Module 1: Business Entities & Formation

A sole proprietorship is a single-owner business with no legal separation from its owner — no filing required, but also no liability shield at all. A general partnership forms automatically whenever two or more persons carry on as co-owners of a for-profit business — no written agreement or filing required — but partners face the same unlimited personal liability, joint and several.

Meinhard v. Salmon, 249 N.Y. 458 (1928), Judge Cardozo’s opinion for the New York Court of Appeals, remains the foundational statement of just how demanding the fiduciary duty between partners (and, in this case, co-venturers) actually is. Two men formed a joint venture to lease and operate a hotel building; near the end of the lease term, the managing partner was approached separately by the landlord with a lucrative new lease covering an even larger redevelopment, and he took the new opportunity entirely for himself without telling his co-venturer at all. The New York Court of Appeals held he breached his fiduciary duty by failing to disclose and share the opportunity, in Cardozo’s now-famous words: “A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” The case remains the leading statement of the real, demanding duty of loyalty partners owe each other — a duty that exists automatically the moment a partnership forms, with no written agreement required to create it.

Example. Peter runs a landscaping business alone under his own name — a sole proprietorship, his personal assets fully exposed to any business liability. Now compare: Peter and John jointly run a catering business, splitting profits evenly, with no written agreement or filing — a general partnership forms automatically, and both Peter and John are personally, jointly and severally liable for partnership obligations.

A limited partnership has at least one general partner (unlimited liability, manages the business) and at least one limited partner (liability generally limited to their investment, but generally must stay out of active management to keep it). A limited liability partnership (LLP) — often used by professional firms — generally shields partners from the partnership’s debts and from other partners’ malpractice.

Frigidaire Sales Corp. v. Union Properties, Inc., 88 Wash. 2d 400 (1977), is a real, practically important case testing exactly how far a limited partner can go before “staying out of management” is violated. Two individuals were limited partners in a limited partnership, but they were also the sole officers and directors of the corporation that itself served as the partnership’s general partner — meaning they were, in that separate corporate capacity, making all the real management decisions for the business. A creditor argued this made them personally liable as if they were general partners themselves, since they were plainly involved in controlling the business. The Washington Supreme Court disagreed, holding that acting as officers and directors of the corporate general partner — a distinct legal capacity from acting individually as a limited partner — didn’t itself trigger personal liability, since their control was exercised through the corporate general partner’s own proper governance structure, not through direct personal involvement in the partnership’s management as limited partners. The case remains a useful illustration of why using a corporate (or LLC) entity as the general partner is such a common structure — it lets the same individuals control the business through the general-partner entity while maintaining their separate limited-partner liability shield.

Example. Peter (general partner) manages a real estate fund; Sam (limited partner) invests capital but stays out of daily management — Sam’s liability is generally limited to his investment, while Peter retains full personal liability. Now compare: if Sam starts actively managing operations just like Peter, Sam risks losing that limited liability protection.

An LLC combines a genuine liability shield for its members with pass-through taxation — the entity itself generally pays no federal income tax, with profits and losses passing through directly to the members’ own returns.

The LLC is a genuinely modern American invention, not a form with roots in old common law the way corporations and partnerships have. Wyoming enacted the first LLC statute in the country in 1977, deliberately designing a hybrid entity that would combine a corporation’s liability shield with a partnership’s pass-through tax treatment — a combination no existing entity offered at the time. For over a decade, most other states were slow to follow, largely because it remained genuinely unclear whether the IRS would actually respect an LLC’s pass-through tax treatment or instead tax it like a corporation. That uncertainty was resolved in 1988, when the IRS issued a formal revenue ruling confirming that a Wyoming LLC meeting certain structural conditions would be taxed as a partnership. Once that federal tax question was settled, every other state adopted its own LLC statute within about a decade, and the LLC has since become the most commonly chosen new-entity structure for American small businesses — precisely because it delivers exactly the liability-plus-pass-through-taxation combination this section describes, without most of a corporation’s formal governance requirements.

Example. Peter and John form an LLC for their catering business. Unlike their earlier general partnership, a customer injured by the business generally can’t reach Peter’s or John’s personal assets — assuming they actually maintain the LLC as a genuinely separate entity, which the rest of this module addresses.

A corporation requires an affirmative state filing — articles of incorporation — to legally exist. The default (C-corporation) structure faces double taxation: tax at the corporate level, then again on shareholder dividends. A qualifying corporation can elect S-corporation status for pass-through taxation while keeping the corporate liability shield.

McDermott Inc. v. Lewis, 531 A.2d 206 (Del. 1987), is the case that articulated Delaware’s modern statement of the internal affairs doctrine, which explains why so many companies incorporate in Delaware even though they operate almost entirely elsewhere. A Delaware corporation had reorganized so that a Panamanian subsidiary became its new parent, and a shareholder challenged how voting rights worked afterward, in part by arguing Panamanian corporate law (rather than Delaware law) should govern certain aspects of the dispute. The Delaware Supreme Court held that a corporation’s internal affairs — the relationships among its shareholders, directors, and officers, and the corporation itself — are governed by the law of its state of incorporation, regardless of where the company actually conducts its business or where a dispute happens to be litigated. That single, predictable rule is exactly why a company with operations entirely in, say, Ohio or Texas might still choose to incorporate in Delaware: doing so guarantees that Delaware’s well-developed, predictable body of corporate law (and its specialized Court of Chancery) will govern the company’s internal governance disputes, no matter where the company’s actual operations or shareholders are located.

