choosing a legal form (7)

Growing and Managing

a Small Business

An Entrepreneurial Perspective

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Chapter 7Choosing a Legal Form of Business


Learning Outcomes

• Understand the various legal entities available for new businesses, including sole proprietorship, partnership, corporation, and LLC.

• Explain the criteria used to decide the best legal form for a particular type of business


Chapter Outline

• The Legal Form of a Company– Sole Proprietorship– Partnership

• Limited Liability Partnership (LLP)– Corporation

• C corporation• S corporation• Limited Liability Company (LLC)

– The Non Profit Corporation• Deciding on a Legal Form

– Milestone Planning


THE LEGAL FORM OF THE COMPANY

• All companies operate under one of four broad legal classifications

• sole proprietorship, • partnership, • corporation, or • limited liability company

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Comparison of Legal Forms


Sole Proprietorship

• The sole proprietorship is an unincorporated business owned by one person

• It is the most common and oldest legal form

• More than 76 percent of all businesses in the United States are sole proprietorships

• Operating as a sole proprietor requires nothing more than a DBA (Certificate of Doing Business Under an Assumed Name) if the entrepreneur does not use his or her name as the name for the business

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Sole Proprietorship – Advantages

• Advantages

– Easiest/least expensive form of ownership to organize– Requires no registration or filing fee– Holds title to all the firm’s assets– Owner receives all income generated by the business– Sole Proprietor has complete decision-making control– Can easily sell or transfer ownership of the company

name and assets (the business is easily dissolved)


Sole Proprietorship - Disadvantages

• Disadvantages

– Bears all business risk– Is subject to all claims of creditors– Has unlimited personal liability for business– Benefits are not business tax deductions– Death/incapacity of owner terminates the business– Hard to raise capital for growth or expansion – limited

to personal savings and loans of the owner– All business income is taxed as personal income


Tax and a Sole Proprietorship

• From a legal or tax perspective, the sole proprietorship does not exist apart from its owner; therefore, it pays no tax.

Consequently, a salary or draw taken by the owner is not considered an expense of the business and cannot be deducted as such

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Drawbacks of a Sole Proprietorship

• Unlimited liability for any claims against the business; as a result, they put at risk their homes, bank accounts, and other assets

• It is also more difficult for sole proprietors to raise capital because they typically rely solely on their own financial statements

• Unless provisions have been made in the owner’s will, the business survives only until the owner dies.


The Hobby Rule

• If a company makes no profit in three out of five years, it is in danger of being judged a hobby, with the result that losses suffered cannot be deducted from gross income to reduce taxable income.

• One test of the hobby rule is whether affairs of the business are conducted in a businesslike manner, for example, maintaining separate personal and business bank accounts, keeping formal accounting records, and so forth.


Tax Forms for Sole Proprietorships

(A minimum, partial list…some may not apply) irs

TAX FORMS FOR THE SOLE PROPRIETOR

• FORM 1040: Individual Income Tax Return• Schedule C: Profit or Loss from Business (or Schedule C-EZ)• Schedule SE: Self-Employment Tax• Form 1040-ES: Estimated Tax for Individuals• Form 4562: Depreciation and Amortization• Form 8829: Expenses for Business Use of your Home

TAX FORMS IF YOU HAVE EMPLOYEES

• Form SS-4: Application for Employer Identification Number• Form 941: Social Security and Medicare Taxes and income tax withholding• Form 941-V: Payment Voucher for SS + FICA Taxes and withholding• Form 940: Federal Unemployment (FUTA) Tax (or Form 940-EZ)


The Partnership

• Partnership– A legal entity formed by two or more co-owners to carry on a

business for profit• Partner Qualifications

– Required: Legal age to contract– Desired: Honest, healthy, capable, and compatible

