1. Forms of Business Ownership6
Forms of Business Ownership
Better Business
3rd Edition
Solomon (Contributing Editor) · Poatsy · Martin
chapter
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2. Choosing a Form of Business Ownership
Owning a
Business
The Five
Most Common Forms –
The designated type of
business as it is
operated in regards to tax
& liability reasons
Sole Proprietorship – the business is owned by a single individual Partnership – two or more people serve as co-owners of the business Corporation (C-Corp) – the business is a separate legal entity S-Corporation – regular corporation that has elected to be taxed under a special section of the IRS Code called Subchapter S. Limited Liability Company (LLC) – a hybrid with characteristics of both a corporation and partnership
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3. Businesses by Type of Ownership
Factors to consider before choosing a form of ownership:
Legal liability
Tax implications
Future capital needs
Cost of formation and ongoing administration
Choosing a form of ownership depends on many factors, including the type of business, the number of owners involved, current and future exposure to risks and liabilities, and the tax situations of the business and its owners.
The U.S. economy—as well as the global economy—is based on a variety of enterprises that include:
Sole proprietorships, which are businesses owned by one person.
Partnerships, in which where two or more people legally share ownership of a business.
Corporations, or businesses that are formed as separate legal entities.
Figure 6.1 in the text shows these common forms of business ownership. This chapter explores each of these forms of business ownership in greater detail.
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Sole Proprietorship
A business that is owned (and usually operated) by one person
The simplest form of business ownership and the easiest to start
Many large businesses began as small, struggling sole proprietorships
The most popular form of business ownership
Learning Objective 1: What are the advantages and disadvantages of a sole proprietorship?
A sole proprietorship is a business owned, and usually operated, by a single individual.
It is the most common form of business ownership because it’s easy to set up.
No legal paperwork needs to be filed to begin a sole proprietorship. (You might need local licensing or permits depending on your business and local laws.)
All the financial information can be reported on the owner’s personal tax returns.
Although a sole proprietorship has only one owner, it can have any number of employees.
Key characteristics of a sole proprietorship are listed in Table 6.1.
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Sole Proprietorship
_________
_________
Advantages
Advantages
Advantages
Advantages
Disadvantages
Disadvantages
___ __ _________
______ _______ ___ ___________
_ ________ ___ ______
_______ ______ ___ ______ ________ ______
Ease of formation
Greater control and flexibility
No separate tax return
Business losses can offset personal income
___ __ _________
______ _______ ___ ___________
_ ________ ___ ______
_______ ______ ___ ______ ________ ______
Ease of formation
Greater control and flexibility
No separate tax return
Business losses can offset personal income
Ease of formation
Greater control and flexibility
No separate tax return
Profit is taxed as personal income to owner
Business losses can offset personal income
Ease of formation
Greater control and flexibility
No separate tax return
Business losses can offset personal income
Unlimited liability
Business owner is personally responsible for the business debts
Potential difficulty in borrowing money
________ _________
________ __________ __ _________ _____
Unlimited liability
Potential difficulty in borrowing money
Unlimited liability
Potential difficulty in borrowing money
The advantages of a sole proprietorship include:
They are easy to set up.
With only one person making all the decisions, sole proprietors have greater control and more flexibility to act quickly.
The income and expenses of a sole proprietorship flow through the owner’s personal tax return.
Sole proprietors can deduct business losses from their personal taxes which reduces the personal taxes owed.
The disadvantages of a sole proprietorship include:
Unlimited liability means that if business assets aren’t enough to pay business debts, then personal assets, such as the sole proprietor’s house, personal investments, or retirement plans, can be used to pay the balance. If the type of business you’re running has the potential for someone to sue you because of errors on your part, you may not want to operate as a sole proprietorship. A sole proprietor is personally responsible for all the debts and liabilities of the business.
Banks will be less willing to lend to you personally, not to your business, with a sole proprietorship structure, so they will be more reluctant to lend large amounts, and the loan will be limited to the amount of your personal assets.
