Business Organization and Transactions FAQ

• In what ways are joint ventures and partnerships alike?
• Do shareholders of closely held corporations have any legal responsibilities to each other?
• What is a shareholder voting agreement?
• Why do corporate laws require that directors explicitly dissent from objectionable board decisions?
• Do limited liability companies follow the partnership or corporation model for termination?
• Can closely held businesses be bought and sold?
• What are the possible consequences of being personally liable for businesses debts and obligations?
• What are the differences between C and S corporations?
• What are the benefits and drawbacks of nonprofit, tax-exempt status?
• What types of legal procedures should corporations maintain?
• What is the legal procedure for merging two companies?
• What is "piercing the corporate veil?"
• Learn More: Business Organizations

In what ways are joint ventures and partnerships alike?

Joint ventures and partnerships share many characteristics. A partnership where two or more individuals or entities join together for a particular "short term" purpose is sometimes called a joint venture. In a partnership or joint venture, each partner has equal ability to legally bind the entire entity. A partner can represent the whole organization in the normal course of business, and his or her legal actions on behalf of the partnership (in this case, the joint venture) create legal obligations.

Example: John's Produce, Inc., and Helen's Packaging Co. form a joint venture to sell prepackaged salad kits. Helen's Packaging purchases new bag sealing equipment for the joint venture without receiving JPI's approval. The packaging company's status as a partner gives it the ability to bind the entire venture even without the other company's consent. The equipment company can enforce the purchase agreement against the entire venture because Helen's Packaging had the apparent authority to bind the venture.

While it is legal to limit the powers of individual partners through a partnership or joint venture agreement, those agreements do not bind the rest of the world. Since businesspeople outside of the partnership have no knowledge of the limitations, they are entitled to rely on the apparent authority of an individual partner as determined by the usual course of dealing or customs in the trade.

Individual members of a partnership or joint venture may face liability for the actions of the partnership or the joint venture. However, new limited liability partnership laws and corporate form options for joint ventures may reduce this risk.

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Do shareholders of closely held corporations have any legal responsibilities to each other?

Corporate law imposes a fiduciary duty on business directors that requires them to act in the best interests of the company's shareholders. For closely held corporations where shareholders work together and may act as directors, there may be a fiduciary responsibility between shareholders in some instances.

The traditional legal view holds that shareholders have no special responsibilities to one another. In closely held businesses, however, majority shareholders can potentially greatly damage the interests of small shareholders. Since most investors do not want to buy closely held shares, minority shareholders have few options when their interests are compromised. In response, some states and courts developed fiduciary duties among shareholders of closely held businesses.

These duties depend on the state and the particular circumstances of the case. Some state court holdings require that majority shareholders exercise the utmost good faith and loyalty to minority shareholders of close corporations.

Example: Jane is a minority shareholder in her grandfather's company. Her grandfather, the majority shareholder, takes dividends himself but refuses to pay her dividends because he believes she will use the money unwisely. Jane's grandfather's actions violate his fiduciary duties to Jane as a shareholder.

Some states do not establish a fiduciary duty, but offer special rights to minority shareholders. In some cases, minority shareholders of close corporations can compel the company to dissolve. Other laws authorize special voting trust rules or other options to boost the power of the minority shareholder.

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What is a shareholder voting agreement?

Shareholders may choose to pool their votes for a particular goal. Voting agreements may specify that the involved shareholders will vote their shares together or cooperatively. Courts usually uphold shareholder voting agreements as long as they relate to voteable issues.

Example: Connie and Val enter into a shareholder agreement that they will never vote for another shareholder, Arlene, for a seat on the board of directors. They also agree that if they are outvoted, they will try to convince the company to pay Arlene less than the other directors. The first part of the agreement is valid because it relates to an issue on which Connie and Val can vote. The second portion cannot be enforced as a shareholder voting agreement because Arlene's pay is within the discretion of the board of directors and will not come up for shareholder vote.

Voting pools may specify exactly how the participating shares should be voted, or they may allow for negotiation and agreement for each individual issue. Many voting pools include an alternative dispute resolution procedure for reaching agreement on such issues.

Some states require that voting pools follow specific guidelines to be valid. These laws may limit the length of a shareholder agreement, or may require that the shareholders deposit a copy of the agreement with the corporation. If a party to a valid voting agreement violates the agreement, the other parties may sue the uncooperative party. Courts may require that the dissenting shareholder vote according to the agreement, or they may disqualify violating votes.

