The neighbors see the work Lily
is doing, and they ask her to help their gardens too. Within a week, Lily has scheduled appointments
and jobs throughout the neighborhood. Using the money she has earned, she places orders for
additional landscaping equipment and materials with a local retailer. Within a month, she is so busy
that she has to hire workers to do some of the more routine tasks, such as mulching and lawn
mowing, for her. By the middle of summer, Lily has applied knowledge she picked up in her business
classes by developing a name for her business (Lily’s Landscaping) and developing marketing
materials such as a Facebook fan page, flyers to be posted at local stores, business cards, and a
YouTube video showing her projects. By the end of the summer, Lily has earned a healthy profit for
all her work and developed valuable know-how on how to run her business. She has to stop working
when the weather gets cooler and she returns to school, but promises herself to restart the business
next summer.
Lily is a sole proprietor, the most common form of doing business in the United States. From a legal
perspective, there is absolutely no difference between Lily and Lily’s Landscaping—they are one and
the same, and completely interchangeable with each other. If Lily’s Landscaping makes a profit, that
money belongs exclusively to Lily. If Lily’s Landscaping needs to pay a bill to a supplier or creditor,
and Lily’s Landscaping doesn’t have the money, then Lily has to pay the bill. When Lily’s
Landscaping enters into a contract to plant a new flower garden, it is actually Lily that is entering
into the contract. If Lily’s Landscaping wants to open a bank account to accept customer payments or
to pay bills, then Lily will actually own the account. When Lily’s Landscaping enters into a contract
promising to pay a worker to mow lawns or lay mulch, it is actually Lily that is entering into that
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contract. Lily can even apply for a “doing business as” or d.b.a. filing in her state, so that her business
can carry on under the fictitious name “Lily’s Landscaping.” Note, however, that legally Lily’s
Landscaping is still no different from Lily herself. Any fictitious name therefore cannot have any
words in it that suggest a separate entity, such as “Corp.” or “Inc.”
Hyperlink: Doing Business As
http://www.business.gov/register/business-name/dba.html
The legal name for a sole proprietorship is the owner’s name. Some business owners are happy to use
their own names for their business, but for marketing and branding reasons many business owners prefer
to use a fictitious name. Using a fictitious name is permitted under state laws where the business operates,
using a filing known as a d.b.a. filing. Explore this Web site to find out how to file a d.b.a. filing in your
state.
There are many advantages to doing business as a sole proprietor, advantages that make this form of
doing business extremely popular. First, it’s easy to create a sole proprietorship. In effect, there is no
creation cost or time, since there is nothing to create. The entrepreneur in charge of the business
simply starts doing business, charging money, and providing goods or services. Depending on the
business, some sole proprietors may need to obtain permits or licenses before they can begin
operating. A pizza restaurant, for example, may need to obtain a food service license, while a bar or
tavern may need to obtain a liquor license. A small grocery store may need a license to collect sales
tax. Do not confuse these governmental permits with legal approval for a business organization; in a
sole proprietorship, the license is granted to the individual owner.
Another key advantage to sole proprietorships is autonomy. Since the owner is the business, Lily can
decide for herself what she wants to do to Lily’s Landscaping. She could set her own hours, grow as
quickly or slowly as she wants, expand into new lines of businesses, take a vacation, or wind down
the business, all at her own whim and direction. That autonomy also comes with total ownership of
the business’s finances. All the money that Lily’s Landscaping takes in, even if it is in a separate bank
account, belongs to Lily, and she can do with that money whatever she wants.
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These advantages must be weighed against some very important disadvantages. First, since a sole
proprietorship can have only one owner, it is impossible to bring in others to the business. Lily
cannot bring in her college roommate to work on Web site design as a partner in the business, for
example. In addition, since the business and the owner are identical, it is impossible to pass on the
business from Lily. If Lily dies, the business dies with her. Of course, she can always sell or give away
the business assets (equipment, inventory, as well as intangible assets such as customer lists and
goodwill).
Raising working capital can be a problem for sole proprietors, especially those early in their business
ventures. Many entrepreneurial ventures are built on great ideas but need capital to flourish and
develop. If the entrepreneur lacks individual wealth, then he or she must seek those funds from other
sources. For example, if Lily decides to expand her business and asks her wealthy uncle to invest
money in Lily’s Landscaping, there is no way for her uncle to participate as a profit-sharing owner in
the business. He can make a loan to her, or enter into a profit-sharing contract with her, but there is
no way for him to own any part of Lily’s Landscaping. Traditionally, most sole proprietors seek
funding from banks. Banks approach these loans just like any other personal loan to an individual,
such as a car loan or mortgage. Down payment requirements may be high, and typically the banks
require some form of personal collateral to guarantee the loan, even though the loan is to be used to
grow the business. Many sole proprietors resort to running their personal credit cards to the
maximum limit, or transferring balances between credit cards, in the early stage of their business.
