Chapter 11
Choosing the
Legal Form of
Organization
Learning Objectives
Ownership/Business Structures
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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
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Legal structure alternatives for business:
– Sole Proprietorship
– Partnership
– Limited Liability Company
– Corporation (C or Subchapter S)
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Choosing the right structure depends
upon:
– Legal and tax ramifications
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Sole Proprietorships
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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 owner’s personal
income tax rate
– No major reporting requirements exist
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Sole Proprietorships (continued)
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Disadvantages of sole proprietorships:
– Owner has unlimited liability for all claims
against the business-all debts must be paid
from the owner’s assets
– Difficult for the owner to raise debt capital
– Survival of the business depends upon the
owner
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Partnerships
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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)
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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
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Based on the Uniform Partnership Act, it
defines the relationship between partners in
terms of
– business responsibilities
– profit sharing
– transfer of interest
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Partnership Agreement (continued)
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Buy-sell Agreement:
– Who is entitled to purchase departing partner’s
share?
– What events trigger a buyout?
– What is the price to be paid for the partner’s
interest?
Key-person life insurance
– Life insurance policy on principal partner members
– Use of proceeds upon partner death to buy out
partner or keep the business going
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Table 11.2: Structuring an Effective
Partnership Agreement
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Corporation
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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
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Owners rights:
– As stockholders they invest capital in exchange for
shares
– No liability for corporation’s debts
– Can only lose the money they invest
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C-Corporation
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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)
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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)
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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
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Advantages:
– Business losses can be passed through for taxation
at entrepreneur’s 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
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Licensed service professionals’ corporation
organized to provide their services
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Limited Liability Company
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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)
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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
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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)
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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
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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 year’s 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)
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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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