in whole or in part.
CHAPTER 4
CORPORATE FORMATION
AND FINANCING
in whole or in part.
CHAPTER 4: CORPORATE FORMATION AND FINANCING 3
in whole or in part.
correspond to the percentage of the individual defendants’ stock ownership. If instead the
amounts had correlated to the quantity and quality of the individuals’ services, for example, the
court might have been persuaded that the compensation had a reasonable basis.
THE ECONOMIC DIMENSION
What are the tax consequences of passing corporate profits on to the shareholders as
dividends? Whether a corporation retains its profits or passes them on to the shareholders as
dividends, the profits are subject to income taxes. In fact, the profits can be subject to double
taxation. The company pays taxes on its profits, and then if the profits are passed on to the
shareholders as dividends, the shareholders must also pay income tax on them. If the profits are
passed on to the officers as compensation, however, the corporation avoids paying additional
taxes on them.
CASE 4.3—QUESTIONS (PAGE 69)
THE ETHICAL DIMENSION
Should the Brennan brothers be held personally liable because they misled their
attorneys? Why or why not? Kenyon & Kenyon may have felt misled because the Brennan
brothers promised to pay their legal bills. Nevertheless, the Brennan brothers did not mislead
their lawyers in a way that justifies piercing the corporate veil. Kenyon & Kenyon was not tricked
or misled into dealing with Brennan’s, Inc., rather than the Brennan brothers themselves. As
lawyers, Kenyon & Kenyon should have been well aware of when the Brennan brothers were
speaking as shareholders and when they were speaking in their personal capacities. Moreover,
as legal counsel, Kenyon & Kenyon also knew which corporate formalities its client did and did
not observe.
THE ECONOMIC DIMENSION
Do corporations benefit from shareholders’ limited liability? If so, how? Yes. A corporation
benefits directly by the limited-liability protection offered to shareholders. The limitation of liability
attracts capital by attracting investors. This also benefits society generally by funding rational
risk-taking in product and service research and development.
ANSWERS TO QUESTIONS IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
1A. Theory
The court would be likely to pierce the veil of the corporation and hold Sharp personally liable.
Because he commingled personal funds with corporate funds and generally treated the
business as his alter ego, as one would treat a proprietorship, the limited liability that
accompanies corporate status could be lost.
4 UNIT ONE: BUSINESS ORGANIZATIONS
in whole or in part.
2A. Articles
Sharp is likely to be personally liable based on piercing the corporate veil due to ignoring the
corporate form. Technical details in the articles of incorporation alone would not be likely to
result in liability being imposed; the fact that the entire operation ignored the corporate status
matters more in losing the liability shield.
3A. Credit
Extending credit to customers is a normal business activity and is not improper. Such details
need not be discussed in the articles of incorporation or the bylaws, which generally concern the
purpose of the business itself and basic ownership structure issues.
4A. Classification
The corporation was formed and operated in Georgia, so it is a domestic corporation. It is
owned by one person, so it is private; its stock is not traded, so it is also a close corporation.
ANSWER TO DEBATE THIS QUESTION IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
The sole shareholder of an S corporation should never be able to avoid liability for
the torts of her or his employees. Perhaps it makes sense to allow individuals to use business
organization forms that allow them to pass through profits to their personal tax returns, but it
makes little sense to allow them to escape liability with such structures when their employees or
agents commit torts. Normally, employees do not have liability insurance or even assets that
could pay for tort judgments against them. Those who suffer from these torts would therefore
end up with nothing, even if they win at trial.
It should make no difference whether an S corporation is owned by one person or by
many persons. A major benefit of all corporations, whatever form they take, has been to shield
shareholders from liability. Therefore, if a shareholder of an S corporation knows that he or she
will not have limited liability, there is less reason to use the S corporation structure. Its use will
decrease as a result.
