LAUNCHING NEW VENTURES – AN ENTREPRENEURIAL APPROACH, 7E Kathleen R. Allen – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Choosing the Legal Form of Organization Chapter 13 – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter Objectives Distinguish between sole proprietorships and partnerships Discuss the corporate form and its advantages and disadvantages Explain the limited liability company Define the nonprofit corporation Make a decision about which legal form to use for which purpose – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter Objectives Discuss how a business entity can evolve from one legal form to another – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Choosing the Legal Form of Organization The choice of legal structure is one of the most important decisions entrepreneurs have to make, as it will affect every aspect of the business, including: ◦ Tax planning ◦ Required paperwork ◦ Cost of maintaining the legal structure ◦ Whether you can raise capital ◦ Level of personal liability you will have – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.1 Making the Decision About Legal Form Ask yourself 7 very important questions: ◦ 1. Does the founding team have all the skills needed to operate this venture? ◦ 2. Do the founders have the capital required to start the business alone or must they raise it through equity capital or debt? ◦ 3. Will the founders be able to run the business and cover living expenses for the first year? – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.1 Making the Decision About Legal Form Ask yourself: (cont) ◦ 4. Are the founders willing and able to assume personal liability for any claims against the business? ◦ 5. Do the founders wish to have complete control over the operations of the business? ◦ 6. Do the founders expect to have initial losses or will the business be profitable almost from the beginning? ◦ 7. Do the founders expect to sell the business one day? – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure Comparison of Common Legal Forms – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.2 Simple Forms: Sole Proprietorships & Partnerships All businesses operate under one of four broad legal structures: ◦ Sole proprietorship ◦ Partnership ◦ Limited liability company ◦ Corporation The legal structure of a new venture has both liability and tax ramifications – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.2a Sole Proprietorship Advantages: ◦ Easy and inexpensive to create ◦ Owner has 100% ownership, profits and losses ◦ Owner has complete authority to make decisions ◦ Income from business taxed at personal rate Disadvantages: ◦ Unlimited liability for all claims against the business ◦ More difficult to raise capital ◦ Survival of business depends on owner – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.2b Partnership Types of Partnerships: General & Limited ◦ General: all partners have unlimited liability ◦ Limited: general partners have unlimited liability and seek capital from limited partners who are forbidden from participating in management Advantages: ◦ All the advantages of sole proprietorships, plus sharing the risk ◦ Partners share ideas, expertise, decisions ◦ Earnings pass through to personal tax returns – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.2b Partnership Disadvantages: ◦ Partners are personally liable for business debts and obligations, even if individual partners sign contracts ◦ Partnership dissolves when partner leaves or dies ◦ Individual partners can be sued for the full amount of partnership debt  That partner can then sue the others to try to recover their shares from them – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.2b Partnership Partnership Agreement: ◦ Wise to draw up a written partnership agreement based on the UPA, which sets responsibilities, profit sharing, and transfer of interest ◦ To protect other partners when one leaves or dies, use a buy-sell agreement:  Who is entitled to purchase the departing partner’s share? Partners or outsiders?  What events trigger a buyout? Disability? Divorce?  What price will be paid for the partner’s interest? – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure Structuring an Effective Partnership Agreement – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3 Corporate Forms A corporation is different from the preceding forms in that it is a legal entity in and of itself ◦ It is chartered or registered by a state, and can survive the death of the owner or the owner’s separation from the business ◦ It can sue, be sued, acquire and sell real property, and lend money ◦ Owners are shareholders who invest capital in the corporation in exchange for shares of ownership ◦ They are not liable for the debts of the corp – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3 Corporate Forms A corporation is different…: (cont.) ◦ Shareholders can lose only the money they have invested ◦ Most new business form a “closely held” corp, owned privately by a few individuals, not traded publicly on the NYSE or other securities exchanges; these are our focus in this chapter ◦ The issue of “going public” arises after a business is established and wants to raise capital – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3a C-Corporation Advantages: ◦ Owners have limited liability, only to limit of their investment ◦ Corp can create different classes of stock to meet the needs of their investors (i.e., non-voting) ◦ Ownership in the corp is easily transferred  Be sure your stock not transferable to undesirable parties such as competitors; use a buy-sell agreement ◦ Corps enjoy status, deference in business ◦ Corps may employ fringe benefits – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3a C-Corporation Disadvantages: ◦ More complex to organize, subject to regulation ◦ Improperly formed or maintained corps have led to business failure or financial hardship ◦ Corporation is taxed at corp level, and dividends paid to shareholders are taxed at individual level ◦ Board of directors has some control ◦ Owners are