The Organizing Function – Choosing a Legal Organizational Structure

• Objectives:• 1 To identify sole proprietorship, partnership, & corporation

as the three primary forms of business organization.• 2. To discuss the organization & characteristics of each

form of business organization• 3. To analyze advantages & disadvantages of each form of

business organization• 4. To show how income taxes are affected by the form of

business organization•  5. To summarize the factors to be considered when

selecting a form of business organization•  6 To compare alternative arrangements for transferring the

income, ownership, & management of a farm business

• Intro: After completing the planning function & determined how to satisfy its customer needs profitably, managers need to form an organizational structure that will permit the firm to accomplish its goals.

• Impact of Adv & Disadv. Managers have to weigh the advantages & disadvantages of sole proprietorship, partnership, & corporate structure before a business is formed, as these impact firm's profits & long-run success.

• Impact of Business Structure: The way a business is structured will have an impact with its performance.

• Impact of Decision Making Process: Who makes what types of decisions can affect the long-run success of agribusiness.

• Cooperatives work best for many agribusinesses. Banding together & sharing of risks & rewards from group have been a part of US agric since colonial days.

• The three basic forms of business organization are: – (1) sole proprietorship (or individual proprietorship), – (2) partnership, – (3) corporation.

• Each has different legal & organizational characteristics, & income tax regulations.

• According to US Agric Census, – nearly 87% of U.S. farms & ranches are sole proprietorships – Approx 10% are partnerships, – 3% are corporations.

• Choice of organization structure may depend on • the size of the business, • the number of people involved in it, • the career stage of the primary operators, • the owners' desire for passing on their assets to their heirs.

• THE SOLE PROPRIETORSHIP• Refers to an individual who owns, manages, assumes all the

risk, & derives all the profits/loss from a business. • Its the most common/popular form of farm business orgzn

cos its easy to form & operate e.g. most family farms are.•  Characteristics: Owner owns & manages the business,

assumes all the risks, & receives all the profits or losses. • A single owner, who acquires & organizes the resources,

provides mgmt, & is solely responsible for the success or failure or debts of the business.

• Organizing or Creating a Sole Proprietorship: – No special legal procedures, permits, or licenses required. – Business not limited in size by either amount of inputs used or

products produced. – Business can be as large or small as owner desires.– Number of employees vary, additional mgmt may be hired, &

property may be co-owned with others.

• Advantages– Easiest to create. – Owner has freedom in operating the business – i.e. is free to

organize & operate business in any legal manner. – Owner makes all mmgmt decisions. – All business profits & losses belong to the owner/sole proprietor.– Business is flexible – e.g. quick decision making regarding

investments, purchases, sales, enterprise combinations, input levels, etc. based solely on owner’s best judgment.

• Disadvantages– Owners personally liable for legal difficulties & debts to business. – Creditors have legal right to take business & personal assets of the

owner in fulfillment of unpaid financial obligations. – Size business limited by capital available to single owner – e.g. if

capital is small, business may be too small to realize economies of size, making it difficult to compete with larger/ more efficient ones

– As business grows, mgmt abilities & time of single owner may be insufficient, thus a large sole proprietorship may need to hire additional mmgmt expertise.

– Lack of business continuity – e.g. death of owner means business may have to be liquidated or reorganizes under new ownership.

• Income Taxes:A sole proprietorship pays income taxes on profit at the tax rates for individual or joint returns. Business profits & capital gains are added to other taxable income earned to determine the individual total taxable income

• Joint Operating Agreements•  Sometimes two or more sole proprietors may carry on some

joint business activities while maintaining individual ownership of their own resources.

• Such an activity is often called a joint operating agreement. They tend to be informal, short-term arrangements.

• Here parties generally pay all costs related to their own assets, -e.g. property taxes, insurance, maintenance, interest on debts. But operating expenses – e.g. veterinarian fees, fertilizer, or utilities may be shared in a fixed proportion.

• The general principle for operating agreement is to share income in same proportion as contributed resources or expenses.

•  An operating budget is a useful tool for evaluating resource contributions profit sharing.

• In this example party A owns all the pasture, buildings, livestock, & fences for the cow herd. Party A will also pay cost of pasture maintenance, & repairing fences & facilities.

• Party B will provide all feed & labor for the cow/calf enterprise & pay all other variable costs.

•  The question, then, is how shld the income from the cattle be divided? The budget shows that party A is contributing 52% of total costs & party B is contributing 48%. Income can be divided in the same proportion.

