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

BUSINESS FORMS: COMPARING THE NUMBERS Total Number of Businesses by Form of Ownership (Millions) Total Net Income by Form of Ownership ($Billions)

SOLE PROPRIETORSHIP: BUSINESS AT ITS MOST BASIC  Advantages:  Ease of Formation 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 CategoryExamplesNumber of Proprietorships (thousands) Professional, Technical, and Scientific Services Law firms, accountants, architects, computer system designers, consultants 2,752 ConstructionResidential construction, commercial construction, specialty contractors 2,491 Retail TradeCar dealerships, restaurants, clothing stores, home & garden stores 2,416 Other ServicesAutomobile repair and body shops, laundries, personal services 1,995 Health CarePhysicians, dentists, chiropractors, psychologists, psychiatrists 1,762 Source for Table: “Sole Proprietorship Returns”, by Kevin Pierce Statistics of Income Bulletin, Summer, 2005, Figure A, p.9; website: )

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 Mutual Agency

LIMITED PARTNERSHIPS Limited Partnership – includes at least one general partner and at least one limited partner 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 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 establishes the mission and objectives.  The Board is elected by the stockholders to represent their interests.

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 Foreign Company – operates in a state other than the state in which it was organized. Alien Company – operates in a country other than the country in which it was organized.

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 TYPE 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 Sole Proprietorships Partnerships Corporations LOWHIGHDEGREE OF COMPLEXITY AND PERPETUITY HIGHLOWDEGREE 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 MergerDefinitionObjectiveExample HorizontalCombine firms in same industry. Increase size Increase market power Gain efficiency AT&T and SBC VerticalCombine companies with buyer-seller relationship. Provide tighter integration and increase control Time Warner and Turner Broadcasting ConglomerateCombination 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.  Subway  Jiffy Lube  7-Eleven  McDonalds  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.