LongCh1
8 The Human Resource Plan: Managers, Owners, Allies, and Directors
|— |CHAPTER 8 LECTURE NOTES |
|1 |Describe the characteristics and value of a strong management team. | |
|PPT 8-1 |Building a Managerial Team |
|Chapter 8 |For many small businesses the owner may be the only manager. |
|The human resource plan: managers, |A strong management team cannot save a poor business model. |
|owners, allies, and directors |Investors value the management team when evaluating a business plan. |
| |It provides diversity of talent, in management and other key skills. |
|PPT 8-2,3 |It assures continuity in case one person leaves the business. |
|Looking Ahead |How does the team concept fit the individualistic nature of most entrepreneurs? |
| |Cite a current example of management weakness in a new or small firm by drawing on an example you know |
|PPT 8-4/TM 8-4,5/TM 8-5 |of personally, an example offered by a student, or an example from a story in a current business |
|Building a management team |periodical. |
| |Achieving Balance |
| |The objective is to build a management team whose skills complement each others |
| |Competence needed in a management team depends on the business. |
| |A proper range of abilities is needed, including minimal skills in basic operations, marketing, and |
| |finance, etc. Balance is critical. |
| |Personal cooperation and compatibility are essential. |
| |Issues that should be addressed and specified at the outset by team members include organizational |
| |structure, ownership share and compensation, and the plan for growth. |
| |How important is entrepreneurial experience for a management team? |
| |Specifying Structure |
| |A management plan should define the relationships among the members of the organization and should |
| |describe the hiring process, job descriptions, and compensation. |
| |If the management staff is too small or limited, consider outside help. |
| |Practical assistance is available from CPAs, attorneys, and bankers. |
| |Some firms use boards of directors. |
| |Other outside consultants are available but not used by many new firms. |
|2 |Explain the common legal forms of organization used by small businesses. | |
|PPT 8-6/TM 8-6 |Choosing a legal form of organization |
|Legal forms of organization |( Emphasize that an entrepreneur need not be a lawyer but that he or she must have enough knowledge of|
| |the legal aspects of a business to know when legal counsel is required. |
| |See if the students can list the three major legal forms of organization discussed in the text (sole |
| |proprietorship, partnership, regular corporation). |
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| |To give students an idea of where the discussion is going, point out the name of each legal form and |
| |its special variations. |
| |Sole proprietorship |
| |General partnership |
| |Limited partnership |
| |Regular corporation |
| |Subchapter S corporation |
| |Limited liability company |
| |The sole proprietorship option |
|PPT 8-7/TM 8-7,8 |A sole proprietorship is a business owned and operated by one person. |
|The Sole Proprietorship |Its advantages: the single owner has title to all business assets, the owner receives all profits, and |
| |the owner is free from partner interference. |
| |Its disadvantages: the lack of limits on personal liability, the lack of tax benefits, and the death of|
| |the proprietor terminates the business. |
| |The partnership option |
|PPT 8-9 |A partnership is a voluntary association of two or more persons to carry on, as co-owners, a business |
|The Partnership Option |for profit. |
| |Its advantages are that it pools managerial talent, spreads the workload (compared to a |
|PPT 8-10 |proprietorship), and is easier to create. |
|Partnership insights |Its disadvantages are unlimited liability (unless you are a limited partner), the fact that the death |
| |of a partner can terminate the partnership, the possibility of personal conflicts between partners, and|
|PPT 8-11/TM 8-11 |the loss of control (compared with a sole proprietorship). |
|The Advantages and Disadvantages of|Qualifications of partners |
| |How important is agreement between partners? Review the advantages and disadvantages in Figure 8-2 |
|Partnerships |with the students. |
|[Acetate 8-11] |Emphasize that 60% of those surveyed believed partnerships are more bad than good. |
| |Go over the main questions to ask when setting up a partnership: |
| |What is our business concept? |
| |How are we going to structure ownership? |
| |Why do we need each other? |
| |How do our lifestyles differ? |
| |Rights and duties of partners |
