978-1133019145 Chapter 7 Solution Manual

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CHAPTER 7

Corporations

THEME

Alternative forms of business organizations

were explored in Chapters 2 through 6. Chapter

7 introduces the corporation. The discussion in

Chapter 7 focuses on the definitions and nature

of corporations. This chapter and the rest of the

text focus on business corporations unless oth-

erwise noted.

CHAPTER GOAL

The goal of this chapter is for students to be-

come familiar with the following terms and

topics concerning corporations:

• Corporation

• Corporation characteristics

• Various types of corporations

• Advantages and disadvantages of doing

business as a corporation compared to other

forms of business organization

• The role of corporate paralegals

• Resources available to corporate paralegals

SUGGESTED APPROACH

Many of the discussions in the text regarding

corporations refer to the Model Business Corpo-

ration Act (MBCA), as amended through 2009.

Students should be asked to locate and become

familiar with the Business Corporation Act (or

similar act) in their home state. The current ver-

sion of the MBCA, as well as links to the busi-

ness corporation acts of each state, is available

on the CourseMate website that accompanies

this text at http://www.cengagebrain.com.

Discussing prominent corporations from

the students’ home state is often a good way to

get students interested in the topic of corporate

law.

This chapter also begins an examination

of the role of the corporate paralegal. Students

may be interested in exploring the different

types of careers corporate paralegals may have.

A corporate paralegal guest speaker or a panel

of corporate paralegals with diverse careers may

be of interest to the students at this time.

LECTURE NOTES

An Introduction to Corporations

1. Corporations are artificial entities separate

from their owners that may exist perpetual-

ly and have certain rights and powers exer-

cised through their agents.

2. Because the corporation is a separate enti-

ty, the corporation itself is liable for any

debts and obligations it incurs.

3. Corporate shareholders, directors, and of-

ficers are generally free from personal lia-

bility for the debts and obligations of the

corporation.

4. The corporation’s state of domicile is the

state in which the corporation was incorpo-

rated.

5. Internal affairs of the corporation are gen-

erally governed by state statutes of the cor-

poration’s state of domicile.

6. Corporations are also subject to common

law, case law, federal statutes, and local

ordinances.

7. Most state business corporation acts are

modeled after the Model Business Cor-

poration Act, first published in 1950, or

the 1984 Revised Model Business

Corporation Act. The 1984 Revised

Model Business Corporation Act con-

tinues to be revised periodically.

Corporations in the United States

8. With business receipts of several trillion

dollars each year, large corporations play a

very important role in the economy of the

United States.

9. In 2007, more than half of the households

in the United States owned shares of stock

or mutual funds.

CHAPTER 7 Corporations 49

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Corporate Rights and Powers

10. Corporations, as artificial persons, are enti-

tled to many of the same rights as natural

persons.

11. The state business corporation act may

enumerate specific powers granted to cor-

porations. In general, state statutes grant a

corporation the right to perpetual duration

and succession in its corporate name and

all the powers of an individual to do all

things necessary or convenient to carry out

the corporation’s business and affairs.

Advantages of Doing Business as a

Corporation

12. Transacting business as a corporation of-

fers many advantages over other types of

business organizations, including the fol-

lowing:

• Corporations provide officers, direc-

tors, and shareholders with limited lia-

bility.

• The corporation has the ability to exist

perpetually. Shares of stock may be

sold or gifted to others without affect-

ing the continuity of the corporation or

its business.

• The centralized management of a cor-

poration may streamline the decision-

making process.

• The ownership interest of a corporation

may be easily transferred.

• Owners of a corporation may be in a

position to take advantage of several

qualified benefit plans.

• The shareholders of a corporation may

choose its tax year.

• Corporations have increased potential

for raising capital.

Disadvantages of Doing Business as a

Corporation

13. Transacting business as a corporation has

its disadvantages as compared to other

types of business organization, including

the following:

• Corporations are one of the most com-

plex types of business organization,

and the formation and operation of

corporations involves more formalities

and reporting requirements than most

other forms of business.

• The double taxation on corporate in-

come, as well as the taxes assessed on-

ly on corporations, can be a serious

disadvantage to transacting business as

a corporation.

Piercing the Corporate Veil

14. Under certain circumstances, the corporate

veil may be pierced and the corporate enti-

ty disregarded. If the corporate veil is

pierced, the corporate shareholders, direc-

tors, or officers may be held personally ac-

countable for the corporation’s obligations.

