Chapter 8 Forms of Business Organization and Personal Liability Dr. David P Echevarria All Rights Reserved Accounting and Finance for Entrepreneurs EBD-301

Business Organizations Decision Criteria Desired degree of personal liability The method of taxation of business profits Principal Forms of Business Organization Sole Proprietorship Partnership S-corporation C-Corporations Limited Liability Company (LLC) Dr. David P Echevarria All Rights Reserved

Business Organizations In the early going for any new venture, the owners of a new business will be personally liable for all the obligations incurred by the business to its trade suppliers and to any lenders from whom they borrowed funds regardless of the form of business. Sole proprietorships and partnerships will always be liable for all of the obligations incurred by the business As businesses get larger, the corporate form is the preferred organizational form to limit personal liability Dr. David P Echevarria All Rights Reserved

Business Organizations Corporation Forms C-Corporation Major draw back is the double taxation of business income S-Corporation Avoids the double-taxation of business income Critical Issue: Piercing the Veil of Limited Liability Owner/managers may face personal liability for debts of the business if the business declares bankruptcy See: http://blogs.law.harvard.edu/corpgov/2014/03/27/the-three- justifications-for-piercing-the-corporate-veil/ Dr. David P Echevarria All Rights Reserved

Sole Proprietor Simplest form of business organization Unincorporated business owned by a single individual Owner and business treated as one tax entity Owner files a form 1040, U.S. Individual Income Tax Return along Schedule C: Profit or Loss From Business Schedule SE: Self-Employment Tax Form 941 or 944: Employer’s QUARTERLY Federal Tax Return Form 940: Employer's Annual Federal Unemployment (FUTA) Tax Return IRS Publication 334 should be consulted for specific issues regarding filing and paying business taxes, accounting methods, computing profits (or loss), legal business expenses, self-employment taxes, several important issues, and frequently asked questions (FAQs). Dr. David P Echevarria All Rights Reserved

Sole Proprietor Business can be run full or part time important distinction; “trade or business is generally activity carried on to make a profit.” Even an individual with a full time employment and operating a business “on the side” is considered to be self-employed. Hobby or Business? A hobby is an activity not engaged in for profit. Major disadvantage: owner is personally responsible for all of the business’s liabilities. Dr. David P Echevarria All Rights Reserved

Partnership An unincorporated business venture in which 2 or more individuals share the operation and profits of the business. IRS Publication 541 Partnerships is the reference document Partnership must file Form 1065 U.S. Return of Partnership Income Each Partner must receive and file Schedule K-1 (Form 1065) along with their Form 1040 Each partner must file and pay self-employment tax and pay roll taxes the same as sole proprietors Dr. David P Echevarria All Rights Reserved

Partnership Two Categories of Partnerships General: GPs manage the company Limited: LPs are mainly investors Personal Liability of Partners Partners are personally liable for the partnerships obligations and debt Each partner can act on behalf of the partnership – they can legally encumber the partnership Limits to encumber must be spelled out in the partnership agreement Limited Liability Partnership (LLP): Partners not liable for misdeeds of other partners. They are always liable for their own illegal acts. Dr. David P Echevarria All Rights Reserved

Limited Liability Company Formed under state statutes IRS Form 8832 is the key reference document LLCs can elect to be taxed as corporations, partnerships, or as just simply on an individual’s Form1040 Filling form 8832 Entity Classification Election directs the IRS to treat and tax the LLC as a corporation. The LLC then files a form 1120 U.S. Corporation Tax Return May also elect to be treated as a Disregarded Entity; A disregarded entity is an eligible entity that is treated as an entity not separate from its single owner for income tax purposes. Dr. David P Echevarria All Rights Reserved

Limited Liability Company An LLC may elect to be treated as a partnership for income tax purposes File Form 1065 U.S. Return of Partnership Income If Form 8832 is not filed, IRS will treat the LLC as an entity not separate from its owner (effectively the same as a sole proprietor) Dr. David P Echevarria All Rights Reserved

S Corporations Principal advantage of an S-corporation is the avoidance of the double taxation of profits. Maximum of 100 shareholders (owners) S-Corporations file a Form 1120-S S-corporations are exempt from taxation other than taxes on certain capital gains and on passive income (rents, royalties) All profits pass directly to the owners – who report income on their respective Form 1040 Owners must file a form 2553, Election by a Small Business Corporation, to be taxed as an S-corporation. Dr. David P Echevarria All Rights Reserved

C corporations Corporation is a legal form of organization of persons and material resources, chartered by the state for the purpose of conducting business Owned by the shareholders Business is governed by a Board of Directors Officers are elected to run the business on a day-to-day basis Business must abide by the laws and statutes of the state in which they are incorporated C-Corps. May have an unlimited number of shareholders May be public or privately held Dr. David P Echevarria All Rights Reserved

C corporations Provides protection to its shareholders from the corporation’s liabilities subject to the double taxation of profits As income to the corporation As income to shareholders who receive dividends State corporate regulations require; A Business Name Certificate or Articles of incorporation along with Bylaws Must hold annual meetings Dr. David P Echevarria All Rights Reserved

C corporations C-Corps are the best way to protect personal assets C-Corps have better access to capital markets Must have an Employer Identification Number (EIN) C-Corps file a Form 1120 Dr. David P Echevarria All Rights Reserved

Caveats The preceding discussions on organizational form and taxation issues should alert the budding entrepreneur to the importance of considerations affecting the management of the business. The IRS is the first and best source of information and instructions on the use of various forms. Business owners should also consult competent tax accountants about specific issues not readily found in IRS publications. Dr. David P Echevarria All Rights Reserved

Homework What are the two most important considerations when determining what type of business form you will adopt? What are the 5 principal forms of business organization? Which form of business organization carries the most personal liability? Which form carries the least personal liability? What does it mean when a court of law “pierces the veil of limited liability”? Limited liability companies are business forms formed under state law. What elections can LLCs make with respect to how they will be taxed? Why is the form 8832 important with respect to an LLC? Dr. David P Echevarria All Rights Reserved

Homework 7. What is the limit of personal liability of a stockholder in a C-corporation? 8. Describe the purpose of the following forms: Form 941 Form 944 Form 940 Schedule C Schedule SE Dr. David P Echevarria All Rights Reserved