Sherill Chapter 08.doc

CHAPTER 8

BUSINESS LEGAL FORMS

LEARNING OBJECTIVES

After reading this chapter, students should be able to:

Evaluate the various legal forms of business. Understand the differences between a sole proprietorship and a partnership. Explain why a partnership agreement is necessary. Explain the process for forming a limited liability company. Understand the reasons that a new venture should incorporate. Identify the differences between an S-corporation and a C-corporation.

CHAPTER OUTLINE AND LECTURE

8-1 INTRODUCTION

The three modules of the business process capital, revenue and cost are deeply intertwined. Any actions taken to modify one component usually have an effect on the other two. The three components of the business process are common to all businesses.

Launching a new venture normally requires an infusion of capital during the early stages, usually in the form of an investment or loan on behalf of the entrepreneur or other interested parties.

Before capital can be raised, however, the venture must establish a legal form that will enable it to solicit and raise debt or equity capital.

All entrepreneurs must decide what type of legal form they should use as the structural basis of their company. The most commonly used business legal forms are:

o Sole proprietorshipo Partnershipo Limited liability companyo Corporationo Nonprofit corporation

Chapter 8: Business Legal Forms 8-2

Selecting the legal form that best suits the venture’s needs and long-term goals requires the entrepreneur to weigh a number of factors, such as the source of start-up financing, the proposed ownership and management structure, the potential for liability, tax treatment, and the expense and formalities associated with setting up and maintaining the legal form itself.

8-2 SOLE PROPRIETORSHIP

The oldest, most common form of private business ownership in the United States is the sole proprietorship.

A sole proprietorship is a business owned and managed by one individual.

o The person may receive help from others in operating the business but, is the only owner.o In the eyes of the law, the sole proprietor simply is the company.o Typically the sole proprietor owns a small service or retail operation that frequently

caters to a group of regular customers. o The owner normally provides the capital needed to start and operate the business through

personal savings or borrowed money.

8-2a Advantages of a Sole Proprietorship

Many people desire to be their own boss, write their own paycheck, and set their own working hours. A sole proprietorship accomplishes this goal and takes it a step further.

If something should happen to the owner, the business immediately ceases to exist. From a tax perspective, the owner pays taxes on all earnings from the sole proprietorship at

the personal income tax rate. The advantages of a sole proprietorship go beyond being one’s own boss, they include:

o Ease of starting: A sole proprietorship is the easiest way to start a business.

Most states require no legal forms to be filed. Some do recommend registering the firm name with the state or county

clerk office, especially when using an assumed name (i.e., when operating other than under the proprietor’s name).

This form is usually called a DBA, or doing business as, and usually entails a small filing fee.

o Control: The sole proprietor has sole control of the business.

That is, the owner is in charge of marketing, sales, customer relations, and maintenance.


o Sole participation in profits and losses: The sole proprietor has no outside investors, he or she is the only one to participate in the profits and losses of the business.

o Use of owner’s abilities: Sole proprietors have the satisfaction of running their business and making as much money as their abilities will allow.

o Tax breaks: In sole proprietorship the business itself pays; no income tax. o Secrecy: The owner, there is no need for disclosure of business information. o Ease of dissolving: If the sole proprietor decides to dissolve the business for any reason,

there are no legal complications.

8-2b Disadvantages of a Sole Proprietorship

Sole proprietorships also have a number of disadvantages, which include:

o Unlimited liability: The law provides that the sole proprietor’s total wealth may be used to satisfy claims against the business, means that almost everything the entrepreneur owns could be sold to pay any debts or legal claims against the business.

o Difficulty in raising capital: For most sole proprietors, their investment in the business is limited to their personal wealth.

o Limitations in managerial ability: The sole proprietor must have or must obtain all the know-how needed to manage the business.

o Lack of stability: Death, illness, bankruptcy, or retirement of the owner terminates the proprietorship.

o Demands on time: Sole proprietors often work sixty to eighty hours a week, especially when the business is new.

o Difficulty in hiring and keeping highly motivated employees: The sole proprietor is the business. Workers with their own visions and goals and a high drive to succeed often have to quit the sole proprietorship to find opportunities for personal growth.

8-3 PARTNERSHIP

Partnership law in the United States has been derived from the Uniform Partnership Act (UPA), originally introduced in 1914 by the National Conference of Commissioners on Uniform State Laws and subsequently enacted in forty-nine states.

The more recent Revised Uniform Partnership Act (RUPA) was approved in 1994, bringing the law of partnerships in line with modern business practices and trends while retaining many of the valuable provisions in the original act. It was amended in 1997 to provide limited liability for partners in a limited liability partnership.

Section 6 of the Uniform Partnership Act defines partnership as “an association of two or more persons to carry on as co-owners of a business for profit.”

o A partnership can be based on a written contract or a voluntary and legal oral agreement.


o Other than the difference in the number of owners, a partnership is similar in many respects to a sole proprietorship.

o In a partnership, the co-owners share everything, including the risk, hard work, assets, and profits.

