Business Associations Class Notes 5/10/04


Shipman’s office is in 215.  There will be one in-class exam scheduled as scheduled by the Dean’s Office.  It will be all essay, 5-7 moderately brief problem-type questions.  I think he said it will be three hours long.  If you don’t cut to the chase by the third full paragraph, you’re probably never going to cut to the chase.  So cut to the chase when you write for a Shipman exam!


Old exam questions will be available for our study.  There will be a review session coming up soon.


Why are we here?


This is a bar subject: agency, partnership, and corporations are a big bar subject.  In a couple of years, we’ll be able to connect with the bar review people and figure out what’s what.


Agency is the “step-child” of the curriculum.  We’ll be taught enough in here to hook up with the bar review people.  “Spinach before ice cream.”  Take your bar courses!  The bar review people start in the “middle”.  The Ohio bar has been tightened up in the last eight years.  Five years ago, the median grade was made into the minimum grade.  It’s not an impossible bar, but it’s become more difficult.  So take the bar courses so that you’ll “hook up”.


Also, a lot of lawyers actually do this type of work.  If you practice family law, you’ll use this stuff every day.  If you do real estate law, franchise law, international law, tax law and stuff like that you’ll use this material every day you practice.  If you litigate, you’ll see a lot of litigation in this area.


Finally, business is very important in the “American scheme of things”.  This course is basic literacy for understanding business in the United States.


What about disadvantages of the course?  It’s intense!  If you fall asleep, you’re screwed!  You have to keep your outline up-to-date because we’ll cover the equivalent of eight sessions per week.  But the advantage is that people are more relaxed in the summer than general.  And the weather is better!  That’s a plus.  Also, the concentrated nature of the class helps keep your mind on the subject.  During the semester, you can get distracted by other courses.


But another disadvantage is that it will be the first course with a heavy emphasis on statutes and regulations.  They are taken seriously.  We don’t practice philosophy concerning the statutes and regulations, we master them.  Some will love it, some will hate it, but it’s a fact of life that lawyers must deal with this.


This is the first course in law school that is heavily operational.  Evidence, Tax, Secured Transactions, and International Business are also heavily operational.  We look at the conceptual end too, but mostly the operational side.  We’ll spend a modest amount of time on the role of the lawyer in these transactions, which is important because lawyers can get themselves in a lot of trouble.


So, prepare reasonably well each day, take good notes, outline once a week, come to the review sessions, and it will come together in a good way by the end.  There are advanced courses beyond this, but the foundational course is usually the most important.


If you must miss a class or two, don’t worry about it, but if it goes beyond that, check with Shipman or give his secretary a memo.  Shipman expects reasonably good attendance.


Another minus: these classes are long!  At 12:40, we’ll get a 15 minute break.  We’ll get back at 12:55 and wrap up at 1:30.  Nobody can stand 100 minutes of this stuff.


John Locke


Let’s begin at the beginning (a very good place to start)…with John Locke.  In the 1670’s, he wrote in support of the Whig view of the world.  The Whigs were opposed to the views of Hobbes, who supported absolute power in the king.  Locke’s writing blends economics and political science.  It goes well beyond Aristotle and Plato, who were very disdainful of commercial and business undertakings.  But by Locke’s time, the situation had changed both in Britain and in other places.  He arrived at the simplistic but absolutely true formula that in order to make money, you had to add labor to capital.


The Wealth of Nations


About 100 years later, Adam Smith came around with The Wealth of Nations.  Smith went beyond Locke and talked about the need for management added to labor and capital and the need for free markets, which both Britain and the United States adopted.  As we’ll see tomorrow, the big devotees of Adam Smith in the United States were not the Federalists, but the Jeffersonians.  This surprises a lot of people!




1.     Sole proprietorship

2.     General partnership and three related types

3.     Not-for-profit (can be incorporated or not) – Note: Can be charitable or non-charitable

4.     For-profit corporations (business corporations) – can be mutual

5.     Some trusts


Everybody classifies associations a different way.  This is Shipman’s way, and it’s as good as anything.


