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Module 11
Business Organizations
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Learning Objectives
Upon successful completion, the student will be able to:
Compare sole proprietorship and partnerships;
Analyze business judgment rules;
Explain limited liability;
Analyze important court cases.
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Sole Proprietorship
A person doing business for him/herself (sole proprietor)
Usually the proprietor owns all of the business
Responsible for control of the business
Responsible for management
Responsible for liabilities/debts
May hire agents – liable for them as well
Capital must come from the owner’s resources or is borrowed.
Business Profits are taxed personally to the proprietor.
Record keeping formalities are at the owner’s discretion.
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Partnerships
Definition: An association of two or more persons to carry on
business as co-owners for a profit
Partners control the operations and profits equally unless agreement
says otherwise
Under most state laws, a partnership may be sued as an entity.
Most states have adopted the Uniform Partnership Act (UPA) and
Revised Uniform Partnership Act (RUPA). Court look there for
guidance when partnership agreement silent.
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Partnerships (2)
No required to enter into a formal agreement for a partnership to
exist at law
However, agreements are preferable, especially regarding finances,
management and dissolution issues
If the Partnership Agreement is silent, the UPA governs (“default
rules”).
Each of the partners has a fiduciary duty to other partner(s)
benefit
If the agreement does not state otherwise, the profits of the
partnership are divided equally.
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Zhou v. Bickley
Bickley worked at a Yamaha shop. Met Zhou and Zhang (Z&Z).
Bickley told them the Yamaha shop was going out of business.
Suggested they help him open a new motorcycle repair shop.
All three signed two-year lease on building for the shop. Z&Z paid
security deposit & 1st month’s rent. They helped pay for inventory;
helped get the shop ready. Gave Bickley more money when he
asked.
Z&Z asked for keys to building; Bickley refused. Asked to see
receipts and invoices; he refused. Asked to work at the shop; he
refused. Demanded a written agreement; he refused. Attorney sent
a demand letter on behalf of Z&Z; he ignored it.
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Zhou v. Bickley (2)
Suit was filed. Demanded return of funds expended.
Bickley counterclaimed for breach of contract by his partners.
Trial court held: No partnership, only “a vague agreement to open a
motorcycle repair shop.” Bickley operated as a sole proprietor who
borrowed money that he owed to Z&Z. Bickley appealed.
Mere fact parties called themselves partners and referred to
business as a partnership, did not make them partners.
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Zhou v. Bickley (3)
Z&Z and Bickley contributing money for expenses and signed a
lease, is no binding contract, much less a partnership. A reasonable
person could conclude that Z&Z simply intended to enter into a
partnership agreement in the future.
Bickley denied Z&Z access to building; denied access to financial
records; and refused to let them participate in the operations of
business. Actions not consistent with a partnership.
Affirmed: All parties did not intend to do things that would constitute
a partnership. Doing things which constitute a partnership
determines if parties are partners.
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Termination of a Partnership
Dissolution occurs when an event takes place to dissolve the
partnership.
Change of the composition of the partners
Withdrawal of a partner
Bankruptcy, death, or withdrawal of a partner dissolves partnership.
Winding up of the partnership involves completing any unfinished
business.
Common: Partnership purchases life insurance on partners;
proceeds used to buy back the interest of deceased partner from her
estate.
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Limited Partnership
Definition: 2 or more persons (partners) who have agreed to carry
on a business venture for profit
Must have a written agreement filed with the state
Called Certificate of Limited Partnership. Puts 3rd parties on notice that
limited partners assets not available to satisfy any claims against the
limited partnership
General partners (at least one)
Manage the business; are personally liable to creditors; have a duty to
account to the limited partners
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Limited Partnership (2)
Limited partners (at least one) are investors only
May not manage the business; are not liable for debts beyond their
contributions
Limited partners become general partners at law if they participate in
or manage the business (lose their limited liability).
Most states use some form of the Uniform Limited Partnership Act
(ULPA) or Revised Uniform Limited Partnership Act.
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Eagles Landing Development, L.L.C. v.
Eagles Landing Apartments, L.P.
Eagles Landing Development LLC (Eagles) contracted to build
apartments for Eagles Landing Apartments, LP (ELA) for $1.4
million.
ELA’s general partner was Bluff City.
Two limited partners, PNC (a limited partnership) & Columbia (a
corporation).
Eagles completed work but still was owed $931,000.
Agreement stated that Bluff City’s contribution would not exceed net
cash flow from rental of apartment.
