CHAPTER 6: BUSINESS
FORMATION
Choosing the Form that Fits
CHOICES, CHOICES, CHOICES
Form of ownership affects:
The form of ownership
of a business is a
big decision.
• Operation
• Start-up Costs
• Profit Distribution
• Taxes
• Management Succession plans
The “Big Three” is Becoming the
“Big Four”:
• Sole Proprietorship
• Partnership
• Corporation
• Limited Liability Company
SOLE PROPRIETORSHIP: BUSINESS AT
ITS MOST BASIC

Advantages:
 Ease
of Formation
 Retention
 Pride
of Control
of Ownership
 Retention
 Possible
of Profits
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
Category
Examples
Number of
Proprietorships
(thousands)
Professional, Technical,
and Scientific Services
Law firms, accountants, architects, computer
system designers, consultants
2,752
Construction
Residential construction, commercial
construction, specialty contractors
2,491
Retail Trade
Car dealerships, restaurants, clothing
stores, home & garden stores
2,416
Other Services
Automobile repair and body shops,
laundries, personal services
1,995
Health Care
Physicians, 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: http://www.irs.gov/pub/irs-soi/03solp.pdf )
BUSINESS FORMS: COMPARING THE
NUMBERS
Total Number of Businesses by Form of
Ownership (Millions)
Total Net Income by Form of Ownership
($Billions)
PARTNERSHIPS: TWO HEADS CAN BE
BETTER THAN ONE

Advantages:
 Pooled
Financial
Resources
 Shared
 Ease
 Tax
Responsibilities
of Formation
Advantages

Disadvantages:
 Unlimited
Liability
 Disagreements
 Difficulty
in
withdrawing from
agreement
 Lack
of Continuity
LIMITED PARTNERSHIPS
Limited Partnership –
includes at least one
general partner and at
least one limited partner
Limited partners have limited
liability.
Limited Liability Partnership –
All partners are actively
involved but they have some
form of limited liability. The
amount of liability differs
per state.
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.
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.
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
S Corp.
KEY ADVANTAGE
• IRS does not tax earnings separately.
• Stockholders have limited liability.
Statutory Close • Not require to have a board or hold annual
meetings.
Corp.
• Owners can participate in management
while maintaining limited liability.
Nonprofit
Corp.
• Earnings are exempt from federal and state
income taxes.
• Members/directors have limited liability
• Contributions made by individuals are taxdeductible
LIMITATIONS
• No more than 100 stockholders
• Stockholders must be US citizens or
permanent residents
• Limited number of stockholders.
• Stockholders must offer shares to owner
first before selling publicly
• Not all states allow this corporation type
• 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
 Tax
Liability
Pass-Through
 Simplified
Management and
Operation
 Flexible
Ownership

Disadvantages:
 Franchise
 Foreign
Taxes
Status in other
States
 State
Law Differences
 Limited
to Select
Industries
COMPARING BUSINESS FORMS
HIGH
Sole
Proprietorships
LOW
DEGREE OF PERSONAL LIABILITY
Partnerships
DEGREE OF COMPLEXITY AND PERPETUITY
LOW
Corporations
HIGH
CORPORATE RESTRUCTURING
Mergers – two companies
agree to a combination of
equals.
Acquisitions – when one
firm buys another.
Corporations look for:
 Growth
opportunities
 Operational efficiencies
 Competitive advantages
TYPES OF MERGERS AND ACQUISITIONS
Type of Merger
Definition
Objective
Example
Combine firms in same
industry.
• Increase size
• Increase market power
• Gain efficiency
AT&T and SBC
Vertical
Combine companies
with buyer-seller
relationship.
• Provide tighter
integration and increase
control
Time Warner
and Turner
Broadcasting
Conglomerate
Combination of
unrelated companies.
• Increase company’s
diversity.
GE acquiring
RCA
Horizontal
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

Disadvantages:
 Costs
and Support
 Lack
of Control
 Brand
Recognition
 Negative
 Access
to Funding
 Growth
Ben & Jerry franchises its
PartnerShops to non-profit
corporations.
Halo Effect
Challenges
 Restriction
 Poor
on Sale
Execution