Sole proprietorships


Sole proprietorships have a long history, and they are still around today.  Joe Jones runs a small grocery store as a sole proprietor.  What does that mean?  There is no business association there.  Joe is simply running it.  His whole estate is liable for all of the debts of the grocery store.  If he wants to sell the grocery store, he has to make out the bills of sale and the deeds and then he’ll have to consider tax factors.  With a sole proprietorship, the individual Form 1040 of Joe Jones will reflect his income or loss from the grocery store along with his other income or loss.  Where is it reflected?  It’s on Schedule C of Form 1040.  Joe will be taxed on his total income (if he’s single) at the current tax rate, which runs up to about 36% for federal income tax, and in Ohio it will run up to 6.9%.  It’s higher in a few states.


But is that all?  No.  His income, up to a maximum of about $82,000, will be subject to a self-employment tax (yuck).  That’s part of the Social Security system.  This tax will be about 160% of what an employee of an incorporation would pay.  If you’re an employee, you pay about 7-8% on the first $80,000, and the corporation pays the same amount.  It goes into your Social Security account.  If you’re a sole proprietor, you have to pay both income tax and the substantial self-employment tax.  But that’s not all either!  There’s a Medicare tax that is unlimited in amount.  Are we finished?  No.  Joe should be using either a corporation or an LLC (a limited liability company).  The LLC is a “child” of the last twenty years.  What is its big advantage?  It has all the tax advantages of a general partnership, and it also has the corporate advantage of limited liability.  No one who is thinking advertently uses a sole proprietorship or a general partnership.  You’ll go for an LLC or a corporation.


Another comment on Mr. Jones.  We’re not finished with him yet.  If Joe is married, he will most likely file a joint return with his wife.  At times, they’re better off filing separate returns, but that is relatively rare.  Usually, you’ll save money filing joint returns.  Does the wife take a risk by signing the joint federal income tax return?  Family law and tax law will constantly bubble up in this course, and this is a family/tax law problem.  If the wife files her own separate return, then she has no individual liability if her husband’s return is screwed up.  If a joint return is filed, generally, the wife will have joint and several liability, even if the screw-up relates to the husband’s income, but there are two or three affirmative “innocent spouse” defenses that sometimes work and sometimes don’t.  We’ll see more about this when we take more tax courses.  When you file a joint return, each spouse has a duty to make sure that the tax return is in order.  “You’re in bed with your spouse in more ways than one…and you can get screwed in more ways than one, as Bubba would say.”


We won’t talk about sole proprietorships very much, because a lawyer setting one of these up is almost malpractice per se.  Usually, if a business is getting set up this way, the guy is doing it himself.


For today, we read the old statute on general partnerships.  This is the statute as of 1914.  In Ohio, we have a version of that old statute, and that’s what we will work with.  Toward the end of the year, when we look at partnerships in detail, we’ll look at the newer statute that is in effect in about 75% of the states.  It’s called RUPA: the Revised Uniform Partnership Act.  Each state has slightly different versions of the thing, the casebook material has a lot of text on RUPA, and we will consider it.  But: if Shipman sets up “a partnership problem in Ohio” on an exam, and most of his questions are set in Ohio, then we should cite to UPA 1914, not RUPA.  We can discuss what RUPA does, but only by analogy.  That’s the only way that Ohio courts will currently consider RUPA.  If there’s a close question under UPA 1914, the courts will go with the way the RUPA does it.


General partnerships


Here’s the definition: A general partnership is one in which all partners are general partners.  The emphasis here is on general.  Under UPA §§ 1-18, plus 40, there is joint and several liability on the part of all partners for the tort debts of the general partnership, and there is joint liability for all of the partners’ contract debts.  When you read §§ 18 and 40 and put them together, you will find that you can sue not only the partnership for the assets it has, but if it doesn’t have enough, you can go after the individual partners and reach their personal estates.  Ouch!  That’s called the disadvantage of unlimited personal liability.  It’s a big disadvantage…how come?  No one with any sense advertently forms a general partnership today.  For a lawyer to recommend it is malpractice per se.  Why?  We’ll find at the end of the course that in the last 25 years, the LLC has arrived and the Ohio LLC statute, O.R.C. § 1705, is excellent.  The LLC, with proper drafting, will give the tax advantages of a general partnership with the limited liability advantage of a corporation.  “AC/DC!  Going both ways at the same time and loving it!  A business feast!”


Why are we putting partnerships off until the end of the course?  There are two tough parts of the course.  (1) Securities, which we’ll get to in about 2.5 weeks.  (2) Partnerships are tough.  They’re not superficially tough, but when we go through them in depth, we’ll have headaches.  We won’t frontload the course with them.  Also, corporations are more logical, and once you go through the logical corporate setup, you can make the transition to partnerships fairly easily.  Just learning partnerships on its own without some agency law under our belts will drive us crazy.