Hyperlink: Small Businesses Squeezed as Banks Limit Lending
http://www.npr.org/templates/story/story.php?storyId=113816657
During the Great Recession, many banks faced a liquidity crisis as loans they made performed poorly.
Lending tightened, interest rates went up, credit lines went down, and standards became higher. The
effect on many sole proprietors, including those featured in this National Public Radio story, has been
very challenging.
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In certain industries, entrepreneurs may be able to find financing through venture capital. Venture
capital firms combine funds from institutional investors and high net-worth individuals (known
as angel investors) to identify promising start-ups, and to fund them in a private placement offering
until the start-up has developed its technology to a commercially feasible stage. At that point the
venture capital firm seeks an exit strategy, typically through offering sale of the business to the public
in an initial public offering (IPO).
Tax planning can also be challenging for the sole proprietor. Since there is no legal distinction
between the owner and the business, all the income generated by the business is treated as ordinary
personal income to the owner. The United States has several income tax rates depending on the type
of income being taxed, and ordinary personal income typically suffers the highest rate of taxation.
Being able to plan effectively to take advantage of lower income tax rates is very difficult for the sole
proprietor.
Finally, sole proprietors suffer from one hugely unattractive feature: unlimited liability. Since there is
no difference between the owner and the business, the owner is personally liable for all the business’s
debts and obligations. For example, let’s say that Lily’s Landscaping runs into some financial trouble
and is unable to generate planned revenue in a given month due to unexpectedly bad weather.
Creditors of the business include landscaping supply stores, employees, and outside contractors such
as the company that prints business cards and maintains the business Web site. Lily is personally
liable to pay these bills, and if she doesn’t she can be sued for breach of contract. Some proprietors
are very successful and can generate many hundreds of thousands of dollars in profit every year.
Unlimited liability puts all the personal assets of the sole proprietor reachable by creditors. Personal
homes, automobiles, boats, bank accounts, retirement accounts, and college funds—all are within
reach of creditors. With unlimited liability, all it takes is one successful personal injury lawsuit, not
covered by insurance or exceeding insurance limits, to wipe out years of hard work by an individual
business owner.
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For these reasons, while sole proprietors are still the most common way of doing business in the
United States, they are in many ways the most unattractive. Thankfully, modern business law creates
real and viable alternatives for sole proprietors, as we’ll discuss shortly.
K E Y T A K E A W A Y S
Sole proprietorships are the most common way of doing business in the United States. Legally, there is no
difference or distinction between the owner and the business. The legal name of the business is the
owner’s name, but owners may carry on business operations under a fictitious name by filing a d.b.a.
filing. Sole proprietors enjoy ease of start-up, autonomy, and flexibility in managing their business
operations. On the downside, they have to pay ordinary income tax on their business profits, cannot bring
in partners, may have a hard time raising working capital, and have unlimited liability for business debts.
E X E R C I S E S
1. Many household services professionals such as carpenters, plumbers, and electricians do business as sole
proprietors. If they make a promise to their customers that their work (not the products themselves) will
be free from defects for a certain period of time (i.e., a warranty), and then subsequently sell their
business assets to another individual, is the buyer bound by the promises made by the seller? Why or why
not?
2. D.b.a. statutes prohibit sole proprietors from using certain words such as “company,” “Corp.” or “Inc.” in
their fictitious names. Why do you think this rule exists?
3. If a sole proprietor dies suddenly, what do you think happens to the business run by the sole proprietor?
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11.2 Partnerships
L E A R N I N G O B J E C T I V E S
1. Learn about how general and limited partnerships are formed.
2. Explore the major differences between general and limited partnerships.
3. Understand major advantages and disadvantages to doing business as general or limited partnerships.
Let’s assume that after her first summer running Lily’s Landscaping, Lily decides that it’s time to
take her business to the next level. She has gathered a lot of expertise in running the operations in
her business, from placing orders with suppliers to scheduling workers for client projects. She
realizes, however, that she’s not very good at marketing or accounting, and that if her business is to
grow, she needs to bring someone on board who can create a strong brand and strategy for growth,
as well as keep good records of her accounts so that she can plan for the future. Fortunately, her good
friend Adam is a double major in accounting and marketing, and after a series of discussions, Adam
and Lily decide to run Lily’s Landscaping together.
