Chapter 16Chapter 16

Business OrganizationsBusiness Organizations

Chapter 16Chapter 16

Business OrganizationsBusiness Organizations

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Chapter ObjectivesChapter Objectives1. Identify and describe the three major

traditional forms of business organization.2. Summarize the advantages and

disadvantages of doing business as a partnership and as a corporation, respectively.

3. Specify how the limited liability company addresses needs that are not met by traditional forms of business.

4. Define the term franchise, and indicate how a franchising relationship arises.

5. Describe the roles of corporate directors, officers, and shareholders.

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Major Traditional Major Traditional Business FormsBusiness Forms

Entrepreneurs have used three major forms to structure their business enterprises:

Sole Proprietorshi

pPartnership

Corporation

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Sole ProprietorshipSole ProprietorshipThe simplest form of business; used by anyone who does business without creating an organization.The owner is the business.The owner pays personal income taxes on all profits and is personally liable for all business debts.

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PartnershipPartnershipGeneral partnerships Created by agreement of the parties; not treated as an

entity except for limited purposes. Partners have unlimited liability for partnership debts, and each partner normally has an equal voice in management. Income is “passed through” the partnership to the individual partners, who pay personal taxes on the income.

Limited partnerships Must be formed in compliance with statutory requirements.

A limited partnership consists of one or more general partners, who have unlimited liability for partnership losses, and one or more limited partners, who are liable only to the extent of their contributions. Only general partners can participate in management.

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CorporationCorporationA corporation is formed in compliance with statutory requirements, is a legal entity separate and distinct from its owners, and can have perpetual existence.The shareholder-owners elect directors, who set policy and hire officers to run the day-to-day business of the corporation.Shareholders normally are not personally liable for the debts of the corporation.The corporation pays income tax on net profits; shareholders pay income tax on disbursed dividends.

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S CorporationsS Corporations

Corporations can further be divided based on their tax status.

S Corporations C Corporations

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Qualification Qualification Requirements Requirements

for S-Corporationsfor S-CorporationsThe corporation must: be a domestic corporation. not be a member of an affiliated group of

corporations. have only shareholders that are individuals,

estates, or certain trusts. Corporations, partnerships, and nonqualifying trusts cannot be shareholders.

have seventy-five or fewer shareholders. have only one class of stock, although not all

shareholders need have the same voting rights. not have shareholders who are nonresident

aliens.

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Limited Liability Limited Liability CompaniesCompanies

The limited liability company (LLC) is a hybrid form of business organization that offers the limited liability feature of corporations but the tax benefits of partnerships.Unlike limited partners, LLC members participate in management.Unlike shareholders in S corporations, members of LLCs may be corporations or partnerships, are not restricted in number, and may be residents of other countries.

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Limited Liability Limited Liability Company (LLC) StatutesCompany (LLC) Statutes

Interest in LLCs mushroomed after a 1988 ruling by the IRS that Wyoming’s LLCs would be taxed as partnerships instead of as corporations.Given the fact that the tax and liability characteristics of partnerships and corporations have long been in existence, why is it that LLC statutes have emerged only recently?

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Tax Aspects of Tax Aspects of Partnerships and Partnerships and

CorporationsCorporationsFederal Income Tax

TAX ASPECT

Accumulation

Capital Gains

PARTNERSHIP CORPORATION

Partners are taxed on proportionate shares of partnership income, even if not distributed; the partnership files information returns only.

Partners are taxed on accumulated as well as distributed earnings.

Partners are taxed on their proportionate shares of capital gains, which are taxed at the ordinary income rate.

The income of the corporation is taxed; stockholders are also taxed on distributed dividends. The corporation files corporate income tax forms.

Corporate stockholders are not taxed on accumulated earnings. There is, however, a penalty tax, in some instances, that the corporation must pay for “unreasonable” accumulations of income.

The corporation is taxed on capital gains and losses.

