978-1285427003 Chapter 28 Lecture Note Part 1

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Suggested Additional Assignments

Interview: Entrepreneur

Student could interview an entrepreneur to ask why he or she chose a particular form of business. Did the

entrepreneurs understand the legal issues involved? Did they simply rely on lawyers in making their

selections? Or did they “fall into” a choice such as sole proprietorship or corporation without thinking?

Research: Costs of Forming a Business Organization

Ask students to find out how much it costs in your state to form different types of organizations. They can

call the State House or log on to the Secretary of State’s web site to find out about initial filing fees and

annual charges. What about lawyer’s fees?

Research: Close Corporation Statutes

Ask students to find out whether your state has a close corporation statute. Must a corporation elect to be

treated as a close corporation, or can any corporation take advantage of the special provisions if it meets

the statutory requirements?

Research: Franchise O ering Circulars

Ask students to obtain an offering circular for a franchise. They can order one from a franchisor that

advertises in the Wall Street Journal or online at http://www.Franchise-Update.com/. Students are often

interested to see what these circulars look like and are impressed by their length.

Research: Joint Ventures

Have students prepare a list of three to five recently-announced joint ventures. They may be surprised to

learn how common they are.

Research and Drafting Exercise: Choosing a Form of Business Organization

Divide students into nine groups. Give each group a piece of paper with one form of organization written

at the top: Sole Proprietorship; General Partnership; Limited Liability Partnership (LLP); Professional

Corporation; Limited Partnership; Limited Liability Limited Partnership; C Corporation; S Corporation;

Close Corporation; or Limited Liability Company (LLC). Ask each group to think of a business that

would be appropriate for this form of organization. For instance, a group of students might decide that a

sole proprietorship would be appropriate for a watercolor artist because her liability would be low and she

would have little interest in selling stock in the business. Typically, students at all levels (from

undergraduates through executive MBAs) engage in interesting and thoughtful discussions in their efforts

to apply what they have read to specific business ideas. Students should capture their ideas on Power

Point slides, overheads, or on paper to present during class.

As the class discusses the forms of business organization, each group assigned to that form should

present the reasons why this form is appropriate for its business. As each group makes its presentation, the

instructor can ask questions and direct the discussion to cover all of this chapter’s important points.

Chapter Overview

Chapter Theme

No one form of organization is right for every business. The proper choice depends upon factors such as

sources of financing, tax issues, liability concerns, and the entrepreneur’s goals (to go public, for

instance). In choosing a form of organization, it is important for the entrepreneur to consider all of these

issues.

General Concepts

Taxable versus Non-Taxable Entity

Tax treatment under the Internal Revenue Code is often a primary consideration in choosing a form of

organization. Business organizations are taxed either as partnerships or as corporations. To be “taxed as a

partnership” means that the entity itself pays no income tax, only the owners of the organization pay tax

on its earnings. C Corporations, on the other hand, pay federal income tax on their earnings and then

shareholders also pay tax on any dividends. To be taxed as a corporation, then, is to be subject to double

taxation under the Internal Revenue Code

Question: To say that an organization is “taxed as a partnership” or “not a taxable entity” is simply a

euphemism for saying that it is not taxed at all. Some commentators argue that organizations receive

valuable privileges— such as limited liability—and should, in return, pay taxes. Do you agree?

Answer: A fair division of the country’s tax burden is always a controversial topic. Some argue that

Question: But does it make sense for some forms of organizations, such as C corporations, to pay

taxes while S corporations and LLCs do not?

Answer: The theory is that start-ups (such as S corporations or LLCs) need special nurturing, but

Question: Traditionally, law firms and accounting firms were partnerships in which each partner

faced unlimited liability for the partnership’s debts. The partnerships themselves were not taxable

entities. With LLCs and LLPs, the liability burden is much lighter but the tax burden is no heavier. Is

this fair?

Answer: There is no reason why liability issues and tax burden should necessarily be linked. Should

Limited Liability versus Unlimited Liability

Unlimited liability means that an owner of a business is personally liable for the business’s financial

obligations to the full extent of the owner’s personal assets. In other words, a business creditor may be

able to seize and sell any of the owner’s personal assets to satisfy business debts.

