A corporation is an artificial person that is created by governmental action. The corporation exists in the eyes of the law as a person, separate and distinct from the persons who own the corporation (stockholders). This means that the property of the corporation is not owned by the stockholders, but by the corporation. Debts of the corporation are debts of this artificial person, and not of the persons running the corporation or owning shares of stock in it. The corporation can sue and be sued in its own name. The shareholders cannot normally be sued as to corporate liabilities.
Model Corporation Acts
Most States have a general corporation code that lists certain requirements, and anyone who satisfies these requirements and files the necessary papers with the government may automatically become a corporation. In 1950, the American Bar Association published a Model Business Corporation Act (MBCA) to assist State Legislatures in modernizing State corporation laws. In 1984, a revision of this Model Act was published (RMBCA). All states have adopted various versions of the MBCA or the RMBCA with only slight variations.
Formation
A corporation is formed by obtaining approval of a Certificate of Incorporation, Articles of Incorporation, or a Charter from the State of incorporation. The Secretary of State is usually the official who approves or disapproves this certificate. The Revised Model Business Corporation Act (RMBCA) has done away with the Certificate of Incorporation in an attempt to simplify the paperwork handled by the Secretary of State. Under the RMBCA, a corporate existence begins when the Articles of Incorporation are filed with the Secretary of State.
One or more natural persons or corporations may act as incorporators of a corporation by signing and filing Articles of Incorporation with the designated state government official (usually the Secretary of State). These Articles are often filed in duplicate, and the Secretary of State, when satisfied that the Articles conform to the State’s corporation statutes, stamps filed and the date on each copy. The Secretary of State then retains one copy and returns the other copy, along with a filing fee receipt, to the corporation.
The Articles of Incorporation must contain the following:
- The name of the corporation;
- The number of shares of stock the corporation is authorized to issue;
- The street address of the corporation’s initial registered office and the name of its initial registered agent; and
- The name and address of each incorporator.
The Articles may contain optional provisions such as the purpose for which the corporation is organized. However, if the Articles contain no purpose clause, the corporation will automatically have the purpose of engaging in any lawful business. Also, if no reference is made to the duration of the corporation in the Articles, it will automatically have a perpetual duration. Under the RMBCA, corporate existence begins when the Articles are filed with the Secretary of State. Under the older practice still followed by many States, corporate existence begins upon the issuance of a Certificate of Incorporation by the Secretary of State.
Shareholders
The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The board of directors elects the officers and is responsible for the management and policy decisions of the corporation. The dealings of the corporation are carried out by the officers and employees of the corporation under the authority delegated by the directors of the corporation.
Shares must be issued to those individuals who will be owners of the corporation. This is also the case even if only one individual will own the corporation. Ownership of a corporation can be transferred by sale of all or a portion of the stock. Additional owners can be added either by selling stock directly from the corporation or by having the current owners sell some of their stock. Small businesses that are corporations are often owned by a small group of shareholders who all work in the business. Often these shareholders formally agree to certain restrictions on the sale of their shares, so they can control who owns the corporation.
Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to follow certain procedures before accepting investments in exchange for shares of stock (the “securities”). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Many small corporations are exempted from the registration process under federal and state laws. For example, SEC rules don’t require a corporation to register a “private offering,” which is a non-advertised sale of stock to a limited number of people (generally 35 or fewer).
Directors
Each director must attend meetings of the board, which must be held no less than once a year. Each director on the board is given one vote. Usually the vote of a majority of the directors is sufficient to approve a decision of the board. Directors must make sure that major corporate actions are recorded (e.g., minutes of meetings) and were taken behalf of the corporation.
Corporate Officers
Corporate officers are elected by the Board of Directors and are responsible for conducting the day-to-day operational activities of the corporation. Corporate officers usually consist of the following: a President, Vice-President, Secretary, and Treasurer, though one person may hold more than one office. Terms of directors often are for more than one year and are staggered to provide continuity. Shareholders can elect themselves to be on the board of directors.
Bylaws
The bylaws of a corporation are the internal rules and guidelines for the day-to-day operation of a corporation, such as when and where the corporation will hold directors’ and shareholders’ meetings and what the shareholders’ and directors’ voting requirements are. Typically, the bylaws are adopted by the corporation’s directors at their first board meeting. They may specify the rights and duties of the officers, shareholders and directors, and may deal, for example, with how the company may enter into contracts, transfer shares, hold meetings, pay dividends and make amendments to corporate documents. They generally will identify a fiscal year for the corporation.
Classification of Corporations
A corporation is called a domestic corporation with respect to the State under whose law it has been incorporated. Any other corporation going into that State is called a foreign corporation. For example, a corporation holding a Texas Charter is a domestic corporation in Texas, but a foreign corporation in all other States. A foreign corporation must qualify to do business in a foreign State.
A corporation whose shares are held by a single shareholder or a closely-knit group of shareholders (such as a family) is known as a close corporation. The shares of stock are not traded publicly. Many of these types of corporations are small firms that in the past would have been operated as a sole proprietorship or partnership, but have been incorporated in order to obtain the advantages of limited liability or a tax benefit or both.
A corporation may be organized for the business of conducting a profession. These are known as professional corporations. Doctors, attorneys, engineers, and CPAs are the types of professionals who may form a professional corporation. Usually there is a designation P.A. or P.C. after the corporate name in order to show that this is a professional association or professional corporation.
A nonprofit corporation is one that is organized for charitable or benevolent purposes. These corporations include certain hospitals, universities, churches, and other religious organizations. A nonprofit entity does not have to be a nonprofit corporation, however. Nonprofit corporations do not have shareholders, but have members or a perpetual board of directors or board of trustees.
A Subchapter S corporation is a corporation in which the shareholders elect to be treated as partners for income tax purposes. Shareholders still have limited liability protection of a corporation, but income is treated like partnership income. Subchapter S refers to a particular subdivision of the Internal Revenue Code. The number of shareholders is limited and neither corporations nor partnerships can be shareholders in a Subchapter S corporation. Also, shareholders must be U.S. citizens or resident aliens.
