5 Forms of Business

Ownership

A friendship founded on
business is a good deal better
than a business founded on
friendship. —John D. Rockefeller

It’s just paper. All I own is a

pickup truck and a little
Wal-Mart stock. —Sam Walton

On completion of this chapter, you will be able to:

1 Explain the advantages and the disadvantages of the three major forms
of ownership: (A) the sole proprietorship, (B) the partnership, and
(C) the corporation.
2 Discuss the advantages and the disadvantages of the S corporation, the
limited liability company, the professional corporation, and the joint
venture.

159
160 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Once an entrepreneur makes the decision to launch a business, one of the first issues he or
she faces is choosing a form of ownership. Too often entrepreneurs invest insufficient time
and effort in evaluating the impact that the various forms of ownership would have on them
and their businesses. They simply select a form of ownership by default or choose the form
that appears to be most popular at the time. Choosing a form of ownership is important
because it is a decision that has far-reaching effects for both the entrepreneur and the busi-
ness. Although the decision is not irreversible, changing from one ownership form to
another can be difficult, time consuming, complicated, and expensive. In many instances,
switching an existing business from one form of ownership to another can trigger onerous
tax consequences for the owners. Therefore, it is important for entrepreneurs to get it right
the first time.
There is no one “best” form of ownership. The form of ownership that is best for one
entrepreneur may not be suitable at all for another. Choosing the “right” form of ownership
means that entrepreneurs must understand the characteristics of each form and how well
those characteristics match their business and personal circumstances. Only then can an
entrepreneur make an informed decision about a form of ownership. The following are
some of the most important issues entrepreneurs should consider when they are evaluating
the various forms of ownership:
Tax considerations. The amount of net income an entrepreneur expects the business to
generate and the tax bill the owner must pay are important factors when choosing a
form of ownership. The graduated tax rates that apply to each form of ownership, the
government’s constant tinkering with the tax code, and the year-to-year fluctuations in
a company’s income make some forms of ownership more attractive than others.
Liability exposure. Certain forms of ownership offer business owners greater protec-
tion from personal liability that might result from financial problems, faulty products,
and a host of other difficulties. Entrepreneurs must decide the extent to which they are
willing to assume personal responsibility for their companies’ financial obligations.
Start-up and future capital requirements. Forms of ownership differ in their ability to
raise start-up capital. Depending on how much capital an entrepreneur needs and
where he or she plans to get it, some forms are superior to others. In addition, as a
business grows, so does its appetite for capital, and some forms of ownership make it
easier to attract external growth capital than others.
Control. By choosing certain forms of ownership, an entrepreneur automatically gives
up some control over the company. Entrepreneurs must decide early on how much
control they are willing to sacrifice in exchange for help from other people to build a
successful business.
Managerial ability. Entrepreneurs must assess their skills and abilities to manage a
business effectively. If they lack ability or experience in key areas, they may need to
choose a form of ownership that allows them to bring in other owners who can provide
the necessary skills for the company to succeed.
Business goals. How big and how profitable an entrepreneur plans for the business to
become will influence the form of ownership chosen. Businesses often switch forms of
ownership as they grow, but moving from some formats to others can be extremely
complex and expensive.
Management succession plans. When choosing a form of ownership, business owners
must look ahead to the day when they will pass their companies on to the next genera-
tion or to a buyer. Some forms of ownership make this transition much smoother than
others.
Cost of formation. Some forms of ownership are much more costly and involved to
create. Entrepreneurs must weigh carefully the benefits and the costs of the particular
form they choose.
When it comes to organizing their businesses, entrepreneurs have a wide choice of
forms of ownership, including a sole proprietorship, a general partnership, a limited
partnership, a corporation, an S-corporation, and a limited liability company. Figure 5.1
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 161

Limited-liability FIGURE 5.1

companies
2.9% Forms of Business
Sole Ownership.
proprietorships
71.6%
(A) Percentage of
Businesses;
(B) Percentage of Sales
Corporations
20.2% Source: BizStats.com, “Total
Number of U.S. Businesses,”
http//:www.bizstats.com/
businesses/htm

Partnerships
5.4%

Partnerships Corporations
8.8% 84.7%

Sole proprietorships
4.9%
Limited-liability companies
1.7%

provides a breakdown of these forms of ownership. Notice that sole proprietorships

account for the greatest percentage of businesses, but corporations generate the largest
proportion of business sales. This chapter discusses the key features of these various
forms of ownership, beginning with the three most basic forms: the sole proprietorship,
the partnership, and the corporation.

Come up with the Perfect pronunciation was unclear, and it was not particularly
memorable. Rohan decided to hire a San Francisco
Moniker for Your Business naming company, Igor International, to help him come

W
up with a better name for his company. After much
hen Mike Rohan started a financial software com- research and analysis, Rohan settled on Rivet. Because it
pany in 2002, he came up with what he thought was a is reminiscent of the sound that a frog makes (“ribbet”),
clever business name: Aucent. Within two years, Rohan the name has a friendly tone and is easy to remember.
realized that the company’s name had become a liabil- Before adopting the new name, the Rohan tested it on
ity. It failed to suggest to potential customers exactly existing customers and others; almost all were enthusi-
what Aucent could do for them, it was hard to spell, its astic about it.
162 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

For another company in Stamford, Connecticut, the thesaurus, and samples (or graphics) of your com-
choice of a business name became the company’s worst pany’s products and services will help to stimulate
enemy. GHB Marketing Communications started getting creativity.
numerous e-mails and phone calls requesting a certain 4. After allowing them to percolate for a few days,
product. Sounds harmless, right? Wrong! The product evaluate the names generated in the brainstorm-
that many of those customers were seeking was GHB, ing session. Narrow the list of choices to 10 or so
an illegal drug also known as ecstasy. “Imagine having a names with the greatest potential. Print each
30-year-old company named LSD, Inc. in the late 60s,” name in large font on a single page and look at
explains company President Mark Bruce. “Then you can them. Which ones are visually appealing? Which
begin to understand what we went through.” The new ones lend themselves to being paired with a
name (HiTechPR) costs the owners $20,000. clever logo?
Choosing a memorable name can be one of the 5. Reassemble your creative group, present each
most enjoyable—and most challenging—aspects of name you have printed, and discuss its merits and
starting a business. It also is an extremely important task challenges. It helps to have a designated person to
because it has long-term implications and is the single record the group’s comments. The group may
most visible attribute of a company. The business name come to a consensus on a preferred name; if not,
is the first connection that many customers will have you can use a round-by-round voting process to
with a company, and it should create an appropriate move the group toward a consensus.
image in their minds. “A name is a cornerstone for 6. Conduct a search at the U.S. Patent and Trademark
branding,” says the president of one small design firm Office Web site (http://www.uspto.gov) to see
specializing in branding. If done properly, a company’s whether the leading names on your list are already
name will portray the business’s personality, will stand registered trademarks for existing businesses.
out in a crowd, and will stick in the minds of consumers. Remember, however, that the same name can be
Large companies may spend hundreds of thousands of registered as a trademark as long as the product,
dollars in their search for just the right name. Although service, or company’s business does not overlap. If
entrepreneurs don’t have the resources to enable them your company conducts e-commerce, you will
to spend that kind of money to find the ideal name, need to check with one of the name registration
they can use the following process to come up with the services to see whether a dot-com version of the
perfect name for their businesses: name is available.
7. Make your choice. Including input from others is
1. Decide on the image you want your company to
useful when selecting a business name, but the
project to customers, suppliers, bankers, the press, final choice is yours.
the community, and others. Do you want to create 8. Register your company name with the U.S. Patent
an air of sophistication, the suggestion of a bar- and Trademark Office. Doing so gives you maxi-
gain, a sense of adventure, the implication of trust- mum protection from others using the name you
worthiness and dependability, or a spirit of fun and worked so hard to create.
whimsy? The right name can go a long way toward
communicating the right image for a company. Other helpful tips for creating the ideal business
2. Make a list of your competitors’ business names.
name include the following:
The idea is not to borrow from their ideas but to r Look at your name from your potential customer’s
try to come up with a name that is unique. Do you perspective. Do customers need reassurance
notice any trends among competitors’ names? (Gentle Dentistry), or do they prefer a bit of
What are the similarities? What are the differences? humor (Barking Lot Dog Grooming)? Other
3. Work with a group of the most creative people options include using a name that conveys an
you know to brainstorm (refer to Chapter 2 for image to your customers that expresses your busi-
details on the brainstorming process) potential ness strategy. For example: Discount Hair Products,
names for your business. Don’t worry about qual- Quality Muffler, or Pay-Less Auto Detailing. In
ity at this point; the goal is to generate a large addition, most of us are familiar with the really
quantity of names. The idea is to come up with at upscale practice of including foreign phrases
least 100 potential names. Having a dictionary, a (especially French) to convey an exclusive image.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 163

La Petite Day care sounds more up scale than the great name in the 50s, but it would have died a
Small Day Care. horrible death in the 60s as long, straight locks
r Decide the most appropriate single quality of the became the norm.
business that you want to convey and incorporate r Be careful that the name, while catchy and cute,
it into your business name. Avoid sending a mixed doesn’t create a negative image. Ask yourself:
or inappropriate message. Avoid business names Does Rent-a-Wreck attract you because you think
that might leave potential customers confused you’ll save money on a car rental or does the name
about what your business does. Remember: The put you off because you question the reliability of
company name will be displayed on all of your their cars?
advertising and printed material. r Once you have selected a suitable name, practice
r Avoid names that are hard to spell, pronounce, or using it for a few days. Try it out on friends and
remember. This is especially true if your business is family. “Hello, I am the CEO of FlubberDuds” may
an Internet company or if you plan to have a Web get on your nerves after the first few times.
site. Try typing in “posiesbythedozenandthensome- r Finally, after all is said and done and you are com-
fromrosie.com” a few times before you decide this fortable with your choice, conduct a name search
is the name for your online flower store! to make sure that no one else in your jurisdiction
r Select a name that is short, fun, attention getting, has already claimed the name. This is an especially
and memorable. Not only is Google fun to say, it is tedious chore if you are starting an Internet com-
also quite memorable (and quite successful, too; pany. Registering a domain name sometimes can
how many times do you hear people using this be daunting because you will find that your bril-
company name as a verb? “I googled myself and liant idea is already registered.
found 27 hits!”) The name can be your initial
There are millions of names in the marketplace. Coming
marketing tool for attracting new customers.
up with the one that is just right for your business can
Rosiesposies.com may be a better choice in the
help greatly in creating a brand image for your business.
example in the previous bullet. Naming experts say
Choosing a name that is distinctive, memorable, and
that a great name has “emotional hang time,” a
positive can go a long way toward helping you achieve
football metaphor to describe a name that stays in
success in your business venture. What’s in a name?
your mind.
Everything!
r Be creative but maintain good taste! Lisa Rothstein
found the perfect name for her business, which
sells fresh-baked gourmet brownies as corporate Sources: Alex Frankel, “The New Science of Naming,” Business 2.0,
December 2004, pp. 53–55; Rhonda Abrams, “Sometimes Business
gifts: Brownie Points. Rothstein’s company name Success Is All in the Name,” Business, July 23, 2000, p. 3; Paul Tulenko,
recently won the “Name to Fame” contest spon- “Choose Name Carefully for Start-up Business,” Business, February 6,
sored by Entrepreneur magazine and the Small 2000, p. 3; Jerry Fisher, “You Name It,” Entrepreneur B.Y.O.B.,
December 2001, pp. 112–116; Elizabeth Weinstein, “GHB Marketing
Business Television Network. Rothstein and a
Finds Its Name Is One Thing It Doesn’t Want To Plug,” Wall Street
college roommate came up with Brownie Points Journal, June 7, 2001, p. B1; Andrew Raskin, “The Name of the Game,”
long before Rothstein ever decided to launch Inc., February 2000, pp. 31–32; Rhonda Adams “Sometimes Business
the business. Success Is All in the Name,” Business, July 23, 2000, p. 3; Tomima
Edmark, “What’s in a Name?” Entrepreneur, October 1999, pp.
r Make sure the name you choose won’t get dated 163–165; Jeff Wuorio, “’Oedipus Wrecks’ and Other Business Names
quickly. Big Stiff Hair Salon might have been a to Avoid,” bCentral, www.bCentral.com/articles/wuorio/153.asp.

