Chapter 1



Chapter 1

The Alternatives: A Basic Overview

Introduction

This chapter provides a brief overview of the business organizations adopted in most states. Business organizations are based largely upon state statute; therefore, the existence, formation, and ramifications of each form may vary from state to state.

Lecture Notes

□ Business Organizations: Overview

The following are the basic organizational forms that we will cover during this course:

1. Sole Proprietorships

2. Partnerships

a. General Partnerships

b. Limited Partnerships

i. Limited Partnerships

ii. Limited Liability Partnerships

iii. Limited Liability Limited Partnerships

iv. Limited Partnership Associations

3. Corporations

4. Limited Liability Companies

Personal Liability

One of the most important considerations in forming any business organization is whether the owner will be personally liable for the debts and obligations of the business. Personal liability is an individual’s responsibility to pay the debts and obligations of a business from personal assets (e.g., family home, personal car, personal bank account, etc.).

Example: Pam starts a small jewelry-making business from her home. She operates as a sole proprietor, a business form that offers its owner no personal liability protections. Two months after Pam starts her business, a child chokes on one of the beads and dies. The parents sue Pam for the death of their child. If Pam is found negligent, she may have to sell her family home, her personal car, and even use money out of her personal bank account to compensate the parents.

A basic overview of the various organizational forms is helpful in order to effectively compare the advantages and disadvantages that each offers.

Sole Proprietorships

A sole proprietorship is a business conducted by one person.

Advantages of a Sole Proprietorship

1. simplicity of formation

2. flexibility of management

Disadvantages of a Sole Proprietorship

1. personal liability

2. termination at owner’s death

□ Partnerships

A partnership is an association of two or more persons (including corporations, entities) for profit.

The business for-profit element is crucial. This requirement precludes and protects nonprofit and charitable organizations from forming a partnership, in order to protect do-gooders from personal liability (responsibility) for the debts and obligations of the partnership.

Advantages of a Partnership

The advantage of a partnership is management rights for partners.

Disadvantages of a Partnership

1. personal liability for debts and obligations of business

2. termination on death or withdrawal of one or more partners

Taxation

One major advantage of a partnership over a corporation is pass-through taxation. The partnership is not viewed by the Internal Revenue Service (IRS) as an entity separate from its owners; therefore, the IRS does not tax the business at the partnership level. Rather, the IRS “passes through” the partnership form and taxes the individual partners, personally, on the partnership profits.

___________________________________________________________________________

Partnership Forms

General Partnerships

Limited Partnerships

Limited Partnerships

Limited Liability Partnerships

Limited Liability Limited Partnerships

Limited Partnership Associations

___________________________________________________________________________

➢ General Partnerships (Traditional Partnership)

In a general partnership, all partners can be involved in the management of the business and all partners are personally liable for the debts and obligations of the business.

Note: The general partnership easily can be formed by two or more people simply beginning business together. No formalities are required to form a partnership; thus, it is the “default” business form.

Registered Limited Liability Partnerships:

All states and the District of Columbia recognize registered limited liability partnerships. This form of partnership limits the personal liability of partners for the wrongful acts and omissions of their partners, as well as the contractual obligations of the partnership.

An LLP has general partners who manage and are personally liable for

1. the partnership contracts

2. their own negligence or malfeasance

3. negligence or malfeasance that they participated in, supervised, or had knowledge of.

Partial-Shield States Versus Full-Shield States

States are almost evenly divided regarding the personal liability protections afforded by LLPs. Half of the states are partial-shield states and half are full-shield states.

Partial-shield states protect partners in an LLP from personal liability for the negligence or malfeasance of their partners unless they participated in, supervised, or had knowledge of their partners’ actions.

Full-shield states protect partners from personal liability for the negligence or malfeasance of their partners as well as all other business or contractual obligations. This shield protects partners from all personal liability for the partnership debts or obligations. However, it is important to note that all partners in an LLP remain personal liable for their own negligence or malfeasance.

➢ Limited Partnerships

Limited partnerships were created in order to limit the personal liability of partners, thus the name limited partnerships.

Evolution of the Limited Partnership

With each new limited partnership form came new or different liability protections. As with all business forms, the limited partnership form evolved to address the desire of business owners to expand their personal liability protections.

1. Limited Partnerships (LP)

A limited partnership has

1. general partners who manage the business and have personal liability

2. limited partners who invest in the business and have no personal liability

A key to understanding the liability protections of limited partnerships is to remember that with management comes responsibility.

