Ch.6 Business Formation: Choosing the Form that Fits
Ch.6 Business Formation: Choosing the Form that Fits BUS 100
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This 8 page Class Notes was uploaded by Ashli Rutledge on Wednesday September 30, 2015. The Class Notes belongs to BUS 100 at Central Michigan University taught by Olsen, Jennifer in Fall 2015. Since its upload, it has received 78 views. For similar materials see Essential Business Skills in General at Central Michigan University.
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Date Created: 09/30/15
Chapter 6: Business Formation 6-1 Business Ownership Options: The Big Four When entrepreneurs make decisions they have to decide what form they will use. The form affects the establishing and operating the firm, cost to start the business, how profits are distributed, types of taxes the company has to pay. There are four forms of ownership: 1. Sole proprietorship: owned and managed by a single individual. Company earnings are like the owner’s income. Any debts are considered the owner’s debts. 2. Partnership: agreement of two or more people (co- owners) General partnership: each partner has the right to participate in the company’s management and share the profits. But has unlimited liability for the debts of the company. 3. Corporation: business entity created by filing a form (articles of incorporation): a document filed with a state government to establish the existence of a new corporation. A corporation is considered to a legal entity that is separate and distinct from its owners. They can enter into binding contracts, borrow money, own property, pay taxes, initiate lawsuits in its own name. 4. Limited liability company (LLC): hybrid form of business ownership; a legal entity separated from its owners. It offers its owners limited liability for the debts of their business. More flexible than a corporation in terms of tax treatment. Some states allow single-person LLCs that are taxed if they were sole-proprietorships. 6-2 Advantages and Disadvantages of Sole Proprietorships: 6-2a Advantages -Ease of Formation: paperwork and costs are minimal. No special forms to be filed or special fees to be paid. -Retention of Control: you’re in control. You manage the way you want. “You are your own boss”. Sole Proprietorship also looks attractive. -Pride of ownership: feeling of pride and personal satisfaction they gain from owning and running their own business. -Retention of Profits: if your business is successful, all the profits go to you—minus the personal taxes. -Possible Tax Advantage: the earnings are taxed only as income of the proprietor. This avoids the undesirable possibility of double taxation of earnings. 6-2b Disadvantages: -Limited Financial Resources: raising money to finance growth. Banks are reluctant to lend money. Suppliers may be unwilling to provide supplies. Sole proprietors are dependent on their own wealth and income of their company. -Limited Ability to Attract and Maintain Talented Employees: unable to pay the high salaries that experience employees get when they work for big companies. -Heavy Workload and Responsibilities: very long hours and lots of stress. As well as making decision in areas where they may lack expertise. -Lack of Permanence: if the owner dies, retires or withdraws the company legally ceases to exist. Even under new ownership it becomes a different firm. 6-3 Partnerships: Two Heads (and Bankrolls) Can Be Better Than One: 6-3a Formation of General Partnerships: a partnership is formed when the partners enter into a voluntary partnership agreement. Verbal agreements are often a disaster. So it is suggested everything is put into writing and draw up an agreement. Well written agreements prevent disasters later along the road. 6-3b Advantages of General Partnerships: -Ability to Pool Financial Resources: more owners investing in the company will make a stronger financial base. -Ability to Share Responsibilities and Capitalize on Complementary Skills: sharing the burden of running a business. Tasks and jobs can be divided based on who’s best at what. -Ease of Formation: forming a partnership is easy, but verbal agreements aren’t recommended for long term partnerships. -Possible Tax Advantages: Earnings of a partnership are untouched by the IRS and are taxed only as the partner’s personal income. 6-3c Disadvantages of General Partnerships -Unlimited Liability: not only liable for your mistake but your partner’s as well. - Potential for Disagreements: can’t agree on how to run the business can complicate and delay decision making. - Lack of Continuity: if a current partner withdraws from the partnership, the relationships among the participants will clearly change. This determines how long a partnership will be. - Difficulty in Withdrawing from a Partnership: remains personally liable for any debts or obligations the firm had at the time of withdrawal. 6-3d Limited Partnerships: limited partnership: is a partnership arrangement that includes at lease on general partner and at least one limited partner. They contribute financially to the company and share in its profits. General partners have the right to participate fully in managing their partnership. Limited partners cannot actively participate in its management. 6-3e Limited Liability Partnerships (LLP): another partnership arrangement that is attractive to partners who want to limit their personal risk. Amount of liability protection offered by LLPs varies among states. LLPs offer “full shield” protection, meaning that partners have limited liability for all claims against their company. 6-4 Corporations: The Advantages and Disadvantages of Being an Artificial Person C-Corporation: the most common type of corporation which is legal business entity that offers limited liability to all of its owners, who are called stockholders. 6-4a Forming a C-Corporation: corporate by laws: basic rules governing how a corporation is organized and how it conducts its business. Some states are known for their simple forms, inexpensive fees, low corporate tax rates, and “corporation-friendly” laws and court systems. 6-4b Ownership of C Corporation: stockholders: an owner of a corporation, one key difference between two types of stock involves voting rights; common stockholder. Institutional Investors: mutual funds, insurance companies, person funds, and endowment funds, pool money from a large number of individuals and use these funds to buy stocks and other securities. 6-4c The Role of the Board of Directors board of directors: individuals who are elected by stockholders of a corporation to represent their interests. 6-4d Advantages of C Corporations: -limited liability: stockholders are not personally liable for the debts of their company. -permanence: unless the articles of incorporation specify a limited duration, corporations can continue operating as long as they remain financially viable. -Ease of Transfer Ownership: its easy for stock holders of publicly traded C Corporations to withdraw from ownership. -Ability to Raise Large Amounts of Financial Capital: corporations can raise large amounts of financial capital by issuing shares of stock or by selling formal IOUs called corporate bonds. 6-4e Disadvantages of C Corporations: -Expense and Complexity of Formation and Operation: establishing a corporation can be more complex and expensive than forming a sole proprietorship. -Complications When Operating in More Than One State: when a business that’s incorporated in one state does business in other states “domestic corporation”. -Double Taxation of Earnings and Additional Taxes: IRS considers a C Corporation to be a separate legal entity and taxes its earnings accordingly. -More Paperwork, More Regulation, and Less Secrecy: corporations require more paperwork than other forms of business. Are required to send annual statements to all shareholders and file detailed quarterly and annual reports to Securities and Exchange Commission. -Possible Conflicts of Interest: high compensation packages for top executives even when their companies performed poorly. How Double Taxation Reduces Earnings for Stockholders: Pre-tax Corporate earnings Corporate taxes After tax corporate earnings stockholders personal income taxes stockholders after-tax income 6- 4f Other Types of Corporations Same but Different: S corporations: a form of corporation that avoids double taxation by having its income taxed as if it were a partnership. Statutory close (or closed) corporation: a corporation with a limited number of owners that operates under simpler, less formal rules than a C corporation. Non profit corporation: a corporation that does not seek to earn a profit and differs in several fundamental respects from C corporations. 6-4g Corporate Restructuring: Merger and Acquisitions: Acquisition: occurs when one firm buys another firm Merger: occurs when two formerly independent business entities combine form a new organization. Divestitures: When Less is More Divestitures: the transfer of total or partial ownership of some of a firms’ operations to investors or to another company. One common type of divestiture is a “spin off” it occurs when a company issues stock in one of its own divisions or operating units and sets it up as a separate company. A “carve out” is like a spin off in that the firm converts a particular unit or division into a separate company and issues stock in the newly created corporation. 6-5 The Limited Liability Company: The New Kid on the Block: 6-5a Forming and Managing an LLC: They are created by filing a document and paying filing fees in the state where the business is organized. Organizers of most LLCs also draft an operating agreement. Some states require LLCs to publish a notice of intent to operate as a LLC. Exhibit 6.6 Types of Mergers and Acquisitions: Horizontal Merger: combination of firms in the same industry Vertical Merger: combination of firms that are at a different stage in the production of a good service, creating a “buyer-seller” relationship Conglomerate Merger: combination of firms in unrelated industries. 6-5b Advantages of LLCs -limited liability: similar to corporation, all owners of an LLC have limited liability. -tax pass-through: for tax purposes the owners of LLCs may elect to have their companies treated as either a corporation or partnership. -Simplicity and Flexibility in Management and Operation: unlike corporations LLCs aren’t required to hold regular board meetings. 6-5c Limitations and Disadvantages of LLCs: Complexity of Formation: LLCs can take more time to form than sole proprietorships. Annual Franchise Tax: many states require LLCs to pay an annual franchise tax Foreign Status in Other States: LLCs must register or qualify to operate as “foreign” companies when they do business in states other than the state. Limits on Types of Firms that Can Form LLCs: Most states do not permit banks, insurance, companies, and nonprofit orgs to operate as LLCs. Differences in State Laws: only a few states have adopted the Revised Uniform Limited Liability Company Act. until everyone does its more likely to be a complex endeavor. 6-6 Franchising: Proven Methods for a Price franchise: licensing arrangement under which one party (the franchiser) allows another partner (franchisee) to use its name, trademark, patents, copyrights, business methods, and other property in exchange for monetary payments and other considerations. Two most popular types of franchise arrangements: -distributorships: type of franchising arrangement in which the franchisor makes a product and licenses the franchisee to sell it. Business format franchise: broad franchise agreement in which the franchisee pays for the right to use the name, trademark, and business and production methods of the franchisor. Ex: arrangement between automakers and the dealerships that sell their cars. In this kind of franchisor grants the franchisee the right to both make and sell its good or service. The franchisor usually provides a wide range of services to the franchisee like site location, training, and obtaining finances. 6-6a Franchising in Today’s Economy one of the biggest trends in franchising is expanding into foreign countries. Competition is less intense and markets are less saturated. Real Fact: McDonalds has 14,780 franchise outlets in foreign countries, subway 11,842 and Curves 3,087. 6-6b Advantages of Franchising: -Less risk: people interested can research past experiences of franchising before investing. -Training & Support: franchiser normally provides the franchise with training and support. They send out newsletters, provide internet, toll free number for phone support. -Brand Recognition: giving the company even more exposure to the consumers. -Easier Access to Funding: bankers may be willing to loan more $$$ to an established franchise name. 6-6c Disadvantages of Franchising: -Costs: requires initial franchise fee when entered into agreement. As well as an ongoing royalty (% of monthly sales revenue) -Lack of Control: requires franchisee to follow franchisors procedures to the letter. -Negative Halo Effect: incompetence behavior can create a negative perspective. -Growth Challenges: franchisee agreements usually limit the franchisees territory and require franchisor approval before expanding in other areas. Restrictions on Sale: franchise agreements prevent franchisees from selling their franchises to other investors without approval from the franchisor. -Poor Execution: sometimes the company does a poor job of screening franchisees, which could lead to a negative halo effect.