Nothing in fine print is ever good.

Anonymous

It¶s just paper ± all I own is a pickup truck and a little Wal-Mart stock.
--Sam Walton

 
 

Students will be able to:
1. jescribe the advantages and disadvantages of the sole proprietorship.
2. jescribe the advantages and disadvantages of the partnership.
3. jescribe the advantages and disadvantages of the corporation.
4. jescribe the features of the alternative forms of ownership such as the S corporation, the
limited liability company, and the joint venture.

O
 
I. Introduction
A. Each form of ownership has its own unique set of advantages and disadvantages.
1. The key to choosing the ³right´ form of ownership is the ability to understand the
characteristics of each and knowing how they affect an entrepreneur¶s business
and personal circumstances.
2. The issues the entrepreneur should consider in the evaluation process:
a) Tax considerations. Because of the graduated tax rates under each form of
ownership, the government's constant tinkering with the tax code, and the
year-to-year fluctuations in a company's income, an entrepreneur should
calculate the firm's tax bill under each ownership option every year.
b) Liability exposure. Certain forms of ownership offer business owners greater
protection from personal liability due to financial problems, faulty products,
and a host of other difficulties.
c) Start-up and future capital requirements. Forms of ownership differ in their
ability to raise start-up capital.
d) Control. Entrepreneurs must decide early on how much control they are
willing to sacrifice in exchange for help from other people in building a
successful business.
e) Managerial ability. If an entrepreneur lack skills or experience in certain
areas, he/she may need to select a form of ownership that allows him/her to
bring into the company people who possess those skills and experience.
f) Business goals. How big and how profitable an entrepreneur plans for the
business to become will influence the form of ownership chosen.
g) Management succession plans. Some forms of ownership make this transition
much smoother than others. In other cases, when the owner dies, so does the
business.
h) Cost of formation. Some forms of ownership are much more costly and
involved to create than others. Entrepreneurs must weigh carefully the
benefits and the costs of the particular form they choose.

c

c Section II Building the Business Plan: Beginning Considerations

3. Business owners have traditionally had three major forms of ownership from
which to choose: the sole proprietorship, the partnership, and the corporation.
a) See Figure 3.1.
b) In recent years, various hybrid forms of business ownership have emerged; the
S corporation, the limited liability company, and the joint venture.

GAINING THE COMPETITIVE EjGE

What joes the Name of Your Business Convey to Potential Customers?


GHB marketing Communications started getting numerous emails and phone calls requesting a
certain product. The product that individuals were seeking was GHB ± an illegal drug known
as ecstasy. The new name (HiTechPR) costs the owners $20,000.

Choosing a memorable name can be one of the most fun ± and most challenging ± aspects of
starting a business. Larger companies spend hundreds of thousands of dollars researching
names. While, small businesses do not normally have unlimited resources at their disposal, you
can use the same tools and development process that larger companies use to catch the
customer¶s eye.

Look at your name from your potential customer¶s perspective. The customer may want to be
reassured (Gentle jentistry) or the may prefer a bit of humor (The Barking Lot jog
Grooming). Other choices might be to convey an image to your customers that is compatible
with your business strategy.

Whatever the image you wish to communicate to an audience of potential customers, the
process of choosing the ³perfect´ name involves a series of steps.

1. jecide the most appropriate single quality of the business that you wish to convey. Avoid
sending a mixed or inappropriate message.
2. Avoid names that are hard to spell, pronounce or remember.
3. Attempt to select a name that is short, attention getting and memorable.
4. Be creative, but in good taste!
5. Make sure your choice of a name won¶t get dated quickly.
6. Be careful that the name, while catchy and cute, doesn¶t create a negative image.
7. Once you have selected a suitable name, practice using it for a few days.
8. Finally, conduct a name search to make sure that no one else in your jurisdiction has
already claimed the name.

II. The Sole Proprietorship

A. jefined
1. The sole proprietorship is a business owned and managed by one individual. This
form of ownership is by far the most popular.

B. Advantages of a Sole Proprietorship

 Chapter 3 Choosing a Form of Ownership c

1. Simple to create. One attractive feature of a proprietorship is the ease and speed
of its formation. An entrepreneur can complete all of the necessary paperwork in a
single day.
2. Least costly form of ownership to establish. It is generally the least expensive
form of ownership to establish, as there is no need to create and file the legal
documents that are recommended for partnerships and are required for
corporations.
a) In many jurisdictions, entrepreneurs planning to conduct business under a
trade name are usually required to acquire a Certificate of joing Business
under an Assumed Name from the secretary of state.
b) In a proprietorship, the owner is the business.
3. Profit incentive. Once the owner has paid all of the company's expenses, she can
keep the remaining profits (less taxes, of course).
4. Total decision-making authority. The sole proprietor is in total control of opera-
tions and can respond quickly to changes. The ability to respond quickly is an
asset in a rapidly shifting market.
5. No special legal restrictions. The proprietorship is the least regulated form of
business ownership.
6. Easy to discontinue. If the entrepreneur decides to discontinue operations, he can
terminate the business quickly, even though he will still be liable for all of the
business's outstanding debts and obligations.