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Why do corporate laws require that directors explicitly dissent from objectionable board decisions?

When a director faces a board decision regarding an objectionable or even illegal matter, he or she cannot escape personal liability for the corporate action unless the director records his or her dissent, either at the time of the vote or within a short period thereafter. The director's pursuit of legal protection through this procedure serves multiple purposes.

• The dissenting director will not be liable for any legal problems arising from the vote;
• Other directors may rethink a questionable position or action; and
• Shareholders who examine the voting record receive notice of potential problems.

The law uses this requirement to push directors to state their misgivings, with the hope that their dissent will guide their corporations toward better business practices, avoid damaging third parties, and reduce the number of lawsuits. Directors must stay abreast of the board's activities, and should be prepared to dissent to actions that may implicate them personally.

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Do limited liability companies follow the partnership or corporation model for termination?

Limited liability companies are more fragile than corporate business organizations. As with partnerships, an outside occurrence can signal the end of a limited liability company's existence. Depending on the state statute, a limited liability company may formally terminate if an owner experiences:

• Death;
• Retirement from the company;
• Resignation from the company;
• Personal bankruptcy; or
• Expulsion from the company by the other owners.

Once dissolution is brought on by one of these events, the remaining members typically must wrap up the company's remaining obligations and terminate the organization. However, if two or more members remain, they can avoid termination by agreeing to continue the business. In this case, members should review state limited liability company laws for formal requirements to remain in business.

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Can closely held businesses be bought and sold?

Individuals and other businesses can acquire closely held businesses as long as the current shareholders are willing to sell. Since many closely held businesses involve family relationships, emotional events including divorce, estrangement, or death may precipitate the business sale. Needless to say, these circumstances may complicate any business transaction.

One difficulty in purchasing or selling a closely held business involves valuation. Since shares in closely held businesses are not commonly traded, parties may find it nearly impossible to agree on a fair price for the business. Financial professionals and lawyers can help the parties value the business and reach an amicable agreement for its transfer.

Another common issue involves the transferability of the business interest, which depends on the underlying business form. Some transfers cause no problems whatsoever. For sole proprietorships, the buyer purchases the company's assets and takes over operations. Partnerships and limited liability companies do not transfer as easily. If a partner or limited liability company owner sells his or her interest, the buyer cannot participate in the business without the other owners' consent. Essentially, the buyer succeeds to the seller's profits and losses in the business unless the other parties agree to allow him or her into their circle. Corporate ownership interests cause the fewest problems because corporate shareholders may sell their entire interests.

Experienced competition may destroy the value of the purchased business. Purchasers of closely held businesses should consider having the sellers sign non-compete agreements. These agreements prevent sellers from using their expertise and market knowledge to compete against the purchaser in his or her new venture. Courts generally uphold these agreements so long as they do not extend too far geographically or chronologically.

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What are the possible consequences of being personally liable for businesses debts and obligations?

Personal liability can devastate the accumulated riches of a lifetime of work. This form of liability opens the individual to claims for a wide range of business obligations. Most people realize that personal liability may extend to business losses, but other obligations may also reach individuals, including:

• Damage awards in lawsuits;
• Tax deficiencies and penalties; and
• Back wages and benefit payments.

Example: Wendy operates a trucking company as a sole proprietor. One of her drivers causes an accident that kills several people. The company's insurance and assets are inadequate to cover the damages awarded in the wrongful death suit, so the plaintiffs enforce their judgment against Wendy's personal assets.

The limited liability offered by incorporation shelters business owners from personal liability. Some insurance can also help cover business owners, directors, and officers. However, if an owner or director performs certain personal acts, behaves illegally, or fails to uphold statutory requirements for corporate status, he or she may face personal liability despite the corporate shelter.

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What are the differences between C and S corporations?

The Internal Revenue Code allows for two different levels of corporate tax treatment. Subchapters C and S of the code define the rules for applying corporate taxes.

Subchapter C corporations include most large, publicly-held businesses. These corporations face double taxation on their profits if they pay dividends: C corporations file their own tax returns and pay taxes on profits before paying dividends to shareholders, which are subsequently taxed on the shareholders' individual returns.

Subchapter S corporations meet certain requirements that allow the business to insulate shareholders from corporate debts but avoid the double taxation imposed by subchapter C. To receive subchapter S treatment, corporations:

• Must be domestic;
• Must not be affiliated with a larger corporate group;
• Must have no more than one hundred shareholders;
• Must have only one class of stock;
• Must not have any corporate or partnership shareholders; and
• Must not have any nonresident alien shareholders.