The Sole Proprietorship LEARNING OBJECTIVES

1A. Explain the advantages and
The simplest and most popular form of ownership remains the sole proprietorship. The disadvantages of the sole
sole proprietorship, as its name implies, is a business owned and managed by one indi- proprietorship.
vidual. Sole proprietorships make up nearly 72 percent of all businesses in the United
States.
164 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

sole proprietorship The Advantages of a Proprietorship

a business owned and managed
Simple to Create One of the most attractive features of a proprietorship is how fast and
by one individual; the business and
the owner are one and the same in
simple it is to begin. If an entrepreneur wants to operate a business under his own name
the eyes of the law. (e.g., Strossner’s Bakery), he simply obtains the necessary licenses from state, county,
and/or local governments and begins operation! For most entrepreneurs, it is possible to
start a proprietorship in a single day.

Least Costly Form of Ownership to Begin In addition to being easy to begin, the
proprietorship is generally the least expensive form of ownership to establish. There is no
need to create and file legal documents that are recommended for partnerships and
required for corporations. An entrepreneur simply goes to the city or county government,
states the nature of the business he or she will start, and pays the appropriate fees and
license costs. Paying these fees and license costs gives the entrepreneur the right to
conduct business in that particular jurisdiction.
Someone planning to conduct business under a trade name should acquire a
Certificate of Doing Business under an Assumed Name from the secretary of state. The fee
for filing this certificate usually is nominal. Acquiring this certificate involves conducting
a legal search to ensure that the name chosen is not already registered as a trademark or a
service mark with the secretary of state. Filing this certificate also notifies the state who
owns the business. In a proprietorship, the owner is the business.

Profit Incentive One major advantage of proprietorships is that once owners pay all of
their companies’ expenses, they can keep the remaining profits (less taxes, of course). The
profit incentive is a powerful one, and profits represent an excellent way of “keeping score”
in the game of the business. Sole proprietors report the net income of their businesses on
Schedule C of IRS Form 1040, and the amount is taxed at the entrepreneur’s personal tax
rate. Because they are self-employed, sole proprietors’ income from their business activities
also is subject to the self-employment tax, which currently stands at 15.3 percent (an
amount equal to the 7.65 percent employers pay plus the 7.65 percent employees contribute
toward the Social Security and Medicare programs) of the proprietor’s income. A ceiling on
the Social Security portion of the self-employment tax does apply.

Total Decision-Making Authority Because the sole proprietor is in total control of

operations, he or she can respond quickly to changes, which is an asset in a rapidly shifting
market. The freedom to set the company’s course of action is a major motivational force.
For those who thrive on the enjoyment of seeking new opportunities in business, the
freedom of fast, flexible decision making is vital. Many sole proprietors thrive on the
feeling of control they have over their personal financial futures and the recognition they
earn as the owners of their businesses.

No Special Legal Restrictions The proprietorship is the least regulated form of

business ownership. In a time when government requests for information seem never
ending, this feature has much merit.

Easy to Discontinue If an entrepreneur decides to discontinue operations, he or she can

terminate the business quickly even though he or she will still be personally liable for any
outstanding debts and obligations that the business cannot pay.
Entrepreneurs considering the sole proprietorship as a form of ownership also must be
aware of its disadvantages.

The Disadvantages of a Proprietorship

unlimited personal liability Unlimited Personal Liability Probably the greatest disadvantage of a sole proprietorship
a situation in which the sole is the unlimited personal liability of the owner, which means that the sole proprietor is
proprietor is personally liable for all personally liable for all of the business’s debts. Remember: In a proprietorship, the owner
of the business’s debts. is the business. He or she owns all of the business’s assets, and if the business fails,
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 165

creditors can force the sale of these assets to cover its debts. If unpaid business debts
remain, creditors can also force the sale of the proprietor’s personal assets to recover
payment. In short, the company’s debts are the owner’s debts. Laws vary from one state to
another, but most states require creditors to leave the failed business owner a minimum
amount of equity in a home, a car, and some personal items. The reality is that failure of a
business can ruin a sole proprietor financially.

When Max Baer started a production studio in Memphis, Tennessee, he chose to operate
as a sole proprietor. Then, a former employee sued Baer. Although he negotiated a mod-
est out-of-court settlement in the case, Baer realized that a sole proprietorship left all of
his personal assets at risk and converted his company into a corporation to gain the
Max Baer
benefit of limited personal liability.1

Limited Skills and Capabilities A sole proprietor has total decision-making authority,
but that does not mean that he or she has the range of skills that running a successful
business requires. Each of us has areas in which our education, training, and work
experiences have taught us a great deal; yet there are other areas in which our decision-
making ability is weak. Many business failures occur because owners lack the skills,
knowledge, and experience in areas that are vital to business success. Owners tend to push
aside problems they don’t understand or don’t feel comfortable with in favor of those they
can solve more easily. Unfortunately, the problems they set aside seldom solve themselves.
By the time an owner decides to ask for help in addressing these problems, it may be too
late to save the company.

Feelings of Isolation Running a business alone allows an entrepreneur maximum

flexibility, but it also creates feelings of isolation; there is no one else to turn to for help
when solving problems or getting feedback on a new idea. Most sole proprietors will admit
that there are times when they feel the pressure of being alone and fully and completely
responsible for every major business decision. It’s a challenge to learn what you need to
know about aspects of the business about which you may have had little, or no, previous
experience.

Limited Access to Capital If a business is to grow and expand, a sole proprietor often
needs additional financial resources. However, many proprietors have already put all they
have into their businesses and have used their personal resources as collateral to acquire
loans, making it difficult to borrow additional funds. A sole proprietorship is limited to
whatever capital the owner can contribute and whatever money he or she can borrow. In
short, unless they have great personal wealth, proprietors find it difficult to raise additional
money while maintaining sole ownership. Most banks and other lending institutions have
well-defined formulas for determining borrowers’ eligibility. Unfortunately, many sole
proprietorships cannot meet those borrowing requirements, especially in the early days of
business.

Lack of Continuity of the Business Lack of continuity is inherent in a sole

proprietorship. If the proprietor dies, retires, or becomes incapacitated, the business
automatically terminates. Unless a family member or employee can take over (which
means that person is now a sole proprietor), the business could be in jeopardy. Because
people look for secure employment and an opportunity for advancement, proprietorships
often have trouble recruiting and retaining good employees. If no one is willing to step in
to run the business in the founder’s absence, creditors can petition the courts to liquidate
the assets of the dissolved business to pay outstanding debts.
Some entrepreneurs find that forming partnerships is one way to overcome the disad-
vantages of the sole proprietorship. For instance, when one person lacks specific manager-
ial skills or has insufficient access to needed capital, he or she can compensate for these
weaknesses by forming a partnership with someone with complementary management
skills or money to invest.
166 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

LEARNING OBJECTIVES The Partnership

1B. Explain the advantages and
disadvantages of the partnership. A partnership is an association of two or more people who co-own a business for the pur-
pose of making a profit. In a partnership the co-owners (partners) share the business’s
partnership assets, liabilities, and profits according to the terms of a previously established partnership
an association of two or more agreement (if one exists).
people who co-own a business for The law does not require a partnership agreement (also known as the articles of part-
the purpose of making a profit. nership), but it is wise to work with an attorney to develop one that spells out the exact sta-
tus and responsibility of each partner. All too often the parties think they know what they
are agreeing to, only to find later that no real meeting of the minds took place. A
partnership agreement partnership agreement is a document that states in writing the terms under which the
a document that states in writing partners agree to operate the partnership and protects each partner’s interest in the busi-
the terms under which the ness. Every partnership should be based on a written agreement. “When two entrepreneur-
partners agree to operate the ial personalities are combined, there is a tremendous amount of strength and energy, but it
partnership and protects each
must be focused in the same direction, or it will tear the relationship apart,” explains one
partner’s interest in the business.
business writer. “A good partnership agreement will guide you through the good times,
provide you with a method for handling problems, and serve as the infrastructure for a suc-
cessful operation.”2

After several years of running his own business that specialized in creating government
databases, Ken Clansky decided to enter into a partnership with the owner of a company
whose services complemented those Clansky’s business offered. The two agreed to be
equal partners in the combined venture, but they neglected to create a partnership agree-
Ken Clansky
ment. They soon discovered that their business goals and their managerial styles differed
significantly, and conflicts surfaced. In retrospect, “We were both trying to run the show,”
says Clansky, who left the partnership and made a career change. “A business partnership
is much more complex than it seems,” he says.3

