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Debate This:
S Corporations
William Sharp was the sole shareholder and manager of Chickasaw Club, Inc., an S corporation that operated a popular nightclub of the same name in Columbus, Georgia. Sharp maintained a corporate checking account but paid the club’s employees, suppliers, and entertainers in cash out of the club’s proceeds. Sharp owned the property on which the club was located. He rented it to the club but made mortgage payments out of the club’s proceeds and often paid other personal expenses with Chickasaw corporate funds.
At 12:45 a.m. on July 31, eighteen-year-old Aubrey Lynn Pursley, who was already intoxicated, entered the Chickasaw Club. Chickasaw employees did not check Pursley’s identification to verify her age, as required by a city ordinance. Pursley drank more alcohol at Chickasaw and was visibly intoxicated when she left the club at 3:00 a.m. with a beer in her hand. Shortly afterward, Pursley lost control of her car, struck a tree, and was killed. Joseph Dancause, Pursley’s stepfather, filed a tort lawsuit against Chickasaw Club and William Sharp. Using the information presented in the chapter, answer the following questions.
- Under what theory might the court in this case make an exception to the limited liability of share-holders and hold Sharp personally liable for the damages? What factors would be relevant to the court’s decision?
- Suppose that Chickasaw’s articles of incorporation failed to describe the corporation’s purpose or management structure as required by state law. Would the court be likely to rule that Sharp is personally liable to Dancause on that basis? Why or why not?
- Suppose that the club extended credit to its regular patrons in an effort to maintain a loyal clientele, although neither the articles of incorporation nor the corporate bylaws authorized this practice. Would the corporation likely have the power to engage in this activity? Explain.
- How would the court classify Chickasaw Club, Inc.—domestic or foreign, public or private?
Debate This:
The sole shareholder of an S corporation should not be able to avoid liability for the torts of her or his employees
CHAPTER 33: Corporate Formation and Financing
803
Chapter Summary: Corporate Formation and Financing
Nature and Classification
A corporation is a legal entity distinct from its owners. Formal statutory requirements, which vary
somewhat from state to state, must be followed in forming a corporation. Under U.S. law, a corporation
is recognized as an artificial legal person and enjoys the same rights that U. S. citizens enjoy.
1. Corporate personnel—Shareholders, whose liability is limited to the amount of their investments,
own the corporation. They elect a board of directors to govern the corporation. The board of directors hires corporate officers and other employees to run the firm’s daily business.
2. Corporate taxation—The corporation pays income tax on net profits, and shareholders pay income
tax on the disbursed dividends that they receive from the corporation (double-taxation feature).
3. Torts and criminal acts—The corporation is liable for the torts committed by its agents or officers
within the course and scope of their employment (under the doctrine of respondeat superior).
A corporation can be held liable (and be fined) for the criminal acts of its agents and employees.
4. Domestic, foreign, and alien corporations—A corporation is referred to as a domestic corporation
within its home state (the state in which it incorporates), as a foreign corporation by any state that
is not its home state, and as an alien corporation if it originates in another country but does business in the United States.
5. Public and private corporations—A public corporation is formed by a government (for example, a
city or town). A private corporation is formed wholly or in part for private benefit. Most corporations are private corporations.
6. Nonprofit corporations—Corporations formed without a profit-making purpose.
7. Close corporations—Corporations owned by a family or a relatively small number of individuals,
often members of the same family. Transfer of shares is usually restricted.
8. S corporations—Small domestic corporations that receive special tax treatment under
Subchapter S of the Internal Revenue Code. Shareholders enjoy limited liability while avoiding
double taxation.
9. Professional corporations—Corporations formed by professionals (such as physicians and lawyers).
For liability purposes, some courts disregard the corporate form and treat the shareholders as partners.
10. Benefit corporations—Corporations formed to benefit the public as a whole and have a material
positive impact on society and the environment.
Formation and Powers
1. Promotional activities—A person who enters contracts on behalf of the future corporation is personally liable on all preincorporation contracts until the corporation is formed and assumes the
contracts by novation.
2. Incorporation procedures—Procedures vary among the states, but the basic steps are as follows:
a. Select a state of incorporation.
b. Secure an appropriate corporate name.
c. Prepare the articles of incorporation. The articles must include the corporate name, the number
of shares of stock the corporation is authorized to issue, the names and addresses of the registered office and agent, and the name and address of each incorporator.
d. File the articles with the secretary of state. The state’s filing of the articles authorizes the corporation to conduct business.
3. First organizational meeting—The main function of the meeting is to adopt the bylaws, or internal rules
of the corporation, but other business, such as election of the board of directors, may also take place.
4. Improper incorporation—A corporation that has complied with the conditions for incorporation
has de jure status. A minor defect in formation generally does not affect this status. If a defect is
substantial, courts in some states may hold that the corporation has de facto status and treat it as a
corporation despite the defect.
5. Corporation by estoppel—If a firm is not incorporated but represents itself to be a corporation and
is sued as such by a third party, it may be held to be a corporation by estoppel.
(Continues )
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804
UNIT FIVE: Business Organizations
6. Corporate powers—
a. Express and implied powers—The express powers of a corporation are found in its articles of
incorporation, in the law of the state of incorporation, and in the state and federal constitutions.