Limited liability means that an owner is liable for the debts of the business only to the extent of the

owner’s investment in the business. If an owner has limited liability then business creditors may seize and

sell all assets owned by the business, but may not look to the owner’s personal assets to satisfy business

obligations. In other words, the owner can lose everything she invested in the business, but not other,

unrelated, assets.

Note: There is a chart in the text that lists the characteristics of each type of business organization.

Sole Proprietorships

A sole proprietorship is easy and inexpensive to form, but the entrepreneur is personally liable for all

debts of the organization. Debt or personal assets are the only sources of financing.

Question: Why do 76 percent of all small businesses choose to operate as sole proprietorships?

Answer: Many are too busy to consult a lawyer. Others are avoiding the legal and filing fees.

Corporations

Corporations in General

As is the case for all forms of organization, corporations have advantages and disadvantages.

Limited Liability

Although employees and individual shareholders have no personal liability for corporate debts, it is

important to remind students that individuals are always liable for their own negligence. An entrepreneur

who incorporates her business will still be liable if she commits a tort.

Question: Suppose that Loretta opens a candy shop on Main Street. Wary about her potential liability

serving food to the public, she incorporates her business. However, she fails to follow the

manufacturer’s suggestions and refrigerate her fudge. As a result, every mother in town falls ill after

eating gifts of fudge on Mother’s Day. The business has a bank account with a few thousand dollars.

Loretta has $100,000 in savings in a mutual fund account. Will the injured mothers have a right to the

mutual funds, or only the bank account?

Answer: Loretta herself was negligent–she failed to follow the manufacturer’s instructions. The

Transferability of Interests

Corporations provide flexibility for enterprises small (with one owner) and large (with thousands of

shareholders). As we will see, partnership interests are not transferable without the permission of the

other partners, whereas corporate stock can be bought and sold easily.

Duration

When a sole proprietor dies, legally so does the business. But corporations have perpetual existence:

they can continue without their founders.

Logistics

Corporations require substantial expense and effort to create and operate. The cost of establishing a

corporation includes legal and filing fees, not to mention the cost of the annual filings that states

require. Corporations must also hold annual meetings for both shareholders and directors. Minutes of

these meetings must be kept indefinitely in the company minute book.

Taxes

Because corporations are taxable entities, they must pay taxes and file returns.

S Corporations

Congress created S corporations (aka “S corps”) to encourage entrepreneurship by offering tax

breaks. The name “S corporation” comes from the provision of the Internal Revenue Code that

created this form of organization. Shareholders of S corps have both the limited liability of a

corporation and the tax status of a partnership. Like a partnership, an S Corp is not a taxable entity—

all the company’s profits and losses pass through to the shareholders, who pay tax at their individual

rates. It avoids the double taxation of a regular corporation (called a “C corporation”). If, as is often

the case, the startup loses money, investors can deduct these losses against their other income.

S corps do face some major restrictions:

• There can be only one class of stock (although voting rights can vary within the class).

• There can be no more than 100 shareholders.

• Shareholders must be individuals, estates, charities, pension funds, or trusts, not partnerships or

corporations.

• Shareholders must be citizens or residents of the United States, not non-resident aliens.

• All shareholders must agree that the company should be an S corporation.

Although most states follow the federal lead on S corporations, a small number require these

companies to pay state corporate tax.

Close Corporations

Originally, the terms close corporation and closely held corporation referred simply to a company whose

stock was not publicly traded (in other words, a “privately held” company). Now “close corporations”

usually means not merely a privately held company, but one that has taken advantage of the close

corporation provisions of its state code. Although the provisions of close corporation statutes vary from

state to state, they tend to have certain common themes: protection of minority shareholders, transfer

restrictions, flexibility, and dispute resolution.

Students are often confused about the differences among C corporations, S corporations, and close

corporations. State statutes authorize the creation of a corporation, but the IRS determines its tax

status. Thus, state law determines if an organization is a regular corporation or a close corporation.