C. jisadvantages of a Sole Proprietorship

1. Unlimited personal liability. The sole proprietor is personally liable for all of the
business's debts.
2. Limited access to capital. Many proprietors have already put all they have into
their businesses and have used their personal resources as collateral on existing
loans, so it is difficult for them to borrow additional funds.
3. Limited skills and abilities. A sole proprietor may not have the wide range of
skills running a successful business requires. Many business failures occur
because owners lack skills, knowledge, and experience in areas that are vital to
business success.
4. Feelings of isolation. Running a business alone allows an entrepreneur maximum
flexibility, but it also creates feelings of isolation most small business owners
report that they sometimes feel alone and frightened when they must make
decisions knowing that they have nowhere to turn for advice or guidance.
5. Lack of continuity for the business. If the proprietor dies, retires, or becomes
incapacitated, the business automatically terminates.
c Section II Building the Business Plan: Beginning Considerations

IN THE FOOTSTEPS OF AN ENTREPRENEUR

A Brief History

Many environmental factors must be analyzed when trying to decide which form of ownership
is best. The 1981 Tax Act lowered the maximum individual tax rate from 70% to 50%. At the
same time, the maximum corporate rate decreased from 48% to 46%. Then in 1986, the Tax
Reform Act (TRA 86) established the maximum individual rate became 28%, compared to the
maximum corporate of 34%. TRA 86 led to an increased popularity of conduit entities such as
partnerships and S corporations, vis-a-vis C corporations. Today, the individual rate once again
exceeds the corporate rate, though not at the magnitude prior to 1981.

Accounting firms organized as general partnerships were devastated by their legal

responsibility for the savings and loan crisis. As a result, the S corporation became a viable
choice as owners sought to limit their personal legal liability. However, restraints on
ownership and capital structure limited the usefulness of the S corporation. Then in 1991,
Texas enacted the first LLP statute. Many states initially restricted the use of LLCs by
professionals such as physicians and attorneys. LLPs filled this void and provided better
liability protection than general partnerships, but somewhat less than LLCs.

1) For many entrepreneurs, the taxation and personal liability concerns often cloud their
reasoning when deciding on a form of ownership. The following are a series of business
conditions that are unique to Jody Jeffers and her potential business. You have been asked
to evaluate these specific conditions and make a recommendation to her about the most
appropriate form of ownership. The conditions are:
a) Three years ago Ms Jeffers inherited a large sum of money and, although invested, her
earnings place her in the highest federal tax bracket
b) Ms. Jeffers plans to use the invested funds as collateral to borrow 20% of what she
needs to start a new business venture.
c) Ms. Jeffers has eight close friends who indicate that they are each willing to invest in
the business to cover the remaining 80% of financial capital requirements.
d) The business will involve a fleet of automobiles on the road 10 ± 15 hours each day.
e) A legal question exists as to whether the drivers are company employees or contract
workers.
f) Because this new venture is a dramatic new concept, there is honest debate as to its
economic viability.
g) In the event the business fails, an issue to the ownership of some of the firm¶s inventory
would be in question.
—

Student¶s answers may vary. Most common answer will suggest LLC as the
most appropriate form of ownership.

III. The Partnership

A. jefined
1. A partnership is an association of two or more people who co-own a business for
the purpose of making a profit. In a partnership the co-owners (partners) share the
 Chapter 3 Choosing a Form of Ownership c!

business's assets, liabilities, and profits according to the terms of a previously

established partnership agreement.
2. The law does not require a written partnership agreement (also known as the
articles of partnership), but it is wise to work with an attorney to develop one.
a) The partnership agreement is a document that states in writing all of the terms
of operating the partnership for the protection of each partner involved.
b) Every partnership should be based on a written agreement.
3. When no partnership agreement exists, the Uniform Partnership Act governs the
partnership, but its provisions may not be as favorable as a specific agreement
hammered out among the partners.
4. Probably the most important feature of the partnership agreement is that it
addresses in advance sources of conflict that could result in partnership battles
and the dissolution of a business that could have been successful.
5. The standard partnership agreement will likely include the following:
a) Name of the partnership.
b) Purpose of the business. What is the reason the partners created the business?
c) jomicile of the business. Where will the principle business be located?
d) juration of the partnership. How long will the partnership last?
e) Names of the partners and their legal addresses.
f) Contributions of each partner to the business, at the creation of the partnership
and later. This would include each partner's investment in the business.
g) Agreement on how the profits or losses will be distributed.
h) Agreement on salaries or drawing rights against profits for each partner.
i) Procedure for expansion through the addition of new partners.
j) jistribution of the partnership's assets if the partners voluntarily dissolve the
partnership.
k) Sale of partnership interest. How can partners sell their interests in the
business?
l) Absence or disability of one of the partners.
m) Voting rights. In many partnerships, partners have unequal voting power. The
partners may base their voting fights on their financial or managerial
contributions to the business.
n) jecision-making authority. When can partners make decisions on their own,
and when must other partners be involved?
o) Financial authority. Which partners are authorized to sign checks, and how
many signatures are required to authorize bank transactions?
p) Handling tax matters. The Internal Revenue Service requires partnerships to
designate one person to be responsible for handling the partnership's tax
matters.
q) Alterations or modifications of the partnership agreement. As a business
grows and changes, partners often find it necessary to update their original
agreement.

B. The Uniform Partnership Act

1. The Uniform Partnership Act (UPA) codifies the body of law dealing with
partnerships in the United States.
" Section II Building the Business Plan: Beginning Considerations

2. Under the UPA, the three key elements of any partnership are common ownership
interest in a business, sharing the business's profits and losses, and the fight to
participate in managing the operation of the partnership.
3. Under the act, each partner has the right to:
a) Share in the management and operations of the business.
b) Share in any profits the business might earn from operations.
c) Receive interest on additional advances made to the business.
d) Be compensated for expenses incurred in the name of the partnership.
e) Have access to the business's books and records.
f) Receive a formal accounting of the partnership's business affairs.
4. The UPA also sets forth the partners' general obligation. Each partner is obligated
to:
a) Share in any losses sustained by the business.
b) Work for the partnership without salary.
c) Submit differences that may arise in the conduct of the business to majority
vote or arbitration.
d) Give the other partner complete information about all business affairs.
e) Give a formal accounting of the partnership's business affairs.
5. A partnership is based above all else on mutual trust and respect.

