CHAPTER 6: BUSINESS FORMATION

Choosing the Form that Fits

CHOICES, CHOICES, CHOICES

The form of ownership of a business is a

big decision.

Form of ownership affects:

• Operation• Start-up Costs• Profit Distribution• Taxes• Management Succession plans

The “Big Three” is Becoming the “Big Four”:

• Sole Proprietorship• Partnership• Corporation• Limited Liability

Company

SOLE PROPRIETORSHIP: BUSINESS AT ITS MOST BASIC

Advantages: Ease of Formation

Retention of Control

Pride of Ownership

Retention of Profits

Possible Tax Advantages

Disadvantages: Limited Financial

Resources

Unlimited Liability

Limited ability to attract and maintain talented employees

Lack of Permanence

MOST COMMON TYPES OF SOLE PROPRIETORSHIPS

Category Examples Number of Proprietorships

(thousands)

Professional, Technical, and Scientific Services

Law firms, accountants, architects, computer system designers, consultants

2,752

Construction Residential construction, commercial construction, specialty contractors

2,491

Retail Trade Car dealerships, restaurants, clothing stores, home & garden stores

2,416

Other Services Automobile repair and body shops, laundries, personal services

1,995

Health Care Physicians, dentists, chiropractors, psychologists, psychiatrists

1,762Source for Table: “Sole Proprietorship Returns”, by Kevin Pierce Statistics of Income Bulletin, Summer, 2005, Figure A, p.9; website: http://www.irs.gov/pub/irs-soi/03solp.pdf )

BUSINESS FORMS: COMPARING THE NUMBERS

Total Number of Businesses by Form of Ownership (Millions)

Total Net Income by Form of Ownership ($Billions)

PARTNERSHIPS: TWO HEADS CAN BE BETTER THAN ONE

Advantages: Pooled Financial

Resources

Shared Responsibilities

Ease of Formation

Tax Advantages

Disadvantages: Unlimited Liability

Disagreements

Difficulty in withdrawing from agreement

Lack of Continuity

LIMITED PARTNERSHIPS

Limited Partnership – includes at least one

general partner and at least one limited partner

Limited Liability Partnership – All partners are actively

involved but they have some form of limited liability. The

amount of liability differs per state.

Limited partners have limited liability.

GENERAL VS LIMITED PARTNERSHIPS

General Partnerships All partners have the right to participate

in the management of the firm and share in any profits/losses.

Limited Partnerships All partners contribute financially and

share in the profits but the limited partner(s) cannot actively participate in management.

FAMILY LIMITED PARTNERSHIPS

Parents as general partners Children as limited partners Parents transfer assets to limited

partners while still maintaining control, this strategy: Reduces gift and inheritance taxes Protects family assets from

creditors and lawsuits But watch out for the IRS –

Family Limited Partnerships can attract tax auditors!

CORPORATIONS: AN ARTIFICIAL REALITY

A corporation is a legal entity, separate and distinct from its owners.

Corporations are owned by stockholders. The Board of Directors establishes the

mission and objectives. The Board is elected by the stockholders to

represent their interests.

CORPORATIONS

Advantages: Limited Liability

Permanence

Easy to Transfer Ownership

Ability to Raise Capital

Specialized Management

Disadvantages: Expense/complexity of

formation and operation

Double Taxation

Paperwork and Regulation

Conflicts of Interest

OTHER TYPES OF CORPORATIONS: SAME BUT DIFFERENT

S Corporation

Closed Corporation

Non-profit

Corporation

COMPARING TYPES OF CORPORATIONS

TYPETYPE KEY ADVANTAGEKEY ADVANTAGE LIMITATIONSLIMITATIONS

S Corp. •IRS does not tax earnings separately.

•Stockholders have limited liability.

•No more than 100 stockholders•Stockholders must be US citizens or permanent residents

Statutory Close Corp.

•Not require to have a board or hold annual meetings.

•Owners can participate in management while maintaining limited liability.

•Limited number of stockholders.•Stockholders must offer shares to owner first before selling publicly

•Not all states allow this corporation type

Nonprofit Corp.

•Earnings are exempt from federal and state income taxes.

•Members/directors have limited liability

•Contributions made by individuals are tax-deductible

•May have dues paying members but no stockholders.

•Can’t distribute dividends.•Can’t make political donations.•Must keep accurate records to document tax-exemption.

LIMITED LIABILITY COMPANY: THE NEW KID ON THE BLOCK

Advantages: Limited Liability

Tax Pass-Through

Simplified Management and Operation

Flexible Ownership

Disadvantages: Franchise Taxes

Foreign Status in other States

State Law Differences

Limited to Select Industries

COMPARING BUSINESS FORMS

Sole

Proprietorships

Partnerships Corporations

LOW HIGHDEGREE OF COMPLEXITY AND PERPETUITY

HIGH LOWDEGREE OF PERSONAL LIABILITY

CORPORATE RESTRUCTURING

Corporations look for: Growth opportunities Operational efficiencies Competitive advantages

Mergers – two companies agree to a

combination of equals.

Acquisitions – when one firm buys

another.

TYPES OF MERGERS AND ACQUISITIONS

Type of Merger

Definition Objective Example

Horizontal Combine firms in same industry.

•Increase size•Increase market

power•Gain efficiency

AT&T and SBC

Vertical Combine companies with

buyer-seller relationship.

•Provide tighter integration and increase control

Time Warner and

Turner Broadcasti

ng

Conglomerate

Combination of unrelated

companies.

•Increase company’s diversity.

GE acquiring

RCA

FRANCHISING: PROVEN METHODS FOR A PRICE

Not a form of ownership but an operation option. SubwaySubway Jiffy LubeJiffy Lube 7-Eleven7-Eleven McDonaldsMcDonalds

The franchisee uses the brand name, trademark and practices of the franchisor.

FRANCHISING

Advantages: Less Risk

Training and Support

Brand Recognition

Access to Funding

Disadvantages: Costs

Lack of Control

Negative Halo Effect

Growth Challenges

Restriction on Sale

Poor Execution

Ben & Jerry franchises its PartnerShops to non-profit corporations.