of 36 /36
Chapter 3 - Choosing a Form of Ownership Nothing in fine print is ever good. Anonymous It’s just paper – all I own is a pickup truck and a little Wal- Mart stock. --Sam Walton Learning Objectives Students will be able to: 1. Describe the advantages and disadvantages of the sole proprietorship. 2. Describe the advantages and disadvantages of the partnership. 3. Describe the advantages and disadvantages of the corporation. 4. Describe the features of the alternative forms of ownership such as the S corporation, the limited liability company, and the joint venture. Instructor’s Outline I. Introduction A. Each form of ownership has its own unique set of advantages and disadvantages. 1. The key to choosing the “right” form of ownership is the ability to understand the characteristics of each and knowing how they affect an entrepreneur’s business and personal circumstances. 2. The issues the entrepreneur should consider in the evaluation process: a) Tax considerations. Because of the graduated tax rates under each form of ownership, the government's constant tinkering with the tax code, and the year- to-year fluctuations in a company's income, an entrepreneur should calculate the firm's tax bill under each ownership option every year. b) Liability exposure. Certain forms of ownership offer business owners greater protection from personal liability due to financial problems, faulty products, and a host of other difficulties. 45

Chapter 3 Entrepreneurship by Zubair A Khan

Embed Size (px)

DESCRIPTION

Chapter 3 Entrepreneurship by Zubair A Khan.

Text of Chapter 3 Entrepreneurship by Zubair A Khan

Chapter 3 - Choosing a Form of Ownership Nothing in fine print is ever good. Anonymous Its just paper all I own is a pickup truck and a little Wal-Mart stock. --Sam Walton Learning Objectives Students will be able to: 1. Describe the advantages and disadvantages of the sole proprietorship. 2. Describe the advantages and disadvantages of the partnership. 3. Describe the advantages and disadvantages of the corporation. 4. Describe the features of the alternative forms of ownership such as the S corporation, the limited liability company, and the joint venture. Instructors Outline I. Introduction A. Each form of ownership has its own unique set of advantages and disadvantages. 1. The key to choosing the right form of ownership is the ability to understand the characteristics of each and knowing how they affect an entrepreneurs business and personal circumstances. 2. The issues the entrepreneur should consider in the evaluation process: a) Tax considerations. Because of the graduated tax rates under each form of ownership, the government's constant tinkering with the tax code, and the year-to-year fluctuations in a company's income, an entrepreneur should calculate the firm's tax bill under each ownership option every year. b) Liability exposure. Certain forms of ownership offer business owners greater protection from personal liability due to financial problems, faulty products, and a host of other difficulties. c) Start-up and future capital requirements. Forms of ownership differ in their ability to raise start-up capital. d) Control. Entrepreneurs must decide early on how much control they are willing to sacrifice in exchange for help from other people in building a successful business. e) Managerial ability. If an entrepreneur lack skills or experience in certain areas, he/she may need to select a form of ownership that allows him/her to bring into the company people who possess those skills and experience. f) Business goals. How big and how profitable an entrepreneur plans for the business to become will influence the form of ownership chosen. g) Management succession plans. Some forms of ownership make this transition much smoother than others. In other cases, when the owner dies, so does the business. h) Cost of formation. Some forms of ownership are much more costly and involved to create than others. Entrepreneurs must weigh carefully the benefits and the costs of the particular form they choose.45

46

Section II Building the Business Plan: Beginning Considerations

3. Business owners have traditionally had three major forms of ownership from

which to choose: the sole proprietorship, the partnership, and the corporation. a) See Figure 3.1. b) In recent years, various hybrid forms of business ownership have emerged; the S corporation, the limited liability company, and the joint venture. GAINING THE COMPETITIVE EDGE What Does the Name of Your Business Convey to Potential Customers? GHB marketing Communications started getting numerous emails and phone calls requesting a certain product. The product that individuals were seeking was GHB an illegal drug known as ecstasy. The new name (HiTechPR) costs the owners $20,000. Choosing a memorable name can be one of the most fun and most challenging aspects of starting a business. Larger companies spend hundreds of thousands of dollars researching names. While, small businesses do not normally have unlimited resources at their disposal, you can use the same tools and development process that larger companies use to catch the customers eye. Look at your name from your potential customers perspective. The customer may want to be reassured (Gentle Dentistry) or the may prefer a bit of humor (The Barking Lot Dog Grooming). Other choices might be to convey an image to your customers that is compatible with your business strategy. Whatever the image you wish to communicate to an audience of potential customers, the process of choosing the perfect name involves a series of steps. 1. Decide the most appropriate single quality of the business that you wish to convey. Avoid sending a mixed or inappropriate message. 2. Avoid names that are hard to spell, pronounce or remember. 3. Attempt to select a name that is short, attention getting and memorable. 4. Be creative, but in good taste! 5. Make sure your choice of a name wont get dated quickly. 6. Be careful that the name, while catchy and cute, doesnt create a negative image. 7. Once you have selected a suitable name, practice using it for a few days. 8. Finally, conduct a name search to make sure that no one else in your jurisdiction has already claimed the name.II. The Sole Proprietorship A. Defined 1. The sole proprietorship is a business owned and managed by one individual. This

form of ownership is by far the most popular.B. Advantages of a Sole Proprietorship

Chapter 3 Choosing a Form of Ownership

47

1. Simple to create. One attractive feature of a proprietorship is the ease and speed

2.

3. 4.

