Section I - The Challenges of Entrepreneurship



Chapter 5 Forms of Business Ownership

Part 1: Learning Objectives

1. Explain the advantages and the disadvantages of the three major forms of ownership: the sole proprietorship, the partnership, and the corporation.

2. Discuss the advantages and the disadvantages of the S corporation, the limited liability company, the professional corporation, and the joint venture.

Part 2: Class Instruction

Introduction

The most attractive form of business ownership meets the specific needs of the business and its owners in these eight areas:

1. Tax considerations

2. Liability exposure

3. Start-up and future capital requirements

4. Control

5. Managerial ability

6. Business goals

7. Management succession plans

8. Cost of formation

Business owners may need to make concessions due to the trade-offs associated with eight these factors.

The major forms of ownership include:

• Sole proprietorship

• Partnership

• Corporation

• S corporation

• Limited liability company

• Joint venture

The data regarding the distribution of the percentage of each business form and the percentage of total business sales revenues illustrates the dominate forms of business ownership.

Figure 5.1 – Forms of Business Ownership on page 166 illustrates this information

The Sole Proprietorship LO 1

The sole proprietorship is the most popular type of ownership, defined as business owned and managed by one individual.

Advantages of the sole proprietorship include:

1. Simple to create

2. Least costly form of ownership to begin

3. Profit incentive

4. Offers total decision-making authority

5. No special legal restrictions

6. Easy to discontinue

Disadvantages of the sole proprietorship include:

1. Unlimited personal liability

2. Limited skills and capabilities

3. Feelings of isolation

4. Limited access to capital

5. Lack of continuity for the business

The sole proprietorship has implications regarding the claims of the business’s creditors and the owner’s personal assets. They are treated the same under this unlimited liability situation.

The Partnership

A partnership is an association of two or more people who co-own a business for the purpose of making a profit. This association between the owners is defined by the partnership agreement and The Uniform Partnership Act (UPA), which codifies the body of law dealing with partnerships.

Advantages of a partnership include:

1. Easy to establish

2. Complementary skills

3. Division of profits

4. Larger pool of capital

5. Ability to attract limited partners

Types of partnerships include:

1. Limited partnership

2. Limited liability partnership

3. Master limited partnership

Additional partnership advantages include:

1. Easy to establish

2. Complementary skills

3. Division of profits

4. Larger pool of capital

5. Ability to attract limited partners

This list can be expanded further to include:

6. Little governmental regulation

7. Flexibility

8. Taxation

Disadvantages of partnership include:

1. Unlimited liability of at least one partner

2. Capital accumulation

3. Difficulty in disposing of partnership interest without dissolving the partnership

4. Lack of continuity

5. Potential for personality and authority conflicts

Limited partnerships are composed of at least one general partner to actively participate in the business and one or more limited partners that look much like investors in the business, each with specific roles.

Corporations

The corporation is a separate entity apart from its owners, and may engage in business, make contracts, sue and be sued, and pay taxes. It is a legal entity and represents the most complex form of business ownership.

“C corporations” are creations of the state and are categorized as either:

1. Domestic corporation

2. Foreign corporation

3. Alien corporation

Corporation can be publicly held by many, or closely held by a relatively small number of owners.

The process of incorporation includes:

1. Certificate of Incorporation

2. Bylaws

Advantages of a corporation include:

1. Limited liability of stockholders

2. Ability to attract capital

3. Ability to continue indefinitely

4. Transferable ownership

Disadvantages of a corporation include:

1. Cost and time involved in the incorporation process

2. Double taxation

3. Potential for diminished managerial incentives

4. Legal requirements and regulatory red tape

5. Potential loss of control by the founder(s)

Other Forms of Ownership LO 2

“S” corporation: An “S” corporation, standing for “small,” is the same as any other corporation, except that a distinction applies for federal income tax purposes.

The criteria for businesses seeking “S” status are that the venture must:

• Be a domestic (U.S.) corporation

• Not have a nonresident alien as a shareholder

• Have only one class of common stock so all shares have the same rights

• Limit shareholders to individuals, estates, and certain types of trusts

• Not have more than 100 shareholders

• Have less than 25 percent of the corporation’s gross revenues during three successive tax years came from passive sources

Advantages of an S corporation include:

• Retains all of the advantages of regular corporations

• Passes all profits/losses through to individual shareholders

• Avoids double taxation

• Avoids taxes paid on assets that have appreciated in value and are sold

Disadvantages of an S corporation include:

• Increase in individual tax rates above maximum corporate tax rate

• Many fringe benefits cannot be deductible business expenses

Choosing an “S” corporation wisely is important to optimize the advantages this entity offers.

