Bus Org Outline draft PDF

SOLE PROPRIETORSHIP 1. Definition A sole proprietorship is a business owned by one individual who has not registered the business in another legal form. ○ Default Status: Single-owner businesses default to sole proprietorship unless the owner files paperwork for anothe...

SOLE PROPRIETORSHIP 1. Definition A sole proprietorship is a business owned by one individual who has not registered the business in another legal form. ○ Default Status: Single-owner businesses default to sole proprietorship unless the owner files paperwork for another form (e.g., LLC, Corporation). ○ Filing Office: Paperwork is usually filed with the Secretary of State Office or its equivalent (varies by state). Handles business-related documents (e.g., articles of incorporation). Examples: California: "Business Entities Section." Delaware: "Corporations Division." Florida: "Department of State." No Legal Distinction: The sole proprietor and the business are legally the same entity. ○ All business assets are personally owned by the proprietor. Example: Smith’s plumbing tools are his personal assets, not separate business assets. 2. Governing Law No Separate Law: ○ Since the sole proprietorship has a single owner, there is no need for business entity statutes (which define rights/duties of multiple owners/managers). Sole proprietorships operate without a distinct body of law. 3. Management Owner Authority: ○ The sole proprietor has full control over business decisions. ○ No formalities (e.g., meetings, votes) are required. Delegation: ○ Sole proprietors can hire employees and delegate authority as needed. 4. Liability Exposure Unlimited Personal Liability: ○ The proprietor is personally liable for all business debts and obligations. ○ Business creditors can go after both business and personal assets. Example: If Smith’s plumbing business defaults on its lease, creditors can seize: Business assets (e.g., plumbing tools). Personal assets (e.g., Smith’s house, car). ○ Proprietors are also liable for torts committed by the business or its employees.  Example: A plumbing error causing water damage could result in a personal lawsuit against Smith. 5. Taxation Income/Loss Ownership: ○ The proprietor is entitled to all business income and responsible for all losses. Tax Reporting: ○ Business income/loss is reported on the proprietor’s personal tax return (Form 1040, Schedule C). ○ The business does not file or pay separate federal income taxes. 6. Legal Name Default Legal Name: ○ The business's legal name is the owner's legal name. Example: Robert B. Smith for "Smith’s Plumbing." DBA (Doing Business As): ○ Sole proprietors often operate under a different name for marketing purposes. Example: Smith may use "AAA Plumbing" for branding. ○ Legal documentation retains the proprietor's name with a DBA designation: Example: "Robert B. Smith, DBA AAA Plumbing." ○ DBA usage varies by state and may be referred to as an assumed or fictitious name. Partnership 1. Definition A partnership (or "general partnership") is a for-profit business with two or more owners who have not registered the business in another legal form. ○ Default Status: Multi-owner for-profit businesses default to general partnerships unless paperwork is filed for another form (e.g., LLC, Corporation). ○ Owners: Referred to as partners. 2. Governing Law Governed by the partnership statute of the state where it is organized. ○ Typically based on either: Uniform Partnership Act (UPA). Revised Uniform Partnership Act (RUPA) (adopted by most states since 1994, with amendments through 2013). ○ State Variations: States can modify or choose not to adopt UPA/RUPA amendments, so always consult the specific state statute. ○ Jurisdiction: If no explicit agreement on the state of organization:  Common law rule: Jurisdiction where the partnership contract was made governs. RUPA Rule: Law of the state where the partnership's principal office is located governs. 3. Partnership Agreement Written Agreement (preferred, though not legally required): ○ Reduces disputes and allows for detailed customization of rules. Default Rules: Partnership statutes provide default rules that apply unless altered by the partnership agreement. ○ Example: Default rule: Equal profit sharing among partners. Agreement can adjust profit sharing to reflect contributions. Key Topics Addressed: ○ Management structure. ○ Profit/loss allocation. ○ Taxation. ○ Admission/withdrawal of partners. ○ Dissolution provisions. Statutory Exceptions: ○ Some rules in the partnership statute cannot be overridden by agreement. Oral Agreement: Possible but less practical and prone to disputes. 4. Management Customizable Structure: Specified in the partnership agreement. Common structures include: ○ Managing Partner: One partner makes decisions. ○ Management Committee: A group of partners makes decisions. ○ Equal Voting: Each partner has one vote. ○ Proportional Voting: Voting power based on capital contributions. Major Decisions: ○ Typically require a partnership vote (e.g., admitting new partners, dissolution). ○ Voting thresholds can vary (e.g., majority, supermajority, unanimous). Default Rule: ○ Equal management rights for all partners if no agreement specifies otherwise. 5. Liability Exposure Personal Liability: ○ Partners are personally liable for partnership obligations (e.g., debts, contracts, torts). Example: A failed partnership loan allows creditors to pursue any partner’s personal assets. ○ Joint and Several Liability:  Partners can be sued individually or collectively for partnership obligations. Tort victims and creditors can recover from any one partner. Exhaustion Rule: ○ Creditors must exhaust partnership assets before pursuing partners' personal assets. ○ Little practical effect if the partnership has no assets. 6. Taxation Governed by Subchapter K of the Internal Revenue Code (IRC): ○ Pass-Through Taxation: Partnership itself does not pay federal income tax. Profits/losses are allocated to partners and reported on their personal tax returns (via Form 1040, Schedule E). ○ Information Filing: Partnership files Form 1065 annually, detailing income, deductions, and allocations. Subchapter C or S Option: ○ Partnerships can opt into C Corporation or S Corporation taxation instead of Subchapter K. Limited Liability Partnership (LLP) 1. Definition Limited Liability Partnership (LLP): ○ A for-profit business with two or more owners. ○ Must file a statement of qualification with a state’s secretary of state office to elect LLP status. ○ Key Feature: Partners are not personally liable for the obligations of the partnership. Liability is limited, unlike the unlimited liability in a general partnership. 2. Governing Law LLPs are governed by the general partnership statute of the state where they are organized. ○ LLP Status: Achieved by electing LLP provisions within the state’s general partnership statute. ○ Unified Statutes: States do not have separate LLP statutes; they incorporate LLP provisions into the general partnership statute. 3. Partnership Agreement Written Agreement (common but not required): ○ Covers the same matters as in a general partnership agreement: Management structure.  Allocation of profits and losses. Partner taxation. Admission/withdrawal of partners. Dissolution. ○ Customization through the agreement allows for tailored rules, as in a general partnership. Same Rules Apply: ○ The principles regarding general partnership agreements apply equally to LLPs. 4. Management Structure: ○ Follows the same management principles as general partnerships, including: Managing partner, management committee, or shared management among partners. Voting on major decisions with thresholds (e.g., majority, unanimous). ○ Default Rule: Equal management rights if not specified otherwise. No Distinction: LLP management rules mirror those of general partnerships. 5. Liability Exposure Key Differentiator: ○ Limited Liability: LLP partners are not personally liable for the partnership's obligations just because they are partners. Personal assets are generally protected. ○ Liability Shields: Partial Shield (historical): Partners were not liable for negligence/misconduct by others but were liable for other obligations (e.g., contracts). Full Shield (current in all but two states as of 2019: Louisiana and South Carolina): Partners are not liable for any partnership obligations due to their status as partners. Exceptions: Partners remain personally liable for their own negligence, misconduct, or wrongful acts. 6. Taxation Same as General Partnerships: ○ Governed by Subchapter K of the Internal Revenue Code (IRC). ○ Pass-Through Taxation: LLP profits/losses are passed through to partners' individual tax returns. Partnership files an annual information return (Form 1065). ○ Subchapter C or S Option: LLPs can elect taxation as a corporation under Subchapter C or S. Limited Partnership (LP) 1. Definition Limited Partnership (LP): ○ A partnership with at least one general partner and one or more limited partners. ○ Must file a certificate of limited partnership with a state’s secretary of state office. ○ Roles and Liability: General Partners: Have management rights. No liability shield; personally liable for partnership debts and obligations. Limited Partners: Have no management rights. Receive a liability shield; not personally liable for partnership debts or obligations. 2. Governing Law Governed by the limited partnership statute of the state in which it is organized (i.e., where the certificate of limited partnership is filed). States base their statutes on the Uniform Limited Partnership Act (ULPA), except Louisiana, which follows its own laws. 3. Limited Partnership Agreement Written Agreement (commonly used): ○ Covers similar matters as a general partnership agreement but includes additional provisions for: Rights and obligations of limited partners. Allocation of management duties among general partners. ○ Tailoring: Statutes provide default rules, which can be adjusted in the agreement to meet the partnership’s needs. Review the limited partnership agreement first when advising on legal issues. 4. Management Control Structure: ○ General Partners: Responsible for managing the partnership’s business. Limited partners generally cannot participate in management or control. ○ Multiple General Partners:  The agreement may specify management allocation, e.g.: Designating a managing partner. Other general management structures (similar to those in general partnerships). Limited Partners: ○ Passive role; participation in management may affect liability protection (see "Control Rule"). 