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Eagles Landing Development, L.L.C. v.
Eagles Landing Apartments, L.P. (2)
Cash flow was not good; no money there. All cash invested in ELA
by partners was gone.
Eagles sued for contribution by PNC and Columbia.
Trial Court Held: ELA owed the $931,000.
ELA appealed.
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Eagles Landing Development, L.L.C. v.
Eagles Landing Apartments, L.P. (3)
Columbia and PNC contend they cannot be charged with liability of
partnership under Development Agreement because they were
limited partners.
Court agreed.
Unlike general partners, a Limited Liability Partnership protects
partners.
As partners in an LLP, neither Columbia or PNC can be held liable
for partnership debts.
Trial court wrongly disregard PNC and Columbia’s status as LLPs.
HELD: Affirm trial court’s judgment and amount of $ owed.
Reverse assessment of judgment to PNC and Columbia
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Corporations
Are legal “entities” or “persons”
Can sue & be sued
Have liability
It has constitutional rights
Except the privilege against self-incrimination (only officers &
employees have that right)
Must meet formal requirements according to state statutes. States
issue corporate charter.
Liable for agents’ actions and contracts
Each state has its own corporation laws; federal government places
very limited role.
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Creating a Corporation
Articles of Incorporation and an application are sent to the
appropriate state office
Name & Address of corporation
Name and Address of registered agent
Purpose of business
Class(es) of stock and par value
Names & Addresses of incorporators
The state issues a Certificate of Incorporation
Enact bylaws or rules that govern internal operations Issue the corporation’s
stock
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Major Parties in a Corporation
Shareholders
Owners of the corporation; no day-to-day control of activities
Shareholder meetings need quorum (usually more than ½ total shares
present)
Most shareholders give their proxy to 3rd parties to represent them.
Shareholders elect Board of Directors
No legal relationship to creditors
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Major Parties in a Corporation (2)
Board of Directors
Have management power over large decisions
Can be removed from office by shareholders at an election or for cause
(breach of duty/misconduct)
Have fiduciary duty of loyalty to the shareholders
Managers
Appointed/hired by directors to manage day-to-day decisions
Have duties of care & loyalty to directors
Employees
Workers
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Business Judgment Rule
Makes directors & managers immune from liability
When problems result from honest mistakes in judgment
If there is a reasonable basis for their decisions
If they act in good faith
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Storetrax.com, Inc. v. Gurland
Gurland founded Storetrax.com – internet-based commercial real
estate listing service in Maryland in 1998. Incorporated as a
Delaware corporation in 1999.
He agreed for a group of investors to buy majority share. He was
president and member of the Board of Directors.
Employment contract said that he had a year’s worth of pay in case
he was fired.
Two years later, he was removed as president, but stayed on the
Board for another year.
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Storetrax.com, Inc. v. Gurland (2)
Requested severance pay, but was denied it. He sued.
Board claimed he was not due severance pay because his job
duties, title and salary changed.
Also, as Board member, they claimed he breached a fiduciary duty
by suing the company.
Trial court held for Gurland. Storetrax appealed.
There is a fiduciary duty of directors to the corporation. However,
individual interest that may conflict with those of the corporation.
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Storetrax.com, Inc. v. Gurland (3)
When conflicts of interest arise, courts look to see if director’s
dealings are in “good faith and fair dealing.” A director can find a
“safe harbor” by disclosing to the corporation the conflict and
important facts to the remaining shareholders or directors.
Gurland had a conflict as an aggrieved former employer and his duty
as director of the corporation.
Gurland’s seeking severance pay was not in corporation’s best
interest, but he notified Storetrax sufficiently of imminence of lawsuit
and reason for it.
Gurland’s notification gives him the protections of “safe harbor”.
HELD: Affirmed. Gurland receives severance pay.
