1. Choosing the Legal Form of Organization
Chapter 11
Choosing the Legal Form of Organization

2. 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 the decision about which legal form to use for which purpose
Discuss how a business entity can evolve from one legal form to another

3. Table 11.1: Comparison of Legal Forms

4. 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

5. Sole Proprietorships Advantages of sole proprietorships:
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

6. Sole Proprietorships (continued)
Disadvantages of sole proprietorships:
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

7. Partnerships
Partnership - two or more people agree to share the assets, liabilities, profits of a business
Advantages:
Have 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

8. Partnerships (continued)
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

9. Partnership Agreement
Based on the Uniform Partnership Act, it defines the relationship between partners in terms of…
business responsibilities
profit sharing
transfer of interest
Buy-sell Agreement:
Who is entitled to purchase the 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
Use of proceeds upon the partner’s death to buy out partner or keep the business going

10. Table 11.2: Structuring an Effective Partnership Agreement

11. 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-sell real property
Lend money
Owners rights:
As stockholders they invest capital in exchange for shares
No liability for corporation’s debts
Can only lose the money they invest

12. C-Corporation Advantages: Limited liability for owners
Capital can be raised through sale of stock
Ownership is transferable
Binding contracts do not need individual owner signature
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

13. C-Corporation (continued)
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

14. C-Corporation (continued)
Where to incorporate:
In the state in which the business is located
In states with favorable tax laws
Delaware - if seeking venture capital

15. S-Corporation Advantages:
Business losses can be passed through for taxation at entrepreneur’s personal tax rate
Avoids double taxation of income
Disadvantages:
Retained earnings no longer available for expansion or diversification
No deductions on medical reimbursements or health insurance plans

16. Professional Corporations
Licensed service professionals’ corporation organized to provide their services

17. Limited Liability Company
Privately held companies which incorporate under strict guidelines
Advantages:
Tax and liability pass through obligations
Limited liability
Continuity of life
Centralized management
Free transferability of interests
No limits on number of members or status

18. Limited Liability Company (continued)
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
May not have foreign ownership rights

19. The Nonprofit Corporation
A corporation established for charitable, public, religious purposes or for mutual benefit as recognized by federal and state laws.
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-private agencies
May qualify for tax-exempt status

20. The Nonprofit Corporation (continued)
Disadvantages:
Profits cannot be distributed as dividends
Corporate money cannot be contributed to political campaigns or for lobbying
Entrepreneur gives up proprietary interest in the corporation
Upon dissolution, all assets must transfer to another tax-exempt nonprofit organization
Substantial profits must come only from related activities
It must pay taxes on profits

21. Making the Decision About Legal Form
Ask the right questions
Does the founding team have the necessary operational skills?
Do the founders have the required start up capital?
Will the founders be able to run the business and cover the first year’s living expenses?
Are the founders willing/able to assume personal liability for claims against the business?
Do the founders wish to have complete control over operations?
Do the founders expect initial losses?
Do the founders expect to sell the business some day?

22. Making the Decision About Legal Form (continued)
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-members