Enterprise Organizational Forms Preview Lecture 1

1. Enterprise Organizational Forms PreviewLecture 1 Sole Proprietorship Partnerships vs. Corporations Not-for-Profits vs. For-Profits

2. Sole Proprietorship…small and simple and risky You can conduct business as an individual – the main historical mode. • You and your enterprise are co-defined: • You pay taxes on the profits. • You are responsible for debts. • Not much reason remains to be a SP.

3. Partnerships Multi-person business arrangements evolved slowly, often time or event-delimited, mercantile. • Formal (contractual) partnerships • emerged in response to problems: • Complexity and reach of the business • Capital aggregation • Continuity

4. Partnerships effects Historically, partnerships: • Easy (and cheap) to form • Had no “double taxation of dividends” (U.S.); report income on personal taxes • Present problems in dissolution/ death • Issues with “incomplete contracts” • No limitations of liabilities – e.g. Lloyds With recent U.S. changes, little reason remains to operate in “naked” mode.

5. Birth of the “company” “Chartered companies” (e.g. British East India Co.) Through mid-1800s “small scale capitalism” with market transactions, esp. manufactures • Model of legal structure evolves in Britain through 1800s • Corporations became “persons” under law • Limitation of liability introduced. Early 1900s -- managerial capitalism, wide ownership and separation of owners/ managers

6. Modern US corporations • Persistent existence • Can finance through equity dilution • Stock may be easily acquired/ disposed • Recognized legal status (“person”) separate from shareholders or directors • Limited liability • Unless exempt, entity taxed on profits • “Agency problem” introduced

7. Examples Local Health-Related Companies • Methodist Hospital, Houston • Houston Buyers’ Club • Houston Eye Associates • Houston Substance Abuse Clinic, Inc. • Cyberonics, Inc. • Quest Diagnostics, Inc.

8. Hybrid forms…LLCs Limited Liability Companies (LLCs/ LCs): • Aka “Limited Liability Corporations,” professional companies, PLC or PLLC • Relatively new to the US; state statute controls formation and regulation • Hybrid of partnerships and corporations

9. Benefits of LLCs Limited Liability Companies (LLCs/ LCs): • Limit owner’s financial responsibility • File articles of organization – limited info • Members may participate fully in the company • Not subject to tax on the entity but may elect pass-through – like partnerships • May encapsulate separate assets.

10. Hybrid forms…LLPs Limited Liability Partnerships – start Texas 1991 • Previously, limited partnerships could protect limited partners from liability but not the general partner(s) • Designed for professional services firms; partners cannot escape liability for their own torts but do not want liability for others’ malpractice • State laws govern how the limitation works; many protect only against malpractice not trade debts. • “Check the box” regulations (1997)

11. Not-for-ProfitsCharitable vs. Social Welfare Organizations • What they are and how they • differ in purpose • Tax effects on the organization • Differing donor tax effects

12. What is a Not-for-Profit (NFP)?(per the IRS) “Tax exempt” refers here to the status of the organization and not effect on donor. Two most common NFP types: 501(c)(3) – charitable, educational, etc. >200K public charities have filed >50K private foundations; grant-making vs. operating 501(c)(4) – social welfare organizations >120K file under this + other types NFP

13. 501(c)(3) – charitable, + Corporation, community chest, fund or foundation with limited activities recognized under 501(c)(3) by the IRS Exempt purposes include charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and the prevention of cruelty to children or animals.

14. “Charitable” purpose…wide-ranging but not unlimited “The term… includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening the burdens of government; lessening of neighborhood tensions; elimination of prejudice and discrimination; defense of human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”

15. Examples of 501(c)(3)s… • Consumers Union – educational • Ford Foundation – private foundation • United Way – public charity • UT Campus Cat Coalition – cat control • Red River Athletic Conf. – amateur sports • Low Income Taxpayer Clinics – defined by statute; Fed matching funds available • ExxonMobil Foundation – cultural/ educational What forms are precluded for NFPs?

16. A few 501(c)(3) statistics… As of 2001, 501(c)(3) filers had: $1.0Trillion in net worth $895B in total revenue $211B in contributions $122B in public contributions $89B in government grants $630B in program service revenue $861B in total expenses $739B in program expenses $109B in management/ general expenses Source: IRS

17. Source: http://www.guidestar.org/news/features/fdtn_expense_2005.pdf

18. What 501(c)(3)’s cannot do Pay earnings to private shareholders Lobby for legislation Campaign for or against political candidates Dissolve and then distribute assets to individuals or non-qualified organizations; state law controls.

19. Hospitals as “charitable” entities • Based on British common law: relief of poor; education; religion; social good. • In U.S. precedent set during Civil War • 1923 – “charitable” as relief of poverty • 1956 – “financial ability” standard • 1969 – “community benefit” standard State law controls exemption from state taxes…

20. Most hospitals in U.S. are 501(c)(3) entities 2003 data(http://www.bizstats.com/emprodhealth.htm): Taxable 1345 with $40B revenue Exempt 5340 with $330B revenue Health Care NFPs received 93.2% of revenues from selling program services (2001, IRS). Question: Do FP and NFP hospitals behave differently?

21. 501(c)(4) – social welfare Must be at least community-wide Civic associations qualify; tenant, homeowner and social clubs do not. Exempt from paying taxes on earnings; donations generally not tax deductible Effectively bound by the same political rules as 501(c)(3)’s; but may lobby for “germane” legislation Dues allocated to lobbying not tax exempt Other aspects of political process in gray area

22. Examples of 501(c)(4)’s • NAACP • National Rifle Association • National Organization of Women • National Association of Cancer Patients Note the “advocacy nature” of these… Often a 501(c)(4) has a 501(c)(3) education foundation.

23. NFP’s and tax rules NFP income is essentially tax exempt. They are liable for unrelated business income tax (UBIT): trade regularly carried on with public, unrelated to purpose other than internal. NFP’s cannot just sit on large portfolios. Within limits, 501(c)(3) donors receive a tax deduction (not a tax credit) – in effect, society subsidizes gifts per the donor tax effect. Question: Why are hospital gift shops staffed by volunteers?

24. 501(c)(3) tax treatment contentious “…although business income not related to a nonprofit’s mission is subject to tax, much of it escapes taxation.” (CBO, “Taxing the Untaxed Business Sector, July 2005) Untaxed business sector generates at least 5.3% of NDP; of that, NFPs producing private (not public) goods generate ~ 3.4% of economy’s NDP. Question: what would happen if the Feds taxed NFPs on these gains?

25. NFP’s and Financing “Qualified 501(c)(3) bonds are tax-exempt qualified private activity bonds issued by a state or local government, the proceeds of which are used by a 501(c)(3) charitable organization in furtherance of its exempt purpose.” http://www.irs.gov/pub/irs-pdf/p4077.pdf Here, “tax exempt” refers to the returns to the lender. Effects discussed later in course.

26. Key Take-away Messages • How you organize determines tax, finance instruments/ costs, and liability. • Society supports a wide range of charitable and social purposes, but • While all tax exempt organizations are non-profit, not all non-profits are tax-exempt.