“Citizenship” of Corporations
For certain purposes, such as determining the right to bring a lawsuit in Federal Court, a corporation today is deemed a citizen of any State in which it has been incorporated and also of the State where it has its principal place of business. Therefore, a corporation can be a citizen of more than one State. For example, a corporation incorporated in New York is a New York corporation even though its shareholders are citizens of many other States. A Delaware corporation having its principal place of business in New York is deemed to be a citizen of New York as well as of Delaware.
Before doing business in another State, a foreign corporation generally must register with the Secretary of State of that State, file copies of its Articles of Incorporation, pay certain taxes, and appoint a resident agent for service of process.
Piercing the Veil
Ordinarily, a corporation will be regarded and treated as a separate legal person, and the law will not look beyond a corporation to see who owns it. However, a court may disregard the corporate entity and pierce the corporate veil in exceptional circumstances. The decision whether to disregard the corporate entity and go directly against the shareholders is made on a case-by case basis, and courts generally will look to more than one factor. Factors that may lead to piercing the corporate veil are:
- Failure to maintain adequate corporate records and the commingling of corporate and personal funds;
- Grossly inadequate capitalization (debt/equity ratio too high);
- The formation of a corporation to evade an existing obligation;
- The formation of a corporation to perpetrate a fraud;
- Improper diversion of corporate assets; and
- Injustice and inequitable circumstances would result if the corporate entity were recognized.
A court will not go behind the corporate identity merely because a corporation has been formed to obtain tax savings or to obtain limited liability for its shareholders. One-person, family, and other closely-held corporations are permissible and fully entitled to all of the advantages of corporate existence. However, factors that lead to piercing the corporate veil more commonly exist in these kinds of corporations. It is extremely difficult to pierce a corporate veil in most situations. Some courts use different terminology when disregarding the corporate entity. The court may state that the corporation is the alter ego of the shareholders, and the shareholders should therefore be held liable.
A holding company is a company, usually a corporation, which is created to own the stock of other corporations, often using the stock holdings to control the management and policies of the corporations.
Promoters
Promoters are the people that bring the corporation into existence. They bring together other people interested in the company, solicit stock purchasers, and sometimes make contracts to be assigned later to the corporation. A corporation is not liable on a contract made by a promoter unless the corporation takes some sort of affirmative action to adopt the contract. The promoter still remains personally liable on the contract unless released by the other contracting party. The contract can provide that the promoter will be released from personal liability upon adoption of the contract by the corporation.
Corporate Powers
Corporations have some of the same powers as a natural person, such as the right to own property. If a corporation acts beyond the limits of its powers, the act is ultra vires. This is an act or contract that the corporation did not have authority to do or make. Modern corporation statutes give corporations broad powers, and the likelihood that a corporation will act beyond its powers is rare.
All corporations do not have the same powers. For example, corporations that operate banks, insurance companies, and railroads generally have special powers and are subject to special statutory restrictions.
As long as the Federal and State Constitutions are not violated, a State Legislature may give corporations any lawful powers. The RMBCA grants a corporation the same powers as an individual to do all things necessary or convenient to carry out its business and affairs.
Modern corporation statutes give corporations a wide range of powers. A corporation has perpetual succession or continuous life. In other words, it has the power to continue as a unit indefinitely or for a stated period of time regardless of any changes in the ownership of its stock. If no period of time is fixed for the duration of the corporation, the corporation will exist indefinitely until it is legally dissolved. If the period of existence is limited, the corporation can extend the period by meeting certain statutory requirements.
Samples of Corporate Powers
- Corporations have the power to enter into contracts just like an individual.
- Corporations have the power to borrow money in carrying out their business purposes.
- A corporation can borrow money by issuing bonds. The bonds issued by a corporation are subject to Article 8 of the UCC (“Investment Securities”).
- A corporation may sell or lease its property. However, in most States a corporation may not sell or mortgage all or substantially all of its assets without the consent of the majority of the shareholders.
- Obviously a corporation has the power to incur debt and mortgage its property as security for debt.
- Corporations may acquire the stock of another corporation and be a stockholder of another corporation.
- Generally, a corporation may purchase its own stock if it is solvent, and this stock will be known as treasury stock. Treasury stock maintains the status of outstanding stock, but is regarded as inactive and cannot be taken into consideration regarding votes by the shareholders. Also, dividends cannot be declared regarding treasury stock. The RMBCA eliminates the concept of treasury stock and calls this type of stock authorized, but unissued, stock.
- A corporation has the power to do business in other States. However, by doing business in other States, the corporation may have to qualify as a foreign corporation to do business in that State which usually involves registering with the Secretary of State.
- A corporation may be a member of a partnership and may be a limited or general partner of a limited partnership.
- Corporations can pay pensions and establish pension plans for its employees.
- The RMBCA even authorizes a corporation to make charitable contributions.
Ultra Vires Acts
If a corporation acts beyond the scope of the powers granted by its charter and the statutes of the State under which it is governed, the corporation’s act is declared as ultra vires. However, modern corporation statutes give such a broad scope of powers that it is difficult to find an action that is ultra vires. Say a mining corporation begins to manufacture television sets. In such a situation, there might be an ultra vires transaction if the corporate charter restricted the corporation’s powers to mining and related-such activities. However, this type of situation is extremely rare.
Nonprofit corporations have a more restricted range of powers than business corporations, and it would be more likely to find an ultra vires act in a nonprofit corporation than a profit corporation.
Name of Corporation
A corporation must have a name to identify it. Most States require that the corporate name contain some indication that it is a corporation, such as corporation, company, incorporated, limited, or an abbreviation of these words.
Seal
A corporation may have a seal which can be used to show that a contract or a document is being executed pursuant to valid corporate authority.
Consolidations Mergers and Acquisitions
Mergers and acquisitions is a phrase used to describe certain types of financial activities in which corporations are bought and sold. A merger occurs when two corporations merge, in other words, one absorbs the other. One corporation preserves its original charter and identity and continues to exist. The other corporation disappears, and its corporate existence terminates. Generally, the corporate entity which continues the business after a merger will succeed to all of the rights and property of the other entity and will also be subject to all of its debts and liabilities.
A corporation may merely purchase or acquire the assets of another corporation. This would not be a merger In an acquisition, the purchaser does not become liable for the obligations of the business whose assets are being purchased.