15. The corporate veil may be pierced when a

corporation is formed or operated to com-

mit fraud or other illegal activity, or to de-

fend a crime.

16. The corporate veil of a small corporation

may be pierced to prevent an inequity, in-

justice, or fraud, especially when the corpo-

rate formalities are not followed and the

corporation is found to be merely an alter

ego of a sole shareholder.

Types and Classifications of Corporations

17. Business corporations are by far the most

common type of corporation in the United

States.

18. Professional corporations are formed only

for the purpose of rendering the services of

a single profession.

19. All shareholders of professional corpora-

tions must be licensed professionals.

20. Nonprofit corporations, or not-for-profit

corporations, are formed only for certain

nonprofit purposes.

21. Certain nonprofit corporations may qualify

to be tax-exempt, but an application must

be made to the Internal Revenue Service

pursuant to IRC § 501(c).

50 PART I Guide for Instructors and Answers to Chapter Review Questions

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22. S Corporations are a special type of corpo-

ration formed pursuant to Subchapter S of

the Internal Revenue Code.

23. S Corporations are taxed as partnerships.

24. Shareholders of corporations who wish

partnership taxation status may file an

election to be treated as an S Corporation

with the Internal Revenue Service on

Form 2553.

25. S Corporations must meet several eligibil-

ity requirements. For example, S Corpora-

tions may have no more than 100

shareholders and the corporation may not

issue more than one class of stock.

26. Pass-through taxation has made the S Cor-

poration one of the most popular types of

business organization in the United States.

27. Corporations with a small number of

stockholders and stock that is not publicly

traded are often referred to as closely held

corporations or close corporations. These

corporations are subject to the business

corporation acts of their states of domicile.

28. Many states have adopted special close

corporation statutes that take into consider-

ation the unique characteristics of the

smaller corporation. Qualifying corpora-

tions may elect to be treated under the

close corporation statutes in certain states.

29. Close corporation statutes may provide

for restrictions on the transfer of shares

of close corporations. They may also

provide that close corporations are not

subject to all of the formalities placed on

other corporations.

30. Parent corporations hold stock in their sub-

sidiary corporations sufficient to control

the subsidiaries.

31. The terms sister corporation and affiliate

corporation refer to corporations owned or

controlled by the same owners.

The Paralegal’s Role

32. Corporate paralegals who work for corpo-

rations and for law firms that represent cor-

porations perform a wide variety of tasks.

Resources

33. Resources commonly used by corporate

paralegals include the following:

• State statutes

• Federal statutes

• Secretary of state (or other state corpo-

ration agency) resources

• Online information on corporations

34. The following types of information may be

found online to assist corporate paralegals:

• State corporate statutes

• Federal statutes concerning corporations

• Case law concerning corporations

• General research for corporate law

issues

• General information and treatises

concerning issues in corporate law

• Information concerning filing corporate

documents

• Financial and other information on

publicly held corporations

• Annual reports and other pertinent

documents filed with the Securities and

Exchange Commission

• Forms for forming corporations and

transacting business as a corporation

• Discussions concerning corporate law

• Association information, including

listservs and online discussions for

corporate paralegals

CASE BRIEFS

Hunting v. Elders, 597 S.E.2d 803

(Ct.App.2004)

Purpose: This case is an example of a success-

ful attempt to pierce the corporate veil of a cor-

poration when the corporation is found to be the

alter ego of its owner.

Facts: This case is an appeal by a defendant in

an action that was commenced to recover dam-

ages sustained in an accident caused by a drunk

driver. Catherine Hitchcock, the plaintiff in this

case represented by a guardian ad litem, brought

suit against Chris Gordon, the drunk driver who

CHAPTER 7 Corporations 51

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caused an accident that left Hitchcock perma-

nently brain damaged, as well as Elmyer Enter-

prises, Inc., the owner and operator of the bar

that served Gordon, and William Elders, share-

holder of Elmyer Enterprises.

In the first portion of the bifurcated trial in this

matter, damages of $1.5 million were awarded

against Gordon and Elmyer Enterprises. The

second phase of the trial, which is the subject of

the appeal, resulted in a holding that Elders was

the alter ego of Elmyer Enterprises, justifying

piercing the corporate veil, thereby holding El-

ders personally liable for the $1.5 million ver-

dict. Evidence presented at trial indicated that

corporate formalities were not followed for

Elmyer Enterprises and that the corporation was

undercapitalized. Testimony by one expert wit-

ness, a forensic accountant, indicated that Elders

siphoned off between $400,000 and $800,000

from the business over a three-year period. Tes-

timony by another expert witness indicated that

Elmyer Enterprises had income that was unac-

counted for and profit that was not adequately

revealed. He further testified that, in his opinion,

Elders was the alter ego of Elmyer Enterprises.

