General Understanding of Corporate Form and Transactions

What is a Business Organization?

Before discussing and understanding international organizations, or multinational enterprises as they are sometimes called, we first need a cursory review of more basic concepts of business organizations. This chapter will discuss some key structures of business organizations, as well as the advantages and disadvantages of both. Having a peripheral understanding of these concepts establishes the groundwork for understanding multinational enterprises.

For example, assume that two people, together, create an organization called Business A. Business A needs office space, therefore, it is Business A that enters into the office leasing agreement, Business A that purchases the equipment and furniture, hires employees, pays for the software, and collects revenues. When Business A applies for a loan or a credit card, it is the credit score of Business A, not the credit score of the owner or their business partner, that matters. In other words, the entity the individuals created that is engaged in the business is separate from the individuals, its founder, and owners.

Basic Facts:

The business has a birthplace – that is the place it was created, registered, or incorporated in. The business has a place of residence (or “citizenship”) – a place where it “lives.” Sometimes this is the “principal place of business,” which is essentially the main location where the entity operates. The “resident location” of a business organization can be a complicated analysis, and determining it is a rather essential matter. The primary reason for this is that the place of incorporation and place of residence of a business can be very important factors in determining everything from the laws that control the operations of that business to the taxes that it pays.

A Business organization has constituents as well. Constituents are people and organizations to which the business answers. These constituents include:

• Owners, such as Shareholders, members, or partners
• Managers, including executives and board members
• Employees
• Customers
• Partners, contractors, and other third-party affiliates
• The Public
• The Government

Finally, business organizations have rights, liabilities, obligations, limitations, and lots of other characterizations that parallel those of their human founders/owners/operators, but are, or should be if the corporation is engaged in good governance, distinct from those individuals. The remainder of this chapter will on this final element of business organizations, the rights and liabilities of corporations. Most often, the privileges and duties, or the rights and liabilities, of a business depend on the type of entity that is created.

Corporations

The corporate entity is the most complex and the most administratively burdensome type of all business organizations. It also has the greatest variance in size, ranging from one to millions of owners.

As discussed earlier, a corporation is a “legal person” – a separate legal entity from its founders, owners, and managers. Therefore, corporations are treated as artificial persons created by the government. This means they can sue or be sued in their names, enter into and enforce contracts, hold title to and transfer property, have bank accounts, be found civilly and criminally liable for violations of law, etc. As such, corporations must comply with a wide variety of laws, not just the federal and state corporate laws, but also federal and state securities laws, antitrust laws, banking laws that regulate how corporate securities are issued and sold, to laws that govern requirements of fiduciary conduct such as requiring corporations to make full disclosures to shareholders and investors.

Ownership, Stock, and Basic Corporate Structure

The owners of corporations are called shareholders or stockholders. The portion of the corporation that each shareholder owns depends on the percentage of stock they hold. For example, if a corporation has issued 100 shares of stock, and an investor owns 30 shares, that investor owns 30 percent of the company (corporations often issue different classes of stock, each with its rights, capabilities, and limitations, but we will not explore that here).

To have an operating and functioning corporation, the shareholders must establish officers and directors. The officers are the executives that run the corporation’s day-to-day affairs, such as the CEO and CFO, while the directors are primarily from outside the corporation and are legally responsible for governing the corporation and its finances, overseeing the CEO, and setting strategic direction. The board also approves the distribution of income to shareholders in the form of cash payments called dividends.

A corporation has express and implied powers. Express powers are established by the law (either through statutes or common law) and through the corporation’s governing documents, such as its bylaws. Generally, such powers include:

• Purchase, own, lease, sell, mortgage, or otherwise deal in real and personal property;
• Make contracts;
• Lend and borrow money;
• Incur liabilities;
• Issue notes, bonds, and other obligations;
• Invest and reinvest funds; and
• Sue and be sued in its corporate name.

Corporations also have other ordinary and implied powers, such as opening a bank account and reimbursing their employees for expenses.

The Benefit of Incorporating

The corporate form of organization offers several advantages, including limited liability for shareholders, greater access to financial resources, specialized management, and continuity of existence.

The most important benefit of incorporation is the limited liability to which shareholders are exposed: As long as the proper corporate form has been maintained, owners (stockholders) and managers of corporations are not responsible for the obligations of the business, and they can lose no more than the amount that they have personally invested in the company. In other words, if the corporation is unable to pay its debts or goes bankrupt, the creditors can only pursue recovery of their money from the assets of the corporation, not the personal assets of the owners (shareholders) or managers (officers, or directors).