C. Advantages of the Partnership

1. Easy to establish. Like the proprietorship, the partnership is easy and inexpensive
to establish. In most states, partners must file a Certificate for Conducting
Business As Partners if the business is run under a trade name.
2. Complementary skills. In successful partnerships, the parties' skills and abilities
complement one another, strengthening the company's managerial foundation.
3. jivision of profits. The partnership agreement should articulate the nature of each
partner's contribution and proportional share of the profits. If the partners fail to
create an agreement, the UPA says that the partners share equally in the
partnership's profits, even if their original capital contributions are unequal.
4. Larger pool of capital. The partnership form of ownership can significantly
broaden the pool of capital available to a business. Undercapitalization is a
common cause of business failures.
5. Ability to attract limited partners. Every partnership must have at least one
general partner (although there is no limit on the number of general partners a
business can have).
a) General partners have unlimited personal liability for the company's debts and
obligations and are expected to take an active role in managing the business.
b) Limited partners, on the other hand, cannot take an active role in the operation
of the company. They have limited personal liability for the company's debts
and obligations. Essentially, limited partners are financial investors who do
not participate in the day-to-day affairs of the partnership.
6. Little governmental regulation.
7. Flexibility. Partnerships can generally react quickly to changing market
conditions, because no giant organization stifles quick and creative responses to
new opportunities.
 Chapter 3 Choosing a Form of Ownership #

8. Taxation. The partnership itself is not subject to federal taxation. The partnership,
like the proprietorship, avoids the "double taxation'' disadvantage associated with
the corporate form of ownership.

j. jisadvantages of the Partnership

1. Unlimited liability of at least one partner. At least one member of every
partnership must be a general partner. The general partner has unlimited personal
liability, even though he is often the partner with the least personal resources.
2. Capital accumulation. It is generally not as effective as the corporate form of
ownership, which can raise capital by selling shares of ownership to outside in-
vestors.
3. jifficulty in disposing of partnership interest without dissolving the partnership.
Often, a partner is required to sell his interest to the remaining partner. Even if the
original agreement contains such a requirement and clearly delineates how the
value of each partner's ownership will be determined, there is no guarantee that
the other partners will have the financial resources to buy the seller's interest.
4. Lack of continuity. Partners can make provisions in the partnership agreement to
avoid dissolution due to death if all parties agree to accept as partners those who
inherit the deceased's interest.
5. Potential for personality and authority conflicts. Being in a partnership is much
like being married. Making sure partners' work habits, goals, ethics, and general
business philosophy are compatible is an important step in avoiding a nasty
business divorce. The demise of many partnerships can often be traced to
interpersonal conflicts and the lack of a partnership agreement for resolving those
conflicts.
6. The law of agency binds partners. A partner is like a spouse in that decisions
made by one, in the name of the partnership, bind all. Each partner is an agent for
the business and can legally bind the other partners to a business agreement.
E. jissolution and Termination of Partnership
1. Partnership dissolution is not the same as partnership termination.
a) jissolution occurs when a general partner ceases to be associated with the
business.
b) Termination is the final act of winding up the partnership as a business.
Termination occurs after the partners have expressed their intent to cease
operations and all affairs of the partnership have been concluded.
2. jissolution occurs as a result of one or more of the following events:
a) Expiration of a time period or completion of the project undertaken as
delineated in the partnership agreement.
b) Expressed wish of any general partner to cease operation.
c) Expulsion of a partner under the provisions of the agreement.
d) Withdrawal, retirement, insanity, or death of a general partner (except when
the partnership agreement provides for a method of continuation).
e) Bankruptcy of the partnership or of any general partner.
f) Admission of a new partner resulting in the dissolution of the old partnership
and establishment of a new partnership.
$ Section II Building the Business Plan: Beginning Considerations

g) Any event that makes it unlawful for the partnership to continue operations or
for any general partner to participate in the partnership.
h) A judicial decree that a general partner is insane or permanently incapacitated,
making performance or responsibility under the partnership agreement
impossible.
i) Mounting losses that make it impractical for the business to continue.
j) Impropriety or improper behavior of any general partner that reflects
negatively on the business.

F. Limited Partnerships

1. A limited partnership, which is a modification of a general partnership, is
composed of at least one general partner and at least one limited partner.
2. In a limited partnership the general partner is treated, under the law, exactly as in
a general partnership. Limited partners are treated as investors in the business
venture, and they have limited liability. They can lose only the amount they have
invested in the business.
3. Most states have ratified the Revised Uniform Limited Partnership Act. To form a
limited partnership, the partners must file a Certificate of Limited Partnership in
the state in which the limited partnership plans to conduct business.
4. The Certificate of Limited Partnership should include:
a) The name of the limited partnership.
b) The general character of its business.
c) The address of the office of the firm's agent authorized to receive summonses
or other legal notices.
d) The name and business address of each partner, specifying which ones are
general partners and which are limited partners.
e) The amount of cash contributions actually made, and agreed to be made in the
future, by each partner.
f) A description of the value of noncash contributions made or to be made by
each partner.
g) The times at which additional contributions are to be made by any of the
partners.
h) Whether and under what conditions a limited partner has the right to grant
limited partner status to an assignee of his or her interest in the partnership.
i) If agreed upon, the time or the circumstances when a partner may withdraw
from the firm (unlike the withdrawal of a general partner, the withdrawal of a
limited partner does not automatically dissolve a limited partnership).
j) It agreed upon, the amount of, or the method of determining, the funds to be
received by a withdrawing partner.
k) Any right of a partner to receive distributions of cash or other property from
the firm, and the times and circumstances for such distributions.
l) The time or circumstances when the limited partnership is to be dissolved.
m) The rights of the remaining general partners to continue the business after
withdrawal of a general partner.
n) Any other matters the partners want to include.
 Chapter 3 Choosing a Form of Ownership

5. Limited partners can make management suggestions to the general partners,
inspect the business, and make copies of business records.
6. A limited partner is, of course, entitled to a share of the business's profits as
agreed on and specified in the Certificate of Limited Partnership.
7. The primary disadvantage of limited partnerships is the complexity and the cost of
establishing them.

