Types of Business Entities
Types of Business Entities
Understanding the different entity types matters for contracts because each type determines who can bind the entity and how liability flows when things go wrong.
Corporations exist as separate legal entities from their owners (shareholders). A board of directors manages the corporation, which has perpetual existence. The tradeoff: corporations face double taxation, meaning profits are taxed once at the corporate level and again when distributed to shareholders as dividends.
Partnerships are owned and managed by partners, with profits taxed only at the partner level (pass-through taxation).
- General partnerships impose unlimited personal liability on all partners. If the business can't pay its debts, creditors can go after each partner's personal assets.
- Limited partnerships (LPs) have two classes of partners: general partners carry unlimited liability and run the business, while limited partners enjoy limited liability but typically can't participate in management.
Limited Liability Companies (LLCs) combine features of both corporations and partnerships. They offer flexible management structures, default pass-through taxation (though members can elect corporate taxation), and limited liability for all owners (called "members").
Concept of Limited Liability
Limited liability means an owner's personal assets are shielded from the business's debts and obligations. This protection applies to shareholders in corporations, limited partners in LPs, and members in LLCs.
Why does this matter beyond the obvious? It encourages investment and risk-taking. Without limited liability, most people would never invest in a company they don't personally run, because a single bad quarter could wipe out their savings. By capping an investor's risk at the amount they put in, limited liability makes it far easier for businesses to raise capital.
Corporate Formation and Governance
Process of Corporation Formation
Forming a corporation requires several formal steps. Missing any of them can jeopardize the entity's legal status and, with it, the limited liability protection owners expect.
- Choose a unique corporate name that isn't already registered in the state.
- File articles of incorporation with the state. This public document must include the corporate name, purpose, registered agent, and number of authorized shares. Filing this document is what actually creates the legal entity.
- Adopt bylaws, which are internal rules governing the corporation's management and day-to-day operations. Unlike the articles, bylaws are not filed with the state.
- Appoint an initial board of directors to oversee the corporation.
- Issue stock to shareholders as proof of their ownership interest.
Authority of Corporate Representatives
A corporation can only act through people. The question for contract law is whether a particular person had the authority to bind the corporation.
Corporate officers (CEO, CFO, etc.) are appointed by the board of directors. They can enter contracts on behalf of the corporation through two types of authority:
- Actual authority: expressly granted by the board or the bylaws. For example, the board passes a resolution authorizing the CEO to sign a specific lease.
- Apparent authority: a third party reasonably believes the officer has authority based on the officer's position or the corporation's conduct, even if no express grant exists. A supplier who has always dealt with a VP of Operations on purchasing decisions may reasonably assume that VP can approve a new supply contract.
Corporate agents (employees or other individuals acting on behalf of the corporation) can also bind the corporation, but only within the scope of their agency relationship. A warehouse manager authorized to order supplies likely can't commit the corporation to a multi-year real estate deal.
Personal Liability of Corporate Leaders
Directors and officers generally aren't personally liable for corporate obligations. The business judgment rule reinforces this by creating a presumption that directors and officers acted in good faith and in the corporation's best interests. Courts won't second-guess a business decision just because it turned out badly, as long as the decision-makers were informed and disinterested.
That protection has limits, though. Courts will impose personal liability in several situations:
- Piercing the corporate veil: Courts disregard the corporate entity and hold shareholders personally liable. This typically happens when owners treat the corporation as their personal piggy bank, such as through undercapitalization (starting the business with almost no funding), commingling personal and corporate funds, or failing to observe corporate formalities like holding board meetings and keeping separate records.
- Unauthorized contracts: If a director or officer enters a contract without proper authority, they may be personally liable on that contract rather than the corporation.
- Breach of fiduciary duties: Directors and officers owe the corporation duties of care (making informed decisions) and loyalty (putting the corporation's interests ahead of their own). Violations like self-dealing or gross negligence can strip away personal liability protection.