In a consolidation of two or more corporations, their separate existences cease, and a new corporation with the property and the assets of the old corporations comes into being.
A merger is different from a consolidation in that when two corporations merge, one absorbs the other. One corporation preserves its original charter and identity and continues to exist. The other corporation disappears, and its corporate existence terminates.
A conglomerate is the term describing the relationship of a parent corporation to subsidiary corporations engaged in diversified activities which are unrelated to the activity of the parent corporation. A subsidiary corporation is a corporation whose majority shareholder is another corporation (parent corporation). An example of a conglomerate could be a wire-manufacturing corporation that owns all of the stock of a newspaper corporation and of a drug-manufacturing corporation.
Antitrust
Consolidations, mergers, and asset acquisitions are sometimes prohibited by federal antitrust legislation on the grounds that the effect is to lessen competition in interstate commerce.
Liability of Successor Corporations
When corporations are combined in any way, the question arises as to who is liable for the debts and obligations of the predecessor corporations. Generally, the corporate entity which continues the business after a merger or a consolidation will succeed to all of the rights and property of the predecessors and will also be subject to all of the debts and liabilities of the predecessor corporations. For example, A merges into B. Suppose A had a contract with C. B did not. After the merger, B is liable to C on the contract.
A corporation may merely purchase the assets of another business. This would not be a merger or consolidation. In an acquisition situation, the purchaser does not become liable for the obligations of the business whose assets are being purchased.
Frequently Asked Questions
- How does an individual form a corporation? One or more natural persons or corporations may act as incorporators of a corporation by signing and filing Articles of Incorporation with the designated state government official (usually the Secretary of State). These Articles are often filed in duplicate, and the Secretary of State, when satisfied that the Articles conform to the State’s corporation statutes, stamps filed and the date on each copy. The Secretary of State then retains one copy and returns the other copy, along with a filing fee receipt, to the corporation.
What information must the Articles of Incorporation contain:
The articles of incorporation must contain:
- The name of the corporation;
- The number of shares of stock the corporation is authorized to issue;
- The street address of the corporation’s initial registered office and the name of its initial registered agent; and
- The name and address of each incorporator.
The Articles may contain optional provisions such as the purpose for which the corporation is organized. However, if the Articles contain no purpose clause, the corporation will automatically have the purpose of engaging in any lawful business. Also, if no reference is made to the duration of the corporation in the Articles, it will automatically have a perpetual duration.
What are bylaws of a corporation?
The bylaws of a corporation are the internal rules and guidelines for the day-to-day operation of a corporation, such as when and where the corporation will hold directors’ and shareholders’ meetings and what the shareholders’ and directors’ voting requirements are. Typically, the bylaws are adopted by the corporation’s directors at their first board meeting. They may specify the rights and duties of the officers, shareholders and directors, and may deal, for example, with how the company may enter into contracts, transfer shares, hold meetings, pay dividends and make amendments to corporate documents. They generally will identify a fiscal year for the corporation.
What is a close corporation?
A corporation whose shares are held by a single shareholder or a closely-knit group of shareholders (such as a family) is known as a close corporation. The shares of stock are not traded publicly. Many of these types of corporations are small firms that in the past would have been operated as a sole proprietorship or partnership, but have been incorporated in order to obtain the advantages of limited liability or a tax benefit or both.
What is a professional corporation?
A corporation may be organized for the business of conducting a profession. These are known as professional corporations . Doctors, attorneys, engineers, and CPAs are the types of professionals who may form a professional corporation. Usually there is a designation P.A. or P.C. after the corporate name in order to show that this is a professional association or professional corporation.
What is a non-profit corporation?
A nonprofit corporation is one that is organized for charitable or benevolent purposes. These corporations include certain hospitals, universities, churches, and other religious organizations. A nonprofit entity does not have to be a nonprofit corporation, however. Nonprofit corporations do not have shareholders, but have members or a perpetual board of directors or board of trustees.
What is a Subchapter S corporation?
A Subchapter S corporation is a corporation in which the shareholders elect to be treated as partners for income tax purposes. Shareholders still have limited liability protection of a corporation, but income is treated like partnership income. Subchapter S refers to a particular subdivision of the Internal Revenue Code. The number of shareholders is limited and neither corporations nor partnerships can be shareholders in a Subchapter S corporation. Also, shareholders must be U.S. citizens or resident aliens.
What is the registered agent of a corporation?
The registered agent is the “mailbox” for the corporation. He or she is the person or entity designated by the corporation to receive any documents regarding a lawsuit against the corporation or other official communications. Many corporations use their attorney or a professional corporate service company for this service. The registered agent’s address must generally be a street address in the subject state and the agent must be located at that address. A post office box generally may not be used as the registered agent address.
When does a corporation’s existence begin?
Under the corporate laws of some states, corporate existence begins when the Articles are filed with the secretary of state. Under an older practice still followed by many states, corporate existence begins upon the issuance of a Certificate of Incorporation by the secretary of state.
How is the business of a corporation carried out or managed?
The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The board of directors elects the officers and is responsible for the management and policy decisions of the corporation. The dealings of the corporation are carried out by the officers and employees of the corporation under the authority delegated by the directors of the corporation.
What are the general duties of directors?
Each director must attend meetings of the board, which must be held no less than once a year. Each director on the board is given one vote. Usually the vote of a majority of the directors is sufficient to approve a decision of the board. Directors must make sure that major corporate actions are recorded (e.g., minutes of meetings) and were taken behalf of the corporation. Corporate officers are elected by the Board of Directors and are responsible for conducting the day-to-day operational activities of the corporation. Terms of directors often are for more than one year and are staggered to provide continuity. Shareholders can elect themselves to be on the board of directors.
What officers are elected by the directors?
Corporate officers usually consist of the following: a President, Vice-President, Secretary, and Treasurer, though one person may hold more than one office.
Who actually owns the property of a corporation?
A corporation is an artificial person that is created by governmental action. The corporation exists in the eyes of the law as a person, separate and distinct from the persons who own the corporation (stockholders). This means that the property of the corporation is not owned by the stockholders, but by the corporation. Debts of the corporation are debts of this artificial person, and not of the persons running the corporation or owning shares of stock in it.