Issue: Should the corporate veil be pierced be-

cause corporate formalities were disregarded by

the defendant/appellant and because the defend-

ant apparently siphoned money from the corpo-

ration, which was undercapitalized?

Holding: Yes

Reasoning: “If any general rule can be laid

down, it is that a corporation will be looked up-

poration as an association of persons….”

In this case, the court used a two-

pronged test (Sturkie v. Sifly, 313 S.E.2d 316,

318 [Ct. App. 1984]) to justify piercing the cor-

porate veil and finding defendant/appellant El-

ders personally liable for the debt of Elmyer En-

terprises. The first part of the test considers

whether corporate formalities were observed by

the dominant corporate shareholders. In this

case, the court found they were not. The second

prong of the test requires “that there be an ele-

ment of injustice or fundamental unfairness if

the acts of the corporation be not regarded as the

acts of the individuals” (Sturkie). In this case,

the court found that Elders knew of the plain-

tiff’s claim against the corporation and that he

nevertheless acted in a self-serving and unfair

manner by siphoning off substantial sums of

money, commingling and transferring assets to

different entities, transferring stock in the corpo-

ration to other individuals, and then finally dis-

solving the corporation. The court further found

that “the essence of the fairness test is simply

that an individual businessman cannot be al-

lowed to hide from the normal consequences of

carefree entrepreneuring by doing so through a

corporate shell.” The court found that Elders’s

actions satisfied the second prong of the test for

piercing the corporate veil and found Elders to

be the alter ego of Elmyer Enterprises and per-

sonally liable for that corporation’s obligation to

the plaintiff.

REVIEW QUESTIONS

1. What are four characteristics of a corpora-

tion that distinguish it from the sole propri-

etorship and the partnership?

1. The corporation is an artificial entity

created by law.

2. The corporation is an entity separate

from its owners or managers.

2. If a corporation defaults on its debts, may

the creditors typically look to the share-

holders for payment?

Under what circumstances might the

shareholders become personally liable for

the debts of the corporation?

52 PART I Guide for Instructors and Answers to Chapter Review Questions

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3. Suppose that John’s Appliance, Inc. is a

corporation formed by John Miller. John

Miller is the only owner and employee of

John’s Appliance, Inc., an appliance repair

the corporation to shelter his personal as-

sets. He has put title to the repair truck

(which he often uses for his own personal

enjoyment), all of his equipment and tools,

and his workshop in his own name, alt-

hough he leases these items back to the

corporation. What are some of the potential

problems with this arrangement?

the corporate veil.

What can John Miller do to decrease the

risk that the corporate veil of John’s Appli-

ances, Inc. could be pierced in the event of

2. He should be sure to follow all statu-

3. He should be sure to put himself

4. Dave Breen and Sue Martin would like to

start a business involving themselves and

D&S Equipment, Inc., a corporation that

holds certain of their assets. Could they

form a regular business corporation with

Yes

5. Who elects the directors of a corporation?

Who elects the officers?

Could an individual be a shareholder, di-

rector, and officer all at the same time?

6. Could a group of attorneys and physicians

form a single professional corporation?

Why or why not?

7. Are all corporations incorporated as non-

profit corporations automatically exempt

from paying income tax?

No, nonprofit corporations must meet

poration.

rations and regular business corpora-

tions is that the shareholders of S

9. What are some of the practical differences

between regular business corporations and

statutory close corporations?

1. There is a limit on the number of

CHAPTER 7 Corporations 53

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2. There may be statutory restrictions

3. In many instances statutory close

4. Statutory close corporations often

10. Suppose that Anna and Grace want to start

a business to market a new food product

they have invented. Limited liability is im-

portant to them because of the potential

product liability problems associated with

manufacturing and selling food products.

Initially, Anna and Grace will be the only

investors, and they may not see a profit in

their business for a few years. What types

of business organizations are available to

Anna and Grace?

Anna and Grace would not consider a

partnership or limited partnership if

they are the only investors and they are

both concerned with limiting their per-

What type of organization would you sug-

gest? Why?

A limited liability company or S Corpo-

ration may be the most advantageous

form of business organization, because