Chapter 11 Choosing the Legal Form of Organization

Chapter 11

Choosing the Legal Form of Organization

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Learning ObjectivesOwnership/Business Structures

• Distinguish between sole proprietorships and partnerships

• Discuss the corporate form and its advantages and disadvantages

• Explain the limited liability company• Define the nonprofit corporation• Make the decision about which legal form to use for

which purpose • Discuss how a business entity can evolve from one

legal form to another


Table 11.1: Comparison of Legal Forms

Legal Form

G en era l P artn ersh ip

S -C orp

C -C orp F u ll C orp ora te N on -P ro fit

B rid g e F orm s L L C

P artn ersh ip L im ited P artn ersh ip

S o le P rop rie to r


Sole Proprietorships and Partnerships

• Legal structure alternatives for business:– Sole Proprietorship– Partnership– Limited Liability Company– Corporation (C or Subchapter S)

• Choosing the right structure depends upon:– Legal and tax ramifications


Sole Proprietorships

• Advantages of sole proprietorships:– Easy and inexpensive to create– 100% of ownership+ profits stay with the

owner– Complete decision making authority for the

owner– Income is taxed only at the owner’s personal

income tax rate– No major reporting requirements exist


Sole Proprietorships (continued)

• Disadvantages of sole proprietorships:– Owner has unlimited liability for all claims

against the business-all debts must be paid from the owner’s assets

– Difficult for the owner to raise debt capital– Survival of the business depends upon the

owner


Partnerships

• Partnership - two or more people agree to share the assets, liabilities, profits of a business

• Advantages:– Have same advantages as sole proprietorships– Shared risk of doing business– Shared partner clout with multiple financial

statements– Shared ideas, expertise, decision making– Partners receive pass-through earnings and losses

taxed at their personal tax rates


Partnerships (continued)

• Disadvantages:– Partners are personally liable for all business debts

and obligations– Individual partners can bind the partnership

contractually– Partnership dissolution results when a partner

leaves or dies (unless otherwise stated in partnership agreement)

– Partners can be sued individually for the full amount of partnership debt


Partnership Agreement

• Based on the Uniform Partnership Act, it defines the relationship between partners in terms of – business responsibilities – profit sharing – transfer of interest


Partnership Agreement (continued)

• Buy-sell Agreement:– Who is entitled to purchase departing partner’s

share?– What events trigger a buyout?– What is the price to be paid for the partner’s

interest?• Key-person life insurance

– Life insurance policy on principal partner members– Use of proceeds upon partner death to buy out

partner or keep the business going


Table 11.2: Structuring an Effective Partnership Agreement


Corporation

• U.S. Supreme Court Definition : “An artificial being, invisible, intangible, and existing only in contemplation of the law.”

• Powers include rights to:– Sue and be sued– Acquire-sell real property– Lend money

• Owners rights:– As stockholders they invest capital in exchange for

shares– No liability for corporation’s debts– Can only lose the money they invest


C-Corporation

• Advantages:– Limited liability for owners – Capital can be raised through sale of stock – Ownership is transferable– Binding contracts do not need individual owner

signature– Enjoys status and deference in business circles– Employee access to retirement funds, defined-

contribution, profit-sharing and stock option plans – The entrepreneur can hold personal assets which

can be leased back to the corporation for a fee


C-Corporation (continued)

• Disadvantages:– More complex to organize– Subject to more governmental regulation– Cost more to create– Stockholders do not receive benefit of losses– Ownership control passes to the board of

directors


C-Corporation (continued)

• Where to incorporate:– In the state in which the business is located– In states with favorable tax laws– Delaware - if seeking venture capital


S-Corporation

• Advantages:– Business losses can be passed through for taxation

at entrepreneur’s personal tax rate – Avoids double taxation of income

• Disadvantages:– Retained earnings no longer available for expansion

or diversification– No deductions on medical reimbursements or health

insurance plans


Professional Corporations

• Licensed service professionals’ corporation organized to provide their services


Limited Liability Company

• Privately held companies which incorporate under strict guidelines

• Advantages:– Tax and liability pass through obligations– Limited liability– Continuity of life– Centralized management– Free transferability of interests– No limits on number of members or status


Limited Liability Company (continued)

• Disadvantages:– Formation filing fee is obligatory– Consensus is difficult if there are many

members– It is not a separate tax-paying entity– Members must file quarterly IRS statements– Can be obliged to register with the SEC– May not have foreign ownership rights


The Nonprofit Corporation

• A corporation established for charitable, public, religious purposes or for mutual benefit as recognized by federal and state laws.

• Advantages:– Attractive to corporate donors for business expense

deductions– Can seek cash and in-kind contributions of

equipment, supplies, personnel– Can apply for grants from government-private

agencies– May qualify for tax-exempt status


The Nonprofit Corporation (continued)

• Disadvantages:– Profits cannot be distributed as dividends– Corporate money cannot be contributed to political

campaigns or for lobbying– Entrepreneur gives up proprietary interest in the

corporation – Upon dissolution, all assets must transfer to another

tax-exempt nonprofit organization– Substantial profits must come only from related

activities– It must pay taxes on profits


Making the Decision About Legal Form

• Ask the right questions– Does the founding team have the necessary

operational skills?– Do the founders have the required start up capital?– Will the founders be able to run the business and

cover the first year’s living expenses?– Are the founders willing/able to assume personal

liability for claims against the business?– Do the founders wish to have complete control over

operations?– Do the founders expect initial losses?– Do the founders expect to sell the business some day?


Making the Decision About Legal Form (continued)

• Choosing the right form at each milestone:– Know the strategic plan from the outset– Know the possibilities for changing legal form– Know the expected capital and liquidity

needs– Know the tax implications for owners-

members

Documents

Chapter 11 Choosing the Legal Form of Organization