5. Liability Exposure General Partners: ○ Unlimited Liability: Personally liable for the partnership’s debts and obligations. Limited Partners: ○ Limited Liability: Can only lose their investment in the partnership. Personal assets are protected unless: They participate in management/control of the business. This is known as the "control rule", recognized in many state statutes. Failure Scenario: ○ General partners' personal assets may be used to cover obligations. ○ Limited partners lose only their contributions unless they breach the control rule. 6. Taxation Same as General Partnerships: ○ Governed by Subchapter K of the Internal Revenue Code (IRC). ○ Pass-Through Taxation: Profits and losses are allocated to partners. Partners report allocations on their personal tax returns. ○ Similar Rules: Taxation under Subchapter K applies to limited partnerships as it does to general partnerships. Corporation 1. Definition Corporation: ○ A business entity that files articles of incorporation (or a charter) with a state’s secretary of state office. ○ Key Features: Limited liability for owners (called shareholders or stockholders). Management authority vested in a board of directors elected by shareholders. 2. Governing Law  Governed by the law of the state of incorporation. States either follow: ○ The Model Business Corporation Act (MBCA): Adopted in 32 states (e.g., Florida, Virginia, Wisconsin). ○ Independent Statutes: Other states (e.g., Delaware) use their own corporate laws but may adopt MBCA provisions selectively. Delaware: ○ Most significant non-MBCA state. ○ Incorporation hub for over 50% of publicly traded U.S. companies. ○ Governed by the Delaware General Corporation Law (DGCL). Key Advice: ○ Always consult the specific state’s corporate law statute and governing documents, as statutes vary. 3. Governing Documents Required Documents: ○ Charter (Articles of Incorporation): Includes the corporation’s name, stock details (e.g., types, rights, preferences), and registered agent information. Typically brief (1–2 pages initially). ○ Bylaws: Governs internal processes: Meeting rules, quorum requirements, board qualifications, voting, proxy use, officer appointments, and stock certificates. Optional Documents: ○ Shareholders’ Agreements: Common for closely held corporations. May address: Stock transfer restrictions. Employment of shareholders. Board representation and buy-sell rights. ○ Corporate Governance Principles: Common for publicly held corporations. May outline: Director responsibilities, board committees, meeting rules, and director compensation. 4. Management Centralized Management: ○ Board of Directors: Ultimate authority for managing the corporation. Elected by shareholders. ○ Officers: Appointed by the board for day-to-day business operations. Overseen by the board.  ○ Shareholders do not have statutory authority to manage the corporation. Variations: ○ Closely held corporations: Shareholders often serve as directors and officers. Blurs centralized management but is practical for small businesses. ○ Some states allow corporations with few shareholders to opt out of a board of directors and adopt a partnership-like management structure. 5. Liability Exposure Limited Liability: ○ Shareholders are not personally liable for corporate debts or obligations. ○ Example: MBCA §6.22(b) ensures shareholders are only at risk for the amount invested. Failure Scenario: ○ Shareholders lose their investment in shares. ○ Personal assets remain protected, regardless of management participation. 6. Taxation Subchapter C (C-Corporation): ○ Separate taxable entity: Files an income tax return (Form 1120). Pays corporate income tax at 21%. Distributions (dividends) to shareholders are taxed again on their personal returns (double taxation). Subchapter S (S-Corporation): ○ Pass-through taxation: Profits/losses are allocated to shareholders. Shareholders report their share on personal tax returns (e.g., Form 1040, Schedule E). No corporate income tax, but the corporation must file an informational return (Form 1120S). Key Note: ○ Tax designation (C or S) does not impact corporate governance or liability. Limited Liability Company (LLC) 1. Definition LLC: ○ A business entity created by filing articles of organization (or a similar document) with a state’s secretary of state office. ○ Key Features: Full liability shield for its owners (called members).  Pass-through taxation: Avoids entity-level federal income tax. 2. Governing Law Governed by the law of the state of organization (i.e., where it filed articles of organization). Uniform Limited Liability Company Act (ULLCA): ○ Originally promulgated in 1995, with a revised version (RULLCA) in 2006. ○ As of 2019, 18 states have adopted some version of the RULLCA. Key Advice: ○ Always consult the specific state’s LLC statute as it governs key aspects of LLC operation. 3. Operating Agreement Written Agreement: ○ Known as the operating agreement (or LLC agreement in some states like Delaware). ○ Tailors statutory default rules to meet members' specific needs. Typical Provisions: ○ Management structure: Member-managed or manager-managed. ○ Allocation of profits and losses. ○ Member taxation rules. ○ Transfer of membership interests. ○ Dissolution process. Statutory Limits: ○ Some rules in LLC statutes are mandatory and cannot be overridden by the operating agreement. 4. Management Two Structures: ○ Member-Managed: Default in most states unless otherwise specified in the articles of organization. Resembles partnership-style, decentralized management. All members have authority to manage the LLC. ○ Manager-Managed: Authority is vested in a board of managers elected by members. Resembles corporate-style, centralized management. 5. Liability Exposure Limited Liability: ○ Members are not personally liable for the LLC’s debts or obligations. ○ If the LLC fails: Members risk only their investment in the LLC. Personal assets remain protected.  Uniform Application: ○ All state LLC statutes provide a full liability shield for members. 6. Taxation Multi-Member LLC: ○ Treated like a general partnership for federal income tax purposes. ○ Pass-through taxation applies: Profits/losses flow directly to members. Single-Member LLC: ○ Treated like a sole proprietorship (classified as a disregarded entity by the IRS). ○ Taxation follows the rules for sole proprietors. Key Note: ○ LLC members report profits and losses on their personal tax returns, avoiding corporate double taxation. Other Forms Professional Entity: “PLLP” or “PLLC” or “PC” provide some level of liability protection not owners of professional firms whose professional rules bar them from operating in a form that affords a full liability shield ○ all owners must be licensed to render those specific services that the professional entity offers Close Corporation: Corp. that has elected to be governed by a state’s close corp. statute or provision, by including w/ charter/articles of incorporation a statement such as “this corp. is a statutory close corp.” ○ fixed # of shareholders Nonprofit Corporation: Corp. formed under state’s nonprofit corp. Statute, ○ form is generally limited to companies organized for the public benefit, religious purposed, or the mutual benefit of their members ○ do not issue stock; usually exempt from federal income taxation Benefit Corporation: “B Corp” is a corp. incorporated in a state w/ a benefit corporation statute. Corp files charter/articles of incorporation + provision stating it is a B corp. Exists in 34 states. ○ must have the purpose of creating a general public benefit ○ general benefit = “a material positive impact on society and the environment, taken as a whole, assessed against a third-party standard, for the business operations of a B Corp.” Benefit Limited Liability Company: the unincorporated analog to the B Corp. Only exist in 4 states. Low Profit Limited Liability Company: “L3C” = an LLC whose primary purpose is not profit, but to pursue a socially beneficial purpose. Exists in 11 states Business Trust: business organized under a state’s business trust statute/trust law. ○ Business is managed by trustees pursuant to trust agreement or declaration of trust for the benefit of the business’s owners (“beneficiaries”) o common in mutual funds  Joint Venture: not really a legal concept. When two or more businesses/individuals combine resources to pursue a discrete business opportunity or venture Internal Affairs Doctrine 1. Definition Internal Affairs Doctrine: ○ A choice of law rule that determines which state’s statute governs a business entity’s internal governance. ○ Internal governance includes the rights and duties of owners, managers, officers, and directors. 2. Governing Principle Each state has its own business entity statutes. The applicable statute for a specific business entity is the statute of the state of organization (for LLCs) or state of incorporation (for corporations). 3. Key Consequences Entity Choice: ○ A business can choose the governing state law by selecting the state of organization/incorporation. ○ Example: A company based in Tucson, Arizona, but preferring Nevada’s LLC statute, can organize under Nevada’s LLC statute. The company will be governed by Nevada’s laws, regardless of its physical location or business operations. Certainty and Predictability: ○ Ensures a uniform legal standard for internal governance by applying only the laws of the state of incorporation/organization. 4. Legal Context and Policy Delaware Supreme Court in Vantage Point Partners v. Examen, Inc.: ○ Justification for the internal affairs doctrine in the corporate context: Prevents businesses from being subjected to inconsistent legal standards across jurisdictions. Provides certainty, predictability, and protection of parties’ justified expectations. ○ Only the laws of the state of incorporation govern internal corporate matters. 5. Scope of the Doctrine Applies to:  ○ Relationships among or between: Corporations and their officers, directors, and shareholders. ○ Relationships involving: LLCs, partnerships, and other entities with respect to internal governance. Supported by Restatement (Second) of Conflict of Laws §301: ○ Promotes: Certainty and uniformity of outcomes. Ease of application of legal principles. Protection of justified expectations of parties involved. 