8-3a Partnership Types

The three major partnership types are general partnerships, limited partnerships, and joint ventures.

A general partnership is a business with at least one general partner who has unlimited liability for the debts of the business.

A limited partnership has at least one general partner and one or more limited partners. The joint venture is a special type of partnership established to carry out a special project or

to operate for a specific time period.

General Partnership

Regardless of the percentage of the business they own, general partners have authority to act and make binding decisions as owners of the business. Each general partner is liable for all the debts of the business.

Partners generally share profits and losses according to a plan specified by an agreement between or among them.

o With the authority to act as an owner, each general partner can engage the partnership in binding agreements.

o Unless a partnership agreement prevents a general partner from making such agreements, the partnership is responsible for all actions of each owner.

Limited Partnership

All partnerships must have at least one general partner. A limited partnership includes one or more general partners and one or more limited partners.

The general partners arrange and run the business while the limited partners are investors only.

The limited partner investors receive special tax advantages and protection from liability.

o These partners legally may have no say in managing the business. If this requirement is violated, the “limited” status is dissolved.

o These partnerships are usually found in service industries or in professional firms such as real estate and dentistry.

o They are also used extensively to enable various international arrangements.


o In some states, a special notice must be filed in the county or district in which the limited partnership has its offices.

Joint Venture

Sometimes a number of individuals and businesses join together in order to accomplish a specific purpose or objective or to complete a single transaction.

A joint venture in the United States or abroad is something less than the ordinary partnership, which continues as a business.

o There is some confusion among the courts as to whether a joint venture is a partnership. o For many entrepreneurs, this business form is used to establish international operations. o Working in a joint venture with an international partner can make it easier to enter

foreign markets.

8-3b Advantages of a Partnership

Greater access to capital: The amount of capital may increase significantly. Combined managerial skills: People with different talents and skills may join together.

o Combining these skills could provide the partners with a greater chance of success. This advantage is a critical factor in the success of entrepreneurial ventures.

Ease of starting: Because it involves a private contractual arrangement, a partnership is fairly easy to start.

o The cost of starting a partnership is low; it usually involves only a modest legal fee for drawing up a written partnership agreement, which is not necessary but highly desirable.

Clear legal status: Over the years, legal precedents for partnerships have been established through court cases.

o The legal status of the partnership is clearly understood: lawyers can provide sound legal advice about partnership issues.

Tax advantages: The partnership has some tax advantages over other forms of business.

o In a partnership, as in a sole proprietorship, the owners pay individual taxes on their business earnings, but the partnership as a business does not pay income tax.

8-3c Disadvantages of a Partnership


Unlimited liability: Each general partner is liable for a partnership's debts. Potential disagreements: Decisions made by several people (partners) are often better than

those made by one person.

o Power and authority are divided, and the partners will not always agree with each other. As a result, poor decisions may be made.

o Also, decision-making becomes more time consuming because agreement must be reached before action can be taken.

Investment withdrawal difficulty: A person who invests money in a partnership may have a hard time withdrawing the investment.

o The partnership agreement generally specifies how or when partners may be able to recover their investments.

o In general, the criteria for getting money back out are stringent because cash is a precious resource to a new enterprise.

Limited capital availability: The partnership may have an advantage over the sole proprietorship in the availability of capital, but it does not compare to a corporation in ability to raise capital.

o The amount of financial capital a partnership can raise depends on the personal wealth of the partners and their credit ratings. It also depends on how much they are willing to invest.

Instability: If a partner dies or withdraws from the business, the partnership is dissolved. A new partnership or some other form of business organization must be legally established.

8-4 LIMITED LIABILITY COMPANY

The limited liability company (LLC) is a relatively new legal form that has now been adopted in all fifty states.

The LLC provides all the benefits of a partnership but limits the liability exposure of all investors to the amount of their investment.

Unlike a limited partnership, anyone can participate in the management of an LLC and still have limited liability protection.

o To form a limited liability company (LLC), business owners must file formal articles of organization with their state's LLC filing office and comply with other state filing requirements.

o The LLC can have an unlimited number of investors, who in the parlance of the LLC are known as members.


o Usually the secretary of state’s office will check to see that the firm name is not already in use.

o The LLC is also required to prepare an operating agreement, which is similar to a partnership agreement.

o The operating agreement sets the rules for governing the company as well as the rights and responsibilities of the members.

o The operating agreement is not filed with any state agency but rather is kept by a designated member of the LLC or an assignee, such as an attorney.

Aside from formation requirements, the main difference between a partnership and an LLC is that partners are personally liable for any business debts of the partnership;

o Meaning that creditors of the partnership can go after the partners' personal assets, whereas members (owners) of an LLC are not personally liable for the company's debts and liabilities.

There is one similarity between LLCs and partnerships, however. They both offer pass-through taxation,

o Which means that the owners report business income or losses on their individual tax returns; the partnership or LLC itself does not pay state or federal income taxes.