Lily and Adam have formed ageneral partnership. The moment they agreed to run Lily’s Landscaping
together, and to share in the profits and losses of the business together, the partnership was formed.
Although they formed their partnership verbally, most general partnerships are formed formally,
with partners writing down their agreement in a special type of contract known as
the articles of partnership. The articles can set forth anything the partners wish to include about how
the partnership will be run. Normally, all general partners have an equal voice in management, but
as a creation of contract, the partners can modify this if they wish. As in a sole proprietorship, there
is no state involvement in creating a general partnership because there is no separation from the
business and the partners—they are legally the same.
General partnerships are dissolved as easily as they are formed. Since the central feature of a general
partnership is an agreement to share profits and losses, once that agreement ends, the general
partnership ends with it. In a general partnership with more than two persons, the remaining
partners can reconstitute the partnership if they wish, without the old partner. A common issue that
arises in this situation is how to value the withdrawing partner’s share of the business. Articles of
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partnership therefore typically include abuy/sell agreement, setting forth the agreement of the
partners on how to account for a withdrawing partner’s share, which the remaining partners then
agree to pay to the withdrawing partner (or the spouse or heir if the partner dies).
Hyperlink: A Law Firm Partner Is Fired
http://www.law.cornell.edu/nyctap/I96_0191.htm
After a nearly twenty-year career, Evan Dawson was a partner at a major New York City law firm, White &
Case. In 1988 the firm tried to persuade him to withdraw as a partner, but he refused. In July 1988 the
other partners in the firm voted to dissolve the partnership and then immediately re-formed again,
without Dawson as a partner. He had effectively been fired as a partner from a general partnership.
Dawson filed a suit against White & Case for an “accounting,” claiming that the “goodwill” of the law firm
should be part of the valuation of the partnership. The common law in New York at the time was that
professional partnerships like law firms have no goodwill. The reasoning behind the rule is that as
professionals, law firm partners develop and cultivate their own goodwill with clients, and if a partner
leaves the firm then the goodwill leaves with that partner. The New York Court of Appeals, in its opinion
on this case, held that unless the partnership agreement states otherwise, goodwill is indeed an asset of
the partnership and has to be distributed when the partnership is dissolved.
A general partnership is taxed just like a sole proprietorship. The partnership is considered
a disregarded entity for tax purposes, so income “flows through” the business to the partners, who
then pay ordinary income tax on the business income. The partnership may file
an information return, reporting total income and losses for the partnership, and how those profits
and losses are allocated among the general partners. As is the case for sole proprietors, tax planning
opportunities are limited for general partners.
General partnerships are also similar to sole proprietorships in unlimited liability. Every partner in
the partnership is jointly and severally liable for the partnership’s debts and obligations. This is a very
unattractive feature of general partnerships. One partner may be completely innocent of any
wrongdoing and still be liable for another partner’s malpractice or bad acts.
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Let’s assume that the general partnership formed by Lily and Adam flourishes and becomes
profitable. To grow the landscaping business, they want to bring in Lily’s wealthy uncle as a partner.
The uncle, however, is worried about maintaining limited liability. In most states, they can form
alimited partnership. A limited partnership has both general partners and limited partners. In this
case, Lily and Adam will remain as general partners in the business, but the uncle can become
a limited partner and enjoy limited liability. As a limited partner, the most he can lose is the amount
of his investment into the business, nothing more. Limited partnerships have to be formed in
compliance with state law, and limited partners are generally prohibited from participating in day-
to-day management of the business.
K E Y T A K E A W A Y S
A general partnership is formed when two or more persons agree to share profits and losses in a joint
business venture. A general partnership is not a separate legal entity, and partners are jointly and severally
liable for the partnership’s debts, including acts of malpractice by other partners. Income from a general
partnership flows through to the partners, who pay tax at the ordinary personal income tax rate. In most
states general partners can also bring in limited partners, creating a limited partnership. Limited
partnerships must be formed in compliance with state statutes. Limited partners enjoy limited liability but
generally cannot participate in day-to-day management of the business.
E X E R C I S E S
1. John approaches his friend Kevin and offers Kevin 50 percent of the profits from his new online venture if
Kevin designs the Web site for the venture. Kevin says nothing, and later that night begins work on the
Web site, which he then sends to John for his approval. Have John and Kevin formed a general
partnership? Why or why not?
2. Do you think it’s ethical for a general partnership to fire a partner by dissolving the partnership and then
re-forming without the dismissed partner? Why or why not?
3. Do modern professional firms such as law firms or accounting firms face the same problems as White &
Case did in Note 11.24 "Hyperlink: A Law Firm Partner Is Fired"? Why or why not?
