Law For Small Business (Management 349)Business Organizations (Chapters 1-4)

Professor Charles H. Smith

Fall 2010

Types of Business Entities

• Sole Proprietorship

• Partnership (General or Limited)

• Corporation

• Limited Liability Company (LLC)

• Limited Liability Partnership (LLP)

One or Multiple Owners?• If only one owner, you are accountable to yourself and

your clients only; no need to accommodate other owners.• Advantage of only one owner – no need to check or

compromise with other owners since there are none.• If multiple owners, you must be accountable to your co-

owners and your clients; fiduciary duties owed by owners to each other as well as the business (see next slide).

• Advantage of multiple owners – each owner will bring his/her talents/resources/money into the business to work for the common good.

Duties Owed by Owners to Each Other and the Business• Duty of disclosure owed by owners to each other

– Owners must provide accurate and complete information re business to each other.

• Duties owed by owners to business– Care (aka “business judgment rule” or “due diligence”) – must

use best efforts and act appropriately in context of information and time available; focus not on success but rather on what is done (or not done) given the circumstances such as what owner knows or should reasonably have known.

– Loyalty – cannot (1) compete with business nor (2) use confidential information for personal profit.

– Obedience – must (1) obey instructions and (2) obey laws applicable to business; if conflict, which one should you obey?

Financing the Business• Money is the lifeblood of any business, no matter

what the business does or how big or small it is.– Equity – owners’ contribution of money in

exchange for percentage of ownership.– Debt – borrowing money from financial

institutions, friends, relatives or owners.– Leasing land/equipment – if from owner, must be

at or close to fair market value.– Get everything in writing to avoid problems with

the IRS, alter ego liability, or dispute over whether contribution is an “investment” or a “loan.”

Compensation for Owners

• Salary/commissions.• Share of dividends/profits (if any) – based on some

predetermined time period such as quarter or year.• Interest on loan to business.• Fringe benefits (“perks”) – e.g., medical insurance,

company car, reimbursement for travel, Lakers tickets, etc.

• Again, get it in writing!

Against Whom Can a Judgment be Entered?• May be clear that business is liable and is subject to

having judgment entered against it.• However, business itself may have little or no assets,

or may have gone out of business or filed for bankruptcy by the time legal action taken or judgment is entered.

• So . . . can plaintiff get judgment against owner(s) of business in order to be able to collect on the judgment based on the business’ liability?

• Owner’s personal liability – or lack of liability – for business’ losses/debts/judgments can be big factor in choosing the type of business organization.

Sole Proprietorship• Easiest type of business to start up – and close up – since

little or no documentation required and no need to check or compromise with co-owners.

• Good type of business for someone just starting out on a part-time basis while still going to school or maintaining regular job; some sole proprietorships eventually turn into full-time large businesses, while others never do.

• One owner, who has personal liability for all debts and judgments incurred by the business.

• Business itself not subject to income tax; instead, owner shows income – and expenses – on Schedule C of IRS Form 1040.

• Business expenses – can be deducted for income tax purposes, but keep detailed and up-to-date records.

Introduction to Partnerships• Two or more people in business together for

profit.• Traditional style of doing business – each

partner brings his/her talents/resources/money into the business to work for the common good; examples.

• Relatively easy to start up and operate.• Separate legal entity – can buy, sell, own, sue

and be sued, etc. in its own name.• “Pass-through” entity for income tax purposes;

partnership itself pays no income taxes.

General and Limited Partnerships• General partnership – all partners are

– Involved in business.– Have unlimited personal liability for partnership debts/judgments

of partnership even if no knowledge/involvement (harsh rule).• Limited partnership – two types of partners

– General partner(s) – at least one partner controls partnership business; unlimited personal liability for any business losses/debts/judgments.

– Limited partner(s) – all other partners contribute money only (often called investors or “silent” partners); personal liability for any business losses/debts/judgments limited to amount of investment; cannot be sued for business losses/debts/judgments; worst case scenario – lose investment money.

– Common in real estate investments.

Limited Liability Partnership (LLP)• Like general and limited partnerships, LLP is separate legal

entity and “pass-through” entity for income tax purposes; new business entity created by statute in California in 1996.

• Unlike general and limited partnerships, only available to professionals, such as physicians, lawyers, architects, etc.

• Partner’s personal liability for any business debt/judgment limited to amount of investment; similar to limited partnership except all partners treated like limited partners for liability purposes no matter what partner’s involvement is in the LLP business.

• Exception is partner who commits tort can have unlimited personal liability for tort; usually professional malpractice but can be any tort such as fraud, defamation or negligence.

• Therefore, personal liability issues found in traditional partnerships eliminated.

Need for a Written Partnership Agreement• Partnership usually formed by people familiar with each other

(relatives, friends, co-workers); therefore, written agreement may seem unnecessary but recommended – why?– In the future, other people may become involved.– Original partners’ memories may naturally fade.– “Revisionist history” or “selective memory” (dishonesty).– Writing will provide clarification.– Preparing writing may provide opportunity to (1) deal with

problems before they arise in order to reach compromises or (2) if too many disputes at this stage, partners may conclude that they should not be doing business together and go their separate ways.

Overview of Partnership Agreement• Name and term of partnership business.• Business purpose.• Contribution to business by each partner since all

may have different resources/talents.• Two sides of the money coin

– Partners’ compensation.– Their responsibility for losses.

