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Chapter 35

Forms of Business Organizations

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 35: Forms of Business Organizations

Chapter 35 Ethical Dilemma

As this chapter indicates, a corporation is a legal construct with an identity separate and apart from its owner(s). The primary legal advantage to converting one’s business from an unincorporated enterprise to the corporate form is the ability to avoid personal liability for the business’s financial obligations. Since the corporation is distinguishable from its owner, the owner’s personal assets cannot be seized to satisfy business indebtedness. This effectively means that an owner can “crash and burn” a corporation financially, bankrupt the business, and walk away from the “flaming wreckage” of the corporation without personal obligation for business debts.

Is it ethical for an owner to use the corporate entity to avoid personal obligation for business debts?

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Chapter 35 Ethical Dilemma: As this chapter indicates, a corporation is a legal construct with an identity separate and apart from its owner(s). The primary legal advantage to converting one’s business from an unincorporated enterprise to the corporate form is the ability to avoid personal liability for the business’s financial obligations. Since the corporation is distinguishable from its owner, the owner’s personal assets cannot be seized to satisfy business indebtedness. This effectively means that an owner can “crash and burn” a corporation financially, bankrupt the business, and walk away from the “flaming wreckage” of the corporation without personal obligation for business debts. Is it ethical for an owner to use the corporate entity to avoid personal obligation for business debts?

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Chapter 35 Case Hypothetical

Allison Seizer has a very wealthy father, entrepreneur Warren Seizer of “Chimichonga Chime” restaurant fame, although her family pedigree was not what attracted Blake Patterson to his girlfriend of three years; instead, it was “love at first sight.” Blake proposes to Allison, and the two are married with the blessing of Warren Seizer.

Warren wants the best for his daughter and son-in-law, so he offers a “Chimichonga Chime” franchise to Blake, with a prime location in the center of the Elmwood business district. After one year, it is clear that the newest “Chimichonga Chime” is and will be a tremendous business success. In fact, sales, revenue and profit goals for the restaurant are shattered in its first year of operation, and Blake would like to think that his “hands-on” ownership and operation of the restaurant was an important part of the store’s success.

Unfortunately, the couple’s relationship has suffered over the year, and the term “irreconciliable differences” creeps into marriage conversations. Blake asks for his freedom, and Allison obliges. Wedding bells have been replaced by divorce attorneys.

Warren Seizer is furious. He is firmly convinced that Blake Patterson is to blame for the marriage’s dissolution, because there is no conceivable way (at least in his mind) that his “darling angel,” his “precious daughter,” could be responsible for the divorce. The creative genius behind “Chimichonga Chime” plots justice for his daughter and himself, although some may call it revenge.

On September 1, Warren Seizer personally delivers a Notice of Termination of Franchise to Blake Patterson. The document states that Patterson’s franchise agreement has been terminated for cause, and that he must either close the restaurant, or cease and desist from using the name “Chimichonga Chime,” advertising the franchise chime logo, and selling all franchise-related products, within 30 days.

Who wins: The “ex-father-in-law,” or the “ex-son-in-law?”

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Chapter 35 Case Hypothetical: Allison Seizer has a very wealthy father, entrepreneur Warren Seizer of “Chimichonga Chime” restaurant fame, although her family pedigree was not what attracted Blake Patterson to his girlfriend of three years; instead, it was “love at first sight.” Blake proposes to Allison, and the two are married with the blessing of Warren Seizer. Warren wants the best for his daughter and son-in-law, so he offers a “Chimichonga Chime” franchise to Blake, with a prime location in the center of the Elmwood business district. After one year, it is clear that the newest “Chimichonga Chime” is and will be a tremendous business success. In fact, sales, revenue and profit goals for the restaurant are shattered in its first year of operation, and Blake would like to think that his “hands-on” ownership and operation of the restaurant was an important part of the store’s success. Unfortunately, the couple’s relationship has suffered over the year, and the term “irreconciliable differences” creeps into marriage conversations. Blake asks for his freedom, and Allison obliges. Wedding bells have been replaced by divorce attorneys. Warren Seizer is furious. He is firmly convinced that Blake Patterson is to blame for the marriage’s dissolution, because there is no conceivable way (at least in his mind) that his “darling angel,” his “precious daughter,” could be responsible for the divorce. The creative genius behind “Chimichonga Chime” plots justice for his daughter and himself, although some may call it revenge. On September 1, Warren Seizer personally delivers a Notice of Termination of Franchise to Blake Patterson. The document states that Patterson’s franchise agreement has been terminated for cause, and that he must either close the restaurant, or cease and desist from using the name “Chimichonga Chime,” advertising the franchise chime logo, and selling all franchise-related products, within 30 days. Who wins: The “ex-father-in-law,” or the “ex-son-in-law?”