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11.3 Corporations
L E A R N I N G O B J E C T I V E S
1. Learn about the advantages and disadvantages of corporations.
2. Study roles and duties of shareholders, directors, and officers in corporations.
3. Explore issues surrounding corporate governance.
4. Understand how corporations are taxed.
Figure 11.4 Apple Cofounder Steve Jobs
Source: Photo courtesy of acaben, http://www.flickr.com/photos/acaben/541334636/sizes/o.
So far in this chapter, we have explored sole proprietorships and partnerships, two common and
relatively painless ways for persons to conduct business operations. Both these forms of business
come with significant disadvantages, however, especially in the area of liability. The idea that
personal assets may be placed at risk by business debts and obligations is rightfully scary to most
people. Businesses therefore need a form of business organization that provides limited liability to
owners and is also flexible and easy to manage. That is where the modern corporation comes in.
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Consider, for example, tech entrepreneur and Apple cofounder Steve Jobs (Figure 11.4 "Apple
Cofounder Steve Jobs"). As a young man, he was a college dropout without much ability for
computer engineering. If doing business as a sole proprietor was his only option, Apple would not
exist today. However, Jobs met a talented computer engineer named Steve Wozniak, and the two
decided to pool their talents to form Apple Computer in1976. A year later, the company
was incorporated and in 1980 went public in an initial public offering (IPO). Incorporation allowed
Jobs much more flexibility in carrying out business operations than a mere sole proprietorship
could. It allowed him to bring in other individuals with distinct skills and capabilities, raise money in
the early stage of operations by promising shares in the new company, and eventually become very
wealthy by selling stock, or securities, in the company.
Hyperlink: Great Things in Business
http://cnettv.cnet.com/60-minutes-steve-jobs/9742-1_53-50004696.html
Sole proprietorships are limiting not just in a legal sense but also in a business sense. As Steve Jobs points
out in this video, great things in business are never accomplished with just one person; they are
accomplished with a team of people. While Jobs may have had the vision to found Apple Inc. and
maintains overall strategic leadership for the company, the products the company releases today are very
much the result of the corporation, not any single individual.
Unlike a sole proprietorship or general partnership, a corporation is a separate legal entity, separate
and distinct from its owners. It can be created for a limited duration, or it can have perpetual
existence. Since it is a separate legal entity, a corporation has continuity regardless of its owners.
Entrepreneurs who are now dead founded many modern companies, and their companies are still
thriving. Similarly, in a publicly traded company, the identity of shareholders can change many times
per hour, but the corporation as a separate entity is undisturbed by these changes and continues its
business operations.
Since corporations have a separate legal existence and have many legal and constitutional rights,
they must be formed in compliance with corporate law. Corporate law is state law, and corporations
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are incorporated by the states; there is no such thing as a “U.S. corporation.” Most corporations
incorporate where their principal place of business is located, but not all do. Many companies choose
to incorporate in the tiny state of Delaware even though they have no business presence there, not
even an office cubicle. Delaware chancery courts have developed a reputation for fairly and quickly
applying a very well-developed body of corporate law in Delaware. The courts also operate without a
jury, meaning that disputes heard in Delaware courts are usually predictable and transparent, with
well-written opinions explaining how the judges came to their conclusions.
Hyperlink: How to Incorporate in Your State
http://www.business.gov/register/incorporation
Since corporations are created, or chartered, under state law, business founders must apply to their
respective state agencies to start their companies. These agencies are typically located within the Secretary
of State. Click the link to explore how to fill out the forms for your state to start a company. You may be
surprised at how quickly, easily, and inexpensively you can form your own company! Don’t forget that
your company name must not be the same as another company’s name. (Most states allow you to do a
name search first to ensure that name is available.)
To start a corporation, the corporate founders must file the articles of incorporation with the state
agency charged with managing business entities. These articles of incorporation may vary from state
to state but typically include a common set of questions. First, the founders must state the name of
the company and whether the company is for-profit or nonprofit. The name has to be unique and
distinctive, and must typically include some form of the words “Incorporated,” “Company,”
“Corporation,” or “Limited.” The founders must state their identity, how long they wish the company
to exist, and the company’s purpose. Under older common law, shareholders could sue a company
that conducted business beyond the scope of its articles (these actions are called ultra vires), but most
modern statutes permit the articles to simply state the corporation can carry out “any lawful actions,”
effectively rendering ultra vires lawsuits obsolete in the United States. The founders must also state
how many shares the corporation will issue initially, and the par value of those shares. (Of course, the
company can issue more shares in the future or buy them back from shareholders.)
