Partnerships are quasi-taxable organizations. this means that they

Options for Organizing a Business

Chapter 4

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Learning Objectives

4-1 Define and examine the advantages and disadvantages of the sole proprietorship form of organization.

4-2 Identify two types of partnership and evaluate the advantages and disadvantages of the partnership form of organization.

4-3 Describe the corporate form of organization and cite the advantages and disadvantages of corporations.

4-4 Define and debate the advantages and disadvantages of mergers, acquisitions, and leveraged buyouts.

4-5 Propose an appropriate organizational form for a startup business.

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Figure 4.1 Comparison of Sole Proprietorships, Partnerships/S Corporations, and C Corporations

Source: Scott Greenberg, “Pass-Through Businesses: Data and Policy,” Tax Foundation, January 17, 2017, https://taxfoundation.org/pass-through-businesses-data-and-policy/ (accessed April 10, 2018)

Access the text alternative for these images.

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Table 4.1 Various Forms of Business Ownership

Structure Ownership Taxation Liability Use

Sole Proprietorship One owner Individual income taxed Unlimited Owned by a single individual/easiest way to conduct business

Partnership Two or more owners Individual owners’ income taxed Somewhat limited Easy way for two individuals to conduct business

Corporation Any number of shareholders Corporate and shareholder taxed Limited Legal entity with shareholders or stockholders

S Corporation Up to 100 shareholders Taxed as a partnership Limited Legal entity with tax advantages for restricted number of shareholders

Limited Liability Company Unlimited number of shareholders Taxed as a partnership Limited Avoid personal lawsuits

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Every student of business should be aware that there are three primary forms of organizing a business, whether it is a traditional “brick and mortar” organization, or a virtual corporation that does business exclusively through the Internet.

The three primary forms of business that we will examine are Sole Proprietorship, Partnership, and Corporation. This table compares a sole proprietorship, a partnership, a corporation, an S corporation and an LLC as they relate to ownership, taxation, liability and use. All businesses must select a form of organization that is most appropriate for their owners and the scope of their business.

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Sole Proprietorships 1

Businesses owned and operated by one individual

Most common form of business organization in the United States

Typically employ fewer than 50 people

Comprise nearly three-quarters of all U.S. businesses

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Sole proprietorships, businesses owned and operated by one individual, are the most common form of business organization in the United States. Common examples include many retailers such as restaurants, hair salons, flower shops, dog kennels, and independent grocery stores.

Sole proprietorships are typically small businesses employing fewer than 50 people constitute approximately three-fourths of all businesses in the United States. It is interesting to note that women business owners are less likely to get access to credit than their male counterparts. In many areas, small businesses make up the vast majority of the economy.

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Sole Proprietorships 2

Advantages of Sole Proprietorships

Ease and cost of formation

Secrecy

Distribution and use of profits

Flexibility and control of the business

Government regulation

Taxation

Closing the business

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The major advantages of a sole proprietorship are:

Forming a sole proprietorship is relatively easy and inexpensive.

They make possible the greatest degree of secrecy; minimizes the possibility of competitors gaining trade secrets.

All profits belong exclusively to the owner.

The owner has complete control over the business allowing them to respond quickly to changing business conditions.

Sole proprietorships have the most freedom from government regulation.

Taxes are considered personal income and are taxed at individual tax rates.

It can be dissolved easily.

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Sole Proprietorships 3

Disadvantages of Sole Proprietorships

Unlimited liability

Limited sources of funds

Limited skills

Lack of continuity

Lack of qualified employees

Taxation

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The major disadvantages of a sole proprietorship are:

The owner has unlimited liability in meeting the debts of the business.

Sources of external funds are difficult to find so it is more difficult to obtain funds to start or expand a sole proprietorship.

The owner must have many diverse skills such as management, marketing, finance, accounting, bookkeeping, and personnel management.

The survival of the business is tied to the life of the owner and his or her ability to work.

Qualified employees are hard to find as it is difficult for small proprietors to pay competitive wages and benefits offered by large competing corporations.

Wealthy sole proprietors pay a higher tax rate than they would under the corporate form of business.

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POLLING QUESTION

Colleen wants to start a crafting business as a side job and is considering forming it as a Sole Proprietorship. In your opinion, what disadvantages should she be most concerned about?

Unlimited liability

Limited sources of funds

Lack of continuity

Lack of qualified employees

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Student answers will vary. Students should consider the following points.