| |The importance of written articles of partnership |
| |Agency power—a decision by one partner binds all partners. |
| |Help for ailing partnerships—David Gage (psychologist) comments: |
| |The "divorce" rate of business partnerships is higher than marriages. |
| |Problems usually stem from turf battles over control. |
| |Unclear duties and related disagreements assures conflict. |
| |Conflict may require the services of a business mediator. |
| |Termination of a partnership |
|PPT 8-12/TM 8-12 | |
|Rights and duties of partners | |
| |The C corporation option |
|PPT 8-13/TM 8-13 |The Supreme Court has defined a corporation as “an artificial being, invisible, intangible, and |
|The C Corporation Option |existing only [in relationship to] the law.” |
| |Its advantages are that it is a perpetual entity independent of owners’ lives, that the liability of |
| |owners is limited, that ownership is easily transferable, and that there are tax benefits. |
| |Its disadvantages are the potential loss of majority ownership, the corporate income tax, and state |
| |requirements for creation. |
| |The corporate charter (see elements listed in the chapter) |
| |Rights and status of stockholders |
| |Limited liability of stockholders—a major advantage of the corporate form of ownership |
| |Death or withdrawal of stockholders—ownership in a corporation is readily transferable |
|PPT 8-14/TM 8-14 |Maintaining corporate status—must hold annual meetings, keep minutes of these meetings and maintain |
|Corporate Charter: |bank accounts that are separate from the owner’s accounts. |
|Articles of Incorporation | |
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|PPT 8-15 | |
|Rights and Legal Status of | |
|Shareholders | |
|3 |Identify factors to consider in choosing among the primary legal forms of | |
| |organization. | |
|PPT 8-16/TM 8-16 |Criteria for choosing an organizational form |
|Comparison of Basic Legal |Summarize the three general forms. |
|Forms of Organization |Discuss initial organizational requirements and costs, liability of owners, continuity of business, |
|[Acetate 8-16] |transferability of ownership, management control, attractiveness for raising new capital, and income |
| |taxes. |
| |Emphasize the advantages of each of the different forms of ownership. |
| |Initial organization requirements and costs |
| |costs increase with partnerships and corporations |
|PPT 8-17 |Liability of owners |
|Choosing an |unlimited liability with sole proprietorships and partnerships |
|Organizational Form |Continuity of business |
| |corporations offer continuity |
| |Transferability of ownership |
| |Ownership is most easily transferred in corporation |
| |Management control |
| |Sole proprietors’ have absolute control, partnership control is based on voting and corporations are |
| |controlled by stockholder voting, corporate officers and boards. |
| |Attractiveness for raising capital |
| |Corporations have an advantage because ownership is easily transferred |
| |Income taxes |
| |Sole Proprietorship—business owners report income on their federal income tax returns |
| |Partnerships—partners pay taxes based upon their share of the revenue reported by the partnership |
| |C Corporation—report and pay their own taxes as separate legal entities |
| |Discuss section 1244 stock |
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|PPT 8-18/TM 8-18,19,20 | |
|Forms of Business – Federal Income | |
|Taxes | |
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|PPT 8-21 | |
|Taxes on Gains and Losses | |
|4 |Describe the unique features and restrictions of specialized organizational forms such | |
| |as limited partnerships, S corporations, and limited liability companies. | |
| |Specialized forms of organization |
|PPT 8-22/TM 8-22,23/ |The limited partnership—liability of limited partners is limited to capital invested. |
|TM 8-23,24/TM 8-24 |The S corporation—an arrangement that allows stockholders to be taxed as partners. It is restricted to|
|Specialized Forms of Organization |corporations with 75 or fewer stockholders. |
| |The limited liability company—limited liability, but the tax burden is passed on to the owners and |
| |avoids income tax. |
|5 |Explain the nature of strategic alliances and their uses in small businesses. | |
| |Forming Strategic Alliances |
|PPT 8-25 |Links two or more independent businesses in a common endeavor |
|Forming Strategic Alliances |Common ground for large firms that want to share critical resources, but without the risk and |
| |inflexibility of legally merging the organizations |
| |Strategic alliances with large companies—combine speed, flexibility, and creative energy with the |
