BEC - Notes Chapter 1

http://www.cpa-cfa.org
Sole Proprietorship and Joint Venture
Sole Proprietorship
• Filing not required - simplest form of business ownership
• Sole proprietor not considered a separate entity from the business, so will have to personally file for
bankruptcy
• Personally liable for all obligations of the business
• Life of entity limited to the life of the sole proprietor
• Sole proprietor can transfer interests at will

Joint Ventures
An association of persons or entities for a single transaction or project. JV's are treated as a partnership
(P/S)

General Partnership
General Partnership - an association of two or more persons who agree to carry on as co-owners of an ongoing
business for profit
• Filing not required
• At least two owners of the partnerships
• Personally liable for all obligations of the business
• A partnership may be dissolved after a partner dies or otherwise dissociates from the partnership unless
the partners have agreed otherwise, or vote to continue the partnership
• Taxes flow through the P/S to the partners (taxed at their rates)
• A partner cannot transfer his P/S interest without unanimous consent of the other partners
• A general P/S may file for bankruptcy as a separate entity

In a general P/S
• All partners are general partners
• All partners share equally in mgmt, profits and losses unless agreed otherwise (even when capital
contributions are not equal)
• Within the ordinary course of business a majority vote is needed
• Matters outside the ordinary course of business require unanimous consent
- Admitting new partners
- Confessing a judgement or submitting a claim for arbitration
- Making a fundamental change in the business (sale of goodwill)
- Changing the P/S agreement
- Assignment of P/S property to others
• All partners have unlimited personal liability for obligations of the P/S
• All partners (individually) have the actual or apparent authority to bind the P/S with respect to all normal
partnership business transaction (except when a third party knows the partner lacks actual authority)
- Actual authority - all authority that a principal expressively gives to an agent plus any authority
that is reasonable implied from the express grant (Partner is store manager, reasonable to imply
the partner has the authority to hire employees, buy merchandise, etc)
- Apparent authority extends only to the ordinary course of business (sign a lease, hire/fire
employees, purchasing equipment, granting warranties)
- The P/S may ratify an unauthorized act (if the P/S likes an unauthorized act by partner)
• All partners must approve major business decisions
• A partner who acts outside the scope of his actual authority will be liable to the P/S for any damages
caused by the unauthorized act (breach of contract)

Intent to form a P/S (either Express, orally or in writing, or Implied, in conduct) is the key to general P/S
formation. No express agreement is necessary. An agreement can be implied from conduct showing intent to
1
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
enter into a business for profit together. However, if the P/S wants to exist for mare than a year, an agreement is
required under the statue of frauds

Dissociation (P/S may or may not continue) of a partner does not necessarily cause a dissolution (business it
wound up and then terminated)

Events of a dissociation:
• A partner wants to withdraw
• An event set forth in the P/S agreement that causes a dissociation
• A partner is expelled by unanimous vote
• A partner becomes a debtor in bankruptcy
• A partner dies

When a partner dissociates actual authority ends but apparent authority continues for two years until 3rd party
is given notice.

For debts prior to dissociation, partners remain liable unless released by creditors (novation)
For debts incurred after dissociation, partners are not liable if notice is filled with the state or each 3rd party
Liability of an incoming partner is limited to financial contribution to P/S for debts prior to his/her arrival, and
is personally liable of all debts incurrent by the partnership after he becomes a partner

Events that may cause a dissolution:

• A partner withdraws
• A P/S lasts for a specified length of time
• An event set forth in the P/S agreement that causes a dissolution
• Issuance of judicial decree on application of a partner
• Issuance of a judicial decree on application of a transferee

Distribution of assets
• Step 1: Liquidate assets
• Step 2: Pay creditors (insiders or outsiders); if the liquidation of assets do not cover the costs to pay the
creditors, then the losses are split
• Step 3: If there is leftover after paying creditors, return capital to partners or split losses
• Step 4: If there is anything left, divide profits