6. Broader Conflicts Practice Both state and federal courts consistently apply the laws of the state of incorporation/organization to the entire range of internal affairs. Default vs. Mandatory Rules 1. Definition of Rules Default Rule: ○ Applies unless the parties agree otherwise. ○ Can be altered by agreement between the parties. ○ Example: MBCA §8.08(a) allows shareholders to remove directors without cause unless the corporation's articles of incorporation specify removal only for cause. Mandatory Rule: ○ Applies regardless of a contrary agreement by the parties. ○ Cannot be overridden by contract or agreement. ○ Example: A mandatory rule remains binding unless specified otherwise by law or regulatory authority. 2. Key Characteristics Default Rules: ○ Offer flexibility and accommodate the parties’ preferences. ○ Often identified in statutes by explicit language (e.g., “unless otherwise provided”). Mandatory Rules: ○ Serve public policy objectives. ○ Reflect the drafters’ judgment that certain provisions must be adhered to for fairness or legal compliance. 3. Examples in Statutes RUPA §103:  ○ Generally, RUPA rules are default rules unless specified in §103(b) as mandatory. Corporate Law (MBCA): ○ Example: MBCA §8.08(a): Shareholders can remove directors with or without cause, unless altered in the articles of incorporation. MBCA §8.02: Default rule that directors need not be residents or shareholders unless altered by articles or bylaws. 4. Modifying Default Rules Mechanisms for Overriding: ○ Some rules can be overridden by provisions in: Charter (Articles of Incorporation). Bylaws. Board Resolutions. Levels of Flexibility: ○ Rules requiring amendment of the charter are more “sticky” due to greater formalities. ○ Rules modifiable by bylaws or board resolutions are less “sticky” and easier to change. 5. Purpose and Policy Default Rules: ○ Designed for ease of adoption by most businesses (“off-the-rack” rules). ○ Allow parties to modify provisions to suit their needs. Mandatory Rules: ○ Address public policy concerns. ○ Ensure fairness and compliance even when parties believe alternative arrangements would be more efficient. 6. Working Around Mandatory Rules Parties can sometimes narrow or clarify mandatory rules through negotiation. ○ Example: RUPA §103(b)(4) allows modification of the duty of care but prohibits unreasonable reductions. In some cases, parties may bypass mandatory rules by choosing a different organizational form (e.g., opting for an LLC over a corporation). 7. Practical Implications Legal advisors must: ○ Identify whether a rule is default or mandatory. ○ Understand how specific rules can be altered (e.g., by charter, bylaws, or other means). ○ Consider cost and formalities associated with modifying default rules. Majority vs. Minority Owner Perspective 1. Majority Owner Perspective Control Under Default Rules: ○ In corporations, the majority shareholder (holding a majority of voting shares): Has complete control over the corporation. Can elect and remove the entire board of directors at will. Can reduce the board to a single director and appoint themselves. Implicit Rights: ○ Majority shareholders do not need to alter default rules to secure: Preemptive rights: Right to buy shares in new issuances proportionally. Veto power over corporate actions. ○ These rights are effectively built into their control under default rules. 2. Minority Owner Perspective Lack of Influence: ○ Under default rules, minority shareholders have no guaranteed rights unless negotiated, including: Representation on the board of directors. Preemptive rights to maintain proportional ownership. The right to force the corporation to distribute profits. Driver of Change: ○ To protect their interests, minority shareholders often push for alterations to default rules: May negotiate special provisions as a condition of buying shares. Common protections include: Board representation. Approval rights for major decisions. 3. Implications in Other Entity Forms Partnerships and LLCs: ○ Default rules are generally less favorable to majority owners than in corporations. ○ Majority owners often draft agreements to establish control similar to that of corporate majority shareholders. Customizing Agreements: ○ Partnerships: Changes in partnership agreements can define control, profit sharing, and decision-making. ○ LLCs: Operating agreements often include tailored provisions for management and ownership rights. 4. Strategic Considerations for Clients Majority Owners:  ○ Default rules typically work in their favor, reducing the need for modifications. ○ May draft agreements to cement control and limit minority influence. Minority Owners: ○ Should focus on negotiating changes to protect their interests before investing. ○ Key areas to address: Voting rights and board representation. Profit distributions and buyout provisions. Limitations on unilateral actions by the majority owner. 5. Practical Application Whether to alter default rules depends on whether your client is a majority or minority owner. ○ For majority owners: Maintain or enhance control. ○ For minority owners: Negotiate protective provisions to safeguard their stake. Advisors must: ○ Understand client goals and ownership position. ○ Tailor agreements to reflect the client's role (majority vs. minority). II. Agency Creation of an Agency Relationship 1. Elements of Agency Relationship An agency relationship is formed when the following three elements are satisfied: 1. Principal’s Manifestation of Assent: ○ The principal-to-be communicates (via words, writing, or conduct) intent to associate with the agent-to-be. 2. Agent’s Act on Principal’s Behalf and Subject to Principal’s Control: ○ The agent-to-be agrees to act under the principal’s guidance and authority. 3. Agent’s Consent: ○ The agent-to-be manifests assent to act in this capacity. 2. Definition of Manifestation A manifestation includes: ○ Written or spoken words. ○ Other conduct signaling consent. Example: ○ Monet (the principal-to-be) tells a candidate, “I’d like to hire you to serve as crew chief,” and the candidate nods in agreement. ○ This interaction satisfies the required manifestations from both parties and creates an agency relationship. 3. Agency Relationship in Employment All employees are agents of their employers because: ○ Employment is a consensual relationship. ○ Employees act under the control of the employer (the principal). Authority to Bind: ○ The extent of an employee's authority to bind the employer varies but does not negate the agency relationship. 4. Independent Contractors as Agents Not All Hired Individuals Are Employees: ○ Businesses may hire independent contractors to avoid certain employment laws and reduce costs. ○ Despite this, independent contractors can still be agents if the relationship meets the three elements of agency. Nonemployee Agents: ○ Defined by the Restatement (Third) of Agency. ○ These agents are distinct from employees but still subject to the agency relationship framework. 5. Case Example Priceline.com’s Name Your Own Price Service: ○ Examines whether a platform and its users establish an agency relationship under the defined principles. 6. Practical Considerations To determine if an agency relationship exists: ○ Analyze the manifestations and control in the interaction. ○ Consider whether the agent acts on behalf of the principal. ○ Apply the framework regardless of the label (e.g., employee, contractor). Johnson v. Priceline.com: plaintiffs sued Priceline for breaching a fiduciary duty by failing to disclose that it paid hotels less than consumers’ bids and retained the difference. The court ruled that Priceline did not owe a fiduciary duty because its "Name Your Own Price" service did not create an agency relationship. The plaintiffs relinquished control once they submitted their bids, and Priceline acted as a middleman rather than an agent. The court found that Priceline's promotional materials and the nature of the service did not imply such a relationship, affirming the dismissal of the case. When Is a Principal Bound to a Contract? 1. Basic Agency Law Rule  A principal is bound to a contract made by an agent if the agent acted with actual authority or apparent authority. 2. Actual Authority Definition: ○ Actual authority arises when the agent reasonably believes, based on the principal’s manifestations, that the principal wishes the agent to act on their behalf. Example: ○ Monet (the principal) tells Arroyo (the agent), “I authorize you to charge paint to my account at the paint store.” ○ This grants express actual authority to Arroyo to make purchases on Monet’s behalf. Focus: ○ The principal’s communication to the agent and the agent’s reasonable interpretation of that communication. Implications for Contract: ○ If Arroyo charges paint to Monet’s account, Monet is bound to the contract (i.e., the obligation to pay for the paint). Third-Party Knowledge: ○ Whether Arroyo is bound to the contract depends on the paint store's knowledge: If the store knows Arroyo is acting for Monet, then Arroyo is not personally bound. If the store doesn’t know Arroyo is acting for a principal, Arroyo is personally bound to the contract. Types of Actual Authority: ○ Express Actual Authority: Direct communication by the principal, such as the example above. ○ Implied Actual Authority: Authority necessary to carry out the principal’s express instructions. Example: A crew chief authorized to "run the business" while the principal is on vacation likely has implied authority to sign contracts on behalf of the principal. ○ Implied Actual Authority can also arise from past conduct where the principal’s behavior reasonably suggests authority: Example: Monet’s indifference (shrugging shoulders) to Arroyo’s past charges gives implied authority for similar charges in the future. 