accountable to shareholders first, and others second ◦ The corp must maintain its separate identity – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3a C-Corporation Where to Incorporate: ◦ Check state income tax rates; some are higher than individual tax rates ◦ Usually best to incorporate in the state in which you intend to locate the business ◦ The corporate laws of Delaware include a large body of case law resolving issues ◦ But most states have now modified their corporate laws to be aligned with those of Delaware – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3b S-Corporation An S-corporation is not a tax-paying entity ◦ Passes the profits and losses of the corporation to the shareholders, like a sole proprietorship or partnership ◦ In other respects, operates like a C-corp But limitations to qualify for S-corp status: ◦ No more than 100 shareholders ◦ Shareholders must be U.S. citizens or residents ◦ Partnerships and corporations cannot be shareholders – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3b S-Corporation Advantages ◦ Business losses passed through and taxed at owner’s personal tax rate; can offset income from other sources ◦ S-corp good for those who don’t need to retain earnings (still taxed, though retained) ◦ S-corp good for service businesses with low capital asset requirements, real estate investment firms, when property values rising, and startups projecting a loss in the early years – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3b S-Corporation Disadvantages ◦ S-corp status not good for retaining earnings for expansion or diversification ◦ Not good if there are significant passive losses from investments like real estate ◦ S-corps cannot take advantage of deductions based on medical reimbursements of health insurance plans – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3c The B Corporation A benefit corporation, a for-profit entity with a social mission ◦ Recognized in 26 states and the District of Columbia  12 more states and territory of Puerto Rico have introduced legislation to recognize this form Differs from C-corp in purpose, accountability and transparency Each state has its own requirements – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3d The Nonprofit Corporation A corporation established for charitable, public or religious purposes or mutual benefit To decide whether this form is right, ask: ◦ 1. Do you have a clear idea of what you want to do? ◦ 2. Who will you involve in your nonprofit? ◦ 3. Do you know what paperwork you must file? ◦ 4. Is forming a new organization the best way to accomplish your mission? – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3d The Nonprofit Corporation Advantages: ◦ A nonprofit with tax-exempt status attractive to corporate donors, who can deduct donations as a business expense ◦ The nonprofit (NFP) can seek cash and in-kind contributions of eq1uipment, supplies & personnel ◦ It can apply for grants from government agencies and private foundations ◦ The NFP may qualify for tax-exempt status, free from paying taxes on income generated from nonprofit activities – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.3d The Nonprofit Corporation Disadvantages: ◦ The NFP cannot pay dividends ◦ Corporate money cannot be contributed to political campaigns or lobbying efforts ◦ The entrepreneur gives up proprietary interest in the corporation and dedicates all the assets and resources of the corp to tax-exempt activities ◦ Upon dissolution, its assets must be distributed to another tax-exempt organization ◦ NFPs cannot make substantial profits from unrelated activities – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.4 Limited Liability Company The LLC enjoys the pass-through tax benefits of partnerships in addition to the limited liability of a C-corporation Only privately owned companies can become LLCs Must be formed following strict guidelines which vary from state to state Formed by filing articles of organization similar to articles of incorporation – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.4a Advantages Exhibits the characteristics of a corporation (limited liability, continuity of life, centralized management & free transferability of interests) but still treated as a partnership for tax purposes Avoids the limitations imposed on S-corps ◦ Corporations can be owners (members); more The LLC can become a C-corp so that it can be publicly traded – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.4a Disadvantages A filing fee must be paid when the LLC is formed Not a good form if many members ◦ Difficult to reach consensus ◦ Members must pay quarterly estimated tax payments if LLC makes a profit ◦ If members do not actively manage the LLC, their ownership interests may be treated like securities, and register the sale of their member interests with the SEC – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13.5 Choosing the Right Legal Form at Each Milestone Have a strategic plan in place so that you can choose a legal form that won’t have to be changed, or choose one that can easily be changed when the time is right At startup, typical to experience losses; consider this in choice The legal form of an organization is not a static decision, but one based on needs of the company at the time of formation and into the future – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

New Venture Action Plan Answer the questions on page 227 before considering which legal form to choose Consult with an appropriately qualified attorney to determine the best form to meet your business goals Complete the necessary agreements for the legal form you have chosen (partnership agreement, articles of incorporation, etc.) – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

New Venture Action Plan Determine if you meet the test for tax exemptions under IRC 501(c)(3) if you are founding a nonprofit corporation Meet with a qualified attorney to determine what other legal issues might arise with your particular type of business – © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.