5. 6.

of its formation. An entrepreneur can complete all of the necessary paperwork in a single day. Least costly form of ownership to establish. It is generally the least expensive form of ownership to establish, as there is no need to create and file the legal documents that are recommended for partnerships and are required for corporations. a) In many jurisdictions, entrepreneurs planning to conduct business under a trade name are usually required to acquire a Certificate of Doing Business under an Assumed Name from the secretary of state. b) In a proprietorship, the owner is the business. Profit incentive. Once the owner has paid all of the company's expenses, she can keep the remaining profits (less taxes, of course). Total decision-making authority. The sole proprietor is in total control of operations and can respond quickly to changes. The ability to respond quickly is an asset in a rapidly shifting market. No special legal restrictions. The proprietorship is the least regulated form of business ownership. Easy to discontinue. If the entrepreneur decides to discontinue operations, he can terminate the business quickly, even though he will still be liable for all of the business's outstanding debts and obligations.

C. Disadvantages of a Sole Proprietorship 1. Unlimited personal liability. The sole proprietor is personally liable for all of the

business's debts.2. Limited access to capital. Many proprietors have already put all they have into

their businesses and have used their personal resources as collateral on existing loans, so it is difficult for them to borrow additional funds. 3. Limited skills and abilities. A sole proprietor may not have the wide range of skills running a successful business requires. Many business failures occur because owners lack skills, knowledge, and experience in areas that are vital to business success. 4. Feelings of isolation. Running a business alone allows an entrepreneur maximum flexibility, but it also creates feelings of isolation most small business owners report that they sometimes feel alone and frightened when they must make decisions knowing that they have nowhere to turn for advice or guidance. 5. Lack of continuity for the business. If the proprietor dies, retires, or becomes incapacitated, the business automatically terminates.

48

Section II Building the Business Plan: Beginning Considerations

IN THE FOOTSTEPS OF AN ENTREPRENEUR A Brief History Many environmental factors must be analyzed when trying to decide which form of ownership is best. The 1981 Tax Act lowered the maximum individual tax rate from 70% to 50%. At the same time, the maximum corporate rate decreased from 48% to 46%. Then in 1986, the Tax Reform Act (TRA 86) established the maximum individual rate became 28%, compared to the maximum corporate of 34%. TRA 86 led to an increased popularity of conduit entities such as partnerships and S corporations, vis-a-vis C corporations. Today, the individual rate once again exceeds the corporate rate, though not at the magnitude prior to 1981. Accounting firms organized as general partnerships were devastated by their legal responsibility for the savings and loan crisis. As a result, the S corporation became a viable choice as owners sought to limit their personal legal liability. However, restraints on ownership and capital structure limited the usefulness of the S corporation. Then in 1991, Texas enacted the first LLP statute. Many states initially restricted the use of LLCs by professionals such as physicians and attorneys. LLPs filled this void and provided better liability protection than general partnerships, but somewhat less than LLCs. 1) For many entrepreneurs, the taxation and personal liability concerns often cloud their reasoning when deciding on a form of ownership. The following are a series of business conditions that are unique to Jody Jeffers and her potential business. You have been asked to evaluate these specific conditions and make a recommendation to her about the most appropriate form of ownership. The conditions are: a) Three years ago Ms Jeffers inherited a large sum of money and, although invested, her earnings place her in the highest federal tax bracket b) Ms. Jeffers plans to use the invested funds as collateral to borrow 20% of what she needs to start a new business venture. c) Ms. Jeffers has eight close friends who indicate that they are each willing to invest in the business to cover the remaining 80% of financial capital requirements. d) The business will involve a fleet of automobiles on the road 10 15 hours each day. e) A legal question exists as to whether the drivers are company employees or contract workers. f) Because this new venture is a dramatic new concept, there is honest debate as to its economic viability. g) In the event the business fails, an issue to the ownership of some of the firms inventory would be in question. Answer: Students answers may vary. Most common answer will suggest LLC as the most appropriate form of ownership.

III. The Partnership A. Defined 1. A partnership is an association of two or more people who co-own a business for

the purpose of making a profit. In a partnership the co-owners (partners) share the

Chapter 3 Choosing a Form of Ownership

49

2.

3.

4.

5.

business's assets, liabilities, and profits according to the terms of a previously established partnership agreement. The law does not require a written partnership agreement (also known as the articles of partnership), but it is wise to work with an attorney to develop one. a) The partnership agreement is a document that states in writing all of the terms of operating the partnership for the protection of each partner involved. b) Every partnership should be based on a written agreement. When no partnership agreement exists, the Uniform Partnership Act governs the partnership, but its provisions may not be as favorable as a specific agreement hammered out among the partners. Probably the most important feature of the partnership agreement is that it addresses in advance sources of conflict that could result in partnership battles and the dissolution of a business that could have been successful. The standard partnership agreement will likely include the following: a) Name of the partnership. b) Purpose of the business. What is the reason the partners created the business? c) Domicile of the business. Where will the principle business be located? d) Duration of the partnership. How long will the partnership last? e) Names of the partners and their legal addresses. f) Contributions of each partner to the business, at the creation of the partnership and later. This would include each partner's investment in the business. g) Agreement on how the profits or losses will be distributed. h) Agreement on salaries or drawing rights against profits for each partner. i) Procedure for expansion through the addition of new partners. j) Distribution of the partnership's assets if the partners voluntarily dissolve the partnership. k) Sale of partnership interest. How can partners sell their interests in the business? l) Absence or disability of one of the partners. m) Voting rights. In many partnerships, partners have unequal voting power. The partners may base their voting fights on their financial or managerial contributions to the business. n) Decision-making authority. When can partners make decisions on their own, and when must other partners be involved? o) Financial authority. Which partners are authorized to sign checks, and how many signatures are required to authorize bank transactions? p) Handling tax matters. The Internal Revenue Service requires partnerships to designate one person to be responsible for handling the partnership's tax matters. q) Alterations or modifications of the partnership agreement. As a business grows and changes, partners often find it necessary to update their original agreement.