Financial Structure of a general partnership

• Partners are not required to make any particular contribution to their P/S
• Unless otherwise agreed, partners are required to devote themselves full-time and are not entitled to
remuneration (salary)
• As a general rule, partners have no right to use P/S property for anything other than P/S business
• Partners do not have the right to assign P/S property
• An individual partner's creditors can not use P/S property to settle debts (credit card debt can't be settled
with P/S property)
• Partners right in a P/S do not pass to his estate
• P/S interest is completely different that P/S Property
- Interest in P/S (profit and losses) is assignable, but no mgmt right come with the assignment
- Individual's creditors may go after the P/S interest, not the P/S property
- P/S interest is passes on to a partners heirs

2
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
Partners are generally liable for all contracts entered into and all torts committed by other partners within the
scope of the P/S business

The partners' liability is joint and several for the entire amount. Meaning if the other partners flee the country,
you are liable for all P/S obligations

Limited Liability P/S

A limited liability P/S (LLP) is similar to a G/P in most respects, including sharing of profits/losses, and all the
general advantages and disadvantages of a G/P

Differences
• Not personally liable for debts of the P/S or acts/torts committed by another partner, employee
or agent, but you can lose your investment. But you are still liable for your own acts\
• Must file with the sate

Limited Partnership
• Is comprised of at least 1 general partner who manages the business and is personally liable (for all P/S
debts) and at least one limited partner (whose liability is limited to capital contribution)
• Unanimous consent required for either the GP or LP to sell their interest, or a new partner be added
• Partners must make some type of capital contribution
• Absent an agreement, profit and loss allocation is based on capital contribution
• A LP is like a shareholder, no control power, may assign interest, does not owe fiduciary duty, is not an
agent, has not apparent authority
• A LP may be dissolved by
- Occurrence of time or stated time in the P/S agreement
- Written consent of all general partners
- Withdrawal or death of a general partner
- Judicial decree
• A LP has a right to vote on fundamental changes, inspect the P/S books, transact business with P/S, bring
derivative action
• A LP can lose limited liability is they do any 1 of the following
- Serve as a general partner
- Allowing name to be used in P/S name
- Participate in control (3rd party has reason to believe that the LP is a general partner)

A limited partnership and corporation are both created under a state statute and require filing with the state

Limited Liability Company/Corporation

• Must file with the state articles of organization which includes
- A statement that the entity is an LLC
- The name of the LLC
- The address of the LLC's registered office and registered agent (usually a corporate lawyer)
- Statement about management duties, otherwise all share equally in mgmt
[Similar to articles of incorporation except there is no stock information]
• The owners or members are not personally liable for the obligations of the company
• Income flows through to members
• Members may not sell ownership interest in the LLC without consent of other members
• All members have right to manage, but may adopt agreement to centralize management (manager
managed)
• Like a corporation an LLC is a distinct legal entity, it can own land, sue, file for bankruptcy
3
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
• Each member is an agent and has the actual and apparent authority to bind the LLC.
• Members owe a fiduciary duty
• If the LLC is Manager managed, each manager is an agent, but the other members are not agents and does
not have the power to bind the LLC
• Voting strength based on capital, ownership interest [while in GP, LLP, LP voting strength is equal unless
agreed otherwise]

Events that may cause a termination or dissolution [similar to a GP]:

• Consent of all members
• A partner withdraws, death, retirement, bankruptcy (this cause dissociation and may lead to dissolution]
• A P/S lasts for a specified length of time
• An event set forth in the P/S agreement that causes a dissolution
• Issuance of judicial decree

Profit and loss allocated based on members contributions

Corporation
• Must file with state called articles of incorporation
- Name of corporation
- Name and addresses of the corporations registered agent
- Name and addresses of each of the incorporators
- Number of shares authorized to be issued
- One of more classes of shares must have unlimited voting rights
• Directors are elected by shareholders, directors select executive officers to manage day-to-day operations
• Stockholders, directors, and officers are not personally liable for obligations of the corporation (just lose
investment), but may be liable for torts the individual commits
• Perpetual life, can continue after the death of resignation of owners or managers
• Stock holders free to transfer ownership interest whenever they want to whomever they want\

C Corp - double taxation (if income is distributed to stockholders), corporate tax rates lower than personal rates
S Corp - taxed like a partnership, flowthrough; however there are restrictions on S Corps
- Stock can not be held by more than 100 persons
- Shareholders must be individuals, estates or certain trusts
- The corporation must be domestic
- Can only be one class of stock
- Foreign shareholders are generally prohibited