The First Evolution of Limited Partnerships

Increasingly, limited partners (investors) wanted to participate in the management of the businesses in which they invested their money. However, in a limited partnership, if a limited partner becomes involved in management decisions, he or she loses personal liability protections. Therefore, limited liability partnerships developed to allow all partners to participate in management while maintaining some level of personal liability protections.

2. Limited Liability Limited Partnerships (LLLP)

The Second Evolution of Limited Partnerships

Although the LP offers partners extensive liability protections, partners of an LP remain exposed to personal liability. The limited liability limited partnership expands the liability protections to the fullest extent and protects general and limited partners from personal liability for all obligations of the partnership, whether arising in contract or tort.

Liability Insurance: Public Protection

To protect the public from potential negligence or malfeasance of partners of an LLLP, most states require that LLLPs maintain liability insurance.

Example: Keith and Scott are accountants in an LLLP. While preparing a client’s taxes, Scott accidentally miscalculates the client’s tax liability; therefore, the client pays only half of her tax obligation. The IRS notices the error and sends the client a letter demanding the unpaid portion of the taxes due, as well as penalties and interest. The client can and should make a claim against the LLLP, as well as the business liability insurer; however, the client cannot make a claim against Keith’s or Scott’s personal assets.

□ Corporations

A corporation is considered a person, born of statute. It is a completely separate entity from its owners.

Management and Ownership

A corporation is managed by a board of directors and owned by shareholders.

Advantages of a Corporation

1. Continuity of Life

A corporation exists indefinitely, as long as the appropriate corporate filings are made with the secretary of state.

2. Centralization of Management

The management of a corporation is centralized in its board of directors.

3. Limited Liability of Shareholders

The owners of the corporation are not personally liable for the debts and obligations of the corporation.

4. Free Transferability of Interests

Shareholders and owners of a corporation can freely buy and sell their interests in the corporation because they are investors, not managers.

Disadvantages of a Corporation

The main disadvantage of forming a corporation is double taxation. Because a corporation is a separate “person,” the IRS taxes the business at the corporate level and also taxes the individual shareholders on the corporate profits that they receive as dividends.

Exception: A corporation that qualifies (e.g., has 75 or fewer shareholders, is a domestic corporation, or etc.) may make a subchapter S election and receive the pass-through taxation of a partnership.

□ Limited Liability Company (LLC)

Organization

1. An LLC is owned and managed by its members.

2. A LLC offers its members management rights, limited personal liability, and the pass-through taxation of partnerships.

Advantages of an LLC

1. Management for all members

All members have the right to participate in the management of the LLC unless they opt out.

2. Limited liability for members

Members, including member-managers, are not personally liable for the debts and obligations of the LLC. However, most states require that LLCs carry appropriate liability.

3. Pass-through taxation

LLCs are taxed like partnerships, not corporations.

Disadvantages of an LLC

1. Limited Duration

Many states limit the duration of the LLC to 30 years.

2. Lack of Transferability of Interests

Because members have management rights, owners of an LLC cannot freely sell their interest in the LLC without the consent of the other managers.

3. Liability Insurance: Public Protection

Most states require LLCs to carry appropriate liability insurance in order to protect the public interest.

Answers to Study Questions in Review

1. What is personal liability?

An individual’s responsibility to pay the debts and obligations of a business from personal assets

2. Identify three forms of partnership.

General partnership, limited partnership, limited liability partnership, limited liability limited partnership, limited partnership association

3. Who manages a limited partnership?

General partners

4. Are limited partners personally liable for the debts and obligations of a limited partnership?

No

5. Who owns a corporation?

Shareholders

6. Does a corporation pay taxes on its profits?

Yes

7. What is a limited liability company?

An unincorporated entity that offers its members management rights, limited personal liability, and partnership taxation

Answers to Case Studies in Review

1. Cathy is a fifth-grader who opens a lemonade stand on her block. Would Cathy’s business be considered a sole proprietorship or a partnership? Why?

Cathy’s business would be considered a sole proprietorship because she is in business by herself.

2. Frames ’R Us, Inc., is a local frame shop. Last year its corporate profits were $200,000, and each of its two shareholders received $100,000 in corporate profits. Will Frames ’R Us be taxed on its corporate profits, will the shareholders, or will both? Explain.

Both will be taxed. Corporations are taxed on their profits and shareholders are taxed on the corporate profits that are distributed to them.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download