Chapter 27: Business Organizations: an Introduction

Chapter 27: Business Organizations: An Introduction

Megan Weber, Mike Walden, Ying Strow, Matt Brickey, & Sarah Busch

Edited Nic Schworer and Shelby Pieper

Choosing a form of business can be an overwhelming task for many entrepreneurs. After reading this chapter, it will be clear what the many advantages and disadvantages certain business forms possess, and which type may be best suited for a new line of business. Businesses have a plethora of options in choosing their type of organization, but the most common types are the sole proprietorship, partnership, limited partnership limited liability partnership, corporation, LLC, and Subchapter S Corporation. These business types differ in the way they are formed, management, their transferability of ownership, liability, as well as taxation. All of these factors should be considered when deciding which organization type is best to form a new business, or possibly re-organize an old one.

The following should be considered when establishing a company: [1]

A.  Legal Liability

How much are you willing to assume? A lot of this may depend upon the industry in which the company is going to operate. Within certain types of formations (e.g. sole proprietorships, partnerships) the owner(s) will personally assume liability for their business. If you are not willing to risk your personal assets, setting up a company with unlimited liability will not be the wisest choice.

B.  Tax Implications

Taxation can have large impacts on certain types of organizations. Corporations generally will have greater flexibility than partnerships or sole proprietors in regards to tax. While many corporations are subject to double taxation, this can be avoided with the implementation of the S corporation status. In the beginning years of a company’s existence, the selection of a pass-through formation can be beneficial as losses can typically flow through to the individual’s 1040 and lower their personal tax liability.

C. Cost of formation and ongoing administration

Many costs are ignored when businesses are formed in lieu of a more preferential tax treatment. When a business is incorporated, record-keeping and paperwork are continually required and usually come with a cost. A lot of these administrative costs eat an owner’s time and thus ‘cost’ the organization more than they would like. Unless there are significant tax advantages and you need to be shielded from liability, it would be wise to consider another type of business form.

A.  Flexibility

In order to maximize the flexibility of your company, you must consider the unique risks the different owner(s) are willing to take. Each owner should consider how much financial liability they can afford before a business formation is decided upon. Every owner has a unique situation.

B.  Future Needs

The hard work and excitement invested in the initial formation may clout the reality of the future for many start-up businesses. Establishing a well-written agreement among participating parties to establish guidelines can make decisions down the road much easier (e.g. What if someone wants to sell their part of the organization). The issue of raising capital in the future is also essential to consider.

I. Sole Proprietorships

A sole proprietorship is limited to one owner which in turn creates many advantages and disadvantages. As the only owner of the organization, the individual will be responsible for all of the managerial decisions. On the other side of the equation, the owner will personally assume all of the liabilities, obligations and debts of the business. Creditors can require the owner to pay debts with personal assets including his personal bank account. There is little doubt that the sole proprietorship is a risky business even though it has grown into the largest form of business in the United States.

Advantages and Disadvantages

If an owner is willing to assume the risk, there are many advantages to beginning a sole proprietorship. The organization is very easy to form and operate. Essentially, a sole proprietor can begin doing business at will since neither federal or state governments require formal filing or approval to start. However, if an owner decides to do business under a name other than his (her) own, many states require that a fictitious name statement be filed. If the organization generates profits, the owner is not required to share any of the money. A sole proprietorship is not a legal entity and does not have to pay taxes at an entity level, but rather at the individual level.

Many businesses are turned off by the sole proprietorship because of its lack of resources to raise capital. If the owner does not have a good credit history, attaining adequate capital to provide leverage for the business may prove to be quite difficult.

Taxation of a Sole Proprietorship

The taxation of a sole proprietorship is made simpler due to the fact that a sole proprietorship can be distinguished separately from its owner. Therefore, any income earned by the sole proprietorship is income earned by the owner and is not reported separate. The owner of an organization with greater than $400 of income is required to file a Schedule C Form along with their individual federal tax return, Form 1040, detailing income (loss) of their business for the year. The losses generated from a business can greatly reduce one’s personal tax liability. Many wealthy taxpayers use a sole proprietorship for their investments in the early years when losses are expected.

Besides just having to report the income or losses from a sole proprietorship, the owner is also required to pay a self-employment tax. This tax is for social security and Medicare and is very similar to the tax that is withheld from one’s pay from an employer if you were not in business for yourself. The calculation of the tax is completed on Schedule SE, which also needs to be included with your individual tax return.

II. Partnerships

If the business being started will be owned and/or operated by more than one individual, there are many business organization possibilities. One of the most common types is the partnership. A Partnership in its basic sense consists of two or more people called partners. In different types of partnerships, partners have different legal responsibilities and duties. In a basic partnership, there are general partners who share in the management of business and have unlimited liability to the creditors. Many creditors will require that one or more of the general partners pay debts when the assets of the partnership are insufficient. In short, any of the general partners could potentially be held liable for any of the partnership debt. Although partnerships offer great advantages, the liability assumed by the partners can be quite the risk.

Formation of a Partnership

The formation of a partnership does not require any formalities, but an agreement typically is drawn between the different owners. Merely sharing gross revenues does not imply that a partnership has been formed. Rather, many issues should be decided upon including how to share the profits and losses of the company (See Figure on Next Page). An agreement specifying the details are referred to as the articles of partnership. The failure to comply with the agreement could result in a fine or termination from the entity. Oftentimes poorly drawn partnership agreements can lead to litigation courts where things can turn bad and prove to be very expensive. While a partnership is formed when two or more people begin doing business together without selecting a business form, the costs of not completing a formal partnership agreement can prove to be costly. Additional partners can be added upon unanimous consent of the current partners.