Example. Peter forms a corporation, filing articles of incorporation naming the company and its authorized shares. As a default C-corp, the company pays corporate income tax on its profits, and Peter pays a second tax when the company distributes dividends to him. If the company instead qualifies for and elects S-corp status, that second layer of tax is avoided.

Courts can, in limited circumstances, disregard an entity’s separate existence and hold owners personally liable — the alter ego doctrine, weighing failure to observe formalities, commingling of funds, undercapitalization, and whether respecting the entity would sanction fraud or injustice. This applies to LLCs, not just corporations.

Walkovszky v. Carlton, 18 N.Y.2d 414 (1966), is the classic case teaching that undercapitalization alone, without more, generally isn’t enough to pierce the veil. A man was seriously injured by a taxicab, and it turned out the cab’s owner operated his fleet of roughly twenty cabs through ten separate corporations, each one owning only two or three cabs and carrying just the state-mandated minimum insurance — a structure that meant any single injured plaintiff could reach only that one small corporation’s minimal assets and insurance, not the owner’s much larger overall fleet or personal wealth. The plaintiff argued this deliberately fragmented structure should let him pierce the veil and reach the owner personally. New York’s highest court held that operating with minimal capitalization and only the legally required insurance, standing alone, isn’t enough to justify piercing the veil — courts generally also require some further showing, like the individual owner personally using the corporation as their own alter ego for personal purposes (commingling funds, ignoring formalities), not merely structuring a business to minimize any one entity’s liability exposure, which the court treated as a legitimate use of the corporate form even if it left this particular plaintiff undercompensated. The case remains the standard citation for why undercapitalization is a real factor in veil-piercing analysis, but rarely a sufficient one by itself.

Example. Peter and John form an LLC but continue depositing customer payments into Peter’s personal account and covering Peter’s personal expenses from business funds — a strong commingling problem, creating real risk a court pierces the veil and reaches their personal assets despite the LLC’s formal existence.

The real tradeoffs: liability exposure (sole proprietorship/general partnership offer none; LLC/corporation offer a shield), taxation (pass-through vs. double taxation), and ongoing formalities (simplicity vs. protection, since the shield only holds if actually respected in practice).

Much of the modern flexibility behind these tradeoffs comes from a real, deliberate change in federal tax administration: the “check-the-box” Treasury regulations, effective in 1997. Before then, whether an unincorporated entity like an LLC would be taxed as a partnership (pass-through) or as a corporation (entity-level tax) for federal purposes turned on a genuinely complicated, fact-intensive multi-factor test examining things like whether the entity had centralized management or freely transferable ownership interests — businesses sometimes structured their governance documents specifically to steer clear of factors the IRS treated as too “corporate,” purely for tax reasons. The check-the-box regulations replaced that uncertain test with a simple election: most unincorporated entities can now simply choose, by filing a form, whether to be taxed as a partnership or a corporation, regardless of their actual governance structure. That reform is a real, direct reason entity choice today can focus on liability protection and governance formality — the tradeoffs this section actually covers — rather than on maneuvering around an uncertain federal tax classification test.

Example. A freelance consultant with minimal liability risk might reasonably stay a sole proprietorship for simplicity. Now compare: a growing consulting business taking on larger, riskier client engagements has real reasons to form an LLC — the liability exposure has grown enough that the tradeoff toward more formality and protection now makes sense.

A promoter who signs contracts “on behalf of” a not-yet-formed corporation generally remains personally liable on those contracts unless and until the corporation is formed and adopts them — and even adoption doesn’t always automatically release the promoter without a separate novation.

McArthur v. Times Printing Co., 48 Minn. 319 (1892), is the classic case teaching how a corporation can adopt a promoter’s contract without ever formally voting to do so. A promoter, acting on behalf of a newspaper company he intended to incorporate, signed a one-year advertising and printing services contract with a customer; the corporation was formed shortly afterward and, without any formal board resolution specifically adopting the contract, went ahead and accepted the customer’s services under its terms for several months before later trying to terminate early, arguing it had never formally adopted the pre-incorporation agreement. The Minnesota Supreme Court held that a corporation can adopt a promoter’s contract implicitly, through its own conduct — here, by knowingly accepting the benefits of the contract after formation — just as effectively as through an explicit board vote. The case remains the standard authority for why a newly formed corporation can’t simply accept the practical benefit of a promoter’s pre-incorporation deal while later denying it ever agreed to be bound by it — but the case doesn’t change the separate rule that the promoter generally remains personally liable too, unless the parties additionally agree to release them through a novation.

Example. Peter signs a supply contract “on behalf of” Acme Corp., which he plans to form but hasn’t yet filed articles for. Peter remains personally liable on that contract even after Acme Corp. is formed and starts doing business under it, unless the supplier and the corporation take the further step of actually releasing Peter through a novation.