8-4a Advantages of a Limited Liability Company

Because LLCs combine the best features of both partnerships and corporations, they have many advantages:

Limited liability: The investors in an LLC enjoy limited liability for the commitments and actions of the company.

Pass-through taxation: As with a sole proprietorship, partnership, and S-corporation, the LLC is not separately taxed.

o Profits and losses of the LLC “pass through” to the owners, to be taxed at the individual income tax rate.

Investors can manage: Unlike a limited partnership, which does not allow limited partners to manage, the LLC allows any shareholder to also be a manager without risking limited liability status. This advantage is significant, especially to the founders of a company.

Unlimited membership: The LLC has no restrictions regarding the number of individuals who may participate as shareholders. An LLC can have as many members as necessary.

Ease of organizing: Organizing an LLC is usually a simple matter, requiring only the filing of the articles of organization with the appropriate state secretary.


8-4b Disadvantages of a Limited Liability Company

The disadvantages of an LLC are due primarily to its relatively recent adoption by state legislatures.

o With the LLC form now less than a decade old, many people still don’t understand it well, and courts have only begun to form a record of common law.

o The latter is important because well-established common law makes for a more predictable legal environment.

Other disadvantages of the LLC form of business include:

o Difficulty raising money: The LLC does not allow for the issuance of shares of stock. Rather, anyone who invests in an LLC is considered a member.

Many seasoned and savvy investors are less comfortable with this form of investment and prefer to have actual stock certificates on file with their attorneys.

o No continuity of life: The LLC does not have a reliable continuity of existence. The articles of organization must specify the date on which the LLC’s existence will terminate.

Unless otherwise provided in the articles of organization or a written operating agreement, an LLC is dissolved at the death, withdrawal, resignation, expulsion, or bankruptcy of a member

o Limited transferability: No one can become a member of an LLC (either by transfer of an existing membership or the issuance of a new one) without the consent of members having a majority interest (excluding the person acquiring the membership interest) unless the articles of organization provide otherwise.

8-5 CORPORATION

A corporation is an artificial legal entity typically chartered by a state.

A corporation is usually formed to operate a business. Once chartered, the corporation is completely separate from its owners, has its own life, is

liable for its own debts, and must pay its own taxes. The entrepreneur can choose between two types of corporations. The more commonly known

of the two varieties is the so-called C-corporation.

o This type of legal entity is better known because it is the legal structure for many of the largest companies in the world.


o Most public companies choose this form because of the well-established laws that govern the structure worldwide and because of the multiple options it offers for raising capital.

o The main difference between a C-corporation and other business structures is that a C-corporation files and pays corporate income taxes directly.

o C-corporations are considered a separate legal entity from their shareholders and must pay taxes on income left over after business expenses.

o If the entrepreneur plans to retain profits to finance growth, repay debt, or make other capital expenditures, the C-corporation form could make sense.

o C-corporations can take advantage of corporate income tax rates, which are sometimes lower than personal tax rates.

o For profitable companies, the C-corporation status has the ability to provide greater flexibility in terms of planning and controlling federal income taxes. C-corporations also can deduct the cost of certain fringe benefit packages.

o The C-corporation is taxed twice on its profits, once as a corporation and a second time when those profits are dispersed as dividends or when the company is liquidated. This effect is known as double taxation and is one of the major disadvantages of a C-corporation.

The C-corporation also has advantages for fund-raising because it is the only business form that is allowed to sell both common and preferred stock.

o Common stock is often nonvoting and has restrictions on transfer and redemption. Preferred stock usually includes voting rights and is usually treated preferentially if the company is sold or liquidated.

Special rules and regulations under the Omnibus Budget Reconciliation Act of 1983 permit what is referred to as the S-corporation to use noncorporate tax rates at the request of the shareholders.

o These special regulations allow the shareholders to be treated as individual taxpayers. o To qualify as an S-corporation, a business must meet the following requirements:

It must be incorporated within the United States. It can only sell shares of common stock. All shareholders must be residents of the United States. Shareholders must be natural persons, estates, or trusts. No shareholder can be a partnership or a corporation. Some states limit the number of shareholders. No more than 20 percent of its income can come from passive activities

(such as owning shares of stock in another corporation).

o Like other forms of ownership, the S-corporation has advantages and disadvantages. The primary advantage is that the shareholders’ tax brackets can result in tax savings.


o If a corporation expects to lose money in the first years of operation and if the shareholders will have income from other sources, the S-corporation is preferred.

o The primary disadvantage is that the tax law governing the S-corporation is very complex.

Tax and legal advice is strongly recommended before and after an entrepreneur makes the S-corporation choice.

The best time to terminate S status is when the S-corporation begins to produce very high levels of taxable income.

o Corporations can change legal form from S-corporation status to C-corporation status fairly easily, but there are costs involved.