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Continued...Continued...Exempt Income

TAX ASPECT

Pension Plan

Social Security

Death Benefits

State Taxes

PARTNERSHIP CORPORATION

Partners are not taxed on their proportionate shares of capital gains, which are taxed at the ordinary income rate.

Partners can adopt a Keogh plan, an Individual Retirement Account (IRA), or a 401-K plan.

Partners must pay a self-employment tax (in 1998, 12.4% on income up to $68,400, plus 2.9% Medicare tax on all income).

There is no exemption for payments to partners’ beneficiaries.

The partnership is not subject to taxes. State income taxes are paid by each partner.

Any exempt income distributed by a corporation is fully taxable income to the stockholders.

Employees and officers who are also stockholders can be beneficiaries of a pension trust. The corporation can deduct its payments to the trust.

All compensation to officers and employee-stockholders is subject to Social Security taxation up to the maximum.

Benefits up to $5,000 can be received tax-free by employees’ beneficiaries.

The corporation is subject to state income taxes (although these taxes can be deducted on federal returns).

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Private FranchisesPrivate Franchises

Any arrangement in which the owner of a trademark, trade name, or copyright licenses another to use that trademark, trade name, or copyright, under specified conditions or limitations, in the selling of goods and services.

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Types of FranchisesTypes of Franchises

Distributorship

(e.g. automobile dealerships)

Chain-style operations

(e.g. fast-food chains)

Manufacturing/processingplant

arrangement

(e.g. soft-drink bottling companies, such as

Coca-Cola)

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Franchising ContractsFranchising ContractsA franchising relationship is based on a contract.But the government has enacted laws to protect franchisees from the consequences of contracts into which they have voluntarily entered.Are lengthy franchise contracts necessarily disadvantageous to franchisees? Explain.

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The Franchise ContractThe Franchise ContractOrdinarily requires the franchisee (purchaser) to pay a price for the franchise license.Specifies the territory to be served by the franchisee’s firm.May require the franchisee to purchase certain supplies from the franchisor at an established price.May require the franchisee to abide by certain standards of quality relating to the product or service offered but cannot set retail resale prices.Usually provides for the date and/or conditions of termination of the franchise arrangement. But federal and state statutes attempt to protect certain franchisees from franchisors who unfairly or arbitrarily terminate franchisees.

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Laws Governing Laws Governing FranchisingFranchising

Franchises are governed by contract law, occasionally by agency law, and by federal and state statuary and regulatory laws.

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Case 16.1 Case 16.1 Camp Creek Camp Creek Hospitality Inns, Inc. v. Hospitality Inns, Inc. v.

Sheraton Franchise Corp.Sheraton Franchise Corp.In 1990, Camp Creek Hospitality Inns, Inc., entered into a contract with Sheraton Franchise Corporation to operate a Sheraton Inn franchise west of the Atlanta airport. Another franchise, the Sheraton Hotel Atlanta Airport, already occupied that area, Sheraton named Camp Creek’s facility “Sheraton Inn Hartsfield-West, Atlanta Airport.” Three years later, Sheraton bought another hotel in the vicinity and named it “Sheraton Gateway Hotel, Atlanta Airport.” The Inn suffered with the competition, and Camp Creek filed a suit alleging ITT Sheraton denied Camp Creek the fruits of its contract in breach of the implied covenant of good faith and fair dealing. Why would a franchisor compete directly with its franchises?

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Case 16.2 Case 16.2 Miller v. D.F. Miller v. D.F. Zee’s, Inc.Zee’s, Inc.

