Business Organizations (Class Nineteen) PDF

Legal and Ethical Environment of Business Class Nineteen: Business Organizations Basic Types of Business Organizations: 1) Sole Proprietorships 2) Partnerships a) General Partnerships b) Limited Liability Partnerships 3) Corporations a) Class C Corporations b)...

Legal and Ethical Environment of Business Class Nineteen: Business Organizations Basic Types of Business Organizations: 1) Sole Proprietorships 2) Partnerships a) General Partnerships b) Limited Liability Partnerships 3) Corporations a) Class C Corporations b) Subchapter S Corporations c) Closely Held Corporations d) Professional Corporations e) Limited Liability Corporations 4) Other a) Joint Ventures b) Franchises Business Organizations (continued): We will consider all of these forms of business organizations and discuss the advantages and disadvantages of each type. In our analysis we will focus on: 1) Ease or Difficulty of Formation 2) Tax Consequences 3) Liability of Owners 4) Length of Existence 5) Ease or Difficulty of Transfer Sole Proprietorships: Sole Proprietorships – involves only one person and the easiest to form. Once a person starts conducting business, there is a sole proprietorship. No filing or registration required or charter to obtain from the state No formal documents to prepare describing business operations, etc. Tax “pass-through” meaning the business is not separately taxed No shield or protection from liability, personal liability exists General Partnership: General Partnership – an unincorporated association of two or more co-owners who operate a business for profit. Very easy formation. Actually, the default status for two or more people that do not know any better Tax “pass-through” with profits reported on individual tax returns Individual liability for debts and claims against the partnership even if the debt or claim was caused by another partner Unless there is an agreement otherwise, the partners share equally the profits of the business Unless there is an agreement otherwise, the partners share the management duties of the business Raising capital is more difficult. Since not a corporation the business can not sell stock and must rely on the individual contributions of the partners Partnership interests can not be transferred/sold, etc without the permission of the other partners Limited Liability Partnership: Limited Liability Partnership – another form of partnership that maintains certain benefits but also limits the personal liability of the partners Easy to form Maintains the tax “pass-through” to individual partners and it is not taxed separately Partners are NOT liable for the debts and claims against partnership Does require filings to create with the state Regular filings required and ordinarily there is strict compliance required Example: Joe and Bill form a limited liability partnership by filing all the required documents with the state. For the first two years they also file the annual reports and other docs required. The third year they do not and in the fourth year the partnership is sued by a third party. Because they were not in good status by failing to file, the Courts held that no limited liability partnership existed, and they were each personally liable. Corporations: Corporations – a formal organization that is created (incorporated) by the state. General corporations are class C corporations. These organizations: Corporations can be expensive to form and maintain Their primary aspect is that there is NO LIABILITY to shareholders/owners of the corporation. The corporation itself may be liable for debts and claims, but not the owners. The primary disadvantage of a class C corporation is that it is double taxed. The corporation is taxed on profits and when profits of the corporation are distributed to individual shareholders, it is taxed again Transferability is relatively simple as owners can freely come and go simply by buying or selling shares of stock in the company Subchapter S Corporations: Subchapter S Corporations – sometimes simply called “S corps”. These types of corporations have the best of both worlds: Individual shareholders/owners are NOT LIABLE for the debts or claims against the S corp, although the S corp is. Profits of the S corp do “pass-through” directly to the owner/shareholder and the S corp itself is not separately taxed But there are limitations on who can form an S corp a) There is a limit of 100 shareholders b) There can only be one class of stock c) Shareholders must be individuals, estates, charities, pension funds or trusts and not partnerships or corporations d) All shareholders must be citizens of the US or entities located there e) All shareholders must agree the business is to be an S corp Close Corporations: Close Corporations – these corporations are designed to protect small business owners and are somewhat similar to S corps. Typically has a small number (50 or less) of shareholders There is usually protection of the minority shareholders. Example: Since these corporations have few shareholders and little stock it is difficult if not impossible to sell the stock as there is no real market. It would be easy for the majority shareholder(s) to mistreat the minority. Therefore, close corporations usually require that the majority have a fiduciary duty to the minority. In addition, many also require that corporate action be done only on a unanimous vote Ordinarily shareholders operate the business themselves Transferability may require that existing shareholders be offered the first option to purchase shares of a shareholder that wants to sell Often these corporations may operate without a formal Board of Directors and office holders Professional Corporations: Professional Corporations – also known as PCs, these organizations are still around but newer options may prove better for new formations. They are primarily used by groups such as doctors and lawyers that wanted to limit liability. There is NO LIABILITY for the actions of other members of the corporation. Example: four doctors form a professional corporation. Doctor 1 performs surgery on the wrong foot and the patient wants to sue. The patient has to sue the professional corporation and can not sue Doctors 2, 3 and 4. Unlike a partnership where Doctors 2, 3 and 4 would be liable for the malpractice of Doctor 1. All shareholders must be members of the same profession. Thus, the four doctors are the only ones that can own stock. The executive director of the professional corporation (that is not a licensed doctor) can not. Taxation of the professional corp and its shareholders is very complex Limited Liability Company Limited Liability Company - this business form is the best of both worlds Relatively new form of business first created in 1977 in Wyoming Most other states established them in 1991 Owners of the LLC have no personal liability, only the LLC There is no double tax like a Class C corp, there is a “pass-through” Very easy to create with little annual paperwork to maintain But should have a well-planned