When no partnership agreement exists, the Uniform Partnership Act (UPA) governs a
partnership, but its provisions may not be as favorable as a specific agreement hammered
out among the partners. Creating a partnership agreement is not costly. In most cases the
partners can discuss their preferences for each of the provisions in advance. Once they have
reached an agreement, an attorney can draft the formal document. Banks will often want to
see a copy of the partnership agreement before lending money to a partnership. Probably the
most important feature of the partnership agreement is that it resolves potential sources of
conflict that, if not addressed in advance, could later result in partnership battles and the dis-
solution of an otherwise successful business. Spelling out details—in particular, sticky ones
such as profit splits, contributions, workloads, decision-making authority, dispute resolu-
tion, dissolution, and others—in a written agreement at outset will help to avoid damaging
tension in a partnership that could lead to a business “divorce.” Business divorces, like mar-
ital ones, are almost always costly and unpleasant for everyone involved.
Generally, a partnership agreement can include any terms the partners want (unless
they are illegal). The standard partnership agreement will likely include the following:
1. Name of the partnership.
2. Purpose of the business. What is the reason the business was brought into being?
3. Domicile of the business. Where will the principal business be located?
4. Duration of the partnership. How long will the partnership last?
5. Names of the partners and their legal addresses.
6. Contributions of each partner to the business at the creation of the partnership
and later. This includes each partner’s investment in the business. In some situations
a partner may contribute assets that are not likely to appear on a balance sheet.
Experience, sales contacts, and a good reputation in the community may be reasons
for asking a person to join in partnership.
7. Agreement on how the profits or losses will be distributed.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 167

8. Procedure for expansion through the addition of new partners.

9. Agreement on distribution of assets if the partners voluntarily dissolve the
partnership.
10. Sale of partnership interest. The articles of partnership should include terms defin-
ing how a partner can sell his or her interest in the business.
11. Salaries, draws, and expense accounts for the partners. How much money will each
partner draw from the business? Under what circumstances? How often?
12. Absence or disability of one of the partners. If a partner is absent or disabled for an
extended period of time, should the partnership continue? Will the absent or disabled
partner receive the same share of profits as he or she did prior to the absence or dis-
ability? Should the absent or disabled partner be held responsible for debts incurred
while unable to participate?
13. Dissolution of the partnership. Under what circumstances will the partnership dis-
solve? How will the assets of the business be valued for dissolution?
14. Alternations or modifications of the partnership agreement. No document is writ-
ten to last forever. Partnership agreements should contain provisions for alternations
or modifications.

The Uniform Partnership Act The Uniform Partnership Act (UPA) codifies the body
of law dealing with partnerships in the United States (except in Louisiana, which has not
adopted the UPA and where state law governs in the absence of a partnership
agreement). Under the UPA, the three key elements of any partnership are common
ownership interest in a business, sharing the business’s profits and losses, and the right
to participate in managing the operation of the partnership. Under the act each partner
has the right to:
1. Share in the management and operations of the business.
2. Share in any profits the business might earn from operations.
3. Receive interest on additional advances made to the business.
4. Be compensated for expenses incurred in the name of the partnership.
5. Have access to the business’s books and records.
6. Receive a formal accounting of the partnership’s business affairs.
The UPA also sets forth the partners’ general obligations. Each partner is obligated to:
1. Share in any losses sustained by the business.
2. Work for the partnership without salary.
3. Submit differences that may arise in the conduct of the business to majority vote or
arbitration.
4. Give the other partner complete information about all business affairs.
5. Give a formal accounting of the partnership’s business affairs.
David Gage, a partnership mediator, suggests that partners also create a “partnership
charter,” a document that “serves as a guide for running the business and dealing with one
another.” Whereas a partnership agreement addresses the legal and business issues of run-
ning a business, a partnership charter covers the interpersonal aspects of the partners’ rela-
tionships and serves as a helpful tool for managing the complexity of partnership relations.4
Even with a partnership charter and a partnership agreement, a partnership must have two
more essential elements above all others: mutual trust and respect. Any partnership miss-
ing these elements is destined to fail.

The Advantages of the Partnership

Easy to Establish Like a proprietorship, a partnership is easy and inexpensive to
establish. The owner must obtain the necessary business licenses and submit a minimal
number of forms. In most states, partners must file a Certificate for Conducting Business
as Partners if the business is run under a trade name.
168 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Complementary Skills In a sole proprietorship, the owner must wear many different
hats, and not all of them will fit well. In successful partnerships, the parties’ skills and
abilities usually complement one another, strengthening the company’s managerial
foundation.

While developing a business plan for a competition in their sophomore year at Colgate
University, friends and fraternity brothers Chris Nordsiek, Preston Burnes, and Matt Brown
came up with the idea for a restaurant in Hamilton, New York. The trio realized that each
person had different skills and strengths that complemented those of the others, that
Chilly Willy’s
they shared a common business vision, and that they enjoyed working together. It was
only natural that after graduating Nordsiek, Burnes, and Brown launched Chilly Willy’s, a
fast-service restaurant with a Mexican theme. “If two of us are disagreeing about some-
thing,” says Nordsiek, “we’ll bring in the third guy, and he’ll make the call or arbitrate.
We put the success of the restaurant before everything else.”5

Division of Profits There are no restrictions on how partners distribute the company’s
profits as long as they are consistent with the partnership agreement and do not violate the
rights of any partner. The partnership agreement should articulate the nature of each
partner’s contribution and proportional share of the profits. If the partners fail to create an
agreement, the UPA says that the partners share equally in the partnership’s profits, even if
their original capital contributions were unequal.

Larger Pool of Capital The partnership form of ownership can significantly broaden
the pool of capital available to a business. Each partner’s asset base enhances the
business’s pool of capital and improves its ability to borrow needed funds; together,
partners’ personal assets support greater borrowing capacity.

Ability to Attract Limited Partners When partners share in owning, operating, and
general partners managing a business, they are general partners. General partners have unlimited liability
partners who share in owning, for the partnership’s debts and usually take an active role in managing the business. Every
operating, and managing a partnership must have at least one general partner, although there is no limit on the number
business and who have unlimited of general partners a business can have.
personal liability for the
Limited partners cannot participate in the day-to-day management of a company,
partnership’s debts.
and they have limited liability for the partnership’s debts. If the business fails, they lose
limited partners only what they have invested in it and no more. A limited partnership can attract investors
partners who do not take an active by offering them limited liability and the potential to realize a substantial return on their
role in managing a business and investments if the business is successful. Many individuals find it very profitable to invest
whose liability for the partnership’s in high-potential small businesses, but only if they avoid the disadvantages of unlimited
debts is limited to the amount they liability while doing so.
have invested. Essentially, limited partners usually are financial investors who do not want to partic-
ipate in the day-to-day operation of the business. If limited partners are “materially and
actively” engaged in a business (defined as spending more than 500 hours per year in the
company) or if they hold themselves out as general partners, they will be treated as general
partners and will lose their limited liability protection. Two types of limited partners are
silent partners silent partners and dormant partners. Silent partners are not active in a business but gen-
limited partners who are not active erally are known to be members of the partnership. Dormant partners are neither active
in a business but generally are nor generally known to be associated with the business. We will discuss limited partner-
known to be members of the ships in the next section of this chapter.
partnership.

dormant partners Little Governmental Regulation Like the sole proprietorship, partnerships are not
limited partners who are neither burdened with red tape.
active in a business nor generally
known to be associated with the
Flexibility Although not as flexible as sole ownership, a partnership can generally react
business.
quickly to changing market conditions because the partners can respond quickly and
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 169

© Tribune Media Services, Inc. all rights reserved. Reprinted with permission.

creatively to new opportunities. In large partnerships, however, getting partners’ approval

can slow a company’s strategic actions.

Taxation The partnership itself is not subject to federal taxation. It serves as a conduit for
the profits or losses it earns or incurs; its net income or losses are passed along to the
partners as personal income, and the partners pay income tax on their distributive shares
based on their personal tax rates. The partnership files an informational return, Form 1065,
with the IRS that reports its net income for the tax year and the percentages of the business
that each partner owns. The partnership provides each partner with a Schedule K-1 that
shows his or her share of partnership’s net income (or loss). Partners must pay taxes on
their respective shares of the partnership’s net income, even if none of that income actually
is distributed to them. A partnership, like a sole proprietorship, avoids the “double
taxation” disadvantage associated with the corporate form of ownership.

The Disadvantages of the Partnership

Unlimited Liability of at Least One Partner At least one member of every
partnership must be a general partner. A general partner has unlimited personal liability for
any debts that remain after the partnership’s assets are exhausted. In addition, general
partners’ liability is joint and several, which means that creditors can hold all partners
equally responsible for the partnership’s debts or they can collect the entire debt from just
one partner.

Capital Accumulation Although the partnership form of ownership is superior to the

proprietorship in its ability to attract capital, it is generally not as effective as the corporate
form of ownership, which can raise capital by selling shares of ownership to outside
investors.

Difficulty in Disposing of Partnership Interest without Dissolving the

Partnership Most partnership agreements restrict how partners can dispose of their
shares of the business. Often, an agreement requires a partner to sell his or her interest to
the remaining partner(s). Even if the original agreement contains such a requirement and
clearly delineates how the value of each partner’s ownership will be determined, there is no
guarantee that the other partner(s) will have the financial resources to buy the seller’s
interest. When the money is not available to purchase a partner’s interest, the other
partner(s) may be forced either to accept a new partner or to dissolve the partnership,
distribute the remaining assets, and begin again.
Unless the partnership agreement states otherwise, a partner may sell his or her inter-
est in the business to another person without the consent of the remaining partners.
However, that person does not automatically become a partner in the business. The trans-
feree has the right to receive the former partner’s share of the company’s net income (or
loss), but he or she does not have the right to take an active role in managing the business,
170 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

gain access to the business’s books, or demand a formal accounting of the partnership’s
business affairs.
When a partner withdraws from the partnership, the partnership ceases to exist unless
there are specific provisions in the partnership agreement for a smooth transition. When a
general partner dies, becomes incompetent, or withdraws from the business, the partner-
ship automatically dissolves, although it may not terminate. Even when there are numer-
ous partners, if one chooses to disassociate from the business, the remaining partners will
probably form a new partnership.

Lack of Continuity If one partner dies, complications arise. Partnership interest is often
nontransferable through inheritance because the remaining partner(s) may not want to be
in a partnership with the person who inherits the deceased partner’s interest. Partners can
make provisions in the partnership agreement to avoid dissolution due to death if all parties
agree to accept as partners those who inherit the deceased’s interest.

Potential for Personality and Authority Conflicts Being in a partnership is much

like being in a marriage. Making sure partners’ work habits, goals, ethics, and general
business philosophy are compatible is an important step in avoiding a nasty business
divorce. Engaging in serious discussions with potential partners before launching a
business together is a valuable and revealing exercise. Never assume that you know
how a potential partner will behave in a business setting. One way to “test drive” a
potential partnership is to work with a prospective partner on a joint project to get a
sense of how compatible your work styles, business philosophies, and personalities
really are.
One entrepreneur launched a telecommunications company with three friends but
quickly came to regret his choice of partners. “I was naïve,” he says. “I didn’t screen our
business goals. They wanted the company to pay for their cars and to conduct business
meetings in the Bahamas. I wanted to plow the money back into the business.” Because his
partners voted as a block, this entrepreneur finally realized he was fighting a losing battle.
His partners kept draining the company’s cash to pay for executive perks until the business
collapsed. The entrepreneur and his former friends and partners do not even speak to one
another now.6
No matter how compatible partners are, friction among them is inevitable. They key is
to have a mechanism such as a partnership agreement and open lines of communication for
managing conflict. The demise of many partnerships can be traced to interpersonal con-
flicts and the lack of a procedure to resolve those conflicts.

