BUSINESS ORGANIZATIONS

Chapter 13

Chapter Issues

Major forms of business organizations

How businesses are createdFactors that may influence a

business’s choice of its type of organization

Alternative business forms to apply to various circumstances

Sole ProprietorshipSole Proprietorship

A person doing business for himself/herself Usually the proprietor owns all of the business

property Responsible for control of the business Responsible for management Responsible for liabilities May hire agents--liable for them as well Capital must come from the owner’s resources or

is borrowed Profits from the business are taxed personally to

the proprietor Record keeping formalities are at the owner’s

discretion

General PartnershipGeneral Partnership

Definition: An association of two or more persons to carry on business as co-owners for a profit

General partners control the operations & profits

Each of the partners has a fiduciary duty to the other partner(s)

Under most state laws, a partnership may be sued as an entity

Most states have adopted the Uniform Partnership Act (UPA)

No need to enter into a formal agreement for a partnership to exist at law

However, agreements are preferable, esp. regarding finances, management and dissolution issues

If the Partnership Agreement is silent, the UPA governs

If the agreement does not state otherwise, the profits of the partnership are divided equally

Brown v. Swett & Crawford of Texas, Inc.

Brown was a wholesale insurance broker—middleman between retail insurance agents and insurance company.

Worked closely with Galtney for a company where they shared agreed-upon commissions.

Dallas company, IBS, asked Galtney to open a Houston office for it. Galtney wanted Brown to be with him, so the two were hired as Houston Team One for IBS.

Shared a base salary on shared basis of 42:58 (Brown 42% and Galtney 58%) and they shared commissions similarly.

Ratio adjusted annually based on performance. IBS fired Brown after a year—claimed mishandling of

accounts. He was offered severance pay – rejected it. He sued.

Brown v. Swett & Crawford of Texas, Inc.

Brown claimed wrongful expulsion from a partnership (Houston Team One) – a partnership of IBS, Galtney and himself.

District court held for IBS and Galtney. Brown appealed. HELD: Summary judgment of trial court affirmed. There was no partnership in this case. Texas Revised Partnership Act (TRPA) says “sharing or

having a right to share gross returns or revenues” does not indicate a partnership agreement.

Supreme Court has held that “a community of profit, an interest in profits as profits, as distinguished from . . . compensation” is a necessary element of a partnership.

Brown was entitled to base salary plus 42% of commissions of the IBS Houston office. Brown’s portion of gross commissions was compensation for services rendered, NOT interest in overall profits of IBS.

Therefore no partnership existed; IBS could fire him.

Termination of General Partnership

Termination of General Partnership

Dissolution occurs when an event takes place to dissolve the partnership

Change of the composition of the partners

Withdrawal of a partner Bankruptcy of a partner

concerning the business

Death of a partner Winding up of the

partnership involves completing any unfinished business

If terminated, partnership must be reformed

Limited PartnershipLimited Partnership

Definition: 2 or more persons (partners) who have entered into an agreement to carry on a business venture for profit

MUST have a written agreement that is filed with the state

General partners (at least one) Manage the business Are personally liable to creditors Have the duty to account to the limited partners

Limited partners (at least one) are investors only Do not manage the business Are not liable for debts

Limited partners become general partners if they participate in or manage the business (lose their limited liability)

Termination of Limited Partnership

Termination of Limited Partnership

Similar to the termination of a general partnership

Death, insanity, withdrawal of a limited or general partner will terminate

Bankruptcy of a general partner = termination

Bankruptcy of a limited partner does not

Organization must wind up the business

Creditors are paid and profits are dispersed according to agreement

CorporationsCorporations

Legal “entities”/”persons” Can sue & be sued It has liability It has constitutional rights

Except the privilege against self-incrimination (officers & employees have that right)

MUST meet formal requirements according to state statutes

Liable for agents’ actions and contracts Each state has its own corporation laws; federal

government plays very limited role Close corporation: Shares held by only one or small group

of shareholders; stock not traded on a stock exchange Public corporation: Stock is traded on a stock exchange;

is likely to have many shareholders

Ironite Products Co. v. Samuels

1972: Irwin Fox and Alvin Samuels established Ironite. Articles of incorporation set out guidelines for

operation. Irwin and Alvin orally made decisions about company;

shared equally. Later they formed another company, Sweet Gas.

1989: Invited their sons, Richard Fox and Mark Samuels, to join them – sons would eventually take control.

1990: Richard drafted new bylaws. Alvin made hand-written changes and all agreed to new bylaws.

1993: Irwin died and Richard took over his ½ of the company.

Outsider invited to join Board of Directors for independent tie breaker vote.

Fights began over who should be paid how much and who should control what.

Richard and independent director voted to pay Richard more than Mark.

