Elective 1 Entrepreneurship Dr.

Quiocho

Good order is the foundation of all good things Edmund Burke

To me, going public [incorporating] would be like selling my soul .-Carlton Cadwell, manufacturer

Learning Objectives
After studying the material in this chapter, you should be able to: 1. Name the legal forms of ownership a small business can have 2. Explain the reasons for and against forming a proprietorship 3. Explain the reasons for and against forming a partnership 4. Explain the reasons for and against forming a corporation 5. Discuss some other legal forms a business can take

Business Organizations
y General management, finance, accounting, marketing,

human resource management, or other functions are not restricted to large corporations; it is necessary in all forms and sizes of businesses. y Three major forms of business organizations:
y Sole proprietorship y Partnership y Corporation

Fundamental Differences
y Way firm is taxed y Degree of control owners exert in decisions y Liability of owners y Ease of transferring ownership interests y Ability to raise additional funds y Longevity of the business

Selecting the Right Legal Form

Going into business for yourself and being your own boss is a dream that can become either a pleasant reality of a nightmare. Although it may be satisfying to give the orders, run the show, and receive the income, other factors must be considered when choosing the right legal form to use for the business.

Factors to Consider
When choosing the proper legal form for your business, you should take into account the following: - Your vision regarding the size of your business - The nature of your business - The level of control you desire - Business vulnerability to lawsuits - Tax implications of the different ownership structures - Expected profit (or loss) - Earnings reinvestment - Personal cash needs

Factors to Consider
y For example, to what extent is your family able to

endure the physical, psychological and emotional strains associated with running the business? y Second, how easy is it to start, operate, and transfer to others your interest in the company? y Third, to what extent are you and your family willing to accept the financial risks involved, including being responsible for not only your own losses and debts but also those of other people?

Factors to Consider
y Finally, how much information about yourself,

you family, and economic status are you willing to make public? For example, if you choose the corporate form, information about the businessincluding profits and/or losses may have to be made public knowledge y The choice of legal form does not have to be final. The usual progression is to start as a proprietorship or partnership and then move into a corporation

Why Form a Proprietorship?

A proprietorship is a business that is owned by one person. The vast majority of small business start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibility for running the business. Sole proprietors own all the assets of the business and the profits generated by it.

Why Form a Proprietorship

y Assumes complete responsibility for any of its liabilities or debts y In the eyes of the law and the public, you are one in the same with the business y It is the oldest and most prevalent form of ownership, as well as the least expensive to start y Most small business owners prefer the proprietorship because it is simple to enter, operate, and terminate and provides for relative freedom of action and control-as shown in figure 3.2 y Finally the proprietorship has a favorable tax status. It is taxed at the owner s personal income tax rate

Why Form a Partnership?

A partnership is a voluntary association of two or more persons to carry on as co-owners of a business for profit. A partnership is a business owned by two or more persons who have unlimited liability for its debts and obligations. In partnership, two or more people share ownership of a single business.

Why Form a Partnership?

Like proprietorship, the law does not distinguish between the business and its owners. The partners should a legal agreement that sets forth how decisions will be made, how profits will be shared, how disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed. Yes, it is hard to think about a breakup , when the business is just getting started, but many partnerships split up at crisis times, unless there is a defined process, there will be even greater problems.

Why Form a Partnership?

They also must decide up front how much time and capital each will contribute. As shown in figure 3.3, the partnership is similar to the proprietorship but is more difficult to form, operate, and terminate. As with the proprietorship, profits are taxed only once-on each partner s share of the income-not twice, as in the corporation. Partnerships, however, are generally more effective than proprietorships in raising funds and in obtaining better ideas, management, and credit. According to Paul Lemberg, an equal partnership is an entrepreneurial mistake that can kill your company. In a 50/50 partnership, no one has a final say and decision making bogs down quickly. Or worse still, no one has final say. Good advice-make it 51/49.

How a Partnership Operates

y The Uniform Partnership Act (UPA) governs the operations of partnerships in the absence of other expressed agreements. The Act has done much to reduce controversies in integrating the laws relating to partnerships. y Each partner is responsible for the acts of all the other partners. Thus, all partners except in all limited partners are liable for all the debts of the firm; even the personal property of each partner can be used to satisfy the debts of the partnership. Nor can a partner obtain bonding protection against the acts of the other partner(s). Therefore, each partner is bound by the actions of the other partners.

Types of Partnerships
y General Partnership each partner actively

participates as an equal in managing the business and being liable for the acts of other partners y Limited Partnership one or more general partners conduct the business, while one or more limited partners contribute capital but do not participate in management and are not held liable for debts of the general partners

Rights of Partners
y If there is no agreement to the contrary, has an

equal voice in running the business which can lead to difficulties between the partners y While each of the partners may make decisions pertaining to the operations of the business, the consent of all partners is required to make fundamental changes in the structures itself. The partners share of the profits is presumed to be their compensation; in the absence of any agreement otherwise, profits and losses are distributed equally.