This protection comes with obligations and limitations, however, particularly vis-à-vis officers and directors: because they act on behalf of the corporation, they owe significant legal duties to the company. These duties are typically broken down into two categories. The “Duty of Loyalty” prevents officers and directors from engaging in self-dealing or taking corporate opportunities for themselves, and the “Duty of Care” requires them to make informed decisions that serve a rational and legal business purpose. As long as the officers and directors are acting within the parameters of these duties, their decisions, even really bad ones that might cost the corporation, are protected as “business judgments.” That means their personal assets cannot be touched by any creditors, even if their mistakes cost the corporation and the corporation does not have enough assets to satisfy the creditors. This protection is called the “Business Judgment Rule.”

Therefore, the legal concept of the “Business Judgment Rule” essentially protects the officers and directors of a corporation from any personal liability relating to the actions they take on behalf of the corporation, as long as those actions are deemed to be properly made in the scope of their duties. What does it mean for actions to be properly made in the scope of the duties of officers and directors of the corporation?

First, they must be “disinterested,” meaning directors and officers cannot engage in self-dealing and need to make sure their decisions benefit the corporation as a whole, not just themselves personally.

In addition, to be acting within the scope of their duties, the officers and directors must take “reasonable due care” to make sure they are informed of the various issues relating to the decision. They cannot abuse their discretion –decisions should be made on a rational basis, otherwise, they are not protected.

And, as nearly always in the law, officers and directors must be acting in “good faith” for their actions to be deemed within the scope of their duties. In other words, if the executive is acting with bad intentions towards those to whom they owe a duty, then there is no protection offered for their decisions.

Courts can ignore the business judgment rule if officers and directors are not acting in the scope of their duties as set forth above, but other circumstances might lead such actors to be responsible for the corporation’s losses, and many of those are mere formalities such as commingling of corporate assets with personal ones or leaving the corporation with inadequate capitalization. Therefore, in addition to acting within the scope of their duties, to avoid personal liability for business decisions, it is important that officers and directors:

• Follow the proper corporate procedures;
• Do not commingle funds;
• Do not under-capitalize;
• Do not go against their conscience or let others push them to do anything they do not think they should do; and
• Do not obtain personal benefits through corporate work other than normal compensation and benefits.

Other Incorporation Advantages

Besides limited liability, there are other advantages of corporations.

Financial Resources: By incorporating, a business can raise funds and assets through the sale of shares. This way, as the corporate entity expands and requires additional resources to operate and compete globally, it can gain access to them through selling shares, even if the entity is not profitable. Being incorporated also provides advantages in obtaining debt through bank loans. Note, however, that if the entity is smaller in size and requires guarantees from its owners and/or managers to obtain debt financing, this could obligate those individuals to repay the debt should the corporation fail to do so.

Specialized Management: Any entity can hire talent; however, due to the unique benefits of corporations and their ability to offer greater benefits, corporate entities can attract more skilled employees than some other types of corporate/business entities such as sole proprietorships. Recruiting and retaining this talent, however, can be a challenge and depends on the culture of the organization.

Continuity and Transferability: As discussed earlier, corporations have a legal life distinct and separate from their founders, owners, and operators. As a result, they can live forever. Cigna (the insurance company), Jim Bean (whisky manufacturer), and JP Morgan Chase were all formed in the 1790s, within two decades of America’s independence from Great Britain, and all remain “alive” today. Transferring ownership is not difficult, because shareholders sell their shares to new buyers, a transaction that can now be done at the touch of a button in the case of public corporations.^[1]A founder or majority owner can choose to restrict the transfer of their stock and operate as a privately held entity, owned by a handful of people and not available for sale to the general public.

Disadvantages of Incorporation

There are, however, drawbacks to incorporating as well. This section will explore three key disadvantages.

Double Taxation. Corporations are taxed by the federal and state governments on their profits. Corporations also distribute dividends to shareholders from their profits, the very profits which were already taxed, and those dividends are then separately taxed. In other words, when a corporation generates a profit for the year and distributes that profit to shareholders as a dividend, the same profits are first taxed at the corporate level, then again upon their receipt by the recipients of the dividends at the individual level. There are, however, lots of legal methods corporations can use to minimize tax income and avoid double taxation.

Diverging Interests. Unlike sole proprietorships and partnerships, corporate owners (the shareholders) and managers (the executives and directors) are not necessarily the same. To the extent when situations arise where their interests diverge, and they sometimes do, this structure can present challenges. Managers, for example, might be more interested in career advancement than the overall profitability of the company. Stockholders might care about profits without regard for the well-being of employees.

