This week we will discuss business entities. We will begin with an analysis of the corporation, which is the most significant business form.
To start, corporations can be classified in various ways. A corporation is called a domestic corporation in its own state. If the corporation is formed in one state but doing business in another, it is referred to as a foreign corporation in the other state. A corporation formed in another country is an alien corporation. Corporations may be either public or private. Public corporations are formed by the government. You are likely most familiar with private corporations that are created for a private benefit. Corporations can also be formed as non-profits. This is done because the corporate forms have many advantages (discussed later) even for entities that do not have a profit-seeking motive. Corporations may be closely held. In these corporations, shares are held by few people (and there may be significant restrictions in transferring shares and in protecting the rights of minority shareholders). Finally, there are so-called S-Corporations. These are named after a section of the Internal Revenue Code to avoid the imposition of income taxes at the corporate level.
Although the requirements for forming a corporation differ in the particulars from state to state, these procedures are roughly similar in broad strokes. States will require articles of incorporation that include basic information about the corporation, such as name, purpose, duration, capital structure etc. These will serve as the primary source of authority for its future organization and business functions. Once these article are prepared, signed and filed with the secretary of state (with any required filing fees), the secretary will issue a certificate of incorporation that serves as the corporation’s authorization to conduct business. Once this is done, an organizational meeting will be held. There the board will be elected, bylaws are passed and stock will be issued.
Once the corporation is formed, there are various rules governing the management of the corporation. Normally, the management of the corporation is done by directors and officers. The articles of incorporation determines the number of directors and the manner in which they conduct business. Majority rules on most boards of directors, and the directors are responsible for the declaration of dividends, authorizing major corporate policies, and supervising corporate officers. Officers are responsible for the day-to-day management of the corporation. Ordinarily, they are appointed by the board.
The directors and officers of a corporation owe various fiduciaries duties. As fiduciaries, they are obligated to meet the duty of care. This duty obligates them to be honest and use prudent business judgment in the conduct of corporate affairs. This standard is objective: they must use the degree of care that reasonably prudent people use in the conduct of their own personal business affairs. However, the business judgment rule will prevent the court from second-guessing business decisions as long as there is evidence that the officers properly considered the merits of their decisions. The duty of loyalty is much more strict. This requires directors and officers to subordinate their self-interest to the interest of the corporation. This means no competing with the corporation, usurping the corporation’s opportunities, manifesting a conflict of interest etc.
To end our discussion of corporations, it is important to discuss the ownership of the corporation. The corporation will sell shares, which represent fractional ownership interests in the corporations. This means that the shareholders of a corporation are its owners. As owners, shareholders delegate the power of the corporation to directors and officers. However, shareholders will often be called upon to elect directors and to vote on certain very important corporate decisions such as a sale of all the corporation’s assets.
Now we will discuss business entities other than the corporation. As previously, mentioned the corporation is the most important business entity. This is largely due to limited liability. Limited liability holds that owners (shareholders) are only liable up to the amount of their investment in a corporation for corporate debts. This makes investment in a corporation more attractive as one is only risking that investment. They are not personally liable for the debts of the corporation.
However, corporations also have some drawbacks. There is “double taxation” on the corporation’s income. This means that corporate income is taxed both at the corporate level and the money is taxed again once it is distributed to shareholders in the form of dividends. Additionally, the running of a corporation can be onerous as compared to other forms. Corporate directors and owners must follow certain procedures relating to the keeping of minutes and calling of meetings. Failure to do so can lead to the owners losing limited liability treatment.
Historically, the partnership was another alternative to a corporation. A partnership arises from an agreement between two or more persons to carry on a business for profit.
And a partnership has three essential elements: 1) the sharing of profits or losses; 2) joint ownership of the business; and 3) an equal right in the management of the business.
Each partner has an equal rights in management and profits of the concern, and partners owe fiduciary duties to each other. The partnership avoids the unfavorable tax treatment of the corporation: partnership income is only taxed at the partner level. It is also much more flexible to manage when compared to a corporation. There is no need to meet all the filing requirements surrounding the formation of a corporation. Nor are there strict requirements for calling meetings and running the business. However, the partnership's biggest flaw is that there is no limited liability. Stated another way all partners in a partnership are personally liable for all partnership debts and judgments. Various types of partnerships arose to give members some protection against this liability.
Limited partnerships consist of one general partner and a limited partner. The limited partner has limited liability. However, they may not manage the partnership. The general partner is responsible for managing the LP, however they are personally liable for the partnership’s debts. Limited liability partnerships (LLPS) also exist. These are meant for professionals, and this limits the liability for professionals for malpractice within the LLP.
Seeking to combine the limited liability of corporations with the flexibility and favorable tax treatment of partnerships, various other business forms have been created in recent years. The most popular of these is the Limited Liability Company. This is an attractive form for numerous reasons. The profits are passed through the LLC and taxes are paid personally by members. The owners of an LLC may actively manage the company while still having limited liability. Managers of the LLC do not need to be members of the LLC, and there is no limit of the number of shareholder-members of an LLC. LLCs are a very popular business entity. However, they are not appropriate for all situations. The law surrounding these LLCs is still relatively new, which may make them less attractive investment opportunities as when compared to a corporation.
See attached vidoe
Many of us have thought about starting our own business. If you started a business, what business formation would you use: sole proprietorship, partnership, LLC, corporation, etc.? Why?
Jimmy is the CEO of News Corp. His son, Johnny, runs Television Inc. One day Jimmy suggests that Johnny sell Television Inc. to News Corp. Jimmy and Johnny work together to radically inflate the value of Television Inc. Jimmy brings a proposal to the Board of Directors to buy Television Inc. for $500 million dollars even though the corporation is only worth $2 million. The board of directors diligently examines the transaction, but due to clever forgeries, the board does not discover the radical inflation of the corporation. Jimmy never discloses his relationship with Johnny. The sale goes through, and it is shortly discovered that Television Inc., is practically worthless.
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