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Unlike sole proprietorships, corporations can be quite complicated to manage and typically require
attorneys and accountants to maintain corporate books in good order. In addition to the foundation
requirements, corporate law requires ongoing annual maintenance of corporations. In addition to
filing fees due at the time of incorporation, there are typically annual license fees, franchise fees and
taxes, attorney fees, and fees related to maintaining minute books, corporate seals, stock certificates
and registries, as well as out-of-state registration. A domestic corporation is entitled to operate in its
state of incorporation but must register as a foreign corporation to do business out of state. Imagine
filing as a foreign corporation in all fifty states, and you can see why maintaining corporations can
become expensive and unwieldy.
Video Clip: Monstrous Obligations
Video Clip: The Pathology of Commerce
Owners of companies are called shareholders. Corporations can have as few as one shareholder or as
many as millions of shareholders, and those shareholders can hold as few as one share or as many as
millions of shares. In aclosely held corporation, the number of shareholders tends to be small, while in
a publicly traded corporation, the body of shareholders tends to be large. In a publicly traded
corporation, the value of a share is determined by the laws of supply and demand, with various
markets or exchanges providing trading space for buyers and sellers of certain shares to be traded.
It’s important to note that shareholders own the share or stock in the company but have no legal
right to the company’s assets whatsoever. As a separate legal entity, the company owns the property.
Shareholders of a corporation enjoy limited liability. The most they can lose is the amount of their
investment, whatever amount they paid for the shares of the company. If a company is unable to pay
its debts or obligations, it may seek protection from creditors in bankruptcy court, in which case
shareholders lose the value of their stock. Shareholders’ personal assets, however, such as their own
homes or bank accounts, are not reachable by those creditors.
Shareholders can be human beings or can be other corporate entities, such as partnerships or
corporations. If one corporation owns all the stock of another corporation, the owner is said to be a
parent company, while the company being owned is a wholly owned subsidiary. A parent company
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that doesn’t own all the stock of another company might call that other company an affiliate instead
of a subsidiary. Many times, large corporations may form subsidiaries for specific purposes, so that
the parent company can have limited liability or advantageous tax treatment. For example, large
companies may form subsidiaries to hold real property so that premises liability is limited to that real
estate subsidiary only, shielding the parent company and its assets from tort lawsuits. Companies
that deal in a lot of intellectual property may form subsidiaries to hold their intellectual property,
which is then licensed back to the parent company so that the parent company can deduct royalty
payments for those licenses from its taxes. This type of sophisticated liability and tax planning makes
the corporate form very attractive for larger business in the United States.
Corporate law is very flexible in the United States and can lead to creative solutions to business
problems. Take, for example, the case of General Motors Corporation. General Motors Corporation
was a well-known American company that built a global automotive empire that reached virtually
every corner of the world. In 2009 the General Motors Corporation faced an unprecedented threat
from a collapsing auto market and a dramatic recession, and could no longer pay its suppliers and
other creditors. The U.S. government agreed to inject funds into the operation but wanted the
company to restructure its balance sheet at the same time so that those funds could one day be
repaid to taxpayers. The solution? Form a new company, General Motors Company, the “new GM.”
The old GM was brought into bankruptcy court, where a judge permitted the wholesale cancellations
of many key contracts with suppliers, dealers, and employees that were costing GM a lot of money.
Stock in the old GM became worthless. The old GM transferred all of GM’s best assets to new GM,
including the surviving brands of Cadillac, Chevrolet, Buick, and GMC; the plants and assets those
brands rely on; and the shares in domestic and foreign subsidiaries that new GM wanted to keep. Old
GM (subsequently renamed as “Motors Liquidation Company”) kept all the liabilities that no one
wanted, including obsolete assets such as shuttered plants, as well as unpaid claims from creditors.
The U.S. federal government became the majority shareholder of General Motors Company, and may
one day recoup its investment after shares of General Motors Company are sold to the public. To the
public, there is very little difference in the old and new GM. From a legal perspective, however, they
are totally separate and distinct from each other.
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One exception to the rule of limited liability arises in certain cases mainly involving closely held
corporations. Many sole proprietors incorporate their businesses to gain limited liability but fail to
realize when they do so that they are creating a separate legal entity that must be respected as such.
If sole proprietors fail to respect the legal corporation with an arm’s-length transaction, then creditors
can ask a court to pierce the corporate veil. If a court agrees, then limited liability disappears and
those creditors can reach the shareholder’s personal assets. Essentially, creditors are arguing that the
corporate form is a sham to create limited liability and that the shareholder and the corporation are
indistinguishable from each other, just like a sole proprietorship. For example, if a business owner
incorporates the business and then opens a bank account in the business name, the funds in that
account must be used for business purposes only. If the business owner routinely “dips into” the
bank account to fund personal expenses, then an argument for piercing the corporate veil can be
easily made.