• Partnership Agreement– A document that states explicitly the rights and duties of

partners• Agency Power

– The ability of any one partner to legally bind the other partners


Sharing Workload

Sharing FinancialBurden

Sharing EmotionalBurden

Procuring ExecutiveTalent

Companionship

InterpersonalConflicts

Dilution of Equity

Dissatisfactionwith Partner

Absence of OneClear Leader

Frustration of NotCalling Own Shots

Advantages Disadvantages

The Advantages and Disadvantages of Partnerships


Advantages of a Partnership

• Relatively easy to establish, but a legal partnership agreement should be carefully crafted and signed

• With more than one owner, ability to raise funds may be increased

• Profits flow directly to the partners’ personal tax returns• Talented employees may be attracted to the business if

given the incentive to become a partner• The business will generally benefit when partners have

complementary skills


Disadvantages of a Partnership

• Partners are jointly and individually liable for the actions of other partners

• Profits must be shared with others• Since decisions are shared, disagreements can

occur• Some employee benefits are not deductible from

business income on tax returns• The partnership may have a limited life; it may end

upon the withdrawal or death of a partner


Types of Partnerships

• GENERAL PARTNERSHIP (GP)– Divides responsibility, liability, and profit/(loss) equally,

unless there is a written agreement that states differently

• LIMITED PARTNERSHIP (LLP)– Most of the partners have very limited control and input

regarding management decisions – Their liability is limited to the extent of their investment,

which encourages others to invest in the partnership– More complicated to set up...who will manage, be silent, etc?

• JOINT VENTURE (JV)– Acts like a general partnership, but exists for a limited time

or single project. If activity is repeated, they will be judged a de facto partnership and will have to file as such. Often used in real estate development, rarely used in retailing or services,


Limited Liability Partnership - LLP

• There is at least one principal partner, who actively runs the business and is personally liable for all business debts

• A limited partner’s liability is limited to the size of his/her investment

• Limited partners cannot be active in the management of the business. The penalty for doing so is the loss of their limited liability status.

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Other Types of Partners

• Secret partners: partners who are active but unknown to the public.

• Silent partners: usually inactive partners with a financial interest in the partnership.

• Dormant partners: silent partners not generally known publicly to be a partner (silent & secret)


The Partnership Agreement

A good partnership agreement, whether among individuals or companies, formal or informal, should address the following issues:

The legal name of the partnershipContributions of the partnersThe nature of the businessSales, loans, and leases to the partnershipWithdrawals and SalariesResponsibility and authority of the partnersDissolution of the partnershipArbitration


Tax Forms for PartnershipsA minimum, partial list…some may not apply) irs

TAX FORMS FOR THE PARTNERSHIP

• Form 1065: Partnership Return of Income• Form 1065 K-1: Partner’s Share of Income, Credit, Deductions• Form 4562: Depreciation• Form 1040: Individual Income Tax Return• Form 1040-ES: Estimated Tax for Individuals• Schedule SE: Self-Employment Tax• Schedule E: Supplemental Income and Loss

TAX FORMS IF YOU HAVE EMPLOYEES

• Form SS-4: Application for Employer Identification Number• Form 941: Social Security and Medicare Taxes and income tax withholding• Form 941-V: Payment Voucher for SS + FICA Taxes and withholding• Form 940: Federal Unemployment (FUTA) Tax (or Form 940-EZ)


Corporation

• About 17 percent of U.S. businesses are corporations

• Corporations account for 87 percent of all sales transactions, probably because they are the favored legal form for growing entrepreneurial companies

• The corporation is the only form that is a legal entity and provides limited liability for its owners


The C-corporation

• An ordinary, or regular for-profit corporation chartered by the state and taxed by the federal government as a separate legal entity

TYPES OF C-CORPORATIONS

• A domestic corporation is organized under the laws of the state in which it incorporates.

• A foreign corporation is chartered in a state other than the one in which it transacts business. A California corporation doing business in New York, for example, is considered a foreign corporation.


More Types of C-corporations

• A public corporation is one whose shares are traded on one of the stock exchanges. Growing companies often choose an initial public offering (IPO) as a way to secure the capital for further growth. IPOs are discussed in Chapter 20.