The Limited Liability Company (LLC): The limited liability company is a cross between a partnership and a corporation. LLCs offer many of the advantages of both, but are not subject to the restrictions incurred by “S” corporations. LLCs offer the tax advantage of a partnership, the legal protection of a corporation, and maximum operating flexibility. These advantages make the LLC an attractive form of ownership for smaller companies across many industries.

Creating an LLC is much like creating a corporation through establishing the articles of organization and an operating agreement.

LLCs are limited to no more than two of the following corporate concepts:

• Limited liability

• Continuity of life

• Free transferability of interest

• Centralized management

Professional Corporation: Professional corporations are designed to offer professionals—lawyers, doctors, dentists, accountants, and others—the same advantages of the corporate form of ownership.

Joint Venture: A joint venture is much like a partnership, except the joint venture is formed for a specific and limited purpose. For example, multiple investors may form a joint venture to build a building, sell it, and dissolve the joint venture when that sale is finalized.

Conclusion

The entrepreneur will benefit from an intentional choice regarding the choice of business ownership. Take all the important factors into consideration – liability, taxes, capital requirements, control, managerial abilities, business goals, and a long-term succession plan. The ownership decision has far-reaching effects for both the entrepreneur and the business.

Part 3: Chapter Exercises

You Be the Consultant: “Making a Partnership Work” pages 177-178

1. Research relationships between partners and add at least three guidelines to those listed above.

Examples of students’ additions to this list may include the following:

• Determine what may help manage stressful or conflict-oriented situations to help manage those situations as they arise.

• A common vision of what the venture is to become with a shared work ethic.

• Establish clear guidelines regarding what each partner will invest in the relationship, from a financial and time perspective.

• Talk through possible “what if” scenarios to share the ideas and problem solving skills of each partner.

• A common and clear vision for the venture.

2. Develop a list of the types of behavior that is almost certain to destroy a partnership.

Student responses may include, and are not limited to, the following:

• Lack of follow though based on the agreed division of partner responsibilities and duties

• Lack of communication—talking and listening

• Lack of mutual respect

• Misuse of company funds and resources

• Dishonesty and actions that lead to mistrust

• Conflicting behavior when interacting with people—employees and customers

• Divergent behaviors regarding the management of business finances

3. Suppose that two of your friends are about to launch a business together with nothing but a handshake. “We’ve been best friends since grammar school,” they say. What advice would you give them?

Expect students to apply information from the chapter. For example, a common student response may be as follows:

Have a partnership agreement! This important tool defines the roles and responsibilities of each partner. This agreement can prove invaluable in times of conflict or when a partner wants to change their role or leave the business for any reason. It offers definition and direction for the business and for each partner involved. Seek the advice of an attorney to assist you in the process. The partnership agreement may save your business—and your friendship.

You Be the Consultant: “Which Form is Best?” page 188

1. Which form(s) of ownership would your recommend to the Kinseys? Explain.

A key requirement of the two owners is to minimize their potential liability if an injury should occur. Based on their situation and this requirement, a Limited Partnership, LLC or corporation will be the most desirable forms of ownership for consideration.

2. Which form(s) of ownership would you recommend the Kinseys avoid? Explain.

The Kinseys will not qualify for a sole proprietorship and the requirements for limited liability for both owners will not be met through a General Partnership.

3. What factors should the Kinseys consider as they evaluate the various forms of ownership?

Important factors for the Kinseys’ to consider as they evaluate forms of business ownership include:

• Limited liability to protect the owners’ assets

• Cost of formation

• Ease of formation

• Optimal tax position based on their personal situations and profitability projections.

• The ability to grow and potentially franchise the company.

Part 4: Chapter Discussion Questions

1. What factors should an entrepreneur consider before choosing a form of ownership? (LO 1)

Factors to consider before choosing a form of ownership include:

• Tax considerations – calculate the firm's tax bill under each form of ownership.

• Liability exposure – how much personal liability is involved in the ownership form?

• Start-up capital required – how much capital does the entrepreneur have and how much will he need?

• Control – how much control is involved for each type of business organization? How much is the entrepreneur willing to give up?

• Business goals – how large and profitable does the entrepreneur expect the business to be?

• Management succession plans – consider smooth transition when passing company to the next generation of buyers.

• Cost of formation – some forms are more costly to create.

2. Why are sole proprietorships so popular as a form of ownership? (LO 1)

Sole proprietorships are a popular form of ownership for several reasons. First, they are simple to create. Anyone wanting to start a business can do so by obtaining the necessary licenses from state, county, and/or local governments. This form is normally the least expensive to establish. In addition, the owner has the total decision- making authority, can keep all profits remaining after expenses are paid, and may discontinue the sole proprietorship fairly easily if he or she desires.

