© 2014 by Flat World Knowledge, Inc. 1© 2014 by Flat World Kno.docx

© 2014 by Flat World Knowledge, Inc. 1© 2014 by Flat World
Knowledge, Inc.
The Legal and Ethical Environment of
Business - Version 2.0
Terence Lau and Lisa Johnson
© 2014 by Flat World Knowledge, Inc. 2
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Knowledge, Inc. 3
Business Organizations
Chapter 11
Knowledge, Inc. 4
Introduction
Part - 11.0
Introduction
• Legal entity chartered by the state, with a separate and distinct
existence from its owners
Corporation
• Commercial enterprise, organized for profit of its owners, and
involving the provision of goods or services to a customer
Business
• Persons or entities to whom money is owed
Creditors
• Persons or entities granted a franchise to market or sell a the
franchisor’s goods or services, usually under a franchise
agreement

Franchisees
• Investment where the investor’s maximum possible losses is
the
amount invested
Limited liability
Knowledge, Inc. 6
Sole Proprietorships
Part - 11.1
Learning Objectives
• Understand the importance of sole proprietorships in our
economy
• Explore the advantages presented by doing business as a
sole proprietorship
• Assess the disadvantages and dangers of doing business as
a sole proprietorship
Sole Proprietorships

• Type of business where there is no legal distinction between
the business and its owner
– Most common form of doing business in the United States
• Entrepreneur: Person who organizes a business and
carries the risk of loss and reward of profit with it
– Obtains permits or licenses, depending on the business, before
they can begin operating
– Utilizes venture capital
• Venture capital: Money invested in an unproven or new start-
up business
Advantages and Disadvantages of Sole
Proprietorship
Advantages
• Creation is easy
• No creation time or cost
• Autonomy
• Total ownership of the
business’s finances
Disadvantages
• Impossible to bring in others
to the business and pass

ownership of business
• Raising working capital is
difficult
• Tax planning is challenging
• Unlimited liability:
Undesirable situation where if
the debts of the business
exceed its ability to pay,
creditors may reach the
personal assets of the
business owner
Venture Capital Firms
• Combine funds from institutional investors and angel
investors to identify promising start-ups and fund them in a
private placement
– Angel investors: Affluent individuals who provide capital to
start-up and early-stage businesses
– Private placement: Nonpublic offering in which a business
sells securities to a few chosen and qualified investors to raise
capital
• Seek an exit strategy, by offering sale of the business to
the public in an initial public offering
– Initial public offering (IPO): First time a corporation sells

its shares to members of the public
Knowledge, Inc. 11
Partnerships
Part - 11.2
Learning Objectives
• Learn about how general and limited partnerships are
formed
• Explore the major differences between general and limited
partnerships
• Understand major advantages and disadvantages to doing
business as general or limited partnerships
Partnerships
• Allow multiple individuals to conduct business together
• General partnership: Association of two or more persons
in an unincorporated entity to do business and share profits
and losses

– Articles of partnership: Voluntary contract (typically written)
in which two or more persons decide to conduct business
together and share profits and losses
• Known as partnership agreement
General Partnerships
• Do not involve the state as there is no separation from the
business and the partners
• End on termination of agreement to share profits and losses
• Those with more than two persons, the remaining partners
can reconstitute partnership without the old partner
– Buy/Sell agreement: Agreement between partners to value
and sell a partner’s portion of the business in the event the
partner withdraws or dies
• Considered as a disregarded entity for tax purposes
– Disregarded entity: For tax purposes, an entity that does
not need to file its own tax return or pay taxes
General Partnerships

• File information return
– Information return: Tax return that provides information
only to the taxing authority
• Every partner is jointly and severally liable for the
partnership’s debts and obligations
– Joint and several liability: Creditors or other claimants can
pursue their entire claim against one, several, or all possible
defendants, leaving defendants to sort out their respective
proportions of liability and payment
Limited Partnerships
• Formed in compliance with state law that provides limited
liability to certain limited partners who agree to refrain
from management of the business
• Limited partners are prohibited from participating in day-to-
day management of the business
Knowledge, Inc. 17
Corporations
Part - 11.3

Learning Objectives
• Learn about the advantages and disadvantages of
corporations
• Study roles and duties of shareholders, directors, and
officers in corporations
• Explore issues surrounding corporate governance
• Understand how corporations are taxed
Corporations
• Form of business organization that provides limited liability
to owners and is also flexible and easy to manage
• Possess continuity regardless of its owners
• Can be created for a limited duration, or it can have
perpetual existence
Corporations
• Stock: Capital raised by a corporation through issuance of
shares entitling owners to an ownership interest

• Securities: Any negotiable instruments representing
financial value, such as a bond or stock
• Formed in compliance with corporate law
– Corporate law is state law, and corporations are incorporated
by the states
• Initial public offering (IPO): First time a corporation
sells its shares to members of the public
Formation of a Corporation
• Articles of Incorporation are filed by the founders of the
corporation with the state agency charged with managing
business entities
– Articles of incorporation: Legal document that creates a
corporation when filed and approved by the relevant state
authority
• Founders must state:
– Name of the company which is to be unique and distinctive
• Words like incorporated, company, corporation or limited are
included
Formation of a Corporation