• A closely-held corporation is one whose stock is held privately by a few individuals, often family members such as husband and wife.


How a Corporation is Created

• A corporation is created by filing a certificate of incorporation with the state in which the company will do business.

• A board of directors that will make strategic policy

decisions for the company and hire the officers who will run the business on a day-to-day basis must be established.

• There must be formal documentation of board of directors’ meetings.


Corporate Charter -- Articles of Incorporation

• Name of company• Formal statement of

formation• Type of Business• Location• Duration• Classes and preferences of

stock• Number and par value of

authorized shares

• Voting privileges for each class of stock

• Names of incorporators and directors

• Capital stockholders• Statement of limited liability

for stockholders• Statement of directors’

powers


Rights and Legal Status of Stockholders

• Stock Certificate– A document specifying the number of shares of stock

owned by a shareholder• Pre-emptive Right

– The right of current stockholders to buy new shares of stock before they are offered to the public

• Legal Status– Ownership provides control over the firm– Ownership limits liability to investment in the firm– Ownership can be transferred without affecting the

firm’s operations


Pros and Cons of Incorporation

ADVANTAGES SBA• Business becomes a legal entity with unlimited life • Shareholder liability is limited to the value of investment in stock• Additional capital can be raised through stock sales• Cost of benefits provided to employees is deductible• Can elect S corporation or LLC status if certain requirements are

met• Owners can legally lease their personal assets (like real estate) to

the corporation, thus generating personal income for the owner, while charging the expense to the corporation.

DISADVANTAGES• Process of incorporation takes time and money• Regulated by federal, state, and local agencies - lots of paperwork• Income may be double-taxed…dividends are not tax-deductible


Where to Incorporate?

In comparing states as sites for incorporation, the company should consider the following:

• Cost of qualifying a foreign corporation in areas where the company will do business as compared with the cost of incorporating there

• Capitalization requirements, powers of directors, and flexibility of operations

• Incorporation fees and related taxes

• Rules dealing with tender offers, if the stock will be widely held

• Annual fees and taxes

• State stamp taxes applicable to the original issue of the stock and any later transfers


S corporation

• A financial vehicle that passes the profits and losses of the corporation to the shareholders, much as a partnership does, to be taxed at the individual partners’ rate.

• The profits and losses from the business must be allocated in proportion to each shareholder’s interest.

• An S corporation shareholder may not deduct losses in excess of the original investment


The Subchapter S Corporation

Eligibility Requirements• No more than 100 stockholders• All stockholders must be individuals or trusts• Only one class of stock can be outstanding• Must be a domestic corporation• Must operate on a fiscal calendar year basis• No nonresident alien stockholders• No more than 25% of income from passive sources• Shareholders who work must pay themselves reasonable wages,

otherwise all earnings will be reclassified as taxable wagesBenefits

• Liability limited to investment in corporation• Dividends avoid double taxation (corporate and personal

income)


Limited Liability Company (LLC)

• LLCs are formed by filing articles of organization, similar to articles of incorporation, but their shareholders are called members and their shares of ownership are known as interests

• Like a corporation, the managers, officers, and members are not personally liable for the actions of the company except where they have personally guaranteed these activities.

• Unlike the S corporation, there is no limitation on the number of members or their status, and the LLC can issue more than one class of stock and allow foreign members.


Limited Liability Company (LLC)

• A corporation in which stockholders have limited liability but pay personal income taxes on the business profits– Easier to set up– More flexible– Tax advantage

• Two or more members are required• Limited life (dissolution date specified)• Articles of Organization filed with Secretary of State• Operating agreement specifies who manages the LLC • No one can join the LLC without majority consent


Limited Liability Company (LLC) contd

• LLC’s cannot have more than 2 of the 4 characteristics of a typical corporation, otherwise they will be treated as regular C corporations.