ANSWERS TO ISSUE SPOTTERS IN THE EXAMPREP FEATURE
AT THE END OF THE CHAPTER
1A. Northwest Brands, Inc., is a small business incorporated in Minnesota. Its one
class of stock is owned by twelve members of a single family. Ordinarily, corporate
income is taxed at the corporate and shareholder levels. Is there a way for Northwest
Brands to avoid this double taxation? Explain your answer. Yes. Small businesses that
meet certain requirements can qualify as S corporations, created specifically to permit small
businesses to avoid double taxation. The six requirements of an S corporation are (1) the firm
CHAPTER 4: CORPORATE FORMATION AND FINANCING 5
in whole or in part.
must be a domestic corporation, (2) the firm must not be a member of an affiliated group of
corporations, (3) the firm must have less than a certain number of shareholders, (4) the
shareholders must be individuals, estates, or qualified trusts (or corporations in some cases), (5)
there can be only one class of stock, and (6) no shareholder can be a nonresident alien.
2A. The incorporators of Consumer Investments, Inc., want their new corporation to
have the authority to transact nearly all conceivable types of business. Can they grant
this authority to their firm? If so, how? If not, why not? Broad authority to conduct business
can be granted in a corporation’s articles of incorporation. For example, the term “any lawful
purpose” is often used. This can be important because acts of a corporation that are beyond
the authority given to it in its articles or charter (or state statutes) are considered illegal, ultra
vires acts.
ANSWERS TO BUSINESS SCENARIOS AND BUSINESS CASE PROBLEMS
AT THE END OF THE CHAPTER
4-1A. Incorporation
(Chapter 4—Pages 55–58)
The officers are answerable to the board. Shareholders can be members of the board of
directors and members of the board can be officers. Thus, the partners can be shareholders
officers as agents do not act outside the scope of their authority, neither board members nor
officers are personally liable. Thus, incorporation limits judgments against the corporation to
4-2A. Preincorporation
(Chapter 4—Page 62)
(a) As a general rule, a promoter is personally liable for all pre-incorporation contracts
made by the promoter. The basic theory behind such liability is that the promoter cannot be an
in whole or in part.
in whole or in part.
Castellano’s business partner, and Planet Laundry’s “co–principal.” Because “the one-day delay
in BSC’s formation was, from the [defendants’] perspective, utterly inconsequential, [they]
cannot now be heard to deny BSC’s corporate status.”
findings not consistent with the appellate court’s opinion. No single factor indicating abuse of
corporate form for purposes of piercing corporate veil controls. Factors bearing on abuse of
corporate form for purposes of piercing corporate veil include: (1) whether the corporation is
inadequately capitalized; (2) whether the owners observe corporate formalities; (3) whether the
in whole or in part.
CHAPTER 4: CORPORATE FORMATION AND FINANCING 9
in whole or in part.
accepted the benefit of the entity’s performance, and even partially paid the entity for that
performance.”
integrity, responsibility, and the “Golden Rule”—act with respect to others as you would have
them treat you.
(c) The court concluded, and on appeal the Montana Supreme Court upheld, that the
parties’ written contract was a “fixed price” transaction, but that the oral agreements were on a
improper preparation (form) work. In a rush to complete the project, Weimar “repeatedly advised
his subcontractors to disregard [Lyons’] potential defects.” The court entered a judgment in
Lyons’s favor for $16,763, plus interest, costs, and attorney’s fees. For the deficiencies
attributable to Lyons’s work, the court credited Weimar with $8,967.19 for their repair.
management relations, agreements for LLCs and similar organizations can take longer to
negotiate and write. The tax laws, which for the new forms of business are not entirely clear,
can add to the cost because of additional recordkeeping and accounting for the new entities. All
unincorporated associations are taxed as partnerships at the federal level, and this includes the
managing the firm. It can be either a “member–managed” LLC or a “manager–managed” LLC. In
a member-managed LLC, all of the members participate in management, and decisions are
made by majority vote. In a manager-managed LLC, the members designate a group of persons
to manage the firm. The management group may consist of only members, both members and
in whole or in part.