Not all shareholders in a corporation are necessarily equal. U.S. corporate law allows for the creation
of different types, or classes, of shareholders. Shareholders in different classes may be given
preferential treatment when it comes to corporate actions such as paying dividends or voting at
shareholder meetings. For example, founders of a corporation may reserve a special class of stock for
themselves with preemptive rights. These rights give the shareholders the right of first refusal if the
company decides to issue more stock in the future, so that the shareholders maintain the same
percentage ownership of the company and thus preventing dilution of their stock.
A good example of different classes of shareholders is in Ford Motor Company stock. The global
automaker has hundreds of thousands of shareholders, but issues two types of stock: Class A for
members of the public and Class B for members of the Ford family. By proportion, Class B stock is
far outnumbered by Class A stock, representing less than 10 percent of the total issued stock of the
company. However, Class B stock is given 40 percent voting rights at any shareholder meeting,
effectively allowing holders of Class B stock (the Ford family) to block any shareholder resolution
that requires two-thirds approval to pass. In other words, by creating two classes of shareholders, the
Ford family continues to have a strong and decisive voice on the future direction of the company
even though it is a publicly traded company.
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Shareholder rights are generally outlined in a company’s articles of incorporation or bylaws. Some of
these rights may include the right to obtain a dividend, but only if the board of directors approves
one. They may also include the right to vote in shareholder meetings, typically held annually. It is
common in large companies with thousands of shareholders for shareholders to not attend these
meetings and instead cast their votes on shareholder resolutions through the use of a proxy.
Video Clip: Activist Shareholders at Wal-Mart
Under most state laws, including Delaware’s business laws, shareholders are also given a unique
right to sue a third party on behalf of the corporation. This is called
a shareholder derivative lawsuit (so called because the shareholder is suing on behalf of the
corporation, having “derived” that right by virtue of being a shareholder). In essence, a shareholder
is alleging in a derivative lawsuit that the people who are ordinarily charged with acting in the
corporation’s best interests (the officers and directors) are failing to do so, and therefore the
shareholder must step in to protect the corporation. These lawsuits are very controversial because
they are typically litigated by plaintiffs’ lawyers working on contingency fees and can be very
expensive for the corporation to litigate. Executives also disfavor them because oftentimes,
shareholders sue the corporate officers or directors themselves for failing to act in the company’s
best interest.
One of the most important functions for shareholders is to elect the board of directors for a
corporation. Shareholders always elect a director; there is no other way to become a director. The
board is responsible for making major decisions that affect a corporation, such as declaring and
paying a corporate dividend to shareholders; authorizing major new decisions such as a new plant or
factory or entry into a new foreign market; appointing and removing corporate officers; determining
employee compensation, especially bonus and incentive plans; and issuing new shares
and corporate bonds. Since the board doesn’t meet that often, the board can delegate these tasks to
committees, which then report to the board during board meetings.
Shareholders can elect anyone they want to a board of directors, up to the number of authorized
board members as set forth in the corporate documents. Most large corporations have board
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members drawn from both inside and outside the company. Outside board members can be drawn
from other private companies (but not competitors), former government officials, or academe. It’s
not unusual for the chief executive officer (CEO) of the company to also serve as chair of the board of
directors, although the recent trend has been toward appointing different persons to these functions.
Many shareholders now actively vie for at least one board seat to represent the interests of
shareholders, and some corporations with large labor forces reserve a board seat for a union
representative.
Board members are given wide latitude to make business decisions that they believe are in the best
interest of the company. Under the business judgment rule, board members are generally immune
from second-guessing for their decisions as long as they act in good faith and in the corporation’s
best interests. Board members owe a fiduciary duty to the corporation and its shareholders, and
therefore are presumed to be using their best business judgment when making decisions for the
company.
Shareholders in derivative litigation can overcome the business judgment rule, however. Another
fallout from recent corporate scandals has been increased attention to board members and holding
them accountable for actually managing the corporation. For example, when WorldCom fell into
bankruptcy as a result of profligate spending by its chief executive, board members were accused of
negligently allowing the CEO to plunder corporate funds. Corporations pay for insurance for board
members (known as D&O insurance, for directors and officers), but in some cases D&O insurance
doesn’t apply, leaving board members to pay directly out of their own pockets when they are sued. In
2005 ten former outside directors for WorldCom agreed to pay $18 million out of their own pockets
to settle shareholder lawsuits.