| |infrastructure of a large corporation |
| |Strategic alliances with small companies—combining can increase competitive strength and reach goals |
| |that are otherwise beyond grasp |
| |Setting up and maintaining successful strategic alliances |
| |Establish a healthy networks of contacts |
| |Identify and contact individuals likely to return your call |
|PPT 8-26 |Outline the partner's potential benefits from the alliance |
|Setting Up and Maintaining |Learn to speak and understand the "language" of your partner |
|Successful Strategic Alliances | |
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|6 |Describe the effective use of boards of directors and advisory councils. | |
| |Making the most of a board of directors |
|PPT 8-27/TM 8-27,28 |Dealing with the increasing complexity of business |
|Making the Most of a Board of |Bring in outsiders to lend objectivity to decisions in a family business |
|Directors |Contributions of directors |
| |Fill in the gaps in the experience of the management team |
| |Reviewing major policy decisions |
| |Advising on external business conditions |
| |Providing informal advice on specific problems |
| |Lending credibility to the firm |
| |Selection of directors—outside directors can be more objective |
| |Compensation of directors—aries from little or no pay to much more (upwards of $25,000) |
| |An alternative: an advisory council |
|( |Using Computerized Business Plan Programs Such as BIZPLANBuilder and Business | |
| |Plan Pro | |
| |As the business plan begins to take form, it is important to consider matters related to the management|
| |team and the legal form of organization. Several questions are useful in guiding this part of business|
| |plan formation. |
| |Management Plan Questions: |
| |Who are the members of your management team? What skills, education, and experience do they bring to |
| |the team? |
| |What other key managers do you plan to recruit? |
| |Do you plan to use consultants? If so, describe their qualifications. |
| |What are your plans for future employee recruitment? |
| |What will be the compensation and benefit plans for managers and other employees |
| |What style of management will be used? What will be the decision-making process in the company? What |
| |mechanisms are in place for effective communication between managers and employees? If possible, |
| |present a simple organization chart. |
| |How will personnel be motivated? How will creativity be encouraged? How will commitment and loyalty be |
| |developed? |
| |What employee retention and training programs will be adopted? Who will be responsible for job |
| |descriptions and employee evaluation? |
| |Who will have an ownership interest in the business? |
| |Will the business function as a sole proprietorship, partnership, or corporation? If a corporation, |
| |will it be a C corporation, an S corporation, or a limited liability company? |
| |What are the liability implications of this form of organization? |
| |What are the tax advantages and disadvantages of this form of organization? |
| |If a corporation, where will the corporation be chartered and when will it be incorporated? |
| |What attorney or legal firm has been selected to represent the firm? What type of relationship exists |
| |with the firm’s attorney or law firm? |
| |What legal issues are presently or potentially significant? |
| |What licenses and/or permits may be required? |
| |What strategic alliances are in place, and what others do you plan to establish in the future? Describe|
| |the forms and nature of these alliances. What are the responsibilities of and benefits of the parties |
| |involved? What are the exit strategies? |
| |Who are the directors of the company? What are their qualifications? How will they be compensated? |
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|— |SOURCES OF AUDIO, VIDEO, AND OTHER INSTRUCTIONAL MATERIALS |
The American Management Association offers several items that relate to the topics in this chapter. Effective Team Building is a set of six audio tapes, a workbook, and multiple-choice tests; the set is available for $165. Management Action is a set of six 1-hour audio tapes and a multiple-choice test; the tapes are $99.95 each. How to Recruit, Interview, and Select the Right Person for the Job is a set of three audio tapes for $139. How to Conduct a Performance Review is a self-study course consisting of a workbook and multiple-choice tests; it is available for $110. The AMA also offers several catalogs listing self-study materials, audio tapes, films, and books. You can contact them at (518) 891-5510.