3. Apparent Authority Definition: ○ Apparent authority arises when a third party reasonably believes an agent has authority to act on behalf of the principal, and that belief is based on the principal’s manifestations. Example:  ○ Monet calls the paint store and tells the manager, “I have authorized Arroyo to buy paint on my account.” ○ This creates apparent authority, as the paint store (the third party) reasonably believes Arroyo is authorized to act on Monet’s behalf. Focus: ○ Communication from the principal to the third party and the third party’s reasonable interpretation of the communication. Overlap with Actual Authority: ○ Apparent authority and actual authority often coincide. In the example, if Monet told Arroyo she is authorized and also informed the paint store, both actual and apparent authority would exist. Not Always Direct Communication: ○ Apparent authority does not always require direct or unambiguous communication, as illustrated in the following case (not provided here). Taylor v. Ramsay-Gerding: plaintiffs Todd and C.A. Taylor filed a breach of warranty action after rusting occurred on a hotel they were developing, which had used the "SonoWall" stucco system recommended by their general contractor, Ramsay-Gerding. The Taylors had met with Mike McDonald, ChemRex's territory manager, who assured them of the system's reliability and offered a five-year warranty. After the rusting issue arose, the Taylors sued Ramsay-Gerding and ChemRex for breach of express warranty. The jury found in favor of the Taylors, but the Court of Appeals reversed, ruling McDonald lacked apparent authority to issue the warranty. The Oregon Supreme Court, however, held that McDonald did have apparent authority, as ChemRex’s actions, including giving McDonald the authority to handle warranties and communicate using company letterhead, led the Taylors to reasonably believe he could provide the warranty. The Court reversed the Court of Appeals' decision and remanded the case for further proceedings. 4. Reliance Element for Apparent Authority H.H. Taylor Case: ○ The court imposes a reliance element for finding apparent authority, requiring that the third party must reasonably rely on the belief that the agent has authority. Restatement (Third) of Agency: ○ Unlike some courts, the Restatement (Third) does not impose a reliance requirement for finding apparent authority. 2. Apparent Authority Based on Principal’s Manifestation Agent’s Position as a Manifestation: ○ The appointment of an agent to a particular position (e.g., crew chief) constitutes a manifestation by the principal. Example: ○ Monet hires Bose as a crew chief but tells him not to charge paint. Bose wears a shirt identifying him as a crew chief and goes to a paint store where he charges  paint. The store, recognizing him as a crew chief, allows the charge, believing he has authority. ○ Outcome: Monet is bound to the contract because Bose had apparent authority (even though not actual authority). The store knew Bose was a crew chief through Monet’s manifestations (the shirt), and a crew chief customarily has the authority to charge paint. 3. Apparent Authority Broader Than Actual Authority Lack of Actual Authority: ○ The apparent authority of an agent can be broader than their actual authority. Example: ○ Arroyo, a former agent of Monet, is fired but not informed to the paint store. Arroyo continues charging paint to Monet’s account, and the store, unaware of her firing, allows it. ○ Outcome: Monet is still bound because Arroyo had apparent authority based on prior manifestations, despite having no actual authority after being fired. Lingering Authority: ○ If the store knew or had reason to know of the agent’s termination, then apparent authority would not apply. 4. Imputed Knowledge for Organizations Restatement (Third): ○ Organizations possess the collective knowledge of their employees or agents, known as imputed knowledge. Example: ○ Monet could prevent a claim of apparent authority by showing that an employee of the paint store knew of Arroyo's termination, as that knowledge would be imputed to the organization. General Rule: ○ Notice of a fact that an agent knows or has reason to know is imputed to the principal if it’s material to the agent’s duties to the principal. Estoppel Definition of Estoppel: ○ A business can be bound by a contract entered into by an agent lacking both actual and apparent authority if estoppel applies. Restatement (Third) of Agency:  ○ Estoppel applies when a person has not made a manifestation regarding an actor's authority, but the actor’s actions led a third party to reasonably believe they had authority, causing the third party to change position detrimentally. Example: ○ P has two coagents, A and B. B tells T that A has authority to engage in a transaction contrary to P’s instructions. ○ Outcome: P is estopped from denying B’s authority because P knew of the misleading representation and failed to correct it, even though T did not know the limits of A’s authority. Key Difference from Apparent Authority: ○ Estoppel does not require a manifestation traceable to the principal, but it does require detrimental reliance by the third party (similar to the reliance element in apparent authority in some cases). Inherent Agency Power Definition: ○ Inherent agency power refers to the power an agent has by virtue of the agency relationship, even when the agent lacks actual authority, apparent authority, or estoppel. Restatement (Second) of Agency: ○ Courts may apply inherent agency power to hold the principal liable for unauthorized acts of agents if fairness requires it, especially in cases where agents act beyond their authority due to negligence or overzealousness. Purpose: ○ Inherent agency power exists to protect third parties dealing with agents, ensuring fairness and holding the principal accountable for unauthorized acts that may harm others. Example: ○ A partnership or corporation may be held liable for an agent’s actions under inherent agency power, even if the agent acted beyond their authority. Restatement (Third): ○ The Restatement (Third) chose not to use the term “inherent agency power” but noted that the doctrines of apparent authority and estoppel encompass the justifications for holding principals liable in similar circumstances. Principal's Binding to a Contract 1. Definition of Ratification Restatement (Third) of Agency:  ○ Ratification is the affirmance of a prior act done by another, treating the act as if it had been done by an agent with actual authority. ○ Key Concept: A principal can be bound to a contract even when the agent lacked actual authority, apparent authority, or estoppel, through ratification. 2. How Ratification Occurs Manifesting Assent: ○ The principal manifests assent to be bound by the agent’s act. Conduct Justifying Assumption of Consent: ○ Alternatively, ratification can occur through conduct that justifies a reasonable assumption that the principal consents to the act. 3. Example of Ratification Scenario: ○ Arroyo, an employee at Monet’s painting business, knows that Monet is interested in buying a used basket crane for the business. ○ On her way home, Arroyo sees one for sale and believes it’s a great deal but cannot reach Monet. ○ Acting on her own, Arroyo tells the seller she is buying it on behalf of Monet and writes a check for the down payment. Subsequent Action: ○ The next day, Arroyo informs Monet of the purchase. ○ Monet replies, “Thanks for getting me such a great deal!” Outcome: ○ Monet’s response manifests assent to the deal, effectively ratifying Arroyo’s action. Monet is thus bound to the contract under the doctrine of ratification. Entity-Specific Rules: Partnerships 1. General Rule: Partner as an Agent RUPA §301 establishes that each partner is an agent of the partnership for the purpose of conducting its business. Section 301(1): An act of a partner binds the partnership if: ○ It is within the ordinary course of business of the partnership or the type of business the partnership carries on. ○ The partner has authority to act in such matters (actual or apparent authority). ○ Example: If a partner executes a contract on behalf of the partnership within its regular business scope, the partnership is bound, unless the partner lacked authority and the third party knew or was notified that the partner lacked authority. 2. Authority of Partners  Actual and Apparent Authority: ○ A partner is treated as a general managerial agent, having authority to bind the partnership within the scope of the partnership’s ordinary business. ○ No Requirement for Direct Manifestation: For apparent authority, there is no requirement that a manifestation from the partnership itself must reach the third party. The partnership's business is viewed as a general manifestation that partners have authority to bind the partnership. Section 301(2): If a partner acts outside the ordinary course of business, the partnership is only bound if the act was authorized by the other partners. 3. Notification of Lack of Authority Notification to Third Parties: ○ A partnership can protect itself from unauthorized actions by a partner by sending a notification to third parties about restrictions on the partner's authority. ○ Effective Notification: A notification is effective upon delivery, whether or not it is actually received by the third party. Delivery can occur at the third party’s place of business or another place where they accept communications. Example: ○ If a partnership wants to prevent a partner from entering into an unauthorized contract, it can send a notification to the third party about the partner’s limited authority, and this notification will be effective once delivered, regardless of whether the third party reads it. 4. Common Law Application in Partnerships Despite the provisions of RUPA §301, common law agency principles still apply to partnerships. ○ Example: A partnership may manifest to a third party that a partner has authority to act outside the ordinary course of business. Even if such an act is outside the ordinary course, the partnership may still be bound under common law apparent authority. Elting v. Elting: the Nebraska Supreme Court ruled that partners in a partnership are agents and cannot act on the partnership’s behalf without actual authority. The case involved a farm partnership where Kerwin Elting signed focal point contracts (FPCs) with Cargill on behalf of the partnership, claiming he had discussed them with the other managing partners. However, when the partnership suffered over $2 million in losses from the contracts, Perry Elting and his son Knud, who were unaware of the FPCs, sued Kerwin for acting without proper authority. The court found that the partnership agreement required majority approval from all managing partners for such decisions. Despite Kerwin’s claims, the trial court believed Perry and Knud’s testimony that they had no knowledge of the contracts, and their financial projections did not reflect the FPCs. The court held that Perry could not ratify the contracts without actual knowledge of them, affirming the trial court’s decision to award Perry and his family over $1 million in damages. Corporations 1. Shareholders’ Authority Limited Authority of Shareholders: ○ Shareholders in a corporation do not have authority to bind the corporation. They do not act as agents of the corporation. ○ Example: While shareholders may have decision-making authority in certain corporate matters (like voting on major issues), they cannot independently enter into contracts or act on behalf of the corporation. Conferment of Authority: ○ The board of directors or officers of the corporation can confer actual or apparent authority on a shareholder or anyone else. ○ Example: If the board designates a shareholder as an agent, either expressly or by allowing them to act on behalf of the corporation, that shareholder can have authority to bind the corporation. 