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Close Corporation And S corporation
Close Corporation
20 states allow
Distinguished from a“closely held
corporation” (See Ch. 18)
Limited # of shareholders – 30-50
Shares not sold openly
Shareholders must have agreement
that governs affairs
Not subject to formal rules regarding
shareholder and director meetings
(unlike regular corporations)
S Corporation
Regular C corporation can elect with
IRS to be classified as S Corporation
Have only one class of stock
No more than 100 shareholders
Only natural persons (U.S. citizens or
legal residents) can be shareholders –
not another corporation or partnership
Primarily for tax considerations
Profits/losses allocated to
shareholders who pay income taxes
Very popular in smaller businesses
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Close Corporation and S Corporation
Close Corporation
Minority of states allow
Distinguished from “closely held
corporation” (Ch. 18)
Limited # of shareholders – 30-50
Shares not sold openly
Shareholders must have
agreement that governs affairs
Not subject to formal rules
regarding shareholder and director
meetings (unlike regular
corporations)
S Corporation
Regular C corporation can elect with
IRS to be classified as S Corporation
Have only one class of stock
No more than 100 shareholders
Only natural persons (U.S. citizens or
legal residents) can be shareholders –
not another corporation or partnership
Primarily for tax considerations
Profits/losses allocated to
shareholders who pay income taxes
Popular in smaller businesses
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Professional Corporations (PCs)
Created by state laws
Owners of PC can only be professionals involved in the firm itself
(i.e. MD’s whose practices are tied together)
Created to have limited liability for its members
Example: Doctors join to reduce liability risk for malpractice of a
member-doctor
Stock not sold to outside investors
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Limited Liability Companies (LLC)
LLC treated like a corporation for liability but like a partnership for
federal tax purposes.
State laws have procedures to create LLCs: File Articles of
Organization and State issues a Certificate to operate an LLC
One person can form an LLC in most states
Members have membership interests
Members have limited liability – like a corporation
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Limited Liability Companies (LLC) (2)
Members have an Operating Agreement similar to bylaws of a
corporation.
LLC technically does not have perpetual life. Death, resignation,
retirement, or expulsion of member terminates LLC—like a
partnership.
However, if remaining members consent, LLC can continue (should
be set out in Articles of Organization)
Termination: There is a period of winding up, followed by payment to
creditors and distribution of remaining assets.
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In re 1545 Ocean Avenue, LLC
1545 Ocean Avenue LLC formed for real estate development to renovate a
building
Owned 50-50 by two corporations (Ocean Suffolk & Crown Royal)
Each company had membership certificate in 1545
Operating agreement had no dissolution provisions
Two managers appointed to operate 1545: Crown Royal appointed King;
Ocean Suffolk appointed Van Houten
King and Van Houten argued; King announced Crown Royal would pull out.
King sued for work to stop and the LLC to be dissolved.
Trial court granted King’s requests.
Ocean Suffolk and Van Houten appealed.
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In re 1545 Ocean Avenue, LLC (2)
LLCL 702 (New York LLC Law) states that court must examine the LLC’s
operating agreement
Unilateral action of a single manager was permitted in Article 4.1 of 1545
LLC Operating Agreement
Lets each manager to act autonomously to bind LLC in furtherance of
business of the LLC. Agreement was silent about manger conflicts
1545 can only dissolved if cannot further purpose of LLC; up to members to
work out the problem, not the courts
Dissolution is not granted.
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Organizational Features for Businesses to
Consider
Limited liability
Control
Capital considerations
Taxation
Transferability of ownership interests
Method of creation and termination
Entity as a distinct status separate from its owner
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Business & Taxation
Corporate profits are taxed at corporate tax rate.
Distributed dividends are then taxed at each individual shareholder’s
tax rate.
In effect this is “double taxation” of the same profits.
Partnerships pays no income taxes
Income passes to parties who pay income tax
Limited Liability Company
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Limited Liability
Allows a person to invest in a business without placing their
personal wealth at risk.
Allows investors to be passive toward internal management.
Sole proprietors and general partners have unlimited personal
liability for debts of business, including torts.
Liability of limited partner is limited to capital contributed to limited
partnership.
companies risk only their capital investment if corporation fails –
generally not personally liable for business debts or torts.
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Limit on Limited Liability
Piercing the corporate veil
Affects all limited liability organizations
Prove legal form is a sham
Owners will be treated as if proprietor or partners with unlimited liability.
Usually involves fraud, undercapitalization or failure to follow corporate
formalities
Result: Owners are personally liable for all corporate liability – torts,
contracts, debts
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Morrissey v. Krystopowiez
Davidson was barred from the nursing home business in New
Mexico.
Krystopowiez knew that and agreed to be his front man.
They split profits 50/50.
Krystopowicz was sole shareholder in Silverstone Healthcare, Inc.
which created 10 LLCs, each owning a nursing home.
Revenue was $47 million a year.

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Morrissey v. Krystopowiez (2)
Her daughter, Morrissey, claimed home was negligent in care of her
mother and sued.
Home was in LLC owned by Silverstone; neither had assets and
defaulted on $4.8 million judgment.
Trial court held: Morrissey could not sue Krystopowicz, only
business entities.
