BUSINESS ORGANIZATIONS
Chapter 6
XYZ Enterprises
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Three “partners”
Two (X and Y) contribute funds for startup
The third agrees to contribute extra time in lieu of funds
The business struggles; all investment cash disappears
Partner Z doesn’t produce
How should they split the income/debt?
Will they be personally responsible for the company’s debt?
Chapter Issues
• Major forms of business
organizations
• How businesses are created
• Factors that may influence a
business’s choice of its type of
organization
• Alternative business forms to
apply to various circumstances
• See Exhibit 6.1 – Business
Establishments in the U.S.
Sole Proprietorship
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A person doing business for himself/herself (sole proprietor)
Usually the proprietor owns all of the business property
Responsible for control of the business
Responsible for management
Responsible for liabilities/debts
May hire agents – liable for them as well
Capital must come from the owner’s own resources or is borrowed
Profits from the business are taxed personally to the proprietor
Record keeping formalities are at the owner’s discretion
See Exhibit 6.1
See “Small is Not So Beautiful in Japan”
• Attitudes toward small business by both government and individuals are
very different in Japan than in the U.S.
Partnerships
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Definition: An association of two
or more persons to carry on
business as co-owners for a
profit
Partners or General partners
control the operations & profits
Each of the partners has a
fiduciary duty to the other
partner(s)
– Latta v. Kilbourn: One partner
may not use partnership assets
for own benefit
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Under state laws, a partnership
may be sued as an entity
Most states have adopted the
Uniform Partnership Act (UPA)
and Revised Uniform Partnership
Act
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No need to enter into a formal
agreement for a partnership to
exist at law (can be verbal or
inferred from conduct)
However, agreements are
preferable, esp. regarding finances,
management and dissolution
issues
If the Partnership Agreement is
silent, the UPA governs (default
rules)
If the agreement does not state
otherwise, the profits of the
partnership are divided equally
See Brown v. Swett & Crawford of Texas,
Inc.
THE PARTNERSHIP AGREEMENT
• Basics: name, place/date of formation; identification of
applicable state law
• Finances: parties’ contributions; additional capital
contributions; ownership; distribution of profits; priority
rights (if any) in payments
• Management
• Dissolution: rights of partners to leave; death of a partner;
valuation of partnership shares; limits on transferability of
partnership shares; arbitration (mediation?) of disputes
• Note: partners owe a fiduciary duty to one another
Brown v. Swett & Crawford of Texas
• Brown was a wholesale insurance broker – middleman
between retail insurance agents and insurance company.
• Worked closely with Galtney for a company where they
shared 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.
(Continued)
Brown v. Swett & Crawford of Texas, cont.
• Brown sued, saying wrongful expulsion from a partnership (Houston
Team One) – a partnership comprised 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 partnership interest in overall profits of IBS.
• No partnership existed; IBS could fire him.
Termination of General Partnership
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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
Common: Partnership purchases life
insurance on partners
– Proceeds used to buy back the interest
of deceased partner from her estate
Limited Partnership
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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 filed with the state
– Called Certificate of Limited Partnership
– Puts 3rd parties on notice that limited partners assets not available to
satisfy any claims against the limited partnership
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General partners (at least one)
– Manage the business
– Are personally liable to creditors
– Have the duty to account to the limited partners
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Limited partners (at least one) are investors only
– Do not manage the business
– Are not liable for debts
Limited partners become general partners at law if they participate in
or manage the business (lose their limited liability)
Most states use some form of the Uniform Limited Partnership Act
(ULPA) or Revised Uniform Limited Partnership Act
See Issue Spotter: “Brotherly Love?”: Who should be liable for injury?
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
Corporations
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Legal “entities”/”persons”
Can sue & be sued
Corporation can be liable
It has constitutional rights
– Except the privilege against self-incrimination (only 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
places 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
See Ironite Products Co. v. Samuels
Ironite Products Co. v. Samuels
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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 Sweet Gas – ran under same rules.
1989: Invited their sons, Richard Fox and Mark Samuels, to join them –
sons would eventually take control from Dads.
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)
Ironite Products Co. v. Samuels, cont.
• 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 clearly state 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
• Articles of
Incorporation and an
application are sent
to the appropriate
state office
• The state issues a
Certificate of
Incorporation
– See Exhibit.13.2
• 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
Relationship of Parties of A Corporation
• Shareholders
– Owners of the corporation; no day-to-day control of activities
– Shareholder meetings need quorum (usually more than ½ total
shares present
– Most shareholders give proxy to 3rd parties to represent them.
– Shareholders elect Board of Directors
– No legal relationship to creditors
– See Storetrax.com v. Gurland
• Board of Directors
– Have management power over large decisions
– Can be removed from office by shareholders for cause (breach of
duty/misconduct)
– Have fiduciary duty of loyalty to the shareholders
• Managers
– Appointed/hired by directors to manage day-to-day decisions
– Have broad duties of care & loyalty to directors
• Employees
– Workers
FLOW OF CORPORATE AUTHORITY
Business Judgment Rule
• Makes directors &
managers immune from
liability
• When problems result
from honest mistakes in
judgment
• If there was a reasonable
basis for their decisions
• If they acted in good faith
• Directors’ fiduciary duty
“Your Honor, I’ll Turn
Rocks Into Gold”
• Marinov forms Amrox Corporation.
