Starting a Business
URLs:
http://smallbusiness.findlaw.com
http://www.worldlawdirect.com/builddoc.php
Forms of business:

Sole Proprietorship (SP)

General Partnership (GP)

Limited Liability Partnership (LLP)

Professional Corporations (PC)

Limited Partnerships (LP)

Limited Liability Limited Partnerships (LLLP)

Close Corporations (C corps)

S Corporations (S corps)

Limited Liability Companies (LLC)

Joint Ventures

Business Trusts

Cooperatives

Franchises
Sole Proprietorship (SP)
A sole proprietorship is an unincorporated business owned by a single person.
All profits and losses are reported on the owner’s personal return.
The owner of the business is responsible (personally liable) for all the business debts.
The owner has limited options for financing his business – debt is the only source of
business capital, because there’s no stock or membership to sell.
Sole proprietorship works well for small businesses without large capital needs.
General Partnership (GP)
A partnership is an unincorporated association of two or more co-owners who carry on a
business for profit. Each co-owner id called a general partner.
Liability
Each partner is personally liable for the debts of the enterprise whether or not he caused
them. This form can be particularly risky if the group of owners is large and the partners do
not know each other.
Management
Management of partnership can be difficult when the partnership grows, because all
partners are equal and have an equal right to share in management.
Transfer of Ownership
Capital can be raised either by contributions from partners or by borrowing. Likewise, a
partner can only transfer the value of his partnership interest, not the interest itself. For
example, he cannot transfer the right to participate in the firm management.
If a partner decides to leave the partnership, he’s entitled to the value of his share. But it is
difficult to determine that value. The best thing is to initially negotiate the formula for
calculating the values of partners’ shares.
Dissociation
When a partner leaves, the event is called dissociation. The partnership can choose
between (a) buying out the departing partner or (b) terminating the partnership.
Formation
Partnerships are easy to form. A partnership should have a legal agreement, but is perfectly
legal without one.
Taxes
A partnership is not a taxable entity. All income and losses are passed through to the
partners and reported on their personal income tax returns. (Corporations, on the other
hand are taxable entities and pay income tax on their profits. Shareholders pay tax on the
dividends from the corporation.)
Advantages
Partnerships avoid the double taxation of the corporations and leave less money to the IRS.
Unlike the owners of sole proprietorships, partners in a partnership can rely on their
colleagues for help and capital supply.
Partnerships have substantial laws and tradition behind them.
Limited Liability Partnership (LLP)
Limited Liability Partnership (LLP) is a form of general partnership where the partners
are not personally liable for the debts of the partnership.
Differences from general partnership:

To form a LLP – file a statement of qualification with state officials.

LLPs must file annual reports.
Other attributes of a partnership remain the same:

LLP are not taxable.

LLP can choose its duration (terminate or continue existence after dissociation of a
member).
Risk:
LLP law is still not well developed. It is not clear how much LLP protects the
partners.
Professional Corporations (PC)
In many states PCs provide more liability protection than a partnership. Generally,
members of PCs are not personally liable for a member’s malpractice, but the corporation is.
Limitations
All shareholders of the PC must be members of the same profession. Other valued
employees can own stock.
Expensive and time-consuming technicalities for forming and maintaining the PC (like other
corporations).
PCs pay taxes on their profits – the PC is a taxable entity, like the other corporations.
Salaries, however, are deducted from the firm’s profits.
Limited Partnerships (LP) and Limited Liability
Limited Partnerships (LLLP)
Structure
Limited partnerships (LP) have two types of partners – limited partners and general
partners. LP must have at least one of each. (General partnerships, in contrast, have only
general partners.)
Liability
Limited partners in LP are not personally liable, only the general partners are. Limited
partners are like corporation shareholders. They risk only their investment (called capital
contribution) in the partnership.
To avoid the liability of the general partners, most general partners are, in fact,
corporations. Then, only the assets of the corporation are at risk, not the personal assets of
the corporation owners.
The revised version (not yet passed in any state) of the Uniform Liability Partnership Act
permits a LP to declare itself a limited liability limited partnership (LLLP) in its
certificate of formation. In a LLLP the general partner is not personally responsible for the
debts of the partnership. This provision removes the major disadvantage of the LP.
Taxes
LPs, like GPs, are not taxable entities.
Formation
Unlike the GPs, LPs cannot be formed informally. The general partners must file a
certificate of limited partnership with their Secretary of State.
Management
LPs are managed only by the general partners. Limited partners are passive investors and
cannot manage the partnership.
LP agreements can expand the rights of the limited partners. For example, an agreement
can permit a substantial majority (i.e., two-thirds) of the limited partners to remove a
general partner.
Management of LPs is substantially easier compared to GPs because the limited partners are
not allowed to manage.
Transfer of Ownership
As in the case of GP, limited partners have the right to transfer the value of their
partnership interest. They can sell or give away the interest itself only if the partnership
permits.
Duration
Unless stated otherwise in the partnership agreement, LP’s existence continues even as
partners come and go.
Corporations
State laws regulate corporations, but federal statutes determine their tax status. In many
states small corporations (called closed corporations) are treated differently than big
corporations. Federal tax code also treats small corporations differently, more favorably,
and calls them S corporations. The two sets of statuses are completely independent:
C
Corporation
Regular
Corporation
IRS
State
S
Corporation
Close
Corporation
Corporations in General
Advantages
Corporations protect the managers and investors from personal liabilities for the debts of
the corporation and the actions of others, but not against personal negligence.
In contrast, the limited liability does not protect against all debts. Individuals are always
responsible for their own acts.
In addition to the limited liability, corporations offer another advantage – they are very
flexible in transferring the ownership. While partnership interests are not transferable
without the permission of the other partners, corporate stocks can be easily bought and
sold.
Disadvantages
High expenses and efforts in forming and operating the corporations.
Close Corporations
Traditionally, close corporations (a.k.a. closely held corporations) were companies
whose stocks were not publicly traded on a stock exchange.
Nowadays, close corporations are privately held companies that have taken advantage of
the close corporation provisions of their state code.
Close corporation provisions vary from state to state, but they have common themes:

Protection of Minority Shareholders – set of rules that prevent forming of
alliances between shareholders to dominate other shareholders.

Transfer Restrictions – shareholders can sell their shares only after first offering
them to the other shareholders.

Flexibility – close corporations can operate without a board of directors, a formal
set of bylaws, or annual shareholder meetings.

Dispute Resolution – shareholders can agree in advance on events that would
dissolve the corporation. Even without such an agreement, a shareholder can ask the
court to dissolve the corporation if the other shareholders behave “oppressively” or
“unfairly”. The threat of such an action is a check.
S Corporations (S corps)
S corporations encourage the entrepreneurs by offering tax breaks.
S corps - the best of both worlds:
the limited liability of corporations and
the tax status of partnerships.
Limitations

Only one class of stock (although voting rights can vary within the class)

No more than 75 shareholders.

Shareholders can be individuals, estates, charities, pension funds, or trusts.
Shareholders cannot be partnerships or corporations.

Shareholders must be citizens or permanent residents of the US.

All shareholders must agree that the company should be an S corporation.

Some states treat S corps as C corps. In these states the S corps have to pay state
corporate tax.
Limited Liability Companies (LLC)
An LLC offers the limited liability of a corporation and the tax status of a partnership,
without the disadvantages of an S corporation.
Complex interactions between IRS regulations and state laws make LLCs not as simple as
they should be.
Formation
Two documents needed:

a charter (containing the name and address, and filed with the secretary of the
state), and

an operating agreement (setting the rights and obligations of the owners, called
members). Check www.tannedfeet.com/simple_operating_agreement_for_llc.doc
Limited Liability
Risk is limited to the member’s investment.
Flexibility
Unlike S corps, LLCs can have members that are corporations, partnerships, and
nonresident aliens.
LLCs can have different classes of stocks.
Unlike corporations, LLCs are not required to hold annual meetings or maintain minute
book.
Standard Forms
Unlike with corporations, standard forms for LLCs are not available. This may be good,
considering the state law variations.
Transferability of Interests
Like in a partnership, members must obtain the unanimous permission of the remaining
members before transferring their ownership rights, unless specified otherwise in the
operating agreement.
Duration
Before, the LLCs were dissolved upon the withdrawal of a member (e.g., death, resignation,
bankruptcy).
Current trend in state laws is to permit the LLC operation even after withdrawal of a
member. Unless the operating agreement provides otherwise, the LLC pays the departing
member the value of his interest.
Going Public
Once going public, the LLC loses its favorable tax status and is taxed as a corporation.
There’s no real advantage of using LLC form for public corporations. And there are some
disadvantages – unlike corporations, LLCs do not enjoy well-established set of statutory and
case law that is consistent across states.
Changing Forms
Switching from corporation to LLC is considered by IRS to be a sale of the corporate assets
and would levy a tax on the value of these assets.
Switching from a partnership to LLC or from LLC to a corporation is not a sale and is not
taxable.
Joint Ventures
A joint venture is a partnership for a limited purpose. The purpose must include making a
profit.
In a joint venture only contracts relating to the limited purpose are binding.
Other Forms of Organizations
Business Trusts
A business trust is an unincorporated association run by trustees for the benefit of
investors (who are called beneficiaries).
Investors buy certificates in the trust, like the shareholders buy stocks in a corporation, but
they have fewer rights than the shareholders.
Investors do not elect trustees.
Trustees can take any action without the approval of the investors.
Trustees can issue unlimited number of shares.
The beneficiaries are not liable for the debts of the trust.
Theoretically, the trusties are liable for the trust debts, but the trust agreement usually
protects the trustees.
Trusts are considered as a business form by mutual funds and other investment
management companies.
Cooperatives
Cooperatives are groups of individuals or businesses that join together to gain the
advantage of volume purchases or sales.
Franchises
Franchises are not a separate form of organization.
In US, 1 in 12 small businesses is a franchise. Franchises generate sales of more than $1
trillion per year. Franchises provide jobs for more than 8 million people. Well known
franchises – Dunkin’ Donuts, McDonald’s, Midas Muffler.
Buying a franchise is a compromise between starting an own business and working for
someone else.
Disadvantages