Unlimited liability: Any business owner runs the risk of being sued. If a sole proprietor is sued, the plaintiff could not only ask for assets from said business but also the owner’s own personal assets, i.e. house, car, pension etc. This can be troublesome when starting a new business.

Limited sources of funds: New business owners most often use their own funds to start the business. The challenge is that banks and other financing institutions only look to the owners assets to determine credit. If the sole proprietor does not have well-established or good credit, banks may charge higher interests rates on loans because it is a riskier investment.

Lack of continuity: If a sole proprietor becomes extremely ill or passes away, the business will become defunct. As the sole owner, the life expectancy of the business is directly merged with the sole proprietor.

Lack of qualified employees: It is challenging for a sole proprietor to pay the same wages or offer the same benefits as that of a larger company. For this reason, sole proprietors find if very challenging to recruit and keep highly skilled employees.

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Partnerships 1

A form of business organization defined by the Uniform Partnership Act as “an association of two or more persons who carry on as co-owners of a business for profit”

Least used form of business

Typically larger than sole proprietorships but smaller than corporations

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One way to minimize the disadvantages of a sole proprietorship and maximize its advantages is to have more than one owner. Most states have a model law governing partnerships based on the Uniform Partnership Act. This law defines a partnership as “an association of two or more persons who carry on as co-owners of a business for profit.” Partnerships are the least used form of business. They are typically larger than sole proprietorships but smaller than corporations.

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Partnerships 2

Types of Partnership

General partnership

Limited partnership

Master limited partnership (MLP)

Articles of Partnership

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There are two basic types of partnership: general partnership and limited partnership. A general partnership involves a complete sharing in the management of a business. In a general partnership, each partner has unlimited liability for the debts of the business. Professionals such as lawyers, accountants, and architects often join together in general partnerships.

A limited partnership has at least one general partner, who assumes unlimited liability, and at least one limited partner, whose liability is limited to his or her investment in the business. Limited partnerships exist for risky investment projects where the chance of loss is great. A master limited partnership (MLP) is a limited partnership traded on securities exchanges. MLPs have the tax benefits of a limited partnership but the liquidity (ability to convert assets into cash) of a corporation. Popular examples of MLPs include oil and gas companies and pipeline operators.

Articles of partnership are legal documents that set forth the basic agreement between partners. Most states require articles of partnership, but even if they are not required, it makes good sense for partners to draw them up.

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Partnerships 3

Advantages of Partnerships

Ease of organization

Availability of capital and credit

Combined knowledge and skills

Decision making

Regulatory controls

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When deciding if a partnership is the right ownership choice, advantages and disadvantages must be compared with those offered by other forms of business organization, and not all apply to every partnership.

The advantages of a partnership are:

Partnerships are easy to organize. Starting a partnership requires little more than drawing up articles of partnership.

Partnerships can pool financial resources of the partners. Partnerships have higher credit ratings due to the partner’s combined wealth.

Partners can specialize in their particular areas of expertise such as marketing, production, accounting or service.

Small partnerships can react more quickly to changes in the business environment than can large partnerships and corporations.

Government regulations are few.

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Partnerships 4

Disadvantages of Partnerships

Unlimited liability

Business responsibility

Life of the partnership

Distribution of profits

Limited sources of funds

Taxation of Partnerships

Quasi-taxable organizations

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The disadvantages of partnerships include:

(1) General partners have unlimited liability for the debts of the partnership, just as in a sole proprietorship.

(2) Partners are responsible for each others’ decisions and a bad decision by one partner can put the other partners’ personal resources at risk.

(3) A partnership is terminated when a partner dies or withdraws.

(4) It is difficult to sell a partnership interest at a fair price.

(5) The distribution of profits may not correctly reflect the amount of work done by each partner.

(6) Sources of funds available to a partnership are limited.

Partnerships are quasi-taxable organizations. This means that partnerships do not pay taxes when submitting the partnership tax return to the Internal Revenue Service. The tax return simply provides information about the profitability of the organization and the distribution of profits among the partners. Partners must report their share of profits on their individual tax returns and pay taxes at the income tax rate for individuals.

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POLLING QUESTION

Which of the following is NOT an advantage of a Partnership?