– Whether it is for profit or nonprofit
– Their identity
– Duration of the company’s existence
– Purpose of formation
– Number of shares that will be issued initially, and their par
value
• Par value: Face vale of a security as determined by the
corporation
Types of Corporations
• Operated in the state in which it was incorporated
Domestic corporation
• Incorporated in a state other than where it is seeking to
operate
Foreign corporation
Reasons for Existence of Corporation

• Reward owners of shareholders
• According to Chicago school economists, corporations act
legally to maximize shareholder value
– Chicago school: Neoclassical theory of economics most
closely associated with influential economics faculty from the
University of Chicago
• Corporate social responsibility (CSR): Deliberate
inclusion of the public interest into decision making
Shareholders
• Owners of a corporation
– Closely held corporation: Stock is held by only a small
number of shareholders
• Value of a share is determined by the laws of supply and
demand
• Own share or stock in the company but have no legal right
to the company’s assets
– Have limited liability
Parent Company

• Owns all the stock of another corporation
• Affiliate: Commercial enterprise with some sort of
contractual or equity relationship with another commercial
enterprise
• Subsidiary: Company wholly owned or controlled by
another company
– Formed to hold real property so that premises liability is
limited to that real estate subsidiary only
• Shields parent company and its assets from lawsuits
• Premises liability: Liability of landowners and leaseholders
for torts that
occur on their real property
Legal Implications
• Sophisticated liability and tax planning make corporate
form attractive for larger business in the United States
• Many sole proprietors incorporate their businesses to gain
limited liability
• Failure to respect legal corporation by sole proprietors, with
an arm’s-length transaction, leads creditors to ask a court
to pierce the corporate veil
– Arm’s-length transaction: Made by parties as if they were
unrelated, in a free market system, each acting in its own best
interest

Legal Implications
– Pierce the corporate veil: Equitable doctrine allowing
creditors to petition a court to not permit limited liability to a
corporate shareholder
• If a court agrees then:
– Limited liability disappears
– Creditors can reach shareholder’s personal assets
• Creditors argue that corporate form is a sham to create
limited liability
• Shareholders and corporation are indistinguishable from
each other
Shareholders
• U.S. corporate law allows for creation of different types of
shareholders
• Shareholders of different classes may be given preferential
treatment when it comes to corporate actions
– Examples - Paying dividends or voting at shareholder
meetings

• Dilution: Result when a corporation issues additional
shares, resulting in a reduction of percentage of the
corporation owned by shareholders
Rights of Shareholders
• Preemptive right: Given to existing shareholders in a
corporation to purchase any newly issued stock to maintain
same proportion of their existing holdings
• Outlined in a company’s articles of incorporation or bylaws
• Right to obtain a dividend
– Sanctioned only if the board of directors approves
• Right to vote in annually held shareholder meetings
– Incase some shareholders are not available, proxy is used
• Shareholder derivative lawsuit: Brought by a
shareholder on behalf of a corporation against a third party
Board of Directors
• Group of persons elected by shareholders of company to
set high-level strategy for the company
• Elected by shareholders
• Drawn internally and externally from the company

– Chief executive officer (CEO) of the company does not serve
as chair of the board of directors
– Some corporations seat a representative for shareholders and
large force of labor
Duties of the Members of Board
• Declare and pay corporate dividends to shareholders
• Authorize entry into a new foreign market
• Appoint and remove corporate officers
• Determine employee compensation
• Issue new shares and corporate bonds
– Corporate bonds: Debt obligation issued by corporations to
raise money without selling stock
Duties of the Members of Board
• Fiduciary duty to the corporation and its shareholders
– Business judgment rule: Legal assumption that prevents
courts or juries from second-guessing decisions made by
directors, unless they are proven to act with bad faith or
corrupt motive

• Appoint corporate officers
– Officers: Senior management, often C-Level or Chief Level,
appointed by the board of directors of a corporation to execute
strategy and manage day-to-day matters for the corporation
Types of Fiduciary Duties
• Includes duty not to take corporate opportunities for their
own purposes and a duty not to self-deal
Duty of loyalty
• Involves making decisions that reflect an attentive
relationship to the corporation
Duty of care
Double Taxation
• Imposition of two or more separate taxes on the same pool
of money
– Employer Identification Number (EIN): Unique nine-digit
number issued by the IRS to business entities for purposes of
identification
– Dividend tax: Income tax on dividend payments to

shareholders
S Corporation
• Corporation that, after meeting certain eligibility criteria,
can elect to be treated like a partnership for tax purposes,
thus avoiding paying corporate income tax
• To avoid the double taxation feature, corporations elect to
be treated as an S corporation
– Provide limited liability feature of corporations but the
single-
level taxation benefits of sole proprietorships by not paying
any corporate taxes.
– Cannot have more than one hundred shareholders and cannot
be members of an affiliated group of companies
Knowledge, Inc. 37
Limited Liability
Entities
Part - 11.4

