Chapter 2:



Chapter 2

Choosing a Business Entity

Introduction

This chapter addresses the key issues to consider in determining the organizational alternative that is most advantageous for a client. This broad overview presents concepts that will appear throughout this course.

Lecture Notes

□ Considerations in Choosing a Business Entity

In determining which organizational forms best suits the needs of your firm’s clients, you should consider the following issues:

formalities

management

ownership restrictions

taxation

liability

□ Key Issues

1. Formalities

Clients must be aware of the requirements necessary to form and operate their business. Failure to comply with filing and reporting requirements can expose the business owners to personal liability for debts and obligations of their business.

Example: Corporations require extensive formalities. Articles of incorporation, bylaws, minutes of meetings, and so on are required to form and maintain a corporation. However, to form a general partnership, two or more individuals may simply begin a business together.

2. Management

Some business owners want to be passive investors in a business enterprise, while others want to participate in the daily operations of the business. The degree to which business owners intend to participate in the management and operation of a business enterprise can limit their choice of a business form.

Example: Sam, a computer software engineer, has a great idea for a retail computer software business. He approaches his parents and asks them to invest in his business. His parents want to help Sam out, but they are retired and don’t want to be involved in the business. Sam may choose to form a limited partnership with his parents; he would be the general partner and they would be limited partners.

3. Ownership Restrictions

Businesses that allow their owners to participate in the management of the business (such as limited liability partnerships, limited liability companies, etc.) generally restrict who may own an interest in the business. Thus, not all business owners can freely buy and sell their business interests.

Example: The four Cranston brothers and their families all work their family farm together. The farm is commercially known as Cranston’s Cranny, a limited liability company. On his 25th birthday, the youngest brother, Perry, wants to leave the farm and pursue a career in acting. An investor is interested in purchasing Perry’s interest in the family business, mainly because he would like to split the farm up and sell the property for a residential development. Because the brothers hold the farm as a limited liability company, Perry cannot sell his interest (including management rights) to the investor without the consent of his brothers.

4. Taxation

The tax consequences of the various organizational forms is crucial in determining the appropriate form for a client. Corporations suffer double taxation while partnerships receive single, or pass-through taxation.

5. Liability (Who’s Responsible?)

Protection from personal liability (responsibility) for the debts and obligations of a business is one of the most significant consideration in determining which business form is best for a client.

Example: Rosa is a single mother of five young children. The only asset that she owns is her family’s home, which she was left with when her husband passed away two years ago. To support her family, Rosa starts a cleaning business. She is very careful about her work. One morning the front door of one of the buildings that she cleans is found unlocked. A large amount of cash is missing from one of the offices. The building owner sues Rosa for the loss, claiming that she was negligent in failing to lock the door when she left the building. Rosa has no business insurance. If the building owner wins, Rosa may have to use her personal assets (e.g., the family home) to pay the judgment against her business.

Answers to Study Questions in Review

1. What business forms are created by individuals or entities simply beginning business?

A sole proprietorship and general partnership

2. What document creates a corporation?

The articles of incorporation

3. Identify two business forms that allow individuals to invest in a business without participating in its management.

Limited partnerships and corporations

4. Why do businesses that allow owners to participate in management restrict who may own an interest in the business?

Businesses that allow owners to participate in management may restrict ownership of the business in order to avoid conflict in the operation of the business.

5. What is liability, and why is it important in choosing an organizational form for a business?

Liability is responsibility for debts. Business owners generally want to avoid personal liability for the debts and obligations of their business ventures.

Answers to Case Studies in Review

1. Kent and his brother Craig manage their family’s cattle ranch in Montana. They own the ranch as partners. Your supervising attorney recommends that they form a corporation to protect them from personal liability for any losses the ranch may suffer. Your supervising attorney asks you to briefly explain what personal liability is to Kent and Craig.

Personal liability refers to who is responsible for the debts and liabilities of a business.

2. Laurie wants to open a small bakery in her hometown. Her parents are interested in financing her business. Can they invest in her business without participating in its management or day-to-day operations? Explain.

Yes. Laurie’s parents may invest in her business without participating in its management through a business form such as a limited partnership.

Project Application

Contact your state’s secretary of state to obtain a form for filing a corporation’s articles of incorporation.

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