• Claims to have a PhD in solid state physics from Russia AND
medical degrees from Bulgaria, Sweden and Germany
• Tells investors that he can turn cheap corundum into rubies and
sapphires
• Nothing is produced
• Investors sue that he breached his fiduciary duties; won at district
court
• In appeals court Marinov said “he is developing a linear accelerator
which he wishes to sell to the United Nations.”
• Held: Appeals court affirmed for the investors.
• This claim by Marinov of what he can do are “absolutely incredible.”
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.
(Continued)
Storetrax.com, Inc. v.
Gurland, cont.
• 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, however
• 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)
• 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
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Refer to “Mad at Each Other? . . .” (lawsuit dismissed;
disagreement was “nothing more than a business
dispute”)
Professional Corporations (PCs)
• Created by state laws
• Owners of PC can only be
professionals involved in the
firm itself (i.e. MD’s whose
practices are tied together
• Created to have limited
liability for its members
• Example: Doctors join to
reduce liability risk for
malpractice of a memberdoctor (but not in Wash.)
• Stock usually cannot be sold
to outside investors
• Has special tax treatment with
IRS
See Test Yourself, p. 380
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: Certificate of Formation
– State issues a Certificate to operate as an LLC
• Usually is formed by two or more members (not req’d)
• Members have membership interests
• Limited liability of owners – the same as a corporation
• Members enter into an Operating Agreement
– Similar to bylaws of a corporation
• An LLC does NOT have perpetual life
• Death, resignation, retirement, expulsion of member terminate LLC
• But, if remaining members give consent, LLC can continue (should
be set out in Articles of Organization)
• Termination: There is a period of winding up, followed by payment
of creditors and distribution of profits.
See “Offshore Businesses”: Reasons to have are tax-related, anonymity, professional
services available, solid legal systems, low cost of doing business
LLCs
• Offer limited liability, as do corporations
• Avoid double taxation (of corporation on its
earnings, then on shareholders’ receipts)
• Taxed like a partnership: passes income
through to the members of the LLC
In re 1545 Ocean Avenue, LLC
• 1545 Ocean Avenue LLC formed to develop real estate
• Owned 50-50 by two companies (Ocean Suffolk & Crown
Royal); each company had membership certificate in 1545
• Operating agreement had no dissolution provisions
• Two managers appointed to operate 1545
– Crown Royal appointed King
– Ocean Suffolk appointed Van Houten
• King and Van Houten argued; King announced Crown
Royal would pull out
• King sued for work to stop and the LLC too be dissolved
• Trial court granted King’s requests
• Ocean Suffolk and Van Houten appealed.
continued
In re 1545 Ocean Avenue, LLC, cont.
• LLCL 702 (New York LLC Law) states that court must
examine the LLC’s operating agreement
• Unilateral action of a single manager was permitted in
Article 4.1 of 1545 LLC Operating Agreement
• Lets each manager act autonomously to bind LLC in
furtherance of business of the LLC
• Operating agreement was silent about manager conflicts
• 1545 can only dissolved if cannot further purpose of LLC
• HELD: Lower Court ruling reversed and proceeding
dismissed.
• Dissolution is not granted.
Business &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.
• Partnership pays no income
taxes
– Income passes to parties
who pay tax on their
share of income
• Limited Liability Company
– Treated like a corporation
for liability purposes
– Treated like a partnership
for federal tax purposes
Factors That Influence the Choice of a
Business Organization
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Limited liability
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
See Issue Spotter: “Keeping Things in Order”
See Exhibit 13.3
Limited Liability
(Protecting Personal Financial Risks)
• Allows person to invest in business
without placing all 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 LP.
• 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
• Owner treats corporation as an
“alter ego”
– Co-mingling funds
– No separate records
– Loans money without loan
papers
– No reimbursement for
expenses
• Result: Shareholders are
personally liable for all corporate
liability – torts, contracts, debts
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See KC Roofing Center v. On Top Roofing, Inc.
K.C. Roofing Center v.
On Top Roofing, Inc.
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Nugents owned a series of roofing companies
1977: Russell Nugent Roofing Inc. was incorporated
Russell and wife only shareholders, directors & officers
1985: Corporation name changed to On Top Roofing
1987: On Top Roofing ceased doing business
1987: Nugents did business through new corporation RNR, Inc.
1988: RNR ceased to exist
1988: Replaced by RLN Construction, Inc.
1989: RLN Construction was replaced by Russell Nugent, Inc.
Business was run out of Nugent’s home
In 1986 Nugents paid themselves salaries over $100,000 each
Charged corporation $99,290 in rent for space in their home
K.C. Roofing was owed $45,000 for roofing supplies sold to On
Top Roofing, which no longer existed.
(Continued)
K.C. Roofing Center v. On
Top Roofing, Inc., cont.
• K.C. asked court to pierce the corporate veil and hold Nugents
personally liable.