8-5a Advantages of a Corporation

The power and presence of corporations in American business suggest that this form has certain advantages over other forms of business ownership:

Limited liability: A person investing funds in a corporation receives shares of stock and becomes an owner.

o In a corporation, the liability for the shareholder equals the amount of funds invested.o Thus, if the business is forced to liquidate, each owner loses only the amount of money

he or she has invested.

Skilled management team: The board of directors has the duty of hiring professional Managers, and the owners delegate their power of operating the business to these managers.

o Professional managers are trained and experienced career executives. o They may own shares of stock in the business but usually not enough to control the

corporation.

Transfer of ownership: Shareholders have the right to sell their shares of a corporation's stock to whomever they please, barring a legal restriction on some closed corporations.

o These shares of ownership can be sold whenever the shareholder desires and at the price the buyer is willing to pay.

Greater capital base: The size of a proprietorship or partnership is limited to the amount of capital that one or several people have available and is willing to invest.

o Corporations, however, can attract capital from a large number of investors by selling shares of stock.


Stability: State law varies, but a corporation can usually be chartered to operate indefinitely. Shareholders' deaths, retirement, or sale of stock need not dissolve the business.

o The corporation's policies may be altered by the sale of large blocks of stock, but the business will go on.

o Nor will the death or retirement of the president of the board or the chief executive officer stop the corporation from doing business.

Legal-entity status: A corporation can purchase property, make contracts, or sue and be sued in its corporate name.

o These characteristics distinguish it most clearly from other forms of business organization.

8-5b Disadvantages of a Corporation

As was true with the other forms of business organization, the corporation has some disadvantages:

Difficulty and expense of starting. Starting a corporation involves applying for a charter from a state.

o Each state has its own set of laws; these laws must be considered before an entrepreneur decides where to incorporate.

o An attorney should be hired to complete legal forms. Attorney fees and state charter fees must be paid.

o The chosen state then reviews the application and issues a charter that specifies various restrictions on operations.

Lack of control. The individual shareholder has little control over the operations of the corporation except to vote for a slate of individuals for the board of directors.

o The buying and selling of shares of stock is the only real control an owner has.

Multiple taxation and fees. In addition to an annual franchise tax in the state of incorporation, an annual payment is required by most states for the right to operate as a corporation.

o No such fees are charged to a proprietorship or partnership. Some states levy a corporate income tax on those monies earned within the state.

o At the federal level, the corporation has to pay taxes on its profits.

Lack of secrecy. A corporation must provide each shareholder with an annual report.


o In a closed corporation, the few reports that are circulated usually won't get into the hands of nonowners.

o But when a large number of reports are issued, the reports become public knowledge.o Public disclosure enables competitors and other outsiders to see the corporation's

financial condition.

Lack of personal interest. In most large corporations, management and ownership are separate.

o This separation can result in a lack of personal interest in the success of the corporation. o If the managers are also shareholders, personal interest is enhanced. o It is assumed that employees who are also owners will work harder for the success of the

business, but the accuracy of this assumption is an individual matter. o Most managers have pride in their work and want any business they are involved with to

succeed.

Credit limitations. Banks and other lenders have to consider the limited liability of the owners of a corporation.

o If the corporation fails, its creditors can look only to the assets of the business to satisfy claims.

o For partnerships, the creditors can rely on personal assets of the partners to pay off business debts.

8-6 NONPROFIT CORPORATION

Many organizations are nonprofit corporations; that is, they are not profit-seeking enterprises.

The nonprofit sector includes universities and other schools, charities, churches, volunteer organizations, credit unions, country clubs, government organizations, cooperatives, and a number of other organizations.

o The nonprofit has to make a profit in order to continue to operate. o No organization can run without making a profit or without at least making enough

money to cover expenses. o The nonprofit corporation differs from the for-profit corporation primarily in that the

former is prohibited by law from distributing earnings (paying dividends) to owners.o Whereas the organization can make a profit, pay its expenses, and grow, these profits

cannot be provided to owners in the manner of a for-profit enterprise. o The nonprofit exists because the founders believe that the firm provides something of

value that is not being provided well or at all by other enterprises. o Donations, dues, and the sale of goods or services provide the funds to pay employees

and finance operations.


KEY TERMS

Articles of organization: LLC paperwork that must be filed with the state's LLC filing office (usually the secretary or department of state).

Common stock: Stock associated with a corporation that has no preferential benefits other than indicating a percentage of ownership in the company. Also, nonvoting stock that has restrictions on transfer and redemption.

C-corporation: An artificial legal entity that is formed to operate a business; it is considered a separate legal entity from its shareholders and must pay taxes on income left over after business expenses.

Corporation: An artificial legal entity, typically chartered by a state, that is usually formed to operate a business.

Doing business as (DBA): A form filed with the local county clerk for a sole proprietorship operating other than under the name of the owner.

Double taxation: The situation in which the C-corporation is taxed twice on its profits, once as a corporation and a second time when those profits are dispersed as dividends or when the company is liquidated.