Government Regulation. Regardless of where one sits on the need for more or fewer regulations, the fact remains that corporations are subject to levels of regulation and governmental oversight that can place a burden on small businesses.

Classifications of Corporations by Purpose

 

A Non-Profit Corporation is an organization formed to serve some public purpose rather than for financial gain. As long as the organization’s activity is for charitable, religious, educational, scientific, or literary purposes, it should be exempt from paying income taxes. Additionally, individuals and other organizations that contribute to the not-for-profit corporation can take a tax deduction for those contributions. The types of groups that normally apply for nonprofit status vary widely and include churches, synagogues, mosques, and other places of worship; charitable enterprises; museums; schools; and conservation groups.

A Public Corporation is formed to meet a specific governmental or political purpose. Sometimes this term of art is confused with a corporation that has “gone public,” but the two are very different things. A public corporation meets a governmental purpose, but a publicly held corporation is a corporation that has many shareholders, and its securities are often traded on national stock exchanges.

A private corporation, as opposed to a public one or publicly held one, is formed to conduct privately owned business for profit. And in terms of ownership, the purchase of stock in such entities is not readily available to the public at large through stock exchange markets but must be negotiated as one-off deals with the corporate powers.

There are also Professional Corporations that offer professional services. For example, these are formed by lawyers, doctors, or other professionals.

There are also Closely Held Corporations. These are corporations owned by one or very few shareholders. These are very similar to partnerships. Often, Close Corporations do not need to comply with securities laws, unlike larger and publicly held entities, and otherwise easier to govern and less controlled than larger and publicly held entities.

Lastly, there are also Small or “S” Corporations. These are single taxation entities that are limited to 100 shareholders but are typically solo-owned.

In addition to the above “types” of corporate entities, such entities can also be classified by where they are incorporated. There are three basic types, if we divide them by the location of incorporation.

Location of Formation/Operations	Description
Domestic	A corporation is a domestic corporation in the state in which it is incorporated
Foreign	A corporation is a foreign corporation in states other than the one in which it is incorporated
Alien	A corporation is an alien corporation in the United States if it is incorporated in another country

In summary, corporations are immortal beings, they have shareholders, directors, officers, and employees, they “exist” in one particular state, and they have shareholders who vote and elect their directors. The directors of a corporation, which together form the “board of directors” must meet regularly, vote to approve or disapprove actions, and must have meeting minutes that reflect what occurred during the meeting. The officers set the strategic direction of the corporation while executing the orders of the Board and operating the day-to-day affairs of the entity.

The main advantage of incorporating is limiting the liability of the owners and managers. However, most formations have double taxation, that is, the corporation is taxed on its profits, and its owners are taxed on any of those profits that are distributed to them as income.

Partnerships

A partnership is a for-profit business organization comprised of two or more people. Under various state laws, “persons” can include individuals, groups of individuals, companies, and corporations. So, a partnership can become quite a complex entity, depending on the ownership structure.

Each partner shares directly in the organization’s profits and shares control of the business operation – but how much liability versus profit versus control they each have depends on the terms of the partnership agreement.

Creating a Partnership

A “partnership agreement” defines the rights and obligations of the partners.

It is important to note that nearly all of the respective rights and obligations of the partnership can be contracted around. This means two partners in a partnership could agree that one partner keeps 70% of the profits, but only bears 30% of the liabilities – if that is the arrangement those partners choose. Indeed, this is not an outrageous example. Perhaps one partner is investing the seed capital needed for starting the business, and in exchange for that investment, it is agreed that their liability is limited while their profits are maximized.

What happens if there is no partnership agreement? The existence of a partnership can be implied even if there is no contract between the two partners. Courts will “imply” a partnership exists, by looking at factors such as (1) intention of the parties, (2) sharing of profits and losses (3) joint administration and control of business operation, (4) capital investment by each partner, and (5) common ownership of property.

How are the rights and obligations of the partners defined if there is no partnership agreement? Generally, courts look at the defaults set out under the Partnership Act of the particular state where the partnership exists. The creation, organization, and dissolution of partnerships are governed by state law. Note that many states have adopted the Uniform Partnership Act, (LLI Uniform Business) which sets out a lot of these defaults.

But again, remember that the parties to a partnership contract can, nearly always, reach agreements on how to divide up the rights and obligations between them regardless of what default divisions exist under the Uniform Partnership Act or the partnership act of any particular state.

The Uniform Partnership Act

The Uniform Partnership Act (“UPA”) is a uniform act that has been revised and amended several times and most recently in 2013. It is sometimes referred to as the Revised Uniform Partnership Act (“RUPA”). It was initially proposed by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) for the governance of partnerships by various United States. It essentially provides an outline of standard suggestions for various partnership-related laws and regulations.

