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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.