2. Board of Directors Board’s Role in Decision-Making: ○ Ultimate authority to manage the corporation rests with the board of directors. The board has the power to delegate authority, including appointing executive officers who will manage day-to-day operations. Individual Directors: ○ Individual directors do not have authority to bind the corporation unless acting collectively as a board. An individual director, in their personal capacity, is not an agent of the corporation. ○ Example: A director cannot act alone to sign a contract binding the corporation unless the board has given them specific authority to do so. Board Authority: ○ The board of directors can confer authority on individuals (like officers or employees) to act on behalf of the corporation, but individual directors cannot independently grant authority to others. 3. Officers' Authority Officers as Agents of the Corporation: ○ Officers (such as the CEO or president) of a corporation are agents of the corporation by definition and typically have the authority to bind the corporation in their respective roles.  ○ Corporate Law: This is usually defined by state corporate law or corporate bylaws. MBCA §8.41: ○ Under the Model Business Corporation Act (MBCA), each officer has the authority to perform duties specified in the corporate bylaws or as directed by the board of directors or another officer authorized by the board. ○ Example: The president of a corporation may be authorized to sign contracts and make decisions on behalf of the corporation, subject to the guidelines set by the board or bylaws. 4. Delegation of Authority Authority Hierarchy: ○ Officers typically have the authority to delegate authority to subordinates. This means a subordinate employee, such as an office clerk, might have the authority to make certain purchases for the corporation (like buying office supplies) based on the delegation from higher-ups. ○ Example: The CEO may delegate purchasing authority to a junior staff member, thereby allowing that employee to bind the corporation in limited ways (e.g., buying office supplies). LLCs and Member Authority 1. Authority Rules for LLCs Variability by State: The rules regarding authority within Limited Liability Companies (LLCs) can differ widely depending on the state and the specific LLC's governing documents. Some states follow the RUPA model (as applied to partnerships), while others follow corporate rules or a mix of both. Therefore, state statutes and the operating agreement of the LLC must be consulted to determine the scope of authority of LLC members or managers. 2. Member-Managed LLCs State Statutes: In member-managed LLCs, members may have authority to bind the LLC, but the authority is typically limited to acts that are apparently carrying on the ordinary course of the LLC’s business. This follows the same logic as RUPA with respect to partners. ○ Example: In a member-managed LLC, if a member enters into a contract that is clearly related to the business of the LLC, they are typically authorized to bind the LLC, but the limits on authority can vary based on the operating agreement and state law. 3. Manager-Managed LLCs  State Statutes: In manager-managed LLCs, only managers have authority to bind the LLC, and the authority is similarly restricted to acts apparently carrying on the business of the LLC. Non-managing members generally do not have authority to bind the LLC unless expressly provided in the LLC’s operating agreement. ○ Example: In a manager-managed LLC, only the designated managers have authority to enter into contracts for the LLC, and members without a management role would not typically be able to do so. 4. Examples of State Statutes RULLCA §301(a): Under the Revised Uniform Limited Liability Company Act (RULLCA), specifically §301(a), a member is not an agent of an LLC merely by being a member. ○ Interpretation: This means that, unless explicitly granted authority by the LLC’s operating agreement or other governing documents, a member does not automatically have the right to bind the LLC in any contract or transaction. DLLCA §18-402: Conversely, Delaware Limited Liability Company Act (DLLCA) §18-402 provides that, unless the LLC agreement states otherwise, both members and managers have the authority to bind the LLC. ○ Interpretation: In states like Delaware, unless restricted by the LLC’s operating agreement, members and managers have the authority to act on behalf of the LLC and bind it to agreements. 5. Importance of LLC Operating Agreements Operating Agreements: Since LLC statutes vary, the operating agreement plays a crucial role in determining the specific authority of members and managers. The operating agreement can outline who has the authority to bind the LLC, what restrictions apply, and the scope of that authority. ○ Example: A member-managed LLC may limit the authority of some members or grant certain powers only to specific individuals, while a manager-managed LLC may place more authority in the hands of appointed managers. Ensuring Authority Overview When entering into contracts, businesses must ensure that the person signing the contract on their behalf has proper authority. If a business claims it is not bound by a contract due to the lack of authority of the signatory, a third party may argue against that claim. However, if the business fails to prove the signatory’s lack of authority, the contract may be binding. In the example of a paint store and Monet’s business, Johnson, who has no actual or apparent authority, convinces the store to charge purchases to Monet’s account. The store could eliminate the risk of the charge being unauthorized by confirming Johnson's authority directly with Monet. In practice, this might not always be possible or desirable for businesses. For significant transactions like business acquisitions, ensuring authority is critical. This often involves requiring documents like a Secretary’s Certificate and an Opinion Letter to verify the signatory’s authority. Ensuring Authority in Major Transactions For larger deals (e.g., business acquisitions), the parties will often require certain documents to verify authority: a. Secretary’s Certificate A Secretary’s Certificate is a document signed by the business entity’s secretary, certifying that certain actions were approved by the governing body (such as the board of directors or managers). The secretary ensures that the proper corporate resolutions were passed to grant specific individuals the authority to sign on behalf of the entity. Purpose: This certificate verifies that the board or other governing body has authorized specific individuals (such as the president or CFO) to act on behalf of the business in the transaction. Example: In the case of an asset purchase agreement, the secretary certifies that the board of ABC Corporation has authorized its president, CFO, and executive VP to sign the agreement on behalf of the corporation. The secretary’s certificate is important to prevent issues like forged signatures and to confirm that the necessary resolutions were passed. b. Opinion Letters An Opinion Letter is a legal letter from a law firm representing one party in a transaction to the other party, addressing various legal matters concerning the transaction, including the authority of the individuals signing the agreement. Purpose: The opinion letter is designed to confirm that the individuals executing the agreement have the proper authority, based on resolutions adopted by the business's governing body. Example: In the asset purchase deal, the law firm representing ABC Corporation will confirm that the board authorized specific individuals (e.g., the president or CFO) to execute and deliver the purchase agreement. An opinion letter serves as an additional layer of assurance that the transaction is properly authorized, helping to reduce the risk for all parties involved. c. Statement of Authority RUPA §303: Statement of Partnership Authority Under the Revised Uniform Partnership Act (RUPA), Section 303 allows a partnership to file an optional statement of partnership authority with the secretary of state. This document specifies the actual authority of the partners, meaning it outlines who within the partnership has the authority to bind the partnership in transactions. Key Point: A partner is deemed to have the authority specified in the statement, even if the partner does not actually possess such authority. This is particularly important when the transaction involves a third party that gives value and is unaware that the partner is acting without authority. Real Estate Transactions: If the transaction involves the transfer of real estate, the statement must also be recorded in the relevant office for recording real property transfers. Use in Practice: In significant transactions, it is common for a third party to require a partnership to file a statement of authority. For instance, in an ABC/XYZ transaction, ABC might require XYZ to file a statement confirming that the partners who will be signing documents on XYZ's behalf have the necessary authority. Limitations: The statement can also specify limitations on the authority of certain partners, making it clearer who can and cannot bind the partnership in specific contexts. RULLCA and LLCs A similar provision is available under the Revised Uniform Limited Liability Company Act (RULLCA), which allows for the filing of a statement of authority for an LLC. This serves a comparable purpose to RUPA’s statement of authority but for LLCs. Corporations and State Statutes For corporations, there is no equivalent provision under the MBCA (Model Business Corporation Act) or DGCL (Delaware General Corporation Law). However, some state corporate statutes provide a mechanism to deem certain documents signed by specified officers as binding on the corporation, even if the officers lacked actual authority. Example: California Corporations Code §313: This provision deems documents executed by specific officers (e.g., chairman, president, vice president, CFO, etc.) to be binding on the corporation unless the third party knows the officer lacks authority to sign. Signature Blocks To clarify that an individual is signing on behalf of a business entity (rather than personally), contracts typically include a signature block at the end. Standard Format: The signature block will state the entity’s name, followed by the signature line with the word “By” and the signer’s position below it. This indicates that the individual is signing in their official capacity (e.g., "Joan K. Hernandez, on behalf of ABC Corp."). Purpose: The signature block ensures that it is clear the signer is not personally liable but is acting on behalf of the entity. Liability of Principal for Agent Torts I. Overview of Principal's Liability for Agent Torts 1. Direct Liability: A principal can be directly liable if they negligently hired, trained, or supervised an agent who then committed a tort. ○ Example: A principal negligently hires an employee with a history of violent behavior; if that employee assaults someone, the principal could be directly liable. Legal Justification: Holding the principal liable in this case is based on the principle that the principal's own negligence contributed to the agent’s tortious conduct. The focus is on the principal’s failure to act carefully in hiring or supervising the agent. 