Tap the Power of Teamwork shows employees what they must know and do to play on a winning team, demonstrating how both team members and the organization can profit from the team concept. The 45-minute videotape is available from Communication Briefings, (800) 888-2086.
A series of manuals entitled Incorporating in [Your State] Without a Lawyer is available from PSI Research/Oasis Press. Manuals are available for each of 32 states and cost $24.95 each. A similar manual and software, entitled Corporation Formation Package and Minute Book, are available for California only. All these materials offer a step-by-step presentation of the process of incorporation. Another PSI/Oasis publication, entitled Surviving and Prospering in a Business Partnership, contains ideas on how to deal with partnership problems. You can order these and other materials from PSI Research/Oasis Press at 300 North Valley Drive, Grants Pass, OR 97526, (800) 228-2275.
Finally, a package of materials on business forms, entitled Entrepreneurship: Part I, which includes slides and a cassette tape, is available from Star Productions, 3595 NW 83rd Avenue, Sunrise, FL 33351, (305) 741-6438.
|— |Answers to end-of-chapter |
| |discussion questions |
1. Why would investors tend to favor a new business led by a management team over one headed by a lone entrepreneur? Is this preference justified?
p. 163 - 164tors are concerned that management have a blend of important management skills and that the founder have the ability to perform in a professional way. They realize that the typical “idea person” who starts a business is deficient in some area of management. This preference appears justified for most ventures of substantial size.
2. Discuss the merits of the three major legal forms of organization.
p. 165 - 171roprietorship is the most widely used form of organization. However, the corporation is the most important form when the volume of business activity is considered. Why is this true? Most small firms are proprietorships, but most big firms are corporations. Reasons for dominance of the corporate form among big firms are the feature of limited liability and the possibility of acquiring large amounts of capital. The third legal form of organization is the partnership (with general and limited options), but most entrepreneurs contend that the drawbacks of this form outweigh its advantages.
3. Does the concept of limited liability apply to a sole proprietorship? Why or why not?
p. 165 - 166 The concept of limited liability that applies to the corporate form of organization does not apply to a proprietorship because the business is considered an extension of the individual and not a separate entity. This means that the owner’s personal assets outside the business can be taken by creditors if the business fails.
4. Suppose a partnership is set up and operated without a partnership agreement. What problems might arise? Explain.
p. 169 If articles of partnership are not put in writing, disagreements and misunderstandings may arise about the respective responsibilities of the partners, the way in which profits are to be distributed, and many other matters. This can seriously interfere with the normal profitable operation of the business. By reducing understandings to written form, partners can minimize misunderstandings, differences in viewpoints, and overlooked issues.
5. Evaluate the three major forms of organization in terms of management control by the owner and sharing of the firm’s profits.
p. 172 In a proprietorship, the owner has complete and absolute control. In a general partnership, an owner must share control with the other partner or partners, and each partner generally has the power to make commitments binding on the partnership. In the corporation, control must be shared with other stockholders. This may not be a problem, however, if the majority owner controls practically all of the stock. Indeed, if one owner has as much as 51 percent of the stock, in most states that owner can name the board of directors. However, the majority stockholder usually has some concern about, as well as some legal obligations to, minority stockholders. Hence, dilution of ownership control is a feature of the corporate form of business organization.
In a sole proprietorship, all profits go to the proprietor. In a partnership, however, profits are shared equally unless the articles of partnership stipulate an unequal sharing ratio. In a corporation, profits legally belong to the corporation, but directors (usually named by the majority stockholder) can declare dividends so that stockholders get a share of the earned profits.
6. What is an S corporation, and what is its principal advantage?
p. 175 The S corporation is taxed as a partnership and thus avoids the corporate income tax. Depending on the circumstances of the corporation and the owners, this can create significant tax savings. Its use is limited to small firms.