3. How does personal conflict affect partnerships? (LO 1)

The success/failure of a partnership depends on the cohesiveness of its partners. In the beginning, there is an “emotional high” when the startup of the business begins. Partners are so busy creating strategies and focusing on the new business, that they often do not consider the idea of future conflict with other partners. If this conflict does occur, the partnership may suffer. The mutual goals and general business philosophies may not be shared among the partners at this time. Thus, the demise of many partnerships can often be traced to interpersonal conflict if there are no procedures in place to resolve these problems.

4. What issues should the articles of partnership address? Why are the articles important to a successful partnership? (LO 1)

The major provisions of a partnership agreement include the following:

• The name of the partnership

• The purpose of the business

• The domicile of the business

• The duration of the partnership

• The partners and their legal addresses

• The contribution of each partner to the business

• An agreement on how the profits (or losses) of the partnership will be distributed

• An agreement on salaries or drawing rights against profits for each partner

• The procedure to be followed in the event that the partnership wishes to expand through the addition of a new partner

• How assets of the partnership will be distributed if the partners voluntarily dissolve the partnership

• Sale of partnership interest

• Absence or disability of one of the partners

• Provisions for alteration or modification of the partnership agreement

5. Can one partner commit another to a business deal without the other’s consent? Why? (LO 1)

Yes, if the partner was exercising good faith and reasonable care in the performance of his duties, the law of agency holds that the actions of a general partner binds the other partners to a business deal made in the name of the partnership, without the other's consent.

This is another example of why it is so important to be able to trust your partners!

6. What issues should the Certificate of Incorporation cover? (LO 1)

A Certificate of Incorporation normally will include the following:

• The name of the corporation

• A statement of the purpose of the corporation

• The time horizon of the corporation

• The names and addresses of the corporation

• Place of business

• Capital stock authorization

• Capital required at the time of incorporation

• Provisions for preemptive rights

• Restrictions on transferring shares

• Names and addresses of the initial officers

• The bylaws by which the corporation will operate

7. How does an S corporation differ from a regular corporation? (LO 2)

An S corporation offers many of the same advantages of a corporation—limited liability, capital formation, and others—while being taxed as a partnership. Thus, the S corporation avoids the corporate disadvantage of double taxation.

8. What role do limited partners play in a partnership? What happens if a partner takes an active role in managing the business? (LO 2)

The limited partner is treated, under the law, exactly as in a general partnership. The limited partner(s) is treated more as an investor in the business venture; limited partners have limited liability, and can only lose the amount invested in the business. If the limited partner does take an active part in managing the business, a limited partner may actually forfeit limited liability, taking on the liability status of a general partner.

9. What advantages does a limited liability company offer over an S corporation? A partnership? (LO 2)

An LLC eliminates many restrictions imposed by an S corporation such as: a maximum of thirty-five shareholders, none of whom can be foreigners or corporations; a limitation to one class of stock; restriction on members' ability to become involved in managing the company; and limited personal liability with imposed requirements. The LLC is not subject to such restrictions. There are two advantages an LLC has over a C corporation. First, an LLC offers limited liability and a C corporation does not. In addition, an LLC does not pay income tax and avoids the double taxation of C corporations.

10. How is an LLC created? What criteria must an LLC meet to avoid double taxation? (LO 2)

Creating an LLC is much like creating a corporation. An LLC is required to file two documents: the articles of organization and the operating agreement. The articles of organization establish the company's name, its method of management, its duration, and the names and addresses of each organizer. The operating agreement outlines the provisions governing the business’ conduct.

11. Briefly outline the advantages and disadvantages of the major forms of ownership. (LO 2)

Sole Proprietorship – Least costly to start, offers total control, typically has favorable tax considerations.

Partnership – Typically favorable tax considerations, however, unlimited liability for general partner(s). There are several other forms of partnerships that may be costly to establish but offer the advantage of limited liability.

Corporation – Least favorable tax considerations, costly to establish, however, offers limited liability for owners.

S Corporation and LLC – Combines the more favorable characteristics of both a sole proprietorship and corporation.

Part 6: Online Videos and Podcasts

These online videos may enhance class discussion and provide additional insight for the chapter topics.

• Avoid Legal Pitfalls 3:30 minutes



• Forms of Business Ownership 3:54 minutes



• Limited Liability Companies 1:00 minute



• The Corporation – A Legal “Person” 5:48 minutes



Links to additional online resources are available on the companion Web site at scarborough.

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