B. The Uniform Partnership Act 1. The Uniform Partnership Act (UPA) codifies the body of law dealing with

partnerships in the United States.

50

Section II Building the Business Plan: Beginning Considerations

2. Under the UPA, the three key elements of any partnership are common ownership

interest in a business, sharing the business's profits and losses, and the fight to participate in managing the operation of the partnership. 3. Under the act, each partner has the right to: a) Share in the management and operations of the business. b) Share in any profits the business might earn from operations. c) Receive interest on additional advances made to the business. d) Be compensated for expenses incurred in the name of the partnership. e) Have access to the business's books and records. f) Receive a formal accounting of the partnership's business affairs. 4. The UPA also sets forth the partners' general obligation. Each partner is obligated to: a) Share in any losses sustained by the business. b) Work for the partnership without salary. c) Submit differences that may arise in the conduct of the business to majority vote or arbitration. d) Give the other partner complete information about all business affairs. e) Give a formal accounting of the partnership's business affairs. 5. A partnership is based above all else on mutual trust and respect.C. Advantages of the Partnership 1. Easy to establish. Like the proprietorship, the partnership is easy and inexpensive

2. 3.

4.

5.

6. 7.

to establish. In most states, partners must file a Certificate for Conducting Business As Partners if the business is run under a trade name. Complementary skills. In successful partnerships, the parties' skills and abilities complement one another, strengthening the company's managerial foundation. Division of profits. The partnership agreement should articulate the nature of each partner's contribution and proportional share of the profits. If the partners fail to create an agreement, the UPA says that the partners share equally in the partnership's profits, even if their original capital contributions are unequal. Larger pool of capital. The partnership form of ownership can significantly broaden the pool of capital available to a business. Undercapitalization is a common cause of business failures. Ability to attract limited partners. Every partnership must have at least one general partner (although there is no limit on the number of general partners a business can have). a) General partners have unlimited personal liability for the company's debts and obligations and are expected to take an active role in managing the business. b) Limited partners, on the other hand, cannot take an active role in the operation of the company. They have limited personal liability for the company's debts and obligations. Essentially, limited partners are financial investors who do not participate in the day-to-day affairs of the partnership. Little governmental regulation. Flexibility. Partnerships can generally react quickly to changing market conditions, because no giant organization stifles quick and creative responses to new opportunities.

Chapter 3 Choosing a Form of Ownership

51

8. Taxation. The partnership itself is not subject to federal taxation. The partnership,

like the proprietorship, avoids the "double taxation'' disadvantage associated with the corporate form of ownership.D. Disadvantages of the Partnership 1. Unlimited liability of at least one partner. At least one member of every

partnership must be a general partner. The general partner has unlimited personal liability, even though he is often the partner with the least personal resources. 2. Capital accumulation. It is generally not as effective as the corporate form of ownership, which can raise capital by selling shares of ownership to outside investors. 3. Difficulty in disposing of partnership interest without dissolving the partnership. Often, a partner is required to sell his interest to the remaining partner. Even if the original agreement contains such a requirement and clearly delineates how the value of each partner's ownership will be determined, there is no guarantee that the other partners will have the financial resources to buy the seller's interest. 4. Lack of continuity. Partners can make provisions in the partnership agreement to avoid dissolution due to death if all parties agree to accept as partners those who inherit the deceased's interest. 5. Potential for personality and authority conflicts. Being in a partnership is much like being married. Making sure partners' work habits, goals, ethics, and general business philosophy are compatible is an important step in avoiding a nasty business divorce. The demise of many partnerships can often be traced to interpersonal conflicts and the lack of a partnership agreement for resolving those conflicts. 6. The law of agency binds partners. A partner is like a spouse in that decisions made by one, in the name of the partnership, bind all. Each partner is an agent for the business and can legally bind the other partners to a business agreement. E. Dissolution and Termination of Partnership 1. Partnership dissolution is not the same as partnership termination. a) Dissolution occurs when a general partner ceases to be associated with the business. b) Termination is the final act of winding up the partnership as a business. Termination occurs after the partners have expressed their intent to cease operations and all affairs of the partnership have been concluded. 2. Dissolution occurs as a result of one or more of the following events: a) Expiration of a time period or completion of the project undertaken as delineated in the partnership agreement. b) Expressed wish of any general partner to cease operation. c) Expulsion of a partner under the provisions of the agreement. d) Withdrawal, retirement, insanity, or death of a general partner (except when the partnership agreement provides for a method of continuation). e) Bankruptcy of the partnership or of any general partner. f) Admission of a new partner resulting in the dissolution of the old partnership and establishment of a new partnership.

52

Section II Building the Business Plan: Beginning Considerations

g) Any event that makes it unlawful for the partnership to continue operations or

for any general partner to participate in the partnership.h) A judicial decree that a general partner is insane or permanently incapacitated,

making performance or responsibility under the partnership agreement impossible. i) Mounting losses that make it impractical for the business to continue. j) Impropriety or improper behavior of any general partner that reflects negatively on the business.F. Limited Partnerships 1. A limited partnership, which is a modification of a general partnership, is