• e.g. Budget For A Joint Cow/calf Enterprise (One Head)• Item Value Party A Party B• Variable costs: Hay

$ 90.00 $ $ 90.00 Grain and supplement, 56.00 56.00 Salt and minerals 2.40 2.40 Pasture maintenance 22.50 22.50 Veterinary & health exp. 10.00 10.00 Livestock facilities ' 8.00 8.00 Machinery & equipment 5.00 5.00 Breeding expense 5.00 5.00 Labor 30.00 30.00 Miscellaneous 10.00 10.00 Interest on variable costs 11.95 1.78 10.17

• Fixed costs: Interest on brdg. herd 75.00 75.00 Facilities Dep. & interest 10.00 10.00 Mach/eqpmt Dep & Int 6.50 6.50 Land charge 105.00 105.00

• Total cost $447.35 $233.78 $213.57• Percent contribution 100% 52% 48%

• Partnership• Is a voluntary association of 2 or more persons to carry on,

as co-owners of a business for profit – i.e. the business must be owned by the partners.

• Partnerships are governed by Uniform Partnership Act, which assume an equal partnership in profit, mgmt decision etc. unless a written record specifies a different arrangement

• Types of Partnerships– 1) Ordinary or General Partnership– 2) Limited Partnership: Limited partnership is regularly applied in

large livestock operations where investors want to limit their financial liability and do not wish to be involved in management

• The differences btwn General and Limited Partnerships are: a. Limited partners cannot participate in mgmt of business. b. Financial liability of partnership debt & obligations is

limited to actual investment of limited partner. • Liability of general partners can extend assets.

• Creating a Partnership • Can be created by oral or written agreement. But orally

agreed partnership tend to have more problems than written partnership agreements.

• Most important problems to spell out before partnership can start or the written agreement shld cover the ff points:

• 1. Management: Who is responsible for which management decisions and how will they be made?

• 2. Property Ownership and Contribution: This section shld list property each partner will contribute to the partnership & describe how it will be owned. – Property may be owned by the partnership, or the partners may

retain ownership of their individual property & rent it to the partnership. When the partnership itself owns property, any partner may sell or dispose of any asset without the consent & permission of the other partners. This aspect of a partnership suggests that retaining individual ownership may be desirable if it does not affect use of the asset by the partnership

• 3. Share of Profit and Losses: The method for calculating profits/losses going to each partner shld be described, particularly if there is an unequal division. – Profits are generally divided in proportion to the value of the

assets, labor, & mgmt contributed to the business –i.e. if each of 2 partners contributes 1/2 of assets, labor, & mgmt, they share the profits on a 50-50 basis unless otherwise stated in the agreement.

• 4. Records: Records are important for the division of profits & for maintaining an inventory of assets & their ownership. Who will keep what records shld be part of the agreement.

• 5. Taxation: The agreement shld contain a detailed account of tax basis of property owned & controlled by partnership & copies of the partnership information tax returns.

• 6. Termination: Agreement shld contain date of termination. – If no duration is fixed by the agreement any partner may terminate

the partnership at will. Otherwise, a partnership will terminate upon death or incapacitation of a partner, bankruptcy, or by mutual agreement btwn partners. Termination thro death can be prevented by agreement allowing deceased partner's share to pass to heirs.

• 7. Dissolution: The termination of the partnership on either a voluntary or involuntary basis requires a division of partnership assets. The method for making this division shld be described to prevent disagreements & an unfair division.– **Note Partnerships cannot succeed unless partners have trust &

faith in each other’s ability to make sound business decisions

• General Legal Characteristics• Partnership has three basic characteristics:

a. Profit $ Loss: The sharing of the business profit and loss.b. Property or Assets: Shared control of property.c. Management: Shared management of the business.

• In addition to the above 3 basic characteristics these legal characteristics actually define a partnership:

• 1) Each person involved participates in mgmt decisions• 2) Assets are owned jointly• 3) Sharing of Profits & Loss• 5) The parties (or business) operate under a firm name

• 6) The parties have joint bank account for doing business• 7) The parties keep a single set of business records• **Note: Apart from the above general legal agreement, the

following must be considered by any potential partner:• a. Legally, each partner has an equal voice in mgmt control,

& majority of the partners must control the business unless otherwise stated in the legal agreement

• b. Each partner has an equal right to possession & control of the assets/property for carrying out partnership business c.

• c. Unless otherwise stated, profit/losses are divided according to the specific agreement - i.e. any withdrawals & wages that a partner receives must be treated as advances on his/her share of profit.