Partners Are Bound by the Law of Agency A partner is like a spouse in that
decisions made by one in the name of the partnership bind all. Each partner is an agent for
the business and can legally bind the partnership and, hence, the other partners to
contracts, even without the remaining partners’ knowledge or consent. Because of this
agency power, all partners must exercise good faith and reasonable care when performing
their responsibilities. Consider the case of a partner who signs a three-year lease for a
business jet, a move that only worsens the small company’s cash flow struggles. Although
the remaining partners may not have been not in favor of the decision, they are obligated to
the contract by their partner’s actions.
Some partnerships survive a lifetime, while others suffer from many of the preced-
ing problems. In a general partnership, the continued exposure to unlimited personal lia-
bility for partners’ actions can wear an entrepreneur down. An entrepreneur knowing
that he or she could lose his or her personal assets because of a partner’s bad business
decision is a fact of life in partnerships. Conflicts between or among partners can force
an otherwise thriving business to close. Few partnerships ever put into place a mutually
agreed on means for conflict resolution. Without such a mechanism, disagreements can
escalate to the point at which the partnership is dissolved and the business ceases to
operate.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 171

Keeping a Partnership Thriving

company safe and hid the key. When Jim discovered that
he could no longer raid the company’s cash, he brought
a guard dog to work, put it in the cab of Paul’s truck,
and had the receptionist ask Paul to move his truck.
Three middle managers at a plastics fabricator pur-
chased the company in a leveraged buyout. The busi-
ness took off, and profits climbed much higher than
they had expected. Unfortunately, two of the partners
began plotting to keep most of the largesse for them-
selves by subtly pressuring the third partner out of the
business. They scheduled important business meetings
and “forgot” to tell him about them. They took key cus-
tomers to lunch and did not invite him. They awarded
themselves big raises and gave him an extra week of
vacation. “They threw every humiliation at me they
could think of,” says the third partner, looking back on
the situation. “I was so absorbed with building the
company that I didn’t dream they weren’t.” He was
shocked when his partners walked into his office one
afternoon and announced, “John, when you go home
tonight, don’t bother coming back.” John did come
back—with an exit agreement the three had signed
when they created their partnership. Unfazed, his for-
mer partners used that contract against him as well,
enforcing the noncompete clause the agreement con-
tained against him.
Forming a partnership offers entrepreneurs many advantages but These partnership horror stories (and there are many
can create many business problems as well. What steps can more out there) are enough to discourage any entrepre-
partners take to avoid the pitfalls of partnerships? neur from entering into a partnership. Structured prop-
erly, however, a partnership can be very successful and
quite rewarding for its founders. For instance, Marty
Ambuehl and Neil Clark formed their first business part-
P aul and Jim were great friends who decided to go nership as college friends when they co-founded a
piano moving company on little more than a handshake
into business together. They launched their courier busi-
ness on a handshake and a pledge to share and share and a slap on the back. Years later, when they launched
alike. Trouble soon loomed over the partnership, how- ATM Express, a Billings, Montana, company that distrib-
ever, the result of Jim’s gambling habit. Jim assumed utes automated teller machines, they took a much more
that, as co-founder of the company, he was entitled to formal approach. When their principal investor asked,
help himself to cash whenever he was running low. “What happens if the two of you get to the point
Because of his gambling habit, Jim’s cash often ran low. where you don’t want to be partners anymore,” they
Paul managed to cope with Jim’s “withdrawals” until created employment contracts that locked them into
two large thugs camped out in the foyer of the business the partnership for five years. They also created a buy-
and refused to leave until they collected $2,500 for Jim’s sell agreement that gives one partner the right of first
losing Super Bowl bet with a bookie. Paul locked the refusal if the other partner decides he wants out.
172 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Ambuehl and Clark also drew up documents that their relationships. You cannot delegate or ignore
addressed the ways in which they agreed to handle big this role; otherwise, the partnership is destined
decisions and difficult problems that they knew would to fail.
eventually arise. That document alone proved to be r Respect your differences but expect to work out
quite valuable when they had the opportunity to pur- conflicts. When potential sources of conflict exist,
chase a related business. Ambuehl saw the purchase as address them immediately. Festering wounds
a major opportunity for their business to grow, but seldom heal themselves.
Clark saw it as a huge risk and was reluctant to take r Divide business responsibilities and duties accord-
such a big step. To resolve the stalemate, the partners ing to each partner’s skills, interests, and abilities.
turned to their agreement: They would make a major r Be prepared to change. Be open to new opportu-
move such as an acquisition only if both of them agreed nities, and share with your partners what you see.
on it. “If there’s no agreement, there’s no deal,” says Partnerships must evolve to survive.
Clark. “That’s the solution.” Ambuehl agrees. “You’re r Help your partners to succeed. Work hard to see
fooling yourself if you think there’s never going to be a that every partner plays a role in the business that
disagreement,” he says. “Neil and I don’t try to back affords him or her the opportunity to be successful.
one another into a corner. We know we have to bend.” r Make sure your partners are people you admire,
Avoiding ugly and costly business divorces that too respect, and enjoy being around.
often bring an end to businesses requires an ongoing
1. Research relationships between partners and add
and active effort. Experts suggest that partners follow
at least three guidelines to those listed above.
these guidelines to keep their partnerships going strong:
2. Develop a list of the types of behavior that is
r Ask yourself, “Do I really need a partner?” A almost certain to destroy a partnership.
potential partner should bring to the business 3. Suppose that two of your friends are about to
skills, contacts, financing, knowledge, or some- launch a business together with nothing but a
thing else that you don’t have. The ideal partner is handshake. “We’ve been best friends since gram-
one whose skills, talents, and abilities complement mar school,” they say. What advice would you give
yours rather than mirror them. them?
r Take a close look at what you’re getting. How well
Sources: Dimitra Kessenides, “Happy Together,” Inc., November
do you really know your potential partner? One of
2004, pp. 54–56; Robert A. Mamis, “Partner Wars,” Inc., June 1994,
the best ways to test your compatibility is to work http://pf.inc.com/magazine/19940601/2956.html; Rosabeth Moss
on projects together before you decide to go into Kanter, “Six Rules for a Happy Marriage . . . Uh, Partnership”, Business
business with one another. 2.0, April 2002 p. 114; Paulette Thomas, “Networking Provides
Partnership’s Funding,” Wall Street Journal, October 14, 2003, p. B4;
r Invest in the relationship, not just the deal mak- Nichole L. Torres, “A Week in Review,” Entrepreneur, October 2005,
ing. Partners must constantly work to strengthen pp. 92–94.

Limited Partnerships
limited partnership A limited partnership is composed of at least one general partner and at least one limited
a partnership composed of at least partner. In a limited partnership the general partner is treated, under the law, exactly as in a
one general partner and at least general partnership. Limited partners are treated as investors in the business venture, and
one limited partner. they have limited liability for the partnership’s debts. They can lose only the amount they
have invested in the business. Because of this advantage, limited partnerships own many
professional sports teams.
Most states have ratified the Revised Uniform Limited Partnership Act. When forming
a limited partnership, its founders are required to file a Certificate of Limited Partnership
with the secretary of state’s office. Although the requirements vary from one state to
another, the Certificate of Limited Partnership typically includes the following information:
1. The name of the limited partnership.
2. The general character of its business.
3. The address of the office of the firm’s agent authorized to receive summonses or
other legal notices.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 173

4. The name and business address of each partner, specifying which ones are general
partners and which are limited partners.
5. The amount of cash contributions actually made, and agreed to be made in the future,
by each partner.
6. A description of the value of noncash contributions made or to be made by each partner.
7. The times at which additional contributions are to be made by any of the partners.
8. Whether and under what conditions a limited partner has the right to grant limited
partner status to an assignee of his or her interest in the partnership.
9. If agreed on, the time or the circumstances when a partner may withdraw from the
firm (unlike the withdrawal of a general partner, the withdrawal of a limited partner
does not automatically dissolve a limited partnership).
10. If agreed on, the amount of, or the method of determining, the funds to be received
by a withdrawing partner.
11. Any right of a partner to receive distributions of cash or other property from the firm,
and the times and circumstances for such distributions.
12. The time or circumstances when the limited partnership is to be dissolved.
13. The rights of the remaining general partners to continue the business after with-
drawal of a general partner.
14. Any other matters the partners want to include.
Every limited partnership must have at least one general partner, but there is no limit
to the number of general or limited partners allowed. The general partner has the same
rights and duties as under a general partnership: the right to make decisions for the busi-
ness, to act as an agent for the partnership, to use the property of the partnership for normal
business, and to share in the business’s profits. The limited partner does not have the right
to engage actively in managing the business. In fact, if a limited partner takes an active part
in managing the business (more than 500 hours per year), he or she forfeits the limited lia-
bility status and is treated just like a general partner. Limited partners can, however, make
management suggestions to the general partners, inspect the business, and make copies of
business records. A limited partner is, of course, entitled to a share of the business’s prof-
its as specified in the Certificate of Limited Partnership. The primary disadvantage of lim-
ited partnerships is the complexity and the cost of establishing and maintaining them.

Wolfgang Puck, the Austrian-born chef who has won

national acclaim for his unique food combinations such as
scrambled egg pizza with smoked salmon and banana
chocolate chip soufflé, and his wife, Barbara Lazaroff,
Wolfgang Puck
operate three dozen upscale restaurants across the United
States. The largest division of their business, the Food World-famous chef Wolfgang
Company, is a corporation, but Puck and Lazaroff rely on Puck and his wife Barbara
limited partnerships to operate the restaurants in their Lazaroff operate the restaurants
in their company’s Fine Dining
Fine Dining Group. For instance, each of the company’s
Group–Spago, Postrio, and
various Spago’s (Beverly Hills, Palo Alto, Maui, and Las
others-through limited
Vegas) has a distinct collection of owners as do the other partnerships.
restaurants in the group such as Postrio and Chinois.7

Limited Liability Partnerships

Many states now recognize a limited liability partnership (LLP) in which all partners in limited liability partnership
a business are limited partners, which gives them the advantage of limited liability for the (LLP)
debts of the partnership. Most states restrict LLPs to certain types of professionals such as a special type of limited
attorneys, physicians, dentists, accountants, and others. However, many states restrict the partnership in which all partners,
limited liability advantage of LLPs to the results of actions taken by other partners. For who in many states must be
professionals, are limited partners.
instance, if an LLP sells a defective product that injures a customer, the injured customer
could sue the business and the partners as individuals. The partners’ unlimited personal
liability exposure means that their personal assets would be at risk.
174 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Just as with any limited partnership, the partners must file a Certificate of Limited
Partnership in the state in which the partnership will conduct business, and the partnership
must identify itself as an LLP to those with whom it does business. In addition, like every
partnership, an LLP does not pay taxes; its income is passed through to the limited part-
ners, who pay taxes on their shares of the company’s income.