Key Takeaways:

• Approximately 90% of states abide by the Uniform Partnership Act (UPA).
• It applies to general partnerships and limited liability partnerships.
• Defines a partnership as an association of two or more people to carry on as co-owners of a business for a profit.
• Defines relationships of partners to one another, relationships of partners to persons dealing with the partnership, and dissolution and winding up the partnership
• Allows for a partnership to agree to continue within 90 days after a single partner leaves the partnership. This prevents the immediate dissolution of a partnership.
• Governs partnership creation, liabilities, assets, and fiduciary duties.
• Allows partnerships to assign certain assets to particular partners, thus limiting the rights of the partners to the assets assigned to other partners. This, then, protects those assets from creditors who without this division could make claims on all of the aggregate assets in the partnership.
• The duties of the partners concerning their dealings in good faith are stipulated in the act. Such basic standards may not be abolished by any partner or partnership agreement.
• Outlines standards for conversions and mergers, such as changing from a partnership to a limited partnership or merging to create a new entity.
• Provides limited liability protection for general partners in a limited liability partnership.
• Typically applies to small businesses and loose partnerships as larger businesses have detailed agreements in place that govern any changes in a business.

Advantages of Partnerships

As compared with a limited company formation, partnerships have several advantages. Mostly, partnerships benefit from limited formality. Partnerships are generally simpler to manage due to their less complicated accounting process. This is because, for state and federal tax purposes, a partnership is not a taxable entity and so there is no need to complete a corporation tax return. In other words, it is a “pass-through” entity. Partnership income is taxable to the partners in proportion to their share in the company’s profits. This means partners file their personal returns without the need for a corporate tax return. Accounting processes for partnerships are also more streamlined because partnerships are not required to complete and file statements regarding their corporate holdings, maintain statutory books, or maintain other records that corporations are legally required to maintain. Indeed, while formal partnership agreements are par for the course and highly recommended, there is no requirement for formal documentation or registration thereof to form a partnership. Partners can agree to partnerships verbally if they choose.

Partnerships also benefit from the shared leadership structure. As distinct from a corporate entity that can be formed alone, partnerships, by their very definition, require more than one partner. This allows each partner to share financial burdens and obligations with the other partner, provides partners with access to the knowledge, experience, capital, and skills of the other partner, and increases the likelihood of superior decision-making. Two heads, as they say, are better than one.

In addition, partnerships permit ownership and control alignment. Corporations are owned by a separate group of stakeholders (shareholders) from those who control the operations of the entity (officers and directors). Arguably, therefore, the operators in control of the entity are constrained by the preferences of the shareholders in determining the best course of action for the corporation. That is not the case in a partnership, wherein the partners both own and operate the business enterprise. This alignment increases flexibility and streamlines the decisions making process, allowing for greater adaptability to changing circumstances.

Disadvantages of Partnerships

As perhaps is obvious from the list of advantages above, the main disadvantage of partnership structures is that there is no limited liability. Therefore, in a regular partnership structure, the partnership debts can easily become the debts of the individual partners. This means if the business declares bankruptcy, its debtors can pursue the personal assets of the owners/operators, such as their homes and cars, rather than simply the assets of the partnership itself. This is a big downside to forming a partnership. Note that this has led to the formation of limited liability partnerships which try to limit some of this exposure, but for purposes of this text, we are not going to get in the weeds of those.

Corporations vs. Partnerships

The main distinction between a corporation and a partnership is that the corporation is a legal entity that is entirely separate from the parties who own it. It can enter into binding contracts, buy and sell property, sue and be sued, be held responsible for its actions, and be taxed.

Corporations are taxable entities that fall under a different scheme from individuals. Although corporations have a “double tax” problem — both corporate profits and shareholder dividends are taxed — corporate profits are taxed at a lower rate than the rates for individuals.

The structure of an organization, therefore, protects the owners (as well as the managers) of the corporation from legal liability.

Individual states have the power to promulgate laws relating to the creation, organization, and dissolution of corporations. Many states follow the Model Business Corporation Act (MBCA 2016).

Hybrids: S-Corporations and Limited-Liability Companies

Remember that corporations have some advantages and some disadvantages vis-à-vis partnerships. Corporations have more limited liability, easier access to financing, and are generally able to attract skilled and talented employees. But corporations are subject to “double taxation.” Corporations are taxed on their earnings. When these earnings are distributed as dividends, the shareholders pay taxes on these dividends. In addition, the goals of corporate managers, who do not necessarily own stock, and the goals of shareholders, who do not necessarily work for the company, can differ. This can sometimes present a conflict of interest in the operations of a corporation in ways that will not occur in a partnership. In addition, corporations are more costly to set up and subject to more burdensome regulations and government oversight.

