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 Liability Exposure Managerial Ability Business Goals The “Big Three” is Becoming the “Big Four”: Sole Proprietorship Partnership Corporation Limited Liability Company There has been a large amount of growth in the number of LLCs which is becoming another one of the popular business formation types. The Big Three seems to becoming the Big Four.

BUSINESS FORMS: COMPARING THE NUMBERS

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 Law firms, accountants, architects, computer system designers, consultants 2,752 Professional, Technical, and Scientific Services Residential construction, commercial construction, specialty contractors 2,491 Construction Car dealerships, restaurants, clothing stores, home & garden stores 2,416 Retail Trade Automobile repair and body shops, laundries, personal services 1,995 Other Services Physicians, dentists, chiropractors, psychologists, psychiatrists 1,762 Health Care Source 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 )

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

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 have limited liability

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.

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 Elected by stockholders to oversee the operation of their company and protect their interests Oversee the operation of corporation and protect investors’ interest Establish mission and set objectives Rarely get involved in day-to-day management Responsible for monitoring the performance of the corporate officers

Articles of Incorporation Corporate Name Shares of stock the corporation is authorized to issue Number of shares each owner will buy Each owner’s contribution to obtain stock Business of the corporation Management structure of the corporation

CORPORATIONS Disadvantages: Advantages: Expense/complexity of formation and operation Double Taxation Paperwork and Regulation Conflicts of Interest Advantages: Limited Liability Permanence Easy to Transfer Ownership Ability to Raise Capital Specialized Management

OTHER TYPES OF CORPORATIONS: SAME BUT DIFFERENT S Corporation Closed Corporation Non-profit Corporation Review Table 5.1 from text.

COMPARING TYPES OF CORPORATIONS KEY ADVANTAGE LIMITATIONS 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 required 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 High Low HIGH LOW DEGREE OF PERSONAL LIABILITY Sole Proprietorships Partnerships Corporations Low High Note the conflict between ease and perpetuity as well as liability. Comment how business form is an important decision. LOW HIGH DEGREE OF COMPLEXITY AND PERPETUITY

CORPORATE RESTRUCTURING Mergers – two companies agree to a combination of equals. Acquisitions – when one firm buys another. Large corporations constantly look for ways to grow and achieve competitive advantage.

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 Broadcasting Conglomerate Combination of unrelated companies. Increase company’s diversity. GE acquiring RCA Click the link to the FTC website and review any Mergers and Acquisitions currently being reviewed/announced. Also, click the competition tab to review the FTC definitions of M&A as well as current cases and proceedings.

DIVESTITURES: WHEN LESS IS MORE Divestitures allow the firm to streamline their operations and focus Spin-off – setting up the division or part of the business as a separate company Sell stock to existing stockholders Carve-out – setting up a separate business from an operation Sell stock to outside investors