(Continued On Next Slide)

Ironite Products Co. v. Samuels

Mark sued Richard, Ironite and Sweet Gas. Said original agreement of equal shares applied. Defendants said new bylaws would determine

compensation, not old oral agreement. Trial court held that proceeds from operations would

be shared equally by terms of the original agreement. Richard and companies appealed. HELD: Reversed. 1972 Oral Agreement contradicts terms of the bylaws. Oral agreement violated the parol evidence rule and

evidence must be ignored. Written documents show that compensation for the officers is at the discretion of the Board of Directors.

Bylaws Article III, Section I clearly allows Board to manage affairs of the companies, absent proof of wrongdoing.

No allegation that Board perpetrated fraud or made an irrational business judgment.

Richard, Ironite and Sweet Gas win.

Creating A Corporation

Creating A Corporation

Articles of

Incorporation and an application are sent to the appropriate state office

The state issues a Certificate of Incorporation See

Exhibit.13.1 Incorporators hold

a first organization meeting

At the first meeting Elect a Board

of Directors Enact bylaws

or rules that govern internal operations (bylaws cannot contradict the Articles of Incorporation)

Issue the corporation’s stock

Parties To A CorporationParties To A Corporation

Shareholders Owners of the

corporation See Storetrax.com v.

Gurland Board of Directors

Have management power over large decisions

Have fiduciary duties to the shareholders

Managers Appointed/hired by

directors to manage day-to-day decisions

Employees Workers

Storetrax.com, Inc. v. Gurland

Gurland founded Storetrax.com – internet-based commercial real estate listing service in Maryland in 1998.

Incorporated as a Delaware corporation in 1999. Agreed for a group of investors to buy majority share. Became president and member of the Board of

Directors. Employment contract said that he had a year’s worth

of pay in case he was fired. Two years later, he was removed as president, but stayed on the Board for another year.

Requested severance pay, but was denied it. He sued. Board claimed he was not due severance pay because

his job duties, title and salary changed. Also, as Board member, they claimed he breached a

fiduciary duty by suing the company. Lower court held for Gurland. Storetrax appealed.

Storetrax.com, Inc. v. Gurland

HELD: Affirmed. There is a fiduciary duty of directors to the corporation. However, situations arise where a corporate director

may proceed with an individual interest that may conflict with those of the corporation on whose Board he sits.

When conflicts of interest arise, courts look closely if director’s dealings are in “good faith and fair dealing”.

If conflict arises, director can find a “safe harbor” by disclosing to the corporation the conflict and important facts to the remaining shareholders or directors.

Gurland had a conflict as an aggrieved former employer and his duty as director of the corporation.

Gurland’s seeking $150,000 severance pay was not in corporation’s best interest. But, Gurland notified Storetrax sufficiently of imminence of lawsuit. Gurland’s notification gives him the protections of “safe harbor”.

Gurland receives severance pay.

Termination of the Corporation(Dissolution)

Termination of the Corporation(Dissolution)

Voluntary Approval of the

shareholders and the Board of Directors

Articles of Dissolution are filed with the state

Involuntary The state dissolves it Sometimes due to fraud

in the establishment of corporation or bankruptcy of the corporation

“Wind up” business to pay creditors and disburse profits to shareholders

Professional Corporations (PCs)

Created by state laws

Created to have limited liability for its members

Example: Doctors join to reduce liability risk for malpractice of a member-doctor

Stock usually not sold to outside investors

Has special tax treatment with IRS

Corporations & TaxationCorporations & Taxation

Corporate profits are taxed at corporate tax rate.

Dividends are taxed at each individual shareholder’s tax rate.

In effect this is “double taxation” of the same profits.

The Supreme Court has held: There is no “double taxation” under the law, since “two separate entities” (corporations and shareholders) are taxed only once each.

Limited Liability Companies (LLC)

LLC is treated like a corporation for liability purposes but like a partnership for federal tax purposes.

State laws have procedures to create LLC’s Filing a document: Articles of Organization State issues a Certificate to operate as an LLC

Usually is formed by two or more members Members enter into an Operating Agreement

Similar to bylaws of a corporation An LLC does NOT have perpetual life. Termination: upon death, bankruptcy, resignation,

expulsion, or agreement of a member(s); the other members may give consent to continue. There is a a period of winding up, followed by

payment of creditors and distribution of profits.

Factors That Influence the Choice of a Business Organization

Factors That Influence the Choice of a Business Organization

Liability of owners Control Capital considerations Taxation Transferability of

ownership interests Method of creation Entity as a distinct status

separate from its owner Each owner must make

his/her own choice

Limited Liability Allows a person to invest in a

business without placing their personal wealth at risk.

Allows investors to be passive toward internal management.

Sole proprietors have unlimited personal liability for debts of business, including torts.

Liability of limited partner is limited to capital contributed to limited partnership.

Shareholders of corporation and members of limited liability companies risk only their capital investment if corporation fails – generally not personally liable for the business debts or torts.

“Piercing The Corporate Veil”“Piercing The Corporate Veil”

Owner treats corporation as an “alter ego” Co-mingling funds No separate records Loans money without loan

papers Doesn’t receive

reimbursement for expenses

Result: Shareholders are personally liable for all corporate liability--torts, contracts, debts

Miner v. Fashion Enterprises, Inc.

