©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHOOSING THE LEGAL FORM OF ORGANIZATION 10

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives  Distinguish between sole proprietorships and partnerships.  Discuss the corporate form and its advantages and disadvantages.  Explain the limited liability company.  Define the nonprofit corporation.  Make a decision about which legal form to use for which purpose.  Discuss how a business entity can evolve from one legal form to another.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Legal Forms of Organization Figure 10.1

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Making the Decision About Legal Form  Ask the right questions: 1.Does the founding team have the necessary operational skills? 2.Do the founders have the required start up capital? 3.Will the founders be able to run the business and cover the first year’s living expenses? 4.Are the founders willing/able to assume personal liability for claims against the business? 5.Do the founders wish to have complete control over operations? 6.Do the founders expect initial losses? 7.Do the founders expect to sell the business some day?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sole Proprietorships and Partnerships  Legal structure alternatives for business: Sole Proprietorship Partnership Limited Liability Company Corporation (C or Subchapter S)  Choosing the right structure depends upon: Legal and tax ramifications

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sole Proprietorships  Advantages: Easy and inexpensive to create 100% of ownership + profits stay with the owner Complete decision making authority for the owner Income is taxed only at the owner’s personal income tax rate No major reporting requirements exist

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sole Proprietorships (cont’d)  Disadvantages: Owner has unlimited liability for all claims against the business-all debts must be paid from the owner’s assets. Difficult for the owner to raise debt capital. Survival of the business depends upon the owner.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Partnerships  Partnership: two or more people agree to share the assets, liabilities, profits of a business. General and limited  Advantages: Same advantages as sole proprietorships Shared risk of doing business Shared partner clout with multiple financial statements Shared ideas, expertise, decision making Partners receive pass-through earnings and losses taxed at their personal tax rates.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Partnerships (cont’d)  Disadvantages: Partners are personally liable for all business debts and obligations. Individual partners can bind the partnership contractually. Partnership dissolution results when a partner leaves or dies (unless otherwise stated in partnership agreement). Partners can be sued individually for the full amount of partnership debt.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Partnership Agreement  Based on the Uniform Partnership Act, it defines the relationship between partners in terms of: Business responsibilities Profit sharing Transfer of interest

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Partnership Agreement (cont’d)  Buy-sell agreement: Binding contract between partners Who is entitled to purchase departing partner’s share? What events trigger a buyout? What is the price to be paid for the partner’s interest?  Key-person life insurance: Life insurance policy on principal partner members Insurance proceeds upon partner death may be used to keep the business going or buy out the deceased partner’s interest

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structuring an Effective Partnership Agreement Figure 10.2

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporation  U.S. Supreme Court Definition : “An artificial being, invisible, intangible, and existing only in contemplation of the law.”  Powers include rights to: Sue and be sued Acquire and sell real property Lend money  Owners rights: As stockholders they invest capital in exchange for shares of ownership No liability for corporation’s debts Can only lose the money they invest

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C-Corporation  Advantages: Limited liability for owners Capital can be raised through sale of stock Ownership is transferable Enjoys status and deference in business circles Employee access to retirement funds, defined- contribution, profit-sharing and stock option plans The entrepreneur can hold personal assets which can be leased back to the corporation for a fee

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C-Corporation (cont’d)  Disadvantages: More complex to organize Subject to more governmental regulation Cost more to create Stockholders do not receive benefit of losses Ownership control passes to the board of directors

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C-Corporation (cont’d)  Where to incorporate: In the state in which the business is located In states with favorable tax laws Delaware, if seeking venture capital

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. S-Corporation  Not a tax-paying entity  Has largely been replaced by the LLC (Limited Liability Company), a more flexible form  May have no more than 100 shareholders who must be U.S. citizens or residents  Profits & losses must be allocated in proportion to each shareholder’s interest

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. S-Corporation (cont’d)  Advantages: Business losses can be passed through for taxation at entrepreneur’s personal tax rate Avoids double taxation of income  Disadvantages: Not a favorable option if there is desire to retain earnings for expansion or diversification No deductions on medical reimbursements or health insurance plans

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Professional Corporations  Licensed service professionals’ corporation organized to provide their services Limited liability company (LLC) Professional limited liability company (PLLC) Limited liability partnership (LLP)

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Nonprofit Corporation  A corporation established for charitable, public, or religious purposes, or for mutual benefit as recognized by federal and state laws.  Two distinct hurdles for nonprofit operation and tax-exempt status: 1.Must meet state requirements for being designated as a nonprofit corporation and operating as such in a given state 2.Must meet the federal and state requirements for exemption from paying taxes by forming a corporation that falls within the IRS’s narrowly defined categories

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Nonprofit Corporation (cont’d)  Advantages: Attractive to corporate donors for business expense deductions Can seek cash and in-kind contributions of equipment, supplies, personnel Can apply for grants from government agencies and private foundations May qualify for tax-exempt status

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Nonprofit Corporation (cont’d)  Disadvantages: Profits cannot be distributed as dividends. Corporate money cannot be contributed to political campaigns or used for lobbying. Entrepreneur gives up proprietary interest in the corporation. Upon dissolution, all assets must transfer to another tax-exempt nonprofit organization. Cannot make substantial profits from unrelated activities. It must pay taxes on profits.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Limited Liability Company  LLC’s are privately held companies which incorporate under strict guidelines.  Characteristics: Must file in the state in which they intend to do business No minimum number of people required to form Owners are called members, and shares of ownership are called interests Members may manage company or hire others to manage it

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Limited Liability Company (cont’d)  Advantages: Income tax and liability pass through to members Exhibits all 4 characteristics of a corporation: 1.Limited liability 2.Continuity of life 3.Centralized management 4.Free transferability of interests No limits on number of members or status LLC’s may actually possess wholly owned subsidiary corporations Not limited to one class of stock

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Limited Liability Company (cont’d)  Disadvantages: Formation filing fee is obligatory Consensus is difficult if there are many members It is not a separate tax-paying entity Members must file quarterly IRS statements Can be obliged to register with the SEC Allows inclusion of foreign investors

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Choosing the Legal Form  Choosing the right form at each milestone: Know the strategic plan from the outset. Know the possibilities for changing legal form. Know the expected capital and liquidity needs. Know the tax implications for owners and members.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. New Venture Action Plan Answer the seven questions before considering which legal form to choose. Consult with an appropriately qualified attorney to determine the best form to meet your business goals. Complete the necessary agreements for the legal form you have chosen. Determine if you meet the test for tax exemptions under IRC 501(3)(c) if you are founding a nonprofit corporation. Meet with a qualified attorney to determine what other legal issues that may arise.