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Partnership
A voluntary association of two or more persons to act as co-owners of a business for profit
Less common form of ownership than sole proprietorship or corporation
No legal limit on the maximum number of partners; most have only two
Large accounting, law, and advertising partnerships have multiple partners
Partnerships are usually a pooling of special talents or the result of a sole proprietor taking on a partner
Learning Objective 2: What are the advantages and disadvantages of a partnership and a partnership agreement?
A partnership is a type of business entity in which two or more owners (or partners) share the ownership and the profits and losses of the business.
Like a sole proprietorship, a partnership is easily formed. There are no special forms required, although a partnership agreement is recommended.
Also, like a sole proprietorship, many partners will have unlimited liability.
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Types of Partnerships
General partnerships – a business co-owned by 2 or more general partners
- Default arrangement
Simplest to form
Made up of General Partners – a person who has full or shared responsibility for running the business
General partnerships are most common
General partners have UNLIMITED LIABILITY
Limited partnership – a business co-owned by at least one general partner and one limited partner
- General partners – unlimited liability
Limited partners – limited liability (only liable for the amount they invested in business)
Limited partners do not operate business, they provide the capital
There are several types of partnerships. The distinction between the different types usually involves who accepts most or all of the business liability. The two most common partnership forms include general partnerships and limited partnerships.
A general partnership is the “default” arrangement for a partnership and is therefore the simplest of all partnerships to form.
In a general partnership, each partner has unlimited liability for the debts and obligations of the partnership, meaning every partner is liable for his or her own actions, as well as those actions of the other partners and the actions of any employees.
Limited partnerships have two distinctions of partners.
The general partners are full owners of the business, are responsible for all the day-to-day business decisions, and remain liable for all the debts and obligations of the business.
Limited partners are involved as investors and as such are personally liable only up to the amount of their investment in the business and must not actively participate in any decisions of the business.
Limited partnerships can be very complex to form, so it may be worth exploring other business structures before deciding on this strategy.
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Partnership
Advantages
Disadvantages
More owners to contribute capital and effort
Shared managerial and financial responsibility
Utilize complementary skills
Easy to form
Business losses can offset personal income
Profit taxed as personal income of the partners
Must share control—and profits
Need the “right” partner
Differences in opinion on company’s direction
Unlimited liability (general partners only)
The advantages of partnerships include:
More owners help contribute to both the starting and ongoing capital of the business. Multiple people are involved in partnerships, so there is more time available to increase sales, market the business, and generate income.
Sharing the financial responsibility brings in more people who are interested in the company’s overall profitability and are as highly motivated as you are to make the business succeed. Therefore, additional owners, unlike employees, are more likely to be willing to work long hours and go the extra mile. Adding partners to help share the workload also allows for coverage for vacations or when a partner is out due to illness or personal issues.
Moreover, if partners have complementary skills, they create a collaboration that can be quite advantageous.
Like a sole proprietorship, partners report income on their personal tax return and they can use losses to offset income from other sources.
The disadvantages of partnerships include:
Adding partners means sharing profits and control.
Adding the wrong partner can be very problematic.
A potential partner may have different work habits and styles from you, and if the partner’s style isn’t complementary, the differences can prove challenging.
In addition, as the business begins to grow and change, your partner might want to take the business in a different direction than you do.
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9. Partnership Agreement
Capital contributions
Responsibilities of each partner
Decision-making process
Shares of profits or losses
Departure of partners
Addition of partners
What goes into a partnership agreement? Although no formal documentation is required to create a partnership, it’s a good idea to draw up a written document, called a partnership agreement, to formalize the relationship between business partners. The following items should be in the agreement:
Capital Contributions. The amount of capital, including money, equipment, supplies, computers, and any other tangible thing of value, that each partner contributes to begin the business and how additional capital can be added.
2. Responsibilities of Each Partner. Outline the responsibilities of each partner from the beginning to reduce potential conflicts. Also, unless otherwise specified, any partner can bind the partnership to any debt or contract without the consent of the other partners.
3. Decision-Making Process. It is important to consider how decisions will be made. Will just one or two partners make the key decisions? What will be the tiebreaker if needed?
4. Shares of Profits or Losses. Not only should the agreement specify how to divide profits and losses between the partners, but it should also specify how frequently this will be done. Profits could be divided evenly or be proportional to each partner’s initial contribution to the partnership.