composed of at least one general partner and at least one limited partner. 2. In a limited partnership the general partner is treated, under the law, exactly as in a general partnership. Limited partners are treated as investors in the business venture, and they have limited liability. They can lose only the amount they have invested in the business. 3. Most states have ratified the Revised Uniform Limited Partnership Act. To form a limited partnership, the partners must file a Certificate of Limited Partnership in the state in which the limited partnership plans to conduct business. 4. The Certificate of Limited Partnership should include: a) The name of the limited partnership. b) The general character of its business. c) The address of the office of the firm's agent authorized to receive summonses or other legal notices. d) The name and business address of each partner, specifying which ones are general partners and which are limited partners. e) The amount of cash contributions actually made, and agreed to be made in the future, by each partner. f) A description of the value of noncash contributions made or to be made by each partner. g) The times at which additional contributions are to be made by any of the partners. h) Whether and under what conditions a limited partner has the right to grant limited partner status to an assignee of his or her interest in the partnership. i) If agreed upon, the time or the circumstances when a partner may withdraw from the firm (unlike the withdrawal of a general partner, the withdrawal of a limited partner does not automatically dissolve a limited partnership). j) It agreed upon, the amount of, or the method of determining, the funds to be received by a withdrawing partner. k) Any right of a partner to receive distributions of cash or other property from the firm, and the times and circumstances for such distributions. l) The time or circumstances when the limited partnership is to be dissolved. m) The rights of the remaining general partners to continue the business after withdrawal of a general partner. n) Any other matters the partners want to include.

Chapter 3 Choosing a Form of Ownership

53

5. Limited partners can make management suggestions to the general partners,

inspect the business, and make copies of business records.6. A limited partner is, of course, entitled to a share of the business's profits as

agreed on and specified in the Certificate of Limited Partnership.7. The primary disadvantage of limited partnerships is the complexity and the cost of

establishing them.G. Master Limited Partnerships 1. A relatively new form of business structure, master limited partnerships (MLPs),

are just like regular limited partnerships, except their shares are traded on stock exchanges. 2. They provide most of the same advantages to investors as a corporation-including limited liability. 3. Master limited partnership profits typically must be divided among thousands of partners.H. Limited Liability Partnerships 1. Many states now recognize limited liability partnerships (LLPs) in which all

partners in the business are limited partners, having only limited liability for the debts and obligations of the partnership. Most states restrict LLPs to certain types of professionals such as attorneys, physicians, dentists, accountants, and others. Just as with any limited partnership, the partners must file a Certificate of Limited Partnership in the state in which the partnership plans to conduct business. Also, like every partnership, an LLP does not pay taxes; its income is passed through to the limited partners, who pay taxes on their shares of the company's net income. GAINING THE COMPETITIVE EDGE Avoiding Business Divorces A failure to address the most important issues in running the business is why conflicts between partners (and often friends), can quickly arise. Business disputes can normally be traced to one or more of the following: 1) The lack of a written agreement between or among all involved that spell-out the duties, privileges, and obligations of all owners. 2) The incompatibility of the owners as to the ultimate goals of the business. 3) The failure to reach agreement on what role each party will play in the decision-making process. The causes of failure serve to reinforce the need to make every effort to obtain a meeting of the minds of all involved on all relevant strategic and operational issues and to commit the agreement to writing. It is important to include an agreement on how conflicts between coowners will be resolved. Some co-owners have established regularly scheduled meeting times to openly discuss the operation of the business and any issues that are producing conflict. Sharing and discussing these facts provide a common focus for the owners. Just like in a successful marriage, honesty,

54

Section II Building the Business Plan: Beginning Considerations

openness and a willingness to deal with issues causing conflict are critical elements in longterm success in a business.

IV. The Corporation A. Definition 1. The Supreme Court has defined a corporation as "an artificial being, invisible,

intangible, and existing only in contemplation of the law." a) It is the most complex of the three major forms of business ownership (See Figure 3.1). b) Responsible for more than 87 percent of sales and 69 percent of the income gained from the three major forms of ownership (See Figures 3.2 and 3.3). c) It is a separate entity apart from its owners and may engage in business, make contracts, sue and be sued, and pay taxes. d) Because the life of the corporation is independent of its owners, the shareholders can sell their interest in the business without affecting its continuation. 2. Corporations (also known as C corporations) are creations of the state. a) When a corporation is founded, it accepts the regulations and restrictions of the state in which it is incorporated and any other state in which it chooses to do business. b) A corporation doing business in the state in which it is incorporated is a domestic corporation. c) When a corporation conducts business in another state, that state considers it to be a foreign corporation. d) Corporations that are formed in other countries but do business in the United States are alien corporations. 3. Corporations have the power to raise large amounts of capital by selling shares of ownership to outside investors, but many corporations have only a handful of shareholders. a) Publicly held corporations are those that have a large number of shareholders, and their stock is usually traded on one of the large stock exchanges. b) Closely held corporations are those whose shares are in the control of a relatively small number of people, often family members, relatives, or friends. Their stock is not traded on any stock exchange. 4. In general, a corporation must report annually its financial operations to its home state's attorney general. a) There are substantially more reporting requirements for a corporation than for the other forms of ownership.B. Requirements for Incorporation 1. Most states allow entrepreneurs to incorporate without the assistance of an

attorney. a) In some states, the application process is complex, and the required forms are confusing. b) The price for filing incorrectly can be high.

