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Section 2: The Entrepreneurial Journey Begins

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Essentials of Entrepreneurship and Small Business Management

Ninth Edition

Chapter 6

Forms of Business Ownership

Learning Objectives

Explain the advantages and disadvantages of sole proprietorships and partnerships.

Describe the similarities and differences of C corporations and S corporations.

Understand the characteristics of a limited liability company.

Explain the process of creating a legal entity for a business.

In this chapter, you will:

1. Explain the advantages and disadvantages of sole proprietorships and partnerships.

2. Describe the similarities and differences of C corporations and S corporations.

Understand the characteristics of a limited liability company.

Explain the process of creating a legal entity for a business.

Choosing a Form of Ownership

There is no one “best” form of ownership.

The best form of ownership depends on an entrepreneur’s particular situation.

Key: Understanding the characteristics of each form of ownership and how well they match an entrepreneur’s business and personal circumstances.

When an entrepreneur makes the decision to launch a business, one of the first issues he or she faces is choosing a form of ownership.

Factors Affecting the Choice

Tax considerations

Liability exposure

Start-up and future capital requirements

Control

Managerial ability

Business goals

Management succession plans

Cost of formation

These are some of the factors entrepreneurs should consider when they evaluate different forms of ownership.

Major Forms of Ownership

Sole Proprietorship

General Partnership

Limited Partnership

Corporation

S Corporation

Limited Liability Company

Percentage of Business (1 of 3)

Figure 6.1 Forms of Business Ownership: (a) Percentage of Businesses, (b) Percentage of Sales, and (c) Percentage of Net Income

Source: Based on data from Sources of Income, Internal Revenue Service.

When it comes to organizing their businesses, entrepreneurs have a wide choice of forms of ownership, including sole proprietorship, general partnership, limited partnership, corporation, S corporation, and limited liability company. This figure provides a breakdown of these forms of ownership as a percentage of business.

Percentage of Business (2 of 3)

[Figure 6.1 Continued]

Source: Based on data from Sources of Income, Internal Revenue Service.

This figure provides a breakdown of the different forms of ownership as a percentage of sales.

Percentage of Business (3 of 3)

[Figure 6.1 Continued]

Source: Based on data from Sources of Income, Internal Revenue Service.

This figure provides a breakdown of the different forms of ownership as a percentage of net income.

Advantages of a Sole Proprietorship

Simple to create

Least costly form to begin

Profit incentive

Total decision making authority

No special legal restrictions

Easy to discontinue

The simplest and most popular form of ownership remains the sole proprietorship. A sole proprietorship, as its name implies, is a business owned and managed by one individual. Sole proprietorships make up 72% of all businesses in the United States.

Disadvantages of a Sole Proprietorship

Unlimited personal liability

The company’s debts are the owner’s debts.

Limited skills and capabilities

Feelings of isolation

Limited access to capital

Lack of continuity of the business

Entrepreneurs considering the sole proprietorship as a form of ownership must be aware of its disadvantages.

Partnership

An association of two or more people who co-own a business for the purpose of making a profit.

Always wise to create a partnership agreement: states in writing the terms under which the partners agree to operate the partnership and that protects each partner’s interests in the business.

A partnership is an association of two or more people who co-own a business for the purpose of making a profit. In a partnership, the co-owners (partners) share the business’s assets, liabilities, and profits according to the terms of a previously established partnership agreement (if one exists).

Revised Uniform Partnership Act

Three key elements of any partnership under RUPA:

Common ownership in a business.

Agreement on how the business’s profits and losses will be shared.

The right to participate in managing the operation of a partnership.

When no partnership agreement exists, the Revised Uniform Partnership Act (RUPA) governs a partnership.

Advantages of the Partnership (1 of 2)

Easy to establish

Complementary skills of partners

Division of profits

Larger pool of capital

Ability to attract limited partners

Here are some of the advantages of the partnership.

Types of Partners

General Partners:

Take an active role in managing a business.

Have unlimited liability for the partnership’s debts.

Every partnership must have at least one general partner.

Limited Partners:

Cannot participate in the day-to-day management of a company.

Have limited liability for the partnership’s debts.

When partners share in owning, operating, and managing a business, they are general partners.

Limited partners are financial investors in a partnership, cannot participate in the day-to-day management of a company, and have limited liability for the partnership’s debts.

Types of Limited Partners

Two Types of Limited Partners:

Silent Partners:

Not active in a business but are generally known to be members of the partnership

Dormant Partners:

Neither active nor generally known to be associated with the business

Two types of limited partners are silent partners and dormant partners.

Advantages of the Partnership (2 of 2)

Easy to establish

Complementary skills of partners

Division of profits

Larger pool of capital

Ability to attract limited partners

Minimal government regulation

Flexibility

Taxation

Here are some reasons to form a partnership.

Disadvantages of the Partnership

Unlimited liability of at least one partner

Capital accumulation

Difficulty in disposing partnership interest without dissolving the partnership

Potential for personality and authority conflicts

Partners bound by law of agency

A partnership is like a business marriage, and before entering into one, an entrepreneur should be aware of the disadvantages.

Limited Liability Partnerships

All partners in a business are limited partners.

Gives the advantage of limited liability for the debts of the partnership.

Does not pay taxes – income is passed through to the limited partners who pay taxes on their share of the company’s income.

