AGEC 4073 Week 9Lecture Notes
The Organizing Function – Choosing a Legal Organizational Structure
OBJECTIVES
1 To identify the sole proprietorship, partnership, and corporation as the three primary forms of business organization.
2 To discuss the organization and characteristics of each form of business organization
3 To analyze the advantages and disadvantages of each form of business organization
4 To show how income taxes are affected by the form of business organization
5 To summarize the factors to be considered when selecting a form of business organization
6 To compare alternative arrangements for transferring the income, ownership, and management of a farm business
Once an agribusiness has completed the planning function and determined how to satisfy its customer needs profitably, the managers need to devise an organizational structure that will permit the firm to accomplish its goals. There are a variety of advantages and disadvantages surrounding the use of a sole proprietorship, partnership, and corporate structure. These factors need to be carefully weighed before the business is formed, since they can have a major impact on the firm's profits and long-run success.
The way a business is structured can also have a great deal to do with its performance. The decisions surrounding who is responsible to whom and who makes what types of decisions can also affect the long-run success of an agribusiness. Many firms in the agribusiness system have found the cooperative form of business to work the best. The banding together and sharing of the risks and rewards from group buying and selling have been a part of United States agriculture since the colonial days.
Any business, including a farm or ranch business, may be legally organized in a number of ways.
The three basic forms of business organization are: (1) sole proprietorship (or individual proprietorship), (2) partnership, and (3) corporation. Each one has different legal and organizational characteristics, as well as different income tax regulations. According to data from the Census of Agriculture, nearly 87 percent of U.S. farms and ranches are organized as sole proprietorships. Approximately 10 percent are partnerships, and 3 percent are corporations. The proper choice of organization may depend on the size of the business, the number of people involved in it, the career stage of the primary operators, and the owners' desire for passing on their assets to their heirs. A final choice of business organization should be made only after analyzing all possible long-run effects on the business and on the individuals involved.
THE SOLE PROPRIETORSHIP
Refers to an individual who owns, manages, assumes all the risk, and derives all the products from a business. Its the most common popular form of farm business organization because its easy to form and easy to operate e.g. most family farms.
Characteristics
Owner or sole proprietor owns & manages the business, assumes all the risks, and receives all the profits or losses. Its distinguishing characteristic is the single owner, who acquires and organizes the necessary resources, provides the management, and is solely responsible for the success or failure of the business as well as all business debts.
Organizing or Creating a Sole Proprietorship: No special legal procedures, permits, or licenses are required. A sole proprietorship is not limited in size by either the amount of inputs which can be used or the amount of products produced. The business can be as large or small as the owner desires. There can be any number of employees, additional management may be hired, and property may even be co-owned with others. A sole proprietorship does not necessarily need to own any assets; one can exist even when all land and machinery are leased.
Advantages
Easiest to create. Owner has the freedom in operating the business – i.e. is free to organize and operate the business in any legal manner. Owner makes all management decisions. All business profits and losses belong to the owner who is the sole proprietor.
A sole proprietorship is also flexible. Quick decision making regarding investments, purchases, sales, enterprise combinations, input levels, etc. and re solely on owner’s best judgment.
Disadvantages
Owners personally liable for any legal difficulties and debts related to the business. Creditors have the legal right to a take not only the assets of the business but the personal assets of the owner in fulfillment of any unpaid financial obligations.
The size business is limited by the capital available to the single owner. If only a small amount is available, the business may be too small to realize any economies of size, making it difficult to compete with larger and more efficient farms/businesses. At the other extreme, the management abilities and time of the single owner may be insufficient for a large business, making it difficult to become an expert in any one area. Thus, a large sole proprietorship may need to hire additional management expertise.
Another disadvantage of a sole proprietorship is a lack of business continuity. It is difficult to bring children into the business on any basis other than as employees Death of the owner also means the business may have to be liquidated or reorganizes under new ownership. This can be time-consuming and costly, resulting in a smaller inheritance and less income for the heirs during the transition period.
Income Taxes
The owner of a business organized as a sole proprietorship pays income taxes on any business profit at the tax rates in effect for individual or joint returns. Business profits and capital gains are added to other taxable income earned to determine the individual total taxable income.
Joint Operating Agreements
Sometimes two or more sole proprietors may carry on some joint farming activities while maintaining individual ownership of their own resources. Such an activity is often called a joint operating agreement. They tend to be informal, short-term arrangements.