• d. Although the partnership business does not pay taxes, it must file income info & must thus have its own records for income tax purposes. The partners then pay individual taxes on their share of the partnership income

• Advantages• Capital & Mgmt Pooling: Has advantage over a sole

proprietorship in pooling capital of partners to allow a larger business, that can be more efficient than 2 or more smaller businesses. Total mgmt & labor are increased by pooling expertise of all partners. Mgmt efforts can be divided, with each partner specializing in one area of the business.

• Easier to Create:Its easier & cheaper to form than a corpn. It requires more records than sole proprietorship, but not more than a corpn.

• Flexibility of Inclusion: Its a flexible form of business orgn where many types of arrangements can be accommodated in agreement. It fits situations where parents want to bring children & spouses into business. e.g. agreement can be modified to allow for contributions of children mgmt/capital

• No Tax Payment: Pays no tax as profits are distributed as income

• Disadvantages• Unlimited liability for partners in General partnership: Each

partner is held personally & individually responsible for any lawsuits & financial obligations arising from the operation of the partnership – i.e. a partner's personal assets can be claimed by creditors to pay firm’s debts (only in ordinary or general partnership).

• Faith Trust for Success: Any partner, acting individually, can act for the partnership in legal & financial transactions. For this reason the firm can succeed only if partners have faith & trust in other partners’ business abilities.

• Poor Business Continuity: Business ends with death, disagreement, bankruptcy or incapacity of a partner.

• Income Taxes

• No Direct Income Tax Payment: A partnership does not pay any income taxes directly.

• Files Tax Info with IRS: It only files an info income tax return reporting the income & expenses for the partnership.

• Partners Income Taxed at Individual Rate: Income from the partnership is reported by individual partners on their tax returns, based on respective shares of partnership income. Partnership income is, thus, taxed at individual tax rates, with the exact rate depending on the amount of partnership income & other income earned by each partner/taxpayer.

• The Family Partnership

• In agric family partnership is very important cos of the financial requirements for competition

• Make up :– Wisdom & experiences of parents & relatives– Energy & labor of son, daughter, nephews, etc..

• Family partnerships allow younger family members to get experiences on the job & eventually assume mgmt responsibilities. But their senior members make a considerable considerations i.e. provide funds for expansions & land

• Corporation• Defined: Is created by state law and organized for the

purpose of carrying on a business for profit. A corpn is a separate legal entity which must be formed & operated in accordance with the laws of the state in which it is organized.

• Legal Status: It is a legal "person" separated & apart from its owners, managers, & employees. This separation of the business entity from its owners distinguishes a corpn from the other forms of business orgn. As a separate business entity a corpn can– own property – own money, – enter into contracts, – sue, & be sued.

• It has most of the basic rights & duties of an individual.

• Organization and Characteristics of Corporations• Laws affecting formation & operation of corpns vary from

state to state – e.g. several states have laws preventing corpns from engaging in farming or ranching, or place special restrictions on farm and ranch corporations.

• Organizing or Creating Corporations:There are basic steps that apply to forming a farm corpn. These are:– 1. The incorporators file a preliminary application with the

appropriate state official including corpn name.– 2. Incorporators draft a pre-incorpn agreement outlining the major

rights & duties of parties after the corpn is formed.– 3 The articles of incorporation are prepared & filed with the proper

state office.– 4. Incorporators turn property/cash over to the corpn in exchange

for shares of stock representing their ownership share of the corpn.– 5. Shareholders meet to organize the business & elect directors.– 6. Directors meet to elect officers, adopt bylaws, & begin business

in the name of the corpn.

• Three groups of individuals involved in a corporation: shareholders, directors, officers.

• Shareholders: own the corpn. Stock certificates are issued to them for property/cash transferred to the corpn. As owners, they have the right to direct affairs of the corpn, done thro elected directors & at annual meetings.

• Each shareholder has one vote for each share of voting stock owned. Thus a shareholder with 51% or more of voting stock has majority control over business affairs of the corpn. In some corpns capital contributions are exchanged for bonds carry a fixed return, but no voting privileges.

• Directors: elected by shareholders at each annual meeting & hold office for following yr. Are responsible for the mgmt of the business. Number of directors is normally fixed by articles of incorpn.

• Directors hold meetings to conduct corpn’s business affairs & to set broad mgmt policy to be carried out by the officers.

• Officers: are elected & removed by board of directors. Are responsible for the day-to-day running of the corpn within guidelines set by the board. A corpn president may sign certain contracts, borrow money, & perform other duties without board approval but will normally need board approval before committing the corpn to large financial transactions or performing certain other acts.– Note: number of shareholders may be as few as 1 in some states,

while 3 is the minimum number in other states.