So what is the great tax advantage of general partnerships?  We will find after the break that corporations in this country historically have been subject to a double tax.  It’s been modified a lot in the last 45 years, but big portions of it still remain.  This is because a corporation is considered as a full-fledged legal entity separate from the shareholders for tax and other purposes.  As such, historically, the corporation was subject to tax on what it earned, and then, when it paid dividends, the dividends were fully taxable again to the shareholder recipients.  By the end of today, we’ll see that there have been two ameliorations of that, though to some extent it’s still true.   The U.S. Supreme Court upheld the ability of Congress to do this even before the Sixteenth Amendment was passed.  It was said that the government bestows the privilege upon people to set up an entity with limited liability, and thus Congress can levy a tax on that privilege.


A general partnership, because it has three strong non-resemblances to a corporation, is not subject to income taxes.  The emphasis is on income taxes, because a general partnership is subject to excise taxes, it must withhold taxes on salaries of employees, it is subject to sales taxes but it isn’t subject to income taxes.  How has Congress treated general partnerships since 1913?  They have said that, in general, with some exceptions to follow later, the partnership is considered a non-entity for income tax purposes.  The income and losses of the partnership flow through to the individual partners and is taxed to them.  However, by statute, the partnership must file information returns with the IRS.  Those information returns enable the IRS to collect from the partners.


As to employees of the partnership, they’re just like corporate employees.  The partnership must pay and withhold Social Security tax.  Partners pay taxes just like sole proprietors.  Each quarter, they must file a declaration of estimated taxes for the year and pay one-fourth of it.  When they file their final return, they “settle up”.  If they paid too much, they’ll get a refund, and if they paid too little, they’ll have to write another check to the IRS.  Until 1960, general partnerships were very popular in the service areas, for example, law, accounting, medicine, dentistry, and engineering.  This is because there was no double taxation, and state statutes as to law, doctors, dentists and accountants provided that those professions had to practice as sole proprietors or general partnerships to expose to the world not only the assets the partnership owned, but also the personal property of the partners individually.



Congress discerned that there were three significant non-corporate attributes of a general partnership:


1.     Personal liability of all of the partners for the debts of the partnership in addition to the partnership itself being liable.  This is huge!

2.     §§ 18-32 of the UPA 1914 introduce us to the idea that a general partnership is easily dissolved.  Dissolution is defined specially in the UPA and it has an odd meaning.  It doesn’t mean death.  It means a “change in legal relationship among the partners”.  It says, for example, that death, retirement, or bankruptcy of any general partner causes dissolution of the partnership, but not the death of the partnership.  What it does mean, however, is that the party leaving the partnership by death, retirement, or bankruptcy is entitled to the amount credited to her capital account and, unless the parties have contracted otherwise, entitled to that amount in fairly short order.

Compare this to the situation of Jones Retail Store, Inc.  It has four siblings working in the store.  Upon the death of one of the Jones siblings, there is no dissolution, meaning that the widow of the dying Jones sibling cannot get the fair value of the shares from the company unless there is a specific contractual provision to the contrary.  That’s just the opposite from a general partnership because the death, retirement, bankruptcy, or insanity of one or more shareholders of a corporation does not affect the ongoing life of the corporation.  The corollary to that is that the same is true even if one or more or all of the shareholders assign all of their shares to somebody else.  Thus, the corporation is guaranteed by law to have perpetual life!  Whereas with the general partnership, death, retirement, bankruptcy or insanity cause dissolution.  The guy who went crazy can withdraw his whole capital account.

3.     With a corporation, unless there are valid reasonable restraints on alienation, any or all shareholders can sell any or all of their shares to anyone for any reason at any time.  “Daddy Warbucks walks again!”  Needless to say, even the closely held corporation with a few shareholders is set up in such a way to sell its shares to the public if the public wants it.  We’ll spend more time on that later: the IPO.  For example, Google is about to do their IPO.  The owners of Google will be billionaires.  They won’t be as rich as Bill Gates, “but hey, you won’t have to give them soup money.”  The general partnership, on the other hand, is set up for non-public ownership.