How do the initial shareholders fit into the ownership of the corporation?
Shares must be issued to those individuals who will be owners of the corporation. This is also the case even if only one individual will own the corporation. Ownership of a corporation can be transferred by sale of all or a portion of the stock. Additional owners can be added either by selling stock directly from the corporation or by having the current owners sell some of their stock. Small businesses that are corporations are often owned by a small group of shareholders who all work in the business. Often these shareholders formally agree to certain restrictions on the sale of their shares, so they can control who owns the corporation.
What are security laws?
Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to follow certain procedures before accepting investments in exchange for shares of stock (the “securities”). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Many small corporations are exempted from the registration process under federal and state laws. For example, SEC rules don’t require a corporation to register a “private offering,” which is a non-advertised sale of stock to a limited number of people (generally 35 or fewer).
What do the designations domestic corporation and foreign corporation mean?
A corporation is called a domestic corporation with respect to the State under whose law it has been incorporated. Any other corporation going into that State is called a foreign corporation. For example, a corporation holding a Texas Charter is a domestic corporation in Texas, but a foreign corporation in all other States. A foreign corporation may have to qualify to do business in a foreign State.
How does a foreign corporation qualify to do business in another state?
Before doing business in another State, a foreign corporation generally must register with the Secretary of State of that State, file copies of its Articles of Incorporation, pay certain taxes, and appoint a resident agent for service of process.
What is meant by the phrases doing or transacting business in another state by a foreign corporation?
There are many factors used to determine whether a foreign corporation is transacting business in a state and therefore must qualify to do business in that state. Some criteria evaluated include:
- Whether the company has a physical presence in the state;
- Whether the company has employees in the state;
- Whether the company accepts orders in the state; and
- Whether the company has a bank account in the state
This is not a complete list and different states may have different criteria. However, these are some common factors to consider when trying to determine whether it is necessary for a foreign corporation to register or qualify in another state.
I have heard that a corporation can be a citizen of a state. What does this mean?
For certain purposes, such as determining the right to bring a lawsuit in Federal Court, a corporation today is deemed a citizen of any State in which it has been incorporated and also of the State where it has its principal place of business. Therefore, a corporation can be a citizen of more than one State. For example, a corporation incorporated in New York is a New York corporation even though its shareholders are citizens of many other States. A Delaware corporation having its principal place of business in New York is deemed to be a citizen of New York as well as of Delaware.
What does it mean to pierce the corporate veil?
Ordinarily, a corporation will be regarded and treated as a separate legal person, and the law will not look beyond a corporation to see who owns it. However, a court may disregard the corporate entity and pierce the corporate veil in exceptional circumstances. The decision whether to disregard the corporate entity and go directly against the shareholders is made on a case-by case basis, and courts generally will look to more than one factor. Factors that may lead to piercing the corporate veil are:
- Failure to maintain adequate corporate records and the commingling of corporate and personal funds;
- Grossly inadequate capitalization (debt/equity ratio too high);
- The formation of a corporation to evade an existing obligation;
- The formation of a corporation to perpetrate a fraud;
- Improper diversion of corporate assets; and
- Injustice and inequitable circumstances would result if the corporate entity were recognized.
A court will not go behind the corporate identity merely because a corporation has been formed to obtain tax savings or to obtain limited liability for its shareholders. One-person, family, and other closely-held corporations are permissible and fully entitled to all of the advantages of corporate existence. However, factors that lead to piercing the corporate veil more commonly exist in these kinds of corporations. It is extremely difficult to pierce a corporate veil in most situations. Some courts use different terminology when disregarding the corporate entity. The court may state that the corporation is the alter ego of the shareholders, and the shareholders should therefore be held liable.
What are mergers and acquisitions?
Mergers and acquisitions is a phrase used to describe certain types of financial activities in which corporations are bought and sold. A merger occurs when two corporations merge, in other words, one absorbs the other. One corporation preserves its original charter and identity and continues to exist. The other corporation disappears, and its corporate existence terminates. Generally, the corporate entity which continues the business after a merger will succeed to all of the rights and property of the other entity and will also be subject to all of its debts and liabilities.
A corporation may merely purchase or acquire the assets of another corporation. This would not be a merger In an acquisition, the purchaser does not become liable for the obligations of the business whose assets are being purchased.
What is a holding company?
A holding company is a company, usually a corporation, which is created to own the stock of other corporations, often using the stock holdings to control the management and policies of the corporations.
What is an Annual Report?
A annual report is a report that must be filed with your state’s secretary of state each year. This report generally must indicate:
- The corporation’s name and its state or country of incorporation;
- The address of its registered office and the name of its registered agent at that office in this state;
- The address of its principal office;
- The names and business addresses of its directors and principal officers;
- A brief description of the nature of its business;
- The total number of authorized shares, itemized by class and series, if any, within each class; and
- The total number of issued and outstanding shares, itemized by class and series, if any, within each class
How do I determine if the corporate name I want to use is available?
Your state’s secretary of state will make a determination of name availability for corporate entities in response to written requests. There is generally a small fee. If you wish to reserve a corporate name for a business entity, most states will allow you to after completion of and filing the appropriate form generally entitled “Application for Reservation of Name.”
If I incorporate, will anyone else be able to use my name?
Issuance of a name by the secretary of state does not necessarily give a person the exclusive right to use of that name. Many businesses do not choose to incorporate. A secretary of state’s office generally has no record of these and thus cannot search names of unincorporated businesses.
Is there a minimum age for officers of a corporation?
Most states do not have a minimum age requirement but do require that members of the board of directors must be at least 18 years old.
Sole Proprietorships
A sole proprietorship is a form of business ownership in which one individual owns a business. The owner may either be the only worker of the business or he may employ as many people as he needs to run the operation. He can use his own name or a trade name. If a trade name is used, oftentimes the business will be identified on official forms and in the case of a lawsuit by use of the designation “d/b/a” (doing business as). For example, “John Jones, d/b/a Multimedia Designs.”
Advantages:
One advantage to a sole proprietorship is that the owner is not required to pay organizational fees, such as in a corporation. Also, he controls all of the decisions and receives all of the profits. The business’s net earnings are not subject to corporate income tax, but are taxed as personal income.