Limited Liability Entities
• Learn about the development of limited liability entities
• Explore how limited liability entities are created
• Understand why limited liability entities are now heavily
favored
Limited Liability Company (LLC)
• Hybrid form of business that provides limited liability to
owners while being treated as a partnership for tax
purposes
• Members: Owners of limited liability companies
– Possible to create an LLC with only one member
– Can be real persons or they can be other corporations, or
partnerships
– Participate in day-today management of the business
• Taxation is flexible
Formation of LLCs

• Articles of organization are filed with the state agency
charged with chartering business entities
– Typically the Secretary of State
• Require only the name and contact information of the LLC
and its legal agent
– Can be done by any competent business professional without
any legal assistance, for minimal time and cost
Formation of LLCs
• LLCs are not required to:
– Issue stock certificates
– Maintain annual filings
– Elect a board of directors
– Hold shareholder meetings
– Appoint officers
– Engage in any regular maintenance of the entity
• Members enter into a written LLC operating agreement
Operating Agreement

• Agreement (usually written) among LLC members
governing the LLC’s management, rights, and duties
– Absence of an operating agreement makes it difficult to
resolve disputes among members
– Sets forth how the business will be managed and operated
– Contains a buy/sell agreement
– Allows members to operate in their own accord, but it can
also
be a trap for the unwary
Disadvantages of LLCs
• Members have to be careful while interacting with LLCs due
to the risk of piercing the veil
• Fundraising can be difficult as, it is for a sole proprietorship
in the early stages of an LLC’s business operations
• LLCs are not the right form for taking a company public and
selling stock
Limited Liability Partnership(LLP)

• Entity related to LLC
– Designed for professionals who do business as partners
– Allow partnership to pass through income for tax purposes,
but
retain limited liability for all partners
Knowledge, Inc. 45
Bankruptcy
Part - 11.4
Learning Objectives
• Learn about chapter 7, chapter 13, and chapter 11
bankruptcy
• Understand why businesses must be aware of bankruptcy
laws
Bankruptcy Protection
• Debtors file for bankruptcy protection to seek protection of
the federal court
– Once bankruptcy petition is filed, the automatic stay goes into

effect
• Automatic stay: Judicial order that halts all collection
activities for
pre-petition debts
• Pre-petition debt: Debts that a debtor owes to creditors prior
to
filing the bankruptcy petition
• Debtors find automatic stay advantageous as they can:
– Have their assets liquidated to satisfy creditors
– Reorganize debts in a manner that satisfies federal law and the
creditors
Parties Involved in Bankruptcy
• Businesses can be either debtors, creditors or both
– If a business is a debtor that chooses to file for bankruptcy,
the business needs to know the consequences of its actions
• Sole proprietor has no consequence on the business if
bankruptcy is filed for
Legal Implications Associated with Bankruptcy

• When a corporation files for bankruptcy, a chapter 7
bankruptcy should never be used
– Unless the corporation is itself terminating
• Discharge order: Order entered by the bankruptcy judge
to discharge all dischargeable debts of the debtors
• Failure to cease collection activities in violation of the
automatic stay has legal consequences
Table 11.2
Classification of Creditors
• Possess a properly perfected security interest on a particular
piece of
collateral
• Paid before the other types of creditors
Secured creditor
• Do not have secured collateral, but there is an important
public
policy reason to ensure that they are paid
Priority creditor

• Extend debt that is not secured or priority
Unsecured creditor
The Legal and Ethical Environment of Business - Version
2.0Slide Number 2Business
Organizations�IntroductionIntroductionSole
ProprietorshipsLearning ObjectivesSole
ProprietorshipsAdvantages and Disadvantages of Sole
ProprietorshipVenture Capital FirmsPartnershipsLearning
ObjectivesPartnershipsGeneral PartnershipsGeneral
PartnershipsLimited PartnershipsCorporationsLearning
ObjectivesCorporationsCorporationsFormation of a
CorporationFormation of a CorporationTypes of
CorporationsReasons for Existence of
CorporationShareholdersParent CompanyLegal
ImplicationsLegal ImplicationsShareholdersRights of
ShareholdersBoard of DirectorsDuties of the Members of
BoardDuties of the Members of BoardTypes of Fiduciary
DutiesDouble TaxationS CorporationLimited Liability
EntitiesLimited Liability EntitiesLimited Liability Company
(LLC)Formation of LLCsFormation of LLCsOperating
AgreementDisadvantages of LLCsLimited Liability
Partnership(LLP)BankruptcyLearning ObjectivesBankruptcy
ProtectionParties Involved in Bankruptcy Legal Implications
Associated with BankruptcyTable 11.2Classification of
Creditors

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