Lecture Notes on Forms of Business Organization

A. The Four Common Forms of Business Organizations

1.The Sole Proprietorship

a. No legal formalities are required to form a sole proprietorship though a fictitious name
may need to be registered.
b. The sole proprietorship may only have one owner, but there may be many employees.
c. The personal assets of the owner are subject to claims against the business.

2.The General Partnership

a. A partnership is a "a voluntary association of two or more persons to carry on a

business for profit"; the two types of partnership are:

1) A general partnership where all the partners are general partners; and
2) A limited partnership which has at least one general partner and at least one
limited partner.

a) A general partner participates in the management of the firm and as a

result has unlimited personal liability for the debts of the firm;
b) A limited partner does not participate in the management of the firm
and as a result has liability that is limited to his/her capital contribution
(i.e. what was invested in the firm in order to become a limited
partner).

b. No legal formalities are required to form a general partnership; however, a fictitious

name statute may require the firm name to be registered to prevent confusion and/or
fraud.

c. There is often a written general partnership agreement called the “articles of

partnership”, but they are not mandatory.

d. The Uniform Partnership Act (UPA) specifies the terms which govern the
relationship of the general partners where they have no agreement or have not agreed
upon or anticipated a particular situation; the UPA has been adopted in 48 states and
the District of Columbia.

e. Partnerships are not separate legal entities for most purposed nor do they pay taxes;
they do file “information returns” with the IRS to report each partner’s share of
profits and thereby establish the amount of income from the partnership which the
partner must declare as regular income.

f. Each general partner is an agent for the firm and other partners for partnership
affairs.

1) As an agent of the firm a partner can bind the firm contractually and/or may
commit torts for which the firm is liable.

g. The personal assets of the general partners are subject to claims against the
partnership.

1) Each general partner can be held personally responsible to pay third parties
the entire amount of the firm’s debts.
 2) However each partner has a right of contribution against the other partners;
this is an equitable right to force the other partners to pay their fair share of
the firm’s debts where one partner has paid more than his/her fair share.

3. Limited Partnership

a. The general partner (s) manage the firm and have unlimited personal liability for
claims against the business.

b. Limited partners do not participate in the management and do not have personal
liability for claims against the business (of course a limited partner will lose his/her
limited liability if he/she participates regularly in significant managerial decisions.

c. Uniform Limited Partnership Act (ULPA) was widely adopted by the states as has
been its 1976 Revision (RULPA).

1) A limited partnership is similar to a corporation in that it is a “creature of

statute” meaning that in order to create a limited partnership a certificate of
limited partnership must be signed by two or more partners and filed with
the appropriate state official.

2) A limited partner may be held personally liable for the debts of the firm
where the limited partnership is defectively formed.

4. The Corporation
a. Corporations are treated as being separate legal persons apart from their owners.

1 1) Corporations may have perpetual life.

2
2) Owners may usually transfer shares without the consent of the other
shareholders.

3) Ownership of the corporation can be separated from its management.

4) Corporations have limited liability by statute owners will not have personal
liability for claims against the business.

5)Corporations subject to "double taxation".

b. Corporations are chartered under state law.

1) Articles of incorporation must be filed and the resulting charter publicly

recorded.
3 2)This gives notice of limited personal liability of the owners to potential
creditors and customers of the firm.

c. A Subchapter S Corporation is a corporation which is not separately taxed from its

owners (i.e. double taxation avoided) ; however it is only available to closely held
corporations with a small number of shareholders (75 or less).

d. For good cause, courts can pierce the corporate veil, disregarding the corporate
entity; this may happen when a court determines:

1) All the formal steps of incorporation were not carried out.

 2) The corporation was formed to evade obligations or perpetrate a fraud.

3) Periodic meetings of the shareholders and of the board of directors as required

in the bylaws were not held or corporate minutes and financial records were not
maintained.

4) There is intermingling of corporate and shareholder finances.

5) The corporation is formed with inadequate financing.

6)The corporate veil can also be pierced where directors misrepresented the
corporation's financial condition and there was inadequate capitalization.

e. Parent corporations have limited liability for claims against subsidiary corporations but
the corporate veil can be pierced where a court determines it is appropriate to do so.

f. Miscellaneous Corporate attributes.

1) Shareholders "own" the corporation.

4 2)Board of Directors sets policy for corporation.

5 3)Corporate officers manage daily affairs of corporation.

4)Business judgement rule protects officers and directors.

a) This rule provides that corporate officers and directors

are not liable for losses to the corporation as a result
of poor decisions as long as those decisions were arrived at
utilizing due care (i.e. without negligence).

g. Reform of Corporations: Strengthening the Board: Some corporate reform proposals

focus on limiting the ability of management to engage in wrongful acts by giving a
greater role in corporate governance to outsiders and/or creating a more independent
board of directors which could exercise its power to restrict management.