One critical function for boards of directors is to appoint corporate officers. These officers are also
known as “C-level” executives and typically hold titles such as chief executive officer, chief operating
officer, chief of staff, chief marketing officer, and so on. Officers are involved in everyday decision
making for the company and implementing the board’s strategy into action. As officers of the
company, they have legal authority to sign contracts on behalf of the corporation, binding the
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corporation to legal obligations. Officers are employees of the company and work full-time for the
company, but can be removed by the board, typically without cause.
In addition to being somewhat cumbersome to manage, corporations possess one very unattractive
feature for business owners: double taxation. Since corporations are separate legal entities, taxing
authorities consider them as taxable persons, just like ordinary human beings. A corporation doesn’t
have a Social Security number, but it does have an Employer Identification Numbers (EIN), which
serves the same purpose of identifying the company to tax authorities. As a separate legal entity,
corporations must pay federal, state, and local tax on net income (although the effective tax rate for
most U.S. corporations is much lower than the top 35 percent income tax rate). That same pile of
profit is then subject to tax again when it is returned to shareholders as a dividend, in the form of a
dividend tax.
One way for closely held corporations (such as small family-run businesses) to avoid the double
taxation feature is to elect to be treated as an S corporation. An S corporation (the name comes from
the applicable subsection of the tax law) can choose to be taxed like a partnership or sole
proprietorship. In other words, it is taxed only once, at the shareholder level when a dividend is
declared, and not at the corporate level. Shareholders then pay personal income tax when they
receive their share of the corporate profits. An S corporation is formed and treated just like any other
corporation; the only difference is in tax treatment. S corporations provide the limited liability
feature of corporations but the single-level taxation benefits of sole proprietorships by not paying
any corporate taxes. There are some important restrictions on S corporations, however. They cannot
have more than one hundred shareholders, all of whom must be U.S. citizens or resident aliens; can
have only one class of stock; and cannot be members of an affiliated group of companies. These
restrictions ensure that “S” tax treatment is reserved only for small businesses.
K E Y T A K E A W A Y S
A corporation is a separate legal entity. Owners of corporations are known as shareholders and can range
from a few in closely held corporations to millions in publicly held corporations. Shareholders of
corporations have limited liability, but most are subject to double taxation of corporate profits. Certain
small businesses can avoid double taxation by electing to be treated as S corporations under the tax laws.
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State law charters corporations. Shareholders elect a board of directors, who in turn appoint corporate
officers to manage the company.
E X E R C I S E S
1. Henry Ford (Ford Motor Company), Ray Croc (McDonald’s), and Levi Strauss (Levi’s) were all entrepreneurs
who decided to incorporate their businesses and in doing so created long-lasting legacies that outlive
them. Why do you think these entrepreneurs were motivated to incorporate when incorporation meant
giving up control of their companies?
2. Some corporations are created for just a limited time. Can you think of any strategic reasons why founders
would create a corporation for just a limited time?
3. Recently some companies have come under fire for moving their corporate headquarters out of the
country to tax havens such as Bermuda or Barbados. Which duty do you believe is higher, the duty of
corporations to pay tax to government or the duty of corporations to pay dividends to shareholders?
Why?
4. Some critics believe that the corporate tax code is a form of welfare, since many U.S. corporations make
billions of dollars and don’t pay any tax. Do you believe this criticism is fair? Why or why not?
5. It is very easy to start a corporation in the United States. Take a look at how easy it is to start a corporation
in China or India. Do you believe there is a link between ease of starting businesses and overall economic
efficiency?
6. Do you agree with filmmaker Achbar that a corporation might be psychopathic? What do you think the
ethical obligations of corporations are? Discuss.
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11.4 Limited Liability Entities
L E A R N I N G O B J E C T I V E S
1. Learn about the development of limited liability entities.
2. Explore how limited liability entities are created.
3. Understand why limited liability entities are now heavily favored.
By now you should understand how easy yet dangerous it is to do business as a sole proprietor, and
why many business organizations are drawn to the corporation as a form for doing business. As
flexible as the corporation is, however, it is probably best suited for larger businesses. Annual
meeting requirements, the need for directors and officers, and the unattractive taxation features
make corporations unwieldy and expensive for smaller businesses. A form of business organization
that provides the ease and simplicity of sole proprietorships, but the limited liability of corporations,
would be much better suited for a wide range of business operations.