D. F. Zee’s, Inc., owns a Denny’s restaurant in Tualatin, Oregon. Under the franchise agreement, Zee’s agreed to train and supervise employees in accordance with Denny’s Operations and Food Service Standards Manuals. Christine Miller, who worked at Denny’s, was sexually harassed by other employees. When she complained to Stanley Templeton, the manager, nothing was done. Miller then contacted the district franchise manager for Denny’s. Templeton resigned, but the harassment continued. Miller and three other employees filed a suit against Zee’s, Denny’s, and others. Denny’s filed a motion for summary judgment, contending in part that a franchisor cannot be held liable for harassment by franchise employees. Should a franchisor be allowed to control the operation of its franchise without liability for the franchisee’s conduct?

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Is it a Franchise… or Is it a Franchise… or not?not?

Some courts have held that franchises are, in fact, employees.In a number of states, if a business arrangement meets the definition of a franchising relationship under state law, it may be held to be a de facto franchise in that state.Under what common law concept is the degree of control over a worker’s activities a significant factor in determining employee status?

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The Nature of the The Nature of the CorporationCorporation

The corporation is a legal entity distinct from its owners.Formal statutory requirements, which vary somewhat from state to state, must be followed in forming a corporation.The corporation can have perpetual existence or be chartered for a specific period of time.

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Corporate PersonnelCorporate Personnel

The shareholders own the corporation.They elect a board of directors to govern the corporation.The board of directors hires corporate officers and other employees to run the daily business of the firm.

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Corporate TaxationCorporate Taxation

Traditional corporations pay income tax on net profits; shareholders pay income tax on the disbursed dividends that they receive from the corporation.This is what is known as double-taxation feature.

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Torts and Criminal ActsTorts and Criminal ActsThe corporation is liable for the torts committed by its agents or officers within the course and scope of their employment (under the doctrine of respondeat superior).In some circumstances, a corporation can be held liable (and be fined) for the criminal acts of its agents and employees.In certain situations, corporate officers may be held personally liable for corporate crimes.

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Classification of Classification of CorporationsCorporations

A corporation is referred to as a domestic corporation within its home state (the state in which it incorporates).A corporation is referred to as a foreign corporation by any state that is not its home state.A corporation is referred to as an alien corporation if it originates in another country but does business in the United States.

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Corporate Management Corporate Management and Shareholders and Shareholders

The acquisition of a share of stock makes a person an owner and shareholder in a corporation.Although shareholders have no legal title to corporate property, they do have an equitable interest in the firm.

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Shareholders’ MeetingsShareholders’ MeetingsShareholders’ meetings must occur at least annually; special meetings can be called when necessary.Notice of the date, time, and place of the meeting must be sent to the shareholders.Shareholders may vote by proxy and may submit proposals to be included in the company’s proxy materials sent to shareholders before meetings.

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Shareholding VotingShareholding VotingShareholder voting requirements and procedures are as follows: A minimum number of shareholders must be

present at a meeting for business to be conducted; resolutions are passed by simple majority vote.

Cumulative voting may or may not be required or permitted. Cumulative voting gives minority shareholders a better chance to be represented on the board of directors.

A shareholder may appoint a proxy to vote his or her shares.

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Corporate Management: Corporate Management: DirectorsDirectors

A corporation typically is governed by a board of directors.Subject to statutory limitations, the number of directors is set forth in the corporation’s articles or bylaws.

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Election of DirectorsElection of DirectorsThe first board of directors is usually appointed by the incorporators; thereafter, directors are elected by the shareholders.Directors usually serve a one-year term, although longer and staggered terms are permitted under most state statutes.

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Directors’ Qualifications Directors’ Qualifications and Compensationand Compensation

Few qualifications are required; a director can be a shareholder but is not required to be.

Compensation is usually specified in the corporate articles or bylaws.

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Board of Directors’ Board of Directors’ MeetingsMeetings

The board of directors conducts business by holding formal meetings with recorded minutes.The date of regular meetings is usually established in the corporate articles or bylaws; special meetings can be called, with notice sent to all directors.Quorum requirements vary from state to state; usually, a quorum is the majority of the corporate directors.Voting must usually be done in person, and in ordinary matters only a majority vote is required.