IRS regulations determine if the corporation is a taxable entity. Both a close corporation and a regular

corporation can be either an S corporation or a C corporation.

Question: Who establishes the rules to determine if a corporation is an S corporation or a C

corporation?

Question: Who establishes the rules to determine if a corporation is a close corporation?

Question: Are the limitations on S corporations (one class of stock, etc.) serious restraints that

dramatically impede an entrepreneur’s options or minor technicalities?

Answer: The S restrictions essentially eliminate the possibility of venture capital financing. Most

Limited Liability Companies

Limited liability companies are a relatively new form of organization. They offer the limited liability of a

corporation and the tax status of a partnership, but they avoid the restrictions of an S corporation.

You Be The Judge: Ridgaway v. Silk1

Facts: Norman Costello and Joseph Ruggiero were members of Silk, LLC, the owner of Silk Stockings

and Cafe Del Mar, which was a bar and adult entertainment nightclub in Groton, Connecticut. Anthony

Sulls was drinking heavily one night at Silk Stockings and, although he was obviously drunk, employees

at Silk Stockings continued to serve him. Giordano (another member of the LLC) and Costello were

working there that night. They both greeted customers (who numbered in the hundreds), supervised

employees and performed “other PR work.” When Sulls left the nightclub at 1:45 a.m. with two friends,

he drove off the highway at high speed, killing himself and one of his passengers, William Ridgaway.

Ridgaway’s estate sued Costello and Giordano personally. The defendants filed a motion for summary

judgment seeking dismissal of the complaint.

You Be The Judge: Are Costello and Giordano personally liable to Ridgaway’s estate?

Holding: Costello and Giordano’s motion for summary judgment was denied. The claims against

Giordano and Costello on not based on their ownership of the limited liability company. Instead, plaintiff

1 2004 Conn. Super. LEXIS 548 Superior Court of Connecticut, 2004.

alleges that these two defendants were personally negligent on the night that Ridgaway died. Giordano

and Costello were both present, supervising other employees. Therefore, this case cannot be resolved on a

motion for summary judgment.

Question: Are members of an LLC personally liable for the debts of the business?

Question: Isn’t it obvious, then, that the court should grant the motion for summary judgment?

Question: Isn’t the whole point of an LLC to protect personal assets from business liabilities? Why

would the court deny the motion for summary judgment?

Question: Were the two defendants negligent that night?

Question: What could the defendants have done to protect themselves against suit?

Question: Is their status as LLC members useless?

Formation

To organize an LLC, you must have a charter and you should have an operating agreement.

Case: Wyoming.com, LLC v. Lieberman2

Facts: Lieberman was a member of the LLC Wyoming.com. After he withdrew, he and the other

members disagreed about what his membership was worth. Wyoming.com filed suit asking the court to

determine the financial rights and obligations of the parties, if any, upon withdrawal of a member.

The Supreme Court of Wyoming ruled that Lieberman still owned part of the business despite this

withdrawal, but neither the LLC statute nor the company’s operating agreement required the LLC to pay a

member the value of his share. Therefore, neither party had any further rights or obligations. Lieberman

was still an owner but he was not entitled to any payment. Lieberman filed a motion seeking financial

information about the company. The trial court denied the motion; since Lieberman had no rights to a

payout, the company had no obligation to give him financial data.

Issue: Does Lieberman have a right to any financial data about Wyoming.com?

Holding: No, the trial court’s ruling is affirmed. According to the court, the prior Lieberman case held

that no provision exists in either Wyoming state law or the operating agreement requiring any particular

disposition of a members’ equity interest upon their withdrawal as a member. Thus, Wyoming.com could

not legally force Lieberman to sell his interest at any particular value.

No further proceedings are required to resolve this action. Lieberman retains his equity interest and

nothing further is required of either party as a direct result of Lieberman’s withdrawal.

