Welcome to Business Structures!
Hi there! If you are feeling a bit overwhelmed by the "Business Law" portion of the REG exam, you are in the right place. In this chapter, we are going to explore how businesses are built from the ground up. Think of this like choosing the "rules of the game" for a business. Does the owner want total control? Do they want to protect their personal house and car from business lawsuits? That is what Business Structure is all about.
We will break this down into the most common legal entities you'll see on the CPA exam: Sole Proprietorships, Partnerships, LLCs, and Corporations. We will also look at Agency, which is the "glue" that allows people to act on behalf of a business.
Don't worry if this seems like a lot of legal jargon at first—we'll use simple analogies to make it stick!
1. Agency: Acting for Someone Else
Before we look at the businesses themselves, we have to understand Agency. An agent is simply someone who is authorized to act on behalf of another person (the Principal) to deal with a Third Party.
The Agency Relationship
Think of a barista at a coffee shop. The owner (Principal) isn't there, but the barista (Agent) sells you (Third Party) a latte. Because of agency law, that sale is legally binding on the owner.
Creation of Agency: You generally don't need a written contract for an agency to exist, but you do need Consent and a Principal with Capacity (meaning the boss must be sane and an adult). Note: The agent does NOT need capacity—a minor can be an agent!
Duties of the Agent (The "LORA" Mnemonic)
Agents owe their principals a high level of care. Just remember LORA:
1. Loyalty: Put the principal's interests first (no kickbacks!).
2. Obedience: Follow all reasonable directions.
3. Reasonable Care: Don't be negligent.
4. Accounting: Keep the principal's money separate from your own.
Power vs. Right to Terminate
In most cases, either party has the power to quit at any time. However, if they have a contract and quit early, they might not have the legal right to do so and could be sued for damages.
Quick Review: Agency is a fiduciary relationship based on trust. If an agent acts with Authority (Actual or Apparent), the Principal is bound to the contract.
2. Sole Proprietorships
This is the simplest form of business. There is no legal distinction between the owner and the business.
Key Characteristics:
- Formation: No formal filing with the state is required (though you might need a local business license).
- Liability: This is the "scary" part. The owner has Unlimited Personal Liability. If the business owes money, the creditors can go after the owner's personal bank account.
- Transferability: You can't "sell" the sole proprietorship as an entity; you just sell the individual assets.
3. General Partnerships (GP)
A partnership is formed whenever two or more people carry on as co-owners of a business for profit. You don't even have to intend to form a partnership—if you act like one, the law treats you like one!
Key Rules for Partnerships
- Management: Unless agreed otherwise, all partners have equal rights to manage the business, regardless of how much money they put in.
- Profits/Losses: Unless agreed otherwise, profits are shared equally. Losses follow profits.
Example: If the agreement says Partner A gets 70% of profits but is silent on losses, Partner A also takes 70% of the losses.
- Liability: Partners are jointly and severally liable for all partnership debts. This means a creditor can sue any one partner for the entire debt.
Did you know?
You do NOT need a written agreement to form a partnership unless the business is meant to last for more than one year (due to the Statute of Frauds). However, it’s always a good idea to have one!
4. Limited Partnerships (LP)
An LP is a "hybrid." It must have at least one General Partner and one Limited Partner.
- General Partner: Has unlimited personal liability and manages the day-to-day operations.
- Limited Partner: Is basically just an investor. Their liability is limited to their investment (they can only lose what they put in).
- Formation: Unlike a General Partnership, you must file a certificate with the state to exist.
Common Mistake to Avoid: On the CPA exam, remember that if a Limited Partner starts "managing" the business too much, they might lose their limited liability protection in some jurisdictions (though many modern laws have relaxed this).
5. Limited Liability Companies (LLC)
The LLC is the "best of both worlds" and very popular. It provides the limited liability of a corporation with the tax flexibility of a partnership.
- Owners: Called Members.
- Formation: You must file Articles of Organization with the state.
- Liability: Members are not personally liable for the LLC’s obligations. Their risk is limited to their investment.
- Management: Can be "Member-managed" (owners run it) or "Manager-managed" (owners hire a professional manager).
Key Takeaway: The LLC is a separate legal entity from its owners. To keep this protection, members must treat the LLC like a separate business (don't pay your personal mortgage from the LLC checkbook!).
6. Corporations
A corporation is a legal "person" entirely separate from its owners. It can sue, be sued, and enter contracts.
Formation
To start a corporation, you file Articles of Incorporation with the state. This document includes the name, the number of shares authorized, and the name of the Registered Agent (the person who receives legal papers).
The Corporate Hierarchy
1. Shareholders: The owners. They elect the Directors. They have no right to manage the daily business.
2. Board of Directors: The "big picture" people. They make major policy decisions and appoint the Officers.
3. Officers: The "day-to-day" managers (CEO, CFO). They are agents of the corporation.
Piercing the Corporate Veil
Sometimes, the court will ignore the "shell" of the corporation and hold shareholders personally liable. This happens if:
- Shareholders commingle funds (mixing personal and business money).
- The corporation was thinly capitalized (not enough money to start with to meet foreseeable liabilities).
- It was formed to commit fraud.
Fundamental Changes (The "DAMS" Mnemonic)
Most corporate decisions are made by the Board, but "Fundamental Changes" require shareholder approval. Use DAMS to remember them:
1. Dissolution (closing the business).
2. Amendments to the Articles of Incorporation.
3. Mergers or consolidations.
4. Sale of substantially all assets outside the regular course of business.
Quick Summary Table:
- Sole Prop: 1 owner, personal liability, no filing.
- Gen. Partnership: 2+ owners, personal liability, no filing (usually).
- LLC: Members, limited liability, must file Articles of Org.
- Corporation: Shareholders/Directors/Officers, limited liability, must file Articles of Inc.
Final Encouragement
You've made it through the structures! The key to Area II on the REG exam is focusing on who is liable and who has the authority to make decisions. If you can distinguish between a General Partner (liable) and a Limited Partner (not liable), or a Director (big picture) and an Officer (daily tasks), you are well on your way to success. Keep practicing those practice questions!