Certain types of businesses (insurance companies and savings institutions) cannot file for bankruptcy regardless
of what type of entity they are formed as

Most aspects of corporate law are governed by state law, but some aspects (federal tax, securities regulation)
are governed by federal law. The state statue is called Revised Model Business Corporation Act (RMBCA)

Promoters, who raise capital for the corporation, enter into contracts with third parties who are interested in
becoming shareholders (stock subscription)
- Promoters are generally personally liable on the contracts (B1-33 more detail on this)
- Even if the corporation adopts a promoters contract, the promoter remains liable unless the promoter is
released by the third party (novation)

Ultra Vires Act - If the corporation has a narrow purpose cause (some states do not require it) and the
corporation undertakes business outside the clause, it is said to be acting "ultra vires" and may effect the firm.
4
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
• A shareholder may seek an injunction (order from the court) prohibiting the corp from the action
• The corp or shareholders may sue to recover damager from the directors or officers who
authorized the ultra vires act
• The state (usually the attorney general) may bring an action to have the corp dissolved for
committing the act

Bylaws - rules for running the entity. They are not part of the articles of incorporation and are not required to be
filed with the state
• Bylaws may not contain rules that conflict with the articles of incorporation
• Can be amended by board of directors or the shareholders

De jure - all of the requirements for incorporation are met and it will be recognized for all purposes

De facto corporation doctrine - requirements for incorporation are not met, but the business might still be
treated as a corporation, if the incorporators made a good faith attempt to incorporate and operated as if they
had incorporated, the business will be treated as a corporation in all aspects

Doctrine of incorporate Estoppel - requirements for incorporation are not met, but the business might still be
treated as a corporation, if a party who treats a business as if it were a validly formed corporation will be
estopped (legally barred) from claiming in a legal proceeding that the corporation was not validly formed
[if the 3rd party reasonably believes that they were dealing with a corp {not fraud}, then the party can not claim
the corp was not valid]

Defective corporation - entity did not make a good faith attempt to incorporate so shareholders are personally
liable

Piercing the corporate veil - courts hold shareholders, officers or directors, active in operation of the business,
of a de jure (properly formed) corporation will be held liable (because the legislative privilege of conducting
business is being abused). There are three reasons the corporate veil will be pierced:
1. Commingling personal funds with corporate funds
2. Inadequate capitalization - corporation is under capitalized at the time of formation
3. Committing fraud on existing creditors - if the corporation was formed to defraud existing personal
creditors

Foreign corporation - a corporation not incorporated within the state (Cali corp going to NY to do business)
Domestic corporation - incorporated within the state

A foreign corporation may not transact business (maintain an office within the state or conduct regular
intrastate business) within a state it has registered with the state and has obtained a certificate of authority. [So
you don't need to file twice for incorporation]

Quorum - a majority in attendance, so if there are 10 board members, 6 must be present at a meeting to have a
quorum

Operation of a corporation
• A corporation only needs only one director
• The articles of incorporation usually name the initial director, who hold office until the first annual
meeting.
• Directors may be removed by shareholder vote with or without cause
• Director's meetings are only valid if a quorum is present, and action may be taken with a majority of vote
of those present, so if 4 of the 6 approve the action, it would be valid
• Individually, directors have no right or power to act, they are not agents, they owe a fiduciary duty
5
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
• Directors may not vote by proxy, must be there physically
• Individually, officers have powers, they are agents and have fiduciary duties

Fundamental changes require both board and shareholder approval, examples are:
• Amendments to the articles of incorporation
• Mergers
A+B=A; both A&B's boards and shareholders must approve the fundamental change
• Consolidations
A+B=C; both A&B's boards and shareholders must approve the fundamental change
• Share exchanges
A acquires all the outstanding shares of B; A needs only the board approval, B's boards and shareholders
must approve the fundamental change
• Sale of all or substantially all of the corporations assets (purchasing company, buy side, only needs board
approval)
• Dissolutions - termination of corporate existence (could be involuntary through judicial proceedings)

Procedures for fundamental changes

1. Board adopts resolution by majority vote, setting forth the proposed action for shareholder approval
2. Notice to shareholders given whether they are entitled to vote
3. Eligible shareholders vote, need majority
4. Filing of articles, setting forth the action taken, with the state