Excerpts from Justice Kite’s Concurring Decision: I concur with the result reached by the majority in

this matter solely because it is mandated by [the prior Lieberman case]. I joined [the] dissenting opinion

in that case because I found it more appropriate to allow a minority interest owner in an LLC a

mechanism to realize the value of his equity interest. [The court should consider that] those rights and

responsibilities in the context of other forms of business organizations are well developed and may

provide guidance in the realm of the LLC.

Question: Does Mr. Lieberman want to be a part of this LLC any longer?

2 2005 WY 42; 109 P.3d 883; 2005 Wyo. LEXIS 48. Supreme Court of Wyoming, 2005.

Question: According to the court, why can’t Mr. Lieberman withdraw from Wyoming.com?

Answer: According to the court, Mr. Lieberman cannot withdraw from Wyoming.com because the

Question: This seems like a crazy result: forcing a person to remain a member of an LLC but not

allowing that person to receive the value of his equity share. How could this result have been

avoided?

Answer: This result could have been avoided if Wyoming.com had been more thorough in drafting its

Flexibility

Unlike S corporations, LLCs can have members that are corporations, partnerships, or non-resident aliens.

LLCs can also have different classes of stock. Unlike corporations, LLCs are not required to hold annual

meetings or maintain a minute book.

Transferability of Interests

Unless the operating agreement provides otherwise, the members of the LLC must obtain the unanimous

permission of the remaining members before transferring their ownership rights. This is yet another

reason to have an operating agreement.

Duration

It used to be that LLCs automatically dissolved upon the withdrawal of a member (owing to, for example,

death, resignation, or bankruptcy). The current trend in state laws, however, is to permit an LLC to

continue in operation even after a member withdraws.

Going Public

Once an LLC goes public, it loses its favorable tax status and is taxed as a corporation, not a partnership.

Changing Forms

Some companies that are now corporations might prefer to be LLCs. However, the IRS would consider

this change to be a sale of the corporate assets and would levy a tax on the value of these assets.

Piercing the LLC Veil

Similar to shareholders in a corporation, members of an LLC can be held personally liable for the debts of

the LLC for failing to comply with the technicalities of the law.

Case: BLD Products, LTC v. Technical Plastics of Oregon3

Facts: Mark Hardie was the sole member of Technical Plastics of Oregon, LLC (TPO). The company

operated out of Hardie’s home, and Hardie regularly used TPO’s accounts to pay such personal expenses

as landscaping, housecleaning, personal credit card bills, his stepson’s tuition, family vacations, and

miscellaneous bills from GI Joe’s, Wrestler’s World, K-Mart, and Mattress World. Hardie deposited cash

advances from his personal credit cards to the TPO account. Hardie did not take a salary from TPO. When

TPO filed for bankruptcy, it owed BLD Products approximately $120,000 for goods that it had purchased.

3 2006 U.S. Dist. LEXIS 89874, United States District Court for the District of Oregon, 2006.

BLD argued that the doctrine of piercing the corporate veil of a corporation to hold its shareholders

personally liable should apply in this case to the LLC, thus making Hardie personally liable for TPO’s

debts.

Issues: Does the corporate doctrine of piercing the corporate veil apply to LLC’s? Should Hardie be

personally liable for TPO’s debts?

Holding: Yes, the doctrine of piercing the corporate veil does apply to LLC’s. Yes, Hardie should be

personally liable for TPO’s debts. The court concluded that the doctrine of piercing the corporate veil

does apply to LLC’s. According to that doctrine, three requirements must be satisfied before a court will

pierce the corporate veil and hold shareholders personally liable for the debts of the corporation:

1. the defendant controlled the debtor corporation;

2. the defendant engaged in improper conduct; and

3. as a result of that improper conduct plaintiff was unable to collect on a debt against the insolvent

corporation.

According to the court, there is no question that Hardie controlled the corporation. Regarding the

second prong, there is substantial evidence of improper conduct, such as comingling assets, and a general

disregard of TPO’s LLC form and status as a separate legal entity. Hardie frequently, and in significant

amounts paid his personal expenses from the TPO business account. There is inadequate documentation

about how funds flowed between Hardie, as an individual, and TPO. Hardie treated TPO and its assets as

his personal funds.

