CHOICE OF ORGANIZATIONAL FORM

Recap of previous lectures - partnerships and corporations

  • Passive investment income-
  • person who is making the investment but not involved in the company would be an example of passive investment income - income would be the income for the corporation - more passive income the more it doesn't look like a partnership which is for the most part active investment - will not get terminated unless it happens for three consecutive years
  • How to raise capital
  • Loans
  • Fundraising
  • sell shares
  • business income

LIMITED LIABILITY COMPANY

  • hybrid between corporations and partnerships - they take the best features and form a completely new form of business association
  • are considered separate legal entities like a corporation which allows it to have favorable features but is still taxed like a partnership - CONDUIT TAXATION
  • LLCs are created by filing articles of organization which are similar to articles of incorporation
  • adopts operating agreement or regulation which is roughly the same as a corporation's bylaws or partnership agreement

DIFFERENCES

  • operating agreement controls over articles of organization whereas articles of incorporation controls over bylaws
  • owners of LLCs are called MEMBERS
  • use of OFFICERS and directors are called MANAGERS - roughly similar to but not always the same as directors

HISTORY or development in the past twenty years

  • first statute in Wyoming in 1977 - the idea was to let small business owners have flexible style of business but with the idea of LLP. But in the end no benefits if taxed like a corporation
  • so by 1988 the innovative idea - Florida had only adopted - but unexpectedly the IRS agreed to tax LLCs like partnership in SOME instances which created a new fervor. Then other states enacted statutes - but still limited - could only have two of the advantages of corporations - centralized management, perpetual existence, limited liability, transferability of interest
  • In 1993 the IRS decided that all LLCs would be taxed like partnership unless they wanted to be taxed like a corporation - which is another course - generally partnership style is better because corporations have double taxation
  • Now all LLCs have these benefits

ADVANTAGES
/
DISADVANTAGES
- limited liability
- favorable tax treatment
- most flexible form of business - contractarian philosophy that members of LLC will contract for whatever they want
- still have opportunity for four core attributes of corporations - like centralized management can be member-managed or manager-managed
- default rule as now free transferability of interests and perpetual existence / - formation involves a great deal of contracting
- operating agreement controls over the articles of organization
- easier to pierce the corporate veil? but there is uncertainty because it's still a new concept of business association - how the courts will treat the LLC - lack of stability in court's handling of issues
- variation among the state statutes
- additional state tax burdens - NY has the lowest LLCs because it has the highest tax burdens compared to CA and DE which have the most favorable climates for LLCs

Why doesn't everyone file as LLCs if they’re so great?

a public company cannot be an LLC

over five hundred members, risk of corporate tax burden

some tax burdens in states can be serious drawback

sometimes complex to convert from a corporation to an LLC - dissolution is not so easy especially when there are substantial assets - a great of inertia

nevertheless the LLC becomes an attractive choice for smaller businesses

supplemental materials packet include rules for LLCs

______

Discussion of the PTC simulation

GENERAL PARTNERSHIP/LIMITED LIABILITY PARTNERSHIP / LIMITED PARTNERSHIP/LLLPs / C CORPORATION / S CORPORATION / LIMITED LIABILITY COMPANY
Bernie wants more voting power / - full liability shield
- tax advantages
Bernie as limited partner and everyone else as general partner and liability / - liability - includes personal liability
- issue of growth and wanting to go public - get the tax benefit now and then revert to C Corporation
- All three on the board because Bernie wants some say in the corporation - some voting power - need to have him on the board because he has invested more than twenty-five percent of the company's capital - needs to be active member
- could make Bernie get thirty percent by providing a loan to the company not just seeing it as a straight out 600,000 investment / - liability
- more member-managed or manager-managed?
- idea of going public in the future

Choice of Organizational Form continued

Recap of last class - different types of partnerships -

  • LPs - control rule - limited partners can vote on major decisions - but RULPA eliminates the control rule
  • still need to understand because no state has adopted the RULPA which was enacted in 2001
  • five states are considering but none have adopted it.
  • LLP and LLLP - professional corporation - corporation for all other purposes but shareholders are stil liable for their own negligence –
  • the idea is that professional corporations involve anyone providing professional services - attorneys, doctors
  • against public policy not to be responsible for professional practice - malpractice
  • PC - professional corporation; professional organizations are not permitted to be corporations because of public policy - CANNOT be a corporation (see page 5 of supplemental readings packet)

