Limited Liability Companies and Special
Forms of Business
Chapter 18
LIMITED LIABILITYCOMPANIES
AND SPECIAL FORMS OF BUSINESS
What does limited mean?
I. Overview
Business entity choices are strategic decisions based on a number of factors. These elements include choosing the best options for potential capital investment and financial growth, protection from personal liability, and tax planning. No one-entity format is ideal for all objectives. However, recent trends lead to the use of the limited liability company format as the best vehicle for providing the “best of both worlds.” Those worlds are the single-layered conduit taxation of proprietorships and partnerships with the limited personal liability accorded to shareholders of a corporation.
The actual advent of limited liability companies does not begin with U.S. legal history. Many countries have allowed for the formation of limited liability companies for a long time. The limited liability company format was not used in the U.S. until the late 1970s.
Why is it that it took so long for this format to catch on in the U.S.? In 1978, the Internal Revenue Service issued a Revenue Ruling with regard to a new limited liability company statute just enacted the year before in Wyoming. Under that ruling, if certain elements of the corporate format were deemed to be missing from the limited liability company format, it would be taxed as partnership and not a corporation. This tax ruling opened the virtual floodgates. Many state legislators enacted laws similar to the Wyoming statute. They wanted to attract new capital from overseas (where limited liability companies have long been accepted) and also provide an attractive legal infrastructure for start-up companies and the like.
The myriad of business organization formats has grown in recent years throughout the vast majority of states. Thus, it is not surprising that there is a call for more uniformity among the states vis-à-vis the passage of laws creating limited liability companies. The group most responsible is the National Conference of Commissioners on Uniform State Laws. In 1995, this group issued the Uniform Limited Liability Company Act (U.L.L.C.A.). This act takes the traditional precedents created by agency law, the various forms of partnerships, and corporations and marries them to a cohesive set of rules for limited liability companies. The states, in turn, are free to adopt their own variations on the basic themes set out in the U.L.L.C.A. These statutes will be “adjusted” over time, experience, and court decisions. All in all, it is a most interesting time in our legal history. In many ways, we are still playing catch-up with the rest of the world. But given the vitality and ingenuity of the U.S. legal system coupled with the current economic growth in so many new start-up businesses, the horizon for this type of business format looks bright indeed.
II.Hypothetical Multi-Issue Essay Question:
Why would potential business owners consider forming a Limited Liability Company?
III.Outline
Limited Liability Company (LLC)
An unincorporated business that combines the most favorable attributes of general partnerships, limited partnerships, and corporations
An LLC is a separate legal entity—an artificial person—that can own property, sue and be sued, enter into and enforce contracts, etc. They are owned by members and can choose to be taxed as a partnership
Members are normally liable for the LLC’s debts, obligations, and liabilities only to the extent of their capital contributions. Managers are not personally liable.
The Uniform Limited Liability Company Act codifies law throughout the states but is not law unless adapted by the states. The law dictates LLC formation and operation.
LLC’s do not have the ownership restriction of S Corporations.
Members to not have unlimited liability of general partners.
Members can participate in management unlike limited partners.
Existing businesses may convert to an LLC.
An LLC can be either member-managed where all members can bind or manager-
managed where only designated managers can bind. Managers owe a duty of
loyalty to be honest and not act against the interests of the LLC.
Articles of Organization of an LLC must be filed with the state to form an LLC. They include:
The name of the LLC
The address of the LLC’s initial office
The name and address of the initial agent for service of process
The name of each organizer
Whether the LLC is a term LLC, and if so, the term specified
Whether the LLC is to be manager-managed
Whether one or more of the members of the LLC are to be personally liable for the LLC’s debts and obligations
Fiduciary Duties Owed to an LLC
Duty of loyalty
Limited duty of care
Duty of good faith and fair dealing
No fiduciary duty owed by a nonmanager-member
Dissolution of an LLC
An LLC is dissolved upon the occurrence of any of the following
An event specified in the operating agreement
The occurrence of an event that makes it unlawful for all or substantially all of the business of the LLC to be continued
A member applies to a court to have the LLC dissolved by judicial decree
The secretary of state commences a proceeding to dissolve an LLC administratively
Limited Liability Partnership – all partners are limited partners with limited liability. They are often restricted by the state and required to carry certain insurance.