7. Why are strategic alliances important for many small businesses? What steps can an entrepreneur take to create strategic alliances and to prevent their failure?
p. 176 - 177 According to strategic alliance experts, strategic alliances are becoming crucial in building businesses of all kinds and at an earlier stage than ever before. They can decrease cycle time by allowing startups to access another firm's resources. Since an opportunity will often go to the entrepreneur who is fast enough to exploit it, many now see strategic alliances as an essential part of their plan for growth. Such partnerships represent one way to cope with the rapid change of today's business environment.
Two-thirds of all alliances run into serious problems within two years of their creation, and 70% of them do not survive, which shows that alliances are hard to manage. Taking some basic steps can help entrepreneurs establish healthy alliances and reduce the risk of their failure. These are (1) establish a healthy network of contacts, (2) identify and contact individuals within the firm who are likely to return your call, (3) outline the partner's continuing financial benefits from the alliance, (4) show the partner that your firm can deliver value to the alliance across several fronts, and (5) learn to speak and understand the "language" of your partner. Despite sound planning and execution, many strategic alliances fail, but some up-front planning can head off unnecessary failures.
8. How might a board of directors be of value to management in a small corporation? What qualifications are essential for a director? Is ownership of stock in the firm a prerequisite for being a director?
p. 178 In the small corporation, a properly selected board of directors can be of real value to the entrepreneur. The board members can be called on to advise the entrepreneur on the solution of major problems; that is, they can act as de facto management consultants. They can also assist with policy formulation and redefinition of business strategy.
The business owner should select outside board members on the basis of their interest in and potential contributions to the organization. Many individuals are potentially good board members, and the best available talent should be selected. The purchase of stock should not be required, although such an agreement might make service on the board of directors an attractive proposition for a capable director.
9. What may account for the failure of most small corporations to use boards of directors as more than rubber stamps?
p. 178 There are no doubt many reasons. Many small business owners have never even thought about the possibility. Some owners are confident of their own abilities and see no benefit in having a board. Others have misconceptions concerning difficulty in attracting board members and levels of compensation. Probably the greatest reason is lack of assurance that a board would be of real value.
10. How do advisory councils differ from boards of directors? Which would you recommend to a small company owner? Why?
p. 180 An advisory council is similar to a board, but members generally do not have a legal liability to the stockholders. Some individuals may be reluctant to accept directorships if they entail legal liability. Either system can function effectively. The advisory council system should be used if necessary to attract qualified contributors to the business. Also, advisory councils appear less threatening to some owners.
|— |COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS |
Situation 1
1. How relevant are the individual personalities to the success of this entrepreneurial team? Do you think Green and Stroder have a chance to survive their “partnership”? Why or why not?
Personalities of partners are extremely relevant to the success of a business. The fact that Green and Stroder were close friends as teenagers suggests that they will be able to get along with each other. Since they have agreed to have Stroder do all the work, there should not be many opportunities for a “personality clash.” This should be a fair arrangement. If not, problems may arise regardless of the personalities involved.
2. Do you consider it an advantage or a disadvantage that the members of this team are the same age?
In most cases it is probably an advantage. World views often vary from age to age, and they can influence individual priorities regarding money, family, and life in general. However, the amount of experience, which usually comes with age, is about the same for each of these young entrepreneurs, and this may prove to be a major limitation of the team.
3. Which legal form of organization would you propose for STARTOVER? Why?
A limited partnership may be a good selection. Green is only supplying cash, and he would be the limited partner. It appears that he has greater personal assets than Stroder, and this arrangement would limit Green’s exposure to liability claims that might arise through activities of the business.
4. If Stroder and Green decided to incorporate, would STARTOVER qualify as an S corporation? If so, would you recommend this option? Why or why not?
The STARTOVER business should qualify for S corporation status. It is a domestic business; there are fewer than 35 stockholders, and all are individuals; and the business does not own stock in another corporation. This probably is not a favorable option, however. None of the tax advantages of an S corporation would appear to be attractive at this time. If, at a later date, there is a strong need for growth capital, the entrepreneurs may want to consider incorporation and declare S status.
