Topic 5: Forms of Business Ownership

Factors Affecting the Choice

Control - entrepreneur must decide early on how much control they are willing to sacrifice in exchange for help from other people.

Managerial ability - entrepreneur must assess their skills and abilities to manage a business effectively.

Start-up and future capital requirements

Business goals - how big and how profitable an entrepreneur plans for the business to become influences the form of ownership choose.

Liability exposure - entrepreneur must decide the extent to which they are willing to assume personal responsibility for their companies’ financial obligation.

Management succession plans - business owner must look ahead to the day when they will pass their companies on the next generation or to a buyer.

Tax considerations - the amount of net income an entrepreneur expect to generate, and the tax bill the owner must pay are important factor.

Cost of formation

Advantages of Sole Proprietorship

Profit incentive - once owner pay all their companies' expenses, they can keep the remaining profits; sole proprietors report the net income and the amount is taxed at the entrepreneur's personal tax rate.

Total decision making authority - the freedom of fast and flexible decisions.

Least costly form to begin - it is the least expensive and there is no need to create and file legal documents.

No special legal restrictions

Simple to create - obtain license from state or country, or local government and it is possible to begins operations in a single day.

Easy to discontinue - can terminate the business quickly, even though he or she will still be personally liable for outstanding debts.

Disadvantages of Sole Proprietorship

Feelings of isolation - pressure alone.

Limited access to capital:

  • proprietors difficult to raise additional money and maintain sole proprietors.
  • most banks and lending institutions have well-defined formula for determining borrowers' eligibility.
  • many sole proprietors cannot meet borrowing requirements.

Limited skills and capabilities - many business failures occur because lack the skills, knowledge, and experience in areas that are vital to business success.

Lack of continuity of the business - if the proprietor dies, retires, or become incapacitated, the business automatically terminates.

Unlimited personal liability (the company's debts are the owner's debts) - if unpaid business debts remain, creditors can force the sale of these assets to cover its debts.

Advantages of Partnership

Division of profits - the partnership agreement should articulate each partner's contribution to the business and his or her share of profits.

Larger pool of capital - each partner's asset base enhances the business's pool of capital and improves its ability to orrow needed partners.

Complementary skills of partners - in successful partnership, the parties' skill and ability complement one another. Strengthening the companies' managerial foundation.

Ability to attract limited partners

Easy to establish - inexpensive and obtain necessary business licenses and submit minimal numbers of forms.

Types of Partners

General Partners:

  • Take an active role in managing a business
  • Have unlimited liability for the partnership's debts
  • Every partnership must have at least one general partner

Limited Partners:

  • Cannot participate in the day-to-day management of a company
  • Have limited liability for the partnership's debts.

Tyoes of Limited Partners

Silent partners - not active in a business but are generally known to be members of the partnership.

Dormant partners - neither active nor generally known to be associated with the business.

Minimal government

Flexibility - the partners can respond quickly and creatively to new opportunities.

Taxation - a partnership is not subject to federal taxation.

Disadvantages of Partnership

Difficulty in disposing of partnership interest without dissolving the partnership

Potential for personality and authority conflicts - making sure that the partners' work habits, goals, ethics, and general philosophy are compatible.

Capital accumulation - it is not as effective as the corporate form of ownership, which can raise capital by selling shares of ownership to outside investors.

Partners bound by law of agency

Unlimited liability of at least one partner - at least one member of every partnership must be a general partner; the general partner has unlimited personal liability for any debts remain after the partnership assets exhausted.

Standard Partnership Agreement

  • name of the partnership
  • purpose of the business
  • location of the business
  • duration of the partnership
  • names of the partners and their legal addresses
  • contributions of each partner to the business
  • agreement on how the profits or losses will be distributed
  • procedures for expansion through the addition of new partners
  • agreement on the distribution of assets if the partners voluntarily dissolve the partnership
  • sale of partnership interest
  • salaries, draws, and expense accounts for the partners
  • absence or disability of one of the partner
  • dissolution of the partnership
  • alterations or modifications of the partnership agreement

Avoiding Legal Tangles

Keep minutes of every meeting (formal and informal) of the officers and directors.

Be sure that the corporation’s board makes all major decisions.

Hold annual meetings to elect officers and directors.

Make it clear that the business is a corporation – officers should sign all documents in the corporation’s name.

File all reports and pay all necessary fees required by the state in a timely manner.

Keep corporate assets and the personal assets of the owners separate.

Identify the company as a corporation by using “Inc.” or “Corporation” in the business name.

Advantages of C Corporation

Private placement - A fund raising tool in which a company sell shares of its stock to a limited number of private investors.

Initial public offering (IPO) - A fund raising tool in which a company sell shares of its stock to the public.

Ability to attract capital - A corporation can raise money to begin business and expand by selling shares of its stock to investors. A corporation can sell its stocks to a limited number of private investors in a private placement or to the public through an initial public offering (IPO).

Ability to continue indefinitely - Unless a corporation fails to pay its taxes or is limited to a specific length of life by its charter, it can continue indefinitely.

Limited Liability of stockholders - Creditors of the corporation cannot lay claim to shareholders’ personal assets to satisfy the company’s unpaid debts. The corporate form of ownership does not protect its owners from being held personally liable for fraudulent or illegal acts.

Transferable ownership - Shares of ownership in a corporation are easily transferable. If stockholders want to liquidate their shares, they can sell their shares. Shareholders can also transfer their stock through inheritance to a new generation of owners.

Disadvantages of C Corporation

Pay taxes at the corporate tax rate and stockholders also pay taxes on dividends they receive at their individual tax rates

Potential for diminished managerial incentives

Traditional form of incorporation

Legal requirements and regulatory red tape - recording and reporting, annual meetings, consult board of directors about major decisions, file annual report with the SEC.

Double taxation

Potential loss of control by the founder(s)

Cost and time involved in the incorporation process

The Other Forms of Ownership S Corporation:

  • An S corporation is taxed like a partnership, passing all of its profits or losses through to individual shareholders.
  • To elect "S" status, all shareholders must consent, and the corporation must file with the IRS within the first 75 days of its tax year.
    • follow 1/3, 1/3, 1/3 rule of thumb.