Chapter 18 Governance and Structure: Forms of Doing Business Marianne M. Jennings Business Its Legal, Ethical, and Global Environment 10th Ed. Chapter 18 Governance and Structure: Forms of Doing Business

Comparison of Business Organizations Form Formation Funding Management Sole proprietorship Partnership Limited partnership Corporation S corporation or Subchapter S Limited liability company (LLC) Limited liability partnership No formal requirements Articles of partnership Filing of articles of partnership Formal filing of articles of incorporation Same as above (special IRS filings) Formal filing – articles of organization Filing of articles of limited liability partnership Individual provides funds Capital contributions of partners Capital contributions of general and limited partners Debt (bonds)/equity (shareholders) Same as above Capital contributions of members Individual All partners or delegated to one General partner Board of directors, officers and/or executive committee No centralized management; all members manage or delegate to one member

Comparison of Business Organizations Form Transfer Control Taxes Sole proprietorship Partnership Limited partnership Corporation S corporation or Subchapter S Limited liability company (LLC) Limited liability partnership No transfer Transfer interest but not partner status Same as partnership (except RULPA) Shares (with reasonable restrictions) are easily transferred Restrictions on transfer to comply with S corporation No transfer without consent of the majority No admission without consent of majority Individual pays on individual return Partner takes profits and losses on individual return (flow-through) Same as partnership Corporation pays taxes; shareholders pay taxes on dividends Shareholders pay taxes on profits; take losses Flow-through treatment

Comparison of Business Organizations Form Termination Liability Sole proprietorship Partnership Limited partnership Corporation S corporation or Subchapter S Limited liability company (LLC) Limited liability partnership Death; voluntary Dissolution upon death; withdrawal of partner Same as partnership Dissolved only if limited in duration or shareholders vote to dissolve Same as above Dissolved upon death; bankruptcy Dissolved upon death, bankruptcy Individual Partners are personally liable General partner is personally liable; limited partners liable to extent of contribution No shareholder personal liability unless Watered or Corporate veil Limited liability – only liable to extent of capital contribution Varies by state, but liability for acts of partners is limited in some way

Sole Proprietorships Formation Done by an individual May have a fictitious name Example: Ralph Jones d/b/a Spuds Brewery No formal requirements for formation May have to publish d/b/a name

Sole Proprietorships Sources of Funding Loans Government help Liability: Full Personal Liability of Owner Tax Consequences Owner claims all income and losses No separate filing requirement Management and Control All assets with one person

Sole Proprietorships Transferability of Interest Business can be sold—property, inventory, and goodwill Owner will usually sign a non-compete agreement

Partnerships Governed by the Uniform Partnership Act (UPA) Adopted in 49 states In absence of a partnership agreement, UPA controls Revised Uniform Partnership Act (1994)—adopted in nine states

Partnerships Definition Formation An association of two or more persons to carry on as co-owners, a business for profit Can include corporations and natural persons Formation Voluntary formation: By agreement Draw up articles of partnership Involuntary formation

Information in Articles of Partnership Minimum requirements Names of the partners Name of the partnership Nature of the partnership’s business The time frame of operation Amount of each partner’s capital contribution Managerial powers of partners Rights and duties of partners Accounting procedures for partnership books and records Methods for sharing profits and losses Salaries (if any) of the partners Causes and methods of dissolution Distribution of property if the partnership is terminated Suggested provisions Disability issues Insurance coverage Sale of interest Divorce of one of the partners Indemnity agreements Noncompetition agreements Leaves of absence

Partnership Formation Involuntary Formation: By Implication Sharing of profits Constitutes prima facie evidence that a partnership exists Exceptions—rent, wages, annuity to widow or estate, payment for goodwill

Partnership Formation Case 18.1 Byker v. Mannes (2002) Was there a partnership created? When did the relationship legally end? Is Mannes liable to Byker?

Partnership Formation Involuntary Formation: Partnership by Estoppel (or Ostensible Partner) Results when someone allows the inference to be made that he/she is a partner Allowing name to be used to get a loan

Partnership Funding Sources of Funding Capital contributions of partners Loans by partners Outside loans

Partnership Liability Mutual Principals and Agents Partnership assets reachable by partnership creditors Personal assets reachable by partnership creditors when partnership assets are exhausted Case 18.2 Vrabel v. Acri (1952) Why wasn’t Mr. Acri a defendant? Is Ms. Acri liable for the injuries?