5. Departure of Partners. The partnership agreement should have rules for a partner’s exit, whether it’s voluntary, involuntary, or due to death or divorce. Provisions to remove a partner’s ownership interest are necessary so the business does not need to liquidate.
6. Addition of Partners. The partnership agreement also helps spell out the requirements for new partners entering the partnership.
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Corporations
Most common type of corporation is a “C” corporation
A corporation is a legal entity, separate from its owners
Requirements vary by state, many states are “corporation-friendly”
Corporations are owned by stockholders
Articles of incorporations must be filed and corporate bylaws adopted
Learning Objective 3: How is a corporation formed, and how does it compare with sole proprietorships and partnerships?
A corporation is a specific form of business organization that is legally formed under state laws. A corporation is considered a separate entity apart from its owners; therefore, a corporation has legal rights like an individual, so a corporation can own property, assume liability, pay taxes, enter into contracts, and can sue and be sued—just like any other individual.
However, unlike a sole proprietorship, owners of a corporation have limited liability and are represented in the management of the company through a board of directors.
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11. Special Elements of a Corporation
Corporate ownership
Stock
The shares of ownership of a corporation
2 Types: 1) Common Stock (voting privileges), 2) Preferred Stock (no voting rights, dividends paid first)
Stockholder (aka Shareholder)
A person who owns a share or shares of a corporation’s stock
Dividend
A portion of the corporation’s profit (earnings) that is distributed to stockholders
Board of Directors
The governing body of the corporation, elected by stockholders and appoint corporate officers
Closed (private) corporation
A corporation whose stock is owned by relatively few people and is not sold to the general public
Open (public) corporation
A corporation whose stock is bought and sold on security exchanges and can be purchased by any individual
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Corporate Structure
Shareholders are the owners of the company.
Large publicly-owned corporations are corporations whose stock is owned by more than 25 stockholders and is regulated by the Securities and Exchange Commission.
Shareholders have no involvement in the direct management of the corporation.
Shareholders influence corporate decisions by electing directors, overseeing bylaws and the articles of organization (the title of the document filed to create a corporation), and voting on major corporate issues.
In privately held or closed corporations there are fewer shareholders, and they are generally involved in the management and daily operations of the business. The shares of privately held corporations are not traded on public stock exchanges.
Directors—or the board of directors— set policy for the corporation and make the major business and financing decisions.
The board of directors elects corporate officers and ensures the corporate managers are doing their job.
The Sarbanes-Oxley Act of 2002, mentioned in Chapter 3, includes a new set of standards of accountability for the board of directors. If the members of a board of directors ignore their responsibilities of managing the internal controls of a company, they incur the risk of long prison sentences and huge fines.
Officers are elected by the board of directors and are responsible for the daily operation and management of the company. Typical officers include the President (or Chief Executive Officer), Chief Financial Officer, and Chief Operating Officer. Any “officer” position can be formed if it makes sense for the company.
In large companies, the responsibilities of each officer are demanding enough that separate positions are necessary. In smaller companies, only one or two persons might perform the role of several different officers.
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Corporations
Advantages
Disadvantages
Limited liability – liability is separate from owners; stockholders only can lose what they purchased in corporate stock
Extended life and ownership transfer
Raising capital
Tax benefits
Reporting requirements
Can be difficult and costly to form
Corporations have their own special taxes
Double taxation
Corporations pay a tax on their profit; stockholders who receive a dividend also have to pay a tax
The advantages of corporations include:
Separated Liability. Because a corporation is a separate legal entity and is responsible for its own debts and obligations, one of the main reasons owners incorporate their business is to protect their personal assets. Owners are not personally liable for business debts.
Extended Life and Ownership Transfer. Shareholders own a corporation, so its existence doesn’t depend on its founding members. Shares of ownership are easily exchanged, so the corporation is capable of continuing forever, in theory.
Raising Capital. Incorporating offers a business greater flexibility when raising capital. Banks and venture capitalists are more likely to lend money to a business that is incorporated.