Rights of Partnership
y Articles of Copartnerships are drawn up during the

pre operating period to show rights, duties, and responsibilities of each partner y Corporation is business formed and owned be a group of people, called stockholders, given special rights, privileges, and limited liabilities by law. y C Corporation is a regular corporation that provides the protection of limited liability for shareholders, but its earnings are taxed at both the corporate and shareholder levels

A partnership is required to file Form 1065 with the IRS (www.irs.gov) for information purposes.
The IRS can, and sometimes does challenge the status of a partnership and may attempt to tax it as a separate legal entity. Other forms that may be required are: y Form 1065 K-1: Partner Share of Income, Credit, Deductions y Form 4562: Depreciation y Form 1040: Individual Income Tax Return y Schedule E: Supplemental Income and Loss y Schedule SE: Self-Employment Tax y Form 1040-ES: Estimated Tax for Individuals

Why Form a Corporation?

y In one of the earliest decisions of the U.S. Supreme

Court, a corporation was defined as an artificial being, invisible, intangible, and existing only in contemplation of the law. y In other words, corporation is a legal entity whose life exists at the pleasure of the courts. y The traditional form of the corporation is called C Corporation. (Inc. or Ltd)

Why Form a Corporation?

y A corporation, chartered by the stare in which it is

headquartered, is considered by law to be a unique entity, separate and apart from those who own it y It can be taxed; it can be sued; it can enter into contractual agreements y The owners of a corporation are its shareholders y The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes

How to Form a Corporation

y To form a corporation, articles of corporation must be prepared and filed with the state in exchange for a corporate charter, which states what the business can do and provides other information y One danger in any business is that one of the owners will leave and start a competing business. Even if trade secrets are not stolen, the new competitor will have acquired business knowledge at the corporation s expense y It may not be possible to prevent such defections, but incorporators can make provisions during the incorporation process for recovering damages for any loss the firm suffers

How to Form a Corporation

y One way is to include a buy-sell agreement in the

articles of incorporation. This arrangement details the terms by which stockholders can buy out each other s interest y Also, if the success of the venture is dependent on key people, insurance should be carried on them. This type of insurance protects the resources of the firm in the event of the loss of these people

How a Corporation is Governed

y Stockholders are the corporation s owners. In a small

company, one or a few people may own most of the stock and therefore be able to control it. In a large corporation, however, holders of as little as 10% may be able to control the company. Often the founders have the controlling interest and can pick the people to be on the board of directors.

How a Corporation is Governed

y Board of Directors represents the stockholders in managing the company. Board members can help set goals and plan marketing production, and financing strategies. However, some owners prefer to run the company alone, without someone looking over their shoulder y Sources of effective outside directors, such as experienced businesspeople, investors, bankers, and professionals such as attorneys, CPA, or business consultants y It is becoming difficult, however, to obtain competent outsiders to serve on boards especially of small companies because of liability suits y Corporate Officers usually include the chairman, president, secretary, and treasurer

The S Corporation
y A form of business ownership receiving growing attention in recent years is the S Corporation, a special type of corporation that is exempt from multiple taxation and excessive paperwork. Any business with fewer than 75 stockholders, non of whom are corporate shareholders can apply to such a corporation y S Corporation eliminates multiple taxation of income and the attendant paperwork, as well as certain other taxes. For example, regular corporations must deduct Social Security taxes on income paid to owners employed by firm, as well as pay the employers share of the taxes. But if an owner receives an outside salary above the maximum from which such taxes are deducted, the S Corporation neither deducts nor pays Social Security taxes on the owner s income

Other Forms of Business

y Limited-Liability Company (LLC)

combines the advantages of a corporation, such as liability protection, with the benefits of a partnership, such as tax advantages y Limited Liability Partnership (LLP) is organized to protect individual partners from personal liability for the negligent acts of other partners or employees y Family Limited Liability Partnership (FLLP) is the organizational type where the majority of the partners are related to each other as spouses, parents, grandparents, siblings, cousins, nieces, or nephews

Other Forms of Business

y Professional Service Corporation (PSC)

must be organized fore the sole purpose of providing a professional service for which each shareholder is licensed y Nonprofit Corporations is formed for civic, educational, charitable, and religious purposes y Cooperative is a business owned by and operated for the benefit of patrons using its services y Joint Venture is a form of temporary partnership whereby two or more firms join in a single endeavor to make a profit

Other Forms of Business

Cooperative is a business composed of independent producers, wholesalers, retailers, or consumers that acts collectively to buy or sell for its clients. Usually the cooperative s net profit is returned to the patrons at the end of each year, resulting in no profits and no taxes to it. To receive the advantages of the cooperative, a business must meet certain requirements of federal and state governments. The cooperative form of business is usually associated with farm products purchasing, selling, financing farm equipment and materials, and/or processing and marketing farm products.

Other Forms of Business

Joint Venture working relationships between noncompeting companies are quite popular these days and may become even more so in the future. The usual arrangement is joint venture, which is a form of temporary partnership whereby two or more firms join in a single endeavor to make profit. For example, two or more investors may combine their finances, buy a piece of land, develop it, and sell it. At that time, the joint venture is dissolved.

Sole Proprietorship
y Advantages y Proprietor is sole business decision maker y Proprietor receives all income from business y Income from business is taxed once, at the individualtaxpayer level y Disadvantages y Proprietor is liable for all debts of the business (unlimited liability) y Proprietorship has a limited life y Business has limited access to additional funds

General Partnership
y Advantages y Partners receive income according to terms of partnership agreement y Income from business is taxed once as partners personal income y Decision making rests with the general partners only y Disadvantages y Each partner is liable for all the debts of the partnership y Partnership life is determined by agreement or upon the death of any partner, whichever occurs first y Business has limited access to additional funds

Corporation
y Advantages

Firm has perpetual life y Owners are not liable for the debts of the firm; the most that owners can lose is their initial investment y Firm can raise funds by selling additional ownership interest y Income is distributed in proportion to ownership interest y Disadvantages y Income paid to owners is subjected to double taxation y Ownership and management (decision making) are separated in larger organization
y