CHAPTER 4: CORPORATE FORMATION AND FINANCING 3
in whole or in part.
correspond to the percentage of the individual defendants’ stock ownership. If instead the
amounts had correlated to the quantity and quality of the individuals’ services, for example, the
court might have been persuaded that the compensation had a reasonable basis.
THE ECONOMIC DIMENSION
What are the tax consequences of passing corporate profits on to the shareholders as
dividends? Whether a corporation retains its profits or passes them on to the shareholders as
dividends, the profits are subject to income taxes. In fact, the profits can be subject to double
taxation. The company pays taxes on its profits, and then if the profits are passed on to the
shareholders as dividends, the shareholders must also pay income tax on them. If the profits are
passed on to the officers as compensation, however, the corporation avoids paying additional
taxes on them.
CASE 4.3—QUESTIONS (PAGE 69)
THE ETHICAL DIMENSION
Should the Brennan brothers be held personally liable because they misled their
attorneys? Why or why not? Kenyon & Kenyon may have felt misled because the Brennan
brothers promised to pay their legal bills. Nevertheless, the Brennan brothers did not mislead
their lawyers in a way that justifies piercing the corporate veil. Kenyon & Kenyon was not tricked
or misled into dealing with Brennan’s, Inc., rather than the Brennan brothers themselves. As
lawyers, Kenyon & Kenyon should have been well aware of when the Brennan brothers were
speaking as shareholders and when they were speaking in their personal capacities. Moreover,
as legal counsel, Kenyon & Kenyon also knew which corporate formalities its client did and did
not observe.
THE ECONOMIC DIMENSION
Do corporations benefit from shareholders’ limited liability? If so, how? Yes. A corporation
benefits directly by the limited-liability protection offered to shareholders. The limitation of liability
attracts capital by attracting investors. This also benefits society generally by funding rational
risk-taking in product and service research and development.
ANSWERS TO QUESTIONS IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
1A. Theory
The court would be likely to pierce the veil of the corporation and hold Sharp personally liable.
Because he commingled personal funds with corporate funds and generally treated the
business as his alter ego, as one would treat a proprietorship, the limited liability that
accompanies corporate status could be lost.
4 UNIT ONE: BUSINESS ORGANIZATIONS
in whole or in part.
2A. Articles
Sharp is likely to be personally liable based on piercing the corporate veil due to ignoring the
corporate form. Technical details in the articles of incorporation alone would not be likely to
result in liability being imposed; the fact that the entire operation ignored the corporate status
matters more in losing the liability shield.
3A. Credit
Extending credit to customers is a normal business activity and is not improper. Such details
need not be discussed in the articles of incorporation or the bylaws, which generally concern the
purpose of the business itself and basic ownership structure issues.
4A. Classification
The corporation was formed and operated in Georgia, so it is a domestic corporation. It is
owned by one person, so it is private; its stock is not traded, so it is also a close corporation.
ANSWER TO DEBATE THIS QUESTION IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
The sole shareholder of an S corporation should never be able to avoid liability for
the torts of her or his employees. Perhaps it makes sense to allow individuals to use business
organization forms that allow them to pass through profits to their personal tax returns, but it
makes little sense to allow them to escape liability with such structures when their employees or
agents commit torts. Normally, employees do not have liability insurance or even assets that
could pay for tort judgments against them. Those who suffer from these torts would therefore
end up with nothing, even if they win at trial.
It should make no difference whether an S corporation is owned by one person or by
many persons. A major benefit of all corporations, whatever form they take, has been to shield
shareholders from liability. Therefore, if a shareholder of an S corporation knows that he or she
will not have limited liability, there is less reason to use the S corporation structure. Its use will
decrease as a result.