Master Limited Partnership

master limited partnership A relatively new form of business structure, the master limited partnership (MLP) is just
(MLP) like a regular limited partnership, except that its shares are traded just like shares of com-
a partnership whose shares are mon stock. They provide most of the same advantages to investors as a corporation—
traded on stock exchanges, just including limited liability. Operationally, a master limited partnership behaves like a
like a corporation’s. corporation, and some even trade on major stock exchanges. In 1987, congressional legis-
lation provided that any MLP not involved in natural resources such as oil, natural gas, or
real estate would be taxed as a corporation and consequently eliminated their ability to
avoid the disadvantage of double taxation that corporations experience.

Sunoco Logistics, a company that refines and stores crude oil and refined oil products,
formed a master limited partnership to take advantage of the “pass through” treat-
ment of its net income. Because the MLP simply passes its net income through to its
owners, Sunoco Logistics avoids the double taxation that it would incur if it were a
Sunoco Logistics
corporation.8

LEARNING OBJECTIVES Corporations

1C. Explain the advantages and
disadvantages of the corporation. The corporation is the most complex of the three major forms of business ownership. It is
a separate entity apart from its owners, and may engage in business, make contracts, sue
corporation and be sued, own property, and pay taxes. The Supreme Court has defined the corporation
a separate legal entity apart from as “an artificial being, invisible, intangible, and existing only in contemplation of the law.”9
its owners which receives the right Because the life of the corporation is independent of its owners, the shareholders can sell
to exist from the state in which it is their interests in the business without affecting its continuation.
incorporated.
Corporations (also known as “C Corporations”) are creations of the states. When a
domestic corporation corporation is founded, it accepts the regulations and restrictions of the state in which it is
a corporation doing business incorporated and any other state in which it chooses to do business. A corporation doing
in the state in which it is business in the state in which it is incorporated is a domestic corporation. When a corpo-
incorporated. ration conducts business in another state, that state considers it to be a foreign corpora-
foreign corporation
tion. A corporation that is formed in another country but does business in the United States
a corporation doing business in a is called an alien corporation.
state other than the one in which Corporations have the power to raise large amounts of capital by selling shares of
it is incorporated. ownership to outside investors, but many corporations have only a handful of shareholders.
A publicly held corporation has a large number of shareholders, and its stock usually is
alien corporation traded on one of the large stock exchanges. A closely held corporation has shares that are
a corporation formed in another
controlled by a relatively small number of people, often family members, relatives, friends,
country but doing business in the
or employees. Its stock is not traded on any stock exchange but instead is passed from one
United States.
generation to the next. Many small corporations are closely held.
publicly held corporation A corporation must report annually its financial operations to its home state’s secre-
a corporation that has a large tary of state. These financial reports become public record. If a corporation’s stock is sold
number of shareholders and in more than one state, the corporation must comply with federal regulations governing the
whose stock usually is traded on sale of corporate securities. There are substantially more reporting requirements for a cor-
one of the large stock exchanges.
poration than for the other forms of ownership.
closely held corporation
a corporation whose shares are How to Incorporate
controlled by a relatively small Most states allow entrepreneurs to incorporate without the assistance of an attorney. Some
number of people, often family states even provide incorporation kits to help in the incorporation process. Although it is
members, relatives, friends, or
cheaper for entrepreneurs to complete the process themselves, it is not always the best
employees.
idea. In some states, the application process is complex, and the required forms are
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 175

confusing. The price for filing incorrectly can be high. If an entrepreneur completes the
incorporation process improperly, it is generally invalid.
Once the owners decide to form a corporation, they must choose a state in which to
incorporate. If the business will operate within a single state, it is probably most logical to
incorporate in that state. States differ—sometimes rather dramatically—in the require-
ments they place on the corporations they charter and how they treat the corporations cre-
ated within their borders. They also differ in the tax rates they impose on corporations, the
restrictions they place on corporations’ activities, the capital they require for a company to
incorporate, and the fees or organization taxes they charge to incorporate. Delaware, for
instance, offers low incorporation fees, favorable laws, and minimal legal requirements,
and many corporations are chartered there.
To create a corporation, every state requires a Certificate of Incorporation or charter to
be filed with the secretary of state. The following information is generally required to be in
the Certificate of Incorporation:

The corporation’s name. The corporation must choose a name that is not so similar to
that of another firm in that state that it causes confusion or lends itself to deception. It
must also include a term such as “corporation,” “incorporated,” “company,” or “limited”
to notify the public that they are dealing with a corporation.
The corporation’s statement of purpose. The incorporators must state in general terms
the intended nature of the business. The purpose must, of course, be lawful. An illus-
tration might be “to engage in the sale of office furniture and fixtures.” The purpose
should be broad enough to allow for some expansion in the activities of the business as
it develops.
The corporation’s time horizon. Most corporations are formed with no specific termi-
nation date; they are formed “for perpetuity.” However, it is possible to incorporate for
a specific duration (e.g., 50 years).
Names and addresses of the incorporators. The incorporators must be identified in
the articles of incorporation and are liable under the law to attest that all information in
the articles of incorporation is correct. Some states require one or more of the incorpo-
rators to reside in the state in which the corporation is being created.
Place of business. The street and mailing addresses of the corporation’s principal
office must be listed. For a domestic corporation, this address must be in the state in
which incorporation takes place.
Capital stock authorization. The articles of incorporation must include the amount
and class (or type) of capital stock the corporation wants to be authorized to issue.
This is not the number of shares it must issue; a corporation can issue any number of
shares up to the total number authorized. This section must also define the different
classification of stock and any special rights, preferences, or limits each class has.
Capital required at the time of incorporation. Some states require a newly formed
corporation to deposit in a bank a specific percentage of the stock’s par value prior to
incorporating. preemptive rights
Provisions for preemptive rights, if any, that are granted to stockholders. If a the rights of a corporation’s original
corporation later issues more shares of the stock it is authorized to issue, its original investors to purchase enough
investors’ shares of ownership would be diluted. To prevent this dilution, some corpo- shares of future stock issues to
rations grant preemptive rights to shareholders, which give them the ability to maintain their original percentage
purchase enough shares to maintain their original percentage of ownership in the of ownership in the company.
company. treasury stock
Restrictions on transferring shares. Many closely held corporations—those the shares of its own stock that a
owned by a few shareholders, often family members—require shareholders inter- corporation owns.
ested in selling their stock to offer it first to the corporation. (Shares the corpora- right of first refusal
tion itself owns are called treasury stock.) To maintain control over their owner- a provision requiring shareholders
ship, many closely held corporations exercise their right, known as the right of who want to sell their stock to
first refusal. offer it first to the corporation.
176 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Names and addresses of the officers and directors of the corporation.

bylaws Rules under which the corporation will operate. Bylaws are the rules and regula-
the rules and regulations the tions the officers and directors establish for the corporation’s internal management
officers and directors establish for and operation.
a corporation’s internal
management and operation. Once the secretary of state of the incorporating state has approved a request for incor-
poration and the corporation pays its fees, the approved articles of incorporation become
its charter. With the charter in hand, the next order of business is to hold an organizational
meeting for the stockholders to formally elect directors who, in turn, will appoint the cor-
porate officers.

The Advantages of the Corporation

Limited Liability of Stockholders Because it is a separate legal entity, a corporation
allows investors to limit their liability to the total amount of their investment in the
business. In other words, creditors of the corporation cannot lay claim to shareholders’
personal assets to satisfy the company’s unpaid debts. The legal protection of personal
assets from business creditors is of critical concern to many potential investors.
This shield of limited liability may not be impenetrable, however. Because start-up
companies are so risky, lenders and other creditors often require the founders of corpora-
tions to personally guarantee loans made to the business. Experts estimate that 95 percent
of small business owners have to sign personal guarantees to get the financing they need.
By making these guarantees, owners are putting their personal assets at risk (just as in a
proprietorship) despite choosing the corporate form of ownership.
The corporate form of ownership does not protect its owners from being held person-
ally liable for fraudulent or illegal acts, however. Court decisions have extended the per-
sonal liability of the owners of small corporations beyond the financial guarantees that
banks and other lenders require, “piercing the corporate veil” much more than ever
before. Courts increasingly are holding entrepreneurs personally liable for environmen-
tal, pension, and legal claims against their corporations. Courts will pierce the corporate
veil and hold entrepreneurs liable for the company’s debts and obligations if the owners
deliberately commit criminal or negligent acts when handling corporate business. Courts
ignore the limited liability shield the corporate form of ownership provides when an
entrepreneur:
1. Uses corporate assets for personal reasons or commingles them with his or her
personal assets.
2. Fails to act in a responsible manner and creates an unwarranted level of financial risk
for the stockholders.
3. Makes financial misrepresentations, such as operating with more than one set of
books.
4. Takes actions in the name of the corporation that were not authorized by the board of
directors.
Liability problems associated with piercing the corporate veil almost always originate
from actions and decisions that fail to maintain the integrity of a corporation. The most
common cause of these problems, especially in closely held corporations, is corporate
owners and officers failing to keep their personal funds and assets separate from those of
the corporation.
Table 5.1 offers some useful suggestions for avoiding legal tangles in a corporation.