Chapter 3 Choosing a Form of Ownership

55

2. Once the owners decide to form a corporation, they must choose the state in

which to incorporate. a) States differ--sometimes dramatically--in the requirements they place on the corporations they charter and in how they treat corporations chartered in other states. 3. Every state requires a Certificate of Incorporation or charter to be filed with the secretary of state. a) The corporation's name. Different from any other firm in that state to avoid confusion or deception and include a term such as corporation, incorporated, company, or limited to notify the public that they are dealing with a corporation. b) The corporation's statement of purpose. The incorporators must state in general terms the intended nature of the business. c) The corporation's time horizon. Most corporations are formed with no specific termination date; they are formed "for perpetuity." However, it is possible to incorporate for a specific duration (e.g., 50 years). d) Names and addresses of the incorporators. The incorporators must be identified in the articles of incorporation and are liable under the law to attest that all information in the articles of incorporation is correct. e) Place of business. The post office address of the corporation's principal office must be listed. f) Capital stock authorization. The articles of incorporation must include the amount and class (or type) of capital stock the corporation wants to be authorized to issue. g) Capital required at the time of incorporation. Some states require a newly formed corporation to deposit in a bank a specific percentage of the stock's par value before incorporating. h) Provisions for preemptive rights, if any, that are granted to stockholders. i) Restrictions on transferring share. Many closely held corporations require shareholders interested in selling their stock to offer it first to the corporation. (Shares the corporation itself owns are called treasury stock.) j) Names and addresses of the officers and directors of the corporation. k) Rules under which the corporation will operate. Bylaws are the rules and regulations the officers and directors establish for the corporation's internal management and operation. 4. Once incorporation is approved and the fees are paid, the approved articles of incorporation become its charter. a) The next order of business is to hold an organizational meeting for the stockholders to formally elect directors, who, in turn, will appoint the corporate officers.C. Advantages of the Corporation 1. Limited liability of stockholders. The primary reason most entrepreneurs choose

to incorporate is to gain the benefit of limited liability, which means that investors can limit their liability to the total amount of their investment.

56

Section II Building the Business Plan: Beginning Considerations

a) This legal protection of personal assets beyond the business is of critical

concern to many potential investors.b) Courts are increasingly holding entrepreneurs personally liable for

environmental, pension, and legal claims against their corporations--much to the surprise of the owners, who chose the corporate form of ownership to shield themselves from such liability. c) Courts will pierce the corporate veil and hold owners liable for the company's debts and obligations if the owners deliberately commit criminal or negligent acts when handling corporate business. d) Corporate shareholders most commonly lose their liability protection, however, because owners and officers have commingled corporate funds with their personal funds. e) Positive steps that should be taken to avoid legal difficulties include the following: (1) File all of the reports and pay all of the necessary fees required by the state in a timely manner. (2) Hold annual meetings to elect officers and directors (3) Keep minutes of every meeting of the officers and directors, even if it takes place in the living room of the founders. (4) Make sure that the corporations board of directors makes all major decisions. (5) Make it clear that the business is a corporation by having all officers sign contracts, loan agreements, purchase orders, and other legal documents in the corporations name rather than their own names. (6) Keep corporate assets and the personal assets of the owners separate. 2. Ability to attract capital. a) Corporations have proved to be the most effective form of ownership for accumulating large amounts of capital. 3. Ability to continue indefinitely. a) Unless limited by its charter, a corporation is a separate legal entity and can continue indefinitely. 4. Transferable ownership. a) If stockholders so desire, they may transfer their shares through sale or bequeath to someone else.D. Disadvantages of the Corporation 1. Cost and time involved in the incorporation process. Creating a corporation can

cost between $500 and $2,500, typically averaging around $1,000.2. Double taxation. Because a corporation is a separate legal entity, it must pay taxes

on its net income to the federal, most state, and some local governments before issuing any net income as dividends. a) Then, stockholders must pay taxes on the dividends they receive from these same profits at the individual tax rate. b) Thus, a corporation's profits are taxed twice. 3. Potential for diminished managerial incentives.

Chapter 3 Choosing a Form of Ownership

57

a) Because they created their companies and often have most of their personal

wealth tied up in them, entrepreneurs have an intense interest in ensuring their success and are willing to make sacrifices for their businesses. b) Professional managers an entrepreneur brings in to help run the business as it grows do not always have the same degree of interest in or loyalty to the company. 4. Legal requirements and regulatory red tape. a) Corporations are subject to more legal and financial requirements than other forms of ownership. Managers may be required to submit some major decisions to the stockholders for approval. Corporations that are publicly held must file quarterly and annual reports with the Securities and Exchange Commission (SEC). 5. Potential loss of control by the founders. a) When entrepreneurs sell shares of ownership in their companies, they relinquish some control, especially when they need large capital infusions for start-up or growth.E. The Professional Corporation 1. A professional corporation is designed to offer professionals such as lawyers,

doctors, dentists, accountants, and others the advantage of the corporate form of ownership. 2. It is ideally suited for licensed professionals, who must always be concerned about malpractice lawsuits, because it offers limited liability. 3. They often are identified by the abbreviation P.C. (professional corporation), P.A. (professional association), or S.C. (service corporation).V. Alternative Forms of Ownership A. The S Corporation 1. In 1954 the Internal Revenue Service Code created the Subchapter S corporation. 2. In recent years the IRS has changed the title to S corporation and has made a few

modifications in its qualifications.3. An S corporation is a distinction that is made only for federal income tax purposes

and is, in terms of legal characteristics, no different from any other corporation.4. S corporation criteria. a) It must be a domestic (U.S.) corporation. b) It cannot have a nonresident alien as a shareholder. c) It can issue only one class of common stock, which means that all shares must

carry the same fights (e.g., the fight to dividends or liquidation rights). The exception is voting rights, which may differ. In other words, an S corporation can issue voting and nonvoting common stock. d) It cannot have more than 75 shareholders (increased from 35). 5. By increasing the number of shareholders allowed in S corporations to 75, the new law makes succession planning easier for business owners. 6. The new law also permits them to sell shares of their stock to certain tax-exempt organizations such as pension funds.