Miner, representing a trust, gave Karen Lynn, a corporation, a 10-year lease for space for ladies’ apparel store in Chicago.

Several years later, Lynn in default due to unpaid rent.

Court issued default judgment for $22,162. Trust moved to enforce judgment, but Lynn

had few assets. The trust sued Lynn’s parent corporation

and the owners of the corporation, requesting court to hold them liable.

Trial court dismissed the suit. Trust appealed.

Miner v. Fashion Enterprises

HELD: Judgment creditor may choose to file a new action to pierce the corporate veil in order to hold individual shareholders and directors liable for the judgment of $22,162 against the corporation.

To determine if corporate veil should be pierced, courts look at number of factors Inadequate capitalization Failure to observe corporate formalities Insolvency of the debtor corporation Absence of corporate records, etc.

The court held there were enough factors to allow new action of piercing the corporate veil to go forward.

Transferability of Ownership Interests

Refers to ability of an owner in a business to sell or pass interest to others

In sole proprietorship, selling the business ends the existing proprietorship. Price is FMV to be determined.

If a partner sells or assigns interest in the partnership, the partnership continues, but the new person doesn’t automatically become a partner. New person is just entitled to receive the share of profits the

partner would have received, but can’t participate in management of partnership or right to P-ship information.

Sale of close corporation is like a sole proprietorship sale as price of shares is not determined on a stock exchange Must determine the market value of the close corporation

and its shares. May need specialists to determine value. Sale of stock of public corporations may be traded on

stock exchange. Price is known and therefore no specialists need to be hired

to determine market value.

Duration

Duration is ability to continue to operate in event of death, retirement or incapacity of owner of business

Limited Life: Sole proprietorship terminates with death or

incapacity of proprietor. At common law partnerships and LLC’s are dissolved

by death, retirement or incapacity of a partner, but are not necessarily terminated. (Can reform)

Perpetual Existence: Unless, articles of incorporation provide for period of

duration, corporation has perpetual existence. Death or retirement of shareholder(s) does not bring

termination of the corporation. (In fact, usually does not have any impact on operations of the business.)

Close corporation or LLC with few members – death of a shareholder may impact the business.

Other Forms of Business Organizations

Joint Ventures: General partnership for a limited time & purpose

Cooperatives: Association created to provide economic service to its members

Syndicates: Persons join together to finance a specific project

Franchises

Three types: 1) product distributorships (i.e. Ford Dealership) 2) trademark/trade-name licensing (i.e. Coca-

Cola) 3) business format franchising (i.e. McDonald’s)

Franchisor grants a right to sell goods or services to a franchisee in return for payment of a franchise fee

Uniform product or services and the use of a trademark help the franchisee establish quickly in the market

Franchises

Laws are still developing Federal & state laws protect investors FTC Franchise Rule: Franchisor is required

to give an offering circular (disclosure statement) to potential franchisees

Some states have laws to regulate franchises as well – for example, California, Illinois and New York.

The franchise agreement sets forth rights and obligations of the parties, i.e. territorial rights, fees and royalties, termination, etc. (See Exhibit 13.3)

Coffee Beanery, Ltd. v. Albert

Yurick developing site for a coffeehouse. Shaw approached him about doing it as a Coffee Beanery (CB) franchise.

Yurick thought it was a good deal and convinced Albert to join them. Three of them established Hartland LLC to run franchise and Yurick paid $25,000 franchise fee. Month later, Shaw brought a franchise agreement for each to sign.

They backdated the document to indicate that they had received franchise disclosure document from CB prior to signing (Michigan franchise law requires disclosures be made to potential franchisors at least 10 days before receiving any money from franchisors.)

Shaw did not return copies of the documents for months.

Albert and Yurick had a falling out with Shaw for not working as hard as he should – and also for sexually harassing an employee. They bought out his share of the company.

Shaw pressed for payment on equipment he had purchased for coffeehouse.

Albert and Yurick then quit making payments to CB and claimed franchise agreement was void.

(Continued On Next Slide)

Coffee Beanery, Ltd. v. Albert CB sued for payments due and a declaration by the

court that the contract was valid. Trial court held franchise agreement was valid and

Albert and Yurick were liable for royalties due to CB. Appealed.

CB technically had violated Michigan franchise laws. Violations, however, do not make franchise contract

void and unenforceable. (There are sometimes other remedies such as rescission of contract and damages.)

Defendants continued with the contract and failed to tie any legally recognizable damages under franchise laws.

CB contract did have “several unsavory and unanticipated contract provisions”, however, defendants failed to prove that CB ever sought to enforce any of them.

Yurick and Albert argued that Shaw “duped them” into signing agreement and their guarantee as individuals. Evidence showed that Yurick and Albert knew they were signing the agreement in their individual capacities.

HELD: Affirmed. Yurick and Albert lose.