What Is a Franchise?
A franchise is established when one party licenses another party to use the franchisor’s trade name, trademarks, commercial symbols, patents, copyrights, and other property in the distribution and selling of goods and services
Parties to a Franchise
Franchisor (licensor)
The party who does the licensing in a franchise situation
Franchisee (licensee)
The party who is licensed by the franchisor in a franchise situation
Types of Franchises:
Distributorship—franchisor manufacturer licenses retailer to distribute product
Processing Plant—franchisee manufactures with franchisor’s secret formula
Chain-Style—exclusive geographic area to franchisee
Common Terms of a Franchise Agreement (sets forth terms and conditions of the franchise)
Quality control standards—set to protect name and reputation
Training requirements—required training programs
Covenant not to compete—cannot compete with franchiser for a set time and area
Arbitration clause—set to handle controversies
Common Franchise Fees
Initial license fee—lump-sum privilege
Royalty fee—fee for continued use of name, etc.
Assessment fee—fee for certain periodic changes
Lease fee—rental fee for items leased from franchisor
Cost of supplies—purchased from franchisor
Disclosure Protection
Full disclosure required by FTC franchise rule of specific presale disclosures.
Uniform Franchise Offering Circular and state laws require specific presale disclosures.
Types of Disclosures:
For sales or earnings projections number and percentages of actual franchises
achieving results; cautionary statement; underlying assumptions for any
estimates
Specific boldface disclosures
Termination of a Franchise
For Cause – good reason, often in agreement
Without Just Cause – wrongful termination
Trademarks and Service Marks
A distinctive mark, symbol, name, word, motto or device that identifies the goods of services of a particular franchisor, e.g.,™
Anyone who uses a mark without authorization may be sued for trademark infringement
Misappropriation of a trade secret is called unfair competition
Contract and Tort Liability of Franchisors and Franchisees
Franchisors and franchisees are liable for their own contracts and torts
Typically, the franchisor deals with the franchisee as an independent contractor
Licensing
Business arrangement when owner of intellectual property (licensor) permits another (licensee) to use it.
Joint Venture
Two or more business entities combine resources to a single end.
Strategic Alliance
Two or more companies in same industry agree to accomplish a designated objective.
IV.Objective Questions
Terms:
1.An arrangement whereby an owner of a patent, trademark, trade secret, or product grants a license to another to sell products or services using the name of such owner is generally known as a ______.
2.In a franchise arrangement, the franchisee may be allowed to use the trademarks and service marks of the franchisor. In addition, the franchisee may be allowed to use ______, which are certain ideas that make a franchise successful but which do not qualify for a trademark, copyright, or patent.
3.In a franchise setting, one party, known as the ______licenses another, known as the ______to use a trade name, trademark, commercial symbol, or the like in the distribution and selling of goods and services.
- In the state of its organization an LLC is known as a ______.
5.Each member has equal rights in the management of the business, irrespective of the size of his or her capital contribution if it is a ______LLC.
True/False:
1.____The death of a joint adventurer does not generally terminate a joint venture.
2.____The remedies for breach of a lawful franchise agreement are based on contract theories for
breach of contract.
3.____A franchise agreement cannot limit the geographical territory in which the franchisee can
operate.
4.____The license fee in a franchise arrangement generally does not cover the cost of buildings.
5.____Generally, a license fee is the only compensation that a franchisor can legally collect.
6. _____ Under the U.L.L.C.A. an LLC must designate an agent in the state of organization to receive service of process, notices and demands if the LLC is sued or involved in an administrative proceeding.
7. _____A limited liability partnership always has at least one general partner..
8. _____Unless otherwise agreed, the U.L.L.C.A. mandates that a member has the right to an equal share in the LLC’s profits.
9. _____A member of a member-managed LLC and a manager of a manager-managed LLC do have a limited duty of care which does not include ordinary negligence to the LLC.
10. _____A member of manager-managed LLC who is not a manager owes no fiduciary duty of
loyalty or care, or duty of good faith and fair dealing, to the LLC or its other members.
Multiple Choice:
1. The typical parties to a franchise agreement are usually all but which of the
following?
- Franchisor
- Franchisee
- Licensor
- All are parties to the agreement.