Ability to Attract Capital Because of the limited liability they offer their investors,
corporations have proved to be the most effective form of ownership for accumulating
large amounts of capital. Limited only by the number of shares authorized in its charter
(which can be amended), a corporation can raise money to begin business and expand by
selling shares of its stock to investors. A corporation can sell its stock to a limited number
of private investors in a private placement or to the public through an initial public offering
(or IPO).
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 177

TABLE 5.1 Avoiding Legal Tangles in a Corporation

Steps that entrepreneurs should take to avoid legal problems if they own a corporation include
the following:
r Identify the company as a corporation by using “Inc.” or “Corporation” in the business
name. This alerts all who do business with a company that it is a corporation.
r File all reports and pay all necessary fees required by the state in a timely manner. Most
states require corporations to file reports with the secretary of state on an annual basis.
Failing to do so will jeopardize the validity of your corporation and will open the door for
personal liability problems for its shareholders.
r Hold annual meetings to elect officers and directors. In a closely held corporation, the offi-
cers elected may be the shareholders, but that does not matter. Corporations formed by an
individual are not required to hold meetings, but the sole shareholder must file a written
consent form.
r Keep minutes of every meeting of the officers and directors, even if it takes place in the liv-
ing room of the founders. It is a good idea to elect a secretary who is responsible for
recording the minutes.
r Make sure that the corporation’s board of directors makes all major decisions. Problems
arise in closely held corporations when one owner makes key decisions alone without con-
sulting the elected board.
r Make it clear that the business is a corporation by having all officers sign contracts, loan
agreements, purchase orders, and other legal documents in the corporation’s name rather
than their own names. Failing to designate their status as agents of the corporation can
result in the officers being held personally liable for agreements they think they are signing
on the corporation’s behalf.
r Keep corporate assets and the personal assets of the owners separate. Few things make
courts more willing to hold shareholders personally liable for a corporation’s debts than
commingling corporate and personal assets. In some closely held corporations, owners
have been known to use corporate assets to pay their personal expenses (or vice versa) or
to mix their personal funds with corporate funds into a single bank account. Protect the
corporation’s identity by keeping it completely separate from the owners’ personal
identities.

One of the most successful initial public offerings in recent years was Google’s IPO. When
founders Sergey Brin and Larry Page, who founded the company in their college dorm
room, took their company public, they sold 19.6 million shares at $85 per share, raising
$1.67 billion to fund Google’s growth and expansion.10
Google

You will learn more about IPOs in Chapter 13, “Sources of Financing: Debt and
Equity.”

Ability to Continue Indefinitely Unless a corporation fails to pay its taxes or is

limited to a specific length of life by its charter, it can continue indefinitely. The
corporation’s existence does not depend on the fate of any single individual. Unlike a
proprietorship or partnership, in which the death of a founder ends the business, a
corporation lives beyond the lives of those who gave it life. This perpetual life gives rise to
the next major advantage—transferable ownership.

Transferable Ownership Unlike an investment in a partnership, shares of ownership in

a corporation are easily transferable. If stockholders want to liquidate their shares of
ownership in a corporation, they can sell their shares to someone else. Billions of shares of
stock representing ownership in companies are traded daily on the world’s stock
exchanges. Shareholders can also transfer their stock through inheritance to a new
generation of owners. During all of these transfers of ownership, the corporation continues
to conduct business as usual.
178 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

The Disadvantages of the Corporation

Cost and Time Involved in the Incorporation Process Corporations can be costly
and time consuming to establish and to maintain. The owners are giving birth to an
artificial legal entity, and the gestation period can be prolonged, especially for a novice. In
some states an attorney must handle the incorporation process, but in most states
entrepreneurs can complete all of the required forms alone. However, entrepreneurs must
exercise great caution when incorporating without the help of an attorney. In addition,
incorporating a business requires a variety of fees that are not applicable to proprietorships
or partnerships. The average cost to create a corporation is around $1,000, but, depending
on the complexity of the organization, fees can range from $500 and $2,500. In addition, a
corporation must have a board of directors, and the board must conduct an annual meeting
and maintain written records of that meeting.

Double Taxation Because a corporation is a separate legal entity, it must pay taxes on
its net income at the federal level, in most states, and to some local governments as well.
Before stockholders receive a penny of its net income as dividends, a corporation must
pay these taxes at the corporate tax rate, a graduated tax on corporate profits. Then,
stockholders must pay taxes on the dividends they receive from these same profits at the
double taxation individual tax rate. Thus, a corporation’s profits are taxed twice. This double taxation is
a disadvantage of the corporate a distinct disadvantage of the corporate form of ownership. Under current tax rates
form of ownership in which a (which are progressive for both the corporation and the individual), the magnitude of the
corporation’s profits are taxed double tax ranges from 23.1 percent to 57.1 percent, depending on the corporation’s
twice: at the corporate rate and at earnings.11
the individual rate (on the portion
of profits distributed as dividends). Potential for Diminished Managerial Incentives As corporations grow, they often
require additional managerial expertise beyond what the founder can provide. Because
they have most of their personal wealth tied up in their companies, entrepreneurs have an
intense interest in making them successful and are willing to make sacrifices for them.
Professional managers the entrepreneur brings in to help run the business as it grows do
not always have the same degree of interest in or loyalty to the company. As a result, the
business may suffer without the founder’s energy, care, and devotion. One way to
minimize this potential problem is to link managers’ (and even employees’) compensation
to the company’s financial performance through a profit-sharing or bonus plan.
Corporations can also stimulate managers’ and employees’ incentive on the job by creating
an employee stock ownership plan (ESOP) in which managers and employees become part
or whole owners in the company.

Legal Requirements and Regulatory Red Tape Corporations are subject to more
legal, reporting, and financial requirements than other forms of ownership. Corporate
officers must meet more stringent requirements for recording and reporting management
decisions and actions. They must also hold annual meetings and consult the board of
directors about major decisions that are beyond day-to-day operations. Managers may be
required to submit some major decisions to the stockholders for approval. Corporations
that are publicly held must file quarterly (10-Q) and annual (10-K) reports with the
Securities and Exchange Commission (SEC). These reports are available to the public, and
anyone, including competitors, can access them.

Potential Loss of Control by the Founder(s) When entrepreneurs sell shares of

ownership in their companies, they relinquish some control. Especially when they need
large capital infusions for start-up or growth, entrepreneurs may have to give up significant
amounts of control, so much, in fact, that the founder becomes a minority shareholder.
Losing majority ownership—and therefore control—in a company leaves the founder in a
precarious position. He or she no longer has the power to determine the company’s
direction; “outsiders” do. In some cases, founders’ shares have been so diluted that
majority shareholders actually vote them out of their jobs!
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 179

In 1975, Bill Gates and Paul Allen founded Microsoft as a partnership. At that time, Bill
Gates owned 50% of the business. As the entrepreneurs needed additional capital, they
made an initial public offering. Later, to fund the business’s rapid growth, Gates sold addi-
tional shares of common stock. The result has been a dilution of co-founder Bill Gate’s
Microsoft Inc.
percentage of ownership to 18.5%. However, there is no reason to feel sorry for Gates;
the value of his Microsoft stock has pushed his net worth to $51 billion, making him the
wealthiest person in the United States!12

Other Forms of Ownership LEARNING OBJECTIVES

2. Discuss the advantages and dis-
In addition to the sole proprietorship, the partnership, and the corporation, entrepreneurs advantages of the S Corporation,
can choose from other forms of ownership, including the S corporation, the limited liabil- the limited liability company, the
ity company, the professional corporation, and the joint venture. professional corporation, and the
joint venture.
The S Corporation
In 1954 the Internal Revenue Service Code created the Sub-chapter S corporation. In
recent years the IRS has shortened the title to S corporation and has made a few modifica-
tions in its qualifications. An S corporation is a distinction that is made only for federal S corporation
income tax purposes, and is, in terms of its legal characteristics, no different from any a corporation that retains the legal
other corporation. Although Congress has simplified some of the rules and requirements characteristics of a regular (C)
for S corporations, a business seeking “S” status still must meet the following criteria: corporation but has the advantage
of being taxed as a partnership if it
1. It must be a domestic (U.S.) corporation. meets certain criteria.
2. It cannot have a nonresident alien as a shareholder.
3. It can issue only one class of common stock, which means that all shares must carry
the same rights (e.g., the right to dividends or liquidation rights). The exception is
voting rights, which may differ. In other words, an S corporation can issue voting and
nonvoting common stock.
4. It must limit its shareholders to individuals, estates, and certain trusts, although tax-
exempt creations such as employee stock ownership plans (ESOPs) and pension
plans can now be shareholders.
5. It cannot have more than 100 shareholders (increased from 75), which is an impor-
tant benefit for family businesses making the transition from one generation of own-
ers to another.
6. Less than 25 percent of the corporation’s gross revenues during three successive tax
years must be from passive sources.
If a corporation meets the criteria of an S corporation, its shareholders must actually
elect to be treated as one. An S corporation election may be filed at any time during the
12 months that precede the taxable year for which the election is to be effective. (The
corporation must have been eligible for S status for the entire year.) To make the election
of S status effective for the current tax year, entrepreneurs must file Form 2553 with the
IRS within the first 75 days of the corporation’s fiscal year. All shareholders must con-
sent to have the corporation treated as an S corporation.

The Advantages of an S Corporation An S corporation retains all of the advantages

of a regular corporation, such as continuity of existence, transferability of ownership, and
limited personal liability for its owners. The most notable provision of the S corporation is
that it serves as a conduit for its net income, passing all of its profits or losses through to
the individual shareholders, which means that its income is taxed only once at the
individual tax rate. Thus, electing S corporation status avoids a primary disadvantage of
the regular (or “C”) corporation—double taxation. In essence, the tax treatment of an S
corporation is exactly like that of a partnership. The corporation files an informational
return (1120-S) with the IRS and provides its shareholders with Schedule K-1, which
reports their proportional shares of the company’s profits. The shareholders report their
180 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

portions of the S corporation’s earnings on their individual income tax returns (Form 1040)
and pay taxes on those profits at the individual tax rates (even if they never take the money
out of the business). This tax treatment can cause problems for individual shareholders,
however. If an S corporation earns a profit but managers choose to plow that income back
into the business in the form of retained earnings to fuel its growth and expansion,
shareholders still must pay taxes on their share of the company’s net income. In that case,
shareholders will end up paying taxes on “phantom income” they never actually received.
Another advantage the S corporation offers is avoiding the tax C corporations pay on
assets that have appreciated in value and are sold. S corporations also are not subject to the
self-employment tax that sole proprietors and general partners must pay; however, they are
responsible for payroll taxes (for Social Security and Medicare) on the wages the S corpo-
ration pays its employees. Therefore, owners of S corporations must be sure that the
salaries they draw are reasonable; salaries that are too low or too high draw scrutiny from
the IRS.
One significant change to the laws governing S corporations that benefits entrepre-
neurs involves subsidiary companies. Before 1998, if an entrepreneur owned separate but
affiliated companies, he or she had to maintain each one as a distinct S corporation with its
own accounting records and tax return. Under current law, business owners can set up all
of these affiliated companies as qualified S corporation subsidiaries (“Q Subs”) under the
umbrella of a single company, each with its own separate legal identity, and still file a sin-
gle tax return for the parent company. For entrepreneurs with several lines of businesses,
this change means greatly simplified tax filing. Owners also can use losses from one sub-
sidiary company to offset profits from another to minimize their tax bills.