• The four characteristics are:

– Limited liability to the extent of assets– Continuity of life– Centralization of management– Free transferability of ownership interests


Non-Profit Corporation

• A non-stock corporation formed to provide some form of service or benefit to the public community. Its purpose must be either religious, charitable, educational, literary, or scientific.– No shares are issued– The organization cannot pay dividends– Upon dissolution, assets are given to another nonprofit group

ADVANTAGES• Tax exemption from most federal and state taxes• Able to receive donations that are deductible for the donors• Limited liability for members and directors

DISADVANTAGES• Paperwork to incorporate, create bylaws, keep minutes• Federal and state tax filings, audits, etc.• Cannot participate directly in political activities or campaigns


More about Nonprofit Corporations

• The common misconception about nonprofits is that they are not allowed to make a profit.

• As long as the business is not organized to benefit a single person and is created for a recognized nonprofit purpose, it can earn a tax-exempt profit if it has also met the IRS test for tax-exempt status.

• However, any income it derives from for-profit activities is subject to income tax.


How to Qualify as a Nonprofit Corporation

• To qualify to operate as a nonprofit corporation, a company must pass two distinct hurdles:

1. Meet the state requirements for designation as a nonprofit corporation.

1. Meet the federal and state requirements for exemption from paying taxes by forming a corporation that falls within the IRS’s narrowly defined categories. Under IRS 501(c)(3), a nonprofit may not engage in substantial activity that is not for tax-exempt purposes.


Making the Most of a Board of Directors

• Board of Directors– The governing body of a corporation, elected by the

stockholders– Inside directors

• Board members who work for the firm– Outside directors

• Board members who do not work for the firm• Duties

– Elect the firm’s officers (top management)– Approve management’s plans and policies– Review performance and declare dividends


The Board of Directors (cont’d.)

• Contributions of Board of Directors

– Bring knowledge and experience

• Review policy decisions

• Provide general direction

• Monitor the firm’s ethical behavior

• Mediate and resolve disputes among top management

• Alternative: Advisory Council

– Provides advice but does not have the fiduciary responsibility for the direction of the firm


Tax Forms for Corporations(A minimum, partial list…some may not apply) IRS

• Form 1120 or 1120-A: Corporate Income Tax Return• Form 1120-W: Estimated Tax for Corporation• Form 8109-B: Deposit Coupon• Form 4625: Depreciation• Form 1120S: Income Tax Return for S Corporation• Form 1120S K-1: Shareholder’s Share of Income, Credit,

Deductions• Form 1023: Application for Recognition of Tax Exemption


Choosing an Organizational Form

• Factors that affect the choice of the firm’s structure:

– Initial organizational costs and requirements– Limited versus unlimited liability for the owners– Continuity of business– Transferability of ownership– Management control– Deductibility of salaries, benefits paid to owners– Attractiveness for raising equity capital– Income taxes


Forms of Business—Federal Income Tax

Sole ProprietorshipExample of taxes due from a married couple with $150,000 in income from the business that they operate as self-employed persons.

Range of Taxable IncomeTax Rate$0–$14,300 10%$14,301–$58,100 15%$58,101–$117,250 25%$117,251–$178,650 28%$178,651–$319,100 33%Over $319,100 35%

Income Tax Rate TaxesFirst $ 14,300 10% $ 1,430.00Next $ 43,800 15% $ 6,570.00Next $ 59,150 25% $14,787.50Next $ 32,750 28% $ 9,170.00Total $150,000 $31,957.50


Forms of Business—Federal Income Tax

CorporationExample of taxes due from the profits of a corporation. Any profits of the corporation that are distributed to the stockholders are taxed again as personal income.

Range of Taxable Income Tax Rate$0 to $50,000 15%

$50,001 to $75,000 25%$75,001 to $100,000 34%

$100,001 to $335,000 39%

Income x Tax Rate= TaxesFirst $50,000 15% $7,500Next $25,000 25% $6,250Next $25,000 34% $8,500Remaining $50,000 39% $19,500Total $150,000 $41,750


End Chapter 7

choosing a legal form (7)

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