- A franchise may usually be terminated for cause if:
- the franchisee continues to fail to meet legitimate quality control standards.
- the franchisee fails to meet a quality control standard only once.
- None of the above.
D.Both A and B.
3.Magic Burger Corporation has discovered a new special sauce that has sent its sales off the top of the charts. For a modest fee, Magic Burger Corporation grants franchisees the right to use the special sauce and to use the Magic Burger trade name for marketing purposes. The arrangement between Magic Burger Corporation and its franchisees is best described as which of the following?
A.A chain-style franchise.
B.An area franchise.
C.A processing plant franchise.
D.A distributorship franchise.
4.Which of the following is not an advantage of franchising?
A.Franchising allows the franchisor to reach new markets with its product or services.
B.Both the franchisee and the franchisor are protected from competition in the marketplace.
C.Consumers are generally assured of uniform product quality.
D.The franchisee benefits from the knowledge and resources of the franchisor.
5. Members of an LLC are liable for the debts of the LLC:
- Always.
- To the extent of their capital contributions.
- Never.
- None of the above.
6.A member of a member-managed LLC and a manager of a manager-managed LLC owe the following duties to the LLC:
A. Duty of loyalty only.
B. Duty of care and loyalty.
C. Duty of care only.
D. Neither duty of care nor duty of loyalty.
V.Answers to Objective Questions
Terms:
1.Franchise. This method of doing business has become one of the most important of all. Consider its worldwide implications in such key service industries as food, tourism, and the sale of essential commodities. A growing component of international law involves the interpretation and application of long-term multinational franchise contract agreements.
2.Trade secrets. The interesting aspect of trade secrets is that they are not registered in the same way as certain kinds of other intellectual property, such as patents. Thus they are not as easy to reverse engineer and the like. But they are still considered to be a property and enjoy the protection of the law.
3.Franchisor, franchisee. These are the basic terms used in this body of law.
4. Domestic Limited Liability. Under the U.L.L.C.A. there are three classifications based on the location in which an LLC is organized: domestic, foreign and alien. In the state in which it is organized, it is known as a domestic limited liability company.
5.Member-managed.Under Section 404(a) of the U.L.L.C.A. members have equal say in the management of member-managed limited liability companies.
True/False:
1.True. Although similar in many ways to partnerships, joint ventures are not partnerships and, as such, are not generally dissolved at the death of joint adventurer.
2.True.If the franchise agreement is reached, the injured party may sue for rescission of the agreement, restitution, and damages.
3.False.The franchise agreement is a contractual agreement. Therefore, the agreement can contain any reasonable restrictions to which parties agree.
4.True.The license fee is generally a lump sum payment for the privilege of being granted a franchise.
5.False.There are many types of franchise fees that can be collected by a franchisor including royalty fees, assessment fees, and lease fees.
6. True. Under Section 108 (b) of the U.L.L.C.A. an agent must be appointed for service of process, notices, demands and administrative proceedings.
7.False. This is true of a limited partnership.
8.True. Under Section 405 (a) of the U.L.L.C.A. members share profits equally unless otherwise agreed to.
9.True. If a covered member or manager commits an ordinary Negligent Act that is not grossly negligent, he or she is not liable to the LLC.
10.True. Under Section 409 (h)(1), a non-manager member of a manager-managed
LLC is treated equally to a shareholder in a corporation and does not have these fiduciary duties.
Multiple Choice:
1.D. “A” and “B” are obvious and “C” is the same as “A”.
2.A. “B” would constitute an unreasonably strict application of a just cause termination and would therefore probably be a wrongful termination.
3.A.A chain-style franchise exists when the franchisor licenses the franchisee to make and sell its products or services to the public using its name.
4.B.Franchises are obligated to abide by the antitrust laws the same as any other form of business organization.
5.B. This is a benefit of an LLC.
6.B.Both the duties of care and loyalty are owed to the LLC under Sections 409 (a) and 409 (h)(2) of the U.L.L.C.A.
VI.Answers to Essay Question
An LLC is an unincorporated business combining the most favorable attributes of general partnerships, limited partnerships, and corporations. They can own property, sue and be sued, and enter into contracts. They can choose to be taxed as a partnership and their members are normally liable for the LLC’s debts, obligations, and liabilities only to the extent of their capital contributions.
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