Situation 2
1. What are the advantages and disadvantages of running the business as a sole proprietorship? As a C corporation?
Matthew Freeman must decide whether to remain organized as a sole proprietorship or incorporate his business. Because he is already operating as a sole proprietorship, this would place the least administrative burden on him. He would have fewer reporting requirements. Taxes on his business income would be reported on Schedule C of his personal income taxes. He would also be required to file quarterly estimated tax payments. As a sole proprietorship, however, he has unlimited personal liability for any debts incurred by the business and any lawsuits brought against the business. Thus, his personal property (e.g., house, cars) is at risk. In his particular situation, he will also lose some business if he remains a sole proprietorship because some large companies will not deal with a sole proprietor. Furthermore, Freeman is not considered an employee and cannot enjoy tax-free fringe benefits such as insurance and hospitalization. And when organized as a sole proprietorship no other person can conduct business for the company. These disadvantages of a sole proprietorship can be overcome by incorporating.
If incorporated, Freeman will enjoy limited liability and his personal assets will not be at risk. As an employee of the corporation, he will be entitled to certain fringe benefits. As a corporation, his business may also have greater legitimacy in the eyes of other organizations, including large corporations and lending institutions. Incorporation will, however, involve costs and administrative burdens to establish the corporation. He must draw up legal documents (e.g., articles of incorporation) and issue stock to begin the corporation. This process is usually done in consultation with a lawyer and/or a Certified Public Accountant. The on-going reporting requirements for a corporation are more burdensome than for a sole proprietorship. Corporate records must be maintained and accounts must be kept separate from all personal accounts. Depending on the type of corporation chosen (see notes for next question), Freeman may be subject to double taxation.
2. If Freeman decided to incorporate his business, which types of corporations can he form? Which type would you recommend? Why?
Freeman may choose either a "C corporation" or an "S corporation". Each of these offers the advantage of limited liability and the legitimacy needed for constituents that would prefer not to deal with a sole proprietorship. In choosing between the options, then, other issues should be considered. The primary consideration seems to be the tax implications.
A " C corporation" must pay corporate income taxes on any income. If dividends are declared, the corporation first pays corporate income tax on these and then individual shareholders pay personal income tax on the dividends. An "S corporation" allows a business to have the benefit of limited liability while being taxed as a partnership. Taxable income and losses are passed to the stockholders rather than the corporation paying corporate income taxes. Thus, dividends are not subject to double taxation. An "S corporation" is limited in many other respects (e.g., no more than 75 shareholders, only one class of stock, corporation must be domestic), but none of these are relevant for Freeman’s decision. Thus, it appears that the "S corporation" provides the necessary benefits with the least tax burden.
Situation 3
1. Can two outside members on a board of five make any real difference in the way the board operates?
Two new members can definitely make a difference if the chairman of the board wishes to use them. Voting control is necessary only to force changes. In this case, the majority owner wanted the contributions of the two new members.
2. Evaluate the owner’s choices for board members.
The new board members should be familiar with modern management approaches and able to critique this distributor’s use of traditional management methods. Greater diversity of background might possibly be better—for example, having a financial manager or an owner of another small firm as one of the members.
3. What will determine the usefulness or effectiveness of this board? Do you predict that it will be useful? Why or why not?
The usefulness of this board will depend on the chairman’s ability to draw on the thinking of the outsiders and to tolerate their questions. The chances for success are better if the owner is thoroughly convinced of the importance of this step and not merely excited over a new, hot idea.
What Actually Happened. With the new directors’ help, the chairman installed an operating budget and began drafting a long-term plan. These initial steps represented a move toward modernization of this firm’s management.
|— |Answers to exploring the web exercises |
For each chapter, the instructor’s manual will include a short summary of suggested results students will have after completing the various Web exercises. Because the Web is a constantly changing medium, the answers may vary, and the links may change as well. Thus, answers are only suggested, and the URL for resources, where required, is provided.