– In many small family farm corpns shareholders, directors, & officers are all the same individuals.

• Types of Corporations• There are 2 types of corpns for federal income tax purposes

– 1. Regular corporation, also called C corporation.

– 2.Tax-option corpn or S corporation,

• Differences Btwn C and S Corporations• Major difference btwn the two is in:• the method by which they are taxed by the federal gov’t • the rate at which they are taxed by the federal gov’t. • Subchapter S corpn is not taxed directly, but is used as a

form to transfer income to individual shareholders wha are then taxed at their individual rates ( like in partnership) Thus, capital gains from corpn are treated as long-term gains on individual shareholders income tax returns.

• Both types have same characteristics. But S corpn has some restrictions. These include:– 1. There must be no more than 25 shareholders (a husband & wife

are considered one shareholder even though both own stock).– 2. Shareholders are limited to individuals (no foreign citizens),

estate & certain types of trusts. Other corpns cannot own stock in an S corporation.

– 3. It can have only one class of stock, but voting rights may be different for some shareholders.

– 4 Shareholders must consent to operating as S corp.– 5. It cannot receive more than 80% of its gross receipts from

foreign sources

• Advantages or Attractions to Corpns• Corpns offer benefits including:

– personal liability, – continuity of mgmt, – income tax minimization, – estate planning & – specialization in mgmt decision making.

• Limited Liability:Corpns provide ltd liability for owners & shareholder – i.e. are responsible only to extent of capital they have invested in the corpn. Shareholders’s personal assets cannot be used by creditors to meet debts of corpns.

• Easy Pool of Resources: Enable individuals to pool magm & resources together for larger firm size & specialized mgmt to provide greater efficiency than smaller firms.

• Continuity of Business: Corpns are not terminated by death of a shareholder, as shares pass to heirs.

• It provides a convenient way to divide & transfer business ownership e.g. a retiring farmer can transfer part of the business to children while maintaining an ongoing business.

• Tax Aspects: Corpns usually have income tax advantages, depending on the business, how it is organized. A C corpn is a separate taxpaying entity, & these corpn are subject to different rates than individuals.

• Credit: Easier to obtain credit cos of continuity of corpns.

• Disadvantages• Difficult to Create: Corpn are more costly to form &

maintain than sole proprietorships & partnerships. – e.g. Legal: Certain legal advice & fees are needed when forming

& operating a corpn to ensure compliance with state regulations. – Financial: An accountant is needed during formation & operations

of corpns to handle financial records and tax-related matters.– Filling Fees: Most states require various fees when filing the

articles of incorporation and some annual operating fee or tax on corpns, which are not assessed on other orgzns.

• Double Taxation Income:Double taxation of income for C corpns. After corpn pays tax on its taxable income, after-tax income received by shareholders as dividends is considered taxable income. Many small farm corpns avoid some of this double taxation by distributing most of corpn income to shareholders as rent, wages, salaries, & bonuses. These items are tax-deductible expenses for the corpn but taxable income for the shareholders/employees.

• S corpns do not pay income tax but are taxed like a partnership. Hence, the name "tax-option" corpn. S corpn files tax return info, but shareholders report their share of income, expenses & capital gains for taxation.

• Thus income tax treatment of an S corpn avoids the dividend double-taxation problem of a C corpn.

• More Reporting Activities: Corpns are required to keep minutes of all meetings & annual reports filed with the state

• Comparison Of Forms Of Farm Business Organization• Category Sole proprietor Partnership Corporation• Ownership Single individual 2 or more individuals Legal entity owned by

shareholders• Business Life Terminates on death Agreed term or Forever unless fixed by

terminates at agreement; in death, stock • death of a partner passes to heirs• Liability Proprietor is liable Each partner liable Shareholders not liable for

for debts + personal debt in some cases some assets stockholders may be

asked to cosign corpn notes• Capital Sources Personal, Partner contributions, Shareholders' contributions,

investments loans loans sale of stock, sale of bonds, & loans

• Mgmt Decisions Proprietor Agreement of partners Shareholders elect directors who manage business

• Income taxes Business income is Partnership files IRS info Regular C corpn:Corpn files combined with other info report; each partner's & pays income tax; salaries

income on individual share of income is added to shareholder employees are tax return to individual taxable deductible; shareholders pay

income pay tax on dividends received

Tax option (S) corpn: Shareholders report share of

income, operating loss, capital gain on individual returns; IRS info report filed by corp