58

Section II Building the Business Plan: Beginning Considerations

a) Previous rules limited ownership strictly to individuals, estates, and certain

trusts.7. Violating any of the requirements for an S corporation automatically terminates a

company's S status. a) If a corporation satisfies the definition for an S corporation, the owners must actually elect to be treated as one. Filing IRS Form 2553 (within the first 75 days of the tax year) makes the election, and all shareholders must consent. 8. Advantages of an S Corporation. a) S corporations retain all of the advantages of a regular corporation, such as continuity of existence, transferability of ownership, and limited personal liability for its owners. b) It passes all of its profits or losses through to the individual shareholders, and its income is taxed only once at the individual tax rate. (1) Thus avoiding double taxation. c) Another advantage of the S corporation is that it avoids the tax C corporations pay on assets that have appreciated in value and are sold. (1) Also, owners of S corporations enjoy the ability to make year-end payouts to themselves if profits are high. 9. Disadvantages of an S Corporation. a) When the 2001 tax legislation was enacted it restructured individual tax rates and many business owners switched to S corporations to lower their tax bills. . b) In 1993, Congress realigned the tax structure by raising the maximum personal tax rate to 39.6 percent from 31 percent. c) Entrepreneurs must consider the total impact of tax implications, the size of company net profits, shareholder tax rates, etc., when choosing their corporate form. 10. When Is an S Corporation a Wise Choice? a) Choosing S Corporation status is usually beneficial to start-up companies anticipating net losses and to highly profitable firms with substantial dividends to pay out to shareholders. (1) The owner can use the loss to offset other income or to remain in a lower tax bracket than the corporation, thus saving money in the long run. b) Companies that plan to reinvest most of their earnings to finance growth also find S corporation status favorable. c) Small business owners who intend to sell their companies in the near future will prefer S over C status, because the taxable gains on the sale of an S corporation are generally lower than those on the sale of a C corporation. d) On the other hand, small companies with the following characteristics are not likely to benefit from S corporation status: (1) Highly profitable personal-service companies with large numbers of shareholders, in which most of the profits are passed on to shareholders as compensation or retirement benefits. (2) Fast-growing companies that must retain most of their earnings to finance growth and capital spending.

Chapter 3 Choosing a Form of Ownership

59

(3) Corporations in which the loss of fringe benefits to shareholders exceeds

tax savings.(4) Corporations in which the income before any compensation to

shareholders is less than $100,000 a year.(5) Corporations with sizable net operating losses that cannot be used against

S corporation earning.B. The Limited Liability Company (LLC} 1. A relatively new creation, it is a cross between a partnership and a corporation. 2. Originating in Wyoming in 1977. 3. Combines benefits of the partnership and the corporate forms of ownership but is

not subject to many of the restrictions imposed on S corporations. a) An LLC can have one owner, most have multiple owners (called members). b) An LLC offers its owners limited liability without imposing any requirements on their characteristics or any ceiling on their numbers. c) An LLC does not restrict its members' involvement in managing the company. d) LLCs also avoid the double taxation imposed on C corporations. e) Like an S corporation, an LLC does not pay income taxes; its income flows through to the members, who are responsible for paying income taxes on their shares of the LLC's net income. f) LLCs offer entrepreneurs flexibility. Like a partnership, an LLC permits its members to divide income (and thus tax liability) as they see fit. g) These advantages make the LLC an ideal form of ownership for small companies in virtually any industry. (1) They are becoming especially popular among family-owned businesses because of the benefits they offer. 4. Creating an LLC a) Forming an LLC requires an entrepreneur to file two documents with the secretary of state: the articles of organization and the operating agreement. b) The LLCs articles of organization, similar to the corporation's articles of incorporation, establish the company's name, its method of management (board-managed or member-managed), its duration, and the names and addresses of each organizer. c) In most states, the company's name must contain the words limited liability company, limited company, or the letters L.L.C. or L.C. d) An LLC's charter may not exceed 30 years. (1) The same factors that would cause a partnership to dissolve would also cause an LLC to dissolve before its charter expired. e) The operating agreement, similar to a corporation's bylaws, outlines the provisions governing the way the LLC will conduct business. (1) The operating agreement must create an LLC that has more characteristics of a partnership than of a corporation to maintain this favorable tax treatment. f) Specifically, an LLC cannot have any more than two of the following four corporate characteristics:

60

Section II Building the Business Plan: Beginning Considerations

(1) Limited liability. Limited liability exists if no member of the LLC is

personally liable for the debts or claims against the company.(2) Continuity of life. To avoid continuity of life, any LLC member must have

the power to dissolve the company.(3) Free transferability of interest. To avoid this characteristic, the operating

agreement must state that a recipient of a member's LLC stock cannot become a substitute member without the consent of the remaining members. (4) Centralized management. To avoid this characteristic, the operating agreement must state that the company elects to be "member-managed." 5. LLC Disadvantages. a) They can be expensive to create, often costing between $1,500 and $5,000. (1) It may pose problems for business owners who are considering converting an existing business to an LLC.C. The Joint Venture 1. A joint venture is very much like a partnership, except that it is formed for a

specific, limited purpose. a) Example. Suppose that you have a 500-acre tract of land 60 miles from Chicago. This land has been cleared and is normally used for farming. One of your friends has solid contacts among major musical groups and would like to put on a concert. You expect prices for your agricultural products to be low this summer, so you and your friend form a joint venture for the specific purpose of staging a three-day concert. Your contribution will be the exclusive use of the land for one month, and your friend will provide all the performers as well as technicians, facilities, and equipment. All costs will be paid out of receipts, and the net profits will be split, with you receiving 20 percent for the use of your land. When the concert is over, the facilities removed, and the accounting for all costs completed, you and your friend will split the profits 20-80, and the joint venture will terminate. 2. The "partners'' form a new joint venture for each new project they undertake. The income derived from a joint venture is taxed as if it had arisen from a partnership. 3. In any endeavor in which neither party can effectively achieve the purpose alone, a joint venture becomes a common form of ownership.VI. Summary of the Major Forms of Ownership A. Figure 3.2 1. Shows the liability features of the major forms of ownership discussed in this

chapter. B. Table 3.1 1. Summarizes of the key features of the sole proprietorship, the partnership, the C corporation, the S corporation, and the limited liability company.