Combined knowledge and skills

Distribution of profits

Availability of capital and credit

Ease of organization

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Answer: B. Distribution of profits

This is a disadvantage of a partnership. In a sole proprietorship, the business owner is able to keep 100% of the profits. However, in a partnership, the partners must divide the profits. Answers A, C, and D are all advantages of a partnership.

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Corporations 1

A legal entity, created by the state, whose assets and liabilities are separate from its owners

Has many of the rights, duties, and powers of a person

Can own and transfer property

Can enter into contracts

Can sue and be sued in court

Stock

Dividends

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A corporation is a legal entity, created by the state, whose assets and liabilities are separate from its owners. As a legal entity, a corporation has many of the rights, duties, and powers of a person, such as the right to receive, own, and transfer property. Corporations can enter into contracts with individuals or with other legal entities, and they can sue and be sued in court.

Corporations are typically owned by many individuals and organizations who own shares of the business, called stock (thus, corporate owners are often called shareholders or stockholders). Stockholders can buy, sell, give or receive as gifts, or inherit their shares of stock. As owners, the stockholders are entitled to all profits that are left after all the corporation’s other obligations have been paid. These profits may be distributed in the form of cash payments called dividends.

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Corporations 2

Creating a Corporation

Incorporators create corporation

Each state has a specific procedure called chartering the corporation

Incorporators file articles of incorporation

State issues a corporate charter to the company

Owners establish bylaws and elect a board of directors

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The individuals creating the corporation are known as the incorporators. Each state has a specific procedure called chartering the corporation for incorporating businesses. The incorporators then file legal documents with the state containing basic information, referred to as articles of incorporation. A corporate charter is then issued.

A corporate charter is a legal document that the state issues to a company based on information the company provides in the articles of incorporation. After securing the corporate charter, the owners establish the corporation’s bylaws and elect a board of directors.

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Corporations 3

Types of Corporations

Domestic corporation

Conducts business in the state in which it is chartered

Foreign corporation

Conducts business outside the state in which it is chartered

Alien corporation

Conducts business outside the nation in which it is incorporated

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Corporations 4

Types of Corporations continued

Private corporation

Owned by just one or a few people closely involved in managing the business

No stock is sold to public

Not required to disclose financial information publicly

May become public via initial public offering (IPO)

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A private corporation is owned by just one or a few people who are closely involved in managing the business. These people, often a family, own all the corporation’s stock, and no stock is sold to the public. Privately owned corporations are not required to disclose financial information publicly, but they must, of course, pay taxes.

A private corporation that needs more money to expand or to take advantage of opportunities may have to obtain financing by “going public” through an initial public offering (IPO)—that is, becoming a public corporation by selling stock so that it can be traded in public markets.

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Table 4.5 America’s Largest Private Companies

Company Industry Revenue (in billions) Employees

1. Cargill Food, drink, and tobacco $109.7 150,000

2. Koch Industries Multicompany $100 100,000

3. Albertsons Food markets $59.7 273,000

4. Deloitte Business services and supplies $36.8 244,400

5. PricewaterhouseCoopers Business services and supplies $35.9 223,000

6. Mars Food, drink, and tobacco $35 80,000

7. Publix Super Markets Food markets $34 191,000

8. Bechtel Construction $32.9 55,000

9. Ernst & Young Business services and supplies $29.6 231,000

10. C&S Wholesale Grocers Food, drink, and tobacco $28.1 17,500

Source: “America’s Largest Private Companies,” Forbes,

https://www.forbes.com/largest-private-companies/list/#tab:rank (accessed April 8, 2018).

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Corporations 5

Types of Corporations continued

Public corporation

A corporation whose stock anyone may buy, sell, or trade

May be taken private when all firm’s stock is purchased and can no longer be sold publicly

Two types of public corporations:

Quasi-public

Nonprofit

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A public corporation is one whose stock anyone may buy, sell, or trade. Publicly owned corporations must disclose financial information to the public under specific laws that regulate the trade of stocks and other securities. Public corporations can be “taken private” when one or a few individuals (perhaps the management of the firm) purchase all the firm’s stock so that it can no longer be sold publicly.

Quasi-public corporations and nonprofits are two types of public corporations. Quasi-public corporations are owned and operated by the federal, state, or local government. The focus of these entities is to provide a service to citizens, such as mail delivery, rather than earning a profit. Indeed, many quasi-public corporations operate at a loss. Like quasi-public corporations, nonprofit corporations focus on providing a service rather than earning a profit, but they are not owned by a government entity.