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Major Forms of Business Organizations

  • Sole Proprietorship

  • General Partnership

  • Limited Partnership

  • Corporation

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Major forms of business organizations include the sole proprietorship, the general partnership, the limited partnership, and the corporation.

Sole Proprietorship

  • Definition: Unincorporated business owned by one person

  • Owner has total control

  • Owner has unlimited liability

  • Profits taxed directly as income to sole proprietor

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A sole proprietorship is an unincorporated business owned by one person. With the sole proprietorship form of business organization, the owner has total control, unlimited liability, and profits are taxed directly as income to the sole proprietor.

Advantages and Disadvantages of Sole Proprietorship

  • Advantages

  • Ease of creation (“start-up”)

  • Owner has total managerial control

  • Owner retains profits

  • Disadvantages

  • Personal liability for all business debts/obligations

  • Funding limited to personal contributions and loans

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Sole proprietorship advantages include ease of creation or “start-up,” the owner has total managerial control, and the owner retains profits. The sole proprietorship also has its disadvantages, however, including personal liability for all business debts and obligations, and funding is limited to personal contributions and loans.

General Partnership

  • Definition: Unincorporated business owned and operated by two or more persons

  • Each partner has equal control of business

  • Each partner has unlimited, personal liability for business debts/obligations

  • Profits taxed as income to partners

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A general partnership is an unincorporated business owned and operated by two or more persons. Each partner has equal control of the business, and unlimited, personal liability for all business debts and obligations. Profits are taxed as income to the partners.

Advantages and Disadvantages of Partnership

  • Advantages

  • Ease of creation (“start-up”)

  • Partnership income is partner income

  • Business losses qualify for tax deduction

  • Disadvantages

  • Personal liability for all business debts/obligations, including those incurred by other partners on behalf of partnership

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The advantages of a partnership include ease of creation or “start-up,” partnership income is considered partner income, and business losses qualify for tax deduction. The disadvantage to a partnership is personal liability for all business debts and obligations, including those incurred by other partners on behalf of the partnership.

Limited Partnership

  • Definition: Unincorporated business with at least one general partner, and one limited partner

  • General partner in limited partnership has managerial/operational control over business

  • Limited partner’s liability limited to extent of his/her capital contributions

  • Limited partner has no managerial/operational control over business

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A limited partnership is an unincorporated business with at least one general partner, and one limited partner. The general partner in a limited partnership has managerial, operational control over the business. A limited partner’s liability is limited to the extent of his or her capital contributions, and a limited partner has no managerial, operational control over the business.

Corporation

  • Definition: State-sanctioned business with legal identity separate and apart from its owners (shareholders)
  • Owners’ (shareholders’) liability limited to amount of investment in corporation

  • Profits taxed as income to corporation, plus income to owners/shareholders (“double-taxation”)

  • “S” Corporation can avoid double-taxation

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A corporation is a state-sanctioned business with a legal identity separate and apart from its owners, who are shareholders in the corporation. Shareholder liability is limited to the amount of shareholder investment in the corporation. Corporate profits are taxed as income to the corporation, plus income to the owners. This is referred to as “double-taxation.” An “S” Corporation can avoid double-taxation.

Advantages and Disadvantages of Corporation

  • Advantages

  • Limited liability for shareholders

  • Ease of raising capital by issuing (selling) stock

  • Disadvantages

  • “Double-taxation”

  • Formalities required in establishing and maintaining corporate existence

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Advantages of the corporate form of business organization include limited liability for shareholders, and ease of raising capital by selling stock. Disadvantages include “double-taxation,” and the formalities required in establishing and maintaining a corporate existence.

“S” Corporation

  • Definition: Business organization formed under federal tax law that is considered corporation, yet taxed like a partnership

  • Formed under federal law

  • No more than seventy-five shareholders

  • Shareholders must report income on their personal income tax forms

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An “S” corporation is a business organization formed under federal tax law that is considered a corporation, yet taxed like a partnership. The “S” corporation is limited to 75 shareholders, and the shareholders must report income on their personal income tax forms.