2. Vicarious Liability (Respondeat Superior): A principal is vicariously liable if an agent (e.g., employee) commits a tort within the scope of their employment. ○ Scope of Employment Factors: The agent was performing tasks assigned by the principal. The tort occurred while the agent was acting within the scope of duties and under the principal’s control. ○ Example: A delivery driver working within their shift hours and following company instructions when causing an accident is acting within the scope of employment. II. Determining Employee vs. Non-Employee Agent 1. Employee: An agent who works under the principal’s control, providing supervision, tools, and direction. ○ Example: A store manager. 2. Non-Employee Agent: An independent contractor or non-supervised agent, not directly controlled by the principal. ○ Example: A freelance delivery driver. ○ Vicarious liability typically does not apply to non-employee agents. III. Scope of Employment 1. Within Scope of Employment: Acts that are reasonably related to the principal’s business activities. ○ Example: A cashier running an errand during their shift. 2. Not Within Scope of Employment: Personal or unrelated activities. ○ Example: An employee running personal errands during work hours. IV. Principal-Agent Problem and Fiduciary Duties 1. A. The Principal-Agent Problem ○ Definition: The principal-agent problem arises when there’s a conflict between the interests of the principal (e.g., a business owner) and the agent (e.g., an employee). ○ Agent's Behavior: The agent may not always act in the best interest of the principal, prioritizing their own self-interest instead. Example: An employee may take long breaks or steal from the company, acting in their own interest rather than the company’s. ○ Agency Costs: To address the principal-agent problem, principals incur costs to monitor and control the agent's behavior. Monitoring Costs: Expenses related to overseeing the agent’s actions (e.g., punch clocks, surveillance cameras). Bonding Costs: Costs the agent may incur to bond themselves to the principal’s interests (e.g., insurance against theft). Residual Loss: The remaining costs when the principal cannot fully control the agent’s behavior (e.g., slight inefficiencies or dishonesty). 2. B. Fiduciary Duty of Loyalty ○ Agents owe the principal a fiduciary duty to act loyally and in the principal's best interest. ○ The Restatement (Third) of Agency outlines the fiduciary duties of agents, including: No Material Benefit: Agents should not receive benefits from third parties related to their role without principal consent. No Adverse Dealing: Agents should not act against the principal’s interests in transactions. No Competing: Agents should not engage in competition with the principal or assist the principal’s competitors. No Misuse of Principal’s Property: Agents cannot use the principal's resources or confidential information for personal gain. 3. Enforcement: The principal can sue for breach of fiduciary duties if necessary. ○ Example: A manager stealing company funds. Foodcomm International v. Barry: the court ruled that employees who are not officers or directors can still owe fiduciary duties to their company. The case involved Patrick Barry and Christopher Leacy, senior sales representatives at Foodcomm, who secretly planned to create a competing company, Outback Imports, while still employed by Foodcomm. Despite not holding executive positions, their high-level roles overseeing Foodcomm’s dealings with Empire Beef gave them significant authority, creating an agency relationship with the company. The court found that Barry and Leacy breached their fiduciary duties by using Foodcomm’s resources, misleading the company, and secretly working with Empire to form a rival business. Their actions obstructed Foodcomm’s ability to conduct business, justifying the court’s decision to grant a preliminary injunction. The court affirmed that employees in positions of trust can be held to fiduciary duties, even if they are not officers or directors. II. Principal’s Key Duties to Agents  1. Duty of Fairness and Good Faith: ○ Principals must deal with agents honestly and transparently. ○ Includes: Informing agents about known risks of physical harm or financial loss that the agent is unaware of but relevant to their work. ○ Example: A principal warns an agent about dangerous machinery before assigning a task. 2. Duty to Indemnify: ○ Principals are obligated to compensate agents for certain losses or payments made during the agency relationship. ○ Scope: If the agent makes a payment within their actual authority, the principal must reimburse them. If the agent suffers a loss that should reasonably fall on the principal based on their relationship. ○ Example 1: An agent purchases supplies for a principal within the scope of their authority; the principal must reimburse the agent. ○ Example 2: An agent incurs liability while acting on behalf of the principal; the principal may have to cover those losses unless the agent acted wrongfully. What is a Dividend and Distribution? Dividends and distributions are both ways a company can pay money to its owners, but they are slightly different: 1. Dividends: ○ Dividends are payments made to shareholders of a corporation out of the company’s profits. ○ C Corporations typically pay dividends to their shareholders, which are taxed as income on the shareholder’s personal tax return (often at a lower capital gains rate). ○ Dividends are usually paid on a per-share basis, meaning shareholders get more money if they own more shares. 2. Distributions: ○ Distributions refer to payments made to owners of businesses, but they can apply to different types of business structures, like S Corporations, partnerships, or LLCs. ○ Distributions are typically paid out of the company’s profits or accumulated earnings. ○ For S Corporations, the distributions are usually not taxed as salary and can be tax-free up to the amount of the shareholder’s investment in the business.  However, if the distribution is seen as a way to avoid paying salary-related taxes, it could be reclassified as wages and taxed accordingly. In simple terms: Dividends are paid by corporations (especially C Corps) to shareholders and are taxed as income. Distributions are paid by S Corps, partnerships, or LLCs to their owners, and the tax treatment depends on the specific business structure and how much the owner has invested. Tax Treatment in Business Form Selection I. Importance of Tax Treatment Federal tax considerations heavily influence the choice of business form. Key tax issues: 1. Minimizing federal income tax liability. 2. Minimizing federal employment tax liability. 3. Allocating losses among owners. Classification by Entity Type: 1. Multi-owner unincorporated entities (e.g., LLC, LLP): Default to Sub-K but may elect Sub-C or Sub-S (if eligible). 2. Limited partnerships: Default to Sub-K but may elect Sub-C. 3. Corporations: Default to Sub-C but may elect Sub-S (if eligible). 4. Single-member LLC: Default to disregarded entity but may elect Sub-C or Sub-S (if eligible). III. Subchapter S Eligibility Requirements 1. Entity must: ○ Be domestic (incorporated or organized in the U.S.). ○ Have no more than 100 owners (family members can be treated as one owner under IRC §1361(c)(1)(B)). ○ Limit ownership to individuals, estates, certain trusts, or tax-exempt organizations. ○ Prohibit nonresident alien owners. ○ Have only one class of ownership interests, disregarding differences in voting rights. 2. Ongoing compliance: ○ Eligibility requirements must be continuously met to maintain Sub-S status. ○ Violation (e.g., exceeding 100 owners) results in automatic reclassification to Sub-C. IV. Special Tax Rules for Publicly Traded Entities Default classification for publicly traded unincorporated entities is Sub-C unless 90%+ of gross income is “qualifying income” (e.g., interest, rents, capital gains). Public trading includes ownership interest traded on established markets (e.g., NYSE, NASDAQ). Sub-K and Sub-S Taxation: Overview and Example I. Overview of Pass-Through Taxation 1. Pass-Through Taxation Basics: ○ Under both Sub-K (e.g., partnerships) and Sub-S (e.g., S-corporations), income or loss flows directly to owners. ○ The entity calculates its income/loss and allocates it to owners for inclusion in their personal tax returns. 2. Allocation Rules: ○ Sub-S: Allocations are strictly proportional to ownership percentage. Example: A 40% owner receives 40% of the income or loss. ○ Sub-K: Allocations can vary from ownership percentage based on agreements between the owners (details covered in Section A.3.). II. Example of Sub-S Pass-Through Taxation Scenario: ○ Clare owns 100% of Clare’s Conery Inc. (CCI), which is taxed under Sub-S. ○ In 2018, CCI earned $100,000 after paying Clare a $40,000 salary. ○ Clare’s income tax filing status is single. 1. Income Allocation: ○ As an S-corporation, CCI does not pay federal income tax on its earnings. ○ The $100,000 is allocated to Clare and reported on her personal tax return, along with her $40,000 salary. 