Chapter 3 Choosing a Form of Ownership

61

Chapter Summary 1. Describe the advantages and disadvantages of the sole proprietorship. A sole proprietorship is a business owned and managed by one individual and is the most popular form of ownership. Sole proprietorships offer these advantages: Simple to create Least costly form to begin Owner has total decision making authority No special legal restrictions Easy to discontinue Sole proprietorships suffer from these disadvantages: Unlimited personal liability of owner Limited managerial skills and capabilities Limited access to capital Lack of continuity2. Describe the advantages and disadvantages of the partnership.

A partnership is an association of two or more people who co-own a business for the purpose of making a profit. Partnerships offer these advantages Easy to establish Complimentary skills of partners Division of profits Larger pool of capital available Ability to attract limited partners Little government regulation Flexibility Tax advantages Partnerships suffer from these disadvantages. Unlimited liability of at least one partner Difficulty in disposing of partnership interest Lack of continuity Potential for personality and authority conflicts Partners are bound by the law of agency

3. A limited partnership operates like any other partnership except that it allows limited partners

(primary investors that cannot take an active role in managing the business) to become owners without subjecting themselves to unlimited personal liability for the companys debts.4. Describe the advantages and disadvantages of the corporation. A corporation, the most complex of the three basic forms of ownership, is a separate

legal entity. To form a corporation, an entrepreneur must file the articles of incorporation with the state in which the company will incorporate. Corporations offer these advantages. Limited liability of stockholders Ability to attract capital

62

Section II Building the Business Plan: Beginning Considerations

Ability to continue indefinitely Transferable ownership Corporations suffer from these disadvantages. Cost and time in incorporating Double taxation Potential for diminished managerial incentives Legal requirements and regulatory red tape Potential loss of control by the founders

5. Describe the advantages and disadvantages of the alternative forms of ownership such as the

S corporation, the limited liability company, and the joint venture. An S corporation offers its owners limited liability protection, but avoids the double taxation of C corporations. A limited liability company, like an S corporation, is a cross between a partnership and a corporation. However, it operates without the restrictions imposed on an S corporation. To create a LLC, an entrepreneur must file the articles of organization and the operating agreement with the secretary of state. A joint venture is like a partnership, except that it is formed for a specific purpose. Discussion Questions 1. What factors should an entrepreneur consider before choosing a form of ownership? Answer - Tax considerations. Because of the graduated tax rates under each form of ownership, the government's constant tinkering with the tax code, and the year-to-year fluctuations in a company's income, an entrepreneur should calculate the firm's tax bill under each ownership option every year. Liability exposure. Certain forms of ownership offer business owners greater protection from personal liability due to financial problems, faulty products, and a host of other difficulties. Start-up and future capital requirements. Forms of ownership differ in their ability to raise start-up capital. Control. Entrepreneurs must decide early on how much control they are willing to sacrifice in exchange for help from other people in building a successful business. Managerial ability. If an entrepreneur lack skills or experience in certain areas, he/she may need to select a form of ownership that allows him/her to bring into the company people who possess those skills and experience. Business goals. How big and how profitable an entrepreneur plans for the business to become will influence the form of ownership chosen. Management succession plans. Some forms of ownership make this transition much smoother than others. In other cases, when the owner dies, so does the business. Cost of formation. Some forms of ownership are much more costly and involved to create than others. Entrepreneurs must weigh carefully the benefits and the costs of the particular form they choose.

2. Why are sole proprietorships so popular as a form of ownership? Answer - The sole proprietorship is a business owned and managed by one individual. This form of ownership is by far the most popular. Approximately 74 percent of all businesses in the United States are sole proprietorships. It is very popular for several reasons; the ease and speed of its formation, it is the least costly form of ownership to establish, the owner can keep the profits (less expenses and taxes, of course), total control of operations and can

Chapter 3 Choosing a Form of Ownership

63

respond quickly to changes, it is the least regulated form of business ownership, and it is easy to discontinue. 3. How does personal conflict affect partnerships? How can co-owners avoid becoming sparring partners? Answer - Being in a partnership is much like being married. Making sure partners' work habits, goals, ethics, and general business philosophy are compatible is an important step in avoiding a nasty business divorce. The demise of many partnerships can often be traced to interpersonal conflicts and the lack of a partnership agreement for resolving those conflicts. 4. What issues should the articles of partnership address? Why are the articles important to a successful partnership? Answer - There are two answers, the most complete is related to the partnership agreement drawn up by the partners. The second is the generic issues covered by the UPA when no written agreement exists. The standard partnership agreement will likely include the following: name of the partnership, purpose of the business, domicile of the business, duration of the partnership, names of the partners and their legal addresses, contributions of each partner to the business at the creation of the partnership and later, agreement on how the profits or losses will be distributed, agreement on salaries or drawing rights against profits for each partner, procedure for expansion through the addition of new partners, distribution of the partnership's assets if the partners voluntarily dissolve the partnership, sale of partnership interest, absence or disability of one of the partners, voting rights, decision-making authority, financial authority, handling tax matters, and how alterations or modifications of the partnership agreement will be made. Under the UPA, the three key elements of any partnership are common ownership interest in a business, sharing the business's profits and losses, and the fight to participate in managing the operation of the partnership. Under the act, each partner has the right to: share in the management and operations of the business, share in any profits the business might earn from operations, receive interest on additional advances made to the business, be compensated for expenses incurred in the name of the partnership, have access to the business's books and records, and receive a formal accounting of the partnership's business affairs. 5. Can one partner commit another to a business deal without the other's consent? Why? Answer - the law of agency binds Partners. A partner is like a spouse in that decisions made by one, in the name of the partnership, bind all. Each partner is an agent for the business and can legally bind the other partners to a business agreement. 6. Explain the differences between a domestic corporation, a foreign corporation, and an alien corporation. Answer - A corporation doing business in the state in which it is incorporated is a domestic corporation. When a corporation conducts business in another state, that state considers it to be a foreign corporation. Corporations that are formed in other countries but do business in the United States are alien corporations.