Disadvantages of an S Corporation When the Tax Reform Act (TRA) of 1986

restructured individual and corporate tax rates, many business owners switched to S
corporations to lower their tax bills. For the first time since Congress enacted the
federal income tax in 1913, the maximum individual rate was lower than the maximum
corporate rate. However, in 1993 Congress realigned the tax structure by raising the
maximum personal tax rate to 39.6 percent from 31 percent. This new rate was
4.6 percent higher than the maximum corporate tax rate of 35 percent, making S
corporation status less attractive than before. Today, however, the maximum tax rate for
individuals is 35 percent and for corporations, it is 39 percent. Entrepreneurs
considering both C corporation and S corporation status must consider the total impact
of the decision on their companies, especially the tax implications (including the
impact of the C corporation’s double taxation penalty on the portion of its net income
distributed as dividends).
Another disadvantage of the S corporation is that the costs of many benefits—insurance,
meals, lodging, and others—paid to shareholders with 2 percent or more of stock cannot be
deducted as business expenses for tax purposes; these benefits are then considered to be
taxable income. In addition, S corporations offer shareholders only a limited range of
retirement benefits, while regular corporations make a wide range of retirement plans
available.

When Is an S Corporation a Wise Choice? Choosing S corporation status is usually

beneficial to start-up companies anticipating net losses. In this case, an entrepreneur can
use the loss to offset other income, thus saving money in the long run. Companies that plan
to reinvest most of their earnings to finance growth also find S corporation status favorable.
Small business owners who intend to sell their companies in the near future will prefer “S”
over “C” status because the taxable gains on the sale of an S corporation are generally
lower than those of a C corporation.
On the other hand, small companies with the following characteristics are not likely to
benefit from S corporation status:
r Highly profitable personal service companies with large numbers of shareholders, in
which most of the profits are passed on to shareholders as compensation or retire-
ment benefits.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 181

r Fast-growing companies that must retain most of their earnings to finance growth
and capital spending.
r Corporations in which the loss of benefits to shareholders exceeds tax savings.
r Corporations in which the income before any compensation to shareholders is less
than $100,000 per year.
r Corporations with sizable net operating losses that cannot be used against S corpora-
tion earnings.

Liquidating an S Corporation
Even though an S corporation has perpetual life just like a C corporation, the time may
come when the stockholders want to dissolve the company. Liquidating an S corporation
requires an entrepreneur to take the following actions:
r Pay all taxes and debts.
r Obtain the written approval of shareholders to dissolve the company.
r File a statement of intent to dissolve with the secretary of state’s office in which the
S corporation resides.
r Distribute all remaining assets of the corporation to shareholders.

The Limited Liability Company (LLC)

A relatively new creation, the limited liability company (LLC) is, like an S corporation, limited liability company
a cross between a partnership and a corporation. Like S corporations, LLCs offer their (LLC)
owners limited personal liability for the debts of the business, providing a significant a relatively new form of ownership
advantage over sole proprietorships and partnerships. LLCs, however, are not subject to that, like an S corporation, is a
cross between a partnership and a
many of the restrictions currently imposed on S corporations and offer more flexibility
corporation; it is not subject to
than S corporations. For example, S corporations cannot have more than 100 shareholders,
many of the restrictions imposed
none of whom can be a foreigner or a corporation. S corporations are also limited to only on S corporations.
one class of stock. LLCs eliminate those restrictions. In most states an LLC can have just
one owner, but a few states require LLC to have at least two owners (called “members”).
LLCs offer their owners limited liability without imposing any requirements on their char-
acteristics or any ceiling on their numbers. LLC members can include non-U.S. citizens,
partnerships, and corporations. Unlike a limited partnership, which prohibits limited part-
ners from participating in the day-to-day management of the business, an LLC does not
restrict its members’ ability to become involved in managing the company.
In addition to offering its members the advantage of limited liability, LLCs also avoid
the double taxation imposed on C corporations. Like an S corporation, an LLC does not
pay income taxes; its income flows through to the members, who are responsible for pay-
ing income taxes on their shares of the LLC’s net income. Because they are not subject to
the many restrictions imposed on other forms of ownership, LLCs offer entrepreneurs
another significant advantage: flexibility. An LLC permits its members to divide income
(and thus tax liability) as they see fit, including allocations that differ from their percent-
ages of ownership. Like an S corporation, the members’ share of an LLC’s earnings is not
subject to the self-employment tax. However, the managing member’s share of the LLC’s
earnings is subject to the self-employment tax just as a sole proprietor’s or a general part-
ner’s earned income is.
These advantages make the LLC an ideal form of ownership for many small compa-
nies across many industries—retail, wholesale, manufacturing, real estate, or service.
Because they offer the tax advantage of a partnership, the legal protection of a corporation,
and maximum operating flexibility, LLCs have become an extremely popular form of own-
ership among entrepreneurs.

Marian Fletcher launched a profitable party planning and catering service in 1995 as a
sole proprietorship. Her company, Let’s Go Party, grew quickly, and Fletcher wanted to
bring her daughter into the business as an owner. Reviewing the advantages and disad-
vantages of each form of ownership led Fletcher to create an LLC. “We decided this was
Let’s Go Party
the best way to go for us,” she says. “In case anything happens, my daughter and I won’t
182 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

As the owner of this pastry be liable for anything more than what we have invested
shop knows, operating a sole in the company already.” Fletcher, who set up her LLC
proprietorship offers many without the help of an attorney for just $50, also found
advantages, but entrepreneurs
the LLC’s tax treatment to be a major advantage for her
considering this form of
and her daughter.6
ownership must be aware of its
disadvantages as well.

Creating an LLC is much like creating a corporation. Forming an LLC requires an

entrepreneur to create two documents: the articles of organization (which must be filed
articles of organization with the secretary of state) and the operating agreement. The LLC’s articles of organiza-
the document that creates an LLC tion, similar to the corporation’s articles of incorporation, actually creates the LLC by
by establishing its name, its establishing its name and address, its method of management (board managed or member
method of management, its managed), its duration, and the names and addresses of each organizer. In most states the
duration, and other details. company’s name must contain the words “limited liability company,” “limited company,”
or the letters “L.L.C.” or “L.C.” Unlike a corporation, an LLC does not have perpetual life;
in most states an LLC’s charter may not exceed 30 years. However, the same factors that
would cause a partnership to dissolve would also cause the dissolution of an LLC before its
charter expires.
operating agreement The operating agreement, similar to a corporation’s bylaws, outlines the provisions
the document that establishes for governing the way the LLC will conduct business, such as members’ capital contributions
an LLC the provisions governing to the LLC, the admission or withdrawal of members, distributions from the business, and
the way it will conduct business. how the LLC will be managed. To ensure that their LLCs are classified as a partnership for
tax purposes, entrepreneurs must draft the operating agreement carefully. The operating
agreement must create an LLC that has more characteristics of a partnership than of a cor-
poration to maintain this favorable tax treatment. Specifically, an LLC cannot have any
more than two of the following four corporate characteristics:
1. Limited liability. Limited liability exists if no member of the LLC is personally
liable for the debts or claims against the company. Because entrepreneurs choosing
this form of ownership usually do so to get limited liability protection, the operating
agreement almost always has this characteristic.
2. Continuity of life. Continuity of life exists if the company continues to exist in spite
of changes in stock ownership. To avoid continuity of life, any LLC member must
have the power to dissolve the company. Most entrepreneurs choose to omit this
characteristic from their LLC’s operating agreements.
3. Free transferability of interest. Free transferability of interest exists if each LLC
member has the power to transfer her or his ownership to another person freely and
without the consent of other members. To avoid this characteristic, the operating
agreement must state that a recipient of a member’s LLC stock cannot become a
substitute member without the consent of the remaining members.
4. Centralized management. Centralized management exists if a group that does not
include all LLC members has the authority to make management decisions and to
conduct company business. To avoid this characteristic, the operating agreement
must state that the company elects to be “member managed.”
Despite their universal appeal to entrepreneurs, LLCs suffer some disadvantages.
They can be expensive to create, often costing between $1,500 and $5,000. Unlike cor-
porations, which can operate “for perpetuity,” LLCs have limited life spans. Because
there is no stock involved, this form of ownership also is not suitable for companies
whose owners plan to raise money through an initial public offering or who want to use
stock options or an employee stock ownership plan as incentives for employees.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 183

Entrepreneurs who want to provide attractive benefits to themselves and their employees
will not find this form of ownership appealing because the cost of those benefits is not
tax deductible in an LLC.
Although an LLC may be ideally suited for an entrepreneur launching a new company,
it may pose problems for business owners considering converting an existing business to
an LLC. Switching to an LLC from a general partnership, a limited partnership, or a sole
proprietorship reorganizing to bring in new owners is usually not a problem. However,
owners of corporations and S corporations would incur large tax obligations if they con-
verted their companies to LLCs.
To date, the biggest disadvantage of the LLC stems from its newness. No uniform leg-
islation for LLCs exists (although a Uniform Limited Liability Act is pending at the fed-
eral level). Every state now recognizes the LLC as a legal form of ownership.

Which Form Is Best?

Watoma Kinsey and her daughter Katrina are about to business plan is accurate, they will earn a small profit in
launch a business that specializes in children’s parties. their first year (about $1,500) and a more attractive
Their target audience is upscale families who want to profit of $16,000 in their second year of operation.
throw unique, memorable parties to celebrate special Within five years, they expect their company to gener-
occasions for their children between the ages of 5 and ate as much as $50,000 in profits. They have agreed to
15 years. They have leased a large building and have split the profits—and the workload—equally.
renovated it to include many features designed to If the business is as successful as they think it will be,
appeal to kids, including special gym equipment, a skat- the Kinseys eventually want to franchise their company.
ing rink, an obstacle course, a mockup of a pirate ship, That, however, is part of their long-range plan. For now,
a ball crawl, and even a moveable haunted house. They they want to perfect their business system and prove
can offer simple birthday parties (cake and ice cream that it can be profitable before they try to duplicate it in
included) or special theme parties as elaborate as the the form of franchises.
customer wants. Their company will provide magicians, As they move closer to the launch date for their busi-
clowns, comedians, jugglers, tumblers, and a variety of ness, the Kinseys are reviewing the different forms of
other entertainers. ownership. They know that their decision has long-term
Watoma and Katrina have each invested $45,000 to implications for themselves and for their business, but
get the business ready to launch. Based on the quality they aren’t sure which form of ownership is best for them.
of their business plan and their preparation, they have
negotiated a $40,000 bank loan. Because they both 1. Which form(s) of ownership would you recom-
have families and own their own homes, they want to mend to the Kinseys? Explain.
minimize their exposure to potential legal and financial 2. Which form(s) of ownership would you recom-
problems. A significant portion of their start-up costs mend the Kinseys avoid? Explain.
went to purchase a liability insurance policy to cover the 3. What factors should the Kinseys consider as they
Kinseys in case a child is injured at a party. If their evaluate the various forms of ownership?
184 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

The Professional Corporation

Professional corporations are designed to offer professionals—lawyers, doctors, dentists,
accountants, and others—the advantages of the corporate form of ownership. They are ide-
ally suited for professionals, who must always be concerned about malpractice lawsuits,
because they offer limited liability. For example, if three doctors formed a professional
corporation, none of them would be liable for the others’ malpractice. (Of course, each
would be liable for his or her own actions.) Creating a professional corporation is no dif-
ferent from creating a regular corporation. Professional corporations are often identified by
the abbreviations P.C. (professional corporation), P.A. (professional association), or S.C.
(service corporation). A professional corporation has the following additional limitations
beyond the standard corporation:
r All shares of stock of the corporation must be owned and held by individuals
licensed in the profession of the corporation.
r At least one of the incorporators must be licensed in the profession.
r At least one director and one officer must be licensed in the profession.
r The articles of incorporation, in addition to all other requirements, must designate
the personal services to be provided by the corporation.
r The professional corporation must obtain from the appropriate licensing board a cer-
tification that declares the shares of stock are owned by individuals who are duly
licensed in the profession.