Fund-raising: Methods used by entrepreneurs to obtain money for their ventures.

General partners: The parties in a limited partnership who assumes total liability for the venture.

General partnership: A business in which all partners have unlimited liability for the debts of the business.

Joint venture: A situation in which a number of individuals and businesses join together in order to accomplish a specific purpose or objective or to complete a single transaction.

Limited liability company: A business legal form that provides most of the benefits of a partnership but limits the liability exposure of all investors to the amount of their investment.

Limited partners: Partners in a limited partnership whose liability is limited to the extent of their respective investment.

Limited partnership: A partnership that has at least one general partner and one or more limited partners.

Members: Investors in an LLC.


Nonprofit corporation: An enterprise that is prohibited by law from distributing earnings (paying dividends) to owners; the nonprofit sector includes universities and other schools, charities, churches, volunteer organizations, credit unions, country clubs, government organizations, and cooperatives.

Operating agreement: A written contractual arrangement between or among partners in an LLC that sets the rules for governing the company and establishes the rights and responsibilities of the members.

Partnership: Defined by Section 6 of the Uniform Partnership Act as “an association of two or more persons to carry on as co-owners of a business for profit.”

Partnership agreement: A written contractual arrangement between or among partners in a new venture. The agreement is not necessary but is highly desirable, and drawing it up usually involves only a modest legal fee.

Pass-through taxation: The taxation procedure of an LLC or a partnership; the owners or partners report business income or losses on their individual tax returns.

Preferred stock: Stock in a corporation that has benefits beyond a percentage of ownership in the company, sometimes including such benefits as preferential treatment on liquidation, antidilution privileges, and rights to buy additional stock in the future. Also, stock that usually includes voting rights and is usually treated preferentially if the company is sold or liquidated.

Revised Uniform Partnership Act (RUPA): Revisions to the Uniform Partnership Act that were approved in 1994, which brought the law of partnerships in line with modern business practices and trends while retaining many of the valuable provisions in the original act.

S-corporation: An artificial legal entity that is formed to operate a business; special regulations permit the shareholders of this entity to use noncorporate tax rates and to pass through the income or loss of the corporation to the individual shareholders as if they were partners.

Sole proprietorship: A business owned and managed by one individual.

Uniform Partnership Act (UPA): Law in the United States that regulates partnerships. It was originally introduced in 1914 by the National Conference of Commissioners on Uniform State Laws and subsequently enacted in forty-nine states.

Unlimited liability: The law stipulates that a sole proprietor’s total wealth may be used to satisfy claims against the business.


PRACTICE QUIZ

1. A sole proprietorship is a business owned and managed by a group. Answer: FalseRationale: A sole proprietorship is a business owned and managed by one individual.Reference: 8-2

2. The law provides that the sole proprietor’s total wealth may be used to satisfy claims against the business. Answer: TrueReference: 8-2b

3. A situation in which a number of individuals and businesses join together in order to accomplish a specific purpose or objective or to complete a single transaction is called a joint venture. Answer: TrueReference: 8-3a

4. In a partnership, people with the same talents and skills should join together. Answer: FalseRationale: In a partnership, people with different talents and skills join together.Reference: 8-3b

5. The amount of financial capital that a partnership can raise does not depend on the personal wealth of the partners or on their credit ratings. Answer: FalseRationale: The amount of financial capital that a partnership can raise does depend on the personal wealth of the partners and their credit ratings.Reference: 8-3c

6. If a partner dies or withdraws from the business, the partnership is dissolved. Answer: TrueReference: 8-3c

7. The LLC is not required to prepare an operating agreement, which is similar to a partnership agreement. Answer: FalseRationale: The LLC is required to prepare an operating agreement, which is similar to a partnership agreement.Reference: 8-4

8. An LLC does not have a reliable continuity of existence. Answer: TrueReference: 8-4b

9. A C-corporation does not file or pay corporate income taxes. Answer: FalseRationale: A C-corporation files and pays corporate income taxes directly.Reference: 8-5


10. The power and presence of corporations in American business suggest that the corporate business legal form has certain advantages over other forms of business ownership. Answer: TrueReference: 8-5a

11. In which of the following business legal forms must the company file articles of organization?a. sole proprietorshipb. partnershipc. limited liability companyd. all of the aboveAnswer: CRationale: To form a limited liability company (LLC), business owners must file formal articles of organization with their state's LLC filing office (usually the secretary or department of state) and comply with other state filing requirements.Reference: 8-4

12. In which type of partnership is each person is liable for all the debts of the business?a. generalb. limitedc. unlimitedd. joint ventureAnswer: ARationale: Regardless of the percentage of the business they own, general partners have authority to act and make binding decisions as owners of the business. Each general partner is liable for all the debts of the business.Reference: 8-3a

13. In which type of partnership do investors receive special tax advantages and protection from liability?a. generalb. limitedc. unlimitedd. joint ventureAnswer: BRationale: The limited partner investors receive special tax advantages and protection from liability.Reference: 8-3a