64

Section II Building the Business Plan: Beginning Considerations

7. What issues should the Certificate of Incorporation cover? Answer - Every state requires a Certificate of Incorporation or charter to be filed with the secretary of state. It includes: the corporation's name, the corporation's statement of purpose, the corporation's time horizon, names and addresses of the incorporators, place of business, capital stock authorization, and capital required at the time of incorporation, provisions for preemptive rights, if any, that are granted to stockholders, restrictions on transferring share, names and addresses of the officers and directors of the corporation, and the rules under which the corporation will operate. 8. How does an S corporation differ from a regular corporation? Answer - An S corporation is a distinction that is made only for federal income tax purposes and is, in terms of legal characteristics, no different from any other corporation. S corporation criteria: it must be a domestic (U.S.) corporation, it cannot have a nonresident alien as a shareholder, and it can issue only one class of common stock, which means that all shares must carry the same fights (e.g., the fight to dividends or liquidation rights). The exception is voting rights, which may differ. In other words, an S corporation can issue voting and nonvoting common stock, and it cannot have more than 75 shareholders. 9. How does a joint venture differ from a partnership? Answer - A joint venture is very much like a partnership, except that it is formed for a specific, limited purpose. The "partners'' form a new joint venture for each new project they undertake. The income derived from a joint venture is taxed as if it had arisen from a partnership. In any endeavor in which neither party can effectively achieve the purpose alone, a joint venture becomes a common form of ownership. 10. What role do limited partners play in a partnership? What will happen if a limited partner takes an active role in managing the business? Answer - A limited partnership, which is a modification of a general partnership, is composed of at least one general partner and at least one limited partner. In a limited partnership the general partner is treated, under the law, exactly as in a general partnership. Limited partners are treated as investors in the business venture, and they have limited liability. They can lose only the amount they have invested in the business. Limited partners can make management suggestions to the general partners, inspect the business, and make copies of business records. A limited partner is, of course, entitled to a share of the business's profits as agreed on and specified in the Certificate of Limited Partnership. The primary disadvantage of limited partnerships is the complexity and the cost of establishing them. 11. What advantages does a limited liability company offer over an S corporation? Over a partnership? Answer - Many states now recognize limited liability partnerships (LLPs) in which all partners in the business are limited partners, having only limited liability for the debts and obligations of the partnership. Most states restrict LLPs to certain types of professionals such as attorneys, physicians, dentists, accountants, and others. Just as with any limited partnership, the partners must file a Certificate of Limited Partnership in the state in which the partnership plans to conduct business. Also, like every partnership, an LLP does not pay

Chapter 3 Choosing a Form of Ownership

65

taxes; its income is passed through to the limited partners, who pay taxes on their shares of the company's net income. 12. How is an LLC created? Answer - Forming an LLC requires an entrepreneur to file two documents with the secretary of state: the articles of organization and the operating agreement. The LLCs articles of organization, similar to the corporation's articles of incorporation, establish the company's name, its method of management (board-managed or member-managed), its duration, and the names and addresses of each organizer. In most states, the company's name must contain the words limited liability company, limited company, or the letters L.L.C. or L.C. An LLC's charter may not exceed 30 years. The operating agreement, similar to a corporation's bylaws, outlines the provisions governing the way the LLC will conduct business. The operating agreement must create an LLC that has more characteristics of a partnership than of a corporation to maintain this favorable tax treatment. 13. What criteria must an LLC meet to avoid double taxation? Answer - An LLC cannot have any more than two of the following four corporate characteristics: Limited liability. Limited liability exists if no member of the LLC is personally liable for the debts or claims against the company. Continuity of life. To avoid continuity of life, any LLC member must have the power to dissolve the company. Free transferability of interest. To avoid this characteristic, the operating agreement must state that a recipient of a member's LLC stock cannot become a substitute member without the consent of the remaining members. Centralized management. To avoid this characteristic, the operating agreement must state that the company elects to be "member-managed." Step into the Real World 1. Interview five local small business owners. What form of ownership did they choose? Why? Prepare a brief report summarizing your findings, and explain advantages and disadvantages those owners face because of their choices. 2. Contact your secretary of state to determine the status of limited liability companies in your state. Are they recognized? How does an entrepreneur create one? What requirements must an LLC meet? Report your findings to the class. 3. Invite entrepreneurs who operate as partners to your classroom. Do they have a written partnership agreement? Are their skills complementary? How do they divide responsibility for running their company? How do they handle decision making? What do they do when disputes and disagreements arise? 4. Find in the Yellow Pages of your local telephone book the names of four businesses that you think are effective marketing tools. Also find four companies whose names do little or nothing to help market their products or services. Explain the reasons for your choices. Select a business with the "wrong" name and work with a team of your classmates to brainstorm a better name. 5. Find three local small businesses that are utilizing the Internet to reach their target audience. Interview the owners to determine their level of online involvement for marketing their

66

Section II Building the Business Plan: Beginning Considerations

product/services both regionally and/or nationally. Also, determine from these individuals how they obtained the necessary information for starting a small business (i.e. Small Business Administration, Internet, family, legal counsel, etc). Have them discuss the pros and cons of their choice for information.