Forms of Business Organization. Shareholder Liability. Securities Regulation
Forms of Business Organization
Prior to starting a business, the potential owners should consider the ease of creation, liability of owners, method of taxation and need for raising capital. The principal forms of business organizations include sole proprietorships, partnerships, limited liability partnerships, limited liability companies and corporations.
In a sole proprietorship, one person owns the business, controls all decisions, receives all profits and has unlimited liability for all obligations.
A partnership may be general or limited. A general partnership is created when two or more persons agree to carry on business for profit as co-owners with equal right to manage and share profits that enjoy “pass through” taxation, but involve unlimited personal liability. A limited partnership consists of at least one limited partner and one general partner. The limited partners have liability limited to their capital contributions, but cannot participate in the management of the business. The general partners manage the business and have unlimited liability. All partners enjoy “pass through” taxation.
A limited liability partnership (LLP) is designed for professional service firms such as accountants. This form of business provides limits on personal liability of the partners and allows “pass through” tax advantages.
The limited liability company (LLC) is a hybrid entity that combines the limited liability of a corporation and the tax advantages of a partnership.
Corporations are created by state statute. Corporations have constitutional rights and can be sued, but shareholders are not personally liable for corporate obligations unless certain rare conditions exist such as inadequate capitalization or fraudulent formation. The business judgment rule provides management immunity from liability for corporate acts as long as the acts were made in good faith and with due care.
S Corporations allow up to 100 shareholders with limited liability and the option of being taxed as a partnership.
Entrepreneurs have a variety of business types to consider when starting a business. If you wanted to start a business, would you know which form would be the best for your business?
Let’s match the type of business organization to its definition by reviewing Business Organizations Matching.
Shareholder Liability
As a general rule, shareholders are not personally liable for the debts of the corporation; however, there are certain situations in which courts will hold shareholders liable for the acts or debts of the corporation.
The first situation involves piercing the corporate veil and analyzing the following factors to determine if the situation warrants imposing liability on the shareholders. Factors a court considers include the
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failure to maintain proper records and the commingling of corporate assets with personal or other assets,
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corporation was set up to never make a profit or remain insolvent or is undercapitalized,
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corporation was formed to evade an existing legal obligation,
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diversion of corporate funds or assets by shareholders,
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formation of the corporation was designed to perpetrate fraud or conceal illegal acts,
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an injustice and inequitable consequences would result if the corporate entity was recognized.
The second situation in which the court may ignore the corporate entity is known as the alter ego theory, which is interpreted as the corporation is the alter ego of the wrongdoer. When corporations are so dominated by the interests of a controlling shareholder, officer or director, the corporation loses its separate identity.
Shareholders generally have the right to review the books of a corporation; however, that right may be limited to reasons involving good faith, proper motive and reasonable time and place. Should shareholders be able to inspect documentation that falls under the attorney-client privilege?
Securities Regulation
Securities are instruments such as corporate stocks or bonds that evidence ownership or debt. Securities regulations, both federal and state, concern the sale of investments in companies. The regulations deal primarily with the sale of common stock.
Securities regulations require that extensive background information on an investment be provided before the investment can be purchased by the general public. However, there are exceptions for private placement when the stock or investment is not offered to the general public but to a few qualified investors as defined by state and federal laws. Securities regulations also attempt to level the investment playing field by regulating insider trading.
The Securities Act of 1933 and the Securities Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities. These laws require any company whose shares are publically traded to provide accurate financial information in the form of disclosure statements and in annual reports that investors can use to make informed investment decisions.
Section 10(b) of the 1934 act prohibits use of any manipulative or deceptive device in the sale of securities. Rule 10b (5) prohibits fraud in connection with the purchase or sale of any security. The goal of these rules is to prevent purchase or sale of securities using information that is not available to the public, which is known as insider trading. Any material omission or misrepresentation in connection with the sale or purchase of security may violate these provisions.
Rule 16(b) of the 1934 Act relates to short-swing trading, which is the purchase and sale or the sale and purchase by officers, directors and shareholders owning more than 10% of the equity securities of a public company within a six-month period. The rule was enacted to prevent insiders from taking advantage of information to make short-term profits.
Martha Stewart presents an interesting topic for discussion. Was Martha Stewart convicted of insider trading or making false statements about her activities? The initial indictment contained a count of insider trading, but in the end, she was not convicted on that count. By definition, an insider is a person who has fiduciary duty or other relationship involving trust (Rawls, 2009). Stewart did not breach a fiduciary duty to other investors since she was not an officer of ImClone (Rawls, 2009). Had Stewart not conspired with her broker and then lied about it, she might not have been in near as much trouble. Of course, Stewart's behavior was unethical at the very least (Rawls, 2009).
Learn more about Martha Stewart’s situation by reading the following article and court case.
Rawls, K.L. (2009). Martha Stewart and insider trading. Unpublished manuscript, Business Department, Liberty University, Lynchburg, VA.Retrieved from