Tax Benefits. A corporation is taxed at 15 percent for its first $50,000 in annual profits, whereas the same amount of profits from a sole proprietorship or partnership would be taxed at a rate of 28 percent through individual taxes. This advantage may well apply to those smaller businesses.
The disadvantages of corporations include:
Because a corporation is a separate legal entity, there are many requirements that must be fulfilled in order to maintain corporate status, such as filing an annual report, writing minutes of key meetings, recording financial transactions in a double-entry bookkeeping system, and filing taxes regularly.
Double taxation occurs when the corporation is first taxed on its net income, or profit, then distributes that net income to its shareholders in the form of dividends that the individual shareholder must then pay taxes on.
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S Corporation
Learning Objective 4: What are the major differences among a C corporation, an S corporation, and a limited-liability company?
An S corporation is a regular corporation (a C corporation) that has elected to be taxed under a special section of the Internal Revenue Service code called Subchapter S.
S corporations have shareholders like C corporations.
S corporations must comply with all other C corporation regulations.
What are the advantages of S corporations?
Unlike C corporations, S corporations do not pay corporate income taxes. Instead, as in a partnership or sole proprietorship, the shareholders in an S corporation pay income taxes based on their proportionate share of the business profits and pay the taxes through their own individual tax returns.
The beauty of an S corporation is that it offers the best of both worlds: profits and losses pass through to the shareholders, and the corporate structure provides some limitations on personal liability.
However, the S corporation does not assume liability for an owner’s personal wrongdoings. This is true for any corporate structure.
According to the U.S. Internal Revenue Code, to be an S corporation:
The company must not have more than 100 shareholders
Shareholders must be U.S. citizens or residents.
The company must only issue one class of stock.
The company must distribute proportionately all profits and losses to each shareholder based on each one’s interest in the business.
S corporations are an appropriate structure for owners who meet the requirements for an S corporation and want the legal protection of a corporation but want to be taxed as a sole proprietor or partner.
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15. Limited Liability Company (LLC)
A limited-liability company (or LLC) is a distinct type of business that, like an S corporation, combines the corporate advantages of limited liability with the tax advantages inherent in partnerships.
LLCs are relatively new compared to S and C corporations.
Like a C or S corporation, an LLC requires articles of organization, but an LLC is free of many of the annual meetings and reporting requirements imposed on a C or S corporation, so it’s simpler to maintain.
LLCs are often used by professional corporations formed by accountants, attorneys, doctors, and other similar professionals who want to separate themselves from partner liability but still reap the other benefits of a partnership.
LLCs may be a good choice for start-ups for the tax benefits and easier financing.
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16. Comparing Forms of Business Ownership
There is no one entity that is best for every business. The right form depends on many factors.
A sole proprietorship is a business with only one owner. It is easiest to form and allows the owner to make all the decisions, while accepting full liability.
A limited liability corporation or LLC is very flexible and can work for a business with one or more owners. An LLC protects owners from unlimited liability.
A partnership is a business with two or more co-owners who operate under a voluntary legal agreement. In a general partnership, all the partners participate in the management and accept unlimited liability.
In a limited partnership, some partners are only investors and are referred to as limited partners. The liability of a limited partner is limited to their investment.
A subchapter S corporation gives partners limited liability but avoids double taxation.
Finally, a C corporation is a business entity that is separate from its owners. Owners, referred to as shareholders, have limited liability for the debts of the business. C corporations, especially those that are publicly traded, can raise large amounts of capital through the sale of stock.
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17. Not-for-Profit Corporations
An incorporated business that does not seek a profit
Utilizes revenue available after normal operating expenses for the corporation’s declared social or educational goals
Tax-exempt status granted by federal and state governments
Learning Objective 5: What are the characteristics of not-for-profit corporations and cooperatives?
A not-for-profit corporation (or nonprofit organization) is an incorporated business that does not seek a profit and instead utilizes revenue available after normal operating expenses for the corporation’s declared social or educational goals.
Not-for-profit corporations must apply for tax-exempt status with the federal government and sometimes with the state in which they are incorporated.
Incorporation is not required but is still needed to receive limited liability protection.