G. Master Limited Partnerships

1. A relatively new form of business structure, master limited partnerships (MLPs),
are just like regular limited partnerships, except their shares are traded on stock
exchanges.
2. They provide most of the same advantages to investors as a corporation--
including limited liability.
3. Master limited partnership profits typically must be divided among thousands of
partners.

H. Limited Liability Partnerships

1. Many states now recognize limited liability partnerships (LLPs) in which all
partners in the business are limited partners, having only limited liability for the
debts and obligations of the partnership. Most states restrict LLPs to certain types
of professionals such as attorneys, physicians, dentists, accountants, and others.
Just as with any limited partnership, the partners must file a Certificate of Limited
Partnership in the state in which the partnership plans to conduct business. Also,
like every partnership, an LLP does not pay taxes; its income is passed through to
the limited partners, who pay taxes on their shares of the company's net income.

GAINING THE COMPETITIVE EjGE

Avoiding Business jivorces


A failure to address the most important issues in running the business is why conflicts between
partners (and often friends), can quickly arise. Business disputes can normally be traced to one
or more of the following:
1) The lack of a written agreement between or among all involved that spell-out the duties,
privileges, and obligations of all owners.
2) The incompatibility of the owners as to the ultimate goals of the business.
3) The failure to reach agreement on what role each party will play in the decision-making
process.

The causes of failure serve to reinforce the need to make every effort to obtain a meeting of the
minds of all involved on all relevant strategic and operational issues and to commit the
agreement to writing. It is important to include an agreement on how conflicts between co-
owners will be resolved.

Some co-owners have established regularly scheduled meeting times to openly discuss the
operation of the business and any issues that are producing conflict. Sharing and discussing
these facts provide a common focus for the owners. Just like in a successful marriage, honesty,
 c Section II Building the Business Plan: Beginning Considerations

openness and a willingness to deal with issues causing conflict are critical elements in long-
term success in a business.

IV. The Corporation

A. jefinition
1. The Supreme Court has defined a corporation as "an artificial being, invisible,
intangible, and existing only in contemplation of the law."
a) It is the most complex of the three major forms of business ownership (See
Figure 3.1).
b) Responsible for more than 87 percent of sales and 69 percent of the income
gained from the three major forms of ownership (See Figures 3.2 and 3.3).
c) It is a separate entity apart from its owners and may engage in business, make
contracts, sue and be sued, and pay taxes.
d) Because the life of the corporation is independent of its owners, the
shareholders can sell their interest in the business without affecting its
continuation.
2. Corporations (also known as C corporations) are creations of the state.
a) When a corporation is founded, it accepts the regulations and restrictions of
the state in which it is incorporated and any other state in which it chooses to
do business.
b) A corporation doing business in the state in which it is incorporated is a
domestic corporation.
c) When a corporation conducts business in another state, that state considers it
to be a foreign corporation.
d) Corporations that are formed in other countries but do business in the United
States are alien corporations.
3. Corporations have the power to raise large amounts of capital by selling shares of
ownership to outside investors, but many corporations have only a handful of
shareholders.
a) Publicly held corporations are those that have a large number of shareholders,
and their stock is usually traded on one of the large stock exchanges.
b) Closely held corporations are those whose shares are in the control of a
relatively small number of people, often family members, relatives, or friends.
Their stock is not traded on any stock exchange.
4. In general, a corporation must report annually its financial operations to its home
state's attorney general.
a) There are substantially more reporting requirements for a corporation than for
the other forms of ownership.

B. Requirements for Incorporation

1. Most states allow entrepreneurs to incorporate without the assistance of an
attorney.
a) In some states, the application process is complex, and the required forms are
confusing.
b) The price for filing incorrectly can be high.
 Chapter 3 Choosing a Form of Ownership

2. Once the owners decide to form a corporation, they must choose the state in
which to incorporate.
a) States differ--sometimes dramatically--in the requirements they place on the
corporations they charter and in how they treat corporations chartered in other
states.
3. Every state requires a Certificate of Incorporation or charter to be filed with the
secretary of state.
a) The corporation's name. jifferent from any other firm in that state to avoid
confusion or deception and include a term such as corporation, incorporated,
company, or limited to notify the public that they are dealing with a
corporation.
b) The corporation's statement of purpose. The incorporators must state in
general terms the intended nature of the business.
c) The corporation's time horizon. Most corporations are formed with no specific
termination date; they are formed "for perpetuity." However, it is possible to
incorporate for a specific duration (e.g., 50 years).
d) Names and addresses of the incorporators. The incorporators must be
identified in the articles of incorporation and are liable under the law to attest
that all information in the articles of incorporation is correct.
e) Place of business. The post office address of the corporation's principal office
must be listed.
f) Capital stock authorization. The articles of incorporation must include the
amount and class (or type) of capital stock the corporation wants to be
authorized to issue.
g) Capital required at the time of incorporation. Some states require a newly
formed corporation to deposit in a bank a specific percentage of the stock's par
value before incorporating.
h) Provisions for preemptive rights, if any, that are granted to stockholders.
i) Restrictions on transferring share. Many closely held corporations require
shareholders interested in selling their stock to offer it first to the corporation.
(Shares the corporation itself owns are called treasury stock.)
j) Names and addresses of the officers and directors of the corporation.
k) Rules under which the corporation will operate. Bylaws are the rules and
regulations the officers and directors establish for the corporation's internal
management and operation.
4. Once incorporation is approved and the fees are paid, the approved articles of
incorporation become its charter.
a) The next order of business is to hold an organizational meeting for the
stockholders to formally elect directors, who, in turn, will appoint the
corporate officers.