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Corporations 6

Elements of a Corporation

The board of directors

Elected by stockholders

Sets long-range objectives of the corporation

Ensures objectives are met on schedule

Hires corporate officers

Outside directors

Inside directors

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A board of directors, elected by the stockholders to oversee the general operation of the corporation, sets the long-range objectives of the corporation. It is the board’s responsibility to ensure that the objectives are achieved on schedule. An important duty of the board of directors is to hire corporate officers, such as the president and the chief executive officer (CEO), who are responsible to the directors for the management and daily operations of the firm.

Directors can be employees of the company (inside directors) or people unaffiliated with the company (outside directors). Inside directors are usually the officers responsible for running the company. Outside directors are often top executives from other companies, lawyers, bankers, even professors.

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Corporations 7

Elements of a Corporation continued

Stock ownership

Preferred stock

Do not have say in running the company but have a claim to profits before other stockholders

Common stock

Do not get preferential treatment regarding dividends but have voting rights

May vote by proxy

Have preemptive rights

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Corporations issue two types of stock: preferred and common. Owners of preferred stock are a special class of owners because, although they generally do not have any say in running the company, they have a claim to profits before any other stockholders. Other stockholders do not receive any dividends unless the preferred stockholders have already been paid.

Although owners of common stock do not get such preferential treatment with regard to dividends, they do get some say in the operation of the corporation. Their ownership gives them the right to vote for members of the board of directors and on other important issues. Common stockholders are the voting owners of a corporation. They are usually entitled to one vote per share of common stock.

Common stockholders may vote by proxy, which is a written authorization by which stockholders assign their voting privilege to someone else, who then votes for his or her choice at the stockholders’ meeting. Common stockholders have another advantage over preferred shareholders. In most states, when the corporation decides to sell new shares of common stock in the marketplace, common stockholders have the first right, called a preemptive right, to purchase new shares of the stock from the corporation.

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Corporations 8

Advantages of Corporations

Limited liability

Ease of transfer of ownership

Perpetual life

External sources of funds

Expansion potential

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Because a corporation is a separate legal entity, it has some very specific advantages over other forms of ownership:

The owners have limited liability providing protection to shareholders in that the corporation’s assets and liabilities are separate from its owners.

Ownership (stock) can be easily transferred.

Corporations usually last forever, extending beyond the life of its owners.

Raising money is easier than for other forms of business.

Expansion into new businesses is simpler because of ability of the company to expand into national and international markets.

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Corporations 9

Disadvantages of Corporations

Double taxation

Forming a corporation

Disclosure of information

Employee-owner separation

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Corporations also have disadvantages:

The company is taxed on its income, and owners pay a second tax on any profits received as dividends.

Forming a corporation can be expensive.

Corporations must make information available to their owners, usually through an annual report to shareholders. Because all reports filed with the SEC are available to the public, competitors can access them. Additionally, complying with securities laws takes time.

Most employees are not stockholders of the company for which they work. This separation of owners and employees may cause employees to feel that their work benefits only the owners. Employees without an ownership stake do not always see how they fit into the corporate picture.

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POLLING QUESTION

At 10 years old, Penny has accrued $751 in revenue from her candy sales. She is considering teaming up with her next-door neighbor, Johnny, to form a legal candy business. In your opinion, what type of partnership is best and why?

Partnership – She is too young to go it alone and should partner with her neighbor.

Partnership – She only has $751 in funds and will need more financing.

Sole proprietorship – Unlimited liability isn’t too worrisome because she’s young.

Sole proprietorship – She operates from her parents’ house so her fixed and operating costs are low.

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Student answers will vary. Students should consider the following points.

Partnership – Age. If Penny goes into business with Johnny, who’s 12 years old, he may be able to offer sage advice based on his own experiences. Together, they could form a puerile duo of young entrepreneurs.

Partnership – Money. If Penny goes into business with Johnny, she will have increased the business network from which she can draw funding.

Sole Proprietorship – Unlimited Liability. Penny is only 10 years old. If she goes into business by herself and is sued by an 8-year-old customer who broke his tooth on her lollipop, she would only be liable for her own investment in the enterprise.

Sole Proprietorship – Low Operating Costs. Penny has enough money to get started and can operate from her her parents’ house. She doesn’t need Johnny.

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Other Types of Ownership 1