Disadvantages:
One disadvantage of a sole proprietorship is that the owner is subject to unlimited personal liability for the debts of the business. This is not true in a corporate organization. Also, the investment capital is limited to the resources of the sole proprietor, and this may hurt the growth of the business. Corporations can issue stock and raise capital that way. Another disadvantage is that upon the death of the owner, his authority to make contracts terminates, and this, of course, will effectively kill the business. However, some courts can grant temporary authority for the executor of the owner’s estate to continue the business while the estate is being administered.
Partnerships
A partnership involves combining the capital resources and the business or professional abilities of two or more people in a business. Law firms, medical associations, and architectural and engineering firms often operate under the partnership form.
Advantages:
One advantage is that a partnership allows more than one individual to pool financial resources without the requirement of a formal corporate structure and without the expense of organizational fees.
Disadvantages:
One disadvantage is that each partner has unlimited personal liability for the debts of the partnership. Also, the partnership is technically dissolved by the death of a partner, although there is some statutory relief with regard to winding up the affairs of the partnership after the death of one of the partners. A new partnership can then be formed.
Definition of Partnership
A partnership is defined by the UPA as a relationship created by the voluntary “association of two or more persons to carry on as co-owners of a business for profit.” The people associated in this manner are called partners. A partner is the agent of the partnership. A partner is also the agent of each partner with respect to partnership matters. A partner is not an employee of the partnership. A partner is a co-owner of the business, including the assets of the business.
Rights of Partners
The partnership agreement is the heart of the partnership, and it must be enforced as written, with very few exceptions. Partners’ rights are determined by the partnership agreement. If the agreement is silent regarding a matter, the parties’ rights are typically determined by the UPA.
Name of Partnership
Unless a State statute requires a firm name, a partnership does not have to have one. However, it is customary to have a firm name, and a partnership will probably need one in order to get a tax identification number. A partnership may, as a general rule, adopt any firm name the partners’ desire and may use a fictitious name. However, the name of the partnership cannot be the same as, or deceptively similar to, another partnership’s name for the purpose of stealing business from the other partnership. Many States also require the registration of a fictitious name. For example, a husband and wife may transact business under a partnership name such as G & G Foods. This name does not reveal the names of the partners. Some States will require a certificate to be filed in a City Clerk’s office which would state the names and addresses of the partners.
Who May be a Partner
Persons who are competent to enter into a contract may form a partnership. Generally, an insane person or a minor should not be a partner because they can declare the contract void. Even corporations can be partners in many States, such as Mississippi.
Creation of a Partnership
If parties operate a business for profit as co-owners, a partnership is deemed to be created even though the parties may not have labeled their relationship as a partnership. A partnership does not come into being if the partners do not agree to the elements of a partnership even though they may call it a partnership. The manner in which a business is described in a tax return or on an application for a license is significant in determining whether or not they intend to be operating as a partnership. Remember, a partnership is a voluntary association and exists because the parties agree to be in partnership. However, Courts are interested in substance rather than form. And even though people file an income tax return as a partnership, if they are in fact not partners, but merely have a relationship of, for example, an employer and employer, there is no partnership.
When the parties have not clearly indicated whether or not their business constitutes a partnership, the law has determined several guidelines to aid Courts in determining whether the parties have created a partnership.
- The fact that the parties share profits and losses is strong evidence of a partnership.
- An agreement that does not provide for sharing losses, but does provide for sharing profits, is still evidence of a partnership since it is assumed that the parties will also share losses.
- The sharing of gross revenue is itself very slight, if any, evidence of a partnership.
- Co-ownership of property does not necessarily create a partnership. Also, sharing profits or rents from property that two or more people own does not necessarily create a partnership.
- A partnership may be formed even if some of its members furnish only skill or labor rather than capital to the partnership.
The Partnership Agreement
As a general rule, partnership agreements do not have to be in writing. However, it is crazy to enter into an oral partnership agreement. A partnership agreement must be in writing if it is within the provisions of the statute of frauds, such as a contract that cannot be performed within one year. The formal document that is prepared to evidence the partnership agreement is termed as a partnership agreement or articles of partnership. If matters arise that are not covered by the agreement, the rights of the parties will be determined by statute (such as the UPA) or Court decisions.
Partners as to Third Persons
In some cases, persons who are in fact not partners may be held accountable to third persons as though they were partners. This liability arises when they conduct themselves in such a manner that others are reasonably led to believe that they are partners and to act in reliance on their belief. This is similar to the apparent agency doctrine. For example, suppose the partnership of Able and Baker, in registering its fictitious name, states that Able, Baker and Charlie are partners, and the registration certificate is signed by all three of them. If a creditor sees this registration statement and extends credit to the firm, relying on the fact that Charlie is apparently a partner, Charlie would have partnership liability insofar as that creditor was concerned, even if he was not in fact a partner. However, liability would not arise if Charlie did not know of this registration certificate. However, if he signed the registration certificate, he had knowledge of it.
Partnership Property
In general, partnership property consists of all the property contributed by the partners or acquired for the partnership with its funds. A partnership may own real property as well as personal property.
Partners hold title to partnership property by “tenancy in partnership” or “tenants in common.” This means that each partner has an equal right to use the partnership property for partnership purposes unless there is an agreement to the contrary. Also, a partner possesses no interest in any specific item of partnership property. (For example, a partner does not own 10% of the PC which his secretary uses.) A creditor of the partner cannot proceed against any specific items of partnership property. A creditor can only proceed against the partner’s interest in the partnership.
Assignment of a Partner’s Interest
A partner’s interest in the partnership may be assigned by the partner. However, the assignee does not become a partner without the consent of the other partners. Without this consent, the assignee is only entitled to receive the assignor’s share of the profits of the partnership and the assignor’s interest when the partnership dissolves. The assignee has no right to participate in the management of the partnership or inspect the books of the partnership. A partnership agreement should prevent this type of assignment by giving the remaining partners the right of first refusal regarding any attempted assignment of a partner’s interest.