2. Deductions: ○ Standard Deduction: Clare takes the 2018 standard deduction for single taxpayers ($12,000). ○ Pass-Through Income (PTI) Deduction: Clare qualifies for the 20% deduction on $100,000 of qualifying business income (QBI), reducing taxable income by $20,000. 3. Taxable Income Calculation: ○ Gross income: $140,000 ($40,000 salary + $100,000 pass-through). ○ Deductions: $12,000 (standard deduction). $20,000 (PTI deduction). ○ Taxable income: $108,000 ($140,000 - $12,000 - $20,000). 4. Federal Income Tax Application:  ○ The 2018 federal income tax brackets for single taxpayers are applied to determine Clare's tax liability. III. Additional Considerations 1. Specified Service Trade or Business (SSTB): ○ Certain fields, including law, face additional restrictions and phaseouts on the PTI deduction. ○ These complexities are beyond this summary’s scope. 2. S-Corporation Tax Exceptions: ○ In rare instances, S-corporations may owe taxes (e.g., passive investment income, unrealized built-in gains). b. Sub-K and Sub-S Taxation Both Sub-K and Sub-S enable pass-through taxation, where the business entity calculates its income/loss for the tax year and allocates it directly to its owners, who report it on their personal tax returns. However, allocation rules differ: Sub-S Allocation: Allocations are strictly based on ownership percentages (e.g., 40% ownership = 40% allocation). Sub-K Allocation: Allows for allocations based on agreements rather than ownership percentages. Example 1: Pass-Through Taxation under Sub-S Clare’s Conery Inc. (CCI), an S-corporation, earned $100,000 in 2018 after paying Clare a $40,000 salary. Clare's income includes: 1. Her $40,000 salary. 2. The $100,000 pass-through income from CCI (less applicable deductions). Key Deductions and Taxable Income Calculations: 1. Standard Deduction: Clare takes the $12,000 standard deduction (greater than her $5,000 itemized deductions). 2. Pass-Through Income Deduction (PTI): Clare deducts 20% of the $100,000 pass-through income ($20,000). 3. Taxable Income: ○ $40,000 (salary) + $100,000 (pass-through) - $12,000 (standard deduction) - $20,000 (PTI) = $108,000. Federal Income Tax Calculation: Clare owes $17,040 on the $80,000 taxable portion of the pass-through income: ○ $10,700 @ 12%: $1,284. ○ $43,800 @ 22%: $9,636. ○ $25,500 @ 24%: $6,120.  Combined with her tax on the $28,000 portion of her salary, Clare’s total federal income tax liability increases significantly. Key Takeaways: Marginal rate analysis demonstrates the impact of additional income. Tax liability applies regardless of whether income is distributed to the owner. c. Sub-C Taxation Unlike Sub-K and Sub-S, Sub-C entities are taxed as separate taxpayers: 1. The corporation files a return (Form 1120) and pays a flat 21% corporate income tax (post-2018 reform). 2. Distributions (dividends) to owners are taxed again on the owner's return, often at capital gains rates (e.g., 15%). Example 2: Double Taxation under Sub-C CCI earns $100,000, pays $21,000 in corporate income tax, and distributes the remaining $79,000 to Clare. Clare pays $11,850 (15%) in taxes on the dividend, leaving her with $67,150 after tax. Comparison of Sub-S vs. Sub-C: Sub-S: Clare pays $17,040 in federal income taxes. Sub-C: Combined taxes on CCI and Clare total $32,850. Result: Sub-C’s double taxation costs Clare $15,810 more than Sub-S. Tax Planning Considerations Sub-S taxation is generally more tax-efficient for owners due to the avoidance of double taxation. Sub-C taxation can significantly increase total tax liability, especially if earnings are distributed as dividends. States' tax treatment of S-elections and other nuances (e.g., PTI deduction phase-outs for specified service businesses) must be factored into entity choice. These examples highlight the importance of selecting the appropriate tax structure based on the business's specific circumstances. d. Disregarded Entity Taxation A single-owner LLC is typically treated as a disregarded entity unless it elects to be taxed under Sub-C or Sub-S, provided it meets the eligibility criteria for those tax treatments. A disregarded entity is considered "not separate" from its owner for income tax purposes, meaning:  1. The LLC’s net income or loss is reported directly on the owner’s personal federal income tax return (similar to a sole proprietorship). 2. A single-member LLC (SMLLC) cannot opt for Sub-K taxation because Sub-K applies exclusively to entities with two or more owners. e. Summation When selecting a business entity's tax structure, minimizing tax liability is a key priority for most business owners. Here's how the choices generally stack up: 1. Sub-C Taxation: ○ Disadvantages: Double taxation (on corporate earnings and again on distributions to owners). ○ Result: Sub-C taxation is typically unfavorable and often eliminated as an option unless other business considerations outweigh tax implications. 2. Multi-Owner Businesses: ○ Sub-K versus Sub-S taxation: Both offer pass-through taxation but have significant differences (e.g., allocation flexibility under Sub-K). 3. Single-Owner Businesses: ○ The choice is between disregarded entity taxation and Sub-S taxation. ○ Disregarded entity taxation: Simplified tax reporting, with income and expenses flowing through to the owner’s individual return. Suitable for smaller operations or those prioritizing administrative simplicity. ○ Sub-S taxation: May offer tax benefits, such as eligibility for the 20% pass-through income (PTI) deduction. Allows owners to separate salary income from business profit distributions, potentially reducing overall tax liability. 2. Minimizing Federal Employment Tax Liability Employment taxes, such as Social Security and Medicare taxes (FICA), apply to employee wages and are split between the employer and employee. For 2019, the total FICA tax rate was 15.3% on the first $132,900 of wages and 2.9% on amounts exceeding this threshold. Employers bear half of the cost, while employees pay the other half through paycheck deductions. In contrast, business owners taxed under Sub-K or as a disregarded entity are subject to self-employment (SE) tax, which mirrors FICA but is fully borne by the business owner. For 2019: The SE tax rate was 15.3% on the first $132,900 of income, and 2.9% thereafter.  Owners are responsible for paying the full SE tax, unlike employees who share the burden with their employer. This distinction provides tax planning opportunities, particularly for businesses taxed as Sub-S corporations (Sub-S). Example: Comparing Tax Treatments Assume Gray and Smith co-own AAA Pool Services (APS), which earned $140,000 in net income in 2018. Each owner receives an $80,000 salary, and the net income is distributed equally ($70,000 each). Here’s how their employment tax liability would differ under Sub-K and Sub-S taxation: 1. Sub-K Taxation Tax Base: Each owner pays SE tax on their salary ($80,000) plus their share of net income ($70,000). ○ Total SE Income: $150,000 each. ○ SE Tax Calculation (2019): (132,900×15.3%) + [(150,000−132,900)×2.9%] = 20,829.60 per owner ○ Combined SE Tax: $41,659.20. Employer Cost: $0 (all SE tax is paid by owners). 2. Sub-S Taxation Tax Base: Only salaries ($80,000 each) are subject to FICA tax, while distributions ($70,000 each) are excluded from employment taxes. ○ FICA Tax Calculation (2019): 80,000 × 15.3% = 12,240 per owner ○ Combined FICA Tax: $24,480 (split between APS and owners). Savings Over Sub-K: ○ 41,659.20 − 24,480 = 17,179.20 Planning Considerations Lowering Salaries to Increase Distributions: Gray and Smith could reduce their FICA liability further by decreasing their salaries and increasing distributions. However: ○ The IRS requires reasonable compensation for Sub-S owners. ○ If salaries are deemed unreasonably low, the IRS could recharacterize distributions as wages, leading to back taxes, interest, and penalties. Watson v. Commissioner: In Watson v. Commissioner, the court ruled that money paid to a shareholder as dividends could be reclassified as taxable wages if the reported salary is unreasonably low. David Watson, the sole employee and shareholder of his S corporation, DEWPC, received a modest salary of $24,000 in 2002 and 2003, along with significant profit distributions. The IRS determined that DEWPC underpaid employment taxes and rejected the company’s request for a refund. The court, agreeing with the IRS, found that Watson’s low salary was inconsistent with the market value of his accounting services, which were estimated at $91,044 annually. As a result, the court concluded that the distributions should be treated as taxable wages subject to FICA taxes and upheld the judgment against DEWPC. FICA Taxes (Social Security and Medicare): Wages earned by employees are subject to FICA taxes (Social Security and Medicare), which are split between the employee and the employer. The employee’s share is taken directly from their paycheck. Wages are any money paid for work, but this doesn’t include income from dividends or distributions to owners. Distributions and Dividends: When a business pays dividends or distributions to owners, there are no FICA taxes applied. This is part of what led to the situation in the Watson case, where he tried to take advantage of low salary payments combined with large profit distributions. Withholding Taxes: For employee wages, businesses must withhold federal income taxes, state income taxes, and FICA taxes from each paycheck. However, Sub-K (partnerships) and disregarded entities (like sole proprietorships or single-member LLCs) do not have the same withholding requirements. Allocating and Using Losses in Business 1. Introduction to Business Ownership and Losses ○ Scenario Setup: In many businesses, owners might have different contributions. One owner might have the passion and a great idea but lack money, while the other has financial resources but no idea. ○ Example: Owner 1: You have a great business idea, but no money. Owner 2: Your rich aunt invests $500,000 to help get the business started. Business Entity: You form EFG, LLC. You receive 60% ownership for transferring your idea, and your aunt receives 40% ownership for investing money. 