Exercise 1
Students should list some of the following impacts. The textbook stresses the tax implications; however, the Web site lists other impacts one might want to consider:
• Size and nature of your business
• Level of control
• The level of "structure"
• The business's vulnerability to lawsuits
• Tax implications
• Expected profit (or loss)
• Whether or not you need to re-invest earnings
• Need for access to cash out of the business for yourself
Exercise 2
Students will answer a set of questions about their businesses and the states in which they will be registered. Based on the answers to the questions posed by the Wizard, a list of business structure choices is generated to consider.
Exercise 3
These 10 tips focus on the personal aspect of strategic alliances and build on the text’s premise that “Relationships are advertised as being between companies, whereas in reality relationships are built between people.”
Exercise 4
Every board shares a set of general responsibilities that board members should be prepared to assume when they serve. The following checklist may be helpful to consider when the board conducts its self-assessment.
• Board members agree to attend board meetings and participate in some committee work.
• Directors agree to define the mission and participate in strategic planning to review a company's purpose, priorities, financial standing, and goals.
• Directors must be prepared to approve the selection, compensation, and if necessary, dismissal of the chief executive, and to assure regular evaluation of the executive's performance.
• Directors must assure financial responsibility by:
o Approving the annual budget and overseeing adherence to it.
o Contracting for an independent audit.
o Controlling the investment policies and management of capital or reserve funds.
• Directors agree to oversee and evaluate strategic business plans and support management in carrying out those plans.
• Directors must evaluate how well the board is performing and maintain an effective organization as well as procedures and recruitment.
• As a company evolves from startup to growth toward maturity, the responsibilities and character of its board of directors will evolve as well. Challenges that may come with growth include:
o Weaning directors away from involvement in operations and management.
o Addressing the needs and problems of a large staff.
o Bringing aboard new people and new ideas.
|— |SUGGESTED SOLUTION TO CASE 8: |
| |SILVER ZEPHYR RESTAURANT |
1. Evaluate the simple incorporation, the Subchapter S corporation, and limited partnership options? Note the advantages and disadvantages of each.
Organizational costs. All three options are relatively costly, at least when compared with sole proprietorship or general partnership. The reason is that each has statutory requirements that must be met, a process that requires the services of an attorney to prepare legal forms and meet the specified filing requirements. It appears that there is little relative cost advantage in any one of these three forms of organization when compared with the others. Indeed, the Subchapter S corporation is merely a specialized form of corporation and thus is not particularly different from the general corporation.
Liability. Both the simple corporation and the Subchapter S corporation provide limited liability for investors. This means that each individual risks only the amount he or she invests in the business. In a limited partnership, the limited partners have the same status with respect to their liability—that is, they risk only those assets invested in the business. In the limited partnership, however, there must be at least one general partner, and this partner must have unlimited personal liability. Consequently, both forms of the corporation would have weaknesses as far as borrowing is concerned. The bank would expect one or more of the partners to assume personal liability for the obligations of the corporation. (Of course, the obligation to the corporation could be supplemented by personal guarantees from one or more individuals.) In the case of the limited partnership, the unlimited liability desired by lenders could be provided through the one or more general partners of the firm. Because of state usury laws, however, banks are limited in rates of interest they can charge individual borrowers. For this reason, they may encourage (or force) organization as a corporation in order to charge legally what they regard to be reasonable rates of interest. They might find it unprofitable to loan to the limited partnership at the maximum rate prescribed for personal loans.
Transferability of ownership. Either corporate form is preferable to the limited partnership. It is a simple matter for owners of shares of stock to sell those shares. In the case of the limited partnership, however, there are requirements for consent of existing partners in order to bring in new or additional owners to the partnership. In the case of the Subchapter S corporation, there may possibly be difficulties arising from the transfer of ownership interest. These potential difficulties exist because all owners much agree to the Subchapter S arrangement.
Management control. In both the regular and the Subchapter S corporation, control is vested in a board of directors elected by shareholders. In the limited partnership, only the general partner or partners are permitted to exercise control. Indeed, limited partners forfeit their limited liability if they engage in active management of the business.