Taxation of a Partnership

Like a sole proprietorship, partnership income and losses flow through to the individual partner’s tax returns. Double taxation occurs when taxes get paid twice on income that is coming from the same source. For example, corporations get taxed on any income that it earns, and then its shareholders will get taxed on any cash distributions, and dividends, that they receive from the corporation, therefore creating double taxation. (This is expanded on in Section V, which discusses Corporations.) Unlike corporations, partnerships are not subject to double taxation since the income flows to the partners. Although the company will not pay any taxes on an entity level, they are required to fill out informational Form 1065 which is then passed down to each partner through a Schedule K-1. The Schedule K-1 will detail each of the partner’s shares of partnership income, deductions and tax credits.

Many times partnerships will have losses in their initial years as they get themselves off the ground. The opportunity for a partner to take the partnership losses on their personal taxes serves as a ‘tax shelter’ in reducing taxes. The Internal Revenue Service has guidelines on when certain partnership losses are deductible, but this opportunity makes the formation of a partnership very appealing to newly formed organizations.

Dissolution of a Partnership

The Revised Uniform Partnership Act (RUPA) is a set of partnership rules that has been adopted by many of the states. Within the Act, the rules for the termination of a partnership are outlined. Dissolution of a partnership can occur by a prior agreement, present agreement of partners, or a decree of court. In general, a partnership will automatically dissolve when a partner leaves or dies. However, if the partnership agreement specifies that the partnership will continue and what must be done, the partnership can continue. If a partnership continues, the partner who left or died has a right to receive their share of assets and profits that they are due.

III. Limited Liability Partnerships

An alternative to a partnership is the limited liability partnership (LLP). An LLP offers essentially the same structure as the partnership, but an LLP partner has no obligation for the acts of the other LLP partner's within the organization. (e.g. medical malpractice). However, in some states the partner may be personally liable for the contracts of the business. Another advantage to forming an LLP is that the partners have the option of being taxed as a partnership or a corporation. Only in rare situations would the LLP choose the corporate form of taxation, but it could be a valuable option if the partners are high worth individuals. In the case of being taxed as a corporation, the partners pay federal income tax only on the compensation paid and the partnership distributed profits of the partnership.

Formation of a Limited Liability Partnership

Unlike an ordinary partnership, the formation of a limited liability partnership in many states requires the filing of a form with the Secretary of State. By simply going to the Secretary of State’s website in the state where the partners live, they can find the application. To see a sample form for the state of Missouri, go to http://www.sos.mo.gov/forms/corp/llp6.pdf

IV. Limited Partnerships

As mentioned in the subsequent partnership section, some partnerships have partners with different amounts of liability. Within a limited partnership (LP), there are general partners who have similar rights to partners in general partnerships in that they assume the managerial duties and unlimited personal liability for the company. However, in addition to the general partners, the LP has limited partners who generally do not have any personal liability, but have contributed capital to the LP.

Forming a Limited Partnership

Formation of an LP can be created by complying with state statues regarding limited partnerships. Since the life of a LP is not tied to an individual and is seen as a separate legal entity, it is very important to outline the rules about the transferability and acceptance of new partners at the beginning.

Many businesses choose an LP because it has an opportunity to attract large amounts of capital with smaller amounts of personal liability.

Instructions and forms to start a limited partnership in Missouri can be found by going to: http://www.sos.mo.gov/forms/corp/lp41.pdf

Taxation of a Limited Partnership

An LP has the option of being taxed as a partnership or a corporation. If taxed as a corporate organization, partners will only pay federal income tax on compensation paid to them and distributed profits. However, it is important to understand that under the election of the ‘pass-through’ partnership tax, general and limited partners are subject to different tax treatment. Many times, LP’s will choose the partnership tax option to avoid the double taxation corporations are subject to. While general partners can deduct any of the losses the organization may suffer, limited partners can only deduct losses to the extent of their investment in the business. This type of limited investment is considered to be a passive investment and is subject to a separate set of taxation rules.

V. Corporations

The corporation is the main form of organization for large businesses in the United States. The main characteristic differentiating it from partnerships and sole proprietorships is that a corporation is considered a separate legal entity with rights and liabilities separate from those of its shareholders or owners. A corporation can enter into contracts, be sued, sue other businesses under its name, and acquire, hold, and transmit both real and personal property. A corporation receives the same rights as an individual person under the U.S. Constitution including equal protection, due process, freedom from unreasonable searches and seizures, and freedom of speech. However, some forms of speech are given less protection to corporations than individual people such as freedom of advertising and political contributions.

Corporations are owned by various shareholders who elect a board of directors to manage their business for them, which includes taking care of daily activities. Since the board of directors is separate from the shareholders, the ownership and management of a corporation are likely to be separate as well. Although a shareholder owns part of the corporation, no one shareholder has the right to manage the business, and no officer or director has to be a shareholder.

Forming A Corporation

In order to form a corporation, one must first obtain a state charter by filing Articles of Incorporation with the state. There are several decisions to make before applying to form a corporation. First, the state in which a business wants to incorporate should be chosen. This will usually be the state where the company headquarters is located, or where it conducts most of its business. Some people prefer to incorporate in states that impose few regulations or no corporate income tax, such as Delaware, Nevada, and Wyoming.