Limited Liability Company (LLC)

  • Definition: Business organization with limited liability of a corporation, yet taxed like partnership

  • Formed under state law

  • Owners of LLC (“members”) pay personal income taxes on shares they report

  • No limitation on number of owners permitted in LLC

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A limited liability company, or “LLC,” is a business organization with the limited liability of a corporation, yet taxed like partnership. The LLC is formed under state law. Owners of a LLC, known as “members,” must pay personal income taxes on shares they report. There is no limitation on the number of owners permitted in a limited liability company.

Specialized Forms of Business Organizations

  • Cooperative—Organization formed by individuals to market products

  • Joint stock company—Partnership agreement in which company members hold transferable shares, while all company goods are held in names of partners

  • Business Trust—Business organization governed by group of trustees, who operate trust for beneficiaries

  • Syndicate—Investment group that forms for purpose of financing specific large project

  • Joint Venture—Relationship between two or more persons/corporations created for specific business undertaking

  • Franchise—Agreement between “franchisor” (owner of trade name/trademark) and “franchisee” (person who, by specific terms of agreement, sells goods/services under trade name/trademark)

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Specialized forms of business organizations include the cooperative, the joint stock company, the business trust, the syndicate, the joint venture, and the franchise. A cooperative is an organization formed by individuals to market products. A joint stock company is a partnership agreement in which company members hold transferable shares, while all company goods are held in the names of partners. A business trust is a business organization governed by a group of trustees, who operate the trust for beneficiaries. A syndicate is an investment group that forms for the purpose of financing a specific large project. A joint venture is a relationship between two or more persons or corporations created for a specific business purpose. Finally, a franchise is an agreement between a “franchisor” (the owner of a trade name and/or trademark) and a “franchisee” (a person who, by specific terms of the agreement, sells goods and services under the trade name and/or trademark.)

Advantages and Disadvantages of Franchise (To Franchisee)

  • Advantages

  • Assistance from franchisor in starting franchise

  • Trade name/trademark recognition

  • Franchisor advertising

  • Disadvantages

  • Must meet contractual requirements, or possibly lose franchise

  • Little/no creative control over business

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From the perspective of a franchisee, there are several advantages to the franchise form of business operation, including assistance from the franchisor in starting a franchise, trade name and trademark recognition, and franchisor advertising. Disadvantages to the franchisee include the fact that the franchisee must meet contractual requirements or possibly lose the franchise, and little (if any) creative control over the business.

Advantages and Disadvantages of Franchise (To Franchisor)

  • Advantages

  • Low risk in starting franchise

  • Increased income from franchises

  • Disadvantages

  • Little control (except contractually) over individual franchise

  • Can become liable for franchise, if franchisor exerts too much control

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The advantages of a franchise to a franchisor are low risk in starting a franchise, and increased income from franchising. Disadvantages include little control (except contractually) over an individual franchise, and the franchisor can become liable for a franchise if the franchisor exerts too much control over the management and operation of the franchise.

Types of Franchises

  • “Chain-Style” Business Operation

  • Franchisor helps franchisee establish a business (using franchisor’s business name, and franchisor’s standard “methods and practices”)

  • Distributorship

  • Franchisor licenses franchisee to sell franchisor’s product in specific area

  • Manufacturing Arrangement

  • Franchisor provides franchisee with technical knowledge to manufacture franchisor’s product

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Types of franchises include “chain-style” business operations, distributorships, and manufacturing agreements. In a “chain-style” business operation, the franchisor helps the franchisee establish a business, using the franchisor’s business name and the franchisor’s standard “methods and practices.” In a distributorship, the franchisor licenses the franchisee to sell the franchisor’s product in a specific area. With a manufacturing arrangement, the franchisor provides the franchisee with technical knowledge to manufacture the franchisor’s product.

Top Ten Global Franchises (2009)

  • Subway

  • McDonald’s

  • Liberty Tax Service

  • Sonic Drive In Restaurants

  • Intercontinental Hotels Group
  • Ace Hardware Corp.

  • Pizza Hut

  • UPS Store

  • Circle K

  • Papa John’s International, Inc.

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As of 2009, the top ten global franchises were Subway, McDonald’s, Liberty Tax Service, Sonic Drive In Restaurants, Intercontinental Hotels Group, Ace Hardware Corp., Pizza Hut, UPS Store, Circle K, and Papa John’s International, Inc..