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Directors’ Management Directors’ Management ResponsibilitiesResponsibilities

Directors are responsible for declaring and paying corporate dividends to shareholders; authorizing major corporate decisions; appointing, supervising, and removing corporate officers and other managerial employees; determining employees’ compensation; making financial decisions necessary to the management of corporate affairs; and issuing authorized shares and bonds.Directors may delegate some of their responsibilities to executive committees and corporate officers and executives.

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Role of Officers and Role of Officers and DirectorsDirectors

Directors are obligated to act in good faith, to use prudent business judgment in the conduct of corporate affairs, and to act in the corporation’s best interests.Directors have a fiduciary duty to subordinate their own interests to those of the corporation in matters relating to the corporation.If a director fails to exercise these duties, he or she can be answerable to the corporation and to the shareholders for breaching the duties.

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Case 16.3 Case 16.3 Stokes v. BrunoStokes v. BrunoPoint Cotile Parks Association, Inc. (PCPA), is a nonstock, nonprofit corporation the members of which are limited to owners of lots or building sites within the point Cotile Subdivision. The board of directors, including Gerald Bruno and Michael Wright, adopted resolutions that effectively granted Bruno and Wright the authority to sell certain “common ground” on PCPA’s behalf. Six years later, Bruno and Wright sold themselves unsold lots at a lower price than the board had set. When the board learned of the sale, Craig Stokes and other PCPA members filed a suit against them. The court declared the sale ultra vires and void.Under what circumstances might a sale by a director of corporate property to himself or herself be justified?

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The Business Judgment The Business Judgment RuleRule

This rule immunizes a director from liability for a corporate decision as long as the decision was within the powers of the corporation and the authority of the director to make and was an informed, reasonable, and loyal decision.

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Rights and Duties of Rights and Duties of Officers and ManagersOfficers and ManagersThe rights of corporate officers and other high-level managers are defined by employment contracts, because these persons are employees of the company.Corporate officers normally can be removed by the board of directors at any time with or without cause and regardless of the terms of the employment contracts.Duties of corporate officers are the same as those of directors, because both groups are involved in decision making and are in similar positions of control.

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Rights of ShareholdersRights of ShareholdersShareholders have numerous rights, which may include the following: The right to a stock certificate and

preemptive rights The right to obtain a dividend (at the

discretion of the directors) Voting rights The right to inspect the corporate

records The right to sue on behalf of the

corporation when the directors fail to do so

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Case 16.4 Case 16.4 Dodge v. Dodge v. Ford Motor Co.Ford Motor Co.

In 1916, Henry Ford declared that the company would no longer pay special dividends but would put that money back into the business.Minority shareholders filed a lawsuit against Ford to force declaration of dividend.The court ordered Ford to declare a dividend and the plaintiffs appealed.Generally, how can a court determine when directors should pay dividends?

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Liability of ShareholdersLiability of Shareholders

Shareholders may be liable for: retention of illegal dividends breach of a stock-subscription

agreement the value of watered stock

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Derivative Actions in Other Derivative Actions in Other NationsNations

Derivative Actions in Other Derivative Actions in Other NationsNations

Today, most of the claims brought against directors and officers are those alleged in shareholders’ derivative suits. Other nations, however, are more restrictive in regard to the use of such suits.Do corporations benefit from shareholders’ derivative suits?

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Duties of Majority Duties of Majority Shareholders Shareholders

In certain situations, majority shareholders may be regarded as having a fiduciary duty to minority shareholders and will be liable if that duty is breached.

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For ReviewFor Review1. Which form of business organization is the

simplest?2. What are some advantages and disadvantages of

doing business as a partnership or corporation, respectively?

3. How do limited liability companies and limited liability partnerships differ from traditional corporations and partnerships?

4. What is a franchise? What are the most common types of franchises?

5. What are the duties of the directors and officers of a corporation? If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders compel the directors to act? If so, how?