C. Advantages of the Corporation

1. Limited liability of stockholders. The primary reason most entrepreneurs choose
to incorporate is to gain the benefit of limited liability, which means that investors
can limit their liability to the total amount of their investment.
 Section II Building the Business Plan: Beginning Considerations

a) This legal protection of personal assets beyond the business is of critical
concern to many potential investors.
b) Courts are increasingly holding entrepreneurs personally liable for
environmental, pension, and legal claims against their corporations--much to
the surprise of the owners, who chose the corporate form of ownership to
shield themselves from such liability.
c) Courts will pierce the corporate veil and hold owners liable for the company's
debts and obligations if the owners deliberately commit criminal or negligent
acts when handling corporate business.
d) Corporate shareholders most commonly lose their liability protection,
however, because owners and officers have commingled corporate funds with
their personal funds.
e) Positive steps that should be taken to avoid legal difficulties include the
following:
(1) File all of the reports and pay all of the necessary fees required by the state
in a timely manner.
(2) Hold annual meetings to elect officers and directors
(3) Keep minutes of every meeting of the officers and directors, even if it
takes place in the living room of the founders.
(4) Make sure that the corporation¶s board of directors makes all major
decisions.
(5) Make it clear that the business is a corporation by having all officers sign
contracts, loan agreements, purchase orders, and other legal documents in
the corporation¶s name rather than their own names.
(6) Keep corporate assets and the personal assets of the owner¶s separate.
2. Ability to attract capital.
a) Corporations have proved to be the most effective form of ownership for
accumulating large amounts of capital.
3. Ability to continue indefinitely.
a) Unless limited by its charter, a corporation is a separate legal entity and can
continue indefinitely.
4. Transferable ownership.
a) If stockholders so desire, they may transfer their shares through sale or
bequeath to someone else.

j. jisadvantages of the Corporation

1. Cost and time involved in the incorporation process. Creating a corporation can
cost between $500 and $2,500, typically averaging around $1,000.
2. jouble taxation. Because a corporation is a separate legal entity, it must pay taxes
on its net income to the federal, most state, and some local governments before
issuing any net income as dividends.
a) Then, stockholders must pay taxes on the dividends they receive from these
same profits at the individual tax rate.
b) Thus, a corporation's profits are taxed twice.
3. Potential for diminished managerial incentives.
 Chapter 3 Choosing a Form of Ownership 

a) Because they created their companies and often have most of their personal
wealth tied up in them, entrepreneurs have an intense interest in ensuring their
success and are willing to make sacrifices for their businesses.
b) Professional managers an entrepreneur brings in to help run the business as it
grows do not always have the same degree of interest in or loyalty to the
company.
4. Legal requirements and regulatory red tape.
a) Corporations are subject to more legal and financial requirements than other
forms of ownership. Managers may be required to submit some major
decisions to the stockholders for approval. Corporations that are publicly held
must file quarterly and annual reports with the Securities and Exchange
Commission (SEC).
5. Potential loss of control by the founders.
a) When entrepreneurs sell shares of ownership in their companies, they
relinquish some control, especially when they need large capital infusions for
start-up or growth.

E. The Professional Corporation

1. A professional corporation is designed to offer professionals such as lawyers,
doctors, dentists, accountants, and others the advantage of the corporate form of
ownership.
2. It is ideally suited for licensed professionals, who must always be concerned
about malpractice lawsuits, because it offers limited liability.
3. They often are identified by the abbreviation P.C. (professional corporation), P.A.
(professional association), or S.C. (service corporation).

V. Alternative Forms of Ownership

A. The S Corporation
1. In 1954 the Internal Revenue Service Code created the Subchapter S corporation.
2. In recent years the IRS has changed the title to S corporation and has made a few
modifications in its qualifications.
3. An S corporation is a distinction that is made only for federal income tax purposes
and is, in terms of legal characteristics, no different from any other corporation.
4. S corporation criteria.
a) It must be a domestic (U.S.) corporation.
b) It cannot have a nonresident alien as a shareholder.
c) It can issue only one class of common stock, which means that all shares must
carry the same fights (e.g., the fight to dividends or liquidation rights). The
exception is voting rights, which may differ. In other words, an S corporation
can issue voting and nonvoting common stock.
d) It cannot have more than 75 shareholders (increased from 35).
5. By increasing the number of shareholders allowed in S corporations to 75, the
new law makes succession planning easier for business owners.
6. The new law also permits them to sell shares of their stock to certain tax-exempt
organizations such as pension funds.
 Section II Building the Business Plan: Beginning Considerations