A nonprofit organization cannot be organized for any person’s private gain.
Nonprofit organizations do not issue shares of stock.
Members may not receive personal financial benefit from profits (other than salary).
Some do provide employee benefits, such as retirement plans and health insurance.
If a not-for-profit dissolves, the organization’s assets go to a similar nonprofit.
Donors to corporations can deduct their donations from their taxes. Also, the nonprofit is exempt from paying most federal and/or state corporate income taxes and may also (depending on the state) be exempt from state sales and property taxes.
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18. Mergers and Acquisitions
- Two companies join to form one company
Acquisition
- One company takes over another company
Mergers and acquisitions are two ways companies increase their competitive advantage and gain synergy.
A merger occurs when two companies come together to form one company. Generally, it implies that the two companies involved are about the same size and have mutually agreed to form a new combined company.
An acquisition, on the other hand, occurs when one company completely takes over another company. The purchased company ceases to exist, and it operates and trades under the buying company’s name. Acquisitions are not always welcome.
An unfriendly acquisition occurs when one company tries to take control over another company against its wishes. Unfriendly acquisitions are referred to as hostile takeovers.
An unfriendly or hostile acquisition attempt occurs through a tender offer, where the acquiring firm offers to buy the target company’s stock at a price higher than its current value to induce shareholders into selling.
Another method of acquiring a company against its wishes is through a proxy fight in which the acquiring company tries to persuade the target company shareholders to vote out existing management and to introduce management that is sympathetic to the goals of the acquiring company.
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19. Why Do Mergers and Acquisitions Occur?
Synergy
Innovation
Synergy is the business buzzword often used to justify a merger or an acquisition. It is the idea that when two companies combine, the result is better than each company could achieve individually. Operating or financial economies of scale usually drive synergy as combined firms often lower costs by trimming redundancies in staff, sharing resources, and obtaining discounts accessible only to a larger firm.
For example, Pfizer acquired competitor Wyeth in Their main objective was Wyeth’s portfolio of new vaccines and biotechnology medicines.
Many times, larger companies acquire smaller companies for their innovativeness, and a smaller company will agree to merge or be acquired if it feels it wouldn’t have the opportunity to go public and couldn’t survive alone otherwise. IBM has long used the strategy of adding to their product line through acquisitions. The graph on this slide illustrates the number of technology industry acquisitions for the years 2010 and 2011.
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Types of Mergers
Learning Objective 6: What are the different types of mergers and acquisitions and why do they occur?
There are many different types of mergers:
Horizontal merger: Two companies that share the same product lines and markets and are in direct competition with each other, such as Exxon and Mobil and Daimler-Benz and Chrysler.
Vertical merger: Two companies that have a company/customer relationship or a company/supplier relationship, such as Walt Disney and Pixar or eBay and PayPal.
Product extension merger: Two companies selling different but related products in the same market, such as the 2005 merger between Adobe and Macromedia.
Market extension merger: Two companies that sell the same products in different markets, such as when NationsBank, which had operations primarily in the East Coast and Southern areas of the United States, merged with Bank of America, whose prime business was on the West coast.
Conglomeration: Two companies that have no common business areas merge to obtain diversification. For example, Citicorp, a banking services firm, and Travelers Group Inc., an insurance underwriting company, combined to form one of the world’s largest financial services group, Citigroup, Inc.
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21. Disadvantages of Mergers
More than ½ of all mergers don’t meet expectations because of:
Poor integration
Conflicting corporate cultures
Power struggles in management team
Employee turnover
More than ½ of all mergers don’t meet expectations. There are a number of reasons.
Often, managing a merger will force the top executives to take their eyes off business. Although cost-cutting may be the initial primary focus of some mergers, revenues and profits ultimately suffer because day-to-day activities are neglected.
Additionally, corporate cultures may clash, and communications may break down if the new division of responsibilities is vague.
Conflicts may also arise due to divided loyalties, hidden agendas, or power struggles within the newly combined management team.
Employees may be nervous because most mergers result in the elimination of many jobs, and more turnover may be created as those employees whose jobs may not be threatened by the merger seek employment in a more stable environment.
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