Partnership Tax Issues Partnership does not pay taxes Partnership files informational return Partners report income and losses on their returns

Partnership Management Partnership Control Unless otherwise agreed, each has equal management authority May delegate day-to-day authority to one partner Each partner is mutual principal and agent of the others

Partnership Management Borrowing—Done Routinely In Most Partnerships Unanimous Consent Required for Confession of Judgment, Selling Goodwill, and Admission of Another Partner No Compensation for Work Unless Agreed

Partnership Management Fiduciary Duties Mutual principals and agents Each is to act in the best interests of the partnership Partnership Property Property contributed to the firm or purchased with partnership assets Own property as tenants in partnership

Partnership Management Transfers of Partners’ Interest Partner’s interest is personal property Can be pledged to creditors and transferred Transferee does not become a partner

Partnership Management Transfers of Partners’ Interest Admission of new partner requires unanimous consent Transferring partner is not relieved of liability Some partnership agreements require partners to offer it first to remaining partners

Partnership Dissolution One Partner No Longer Associated With the Partnership Examples: Retirement, death Can Just Be a Change in Structure or Can Proceed to Termination

Partnership Dissolution Dissolution Methods By agreement By operation of law: Death of a partner, bankruptcy of partnership or partner Court order Termination Assets are liquidated Distribute in this order: outside creditors; partners’ advances (loans); capital contributions; profits

Limited Partnerships Governed by Uniform Limited Partnership Act (ULPA) Revised Uniform Limited Partnership Act (RULPA) Recent revision adopted in nearly all states Use ULPA or RULPA when no agreement RULPA addresses the needs of the larger limited partnership

L.P.’s: Formation Structure Formation Must have at least one general partner Must have at least one limited partner Liability of limited partner is limited to capital contribution Liability of general partner is unlimited Formation Must meet statutory requirements; if not met a general partnership may be created

L.P.’s: Formation Must File Certificate of Limited Partnership (see text for list of requirements and note differences between ULPA and RULPA) RULPA is much briefer Corrections Can Be Filed By Limited Partners

L.P.’s: Formation Formation – the RULPA Requires the Following Information for Formation of a Limited Partnership Name - must contain the words “Limited Partnership” Address of principal place of business Name and address of statutory agent for services process Business address of general partner Latest date for dissolution of partnership

L.P.’s: Funding Sources of Funding Limited partners provide most of the financing Limited partners can contribute services under RULPA Loans are used—called advances when made by partners Under RULPA, limited partners can use services already given as a contribution

L.P.’s: Liability Limited Partners Have Limited Liability But Cannot Participate in Management Under RULPA, Can Do the Following and Still Retain Limited Liability Status Can be an employee Can consult with and advise the general partner Can act as a surety guarantor for the limited partnership Can vote on amendments, dissolution, sale of property, and debt assumptions

L.P.’s: Tax Issues Taxed the Same as General Partnerships Partners Report Profits and Losses on Individual Returns Limited Partners Get Direct Tax Benefits With Limited Liability IRS Scrutinizes to be Certain it is a Partnership and Not a Corporation

L.P.’s: Profits Partner Relationships: Management is Responsibility of General Partner Profits and Distributions Authority belongs to general partner to make decisions here Profits and losses are allocated on the basis of capital contributions RULPA requires agreement for splitting profits and losses to be in writing

L.P.’s: Partner Authority General partner has same authority as in general partnership Can restrict by agreement Consent of limited partners required for Admitting a new general partner Admitting a new limited partner (can give authority in the agreement) Extraordinary transactions (selling assets) Limited partners have right to inspect books and records

L.P.’s: Transferability ULPA Allows Transfer of Interests May have significant restrictions on transfer to prevent liability under federal securities laws The more easily an interest can be transferred, the more likely the IRS is to label it a corporation Transfer of a limited partner’s interest does not dissolve the partnership Under RULPA, Assigning Limited Partner Can Be Given the Authority to Make the Assignee a Limited Partner

L.P.’s: Dissolution RULPA Provides for the Following Means Expiration of time period in agreement or event as provided in agreement Unanimous written consent of all partners By court order Withdrawal of general partner

L.P.’s: Dissolution If Termination is Elected, Assets are Distributed as Follows Outside creditors Partners’ distributions Return of capital contributions Remainder split according to agreement

Corporations Characteristics of a Corporation Unlimited duration Free transferability of interest Limited liability Centralized management Legal existence Can hold legal title to property Can sue and be sued

Types of Corporations For Profit Not For Profit Domestic—in the State of Incorporation Foreign—Everywhere Else Government Corporations—Like FNMA Professional Corporations—Limited Liability on Everything Except Professional Malpractice

Types of Corporations Close or Closely Held Corporations: Limited Number of Shareholders, Subject to Less Formality Subchapter S or S Corporation IRS election to be treated as partnership for tax purposes Still have limited liability Limits on size for this election

Types of Corporations The Law of Corporations: Model Business Corporation Act (MBCA) Liberal statute One-third of the states have adopted Revised in 1984

Corporate Formation Must Comply With Statutory Requirements File Articles of Incorporation Name Names and addresses of all incorporators Capital structure of the corporation Types of stock

Corporate Formation File Articles of Incorporation Classes of stock Rights of shareholders Voting rights Statutory agent

Corporate Formation Where to Incorporate Status of state’s corporation laws State tax laws Ability to attract employees Incentives

Corporate Formation Incorporators Idea people—also called promoters Will be personally liable for contracts entered into before incorporation Corporation can ratify contracts—promoter is secondarily liable Corporation can enter into a novation with the third party—promoter or incorporator is released from liability

Corporate Formation Must Hold Initial Meeting After Incorporation Elect new directors Adopt bylaws (day-to-day procedures) Issue stock Ratify pre-incorporation contracts