a) Previous rules limited ownership strictly to individuals, estates, and certain
trusts.
7. Violating any of the requirements for an S corporation automatically terminates a
company's S status.
a) If a corporation satisfies the definition for an S corporation, the owners must
actually elect to be treated as one. Filing IRS Form 2553 (within the first 75
days of the tax year) makes the election, and all shareholders must consent.
8. Advantages of an S Corporation.
a) S corporations retain all of the advantages of a regular corporation, such as
continuity of existence, transferability of ownership, and limited personal
liability for its owners.
b) It passes all of its profits or losses through to the individual shareholders, and
its income is taxed only once at the individual tax rate.
(1) Thus avoiding double taxation.
c) Another advantage of the S corporation is that it avoids the tax C corporations
pay on assets that have appreciated in value and are sold.
(1) Also, owners of S corporations enjoy the ability to make year-end payouts
to themselves if profits are high.
9. jisadvantages of an S Corporation.
a) When the 2001 tax legislation was enacted it restructured individual tax rates
and many business owners switched to S corporations to lower their tax bills.
.
b) In 1993, Congress realigned the tax structure by raising the maximum
personal tax rate to 39.6 percent from 31 percent.
c) Entrepreneurs must consider the total impact of tax implications, the size of
company net profits, shareholder tax rates, etc., when choosing their corporate
form.
10. When Is an S Corporation a Wise Choice?
a) Choosing S Corporation status is usually beneficial to start-up companies
anticipating net losses and to highly profitable firms with substantial
dividends to pay out to shareholders.
(1) The owner can use the loss to offset other income or to remain in a lower
tax bracket than the corporation, thus saving money in the long run.
b) Companies that plan to reinvest most of their earnings to finance growth also
find S corporation status favorable.
c) Small business owners who intend to sell their companies in the near future
will prefer S over C status, because the taxable gains on the sale of an S
corporation are generally lower than those on the sale of a C corporation.
d) On the other hand, small companies with the following characteristics are not
likely to benefit from S corporation status:
(1) Highly profitable personal-service companies with large numbers of
shareholders, in which most of the profits are passed on to shareholders as
compensation or retirement benefits.
(2) Fast-growing companies that must retain most of their earnings to finance
growth and capital spending.
 Chapter 3 Choosing a Form of Ownership !

(3) Corporations in which the loss of fringe benefits to shareholders exceeds

tax savings.
(4) Corporations in which the income before any compensation to
shareholders is less than $100,000 a year.
(5) Corporations with sizable net operating losses that cannot be used against
S corporation earning.

B. The Limited Liability Company (LLC}

1. A relatively new creation, it is a cross between a partnership and a corporation.
2. Originating in Wyoming in 1977.
3. Combines benefits of the partnership and the corporate forms of ownership but is
not subject to many of the restrictions imposed on S corporations.
a) An LLC can have one owner, most have multiple owners (called members).
b) An LLC offers its owners limited liability without imposing any requirements
on their characteristics or any ceiling on their numbers.
c) An LLC does not restrict its members' involvement in managing the company.
d) LLCs also avoid the double taxation imposed on C corporations.
e) Like an S corporation, an LLC does not pay income taxes; its income flows
through to the members, who are responsible for paying income taxes on their
shares of the LLC's net income.
f) LLCs offer entrepreneurs flexibility. Like a partnership, an LLC permits its
members to divide income (and thus tax liability) as they see fit.
g) These advantages make the LLC an ideal form of ownership for small
companies in virtually any industry.
(1) They are becoming especially popular among family-owned businesses
because of the benefits they offer.
4. Creating an LLC
a) Forming an LLC requires an entrepreneur to file two documents with the
secretary of state: the articles of organization and the operating agreement.
b) The LLCs articles of organization, similar to the corporation's articles of
incorporation, establish the company's name, its method of management
(board-managed or member-managed), its duration, and the names and
addresses of each organizer.
c) In most states, the company's name must contain the words limited liability
company, limited company, or the letters L.L.C. or L.C.
d) An LLC's charter may not exceed 30 years.
(1) The same factors that would cause a partnership to dissolve would also
cause an LLC to dissolve before its charter expired.
e) The operating agreement, similar to a corporation's bylaws, outlines the
provisions governing the way the LLC will conduct business.
(1) The operating agreement must create an LLC that has more characteristics
of a partnership than of a corporation to maintain this favorable tax
treatment.
f) Specifically, an LLC cannot have any more than two of the following four
corporate characteristics:
" Section II Building the Business Plan: Beginning Considerations

(1) Limited liability. Limited liability exists if no member of the LLC is

personally liable for the debts or claims against the company.
(2) Continuity of life. To avoid continuity of life, any LLC member must have
the power to dissolve the company.
(3) Free transferability of interest. To avoid this characteristic, the operating
agreement must state that a recipient of a member's LLC stock cannot
become a substitute member without the consent of the remaining
members.
(4) Centralized management. To avoid this characteristic, the operating
agreement must state that the company elects to be "member-managed."
5. LLC jisadvantages.
a) They can be expensive to create, often costing between $1,500 and $5,000.
(1) It may pose problems for business owners who are considering converting
an existing business to an LLC.

C. The Joint Venture

1. A joint venture is very much like a partnership, except that it is formed for a
specific, limited purpose.
a) Example. Suppose that you have a 500-acre tract of land 60 miles from
Chicago. This land has been cleared and is normally used for farming. One of
your friends has solid contacts among major musical groups and would like to
put on a concert. You expect prices for your agricultural products to be low
this summer, so you and your friend form a joint venture for the specific
purpose of staging a three-day concert. Your contribution will be the exclusive
use of the land for one month, and your friend will provide all the performers
as well as technicians, facilities, and equipment. All costs will be paid out of
receipts, and the net profits will be split, with you receiving 20 percent for the
use of your land. When the concert is over, the facilities removed, and the
accounting for all costs completed, you and your friend will split the profits
20-80, and the joint venture will terminate.
2. The "partners'' form a new joint venture for each new project they undertake. The
income derived from a joint venture is taxed as if it had arisen from a partnership.
3. In any endeavor in which neither party can effectively achieve the purpose alone,
a joint venture becomes a common form of ownership.

VI. Summary of the Major Forms of Ownership

A. Figure 3.2
1. Shows the liability features of the major forms of ownership discussed in this
chapter.
B. Table 3.1
1. Summarizes of the key features of the sole proprietorship, the partnership, the C
corporation, the S corporation, and the limited liability company.
 Chapter 3 Choosing a Form of Ownership #


%&

1. jescribe the advantages and disadvantages of the sole proprietorship.
½ A sole proprietorship is a business owned and managed by one individual and is the
most popular form of ownership.
½ Sole proprietorships offer these advantages:
½ Simple to create
½ Least costly form to begin
½ Owner has total decision making authority
½ No special legal restrictions
½ Easy to discontinue
½ Sole proprietorships suffer from these disadvantages:
½ Unlimited personal liability of owner
½ Limited managerial skills and capabilities
½ Limited access to capital
½ Lack of continuity

2. jescribe the advantages and disadvantages of the partnership.