CORPORATIONS - overview of comparisons with other forms of partnerships

Background

  • what makes a corporation?
  • File articles of corporation with the state - choice to incorporate - need to follow corporate formalities and be subject to state requirements
  • so depends on which state the corporation files its articles of incorporation
  • - distinct separate LEGAL ENTITY - capacity or status of its own to do things and actions –
  • corporation can own property, file lawsuits, be sued or sue, enter into contracts, execute conveyances, etc. al. - almost all things individuals can do - A partnership can be made up of corporations -
  • what is the purpose of forming a corporation? PROFIT
  • mission of a corporation is to make money - obvious CUNY bias there?
  • maximize profits for shareholders - corporation makes decisions for the shareholders
  • what are the different types of corporation?
  • publicly held - corporation held by members of the public
  • privately held or closely held or close corporations - are corporations not publicly held - not listed on the stock exchange - usually smaller number of people
  • who are the parties in a corporation?
  • separation of control and ownership - theme that runs throughout the course and within the context of corporation
  • shareholders are the owners of corporation - all decisions made by corporation must be on behalf of shareholders - for the benefit of the shareholders
  • managers - board of directors as managers of the corporation - roles vary - but not involved in daily decision-making process - usually meet infrequently - involved in the bigger picture of decision-making - direction of corporation, etc. al. - amend articles of incorporation - review financial statements
  • Corporate Officers manage the daily everyday activities - derive all authority from the board - but control of daily functioning of corporation - CFO, CEO - officers -CEO also sits on board of directors
  • INSIDE DIRECTORS - directors who are also corporate officers.
  • OUTSIDE DIRECTORS - do not work for the particular company but for another company - CEO of another company - need to strike balance with inside and outside directors who provide perspective and objectivity
  • What are the Shareholder's "power"?
  • EXIT - shareholders can sell their stock but also can
  • VOTE OUT the board of directors
  • SUE the corporation

ARTICLES OF INCORPORATION

  • like the corporation's constitution; shorter and major rules of corporation - filed to put on NOTICE and pay fee –
  • BYLAWS analogized to state statutes - the governing documents for maintenance of corporation - internal for the corporation

FORMS OF BUSINESS

  • many more partnerships and sole propietorships than corporations but the great majority of business revenues come from corporations than partnerships
  • corporations chosen in order to EXPAND - most of the time - why is the corporation the form of choice for larger organizations?

CORPORATIONS

ADVANTAGES - four corporate attributes /

DISADVANTAGES

  1. limited liability - to the amount of the investment
no personal liability because it's a separate legal entity - as if a person - and own negligence - UNLESS criminal conduct, corporation is not properly formed, separate agreement, personal guarantee of loan, piercing the corporate veil, i.e. veil is the limited liability
  1. perpetual existence –
corporation will continue to exist regardless of shareholder's death - can dissolve by shareholder's choice - consent to the termination of corporation's "life"
- just means that corporation won't dissolve unless by choice –
  1. free transferability of shares, i.e. interests - a default rule entire ownership interest is transferable whereas partnerships can only transfer economic interests but cannot due to personal liability –
doesn't impact because shareholders not involved in decision-making and not subject to personal liability - easier means to raise capital - sell stocks
  1. centralized management
/
  1. TAX - double taxation
  1. formation - disadvantage because of state filing and fee - but it's easy so not a major disadvantage
  1. less personal - tends to favor the majority of shareholders' interest - less ties to the business –
How to avoid? Make into a closely held corporation - can also limit the transferability of shares - listed in shareholder agreement - sense of ownership for shareholders fostered

-

-

TAX CONSEQUENCES

Partnerships

LLP, LP, LLLP, GP the same scheme /

Corporations

partnership earns a profit, individuals pay taxes on the profit when distributed.
Why is a partnership taxed only once?
- Because it's not a separate legal entity - individuals who make up the partnership are taxed - as soon as income generated, the partners are taxed
- single level of taxation -PASS THROUGH TAXATION or CONDUIT TAXATION - if the business retains the profit, taxed. If a business loss, the partners benefit because they can be deducted - tax deductible - as if losses by partners. THREE YEAR CARRYOVER / DOUBLE TAXATION problem - taxed on profit when profits earned by the business; and taxed again when paid out in dividends
corporation taxed once - but odd because the ownership interest is taxed and then taxed again - value of shares diminishes - if the income is retained - taxed on profit - but the individual may still be taxed - when you sell the shares when they go up - taxed on gains in the increased value of shares.
If business loss, business loss deducted against income of corporation itself - no individual deduction by shareholders (look at page 7of supplemental readings)

Are there ways to get around double taxation?

  • don't pay dividends and re-invest money into corporation - only one level of taxation when shareholder sells shares
  • if shareholders are managers - pay off as salaries - a deduction - whereas dividends are not deductible. If company earns $100,000 and pays $ 60,000 then only taxed on $ 40,000
  • what's the limitation? Can't pay salary to someone who doesn't work for the company - cannot pay exorbitant salary - must be REASONABLE

Bush's TAX PLAN - temporary legislation - five years and expires 2008

  • tax on dividends reduced by fifty percent
  • supporters of tax cut say that it will correct major distortion on tax system - double taxation unfair - increase consumer spending and investments –
  • the critics say that there's a huge class war - tax cuts for the rich and no benefit for the lower classes - clearly benefits the wealthiest parts of society
  • but supporters say that two-thirds are investors and own stock - but tax cuts not aimed in lower classes stock-owners. Forty-two percent go to the top one percent of investors - trickle down effect
  • criticisms - tax cuts will cost three hundred billion dollars over ten years - but these costs could be paid for payroll taxes –
  • the burden is really placed on middle income families - dividend double taxation is not the only one - other double taxation- sales, import taxes -these could be cured to lighten the load on middle income families -

S CORPORATION as opposed to the C CORPORATION

  • corporation for all other purposes that elects to be taxed under subchapter S of IRS Code
  • corporation itself is actually not paying tax on corporate profit - profit flows through to individual shareholders - S CORPORIATION is taxed like Partnership - CONDUIT TAXATION - Why doesn't everyone tax this way?