Corporate Capital Capital and Sources of Corporate Funds Debt Financing—The Bond Market Short-term financing—loans from banks Bond market Benefits of debt financing Interest is tax deductible Debt holders get paid first Limitation: too much debt renders corporation financially unstable

Corporate Capital Equity Financing—Shareholder Common stock: Has voting rights, receives dividends when paid Preferred stock: Receiver preference over common stock can be cumulative or noncumulative

Corporate Liability Liability Issues Must make full payment for shares—if not, there is liability (water stock); not paying par value Shareholders’ liability generally limited to amount of investment If corporate veil is pierced, there is shareholder liability. Means corporate immunity from liability is set aside

Corporate Liability Reason for Piercing the Veil Inadequate capitalization—must put in enough money to meet the risks of doing business Alter ego theory—separate nature of corporation is disregarded No formalities—personal and corporate properties are mixed together Ignoring corporate formalities—personal elections, meetings Forming to perpetrate a fraud on creditors

Piercing the Veil Case 18.3 U.S. v. Bestfoods, Inc. (1998) Is there a special CERCLA rule for piercing the corporate veil? What must be shown to hold a parent liable for the action of a subsidiary?

Corporate Tax Issues Corporation Pays Tax Shareholders pay tax on dividend income Subchapter S or S Corporation Corporate liability protection with partnership tax status

Corporate Directors Election of Directors Director Liability Elected by shareholders to make corporate policy May operate by committee Hire officers of corporation and set officers’ salaries Director Liability Protected by the Business Judgment Rule. Directors and Officers must act in good forth and with prudence to avoid personal liability Can consult experts but must study issues

Control By Board of Officer Pay Dodd-Frank Requirements on Independence of Compensation Committee and Pay Votes Shareholder “say on pay” vote every three years Independent compensation committee Claw-back provisions in compensation for executives if there is fraud or other illegality

Director Liability Case 18.4 Brehm v. Eisner (2000) Who made the decision to terminate Ovitz? Was hiring Ovitz just a HUGE mistake? Why is there no liability on the part of the directors?

Corporate Liability Officer Liability Increasing personal liability Increasing prosecutions Particularly when environmental laws are violated

Sarbanes-Oxley Act Liability for Officers and Directors Prohibitions on Loans to Officers Code of Ethics for Financing Reporting Lawyer’s new duties to company and officers Board Membership – majority must be independent

Sarbanes-Oxley, Dodd-Frank, and Boards Majority of Independent Directors Only Independent Directors on Audit and Compensation Committees No Loans to Officers Codes of Ethics for Financial Reporting Legal Counsel’s Role Must investigate issues raised Must notify CEO of investigation Must report material violations to CEO Must go to independent directors if problem is not resolved

Shareholder Rights Voting Shareholders Elect the board The Proxy Vote on critical corporate issues Pooling agreement Voting trust

Shareholder Rights Shareholders Have Right to Vote on Mergers, Consolidations, and Sale of All Assets, Not on Acquisition Procedure Board of Directors adopts resolution in favor of combination or sale Resolution with notice of meeting sent to all shareholders Shareholders vote on resolution at meeting

Shareholder Rights Dissenting Shareholders Shareholders not voting in favor of the combination can force corporation to purchase their shares for cash – called appraisal rights Corporation May Use Freeze-Out to Defeat Dissenters’ Rights

Shareholder Rights Shareholders Have Access to Books and Records Under revised MBCA, no ownership requirements Must have proper purpose Generally Shares in a Corporation are Freely Transferable; However Sometimes Transfers are Restricted

Shareholder Rights Transfer Restrictions Must be noted or referenced on stock certificates Must serve a necessary purpose Must be reasonable

Corporate Dissolution Voluntary Board resolution Shareholder approval Involuntary Forced by court or state agency Example: Fraud

Limited Liability Companies History: In Existence Internationally For Some Time GMBH—Europe Limitada—South America LLC—U.S. Nature Aggregate organization Liability shield Income flows through

LLC: Formation Articles of Organization Filed Centrally Name Must Disclose Status – L.L.C. or LLC

Limited Liability Companies Funding: Members Contribute Capital Liability Members stand to lose capital contributions, but their personal assets are not subject to attachment Tax Consequence Income passes through to members LLC does not pay taxes

Limited Liability Companies Management and Control Operating Agreement—specifies voting rights One member or an outside consultant can have operating authority delegated to him or her Transferability of Interest Interest can be transferred Transferee does not become a member unless majority of remaining members approve

Limited Liability Companies Dissolution and Termination Generally withdrawal, death or expulsion of members will dissolve company Some state permit judicial dissolution All state permit voluntary dissolution

Limited Liability Partnership Formation: Must File To Create Funding: Capital Contribution From Partners Liability: Limited Liability For All Tax Consequences: Tax Reporting Entity Not Tax Paying

Limited Liability Partnership Management and Control Partners can participate in management without personal liability for partnership debts Transferability Transfer must be restricted Dissolution and Termination Similar to Limited Partnership

International Issues Joint Ventures Increasing Joint ventures with countries themselves Business structure varies Example: Germany and differing board structures