Additionally, after a business is incorporated, all shareholders must agree to subchapter S treatment prior to electing that option with the Internal Revenue Service. The limitations imposed by the subchapter may affect the transferability and marketability of corporate shares.

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What are the benefits and drawbacks of nonprofit, tax-exempt status?

Many organizations see only the financial benefits of nonprofit and tax-exempt status. Qualifying groups pay no tax on federal, state, and local taxes, and therefore can devote a larger proportion of their resources to achieving their particular goals. The status can also qualify groups for special grants or government funding, as well as special rates for services or even postage. Donors prefer contributions to these groups because they can deduct the payments from their own taxes.

The form of the organization offers advantages in itself. Since nonprofits exist as corporations, they possess all the benefits of corporate status. The corporate form shields owners and managers of the organization from personal liability for the group's actions, subject to certain legal exceptions. Nonprofit incorporation formalizes the group's goals and helps maintain organizational focus as the effort grows.

Despite these advantages, nonprofit and tax-exempt status should not be an automatic goal. Drawbacks to the status include:

• The inability to divide profits among members beyond payment of reasonable salaries;
• Limitations on the sources of the group's incomes; and
• Restrictions on the use of assets to purposes justifying tax exemption.

Some organizations prefer the flexibility and potential for personal gain implicated by for-profit status. Other organizations eschew incorporation entirely. Many smaller organizations will not realize substantial advantages from nonprofit tax-exempt status after going through the intensive application process. Each individual group must weigh the pros and cons of the status carefully in light of their organizational goals and values.

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What types of legal procedures should corporations maintain?

Once incorporators establish a new business, the directors must ensure that it retains its legal status. Depending on the business form, certain legal formalities must be followed for this purpose. Once incorporated, an ongoing business's obligations include:

• Obtaining federal and state tax identification numbers for the business, and filing needed tax returns annually;
• Issuing shares of stock as mandated by the articles of incorporation and securities laws;
• Establishing and maintaining corporate books and records, including accounting ledgers, shareholder records, and corporate minute books;
• Calling and conducting an initial meeting of the board of directors or shareholders as required in the articles of incorporation;
• Holding future meetings at least as often as required by applicable business laws;
• Conforming all decisions and internal procedures to the outline set forth by the articles of incorporation;
• Recording all actions and decisions of the board of directors in the corporate minute book; and
• Maintaining annual registration with the state government as required by law.

Additionally, some businesses must comply with licensing requirements or professional standards to preserve their status. These businesses may need to maintain further records or use special procedures or equipment based on rules for their specific industries.

In many situations, a failure to honor these and other corporate obligations can result in personal liability for directors, officers, or shareholders for business obligations and debts. Because of these harsh consequences and because the specific legal requirements vary depending on the business's location and form, businesses should seek professional legal assistance.

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What is the legal procedure for merging two companies?

Like most corporate law, merger procedures exist at the state level. While these laws vary by jurisdiction, many parts of the merger process remain constant across the nation. Generally, the board of directors for each corporation must initially pass a resolution adopting a plan of merger that specifies the names of the corporations that are involved, the name of the proposed merged company, the manner of converting shares of both corporations, and any other legal provisions to which the corporations agree. Each corporation notifies all of its shareholders that a meeting will be held to approve the merger. If the proper number of shareholders approves the plan, the directors sign the papers and file them with the state. The secretary of state issues a certificate of merger to authorize the new corporation.

Some statutes permit the directors to abandon the plan at any point up to the filing of the final papers. States with the most liberal corporation laws permit a surviving corporation to absorb another company by merger without submitting the plan to its shareholders for approval unless otherwise required in its certificate of incorporation.

Statutes often provide that corporations formed in two different states must follow the rules in their respective states for a merger to be effective. Some corporation statutes require the surviving corporation to purchase the shares of stockholders who voted against the merger.

Each state has its own corporation statutes that govern the mechanics of mergers. Either the state or federal government may wish to investigate the potential anticompetitive effects of a proposed merger. Because of the requirements and variables involved in merging, a corporation considering a merger should consult a lawyer who is experienced in mergers and acquisitions law.

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What is "piercing the corporate veil?"