Merger of a subsidiary (parent owning 90% or more of a subsidiary) - Parent needs only boards approval.
Parent's board makes decision unilaterally

Authorized shares - shares described in the articles of incorporation

Outstanding shares - authorized shares issues to shareholders
Treasury shares - outstanding shares repurchases by the corporation

Par value - minimum price the stock can be issued for legally (to ensure the corporation would be capitalized to
a certain level

Under RMBCA, board of directors can issue the stock price at any level and be issued in exchange for any
benefit to the corporation (services rendered, services to be performed, real estate, etc)
If property is accepted for stock, the board must value the land in good faith
Unpaid stock - a subscriber has promised, but failed, to pay for stock, the subscriber may be liabel to either the
corporation or its creditors

Watered stock - stock that has been issued in exchange for property worth less than the part value

A corporation has no obligation to allocate profits and losses to among shareholders. However, if dividends are
declared by the board of directors, shareholders are treated as unsecured creditors

Cumulative Preferred shares - gets paid dividends in arrears. Gets paid before noncumulative preferred

Noncumulative Preferred shares - gets paid before common stockholders, if a dividend is declared but not paid
within the year, the noncumulative shares lose out

Stock dividends - authorized shares owned by the corporation but unissued, because no assets are issued,
shareholder do not owe federal taxes

6
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
Cumulative voting - each share is entitled to one vote for each director position being filled in any way, so can
cast all votes for one single candidate (protects minority shareholder)
B1-46 example of cumulative voting

Shareholders may vote only is a quorum is present, and they may vote by proxy (appointment valid for 11
months)

Shareholders may enter into several agreements to protect voting power

• Voting trust - all shared owned by the party are transferred to a trustee, who votes and distributed
dividends in accordance with provisions of the voting trust
• Voting agreements - less formalistic, shareholders simple agree among themselves to vote a certain way

Shareholders in small corporations (closely held corporations) can put restriction on the transfer of stock, but
they can not put an absolute bar against selling shares. Examples of restrictions include:
• Right of first refusal - giving specified persons the option to buy shares before selling to an outsider
• Requiring that specified persons approve the transfer of stock
• Prohibiting the transferring of shares to a certain type of persons, such as competitors

Shareholders have the right to inspect the books and records upon request if its for a proper purpose. Improper
purposes to personally benefit the inspecting shareholder include obtaining the contact information of
shareholders to create a commercial mailing list

Pre-emptive rights - the right to purchase additional shares to maintain their proportionate voting strength.
No pre-emptive right unless articles of incorporation provide for them

Dissenting shareholder - vote on a fundamental change and lose. The shareholder may dissent and demand that
the corporation pay them fair value of their shares (buy them out)

Derivative action - the corporation has legal cause of action but refuses to bring action, the shareholder may
that the right to bring derivative action to enforce the corporations rights if three prerequisites are met:
1. Shareholder must have been a shareholder during time of the alleged wrong
2. The shareholder must be suing in the best interests of the corporation
3. The shareholder must have made a demand on the board

Board of directors
• Job to initiate fundamental changes
• Declare dividends
• Uses good faith (talks and relies on the officers, auditors, consultants to make decisions)
• Should not profit from material inside information
• Can not serve on the board of a competitor
• Should disclose conflicts of interest and abstain from voting
- Only liable of the deal is unfair and causes damage to the corporation
• Directors may remove officers with or without cause. The removal can occur even if it breaches the
officers' contract, but the corporation may be liable for damages (not the stockholders or directors)

Corporations are allowed to indemnify (repay) directors for expenses for any lawsuit (for accidents or
negligence, not intentional torts) brought against them in their corporate capacity

Limitation on director's liability - breach of fiduciary duty intentional act

• Financial benefits received by the director for which he was not entitled
• Intentional harm inflicted upon the corporation or shareholders
7
 BEC - Notes Chapter 1
http://www.cpa-cfa.org
• Unlawful distributions authorized by the director (pay dividends which renders the corp. insolvent)
• Intentional violations of criminal law
• Breaches of duty of loyalty

For tax purposes, if a company desires a fiscal year (instead of calendar year), that year end must be approves
by the IRS

Corporations may defer taxes, up to three months, by switching from calendar year end to fiscal year end, must
be approves by IRS