Continuity of the business. This is best assured by using the simple corporate form, which has indefinite life. The life of the Subchapter S corporation may be jeopardized by changes in ownership, particularly by exceeding the maximum number of owners provided or by changing the objectives of the business in such a way as to take them beyond the scope of the Subchapter S requirements. The limited partnership has the greatest problem with continuity. Although the death and withdrawal of limited partners does not affect the life of the business, the death or withdrawal of general partners can dissolve the partnership. Also, it is unlikely that the partnership can extend beyond the life of all of the partners involved.
Taxation. The simple corporation’s income is subject to the corporate income tax, which is imposed regardless of whether the income is distributed or retained in the business. If the income is distributed, individual owners must pay personal income tax on dividends. Therefore, the distributed income is subject to double taxation. The Subchapter S corporation provides a conduit by which business earnings or losses are carried through to the individual owners of the corporation. Owners are then individually taxed on their proportional share of the corporation’s earnings or use their share of any loss in computing their personal income taxes. The Subchapter S corporation per se, however, is not subjected to the corporate income tax. One particular Subchapter S advantage in the early years of business life is that corporate losses can be used by owners to offset other personal income and thus reduce individual income taxes. In the limited partnership, there is no tax on the earnings of the business per se. All profits or losses are carried through to the individual owners, who must report them in calculating their personal income taxes.
2. What is the nature and significance of Section 1244 stock?
It is important that students recognize the risks involved in the initiation of the Silver Zephyr Restaurant. The restaurant industry, for example, is characterized by one of the highest incidences of terminations to business starts of any industry. Similarly, the different objectives of the various “partners” (i.e., concerns of Cochran and Davis versus Ginelli’s need for operating control) may work against the success of the enterprise. Thus, the group must consider the possibility of an unfavorable outcome and attempt to minimize its effects.
Assuming the group decides to incorporate its business, should there be a decline in value and the investors realize a loss, the loss will normally be a capital loss. This form of loss has limited tax value to the investors. However, it is possible to issue stock so that it qualifies under Section 1244 of the Internal Revenue Code. When this is done, realized losses may be deducted by the investors as ordinary income losses up to $50,000 per year (when a joint return is filed, the maximum is $100,000 per year) in computing income tax liability. Although the investors may lose the value of their investment in the restaurant, the losses at least can be used to offset other taxable income.
The ordinary-loss rule in Section 1244 of the Internal Revenue Code applies whether the loss was incurred on the sale of the stock or on its becoming worthless. Section 1244 stock can be used only by original purchasers of stock and, in order to qualify for such treatment, several requirements must be met.
3. Could a limited liability company provide an answer for the “Magnificent Seven"? What would be the disadvantages of this legal form?
The limited liability form of organization would provide the limited liability protection needed to safeguard the personal assets of the investors. It might, consequently, limit the company’s borrowing power in the absence of personal pledges by some stockholders. Possible disadvantages include the personal taxes on profits being kept in the company. Also, the less restrictive C corporation would be more flexible in later moves to “go public” or to sell out. (Some stockholders would probably like to cash in their investment in a few years.)
4. Explain the way in which the multiple entries option might be worked out and evaluate the extent to which it might be used to meet the varied interests of the “Magnificent Seven.”
The three corporations contemplated in the multiple entries option would be (a) a restaurant corporation, (b) a furnishings corporation, and (c) a corporation owning the physical property. Ginelli would have full control of the restaurant corporation and would assume whatever personal liability would be necessary in borrowing for that corporation. Those interested in the fixtures, apparently Ellis and Fischer, could assume ownership of the corporation holding the furnishings. In this way, they would be protected from additional liability as it might pertain to the restaurant itself. Other investors such as Cochran and Davis could participate by investing in the land without incurring the additional liabilities associated with the restaurant business itself. In summary, the multiple entries option would have many of the liability characteristics of the limited partnership arrangement.
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