Sole Proprietorships, Partnerships, Corporations and Potential Liability

14 12 2014

By Mark Ellis, Ph.D. | Alumnus – Loyola University Chicago School of Law

This brief article will examine the sole proprietorship, partnerships, corporations and potential liability. Of course, there are quite a number of other business structures that do exist, (such as LLCs, LLP’s ect), but for the sake of brevity, these common structures will be presented. Moreover, we will also look at the benefits of each. Importantly, we will also examine the potential liability that exists regardless of the organization’s structure. It should be noted that although business organizations take on a variety of forms, each form has its own strengths and vulnerabilities. As such, will examine these strengths and potential vulnerabilities in light of tort law and further examine some of the most common legal issues that occur particularly under the principle of agency theory.

Sole Proprietorship

The simplest form of a business organization is what is known as the sole proprietorship.[1] Due to the fact that a sole proprietorship is completely owned by one person it may seem a bit odd to use the term business organization when discussing issues related to the sole proprietorship.[2] Importantly, although a business entity considered a sole proprietorship will most certainly have a degree of psychological and social identity separate from the individual.[3] In other words, if someone decides to open a landscaping business and gives the business and names such as “West Coast Landscaping” there is a clear distinction made between the business and the sole proprietor. Moreover, business records will oftentimes be kept separate from personal records such as common accounting and bookkeeping. Depending on the size and scope of the business, the sole proprietor may also hire managers, salespeople, or workers who are employed by the business.

As the name infers, sole proprietorship is completely owned by an individual person. The business owner is the single and only agent of the sole proprietorship.[4] As such, the individual who owns the business has complete discretion and decision-making power in the day-to-day operations and long-term objectives of the business.

What may seem to be appealing to this form of business organization is the unlimited freedom that the business owner has when making such decisions. In other words, there are no partners to agree or disagree with. Nor are there boards or committees to confer with and gain permission to make a strategic decision based on a majority vote. As such, the sole proprietor is able to make decisions at a moments notice and has the unlimited power of discretion when making such decisions.[5] Another benefit to the sole proprietorship is that the business owner is able to benefit individually by all of the profits gained by the business. There are no shares to pay out to shareholders, no percentages awarded to other individuals as in partnerships or limited liability entities. That said, the sole proprietor keeps all of the business profits.

The disadvantage of the sole proprietorship is that the owner of the business has virtually no protections.[6] Any debts that are owed can be levied in leaned against the individual owner of the business entity. Further, tax liability may be imposed against the sole proprietor and if the sole proprietor is unable to pay those taxes than the IRS can certainly levy and lean against any personal assets owned by the business owner. Further, in the event of litigation, any judgments awarded to plaintiffs against the business owner can also seek collection from the personal property of the individual named as the sole proprietor. This obviously leaves the business owner incredibly vulnerable and unshielded from legal actions or collection of debts.[7]

Consider for instance if the owner of the previously mentioned the West Coast Landscaping business finds itself in a tort action for negligence. One of the employees who was out in the field and was planting flowers for client had accidentally severed the power supply to a row of condominiums. Because of the lack of power many thousands of dollars worth of damages were incurred and a lawsuit is filed against West Coast Landscaping and its owner. For whatever reason, the owner did not have insurance to cover the damages in the claim and the jury decided for the plaintiff in the lawsuit. Unfortunately, because the sole proprietor assumes complete liability for any tort claims as such, the plaintiff is able to lean and/or levy the assets in order to satisfy the judgment.[8] Based on this scenario alone, it is easy to see that although sole proprietorships do have some advantages as discussed above; it also has disadvantages as the sole proprietor has little or no protection in the event of an unfortunate circumstance as mentioned here.

Partnerships

Another common business entity is a general partnership. As of 2008, there were 670,000 general partnerships in the United States with an average of four partners each.[9] At the outset it is important to note that partnerships fall into several categories. Some of most common are general partnerships, limited partnerships, limited liability partnerships, and limited liability limited partnerships.[10] In the United States the revised uniform partnership act of 1997 clearly states that a partnership regardless of the category is a particular entity that is distinct from his partners.[11]

Interestingly, the revised uniform partnership act of 1997 (also known as RUPA) is clearly distinct from the uniform partnership act of 1917, which at the time did not recognize partnerships as a legal personality distinct from the partners. However, over the process of time, such a view was modified through precedent and other legal changes, which varied from jurisdiction to jurisdiction.[12] For instance, RUPA in contrast to UPA the first entity status on partnerships. RUPA 101 like UPA six, defines a partnership as an association of two or more persons to carry on as co-owners of business for profit. However, RUPA 201 then provides that a partnership is an entity – a clear distinction of the entity identified in and of itself as opposed to a mere identification of a set of partners.[13]

Unlike the sole proprietorship where a particular individual has unlimited decision-making power and position of the assets and profits of the business, by default a partnership will allow for each general partner to have equal right to participate in the various decisions of the business and share in the financial profits.[14] Usually, decisions will be made in the ordinary course of business will be decided by the majority of the partnership. For instance, if a partnership has between five partners, and three of the five partners decide to make a particular business decision, the other two partners will generally concede to the majority decision.

Some of the advantages of the partnership is that partners can leverage their particular assets and gain a higher level of credit lines, have greater access to financial resources, and also may mitigate some of the liability incurred by the business itself. Further, a partnership has the potential to gain dominance in a particular market share depending on the business and short and long-term objectives of the business partners. A disadvantage of a partnership may also be liability as well.