Many states now recognize limited liability partnerships (LLPs), in which all partners in a business are limited partners, giving them the advantage of limited liability for all of the partnership’s debts.

Corporations

Corporation: a separate legal entity from its owners.

Types of corporations:

Publicly held: a corporation that has a large number of shareholders and whose stock usually is traded on one of the large stock exchanges.

Closely held: a corporation in which shares are controlled by a relatively small number of people, often family members, relatives, or friends.

The corporation is the most complex of the three major forms of business ownership. It is a separate entity apart from its owners and may engage in business, make contracts, sue and be sued, own property, and pay taxes.

Avoiding Legal Tangles (1 of 2)

Identify the company as a corporation by using “Inc.” or “Corporation” in the business name.

File all reports and pay all necessary fees required by the state in a timely manner.

Hold annual meetings to elect officers and directors.

Keep minutes of every meeting (formal and informal) of the officers and directors.

Follow these tips to avoid legal tangles in a corporation:

Identify the company as a corporation by using “Inc.” or “Corporation” in the business name.

File all reports and pay all necessary fees required by the state in a timely manner.

Hold annual meetings to elect officers and directors.

Keep minutes of every meeting (formal and informal) of the officers and directors.

Avoiding Legal Tangles (2 of 2)

Be sure that the corporation’s board makes all major decisions.

Make it clear that the business is a corporation – officers should sign all documents in the corporation’s name.

Keep corporate assets and the personal assets of the owners separate.

Never sign or negotiate corporate documents, such as contracts and other agreements, or sign official corporate correspondence, as an owner or shareholder.

In addition:

Be sure that the corporation’s board makes all major decisions.

Make it clear that the business is a corporation – officers should sign all documents in the corporation’s name.

Keep corporate assets and the personal assets of the owners separate.

Never sign or negotiate corporate documents, such as contracts and other agreements, or sign official corporate correspondence, as an owner or shareholder.

C Corporation

Traditional form of incorporation.

Pays taxes at the corporate tax rate and stockholders also pay taxes on dividends they receive at their individual tax rates.

Double taxation: a disadvantage of the corporate form of ownership in which the corporation’s profits are taxed twice, once at the corporate rate and again at the individual rate on the portion of profits distributed to shareholders as dividends.

All large publicly traded companies and some small businesses are C corporations. C corporations are separate legal entities and therefore must pay taxes on their net income at the federal level, in most states, and to some local governments as well.

S Corporation

No different from any other corporation from a legal perspective.

An S corporation is taxed like a partnership, passing all of its profits (or losses) through to individual shareholders.

To elect “S” status, all shareholders must consent, and the corporation must file with the IRS within the first 75 days of its tax year.

Follow 1/3, 1/3, 1/3 rule of thumb.

In 1954, the IRS Code created the Subchapter S corporation, more commonly known as S corporation or S Corp. Unlike C corporations, S corporations do not pay taxes on corporate income. Income earned by S corporations is passed through to the owners, just as it is in a sole proprietorship or a partnership.

Tax Rate Comparison

Table 6.2 Tax Rate Comparison: C Corporation and S Corporation or Limited Liability Company

Blank	C Corporation	S Corporation or LLC
Corporate or limited liability company net income	$500,000	$500,000
Maximum corporate tax	35%	0%
Corporate tax	$175,000	0
After-tax income	$325,000	$500,000
Maximum shareholder tax rate	39.6%	39.6%
Shareholder tax	$65,000*	$198,000**
Total tax paid	$240,000	$198,000
(Corporate tax plus shareholder tax)	Blank	Blank
Total tax savings by choosing an S corporation or limited liability company = $42,000	blank	blank

*Using the marginal 20% tax rate on dividends: $325,000 × 20% = $65,000.

**Using the marginal 39.6% tax rate on ordinary income: $500,000 × 39.6% = $198,000.

Source: U.S. Small Business Administration, 2010.

Table 6.2 shows a comparison of the tax bill for a small company organized as a C corporation and the tax liability of the same company organized as an S corporation (or a limited liability company, which shares the same tax treatment as an S corporation).

Limited Liability Company (LLC)

Resembles an S Corporation but is not subject to the same restrictions.

Two documents required:

Articles of organization: creates an LLC by establishing its name and address, method of management, its duration, etc.

Operating agreement: establishes for an LLC the provisions governing the way it will conduct business.

A limited liability company (LLC), like an S corporation, offers its owners limited personal liability for the debts of the business, providing a significant advantage over sole proprietorships and partnerships.

Creating a Legal Business Entity

The average cost to create a legal business entity is about $1,000, but it can range from $500 to $5,000.

Can use Web sites like MyCorporation and BizFilings and incorporate for just $100.

But, be careful! The cost of filing incorrectly can be high.

States have different regulations on forming business entities.

Establishing and maintaining C corporations, S corporations, and LLCs can be costly and time-consuming.

Conclusion

To choose the best form of ownership, consider the characteristics of each form.

Evaluate tax considerations, liability exposure, start-up and future capital requirements, amount of control over the company, managerial ability, business goals, management succession plans, and cost of formation.

The forms of business ownership include sole proprietorship, general partnership, limited partnership, C corporation, S corporation, and limited liability company.

An entrepreneur must decide among several forms of business ownership when launching a new business. Each form of ownership offers both advantages and disadvantages.