Sometimes, courts will allow plaintiffs to receive compensation from corporate officers, directors, or shareholders for damages rather than limiting recovery to corporate resources. This procedure avoids the usual corporate immunity for organizational wrongdoing, and may be imposed in a variety of situations. The specific criteria for piercing the corporate veil vary somewhat from state to state and may include the following:

• If a business is indistinguishable from its owners in practical terms, courts will not allow owners to benefit from limited liability.

  Example: Fred's Tractors and Fred share the same banking account. Fred signs business contracts in his own name. Fred may be liable for breaching a business contract because he and his company are legally indistinct.

• If a corporation is formed for fraudulent purposes, courts will allow recourse to the owners.
• If a business fails to follow corporate formalities in areas such as record-keeping and decision-making procedures, a court may impose liability on the individuals controlling the business.

The potential for personal liability encourages businesses to observe legal requirements and to avoid damage to third parties.

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Learn More: Business Organizations

Most people approach a new business opportunity with great enthusiasm. While this enthusiasm provides much of the needed fuel to help a new business get started, businesspeople must arm themselves with important legal information that will guide their most basic decisions. The form of a business organization creates specific legal consequences for matters as diverse as taxes, insurance, and management. Once formed, a business faces challenges in its relationships with its shareholders, creditors, employees, and other businesses. Every business concern has important legal issues that can dramatically affect the likelihood of future success. Experienced lawyers can help create a business strategy that manages legal risks.

Business successions take place upon the death or withdrawal of a business owner. Depending on the form of the business, transfers of ownership interests may not achieve a complete change of control. Careful estate planning can minimize problems and facilitate business owners' goals.

Closely held businesses involve a small number of shareholders, and are common forms for family-owned corporations. Due to their low number, shareholders often assume management and direction of the company. This consolidation of responsibilities can lead to specialized legal issues.

Directors' and officers' liability occurs when corporate representatives undertake actions that are illegal, unauthorized, or damaging to the business. While the corporate structure offers protection from liability in most instances, some actions or decisions can expose directors and officers to legal risks even if made in the course of business.

Dissolution of a business may happen for a variety of reasons including management deadlock and unprofitability. Since most business organizations exist in legally-mandated forms, they must use statutory procedures to close their doors. State laws help protect shareholders and creditors of dissolving companies.

Formation and business planning continues long after the articles of incorporation are first written. Businesses must plan for profitability, tax consequences, employment issues, and other concerns. Business forms can change with commercial needs and realities, and savvy businesspeople will keep an open eye for changing risks and opportunities.

Franchising allows a company to use several small businesses to distribute its products and services while maintaining a consistent public image. When a company grants a franchise, it lets another business use and profit from its successful business plan. State and federal laws strike a balance between larger corporations and the small business owner seeking a franchise.

Joint ventures involve two or more companies or individuals in a partnership for a particular purpose. Each contributing member provides capital, expertise, technology, or other special resources to the venture. Special legal liabilities apply to the members of the venture.

Limited liability companies allow their owners to enjoy the tax status of a partnership and the limited liability of a corporation. This relatively new business form is gaining in popularity nationwide, with special state laws addressing formation and operational issues.

Mergers, acquisitions, and divestitures involve structural changes to a company, either through the purchase or the sale of the company or its components. These corporate changes may affect shareholder rights and raise antitrust issues.

Nonprofit and tax-exempt organizations incorporate in order to pursue an organizational goal in the public interest. Nonprofit corporations exist under state law, but must apply to the Internal Revenue Service for tax-exempt status. Although the application process is lengthy, qualifying organizations realize substantial financial benefits.

Partnerships can arise in some instances even when the partners do not intend to form a distinct organization. While some types of partnerships do not impart the liability limitations of other business forms, they do have favorable tax implications. Increasingly, state laws provide for new partnership forms that grant more liability protection.

Reorganizations allow bankrupt businesses to regroup in order to stay open and satisfy creditors as much as possible. The commercial bankruptcy option has many advantages over liquidation, which requires selling off many assets and after which the business ceases to exist.

Shareholders' rights include certain powers of control over the corporation. The corporation must protect shareholder interests, and perform certain legal duties in order to preserve shareholders' prerogatives and options.

Trade associations connect individual businesses and business groups to work together for common goals. Trade associations provide a forum for brainstorming, political action, and industry standardization.

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Disclaimer

This publication and the information included in it are not intended to serve as a substitute for consultation with an attorney. Specific legal issues, concerns and conditions always require the advice of appropriate legal professionals.