14. To qualify as an S-corporation, a business must meet the following requirements:a. It must be incorporated within the United States.b. It can only sell shares of common stock.c. All shareholders must be residents of the United States.d. All of the above.Answer: D


Rationale: In addition to these requirements, all shareholders must be natural persons, estates, or trusts; no shareholder can be a partnership or a corporation; the number of shareholders is limited in some states; and no more than 20 percent of the corporation’s income can come from passive activities (such as owning shares of stock in another corporation).Reference: 8-5

15. Which of the following is not an advantage to creating a partnership?a. clear legal statusb. unlimited liabilityc. greater access to capitald. All of the above.Answer: BRationale: Each general partner is liable for a partnership's debts. If the partnership has no assets and if one partner lacks the personal assets to pay his or her share of the debt, the other partners would be legally obligated to make up the difference, including through the use of personal assets.Reference: 8-3c


QUESTIONS TO BE DISCUSSED

1. What is meant by the term capital? How does the corporate legal form affect the capital structure that a venture can achieve?

Answer: Capital is the money needed to start and operate a business. Launching a new venture normally requires an infusion of capital during the early stages, usually in the form of an investment or loan on behalf of the entrepreneur or other interested parties.

Before capital can be raised, however, the venture must establish a legal form that will enable it to solicit and raise debt or equity capital.

All entrepreneurs must decide what type of legal form they should use as the structural basis of their company. The most commonly used business legal forms are:

o Sole proprietorshipo Partnershipo Limited liability companyo Corporationo Nonprofit corporation

Selecting the legal form that best suits the venture’s needs and long-term goals requires the entrepreneur to weigh a number of factors, such as the source of start-up financing, the proposed ownership and management structure, the potential for liability, tax treatment, and the expense and formalities associated with setting up and maintaining the legal form itself.

REF: 8-1

2. What is the difference between a partnership and a corporation? Between an S-corporation and a C-corporation?

Answer: Section 6 of the Uniform Partnership Act defines partnership as “an association of two or more persons to carry on as co-owners of a business for profit.”

A partnership can be based on a written contract or a voluntary and legal oral agreement. Other than the difference in the number of owners, a partnership is similar in many

respects to a sole proprietorship.

Corporation is an artificial legal entity typically chartered by a state.

A corporation is usually formed to operate a business. Once chartered, the corporation is completely separate from its owners, has its own life,

is liable for its own debts, and must pay its own taxes.


C-corporation files and pays corporate income taxes directly. C-corporations are considered a separate legal entity from their shareholders and must pay taxes on income left over after business expenses.

Special rules and regulations under the Omnibus Budget Reconciliation Act of 1983 permitted the S-corporation to use non-corporate tax rates at the request of the shareholders. These special regulations allow the shareholders to be treated as individual taxpayers.

REF: 8-3, 8-5

3. What are the advantages of the limited liability company legal form? What are the disadvantages?

Answer: The advantages of Limited Liability Company are:

Limited liability: The investors in an LLC enjoy limited liability for the commitments and actions of the company.

Pass-through taxation: As with a sole proprietorship, partnership, and S-corporation, the LLC is not separately taxed.

Investors can manage: Unlike a limited partnership, which does not allow limited partners to manage, the LLC allows any shareholder to also be a manager without risking limited liability status. This advantage is significant, especially to the founders of a company.

Unlimited membership: The LLC has no restrictions regarding the number of individuals who may participate as shareholders. An LLC can have as many members as necessary.

Ease of organizing: Organizing an LLC is usually a simple matter, requiring only the filing of the articles of organization with the appropriate state secretary.

The disadvantages of Limited Liability Company are:

The disadvantages of an LLC are due primarily to its relatively recent adoption by state legislatures.

o With the LLC form now less than a decade old, many people still don’t understand it well, and courts have only begun to form a record of common law.

o The latter is important because well-established common law makes for a more predictable legal environment.

Other disadvantages of the LLC form of business include:

o Difficulty raising money: The LLC does not allow for the issuance of shares of stock. Rather, anyone who invests in an LLC is considered a member.


o No continuity of life: An LLC does not have a reliable continuity of existence. The articles of organization must specify the date on which the LLC’s existence will terminate.

o Limited transferability: No one can become a member of an LLC (either by transfer of an existing membership or the issuance of a new one) without the consent of members having a majority interest (excluding the person acquiring the membership interest) unless the articles of organization provide otherwise.

REF: 8-4a, 8-4b

4. What is meant by the phrase “In the eyes of the law, the sole proprietor simply is the company”? Explain by comparing the sole proprietorship to other corporate legal forms.

Answer: The oldest, most common form of private business ownership in the United States is the sole proprietorship. A sole proprietorship is a business owned and managed by one individual. That person may receive help from others in operating the business but is the only owner. Therefore in the eyes of the law, the sole proprietor simply is the company.