Although liability may be proportionate to each partner in the business organization, there is still a substantial amount of liability against each partner of the business entity by way of debts, or a tort action brought against the company. For instance, under Section 5 of the Revised Uniform Partnership Act, liability for partnership obligations may be incurred. For instance, at common law if an obligation is joint and several, the obligors can be sued either jointly or separately. [15]

The Corporation

One of the most well-known business structures is the Corporation.[16] Like any business entity, the Corporation has both advantages and disadvantages. The main advantages of the corporation are tax benefits, protection from liability by the corporation’s officers and shareholders, the ability to leverage assets and extend credit opportunities.[17]

However, it should be noted that corporations may have a few disadvantages and are certainly not a cure-all for personal liability based on the misconduct, tortious, or even criminal behavior of corporate officers. Further, if in the event that certain legal requirements are not met, plaintiffs who have been injured due to the conduct of responsible parties may be held personally liable without the protection that is generally offered by a legitimately established and operated by the corporation’s management personnel and governing board.

Although we are primarily discussing tort liability and the business entity, it should be noted that criminal behavior is never shielded from the protections afforded by the Corporation. In fact, criminal prosecution against entire boards, managing officers, vice presidents and CEOs have faced severe criminal penalties due to criminal behavior.[18] One of the most obvious examples of criminal behavior and prosecution is the infamous Enron scandal that took place at the beginning of the 21st-century.[19] Prosecutors were able to bring formal prosecution against Enron’s key players who were responsible for one of the most prominent criminal cases in modern history.

Piercing the Corporate Veil

According to Roszkowski (2011)[20] Plaintiffs may disregard corporate existence also known as piercing the corporate veil. As such, Roszkowski suggests that the primary purpose of the corporation is to create limited personal liability for shareholders recognizing the Corporation as a separate legal existence. As such, corporations that incur debt or become the defendant in a lawsuit creditors or plaintiffs will have to collect from the corporate entity itself rather than individuals who would be considered stakeholders in the organization. However, under certain limited circumstances plaintiffs may disregard the Corporation in part or in its entirety and pierce the corporate veil in order to impose personal liability upon shareholders for corporate obligations. Of course, such laying aside of protections afforded in a Corporation must be under certain legal conditions.

In the case Kvassay v. Murray[21] where a plaintiff attempted to hold an individual liable for a corporate obligation the rationale behind the case was to determine whether or not the defendant could be held liable based on the fact that the individual who owned the Corporation frequently wrote personal checks, which were returned for insufficient funds. Moreover, the defendant had owned other corporations, which failed to file appropriate incorporation papers. Further yet, the corporations that were owned by the defendants all had the same address in Wichita Kansas.[22]

The trial court held, and the appellate court affirmed that because of the way the business of the corporation was conducted, the plaintiff was able to pierce the corporate veil and hold individuals responsible for the debts of the corporation.[23] Again, this is an issue where corporations are not functioning as required by law or are simply being used for the purposes of unjust business practices or even fraud.

It is very important to know that businesses structured as a corporation should function as a corporation with all of the required corporate documents filed in their particular state and also operate in accordance with requirements expected of a Corporation. Failure to file the appropriate documents with government entities and failing to function as expected under law creates a substantial amount of liability against owners of a given corporation if plaintiffs can successfully pierce the corporate veil.

Regardless of your business structure, it is very important understand it’s strengths, weaknesses, benefits, and potential liability. Too often, individuals who function within a given structure fail to understand that even a properly formed business organization is not a cure-all, nor is it a shield which provides complete and total immunity for its stakeholders, shareholders, governing body, or individual owner / operator. As such, a proper understanding of potential liability will be critical as we move ahead in our ever-expanding global economy.

[1] Black’s Law Dictionary 10th edition (2014) Thomas – Reuters.

[2] Eisenberg and Cox. Corporations and other Business Organizations – Cases and Materials. (2011) p. 1

[3] Ibid

[4] Black’s Law Dictionary 10th edition (2014) Thomas – Reuters.

[5] Eisenberg and Cox. Corporations and other Business Organizations – Cases and Materials. (2011)

[6] Ibid

[7] Ibid

[8] Ibid

[9] Eisenberg and Cox. Corporations and other Business Organizations – Cases and Materials. (2011) p. 1

[10] Ibid

[11] Ibid

[12] There has been an ongoing evolution of recognizing business entities as legal “persons.” Although this view is simply a product of the ever-changing business environment, it has not gone without extensive public scrutiny and criticism.

[13] Eisenberg and Cox. Corporations and other Business Organizations – Cases and Materials. (2011).

[14] Black’s Law Dictionary 10th edition (2014) Thomas – Reuters.

[15] Ibid

[16] Eisenberg and Cox. Corporations and other Business Organizations – Cases and Materials. (2011)

[17] Ibid

[18] Enron: the real scandal. January 17, 2002. The Economist

[19] Behind the Enron Scandal: Guilty of obstruction – Arthur Andersen. 2002 Time Magazine.

[20] Roszkowski, Mark, E. (2011) Business Law – Principles, Cases, and Policy

[21] Kvassay v. Murray 808P .2d 896 (Kansas app. 1991)

[22] Ibid.

[23] Ibid

Advertisements

Actions

Information

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s




%d bloggers like this: