978-0134741086 Chapter 6 Part 1

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CHAPTER 6. FORMS OF BUSINESS OWNERSHIP

Part 1: Learning Objectives

1. Explain the advantages and the disadvantages of a sole proprietorship and a

partnership.

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

3. Understand the characteristics of a limited liability company.

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

Part 2: Class Instruction

Introduction

The most important issues entrepreneurs should consider when they are evaluating the

various forms of ownership include:

 Business goals

 Management succession plans

 Cost of formation

The major forms of ownership discussed in this chapter include: Sole proprietorship,

general partnership, limited partnership, corporation, S corporation, and limited liability

The Sole Proprietorship. The sole proprietorship is the most popular type of

ownership, defined as business owned and managed by one individual.

The Advantages of a Proprietorship. Advantages of the sole proprietorship include:

 Easy to discontinue

The Disadvantages of Proprietorship. Disadvantages include:

 Unlimited personal liability means that the sole proprietor is personally liable for

all of the business’s debts, as the owner is the business.

 Limited skills and capabilities

defined by the partnership agreement, a document that states in writing the terms under

which the partners agree to operate and that protects each partner’s interest in the

business.

If no partnership agreement exists, the Revised Uniform Partnership Act (RUPA) codifies

the body of law dealing with partnerships in the United States. It specifies three key

 Easy to establish

 Complementary skills

 Division of profits

 Larger pool of capital

 Ability to attract limited partners

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 General partners – partners share in owning, operating, and managing a business.

All partners have unlimited personal liability.

 Limited partners – are financial investors in a partnership, cannot participate in the

day–to–day management, and have limited liability. If the business fails they only

lose the money they have invested in it.

 Silent partners – are not active in a business but generally are known to be

members of the partnership.

partners are treated as investor.

Additional partnership advantages include: minimal governmental regulation, flexibility,

and taxation.

The Disadvantages of the Partnership. Disadvantages include:

 Unlimited liability of at least one partner

all limited partners, giving them the advantage of limited liability for the debts of the

partnership. Most states restrict LLPs to certain types of professionals, such as attorneys,

physicians, dentists, and accountants.

Consider using You Be the Consultant: “Making a Partnership Work” at this point.

Corporations LO 2

creditors often require the founders of small corporations to personally guarantee loans

made to the business. Courts ignore the limited liability shield when an entrepreneur uses

corporate assets for personal reasons, fails to act in a responsible manner and creates an

Chapter 6, Page 102

unwarranted level of financial risk for the stockholders, makes financial

misrepresentations, or takes actions in the name of the corporation that were not

authorized by the board of directors. Refer to Table 6.1, Avoiding Legal Tangles in a

Corporation.

Corporations have the power to raise large amounts of capital by selling shares of

ownership to outside investors. A closely held corporation has shares that are controlled

by a relatively small number of people, and the stock is passed from one generation to the

next instead of being traded on any stock exchange. A publicly held corporation has a

large number of shareholders, and its stock usually is traded on one of the large stock

exchanges.

receive. This double taxation is a distinct disadvantage of the C corporation form of

ownership. If a company intends to seek investment from venture capital or other form of

private equity, it should be established as a C corporation. Advantages of a corporation

include:

 Limited liability of stockholders

 Double taxation

 Potential for diminished managerial incentives

 Legal requirements and regulatory red tape

 Potential loss of control by the founder(s)

S Corporations

and S Corporation or Limited Liability Company.

The criteria for businesses seeking “S” status are that the venture must:

 Be a domestic (U.S.) corporation

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 Limit shareholders to individuals, estates, and certain types of trusts

 Cannot include partnerships, corporations, or nonresident aliens as

shareholders

 Not have more than 100 shareholders

 Have only one class of common stock so all shares have the same rights

 Must be an eligible corporation; certain financial institutions, insurance

companies, and domestic international sales corporations are ineligible.

Advantages of an S corporation include:

 Retains all of the advantages of regular corporations

 Passes all profits/losses through to individual shareholders

of earnings to the shareholders to cover the taxes they will owe, retain one–

third of earnings to fund growth, and earmark the final one-third to pay down

debt, fund debt, or distribute to the owners as a return on their investment.

 Many fringe benefits cannot be deductible business expenses

Choosing an “S” corporation wisely is important to optimize the advantages this entity

currently imposed on S corporations and offer more flexibility than S corporations. LLCs

offer many of the advantages of both, but are not subject to the restrictions incurred by

“S” corporations. LLCs offer the tax advantage of a partnership, the legal protection of a

corporation, and maximum operating flexibility. These advantages make the LLC an

attractive form of ownership for smaller companies across many industries.

How to Create a Legal Business Entity LO 4

C corporations, S corporations, and LLCs can be costly and time consuming to establish

and to maintain. Many entrepreneurs hire attorneys to handle the process, but in most

which to establish the entity. Most will choose the state in which they will operate.

Refer to Table 6.3, Characteristics of the Major Forms of Ownership.

Part 3: Chapter Exercises

You Be the Consultant: “Making a Partnership Work”

1. Research relationships between partners and add at least three guidelines to

those listed above. (LO 1) (AACSB: Interpersonal relations and teamwork)

2. Develop a list of the behaviors that are almost certain to destroy a partnership.

(LO 1) (AACSB: Interpersonal relations and teamwork)