The third prong of the test is whether Hardie’s improper conduct resulted in BLD being unable to

collect on its debt. The court could not be determined as a matter of law whether the inability to pay

$120,000 owed to BLD was due to Hardie’s improper conduct over the years. As a result, the court

granted partial summary judgment that BLD is entitled to pierce the corporate veil, making Hardie

personally liable, but that the amount for which Hardie is liable will have to be determined by a jury.

Question: If Hardy was the only member of the LLC, why does it matter that he used LLC money to

pay for his personal expenses?

Answer: It matters that Hardy used LLC money to pay for his personal expenses because LLC’s (and

other business forms) are separate, independent legal entities, and as such they must be treated

General Question: Piercing the corporate veil is a very difficult argument to win and courts usually

warranted in extraordinary circumstances. Why do you think that is so?

Answer: A court may be reluctant to apply the doctrine because generally it is more preferable to

Legal Uncertainty

LLCs are a relatively new form of organization without a consistent and widely developed body of law.

An important area of legal uncertainty involves managers’ duties to the members of the organization.

Managers do certainly owe a duty to the LLC itself (as opposed to its members), but do members have the

right to enforce this duty?

Case: Tzolis v Wol 4

Facts: Soterios Tzolis owned 25% of Smith Pennington Property Co. LLC which owned a Manhattan

hotel. Herbert Wolff managed the LLC. Tzolis alleged that Wolff first leased and then sold the hotel to

family and friends at a price below market value. Tzolis filed a derivative suit against Wolff on the

grounds that the man had violated his duties to the LLC.

The trial court ruled that members of an LLC had no right to bring a derivative action because the statute

had not explicitly permitted such suits. Tzolis appealed.

Issue: Do members of an LLC have the right to bring a derivative suit against managers of the company?

Excerpts from Justice Smith’s Decision: The derivative suit has been part of the general corporate law

of this state at least since 1832. It was not created by statute, but by case law. [The judge in an 1832 case

said:]

“no injury the stockholders may sustain by a fraudulent breach of trust, can, upon the general

principles of equity, be suffered to pass without a remedy. I will never determine that a court cannot

lay hold of every such breach of trust. I will never determine that frauds of this kind are out of the

reach of courts of law; for an intolerable grievance would follow from such a determination.”

We now consider whether to recognize derivative actions on behalf of the LLC, as to which no

statutory provision for such an action exists. In addressing the question, we continue to heed the

realization: When fiduciaries are faithless to their trust, the victims must not be left wholly without a

remedy. [T]o determine that frauds of this kind are out of the reach of courts of law would lead to “an

intolerable grievance.”

To hold that there is no remedy when corporate fiduciaries use corporate assets to enrich themselves was

unacceptable in 1832, and it is still unacceptable today. Derivative suits are not the only possible remedy,

but they are the one that has been recognized for most of two centuries, and to abolish them in the LLC

context would be a radical step.

[C]ourts have repeatedly recognized derivative suits in the absence of express statutory authorization. In

light of this, it could hardly be argued that the mere absence of authorizing language in the Limited

Liability Company Law bars the courts from entertaining derivative suits by LLC members.

We therefore hold that members of LLCs may sue derivatively.

Question: Why is there legal uncertainty surrounding LLCs?

Question: What is a derivative lawsuit?

Socially Conscious Organizations

More than a dozen states now permit the formation of socially conscious business organizations. These

hybrids are called flexible-purpose organizations, benefit corporations (B corporations), low-profit

limited liability companies (L3Cs), and community interest companies (CICs). To form this type of

organization, a business must pledge to behave in a socially responsible manner as it pursues profits. Note

that these businesses are not nonprofits. Instead, they focus on the triple bottom line: “people, planet, and

profits.”

4 884 N.E.2d 1005; 855 N.Y.S.2d 6; 2008 N.Y. LEXIS 226 COURT OF APPEALS OF NEW YORK,

2008.