2. Loss Allocation Based on Ownership ○ First Year Losses: You expect the business to lose $300,000 in the first year as you develop the idea. ○ Standard Loss Allocation (based on ownership): You (60% owner) would be allocated $180,000 in losses. Your Aunt (40% owner) would be allocated $120,000 in losses. ○ Impact on Taxable Income: You: Since you have minimal income (just a modest salary from the company), you can’t use all the $180,000 in losses. Your salary and the  standard deduction likely offset all your taxable income, leaving you unable to use the losses. Your Aunt: She has other sources of income from investments. Therefore, she can use the full $120,000 of allocated losses and possibly even the entire $300,000 (since she has enough income to offset them). 3. Tax Implications of Loss Allocation ○ Sub-K Taxation: If the business is taxed as a partnership (Sub-K), it’s possible to make "special allocations" of losses and profits that differ from ownership percentages. This can benefit the party with the higher income (your aunt in this case) to maximize tax benefits. ○ Sub-S Taxation: If the business is taxed as an S-corporation (Sub-S), losses must be allocated strictly according to ownership percentage. Special allocations are not allowed under Sub-S. 4. Choosing the Tax Structure for Flexibility ○ To implement special allocations, your business would need to be structured as a partnership or LLC (an unincorporated entity taxed under Sub-K). This gives you the flexibility to allocate losses in ways that benefit the owners most effectively. ○ A business taxed under Sub-S (an S-corporation) does not allow for special allocations; profits and losses must be shared based on ownership percentages. 5. Special Allocations in Sub-K ○ Special allocations allow profits and losses to be distributed based on a method other than ownership percentage. However, such allocations must meet certain requirements to be valid. ○ Important Legal Requirement: To ensure that a special allocation is recognized by the IRS, it must have substantial economic effect. This means the allocation must be made for real economic reasons (like different levels of investment or risk), not just for the purpose of minimizing taxes. 6. Substantial Economic Effect (SEE) ○ Definition of SEE: For an allocation to have substantial economic effect, it must be based on actual economic arrangements between the partners. If an allocation is made only for tax-saving purposes and does not align with the economic realities of the business, the IRS will disregard it. ○ Example of Valid Allocation: Partner 1 (you): Contributes an idea, but lacks cash. Partner 2 (your aunt): Contributes money and agrees to receive 90% of the profits/losses for the first year because she’s the one with the capital. This is seen as valid because it reflects the fact that your aunt has more money invested and assumes more financial risk for the first year. ○ Example of Invalid Allocation: If you both contribute equal amounts but agree that your aunt gets 90% of the profits and losses only for tax reasons (because she’s in a higher tax bracket), this doesn’t have substantial economic effect. The IRS would likely disregard this allocation. 7. IRS Rules on Special Allocations ○ If the IRS determines a special allocation does not have substantial economic effect, it will:  Ignore the special allocation and require that profits and losses be allocated according to ownership percentage. This means the hot dog stand partners would need to file their taxes with a 50/50 split of losses and profits, despite any agreement made in the operating agreement. Liability Exposure in Business Form Selection I. Introduction to Liability Exposure Definition: Liability exposure refers to the risk of personal responsibility that business owners face for the business's obligations. Two Aspects of Liability Exposure: 1. Inside Liability Exposure: The personal liability of the owners for the business’s obligations. 2. Outside Liability Exposure: The ability of creditors to recover from the business’s assets. II. Inside Liability Exposure A. Overview of Inside Liability Exposure ○ The extent to which business owners are personally liable for the business’s debts and obligations varies depending on the legal structure of the business. ○ Business forms with different levels of liability protection: 1. Corporations & LLCs: Provide full protection to owners from inside liabilities. 2. LLPs (Limited Liability Partnerships): Offer full liability protection for most states but have partial liability protection in certain states (Louisiana, South Carolina). 3. Limited Partnerships: Provide liability protection to limited partners, but general partners do not have liability protection. 4. General Partnerships & Sole Proprietorships: Offer no protection against inside liabilities — owners are fully liable. ○ B. Detailed Business Form Protection 1. Corporations & LLCs: - Provide comprehensive inside liability protection to all owners. - Protection is uniform across all states, offering consistency. 2. Limited Partnerships (LP): - Limited partners have full liability protection, but general partners are fully liable. - In many states, the protection for limited partners may be compromised by the “control rule,” which holds that if limited partners exercise too much control, they may lose their liability shield. Historically, some businesses used a corporate general partner to shield both general and limited partners. 3. Limited Liability Partnerships (LLPs): - Typically, LLPs offer full liability protection for partners, except in a few states (California, Oregon,  New York) where they are restricted to professional practices (law, medicine, accounting). Some states have partial-shield laws that may limit the liability protection of partners in LLPs. ○ States with partial-shield laws may not honor liability protection if a business operates in a state that provides full liability shields. 4. General Partnerships & Sole Proprietorships: - No liability protection is provided to the owners. They are fully liable for business debts and obligations. ○ C. Effect of State Laws on Liability Protection - Professional Practice Restrictions In some states, only professionals can use LLPs, which limits the liability shield for non-professionals. Partial Shield States: States like Louisiana and South Carolina may provide limited liability protection for LLP partners. ○ In general, corporations and LLCs offer the best protection across the United States. III. Veil Piercing: Exceptions to Liability Protection A. Definition of Veil Piercing - Veil Piercing: ○ A legal concept where courts disregard the limited liability of an entity (like a corporation or LLC) and hold the owners personally liable for the business's obligations. ○ Veil piercing is an exception to the limited liability offered by entities like corporations and LLCs. B. Factors Leading to Veil Piercing ○ There is no specific formula or bright line test for when veil piercing occurs, but courts often consider the following factors: 1. Fraud or Misrepresentation: If the business is used to perpetrate fraud or deceive creditors, the court may pierce the veil. 2. Undercapitalization: If the business is intentionally underfunded or inadequately capitalized to avoid paying debts, it may lead to veil piercing. 3. Failure to Follow Corporate Formalities: If the business fails to maintain necessary legal documents and formalities (like keeping separate financial records or holding regular meetings), it can increase the likelihood of veil piercing. 4. Alter Ego Doctrine: If the business is essentially an extension of its owners, with no distinction between the owners’ personal and business activities, veil piercing may occur. C. Court's Discretion in Veil Piercing ○ Veil piercing decisions are based on the facts of the case and the court’s interpretation of whether the business is being used to evade liability. ○ There is no one-size-fits-all approach, as courts evaluate whether the limited liability is being abused.  ○ Despite the legal protections offered by LLCs and corporations, veil piercing remains a significant risk in extreme cases. D. Conclusion on Liability Protection ○ While entities like corporations and LLCs provide the best inside liability protection, they are not foolproof. To maintain full liability protection, it is important to follow legal formalities, maintain proper capitalization, and avoid using the entity to perpetuate fraud or other abuses. Baatz v. Arrow Bar: In 1982, Kenny and Peggy Baatz were injured when their motorcycle was struck by Roland McBride, who had been served alcohol while intoxicated at the Arrow Bar. McBride was uninsured, so the Baatzes sued the bar and its owners, Edmond and LaVella Neuroth, arguing the bar's negligence contributed to the accident. The Baatzes also sought to hold the Neuroths personally liable, either directly for serving alcohol or through piercing the corporate veil of Arrow Bar, Inc. The South Dakota Supreme Court upheld the trial court’s decision to dismiss the Neuroths as individual defendants. The Court found no evidence that the Neuroths directly served McBride alcohol or were personally involved in the violation of liquor laws. Additionally, the Court ruled that piercing the corporate veil was not justified, as there was no proof of fraud or misrepresentation. Simply being involved in managing the corporation or guaranteeing its obligations was insufficient to hold the Neuroths personally liable. Inside Liability Exposure Usually used in an “asset protection” industry; generated inside the company - the owners face liability! Corp/LLC: full inside liability shields to all owners regardless of the state of incorporation or organization. ○ all owners personally liable for business’s debts (class notes) LLP: most states provide full inside liability shields; LA and SC provide only partial shields LP: most states afford limited partners with full liability shields, but it can be lost under the control rule ○ limited partners: limited ○ general partners: personally liable GPs/Sole Proprietors: no liability shield regardless of the state of organization; partners personally liable When can owners be liable despite a shield? ○ 1. Piercing the veil ○ 2. Direct involvement of individual in act or omission giving rise to claim ○ 3. Statute or contract imposing individual liability Outside Liability Exposure I. Introduction to Outside Liability Exposure Definition:  ○ Outside liability exposure refers to the ability of creditors of an individual owner to recover the debts from the business's assets. ○ It concerns how creditors can access business assets when personal debts are owed by the owners. Importance of Business Structure: ○ The legal form of the business (corp