ANSWERS TO ISSUE SPOTTERS IN THE EXAMPREP FEATURE
AT THE END OF THE CHAPTER
1A. Northwest Brands, Inc., is a small business incorporated in Minnesota. Its one
class of stock is owned by twelve members of a single family. Ordinarily, corporate
income is taxed at the corporate and shareholder levels. Is there a way for Northwest
Brands to avoid this double taxation? Explain your answer. Yes. Small businesses that
meet certain requirements can qualify as S corporations, created specifically to permit small
businesses to avoid double taxation. The six requirements of an S corporation are (1) the firm
CHAPTER 4: CORPORATE FORMATION AND FINANCING 5
in whole or in part.
must be a domestic corporation, (2) the firm must not be a member of an affiliated group of
corporations, (3) the firm must have less than a certain number of shareholders, (4) the
shareholders must be individuals, estates, or qualified trusts (or corporations in some cases), (5)
there can be only one class of stock, and (6) no shareholder can be a nonresident alien.
2A. The incorporators of Consumer Investments, Inc., want their new corporation to
have the authority to transact nearly all conceivable types of business. Can they grant
this authority to their firm? If so, how? If not, why not? Broad authority to conduct business
can be granted in a corporation’s articles of incorporation. For example, the term “any lawful
purpose” is often used. This can be important because acts of a corporation that are beyond
the authority given to it in its articles or charter (or state statutes) are considered illegal, ultra
vires acts.
ANSWERS TO BUSINESS SCENARIOS AND BUSINESS CASE PROBLEMS
AT THE END OF THE CHAPTER
4-1A. Incorporation
(Chapter 4—Pages 55–58)
The officers are answerable to the board. Shareholders can be members of the board of
directors and members of the board can be officers. Thus, the partners can be shareholders
officers as agents do not act outside the scope of their authority, neither board members nor
officers are personally liable. Thus, incorporation limits judgments against the corporation to
4-2A. Preincorporation
(Chapter 4—Page 62)
(a) As a general rule, a promoter is personally liable for all pre-incorporation contracts
made by the promoter. The basic theory behind such liability is that the promoter cannot be an
in whole or in part.
in whole or in part.
Castellano’s business partner, and Planet Laundry’s “co–principal.” Because “the one-day delay
in BSC’s formation was, from the [defendants’] perspective, utterly inconsequential, [they]
cannot now be heard to deny BSC’s corporate status.”
findings not consistent with the appellate court’s opinion. No single factor indicating abuse of
corporate form for purposes of piercing corporate veil controls. Factors bearing on abuse of
corporate form for purposes of piercing corporate veil include: (1) whether the corporation is
inadequately capitalized; (2) whether the owners observe corporate formalities; (3) whether the
in whole or in part.
CHAPTER 4: CORPORATE FORMATION AND FINANCING 9
in whole or in part.
accepted the benefit of the entity’s performance, and even partially paid the entity for that
performance.”
integrity, responsibility, and the “Golden Rule”—act with respect to others as you would have
them treat you.
(c) The court concluded, and on appeal the Montana Supreme Court upheld, that the
parties’ written contract was a “fixed price” transaction, but that the oral agreements were on a
improper preparation (form) work. In a rush to complete the project, Weimar “repeatedly advised
his subcontractors to disregard [Lyons’] potential defects.” The court entered a judgment in
Lyons’s favor for $16,763, plus interest, costs, and attorney’s fees. For the deficiencies
attributable to Lyons’s work, the court credited Weimar with $8,967.19 for their repair.
management relations, agreements for LLCs and similar organizations can take longer to
negotiate and write. The tax laws, which for the new forms of business are not entirely clear,
can add to the cost because of additional recordkeeping and accounting for the new entities. All
unincorporated associations are taxed as partnerships at the federal level, and this includes the
managing the firm. It can be either a “member–managed” LLC or a “manager–managed” LLC. In
a member-managed LLC, all of the members participate in management, and decisions are
made by majority vote. In a manager-managed LLC, the members designate a group of persons
to manage the firm. The management group may consist of only members, both members and