1)Proposals which might strengthen the board of directors include:

a) Requiring a majority of the board of directors to be outside directors.

b) Specifying minimum qualifications for directors.
c) Requiring directors to own a minimum value of corporate shares.
d) Requiring an audit committee with independent staff and legal
responsibility
e) Requiring a number of directors who represent special interests.
f) Limiting the number of major directorships a single person can hold.
g) Providing adequate compensation of directors.
h) Requiring an ethics committee.

2) These proposals are criticized as being inefficient and productive of conflict

within the board of directors.
 3) Other proposals focus on strengthening the shareholder's role and are referred to as
shareholder democracy.

a) Allowing small groups of shareholders to nominate directors.

b) Modifying the proxy process to increase the chances of independent
shareholders being elected to the Board.
c) Allowing minority groups of shareholders to elect directors.

4) Under current law, shareholders can confront management over specific issues by
submitting a shareholder resolution.

a) These are often proposed in the form of an amendment to the bylaws.

b) Statements of up to 200 words by the proposing shareholder must be included
in management proxy, but management may refute with its own statement.
c) To avoid harassment of the corporation, SEC rules require the resolution to
receive at least 5% of the vote to be brought again; it must get 8% the next time,
and 10% after that to qualify for continued reintroduction.
d)They may not pertain to day to day operations or be beyond corporate powers.
e) Even though shareholder resolutions almost always lose, they may have an
impact on management.

B. Miscellaneous Forms of Organization

1.Joint Venture

a. Similar to a general partnership except that when it is formed the relationship is not anticipated
to be an on-going, long-term effort to conduct business together for profit; it is thus normally a
shorter term relationship than a partnership.

2.Limited Liability Companies (LLC's)

a. Recognized in most states including Virginia.

b. Are creatures of statute; attributes may vary from state to state.
c. Income of LLC taxed like partnership (double taxation avoided).
6 d. Owners called members and enjoy limited liability for LLC debts.

1) Number of shareholders not limited like Sub-Chapter S Corporation.

3. Limited Liability Partnership (LLP)

a. Texas enacted the first LLP statute in 1991 in response to the liability that had been imposed
upon partners successfully sued by the government during the massive savings and loan failures of
the 1980’s; by the mid-1990’s, at least 21 states and the District of Columbia had adopted LLP
statutes.

b. An LLP is a general partnership in form which provides each of its individual partners with
protection against personal liability for certain partnership liabilities; the limit of an individual
partner’s liability depends on the scope of the state LLP statute.

1) Many states provide protection only against tort claims and do not extend protection to a
partner’s own negligence or to the partner’s involvement in supervising wrongful
conduct.
 2) Other states provide broad protection, including protection against contractual claims
brought by the partnership’s creditors.

c. A partnership that renders specific professional services may form an LLP and register as a
professional limited liability partnership (PLLP); while state statutes specify the qualifying
professions for a PLLP, it is normally available only to attorneys, physicians, architects, dentists,
engineers and accountants.

d. In general, an LLP if formed by registering with the appropriate state authority; paying the
registration fee; and including the words LLP in the firm’s name.

5. Master Limited Partnerships (MLP)

a. One of the disadvantages of investing in a limited partnership is the lack of a formal market
for reselling and thus liquidating limited partnership interests.
b. A Master Limited Partnership a limited partnership whose interests are traded on organized
securities exchanges like the New York Stock Exchange.
c. MLP’s are often created by corporations who transfer certain corporate assets to MLP (such
as real estate) and then sell limited partnership interests to investors while the corporation
serves as the general/managing partner of the MLP.
d. An MLP is taxed as a partnership and therefore avoids the double taxation of its distributions
to the limited partners.

6. Franchises

a. A franchise is created when one party ( the franchisor ) licenses another party (the franchisee)
to use the franchisor’s trade name, trademarks, commercial symbols. etc. in the distribution
and selling of goods and services.
b. Normally the franchisor and franchisee are established as separate corporations.
c. Franchising offers franchisee’s access to the franchisor’s knowledge and resources while
operating an independent business; it offers the franchisor to reach new markets; and it
assures customers of uniform product quality.
d. In the past, some franchisors misled potential franchisees concerning the potential financial
earnings of their franchises; in response, the Federal Trade Commission and many states have
enacted laws that require full disclose of the basis for its financial projections of the future
earnings of a franchise prior to selling the franchise to the prospective franchisee.