This brings us to hybrid entities, namely, S-Corps and LLCs. These models attempt to gather the main advantages of corporations and partnerships and bring them together in one entity formation. S-Corporations give small business owners limited liability protection, but tax company profits only once when they are paid out as dividends. Note though, that an S-corporation cannot have more than one hundred stockholders.

Another well-known example of a hybrid model is a limited liability company (LLC). These structures are similar to an S-corporation: the members are not personally liable for company debts and their earnings are taxed only once, when they are paid out as dividends. LLCs, however, have fewer rules and restrictions than an S-corporation. For example, an LLC can have any number of members.

S-Corporation

A corporation that qualifies can elect to be elected to be an S corporation under the Internal Revenue Code. Unlike C corporations, S corporations typically do not pay taxes to the federal government. Instead, most S corporations are taxed indirectly through their shareholders – similar to partnerships.

But an S corporation must have a limited number of shareholders, though, which is limiting when it comes to corporate growth.

Limited Liability Company (LLC)

LLCs are very popular corporate forms in the modern era. They are single tax entities with little administrative complexity, making them very attractive to many business owners and operators.

Some advantages of an LLC include single taxation, ease of creation, and limited liability. Technically, the IRS rules allow LLCs to choose between being taxed as a partnership or corporation, but similar to corporations, the owners of LLCs (the “members”) are not personally liable for debts of the company.

Basic Concepts of an LLC.

• First, the Owners are called “Members” not shareholders or partners
• Second, they are usually created by filing “Articles of Organization” with the state.
• Many states allow single-owner LLC’s, but some require more than one owner.
• Often an “operating agreement” is created between members (similar to a partnership agreement) to govern their relationship, obligations, and rights.

S-Corp v. LLC

An LLC has fewer ownership restrictions. It can have as many members as it wants—it is not restricted to a maximum of 100 shareholders. Additionally, its members do not must be United States residents or citizens. In addition, profits do not need to be allocated to owners based on percentage ownership. Members can distribute profits in any way they want. Finally, an LLC is easier to operate because it does not have as many rules and restrictions as an S-Corporation. It does not elect a board of directors, hold annual meetings, or contend with a heavy record-keeping burden.

The same business judgement rule limitations apply to LLCs and S-Corps as regular corporations. That is, if the operators or owners breach your duties to the organization or engage in self-dealing, they can still be personally liable for their debts. Here are some examples, though, that bind individual owners regardless of the business judgment rule:

First, if the owner personally guaranteed a business debt or bank loan which the company fails to pay, then the owner will be personally liable if that debt is not paid. Therefore, if the corporation does not have the assets to pay it, the bank can pursue the personal assets of the owners or operators.

Another example is the failure to pay employment taxes to the government that was withheld from workers’ wages. For this mishap, owners and operators can be personally liable.

Owners or operators engaged in fraudulent or illegal behavior that harms the company or someone else are also not protected by the Business Judgment Rule. In addition, not treating the corporate entity as a separate legal entity, by using company assets for personal use, makes it likely that the Business Judgment Rule will not offer any protection.

The most common circumstance under which an LLC member is held personally liable for the debts of his or her company is by signing personal loan guarantees.

What is a loan guarantee?

It is a legal agreement made between an individual and a bank that says, “If my company does not repay this loan, I will.” It is the same thing as co-signing a loan.

Why would an LLC member give a bank a personal guarantee?

Because it is often the only way a business can get a loan. Bankers understand the concept of limited liability. They know that if the company goes out of business (and the loan is not guaranteed), the bank is stuck with an unpaid loan because the LLC members are not personally liable for the debts of the company. Therefore, it is important to ensure the entity is sufficiently capitalized.

Bibliography

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MBCA 2016
Model Business Corporation Act: 2016 Revision. 2017. American Bar Association. https://www.americanbar.org/content/dam/aba/administrative/business_law/corplaws/2016_mbca.pdf

Ribstein 2009
Ribstein, Larry E. 2009. “Litigating in LLCs.” The Business Lawyer 64, 3: 739-755. https://www.americanbar.org/content/dam/aba/publications/business_lawyer/2009/64_3/article-litigating-llcs-200905.pdf

LLI Uniform Business
Uniform Business and Financial Laws Locator. Legal Information Institute. Cornell Law School. https://www.law.cornell.edu/uniform/vol7.html#partn