In an operating agreement all parties generally pay all the costs related to ownership of their own assets, such as property taxes, insurance, maintenance, and interest on debts. Operating expenses, such as for seed, fertilizer, veterinarian fees, or utilities may be shared in a fixed proportion, often the same proportion as the value of fixed costs contributed by each party. In other cases, one party or another may pay for all of certain operating costs, such as fuel or feed, as a matter of convenience. In either case, the general principle for an operating agreement is to share income in the same proportion as resources are contributed.
An enterprise budget can be a useful tool for evaluating resource contributions as shown in the cow/calf enterprise budget.
EXAMPLE BUDGET FOR A JOINT COW/CALF ENTERPRISE (ONE HEAD)
ItemValueParty AParty B
Variable costs:
Hay$ 90.00$$ 90.00
Grain and supplement, 56.00 56.00
Salt and minerals 2.40 2.40
Pasture maintenance 22.5022.50
Veterinary and health exp. 10.00 10.00
Livestock facilities ' 8.00 8.00
Machinery and equipment 5.00 5.00
Breeding expense 5.00 5.00
Labor 30.00 30.00
Miscellaneous 10.00 10.00
Interest on variable costs 11.95 1.78 10.17
(10% for 6 months)
Fixed costs:
Interest on brdg. herd 75.0075.00
Livestock facilities
Deprec. and interest 10.0010.00
Mach. and equipment
Deprec. and interest 6.50 6.50
Land charge 105.00 105.00
Total cost $447.35 $233.78$213.57
Percent contribution100%52% 48%
In this situation party A owns all the pasture, buildings, and fences for the cow herd as well as all the livestock. Party A will also pay the cost of maintaining the pastures and repairing fences and other livestock facilities.
Party B will provide all the feed and labor for the cow/calf enterprise and pay all other variable costs.
The question, then, is how should the income from the cattle be divided? The budget shows that party A is contributing 52% of total costs and party B is contributing 48%. Income can be divided in the same proportion or, for convenience, equally since the results are nearly a 50-50 division of costs.
PARTNERSHIP
Is a voluntary association of 2 or more persons to carry on, as co-owners of a business for profit.
i.e. The business must be owned by the partners.
**Partnerships are governed by code of rules called the Uniform Partnership Act, which assume an equal partnership in everything including management decision unless there is a written specifying a different arrangement – i.e. additional rules may be adopted in the partnership agreement by the partners.
Types of Partnerships
1) Ordinary or General Partnership
2) Limited Partnership
Limited partnership is regularly applied in Large Livestock operations where investors want to limit their financial liability and do not wish to be involved in management
The differences between General and Limited Partnerships are:
a.Limited partners cannot participate in the management of the partnership business.
b.Financial liability of partnership debt and obligations is limited to actual investment of partners in the partnership.
c.The liability of general partners can extend even to their personal assets.
Creating a Partnership
Can be created by oral or written agreement. But partnership created by oral agreement tend to have more problems than written partnership agreements. The most important problems needed to spell out before partnership can start are:
1) How are all the business cost shared
2) How are all business revenues shared.
The written agreement should cover at least the following points:
1. Management: Who is responsible for which management decisions and how will they be made?
2. Property Ownership and Contribution: This section should list the property each partner will contribute to the partnership and describe how it will be owned. Property may be owned by the partnership, or the partners may retain ownership of their individual property and rent it to the partnership. When the partnership itself owns property, any partner may sell or dispose of any asset without the consent and permission of the other partners. This aspect of a partnership suggests that retaining individual ownership may be desirable in some cases particularly if it does not affect use of the asset by the partnership
3. Share of Profit and Losses: The method for calculating profits and losses and the share going to each partner should be carefully described, particularly if there is an unequal division. Profits are generally divided in proportion to the value of the assets, labor, and management contributed to the business –i.e. if each of the two partners contributes one-half of the assets, labor, and management, they share the profits on a 50-50 basis unless otherwise stated in the agreement.
4. Records: Records are important for the division of profits and for maintaining an inventory of assets and their ownership. Who will keep what records should be part of the agreement.
5. Taxation: The agreement should contain a detailed account of the tax basis of property owned and controlled by the partnership and copies of the partnership information tax returns.
6. Termination: The agreement should contain the date the partnership will be terminated if one is known or can be determined. A partnership can be terminated in a number of ways. The partnership agreement may specify a termination date. If no duration is fixed by the agreement any partner may terminate the partnership at will. If not, a partnership will terminate upon the incapacitation or death of a partner, bankruptcy, or by mutual agreement between the partners. Termination upon the death of a partner can be prevented by placing provisions in the written agreement that allow the deceased partner's share to pass to the estate and hence to the legal heirs.