These three differences led Congress to say that a general partnership doesn’t resemble a corporation very much.  When we get to the LLC, clever drafters at the state level came up with a new animal from civil law countries like Mexico: the LLC, which had limited liability.  The Clinton Administration was persuaded that most unincorporated business associations, if they “checked the box” on their first return saying that they wanted to be treated as a general partnership for tax purposes, then they’ll be treated that way.  (Subchapter K is the subchapter of the internal revenue code that deals with partnerships.)


We’ll move right along covering just a part of the law of associations.


Not-for-profit associations


If you’ve read Detoqueville, you’re very aware of his emphasis on “voluntary associations”, or non-profit associations in the private sector.  These organizations mediate between the government and the population at large.  Take the church, for example.  Or political parties, or chambers of commerce, or Sunkist.  Or you form “The Committee to Fight the Power Lines”.  All of these are different from General Motors.  Their goal is to make profits for their shareholders.  Not-for-profit associations can be incorporated or unincorporated.  The not-for-profit corporation statute in Ohio is O.R.C. § 1702.  We won’t spend a lot of time on it.  For more information, get the hornbook by Oleck, Not-For-Profit Corporations.


Tomorrow, we’ll talk about a recent Fifth Circuit case involving two famous political figures: Karl Rove and Richard Thornburgh (former United States Attorney General).  Most politicians incorporate their campaign committee.  That’s because at the end of the day, the committee may have run up more debts than they are able to pay.  If you incorporate, then the candidate can walk away from the debts at the end.  On the other hand, Thornburgh did not incorporate his campaign committee.  He hired Rove, who did a good job for him, but he lost, and he owed $400,000 or so to Rove.  Rove was not a shy fellow, and he personally sued Thornburgh.  In “one of the damndest opinions I have ever read”, Shipman found that Texas and Pennsylvania law would govern.  But there’s a federal statute that says that the candidate himself won’t be liable for these debts.  The Fifth Circuit found that Thornburgh wouldn’t be liable in the capacity of a candidate, but would be liable in the capacity of an individual.  The Circuit also found that there was no preemption.  The court chastised Thornburgh for not incorporating, and the rest of the opinion was pretty predictable.  The Circuit concluded that the committee as a quasi-entity would be liable, the actual executives of the committee would be liable, and they held that if the inactive members of such an association ratify or approve in any way, direct or indirect, what the managers have done, they also are liable.  That’s standard American law.  If the campaign committee were incorporated, you wouldn’t get to these levels.  But was Thornburgh, the candidate, himself a member of the committee?  They couldn’t find a formal piece of paper that said he was, but they said it would defy common sense to hold that he wasn’t a member of his own committee.  The bottom line is that Thornburgh is out $400,000, non-tax-deductible!  And this guy was a former Attorney General of the United States!  “Stupidity runs to all social classes and all IQ strata.  You can find some of the smartest IQ people in highest positions doing the goddamndest things that you will ever see.”


They also lectured Thornburgh on a way out of the dilemma if he was stupid enough not to incorporate.  They said that he could have used “non-recourse contracts or notes”.  This is very important!  We’ll run into this three or four times in the course.  If, the court held, the contract with Rove had stated that only the assets of the committee could be reached by Rove, then in a contract case this provision would have been fully valid and would have sent Rove back to Austin without his $400,000.  So the court gave Thornburgh some lectures on how to get it right next time.  He was an “unconscious hero” who taught us through his own pain and suffering “how not to screw up”.


So not-for-profits can be incorporated or not, but you should always incorporate them.  Most states have good statutes about this.  Look at O.R.C. § 1702 or Oleck.


Not-for-profit corporations will not have shareholders, they will have members.  The people who run the not-for-profit will be called directors or trustees.  Below them will be officers.  Beneath them will be non-officer executives.  And below that, you have “the people who actually do the work”.  There will be creditors in a not-for-profit corporation.


Why do we care about § 1702?  At the end of §§ 1701 and 1702, they both state the following: “§ 1701 applies to corporations formed under other chapters (e.g. § 1702), except to the extent that § 1702 is inconsistent with § 1701, in which event you go to § 1702.”  Is it always to determine when there is inconsistency?  No.  Go to § 1702, and you’ll find the mirror image of that.  It says: “In construing this chapter, construe it with § 1701, except if § 1701 is inconsistent, in which case use this statute.”  The specific trumps the general every time.


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