A limited liability company (LLC) is a good solution to this problem. LLCs are a “hybrid” form of
business organization that offer the limited liability feature of corporations but the tax benefits of
partnerships. Owners of LLCs are called members. Just like a sole proprietorship, it is possible to
create an LLC with only one member. LLC members can be real persons or they can be other LLCs,
corporations, or partnerships. Compared to limited partnerships, LLC members can participate in
day-to-day management of the business. Compared to S corporations, LLC members can be other
corporations or partnerships, are not restricted in number, and may be residents of other countries.
Taxation of LLCs is very flexible. Essentially, every tax year the LLC can choose how it wishes to be
taxed. It may want to be taxed as a corporation, for example, and pay corporate income tax on net
income. Or it may choose instead to have income “flow through” the corporate form to the member-
shareholders, who then pay personal income tax just as in a partnership. Sophisticated tax planning
becomes possible with LLCs because tax treatment can vary by year.
LLCs are formed by filing the articles of organization with the state agency charged with chartering
business entities, typically the Secretary of State. Starting an LLC is often easier than starting a
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corporation. In fact, you might be startled at how easy it is to start an LLC; typical LLC statutes
require only the name of the LLC and the contact information for the LLC’s legal agent (in case
someone decides to file a lawsuit against the LLC). In most states, forming an LLC can be done by
any competent business professional without any legal assistance, for minimal time and cost. Unlike
corporations, there is no requirement for an LLC to issue stock certificates, maintain annual filings,
elect a board of directors, hold shareholder meetings, appoint officers, or engage in any regular
maintenance of the entity. Most states require LLCs to have the letters “LLC” or words “Limited
Liability Company” in the official business name. Of course, LLCs can also file d.b.a. filings to
assume another name.
Although the articles of organization are all that is necessary to start an LLC, it is advisable for the
LLC members to enter into a written LLCoperating agreement. The operating agreement typically sets
forth how the business will be managed and operated. It may also contain a buy/sell agreement just
like a partnership agreement. The operating agreement allows members to run their LLCs any way
they wish to, but it can also be a trap for the unwary. LLC law is relatively new compared to
corporation law, so the absence of an operating agreement can make it very difficult to resolve
disputes among members.
LLCs are not without disadvantages. Since they are a separate legal entity from their members,
members must take care to interact with LLCs at arm’s length, because the risk of piercing the veil
exists with LLCs as much as it does with corporations. Fundraising for an LLC can be as difficult as it
is for a sole proprietorship, especially in the early stages of an LLC’s business operations. Most
lenders require LLC members to personally guarantee any loans the LLC may take out. Finally, LLCs
are not the right form for taking a company public and selling stock. Fortunately, it is not difficult to
convert an LLC into a corporation, so many start-up business begin as LLCs and eventually convert
into corporations prior to their initial public offering (IPO).
A related entity to the LLC is the limited liability partnership, or LLP. Be careful not to confuse
limited liability partnerships with limited partnerships. LLPs are just like LLCs but are designed for
professionals who do business as partners. They allow the partnership to pass through income for tax
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purposes, but retain limited liability for all partners. LLPs are especially popular with doctors,
architects, accountants, and lawyers. Most of the major accounting firms have now converted their
corporate forms into LLPs.
K E Y T A K E A W A Y S
The limited liability company (LLC) represents a new trend toward business organization. It allows owners,
called members, to have limited liability just like corporations. Unlike corporations, however, LLCs can
avoid double taxation by choosing to be taxed like a partnership or sole proprietorship. Unless a business
wishes to become publicly traded on a stock exchange, the LLC is probably the most flexible, most
affordable, and most compatible form for doing business today. The limited liability partnership (LLP) is
similar to the LLC, except it is designed for professionals such as accountants or lawyers who do business
as partners.
E X E R C I S E S
1. Most small businesses in the United States are still run as sole proprietorships. Why do you think these
businesses have not converted to the LLC form?
2. Take a look at some of the brands and businesses you are most familiar with. How many of them do
business as an LLC?
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11.5 Concluding Thoughts
Most economists and public policy officials believe that the American economy is a key anchor to
American society and values. Private enterprise and the profit motive allow innovation and
entrepreneurship to flourish, leading to prosperity and peace. Underlying the strength of American
business enterprises is a flexible and easy-to-manage legal system that allows business owners many
options in choosing how to organize their operations. The sole proprietorship, which provides
autonomy and ease in creation, is a dangerous form to do business because of unlimited liability. The
general partnership allows business partners to do business together but similarly carries unlimited
liability. The corporation provides limited liability for its owners but can be unwieldy and
cumbersome to manage, with numerous technical requirements in creation and ongoing
management. Limited liability entities, such as the limited liability company and limited liability
partnership, provide the most flexible choice for doing business, multiple options for tax planning,
and limited liability for owners.