Upfront fee

Annual fee that is percentage of gross sales, not of profit.

Contributions to co-op advertising
Chapter Review
Forms of
Business
Definition
Separate
Taxable
Entity
Personal
Liability for
Owners
Ease of
formation
Transferable
Interests
(easily bought
and sold)
Perpetual
Existence
Sole Proprietorship
(SP)
An unincorporated business owned by a single
person.
No
Yes
Very Easy
No, can only sell
entire business
No
General
Partnership (GP)
An unincorporated association of two or more
co-owners who carry on a business for profit.
Each co-owner is called a general partner.
No
Yes
Easy
No
Depends on
the
partnership
agreement
Management can be difficult.
Supported by law and tradition.
Limited Liability
Partnership (LLP)
A form of general partnership where the
partners are not personally liable for the debts
of the partnership.
No
No
Difficult
No
Depends on
the
partnership
agreement
LLP law is still not well developed.
It is not clear how much LLP
protects the partners.
Professional
Corporation (PC)
A special way for some professional
organization to incorporate – PCs provide
more liability protection than a partnership in
many states
Yes
No – for PC
debts or
malpractice of
others.
Yes – for own
malpractice.
Difficult
Shareholders
must all be
members of
same profession
Yes, as long
as it has
shareholders
Complex tax issues.
Limited Partnership
(LP)
Similar to GP, but with 2 types of partners –
limited partners and general partners.
No
Yes – for
general
partner.
No – for
limited
partners.
Difficult
Yes (for limited
partners), if
partnership
agreement
permits
Yes
Must have at least one partner of
each type.
Usually, the general partner is a
corporation.
Managed only by the general
partners.
Limited Liability
Limited Partnership
(LLLP)
Like LP but the general partner is not
personally liable for the debts of the
partnership
No
No
Difficult
Yes (for limited
partners), if
partnership
agreement
permits
Yes
Must have at least one partner of
each type.
Managed only by the general
partners.
Yes
No
Difficult
Yes
Yes
Yes
No
Difficult
Transfer
Restrictions
Yes
Corporation
Close Corporation
(C corp)
Privately held corporation that have taken
advantage of the close corporation provisions
of their state code.
Other Features
Protection of minority
shareholders. No board of
directors required. Stalemates may
develop.
Forms of
Business
Definition
Separate
Taxable
Entity
Personal
Liability for
Owners
Ease of
formation
Transferable
Interests
(easily bought
and sold)
Perpetual
Existence
Other Features
S Corporation (S
corp)
S-corps – the best of both worlds: the limited
liability of corporations and the tax status of
partnerships.
No
No
Difficult
Transfer
Restrictions
Yes
Only 75 shareholders. Only one
class of stock. Shareholders must
be individuals, estates, trusts,
charities or pension funds and be
citizens or residents of the US. All
shareholders must agree to S
status.
Limited Liability
Company (LLC)
An LLC offers the limited liability of a
corporation and the tax status of a partnership,
without the disadvantages of an S corporation.
No
No
Difficult
Yes, if the
operating
agreement
permits
Yes, generally
(varies by
state)
No limit on the number of
shareholders, the number of
classes of stock or the type of
shareholder.
Joint Venture (JV)
Partnership for a limited purpose.
No
Yes
Easy
No
No
The purpose must include making
a profit.
Business Trust
Unincorporated associations run by trustees
for the benefit of investors (beneficiaries).
Yes
No
Difficult
Yes
Yes
Most commonly used by mutual
funds and other investment
companies.
Cooperative
Groups of individuals or businesses that join
together to gain the advantages of volume
purchases or sales.
All these issues depend on the chosen form of organization.
Franchise
Not a separate form of organization.
A franchise is a compromise between starting
an own business and working for someone
else.
All these issues depend on the chosen form of organization.
Established business. Name
recognition. Management
assistance. Loss of control.
Upfront and annual fees may be
high.
Annual fee is percentage of
revenue, not of profit.
The Federal Trade Commission
(FTC) requires that at least 10
business days prior to sale
franchisors must give prospective
franchisees an offering circular.