½ A partnership is an association of two or more people who co-own a business for the
purpose of making a profit.
½ Partnerships offer these advantages
½ Easy to establish
½ Complimentary skills of partners
½ jivision of profits
½ Larger pool of capital available
½ Ability to attract limited partners
½ Little government regulation
½ Flexibility
½ Tax advantages
½ Partnerships suffer from these disadvantages.
½ Unlimited liability of at least one partner
½ jifficulty in disposing of partnership interest
½ Lack of continuity
½ Potential for personality and authority conflicts
½ Partners are bound by the law of agency

3. A limited partnership operates like any other partnership except that it allows limited partners
(primary investors that cannot take an active role in managing the business) to become
owners without subjecting themselves to unlimited personal liability for the company¶s debts.

4. jescribe the advantages and disadvantages of the corporation.

½ A corporation, the most complex of the three basic forms of ownership, is a separate
legal entity. To form a corporation, an entrepreneur must file the articles of
incorporation with the state in which the company will incorporate.
½ Corporations offer these advantages.
½ Limited liability of stockholders
½ Ability to attract capital
$ Section II Building the Business Plan: Beginning Considerations

½ Ability to continue indefinitely

½ Transferable ownership
½ Corporations suffer from these disadvantages.
½ Cost and time in incorporating
½ jouble taxation
½ Potential for diminished managerial incentives
½ Legal requirements and regulatory red tape
½ Potential loss of control by the founders

5. jescribe the advantages and disadvantages of the alternative forms of ownership such as the
S corporation, the limited liability company, and the joint venture.
½ An S corporation offers its owners limited liability protection, but avoids the double
taxation of C corporations.
½ A limited liability company, like an S corporation, is a cross between a partnership
and a corporation. However, it operates without the restrictions imposed on an S
corporation. To create a LLC, an entrepreneur must file the articles of organization
and the operating agreement with the secretary of state.
½ A joint venture is like a partnership, except that it is formed for a specific purpose.

j  
' 

1. What factors should an entrepreneur consider before choosing a form of ownership?
—


Tax considerations. Because of the graduated tax rates under each form of
ownership, the government's constant tinkering with the tax code, and the year-to-year
fluctuations in a company's income, an entrepreneur should calculate the firm's tax bill under
each ownership option every year. Liability exposure. Certain forms of ownership offer
business owners greater protection from personal liability due to financial problems, faulty
products, and a host of other difficulties. Start-up and future capital requirements. Forms of
ownership differ in their ability to raise start-up capital. Control. Entrepreneurs must decide
early on how much control they are willing to sacrifice in exchange for help from other
people in building a successful business. Managerial ability. If an entrepreneur lack skills or
experience in certain areas, he/she may need to select a form of ownership that allows
him/her to bring into the company people who possess those skills and experience. Business
goals. How big and how profitable an entrepreneur plans for the business to become will
influence the form of ownership chosen. Management succession plans. Some forms of
ownership make this transition much smoother than others. In other cases, when the owner
dies, so does the business. Cost of formation. Some forms of ownership are much more
costly and involved to create than others. Entrepreneurs must weigh carefully the benefits
and the costs of the particular form they choose.

2. Why are sole proprietorships so popular as a form of ownership?

—


The sole proprietorship is a business owned and managed by one individual. This
form of ownership is by far the most popular. Approximately 74 percent of all businesses in
the United States are sole proprietorships. It is very popular for several reasons; the ease and
speed of its formation, it is the least costly form of ownership to establish, the owner can
keep the profits (less expenses and taxes, of course), total control of operations and can
 Chapter 3 Choosing a Form of Ownership 

respond quickly to changes, it is the least regulated form of business ownership, and it is easy
to discontinue.

3. How does personal conflict affect partnerships? How can co-owners avoid becoming
sparring partners?
—


Being in a partnership is much like being married. Making sure partners' work
habits, goals, ethics, and general business philosophy are compatible is an important step in
avoiding a nasty business divorce. The demise of many partnerships can often be traced to
interpersonal conflicts and the lack of a partnership agreement for resolving those conflicts.

4. What issues should the articles of partnership address? Why are the articles important to a
successful partnership?
—
- There are two answers, the most complete is related to the partnership agreement
drawn up by the partners. The second is the generic issues covered by the UPA when no
written agreement exists.

The standard partnership agreement will likely include the following: name of the
partnership, purpose of the business, domicile of the business, duration of the partnership,
names of the partners and their legal addresses, contributions of each partner to the business
at the creation of the partnership and later, agreement on how the profits or losses will be
distributed, agreement on salaries or drawing rights against profits for each partner,
procedure for expansion through the addition of new partners, distribution of the
partnership's assets if the partners voluntarily dissolve the partnership, sale of partnership
interest, absence or disability of one of the partners, voting rights, decision-making authority,
financial authority, handling tax matters, and how alterations or modifications of the
partnership agreement will be made.

Under the UPA, the three key elements of any partnership are common ownership interest in
a business, sharing the business's profits and losses, and the fight to participate in managing
the operation of the partnership. Under the act, each partner has the right to: share in the
management and operations of the business, share in any profits the business might earn from
operations, receive interest on additional advances made to the business, be compensated for
expenses incurred in the name of the partnership, have access to the business's books and
records, and receive a formal accounting of the partnership's business affairs.