No evidence Krystopowicz was directly involved in wrongful death
tort.
Morrissey appealed. Contended that court should pierce corporate
veil.
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Morrissey v. Krystopowiez (3)
Reversed. Usually shareholders cannot be personally liable for
corporations debt. However in equity, court has power to “pierce the
corporate veil.”
Shareholders then answer for corporation’s liability.
To do this:
Subsidiary or other subservient corporation was not operated in a
legitimate fashion, but treated as “alter ego.”
There is moral culpability of shareholder to perpetrate fraud.
Injury is suffered by plaintiff as a result.
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Morrissey v. Krystopowiez (4)
Silverstone and LLCs used to obscure Davidson’s involvement.
Funneled funds to both Krystopowicz and Davidson.
No insurance to meet financial and legal obligations.
Corporate veil is pierced. Krystopowicz is liable for the judgment.
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Transferability of Ownership Interests
Refers to ability of an owner in a business to sell or pass interest to
others
Nontraded Entities
In sole proprietorship, selling the business ends the existing
proprietorship. Price is FMV to be determined.
If a partner sells or assigns interest in the partnership, usually, by
agreement, the partnership continues, but the new person does not
automatically become a partner.
New person is just entitled to receive the share of profits the partner would
have received
Cannot participate in management of partnership or right to partnership
information without permission of other partners; often share is bought by
other partners
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Franchises
Three types:
Product distributorships (i.e. Ford Dealership)
Trademark/trade-name licensing (i.e. Coca-Cola)
Business format franchising (i.e. McDonald’s)
Franchisor grants a right to sell goods or services to a franchisee in
return for payment of a franchise fee
Uniform product or services and the use of a trademark helps the
franchisee establish quickly in the market
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Laws are still developing
Federal & state laws protect investors
FTC Franchise Rule: Franchisor is required to give an offering circular
(disclosure statement) to potential franchisees
Ex: FTC v. Wealth Systems: FTC alleged that 3 entities violated Rule
selling home-based Internet business opportunity by misrepresenting
that purchasers will earn substantial income.
When violations occur, the result is usually that promoted activity is
closed down.
Franchises (2)
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Franchises (3)
Some states have laws to regulate franchises as well – for example,
California.
Many states have business opportunity disclosure filing
requirements.
Most states use the Uniform Franchise Offering Circular (UROC) as
basis of reporting.
State agencies have authority to investigate franchise fraud and
other bad business practices.
Some franchisees given extra protection by state laws. Ex: auto
dealers and gas stations – often have extra rights regarding
termination.
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Franchises (4)
The franchise agreement sets forth rights and obligations of the
parties, i.e. territorial rights, fees and royalties, termination, etc.
Termination
Through explicit events that bring about franchise’s termination
Fixed expiration time
Franchisor’s right to termination re: occurrence of events –
Inspection problems or violations of franchisee
Bankruptcy of franchisor
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Dunkin’ Donuts Franchised Restaurants v.
Sanlip
Three people owned Sanlip, Inc. a Dunkin’ Donuts franchise.
Operated two donut shops in Norcross Georgia
Dunkin’ said defendants breached franchise agreements: Failed to
remodel their shops; Failed to participate in mandatory system-wide
programs; Failed to attend required training; Failed to prepare
immigration forms for new employees; Transferred part ownership
interest in violation of franchise agreement.
Sanlip did not dispute claims. Protested that Dunkin’ was not
allowing owners reasonable chance to sell franchise.
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Dunkin’ Donuts Franchised Restaurants v.
Sanlip (2)
Dunkin’ entered into settlement agreement.
Allowed Sanlip time to try to find buyer.
Sanlip submitted proposed sale agreement. Dunkin’ refused to
accept the buyer. Asked court to order Sanlip to return shops to
Dunkin’.
Sanlip counterclaimed: Dunkin’ rejected a reasonable proposal from
buyer to take over shop.
HELD: Summary Judgment for Dunkin’ Donuts. Defendants must
pay attorneys’ fees and costs.
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Dunkin’ Donuts Franchised Restaurants v.
Sanlip (3)
Dunkin’ may not “unreasonably” reject proposed sale agreement.
Dunkin’ analysis: If store likely will lose money Dunkin’ rejects
proposed sale agreement. Also looks at financial condition of the
buyer if it decides the store may break even.
This is firmly-established policy by Dunkin’ and reasonable.
Dunkin’ has right to terminate the agreement.
Agreements provides Dunkin’ may terminate lease if franchise
agreement for shop is violated.
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