Dissolution and Termination
Partnerships may be dissolved by acts of the partners, order of a Court, or by operation of law. From the moment of dissolution, the partners lose their authority to act for the firm except as necessary to wind up the partnership affairs or complete transactions which have begun, but not yet been finished.
A partner has the power to withdraw from the partnership at any time. However, if the withdrawal violates the partnership agreement, the withdrawing partner becomes liable to the co-partners for any damages for breach of contract. If the partnership relationship is for no definite time, a partner may withdraw without liability at any time.
A partnership may be dissolved by any of the following events:
- expiration of the time stated in the agreement;
- expulsion of a partner by the other partners;
- withdrawal of a partner.
If a partnership does not have a fixed duration, a partner may withdraw at any time and for any reason or no reason without liability to the partnership. If a partner wrongfully withdraws from a partnership, the partner is liable to the other partners for any damages caused by the withdrawal.
Dissolution by Operation of Law
A partnership is dissolved by operation of law in the following instances:
Death of any Partner
A partnership is automatically dissolved by the death of any partner. Even if the remaining parties continue the business after the death of a partner, a new relationship is created in the form of a partnership-at-will until a new formal agreement is executed. A similar result would occur in cases in which a partner withdraws or is expelled. If the other partners continue to operate the business, they are operating as a partnership-at-will until they form a more formal partnership by executing a partnership agreement.
Bankruptcy
Bankruptcy of the partnership or one of the partners causes the dissolution of the partnership.
Illegality
A partnership is dissolved by an event which makes it unlawful for the business of the partnership to be continued. For example, if a State has a law that makes it unlawful for a judge to engage in the private practice of law, a law firm would be dissolved when one of its members becomes a judge.
Dissolution by Decree of Court
There are several situations in which one partner is permitted to obtain the dissolution of a partnership through a Court decree. A partner may judicially dissolve the partnership if one of the partners has been declared insane. Also, if one of the partners has become incapable of performing the terms of the partnership agreement, the partnership can be judicially dissolved. An example of this would be disbarment of an attorney in a law firm. The habitual drunkenness of a partner is a sufficient cause for judicial dissolution. Also, if dissensions in a partnership are so serious and persistent as to make the continuation of the partnership impractical, a judicial dissolution can be obtained. Finally, a partnership can be judicially dissolved if the partnership cannot continue in business except at a loss.
Notice of Dissolution
When the partnership is dissolved by an act of a partner, notice must be given to the other partners unless it is clear that the partner is withdrawing.
Notice of dissolution should also be given to third parties, and this notice should clearly state that the partnership has been dissolved. It is essential that actual notice of dissolution be given to persons who have dealt with the partnership. Failure to give proper notice continues the power of each partner to bind the others in respect to third persons on contracts within the scope of the partnership business.
Winding up Partnership Affairs
If a partner withdraws, is expelled, or dies, the survivor partners must wind up the business of the partnership unless there is an agreement to the contrary. In other words, they cannot continue the business of the partnership, other than winding up the partnership affairs, unless there is an express agreement that permits the continuance of the business by the remaining partners. Although the partners have no authority after dissolution to create new obligations, they do have authority to do acts necessary to wind up the business.
All partnership agreements should have some sort of buy/sell formula in order to buy out the interest of a partner who wants to withdraw. This will allow the partnership business to continue without interruption.
Distribution of Assets
Creditors of the partnership have first claim on the assets of the partnership. Difficulties arise when there is a dispute between the creditors of the partnership and the creditors of the individual partners. The general rule is that the partnership creditors have first claim on the assets of the firm, and the individual creditors (creditors of the individual partners) share in the remaining assets, if any.
After the partnership’s liabilities to non-partners have been paid, the assets of the partnership are distributed as follows:
- Each partner is entitled to a refund of advances made to, or for the benefit of, the partnership;
- Contributions to the capital of the partnership are then returned; and
- The remaining assets, if any, are divided equally as profits among the partners unless there is some agreement which would provide for unequal distribution.
- If the partnership has sustained a loss, the partners share it equally unless there is an agreement between them to the contrary.
Continuation of the Partnership Business
As a practical matter, the business of the partnership is commonly continued after dissolution and winding up. If the business continues, either with the surviving partners, or with them and additional partners, it is a new partnership. As a practical matter, the liquidation of the old partnership may, in effect, be merely a matter of bookkeeping entries.
Authority of Majority of Partners
The decision of the majority of partners will control as far as the day-to-day operations of the partnership. For example, a majority of the partners of a business can decide to increase the business’s advertising and enter into a contract to increase the advertising. This contract will bind the partnership and all of the partners, individually.
When there is an even number of partners, there is a possibility of a partnership deadlock. If the decision is of a nature that it would be impossible to continue the business, and the partners continue to be deadlocked, any one of the partners may petition the Court to order the dissolution of the partnership.
Express Authority of Individual Partners
An individual partner can have express authority to perform certain acts. This authority either comes from the partnership agreement or because a sufficient number of partners have agreed to this authority. A partner has the authority to do the acts that are customary for a member of the partnership who conducts the particular business of the partnership, whether it be a law partnership, medical partnership, accounting partnership, etc.
Customary Authority of Individual Partners
The customary or implied powers of individual partners to do business can be described as follows:
Contracts: A partner may make any contract necessary to the transaction of the partnership’s business.
Sales: A partner may sell the partnership’s goods in the regular course of business. However, this authority is limited to the goods held for sale by the partnership. Example: Mark, Sally and Lucy operate a car dealership as a partnership. Mark sells one of the cars of the partnership to Frank at a price below dealer cost. His motive was that the partnership could get its money back plus a profit in servicing the car. Sally and Lucy sue to avoid the sale to Frank on the grounds that Mark never was authorized to make such a sale to Frank. Is the sale binding on the partnership? The sale is binding since a partner in a selling partnership or trading partnership has authority to sell any of the partnership’s inventory in the regular course of business. No express authorization is needed.
Purchases
A partner may purchase any kind of property within the scope of the partnership’s business.
Loans
A trading partnership would be a partnership which is organized to buy and sell inventory like a grocery business or a car dealership. A partner in this type of partnership may borrow money for the partnership’s business and may execute commercial paper (such as a note) or give security (such as a mortgage or a security interest in the personal property of the partnership). A partner in a nontrading partnership does not ordinarily possess the power to borrow in the name of the partnership. This type of partnership would be a partnership which does not buy and sell, such as a legal partnership, accounting partnership or medical partnership.