5. Can one partner commit another to a business deal without the other's consent? Why?
—


the law of agency binds Partners. A partner is like a spouse in that decisions made
by one, in the name of the partnership, bind all. Each partner is an agent for the business and
can legally bind the other partners to a business agreement.

6. Explain the differences between a domestic corporation, a foreign corporation, and an alien
corporation.
—


A corporation doing business in the state in which it is incorporated is a domestic
corporation. When a corporation conducts business in another state, that state considers it to
be a foreign corporation. Corporations that are formed in other countries but do business in
the United States are alien corporations.
c Section II Building the Business Plan: Beginning Considerations

7. What issues should the Certificate of Incorporation cover?

—


Every state requires a Certificate of Incorporation or charter to be filed with the
secretary of state. It includes: the corporation's name, the corporation's statement of purpose,
the corporation's time horizon, names and addresses of the incorporators, place of business,
capital stock authorization, and capital required at the time of incorporation, provisions for
preemptive rights, if any, that are granted to stockholders, restrictions on transferring share,
names and addresses of the officers and directors of the corporation, and the rules under
which the corporation will operate.

8. How does an S corporation differ from a regular corporation?

—


An S corporation is a distinction that is made only for federal income tax purposes
and is, in terms of legal characteristics, no different from any other corporation. S
corporation criteria: it must be a domestic (U.S.) corporation, it cannot have a nonresident
alien as a shareholder, and it can issue only one class of common stock, which means that all
shares must carry the same fights (e.g., the fight to dividends or liquidation rights). The
exception is voting rights, which may differ. In other words, an S corporation can issue
voting and nonvoting common stock, and it cannot have more than 75 shareholders.

9. How does a joint venture differ from a partnership?

—


A joint venture is very much like a partnership, except that it is formed for a
specific, limited purpose. The "partners'' form a new joint venture for each new project they
undertake. The income derived from a joint venture is taxed as if it had arisen from a
partnership. In any endeavor in which neither party can effectively achieve the purpose
alone, a joint venture becomes a common form of ownership.

10.What role do limited partners play in a partnership? What will happen if a limited partner
takes an active role in managing the business?
—


A limited partnership, which is a modification of a general partnership, is
composed of at least one general partner and at least one limited partner. In a limited
partnership the general partner is treated, under the law, exactly as in a general partnership.
Limited partners are treated as investors in the business venture, and they have limited
liability. They can lose only the amount they have invested in the business. Limited partners
can make management suggestions to the general partners, inspect the business, and make
copies of business records. A limited partner is, of course, entitled to a share of the business's
profits as agreed on and specified in the Certificate of Limited Partnership. The primary
disadvantage of limited partnerships is the complexity and the cost of establishing them.

11.What advantages does a limited liability company offer over an S corporation? Over a
partnership?
—


Many states now recognize limited liability partnerships (LLPs) in which all
partners in the business are limited partners, having only limited liability for the debts and
obligations of the partnership. Most states restrict LLPs to certain types of professionals such
as attorneys, physicians, dentists, accountants, and others. Just as with any limited
partnership, the partners must file a Certificate of Limited Partnership in the state in which
the partnership plans to conduct business. Also, like every partnership, an LLP does not pay
 Chapter 3 Choosing a Form of Ownership 

taxes; its income is passed through to the limited partners, who pay taxes on their shares of
the company's net income.

12.How is an LLC created?

—


Forming an LLC requires an entrepreneur to file two documents with the secretary
of state: the articles of organization and the operating agreement. The LLCs articles of
organization, similar to the corporation's articles of incorporation, establish the company's
name, its method of management (board-managed or member-managed), its duration, and the
names and addresses of each organizer. In most states, the company's name must contain the
words limited liability company, limited company, or the letters L.L.C. or L.C. An LLC's
charter may not exceed 30 years. The operating agreement, similar to a corporation's bylaws,
outlines the provisions governing the way the LLC will conduct business. The operating
agreement must create an LLC that has more characteristics of a partnership than of a
corporation to maintain this favorable tax treatment.

13.What criteria must an LLC meet to avoid double taxation?

—


—n LLC cannot have any more than two of the following four corporate
characteristics:
½ Limited liability. Limited liability exists if no member of the LLC is personally liable for
the debts or claims against the company.
½ Continuity of life. To avoid continuity of life, any LLC member must have the power to
dissolve the company.
½ Free transferability of interest. To avoid this characteristic, the operating agreement must
state that a recipient of a member's LLC stock cannot become a substitute member
without the consent of the remaining members.
½ Centralized management. To avoid this characteristic, the operating agreement must state
that the company elects to be "member-managed."

%


(
)*

1. Interview five local small business owners. What form of ownership did they choose? Why?
Prepare a brief report summarizing your findings, and explain advantages and disadvantages
those owners face because of their choices.
2. Contact your secretary of state to determine the status of limited liability companies in your
state. Are they recognized? How does an entrepreneur create one? What requirements must
an LLC meet? Report your findings to the class.
3. Invite entrepreneurs who operate as partners to your classroom. jo they have a written
partnership agreement? Are their skills complementary? How do they divide responsibility
for running their company? How do they handle decision making? What do they do when
disputes and disagreements arise?
4. Find in the Yellow Pages of your local telephone book the names of four businesses that you
think are effective marketing tools. Also find four companies whose names do little or
nothing to help market their products or services. Explain the reasons for your choices. Select
a business with the "wrong" name and work with a team of your classmates to brainstorm a
better name.
5. Find three local small businesses that are utilizing the Internet to reach their target audience.
Interview the owners to determine their level of online involvement for marketing their
 Section II Building the Business Plan: Beginning Considerations

product/services both regionally and/or nationally. Also, determine from these individuals
how they obtained the necessary information for starting a small business (i.e. Small
Business Administration, Internet, family, legal counsel, etc). Have them discuss the pros
and cons of their choice for information.