Requirements

  • domestic corporation
  • no more than seventy-five shareholders - this used to be thirty-five shareholders in the past - maybe 1997?
  • individuals or estates or other s corporations
  • one class of stock - often a problem for small corporations because it's useful to have different classes of stock to allocate control - NEED TO THINK ABOUT FOR PROJECT - will we incorporate as S Corporation? Only one kind of stock –
  • unanimous consent of shareholders to S corporation

TERMINATION

  • more than twenty-five percent of corporation gross receipts involve passive investment income - after three years - AMOUNT of control
  • if shareholders exceed seventy-five shareholders OR if any shareholders are nonresident aliens, or are not an individual, estate, or qualified trust
  • if second class of stock is issued
  • revoked by the holders of a majority of the corporation's stock

BASIC CONCEPTS AND FIDUCIARY DUTY

Recap of last week’s lecture

midterm project will revolve on a similar fact pattern like PTC - how to control Bernie's power?

  • Jessica's concerns
  • provisions in articles of corporation that limit shareholder's power - to make amendment to articles of incorporation - two-thirds of shareholders have to vote in the Chesapeake's hypothetical
  • perpetual existence - not comfortable with the idea without her
  • easier to go into S corporation to C Corporation instead of the other forms.
  • Michael's concerns
  • LLC because it's the most flexible and also has the limited liability - not risk loving because of his responsibilities with his family
  • member managed preferred
  • Bernie's concerns
  • LLCs - wants member-managed if he wants to be active but manager-managed because he wants to limit involvement
  • with LLP because of the ease to transfer interests to his son

Chesapeake Marine Services Corp. - provides barge and towing services

Facts

  • One thousand shares of common stock
  • Two-thirds vote of shareholders to amend the Articles of Incorporation
  • Fifteen shareholders of which John Apple has 350 shares. No individual has more than 200 shares. why does it matter what other shareholders have? Always think about who has control - how many shares - who's on the board?
  • Board of Directors - Apple, James Lambert the president, two other members of the Lambert family and Nancy Carter - a substantial shareholder - important to clarify the parties involved because of aligned interests
  • JAMES LAMBERT'’s IDEA - double the amount of showers - raise capital but also to shift power in the balance of power
  • COULD NOT GO THROUGH - because Apple was against the idea - must go to the shareholders, why not the board of directors? Because the specific provisions in the Articles of Incorporation - that only allows for one thousand common stocks
  • Apple could not even vote regardless of the votes needed to bring an amendment because the Board must accept the proposal before presenting to the shareholders

TERMINOLOGY

  • Authorized Shares - statute requires corporation to include in AoI the number of shares that have been authorized - which are those stocks allowed to be issued at a certain date
  • Issued Shares - when shares are actually sold to shareholders
  • Outstanding Shares - shares that are issued and still held by the shareholders
  • Treasury Shares - authorized and issued but not outstanding shares - bought back by the corporation

How does a corporation determine the number of shares in the articles of incorporation? Because the fewer shares, the existing shareholders are protected when the corporation is not allowed to issue more shares -anything that goes into articles of incorporation must be decided

  • don't issue too many because original shareholders are not protected
  • also whether you want the board to have the power or the shareholders to issue - depends on who you are
  • some states impose taxes on stocks that are authorized -
  • when people buy stocks - want to gain a sense of what to expect in the future
  • MBCA 2.02(a)

liability risk?

  • None because the shareholders may say no.

How else to raise capital?

Take out loans, issuing bonds , debt, debentures - merge with a company that has more capital, sell assets, business decisions like firing employees, etc. al.

  • MBCA 10.03 need the majority of the vote - unless it requires - default rule is majority vote
  • can you include one-third? No you need a default rule - only if greater than majority vote
  • MBCA 8.01(b) - how to reconcile the conflict - almost everything is in the power of the Board of Directors and very few with shareholders
  • amending articles of incorporation, mergers, if corporation will sell all of its assets
  • but the Board can sell 75 percent without the shareholders. 8.01 gives all powers to Board of Directors and remaining provisions retain some powers for shareholders - biggest power - to vote or dismiss Board of Directors

FIDUCIARY DUTY of directors

  • duty of care and duty of loyalty - still very hard to win a case - heavy presumption for directors
  • duty of care - MBCA 8.30Standards of Conduct for Directors
  • BUSINESS JUDGMENT RULE all about the process of making the decision - not just about the substance - cannot use hindsight
  • good faith - use of ordinary care - not extraordinary care - they are encouraged to take risks because of a capitalist society –
  • manner reasonably believes to be in the best interests
  • person in a like position would reasonably believe appropriate under similar circumstances

Duty of Loyalty

MBCA 8.31 - in subchapter Fbut most states have not adopted it. On page 284 - in Prior MBCA

  • duty of loyalty - subordinate individual self-interests to the corporation - ownership in other interests - if director on both boards

Finish up PAR VALUE