• Management responsibilities/job duties.• Partners’ outside business activities (if any permitted

at all – see duty of loyalty on previous slide).

Overview of Partnership Agreement cont.• Rights/responsibilities/procedures in event of departure of

partner– Voluntary (resignation or retirement).– Involuntary (expulsion or death).

• Continuity of business if partner departs.• Non-compete clause – OK per B & P Code § 16602; must be

reasonable.• Control of business name.• Dispute resolution if partnership problem – mediation,

arbitration or court?• If limited partnership, designate partners as general or limited.

Changes in the Partnership

• Partnership agreement should state how it may be amended (e.g., 51% or 2/3 vote).

• Provide for addition of new partner(s).• Provide specific reasons for expulsion of

partner; e.g., serious violation of partnership agreement or duty, legal action (criminal or civil).

Introduction to Corporations

• Why form a corporation? – #1 reason is shareholders have no personal liability if business (corporation) incurs debts/has judgments entered against it – exception is alter ego rule (see later slides).

• Established business entity – no mystery re applicable law (many statutes and cases).

“People” Components of a Corporation• Shareholders, who appoint/elect the . . .

• Directors, who elect/hire the . . .

• Officers, who hire the . . .

• Employees, who do the real work!

No Attorney Needed to Form a Corporation, but . . .• Attorney involvement should eliminate mistakes.

• Attorney involvement could possibly lead to legal advice about whether corporation is the best entity for your business.

• Attorney involvement should make attorney responsible if any problems with incorporation process; attorney could be sued for malpractice for damages caused by any such problems.

Incorporation Procedures

• Choose a name and reserve it on Cal. Sec’y of State website (good for 60 days); go to http://www.sos.ca.gov/business/corp/pdf/naavreservform.pdf

• Prepare/file articles of incorporation.• Shareholders elect first board of directors.• Board holds first meeting.• Set up corporate bank account – bank will require copy of

board resolution or provide form.• Issue stock to shareholders.• Start-up financial transactions.

Incorporation Procedures cont.• Prepare corporate record book.• State and local government requirements; e.g.,

licenses and permits.• Comply with bulk sales act if purchasing assets of

another business to get started.• Then, after incorporation – continue with state and

local government requirements, annual meetings, and obtain necessary insurance for the corporation (personal coverage will not cover corporate liability).

Introduction to Limited Liability Companies• Limited liability company is often called “LLC” for

short; business name must include “Limited Liability Company,” “L.L.C.” or “LLC” at the end.

• LLC is “new generation” of a corporation with some advantages; e.g., no double taxation.

• LLC’s encounter many of the same issues corporations do; e.g., management, financing, employees, etc.

General Concepts re LLC’s• Corporations Code § 17000 et seq. (Beverly-Killea Limited

Liability Company Act) provides much guidance re “do’s” and “don’ts” of LLC since LLC is created by statute.

• Number of members (owners) required – “one or more” (CC 17050(b)).

• Type of business – almost no limits (CC 17002).• Name – last words of LLC must be “Limited Liability Company,”

“L.L.C.” or “LLC” (CC 17052); name cannot be misleading or same as or resemble name of existing LLC and cannot include several words (CC 17052(c)); name reservation with California Sec’y of State similar to corporation name reservation (CC 17053).

• Financing – member can lend money “and transact other business” with LLC with same rights/obligations as anyone else (CC 17004(b)).

More General Concepts re LLC’s• Members’ compensation – no compensation

permitted that is not set forth in operating agreement (CC 17004(b)).

• Management – governed by CC 17150 et seq.• Documentation needed – articles of organization filed

with Cal. Sec’y of State (CC 17050(a) and 17051 – equivalent of corporation’s articles of incorporation); operating agreement (not required by CC 17059 but recommended – equivalent of corporation’s by-laws); biennial statement (CC 17060 – filed within 90 days of articles then every two years).

Even More General Concepts re LLC’s• Members’ personal liability for LLC

debts/judgments – none solely based on LLC membership; exception is alter ego (CC 17101(b) – see later slides).

• Voting rights – proportionate to ownership interest; usually majority vote unless amendment to articles (then need unanimous vote).

• Review – “Frequently Asked Questions” on Cal. Sec’y of State’s website re LLC’s – http://www.ss.ca.gov/business/llc/llc_faq.htm

Alter Ego Liability• Traditionally applicable to corporations and its shareholders

(common law) but now also applicable to limited liability companies and its members (CC 17101(b)).

• Threshold issue – has the shareholder exercised such control that the corporation has become a mere instrumentality of the shareholder, making the shareholder the real actor?

• If so, then the corporate veil may be pierced and the shareholder may be personally liable for corporate loss/debt/judgment.

• Alter ego is an equitable theory; more likely to be applied if corporate form used to commit fraud or other illegal act.

• General guideline – avoid alter ego liability by maintaining separateness between corporation and shareholder(s).

Alter Ego Liability cont.

• Examples of when corporate veil may be pierced– Failure to comply with corporate formalities; e.g.,

annual meetings, filings with the state.– Commingling personal and corporate

assets/funds.– Undercapitalization (insufficient funds in corporate

bank accounts to cover usual expenses).– Shareholder claims corporate assets/obligations

are own personal assets/obligations.