• District held for K.C. Nugents Appealed.
• HELD: Affirmed. Nugents must pay K.C.
• When corporation is used for an “improper purpose . . . to perpetuate
injustice” and “avoid its legal obligations”, corporate veil is pieced.
• Here:
– 1. Nugents had control of all aspects of business
– 2. Control was used to commit fraud or wrong or other positive legal duty,
including an “unjust act”
– 3. Breach of duty caused unjust loss or injury to plaintiff
• Nugents were avoiding debts to plaintiffs.
• Refused On Top’s obligations to creditors.
• It is unfair, unjust, and inequitable to allow Nugent to hide behind
corporate shield and avoid legal obligations to plaintiffs.
Transferability of Ownership Interests
• Refers to ability of business owner to sell or pass interest to others
• Nontraded Entities
– In sole proprietorship, selling the business ends the 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 its business 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.
• Publicly Traded Corporations
– Public corporation stock may be traded on stock exchange.
– Price is known and therefore no specialists need to be hired to
determine market value.
Duration
• Duration refers to 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.
I’m the Real Owner”
• Shreepriya Gopalan filed suit in federal
court in San Diego against Microsoft,
Google, Apple, McDonald’s Starbucks,
Coca-Cola & 50 other corporations
• Claimed he was actual owner of the
companies.
• Said what was not understood is that he
used the Chinese system, I Ching, to
invent the companies when he was 15 or
16 years old.
• “These companies were I Chinged in
through a metaphysical layer created and
owned by me,” he claimed.
• Despite lack of formal documentation of
company creation, Gopalan asked the
court to confirm his rightful ownership.
Franchises
• Three types:
– 1) product distributorships (i.e. Ford Dealership)
– 2) trademark/trade-name licensing (i.e. CocaCola)
– 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
See Exhibit 6.4: Franchise agreement
Franchises
– Federal & state laws protect investors
– FTC Franchise Rule: Franchisor is required to give an offering
circular (disclosure statement) to potential franchisees
– FTC v. Wealth Systems: FTC alleged that 3 entities violated Section
5 in selling home-based Internet business opportunity by
misrepresenting purchases will earn substantial income.
– Also failed to give purchasers a complete disclosure document
and failed to provide purchasers with earnings claims documents
and did not comply with Franchise Rule’s general media claims
requirements.
– When violations occur, the result is usually that promoted activity is
closed down.
– Some states have laws to regulate franchises as well – for example,
California, Illinois, New York and Washington
– Some franchisees given extra protection by state laws: auto dealers
and gas stations – often have extra rights over other franchises, i.e.
McDonald’s
See International Perspective: “The Difficulty of Starting a Business” (countries
differ re: procedures, time, costs of doing business)
See Issue Spotter: “The Road to Riches?”
Franchises
• The franchise agreement sets forth rights and obligations of
the parties, i.e. territorial rights, fees and royalties, termination,
etc.
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(See Exhibit 6.4)
• Termination
• Through explicit events that bring about franchise’s
termination
• Fixed expiration time
• Franchisor’s right to termination re: occurrence of events –
• Inspection problems or violations of franchisee
• Bankruptcy of franchisor
See Issue Spotter: “The Road to Riches?”
See Test Yourself, p. 235
See “Offering Franchise on the Internet”
 Concern about Internet scams
 FTC has ruled franchises can be marketed through the Internet as long as
franchisor satisfies disclosure requirement of the Franchise Rule
Dunkin’ Donuts Franchised Restaurants,
LLC v. Sanlip, Inc.
• Three individuals owned Sanlip, a Dunkin’ Donuts franchisee.
• Operated two donut shops in Norcross Georgia
• Dunkin’ said defendants breached franchise agreements
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Failed to remodel their shops
Failed to participate in mandatory system-wide programs
Failed to attend required training
Failed to prepare immigration forms for new employees
• Dunkin’ said defendants transferred significant part of franchise
w/o Dunkin’s knowledge in violation of franchise agreement.
• Sanlip did not dispute claims.
• Protested that Dunkin’ was not allowing owners reasonable
chance to sell franchise.
• Dunkin’ entered into settlement agreement.
• Allowed Sanlip time to try to find buyer.
(Continued)
Dunkin’ Donuts Franchised Restaurants,
LLC v. Sanlip, Inc., cont.
• Sanlip submitted proposed sale agreement. Dunkin’ refused to accept
• the buyer. Asked court to order Sanlip to return shops to Dunkin’.
• Sanlip counterclaimed: Dunkin’ rejected reasonable proposal.
• HELD: Summary Judgment for Dunkin’ plus attorneys’ fees & costs.
• Dunkin’ may not “unreasonably” reject proposed sale agreement.
• Dunkin’ analysis:
– If store will lose money Dunkin’ rejects proposed sale agreement.
– Also looks at financial condition of the buyer if it decides store
may break even.
• This is firmly-established policy by Dunkin’ and reasonable.
• Dunkin’ has right to terminate the agreement.
• Lease agreements provides Dunkin’ may terminate lease if franchise
agreement for shop is terminated for any reason.
Your take-away from today’s class