Insurance
A partner may insure the firm’s property.
Employment
A partner may hire the employees that are necessary to carry out the purpose of the partnership.
Claims Against Firm
A partner may pay debts out of the partnership funds or by transferring partnership property.
Claims of Firm
A partner may receive payment of debts. Someone who makes a proper payment to a partner is protected even if the partner to whom the payment is made embezzles the money. The partnership debt would be deemed satisfied and canceled.
Limitations of Authority
The partners may agree to limit the normal powers of each partner. However, if a partner negotiates a contract for the partnership with a third person which exceeds the powers of the partner, the partnership is still bound if the third person was unaware of the agreement limiting the partner’s powers. Of course the partner would be liable to the other partners for any loss caused by his breach of the agreement to limit his powers. If the third person knew of the agreement, the partnership would not be bound. A third person would be bound by any limitation on the partner’s powers if there is any fact present that would put a reasonable person on notice that the partner’s powers are limited.
Nature of Business
A third person must take notice of limitations which arise out of the nature of the partnership’s business. The partnership may be organized for a particular kind of business or profession, and third persons are presumed to know the limitations that are commonly made on partners of such a business. For example, I would not have authority to sell computers from my firm’s office without partnership approval since we practice law, not the business of selling computers.
Scope of Business
A partner cannot bind the partnership to a third person in a transaction which is not within the scope of the partnership’s business unless the partner has express authority to bind the partnership.
Adverse Interest
A third person must take notice of an act of a partner which is obviously against the interests of the partnership. For example, using partnership funds to pay a personal debt would be against the interests of the partnership.
Prohibited Transactions
There are certain transactions a partner cannot enter into on behalf of the partnership unless he is expressly authorized. A third person who enters into such a transaction does so at the risk that the partner has not been authorized by the other partners to enter into such a transaction.
Cessation of Business
A partner cannot bind the partnership by a contract that would make it impossible for the partnership to conduct its usual business.
Suretyship
A partner has no implied authority to bind the partnership by contracts of surety, guaranty, or indemnity for purposes other than the partnership business.
Personal Obligations
A partner cannot satisfy personal obligations or claims of the partnership by interchanging them in any way. For example, a partner cannot satisfy a personal debt to a business by canceling a claim of the partnership against that business.
Duties of Partners
In many respects, the duties of a partner are the same as those of an agent.
Loyalty and Good Faith
Each partner must act in good faith toward the other partners and must not take any advantage over the other partners by misrepresentation or concealment. Each partner owes a duty of loyalty to the partnership, and this duty bars the making of any secret profit at the expense of the firm and bars the use of the firm’s property for personal benefit. A partner cannot promote a competing business, and if he does so, he can be liable for any damages sustained by the partnership. For example, Bill and Steven are partners in a paint store. Steven opens another store in his own name. This second store competes with the partnership store. Bill objects to Steven’s running his own store. Steven says he can do this because there is nothing in the partnership agreement that prohibits such competition. Is he entitled to run his own store in competition with the partnership store? No. Even though the partnership agreement is silent on this point, the duty of loyalty prohibits a partner from competing with the partnership. Therefore, Steven cannot run the competing store unless the partnership agreement, or a modification of the agreement, expressly gives him permission to do this.
Obedience
Partners must observe any limitations adopted by a majority of the partners with regard to the ordinary details of the partnership business. For example, if a majority of the partners operate a retail store and decide that no sales can be made on credit, a partner placed in charge of the store must obey this limitation. If a third person does not know of the limitation, the managing partner will have the power to make a binding sale on credit to such a person, but if the third person does not pay his bill, the partner who violated the limitation is liable for any loss caused by his disobedience to the limitation.
Reasonable Care
A partner must use reasonable care in transacting the partnership’s business and is liable for any loss resulting from a failure to act with reasonable care.
Information
A partner has the duty to inform the partnership of all matters relevant to the partnership. For example, if one partner is going to buy out the interest of another partner, this must be revealed to the partnership.
Management
Each partner has the right to take an equal part in transacting the business of the partnership. It is irrelevant that one partner contributed more than another financially or that one contributed only services when the partnership was formed.
Inspection of Books
All partners are equally entitled to inspect the books of the partnership.
Share of Profits
Each partner is entitled to a share of the profits. The partners may provide that profits shall be shared in unequal proportions. However, in the absence of such an agreement, each partner is entitled to an equal share of the profits without regard to the amount of capital or services contributed to the partnership by each partner.
Compensation
In the absence of an agreement to the contrary, a partner is not entitled to compensation for services performed for the partnership. Partners may agree that one of the partners shall devote full time as manager of the business and may agree that a salary shall be paid to the partner in addition to the managing partner’s share of the profits. This sometimes occurs in legal partnerships or accounting partnerships when one of the partners is appointed managing partner. In most cases, the managing partner practices his profession, but also handles the business affairs of the partnership and is paid or compensated in some way for this extra duty.
Repayment of Loans
A partner is entitled to reimbursement of money advanced to the partnership, such as travel expenses incurred on partnership business.
Contribution and Indemnity
If a partner pays more than his proportionate share of the debts of the partnership, he has a right to reimbursement from the other partners. If an employee of a partnership negligently injures a third person while acting within the scope of employment, and if the injured party collects damages from one partner, this partner is entitled to reimbursement from the other partners in order to divide the loss equally.
Distribution of Capital
If a partnership is dissolved, every partner is entitled to receive a share of the partnership property after due payment of all creditors and the repayment of loans made to the partnership by the partners. Unless otherwise stated in the partnership agreement, all partners are entitled to the return of their capital contributions to the partnership.
Liability of Partners and Partnership
Nature and Extent of Partner’s Liability
Partners are jointly and severally liable for all torts committed by one of the partners in the scope of the partnership business. When partners are held to be liable for an injury caused to a third person, the third person may sue all or any of the members of the partnership.