operating agreement that addresses duties, percent ownership, transfer of interest, etc Flexibility of ownership with other businesses having the option to be members of the LLC; example- a Class C corporation may be an owner of a LLC; a partnership may be an owner of an LLC, etc. The duration of an LLC is perpetual unless the operating agreement provides otherwise Limited Liability Companies (continued): Limited Liability Companies – while one of the primary benefits of an LLC is that members are free of personal liability, there are a few situations that a Court may “pierce the corporate veil,” (allow for individual liability): a) Failure to Observe Formalities – if the member does not observe the distinction between their individual status and the status of the LLC or if the member does not treat the LLC like a separate organization. Example: If an individual member enters into a contract with the LLC, they should put it in writing and observe all formalities. Otherwise, a Court may simply determine that the LLC is a mere shell and not really a separate entity Limited Liability Companies (continued): Limited Liability Companies – more reasons to pierce the corporate veil. b) Commingling Assets – owners need to keep their personal accounts separate and distinct from the assets of the LLC. If a Court can not determine the owner, it will most likely pierce the corporate veil. c) Inadequate Capitalization – if the owners of the LLC do not contribute enough money to the LLC to reasonably operate it, then the Court may require further contributions from the members. d) Fraud – a Court will not allow a member to use the protection of an LLC as a shield against liability for their own wrongdoing. Example: Joe started a business in his garage selling plants. He formed an LLC with himself as the only member with an official address the same as his home address. Joe contact a nursery and bought $50,000 worth of plants to sell by paying $5,000 downpayment and financing the remainder with the nursery. The owner of the nursery had not taken Business Law and did not know to get a security interest in the plants. After a couple of months, Joe realized that selling plants was hard and nobody really liked the ones he was selling. But before Joe shut down the business, he purchased a new computer on credit for $2,000. Joe was the only employee of the business. Joe decided to shut down the business which had no money in the LLC accounts. The Nursery and the computer store both sue the Joe for the debts owed on the plants and the computer. Joe responds that the LLC bought the products and has not money, so there is nothing to get. The Nursery and the computer store claim that the Court should pierce the corporate veil and hold Joe personally responsible. What is the likely result? The Test Applied to Determine Whether to Pierce the Corporate Veil of an LLC: 1) Did the defendant (individual or owner) control the LLC? 2) Did the defendant engage in improper conduct? 3) As a result of the improper conduct, was the plaintiff (lender or creditor) unbale to collect from the LLC? If the answer is YES to all three questions, the Court will likely pierce the corporate veil and determine that Joe is personally liable. Joint Ventures: Joint Ventures – a joint venture is simply a partnership for a limited purpose. The liability for taxes and debts is shared among the participants in the venture, like it were a partnership. Once the venture is over, the business relationship ends Often it is simply a partnership between two businesses that recognize they can profit by working with each other, without the need to actually merge. The partners maintain their independence Franchises: Franchises – although not specifically a separate business formation, franchises are an important concept. There are over 750,000 franchised business outlets that employ almost 10,000,000 people. A franchise combines the best of both worlds by allowing the franchisee to be a relatively independent owner with the advantage of working as part of an existing business. EX: a McDonalds franchise in a small town allows the franchisee to own and operate the day-to-day business with all the existing logos, food products, personnel policies, etc of a long- standing national corporation. The franchisee also receives a continuing level of support and national advertising from the franchisor. Most franchises have a detailed operating manual. Some Drawbacks to a Franchise: 1) Control – some franchisors exert fairly tight control over their franchisees that may interfere with the franchisee’s desire to be relatively independent. 2) Cost – costs can be very high, especially at the beginning. a) Upfront costs are usually several thousand dollars at a minimum and over a million or more. McDonald’s franchisee applicants must have a minimum of $500,000 available in liquid assets and pay a $45,000 franchise fee. Those looking to launch a new McDonald’s franchise can expect to shell out between $1,314,500 and $2,306,500. Existing franchise operations can cost upwards of $1 million. More Drawbacks to a Franchise: b) Royalty Fees are ordinarily required to be paid back to the franchisor as a percentage of gross sales. c) Supplies such as the food packaging, napkins, drink cups, etc, are often manufactured by the franchisor and the franchisee must purchase the products from them. d) Joint advertising. Also common is when the franchisor engages in national or regional advertising, the franchisee may be required to contribute to those costs and expenses. e) System Standards. In order to maintain a uniform look and modern image, franchisees are also ordinarily required to update their buildings and change furniture, counters, etc. which can cost substantial sums. Legal Requirements for a Franchise: The Federal Trade Commission has a Franchise Rule to protect would be franchisees. The rule requires that 14 calendar days before a franchise contract is signed or any money is paid to the franchisor, the franchisor must provide a copy of their Franchise Disclosure Document. This document sets out, at a minimum, the following: 1) History of the franchisor and its key executives 2) Litigation with franchisees 3) Bankruptcy filings by the company and its officers and directors 4) Costs to buy and operate the franchise 5) Restrictions, if any, on suppliers, products and customers Franchise Disclosure Document (continued): 6) Territory that the franchisee may operate 7) Business continuity explaining what circumstances the franchisor can terminate the franchisee and the franchisee’s rights to renew or sell 8) Franchisor’s training program 9) Required advertising expenses 10) A list of current franchisees and those that have left in the prior 3 years 11) A report on prior owners of stores that the franchisor has reacquired 12) Earnings information is not required, but if disclosed, the franchisor must reveal the basis for this information 13) Audited financials for the franchisor 14) A sample set of the contracts that a franchisee is expected to sign