As compared to any other business form in a sole proprietorship:

If something should happen to the owner, the business immediately ceases to exist. From a tax perspective, the owner pays taxes on all earnings from the sole proprietorship

at the personal income tax rate.

REF: 8-2

5. Name at least three advantages of a sole proprietorship. Name at least three disadvantages. In your estimation, do the advantages outweigh the disadvantages?

Answer: The advantages of a sole proprietorship are:

Ease of starting: A sole proprietorship is the easiest way to start a business. Most states require no legal forms to be filed.

Control: The sole proprietor has sole control of the business; the owner is in charge of marketing, sales, customer relations, and maintenance. As the singular owner of the firm, the sole proprietor doesn’t have to have board meetings or meet with shareholders to make changes to the business plan.

Sole participation in profits and losses. Because the sole proprietor has no outside investors, he or she is the only one to participate in the profits and losses of the business.

The disadvantages of a sole proprietorship are:

o Unlimited liability: The law provides that the sole proprietor’s total wealth may be used to satisfy claims against the business, means that almost everything the entrepreneur owns could be sold to pay any debts or legal claims against the business.


o Difficulty in raising capital: For most sole proprietors, their investment in the business is limited to their personal wealth.

o Limitations in managerial ability: The sole proprietor must have or must obtain all the know-how needed to manage the business.

The students should provide their opinion on whether in a sole proprietorship the advantages outweigh the disadvantages.

REF: 8-2a

6. Explain the difference between a general partner and a limited partner. Why does a limited partnership require at least one general partner? Can a general partner be another company? Why does this arrangement make sense?

Answer: General partnership: Regardless of the percentage of the business they own, general partners have authority to act and make binding decisions as owners of the business. Each general partner is liable for all the debts of the business.

Partners generally share profits and losses according to a plan specified by an agreement between or among them.

o With the authority to act as an owner, each general partner can engage the partnership in binding agreements.

o Unless a partnership agreement prevents a general partner from making such agreements, the partnership is responsible for all actions of each owner.

Limited partnership: All partnerships must have at least one general partner. A limited partnership includes one or more general partners and one or more limited partners. The reason for this is:

The general partners arrange and run the business while the limited partners are investors only.

The limited partner investors receive special tax advantages and protection from liability.

REF: 8-3a

7. What are the tax advantages of a partnership structure? Why does a partnership suffer from the disadvantage of “instability”? Explain.

Answer: The partnership has some tax advantages over other forms of business.

In a partnership, the owners pay individual taxes on their business earnings, but the partnership as a business does not pay income tax.


In a partnership if a partner dies or withdraws from the business, the partnership is dissolved. A new partnership or some other form of business organization must be legally established.

REF: 8-3b, 8-3c

8. How does the limited partnership structure differ from the LLC structure? Which of these business forms would you choose if you were starting a new restaurant?

Answer: The LLC provides all the benefits of a partnership but limits the liability exposure of all investors to the amount of their investment. In a limited partnership, the limited partner cannot participate in management of the company.

The students should provide their opinion on whether they would choose a LLC or Limited partnership if they were starting a new restaurant.

REF: 8-4

9. Explain what is meant by the term pass-through taxation. How does that term relate to the concept of double taxation?

Answer: Pass-through taxation: Profits and losses of the LLC “pass through” to the owners, to be taxed at the individual income tax rate.

While a C-corporation is taxed twice on its profits, once as a corporation and a second time when those profits are dispersed as dividends or when the company is liquidated. This is called double taxation.

REF: 8-4a, 8-5

10. Is it legal if a nonprofit corporation earns a profit? Explain.

Answer: The nonprofit corporation has to make a profit in order to continue to operate. No organization can run without making a profit or without at least making enough money to cover expenses. The nonprofit corporation differs from the for-profit corporation primarily in that the former is prohibited by law from distributing earnings (paying dividends) to owners. Whereas the organization can make a profit, pay its expenses, and grow, these profits cannot be provided to owners in the manner of a for-profit enterprise.

REF: 8-6


RUNNING CASE: COMMUTER COFFEE

“The Legal Form”

Introduction: Carlos called the meeting to order with all members present. He asked if everyone had reviewed the financials and if there were any corrections. All agreed that the financials were accurate and fairly stated the projected plans for the business.

Questions for Discussion

1. Do you agree that an LLC legal form is appropriate for Commuter Coffee? Explain by contrasting the advantages and disadvantages of possible alternative legal forms.

Suggested approach: The students should provide their opinion on whether they consider an LLC legal form as an appropriate form for Commuter Coffee. The students should also suggest alternative forms of business forms by looking at the advantages and disadvantages of such business forms. The below mentioned details can provide a background to the student to understand the concept discussed.

Partnership: Section 6 of the Uniform Partnership Act defines partnership as “an association of two or more persons to carry on as co-owners of a business for profit.”

The three major partnership types are: general partnerships, limited partnerships, and joint ventures.

