Chapter 11

Choosing the Legal Form of Organization

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

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Table 11.1: Comparison of Legal Forms

Legal Form
Sole Proprietor

General Partnership

Partnership

Limited Partnership

S-Corp

Bridge Forms

LLC

C-Corp

Full Corporate

Non-Profit

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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

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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 owners personal income tax rate No major reporting requirements exist

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Sole Proprietorships (continued)

Disadvantages of sole proprietorships: Owner has unlimited liability for all claims against the business-all debts must be paid from the owners assets Difficult for the owner to raise debt capital Survival of the business depends upon the owner

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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

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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

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Partnership Agreement
Based on the Uniform Partnership Act, it defines the relationship between partners in terms of
business responsibilities profit sharing transfer of interest Who is entitled to purchase the departing partners share? What events trigger a buyout? What is the price to be paid for the partners interest? Life insurance policy on principal partner members Use of proceeds upon the partners death to buy out partner or keep the business going

Buy-sell Agreement:

Key-person life insurance

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Table 11.2: Structuring an Effective Partnership Agreement

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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 corporations debts Can only lose the money they invest
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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, definedcontribution, profit-sharing and stock option plans The entrepreneur can hold personal assets which can be leased back to the corporation for a fee

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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

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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

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S-Corporation
Advantages: Business losses can be passed through for taxation at entrepreneurs 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

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Professional Corporations
Licensed service professionals corporation organized to provide their services

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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

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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

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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

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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

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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 years 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?
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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 ownersmembers

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