Partners are also jointly and severally liable on all partnership contracts. Each member of a partnership has individual and unlimited liability for the debts of the partnership regardless of the member’s investment or interest in the partnership. Even if a partner only owns 5% interest in the partnership, a judgment against the partnership in the amount of $100,000.00 can be collected from the 5% owner’s personal assets, particularly if the partnership or the other partners did not have the money to pay this debt.
Liability for Breach of Duty
If a partner breaches a duty to the partnership, an injured partner may recover damages from the partner who breached the duty.
Liability of New Partners
A person admitted as a partner into an existing partnership has limited liability for all obligations of the partnership which arose before he was admitted as a partner. This type of claim could only be satisfied out of partnership property and would not extend to the individual property of a newly-admitted partner.
Effect of Dissolution on Partners’ Liability
A partner will remain liable after dissolution of the partnership unless all claims against the partnership have been paid or the creditors of the partnership have released their claims. The dissolution of the partnership does not in and of itself discharge the existing liability of any partner.
Enforcement and Satisfaction of the Claims of Creditors
A partnership is sued by suing the partners doing business as the partnership — John Jones and Sally Jones d/b/a Jones Realty. Creditors of an individual partner must first seek payment from a partner’s personal assets. If these assets are insufficient to satisfy the debt, then the creditor may seek a charging order against the partner’s partnership interest. Pursuant to such an order, a court requires that the partner’s share of the profits be paid to the creditor until the debt is discharged.
LIMITED PARTNERSHIPS
A limited partnership is a modified partnership. It is half corporation and half partnership. This kind of partnership is a creature of State statutes. Many States have either adopted the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA). Mississippi has adopted the Revised Uniform Limited Partnership Act. In a limited partnership, certain members contribute capital, but do not have liability for the debts of the partnership beyond the amount of their investment. These members are known as limited partners. The partners who manage the business and who are personally liable for the debts of the business are the general partners. A limited partnership can have one or more general partners and one or more limited partners.
Under the ULPA, a limited partnership has to be created by executing a certificate which sets forth the name and business address of each partner, states which partners are general partners and which are limited partners, and states certain details about the partnership and the relative rights of the partners. This, of course, is not true in a general partnership. A general partnership is governed by a partnership agreement which is private and which may be oral or written.
The Revised Uniform Limited Partnership Act is somewhat less restrictive as to what needs to be disclosed in this certificate. For example, the names of the limited partners are not required.
The general partners manage the business of the partnership and are personally liable for its debts. Limited partners have the right to share in the profits of the business and, if the partnership is dissolved, will be entitled to a percentage of the assets of the partnership. A limited partner may lose his limited liability status if he participates in the control of the business.
The general rule is that the limited partner’s name cannot appear in the firm name. If the limited partner’s name is used, and this gives the public the impression that the limited partner is an active partner, the limited partner can lose his protection of limited liability and will become liable as a general partner.
The general partners manage the business of the partnership and are personally liable for its debts. Limited partners have the right to share in the profits of the business and, if the partnership is dissolved, will be entitled to a percentage of the assets of the partnership. A limited partner may lose his limited liability status if he participates in the control of the business. The Revised Uniform Limited Partnership Act lists some activities known as safe harbor activities in which limited partners may participate without losing their limited liability.
Limited Liability Partnerships and Companies
A limited liability company (LLC) is a separate legal entity that can conduct business just like a corporation with many of the advantages of a partnership. It is taxed as a partnership. Its owners are called members and receive income from the LLC just as a partner would. There is no tax on the LLC entity itself. The members are not personally liable for the debts and obligations of the entity like partners would be. Basically, an LLC combines the tax advantages of a partnership with the limited liability feature of a corporation.
An LLC is formed by filing articles of organization with the secretary of state in the same type manner that articles of incorporation are filed. The articles must contain the name, purpose, duration, registered agent, and principle office of the LLC. The name of the LLC must contain the words limited liability company or LLC. An LLC is a separate legal entity like a corporation.
Management of an LLC is vested in its members. An operating agreement is executed by the members and operates much the same way a partnership agreement operates. Profits and losses are shared according to the terms of the operating agreement.
Limited Liability Partnerships
A Limited Liability Partnership (LLP) is essentially a general partnership with the limited liability of an LLC. It is owned by partners rather than members. It is may be easier in some respects to convert a general partnership into an LLP as opposed to an LLC. The partnership agreement would only have to be amended for an LLP, but redrafted as an operating agreement for an LLC.
Joint Ventures
A joint venture is a relationship between two or more people who combine their labor or property for a single business undertaking. They share profits and losses equally, or as otherwise provided in the joint venture agreement. The single business undertaking aspect is a key to determining whether or not a business entity is a joint venture as opposed to a partnership.
Elizabeth, Josephine, and Mark entered into an agreement to purchase a tract of land, build houses on it, sell the houses, and then divide the net profit. What kind of business organization was this? This would be a joint venture because resources were pooled, and the profit-sharing operation was limited to one particular operation. The fact that a long period of time might pass before the venture ended would not cause this organization to lose its status as a joint venture.
A joint venture is very similar to a partnership. In fact, some States treat joint ventures the same as partnerships with regard to partnership statutes such as the Uniform Partnership Act. The main difference between a partnership and a joint venture is that a joint venture usually relates to the pursuit of a single transaction or enterprise even though this may require several years to accomplish. A partnership is generally a continuing or ongoing business or activity. While a partnership may be expressly created for a single transaction, this is very unusual. Most Courts hold that joint ventures are subject to the same principles of law as partnerships. The duties owed by joint venturers to each are the same as those that partners owe to each other. For example, partners have a duty of loyalty to one another, and joint venturers would also have the same duty. If a joint venture is entered into to acquire and develop a certain tract of land, but some of the venturers secretly purchase and develop land in their own names to compete with the joint venture, the other joint venturers may be liable for damages for the breach of this duty of loyalty.
A joint venture will last generally as long as stated in the joint venture agreement. If the joint venture agreement is silent on this, it can be terminated by any participant unless it clearly relates to a particular transaction. For example, if a joint venture is created to construct a particular bridge, it will last until the project is completed or becomes impossible to complete because of bankruptcy or some other type situation.
With regard to liability to third persons, generally, joint venturers have the same liability as partners in a general partnership.