The Joint Venture

A joint venture is very much like a partnership, except that it is formed for a specific pur-
pose. For instance, suppose that you own a 500-acre tract of land 60 miles from Chicago
that has been cleared and is normally used in agricultural production. You have a friend
who has solid contacts among major musical groups and would like to put on a concert.
You expect prices for your agricultural products to be low this summer, so you and your
friend form a joint venture for the specific purpose of staging a three-day concert. Your
contribution will be the exclusive use of the land for one month, and your friend will pro-
vide all the performers as well as technicians, facilities, and equipment. All costs will be
paid out of receipts, and the net profits will be split, with you receiving 20 percent for the
use of your land. When the concert is over, the facilities removed, and the accounting for
all costs completed, you and your friend split the profits 20:80, and the joint venture
terminates.
In any endeavor in which neither party can effectively achieve the purpose alone, a
joint venture becomes a common form of ownership. The “partners” form a new joint ven-
ture for each new project they undertake. The income derived from a joint venture is taxed
as if it arose from a partnership.
Table 5.2 provides a summary of the key features of the major forms of ownership dis-
cussed in this chapter.
 TABLE 5.2 Characteristics of the Major Forms of Ownership
Characteristic Sale Propristorship General Partnership Limited Partnership C Corporation S Corporation
Definition A for-profit business owned A for profit-business jointly One general partner and one An artificial legal entity An artificial legal entity
and operated by one person owned and operated by two or more partners with limited separate from its owners that is structured like a
or more people liability and no rights of and formed under state C corporation but taxed
management laws by the federal government
like a partnership
Ease of formation Easiest form of business to Easy to set up and operate; File a Certificate of Limited File articles of incorporation Must meet all criteria to
set up; if necessary, acquire a written partnership agreement Partnership with the secretary and other required reports file as an S corporation;
licenses and permits, register is highly recommended; must of state; name must show that with the secretary of state; must file timely election
fictitious name, and obtain acquire an employer ID number; business is a limited partnership; prepare bylaws and follow with the IRS (within 21/2
taxpayer identification if necessary, register fictitious must have written agreement, corporate formalities months of first taxable
name and must keep certain records year)
Owner’s personal Unlimited Unlimited for general Limited Limited Limited
liability partners, limited for limited
partners
Number of owners One Two or more At least, one general partner Any number Maximum of 100 with
and any number of limited restrictions as to who they
partners are
Tax liability Single tax: personal tax rate Single tax: partners pay on Same as general partnership Double tax: corporation Single tax: owners pay on
their proportional shares at pays tax and shareholders their proportional shares
their individual rate pay tax on dividends at individual rate
distributed
Maximum tax rate 35% 35% 35% 39% corporate plus 35% 35%
individual
Transferability of Fully transferable through sale May require consent of all Same as general partnership Fully transferable Transferable (but transfer
ownership or transfer of company assets partners may affect S status)
Continuity of the Ends on death or insanity Dissolves on death, insanity, Same as general partnership Perpetual life Perpetual life
business of proprietor or on or retirement of a general
termination by proprietor partner (business may continue)
Cost of Formation Low Moderate Moderate High High
Liquidity of the Poor to average Poor to average Poor to average High High
owner’s investment
in the business
Ability to raise Low Moderate Moderate to high Very high High
capital
Formation No special steps required No written partnership Must comply with state Must meet formal Must follow same
procedure other than buying agreement required laws regarding limited requirements specified procedures as C
necessary licenses (but highly advisable) partnership by state law corporation, then elect S
status with IRS

185
186 SECTION II • BUILDING THE BUSINESS PLAN: BEGINNING CONSIDERATIONS

Chapter Summary by Learning Objectives

1A. Explain the advantages and the disadvantages tion, an entrepreneur must file the articles of incorporation
of the sole proprietorship. with the state in which the company will incorporate.
A sole proprietorship is a business owned and managed by Corporations offer these advantages: limited liability of
one individual and is the most popular form of ownership. stockholders; ability to attract capital; ability to continue
Sole proprietorships offer these advantages: They are indefinitely; and transferable ownership.
simple to create; they are the least costly form to begin; the Corporations suffer from these disadvantages: cost and
owner has total decision-making authority; there are no time involved in incorporating; double taxation; potential
special legal restrictions; and they are easy to discontinue. for diminished managerial incentives; legal requirements
They also suffer from these disadvantages: unlimited and regulatory red tape; and potential loss of control by the
personal liability of the owner; limited managerial skills and founder(s).
capabilities; limited access to capital; lack of continuity.
2. Discuss the advantages and the disadvantages of
1B. Explain the advantages and the disadvantages the S corporation, the limited liability company, the
of the partnership. professional corporation, and the joint venture.
A partnership is an association of two or more people who Entrepreneurs can also choose from several other forms of
co-own a business for the purpose of making a profit. ownership, including S corporations and limited liability
Partnerships offer these advantages: ease of establishing; companies. An S corporation offers its owners limited
complementary skills of partners; division of profits; larger liability protection but avoids the double taxation of C
pool of capital available; ability to attract limited partners; Corporations.
little government regulation flexibility; and tax advantages. A limited liability company, like an S corporation, is a
Partnerships suffer from these disadvantages: unlim- cross between a partnership and a corporation, yet it oper-
ited liability of at least one partner; difficulty in disposing ates without the restrictions imposed on an S corporation.
of partnership interest; lack of continuity; potential for per- To create an LLC, an entrepreneur must file the articles of
sonality and authority conflicts; and partners bound by the organization and the operating agreement with the secretary
law of agency. of state.
A professional corporation offers professionals the
1C. Explain the advantages and the disadvantages benefits of the corporate form of ownership.
of the corporation. A joint venture is like a partnership, except that it is
A corporation, the most complex of the three basic forms formed for a specific purpose.
of ownership, is a separate legal entity. To form a corpora-

Discussion Questions
1. What factors should an entrepreneur consider 7. How does an S corporation differ from a regular
before choosing a form of ownership? corporation?
2. Why are sole proprietorships so popular as a form 8. What role do limited partners play in a partnership?
of ownership? What happens if a limited partner takes an active
3. How can personal conflict affect a partnership? role in managing the business?
4. What issues should the articles of partnership 9. What advantages does a limited liability company
address? Why are the articles important to a suc- offer over an S corporation? A partnership?
cessful partnership? 10. How is an LLC created? What criteria must an
5. Can one partner commit another to a business deal LLC meet to avoid double taxation?
without the other’s consent? Why? 11. Briefly outline the advantages and disadvantages of
6. What issues should the Certificate of Incorporation the major forms of ownership.
cover?

Business Plan Pro

Selecting the form of your busi- sion will affect the number of business owners, tax obliga-
ness is an important decision. As tions, the time and cost to form the entity, the ability to raise
this chapter discussed, this deci- capital, and options for transferring ownership.
 CHAPTER 5 • FORMS OF BUSINESS OWNERSHIP 187

Business Plan Exercises ally liable. Is the nature of your business one that
On the Web may present this type of risk? Is this an appropriate
Go to http://www.prenhall.com/scarborough and review the business entity based on that potential outcome?
business entity links associated with Chapter 5. This may
r Once your business becomes profitable, what is the
provide additional information and resources to assist with potential tax ramifications compared to your cur-
your form of business. Enter the search term “business rent situation?
entity” in your favorite search engine and note the resources
r What is your ideal situation regarding the long-
and information that this term generates. term ownership, and what are the possible choices
based on that preference.
Sample Plans r What should you budget for legal fees and other
Go to the Sample Plan Browser in Business Plan Pro and look expenditures to form the business?
at these three business plans: Calico Computer Consulting is a r How much time do you estimate you will need to
sole proprietorship, Lansing Aviation is a limited liability invest to establish this business entity?
company, and Southeast Health Plans, Inc. is a corporation. r Will you need to raise capital? How much capital
After reviewing the executive summaries of each of these will the venture require? Is this form of ownership
plans, why do you think the owners selected this form of optimal for accomplishing that objective?
ownership? Considering their respective industries, what are
As you review the instructions provided within
the advantages and disadvantages that each of these business
Business Plan Pro, refer to the “Characteristics of Major
entities offer the owners? Why are these choices a good match
Forms of Ownership” matrix to help you select the form of
for the business relating to ease of starting, liability, control,
ownership that is best for you and your venture
ability to raise capital, and transfer of ownership?
Building Your Business Plan
In the Software
Review the work that you have completed on your business
Go to the section of Business Plan Pro called “Company
plan. Does your chosen form of ownership “fit” your vision
Ownership.” Look at the comparison matrix of the
and the scope of the business? Will this choice of business
“Characteristics of Major Forms of Ownership,” Table 4.1 on
entity offer the type of protection flexibility you desire for
page 126, and consider the ramifications of your choice.
your business? You may also want to include comments in
r If the business is a sole proprietorship or a partner- your plan regarding changing factors that may require you
ship and the business is sued, you may be person- to reexamine your form of ownership in the future.

Beyond the Classroom . . .

1. Interview five local small business owners. What 2. Invite entrepreneurs who operate as partners to
form of ownership did each choose? Why? Prepare your classroom. Do they have a written partnership
a brief report summarizing your findings, and agreement? Are their skills complementary? How
explain advantages and disadvantages those owners do they divide responsibility for running their com-
face because of their choices. Do you think that pany? How do they handle decision making? What
these business owners chose the form of ownership do they do when disputes and disagreements arise?
that is best for their particular situations? Explain.