Barring express constitutional, statutory, or other prohibitions, the corporation has the implied
power to perform all acts reasonably appropriate and necessary to accomplish its corporate
purposes.
b. Ultra vires doctrine—Any act of a corporation that is beyond its express or implied powers
is an ultra vires act and may lead to a lawsuit by the shareholders or the state attorney
general.
Piercing the
Corporate Veil
To avoid injustice, courts may “pierce the corporate veil” and hold a shareholder or shareholders
personally liable. This usually occurs when the corporate privilege is abused for personal benefit
or when the corporate business is treated so carelessly that it is indistinguishable from that of a
controlling shareholder.
Corporate Financing
1. Bonds—Securities representing corporate debt—funds borrowed by a corporation.
2. Stocks—Equity securities issued by a corporation that represent the purchase of ownership in the
firm. Exhibit 33–1 describes how stocks differ from bonds.
3. Venture capital—Capital provided to new business ventures by professional, outside investors
(venture capitalists, usually groups of wealthy investors and securities firms). Venture capital
investments are high risk but offer the potential for well-above-average returns at some point in
the future.
4. Private equity capital—Private equity firms pool funds from wealthy investors and use this capital
to invest in existing corporations. Usually, a private equity firm buys an entire corporation and then
reorganizes it.
5. Crowdfunding—A cooperative activity in which people network and pool funds and other resources
via the Internet to assist a cause or invest in a venture.
Issue Spotters
1. Name Brand, Inc., is a small business. Twelve members of a single family own all of its stock. Ordinarily, corporate income is taxed at
the corporate and shareholder levels. How can Name Brand avoid this double taxation of income? (See Nature and Classification.)
2. The incorporators of Consumer Investments, Inc., want their new corporation to have the authority to transact nearly any conceivable
type of business. Can they grant this authority to their firm? If so, how? If not, why? (See Corporation Formation and Powers.)
—Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.
Business Scenarios and Case Problems
33–1. Preincorporation. Cummings, Okawa, and Taft are recent
college graduates who want to form a corporation to manufacture and sell personal computers. Peterson tells them he will
set in motion the formation of their corporation. First, Peterson
makes a contract with Owens for the purchase of a piece of land
for $20,000. Owens does not know of the prospective corporate
formation at the time the contract is signed. Second, Peterson
makes a contract with Babcock to build a small plant on the
property being purchased. Babcock’s contract is conditional
on the corporation’s formation. Peterson secures all necessary
capitalization and files the articles of incorporation. Discuss
30301_ch33_hr_785-806.indd 804
whether the newly formed corporation, Peterson, or both are
liable on the contracts with Owens and Babcock. Is the corporation automatically liable to Babcock on formation? Explain.
(See Formation and Powers.)
33–2. Ultra Vires Doctrine. Kora Nayenga and two business
associates formed a corporation called Nayenga Corp. for the
purpose of selling computer services. Kora, who owned 50 percent of the corporate shares, served as the corporation’s president. Kora wished to obtain a personal loan from his bank for
$250,000, but the bank required the note to be cosigned by a third
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CHAPTER 32: Limited Liability Companies and Special Business Forms
781
The cooperative form of business is generally adopted by groups of individuals who wish
to pool their resources to gain some advantage in the marketplace. Consumer purchasing
co-ops, for instance, are formed to obtain lower prices through quantity discounts. Seller
marketing co-ops are formed to control the market and thereby enable members to sell their
goods at higher prices.
Practice and Review
The city of Papagos, Arizona, had a deteriorating bridge in need of repair on a prominent public
roadway. The city posted notices seeking proposals for an artistic bridge design and reconstruction.
Davidson Masonry, LLC—owned and managed by Carl Davidson and his wife, Marilyn Rowe—
decided to submit a bid for a decorative concrete project that incorporated artistic metalwork. They
contacted Shana Lafayette, a local sculptor who specialized in large-scale metal creations, to help
them design the bridge. The city selected their bridge design and awarded them the contract for a
commission of $184,000.
Davidson Masonry and Lafayette then entered into an agreement to work together on the bridge
project. Davidson Masonry agreed to install and pay for concrete and structural work, and Lafayette
agreed to install the metalwork at her expense. They agreed that overall profits would be split,
with 25 percent going to Lafayette and 75 percent going to Davidson Masonry. Lafayette designed
numerous metal salmon sculptures that were incorporated into colorful decorative concrete forms
designed by Rowe, while Davidson performed the structural engineering. The group worked together
successfully until the completion of the project. Using the information presented in the chapter,
answer the following questions.
1. Would Davidson Masonry automatically be taxed as a partnership or a corporation? Explain.
2. Is Davidson Masonry member managed or manager managed?
3. When Davidson Masonry and Lafayette entered into an agreement to work together, what kind of
special business form was created? Explain.
4. Suppose that during construction, Lafayette entered into an agreement to rent space in a warehouse that was close to the bridge so that she could work on her sculptures near the location
where they would be installed. She entered into the contract without the knowledge or consent
of Davidson Masonry. In this situation, would a court be likely to hold that Davidson Masonry was
bound by the contract? Why or why not?
Debate This
Because LLCs are essentially just partnerships with limited liability for members, all partnership
laws should apply.
Key Terms
articles of organization 769
business trust 780
cooperative 780
30301_ch32_hr_767-784.indd 781
joint stock company 780
joint venture 779
limited liability company (LLC) 767
member 768
operating agreement 774
syndicate 780
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