The advantages of partnership include:

Greater access to capital Combined managerial skills Ease of starting Clear legal status Tax advantages

The disadvantages include:

Unlimited liability Potential disagreements Investment withdrawal difficulty Limited capital availability Instability

Limited Liability Company: The LLC provides all the benefits of a partnership but limits the liability exposure of all investors to the amount of their investment.


The advantages of a LLC include:

Limited liability Pass-through taxation Investors can manage Unlimited membership Ease of organizing

The disadvantages of LLC include:

Difficulty raising money No continuity of life Limited transferability

Corporation: A corporation is an artificial legal entity typically chartered by a state.

The advantages of a corporation include:

Limited liability Skilled management team Transfer of ownership Greater capital base Legal-entity status

The disadvantages of a corporation include:

Difficulty and expense of starting Lack of control Multiple taxation and fees Lack of secrecy Lack of personal interest Credit limitations

REF: 8-3, 8-4, 8-5 (Entire sections)

2. How did the group determine the amount of start-up capital needed? Do you agree with the amount they decided on? Explain.

Suggested approach: In the group Shena points out that by looking at the ending cash line on the Cash Flow Projection for Year One without inserting any capital amount; it was possible to see that the absolute minimum amount of capital needed was $60,811. Her justification to this is that the business becomes cash positive in the second month of operations so the negative cash of $60,811 in the first month is the maximum needed because the cumulative cash increased every month after that first month. However though the entire group agrees to this justification, they also plan to consider contingency factors due to the


uncertainties in the projections; they especially emphasize on the fact that the mistakes could be on the projections of the revenue generation. The group further agrees that the $37,000 estimated as revenue should be doubled to cover the initial period of possible revenue shortfall and for misestimates on the cost side. Based on this discussion the group decides on a total start-up capital amount of $140,000, which would provide a contingency of $79,189.

The students should provide their opinion on whether they agree with the method used for calculation on the initial capital requirement.

3. If you were a member of the Commuter Coffee founding team, where would you go for the $8,000 that each has agreed to contribute toward the equity?

Suggested approach: The students should provide their opinion on how they would contribute $8000 toward equity considering that they are a part of the founding team of Commuter Coffee.

As they are planning for a LLC form of business, they must consider the fact that they have a disadvantage of raising funds in that an LLC does not allow for the issuance of shares of stock. Rather, anyone who invests in an LLC is considered a member. Many seasoned and savvy investors are less comfortable with this form of investment and prefer to have actual stock certificates on file with their attorneys.

REF: 8-4b


EXPERIENTIAL EXERCISE 1 “Setting Up an LLC in Your State”

Introduction: The purpose of this exercise is to introduce students to the relative simplicity of establishing a legal business form. This exercise can be conducted outside class or in class if a live Internet connection and printing resources are available.

Suggested approach: Students should go through the procedures of setting up an LLC in their state of residence, stopping short of actually filing papers with the state. After completing the activity, students reflect on the following discussion questions:

1. Why it is necessary to file LLC forms with the state, but the state does not require forms for sole proprietorships or partnerships?

2. How much does it cost to file an LLC in your state of residence? Must any other fees be paid to launch an LLC? How easy was it to find and obtain the necessary documents for the LLC?

3. What other documents on the secretary of state website are useful to an LLC?


EXPERIENTIAL EXERCISE 2 “Choose a Legal Form”

Introduction: For this exercise, students are asked to choose a legal form for a new venture. They are encouraged to debate the advantages and disadvantages of the various legal forms and to try to reach a consensus about which one is best under the circumstances.

Background: The business that needs a legal form is an automobile buying and selling company. The company was founded by a person who has experience purchasing used cars at the local automobile auction and then reselling them through classified ads and other means. The founder of the company, Cars 4 All, does not want to have a traditional used car lot, but he wants to grow beyond the capacity that he can handle alone. The founder has elected to train others to succeed at the auto auction and to sell cars using his proven technique. The founder wants to retain control of the company but is willing to use equity in lieu of salary to lure qualified people to his company. The founder intends to retain 20 percent of everything sold by his employees. The founder wants a legal form that will enable him to share equity, limit personal liability, and allow for future fund-raising to pay for growth.

1. Which business form is best in this situation?

Suggested approach: The students should be grouped into teams of four to six individuals. Each team is required to choose a legal form for the new venture described above.

Each team should be able to clearly state why it chose the form it did and defend its choice to the rest of the class.

After each team presents its choice and rationale, the instructor asks for a vote on which business legal form is best. The team is required to vote for the best form.


OTHER RESOURCES

Websites of interest:

MyCorporation.com provides information on C- and S-corporations.

This page provides information for the C-corporation form.http://www.mycorporation.com/corporation.htm

This page provides FAQs for the S-corporation form.http://www.mycorporation.com/s-corporation/

http://www.mycorporation.com/s-corporation/

http://www.mycorporation.com/corporation.htm

Documents

Sherill Chapter 08.doc