7. Dissolution: The termination of the partnership on either a voluntary or involuntary basis requires a division of partnership assets. The method for making this division should be described to prevent disagreements and an unfair division.
**Note Partnerships cannot succeed unless partners have trust and faith in each other’s ability to make sound business decisions
General Legal Characteristics
Partnership has three basic characteristics:
a.Profit $ Loss: The sharing of the business profit and loss.
b.Property or Assets: Shared control of property.
c.Management: Shared management of the business.
In addition to the above 3 basic characteristics these legal characteristics actually define a partnership:
1) Each person involved participates in management decisions
2) Assets are owned jointly
3) Sharing of Profits & Loss
5) The parties (or business) operate under a firm name
6) The parties have joint bank account for doing business transactions
7) The parties keep a single set of business records
A business ceases to be a partnership if any party does not form part of the business agreement.
**Note: Apart from the above general legal agreement, the following must be considered by any potential partner:
a. Legally, each partner has an equal voice in management control, and majority or the partners must control the business unless otherwise stated in the legal agreement
b. Each partner has an equal right to possession and control of the partnership assets/property for carrying out business of the partnership
c. Unless otherwise stated, profit and losses are divided according to the specific agreement
i.e. any withdrawals and wages that a partner receives must be treated as advances on his/her share of profit.
d. Although the partnership business does not pay taxes, it must file income information and must therefore have its own records for income tax purposes. The partners then pay individual taxes on their share of the partnership income
Liability Considerations Read pp. 98-99.
The Family Partnership
In agriculture the family partnership has been very important is the past, and will be very important in the future because of the financial requirements for competition
Make up -- Wisdom and experiences of parents and relatives
-- Energy and labor of son, daughter, nephews, etc..
Family partnerships allow younger family members to get experiences on the job and eventually assume management responsibilities. But their senior members make a considerable considerations i.e. provide funds for expansions and land
Terminating a Partnership
Easy to terminate. May be terminated by :
Agreement- Between the partners or by the operation of law. Usually termination under agreement came to an end when duration term or business is finished
At Will - If no duration is fixed by the agreement any partner may terminate the partnership at will.
Operation of Law - Dissolution by operation of law occurs in the event of death, bankruptcy, or incapacity of any partner.
THE CORPORATION
Definition: Is a legal entity separated and distinct from the shareholders who won it, form those who manage it, and from its employees.
It is created by business law and is organized for the purpose of carrying on a business for profit
- Has the legal rights and duties of an individual
- It can make contracts
- It can transact business
- It can hold property
- It can sue and be sued.
** The concept of legal separateness sets the corporation apart from the partnership and sole proprietors.
Types of Corporations
The IRS recognizes 2 types of corporations
1) The subchapter C corporation: which is also called regular corporation
2) The subchapter S corporation: which is also known as pseudo or tax-option corporation
The difference between the 2 is:
1) In method by which they are taxed by the federal government
2) In the rate at which they are taxed by the federal government
The subchapter S corporation is not taxed directly, instead it is used to transfer income to the individual shareholders. The shareholders are then taxed at their individual rates, just like the partner in a partnership. The income is transferred to shareholders proportionally to how they contributed capital to the corporation.
The basic requirements of a subchapter S corporation are:
1) It can have only one class of stock.
2) It can have no more than 25 shareholders
3) It can not have non-resident aliens as shareholders
4) It can not have more than 80% of its gross receipts (sales) or capital from foreign sources
5) All shareholders must elect to be taxed as a subchapter S corporation
6) Not more than 60% of the gross receipts can be derived from rents, royalties, and interest
Creating a Corporation
Steps of incorporation may vary from state to state; but include the following:
1) Responsible people are needed to organize and become officials of the new corporation- for agbusiness this is usually family members or close friends
2) A special document, called Articles of Incorporation is filed with the designated state official. These articles provide the laws and the relations between the corporation and its owners/ shareholders, the officials and board of directors
3) An initial tax and certain filing fees will be required
4) Official meetings of the Board of directors is required to deal with specific details of organization and operation.
Example of steps followed in creating a family agribusiness corporation:
-List goals
- Retain the services of an experienced attorney
- Hire a CPA to set up and record accounts
Generally if the organization of a corporation is properly planned the transfer of property or money to the corporation and the receipt of stock by shareholders is not difficult
*The basic requirement is that the Corporation must receive 80% of the floated stock before it can start operating
* Shareholders are only taxed when they sell their stocks.
Major Attractions to Corporations
Benefits include:
-limited personal liability
-Continuity of management
-Income Tax minimization
-Estate Planning
-Specialization of management decision making