Organizational Forms

2. Organizational Forms Sole Proprietorship Partnership Regular “C” Corporation Subchapter S Corporation Limited Partnership (LP) Limited Liability Partnership (LLP) Limited Liability Company (LLC) Not-For-Profit

3. Important Considerations Control: How many cooks in the kitchen? Flexibility: A sports car or a battleship? Liability: Who gets left holding the bag? Longevity: Nobody lives forever… Access to Capital: Sweat equity or OPM? Taxation: Once, twice, or not at all? Bureaucratic BS: How red is the tape? Cost: Pay a little or pay a lot?

4. Sole Proprietorship • Simplest to start and maintain • Most common structure • Least costly • Highest personal risk • Income is taxed as personal income

5. Sole Proprietor Taxation Taxable income “passes through” the business Personal income and business income are combined and taxed as one Puts you in a high tax bracket Losses can be used to offset personal income

6. Sole Proprietorship Taxes Form 1040 (PDF) Schedule C: Profit and Loss From Business -- Sole Proprietor (PDF) Form 1040 ES: Acceleration Estimate Tax for Individuals -- Must estimate expected income tax for the coming year (PDF) Quarterly vouchers and payments

7. Sole Proprietorship Legal No registration required if business is in your own name If you change the name or use anything other than your own name, must file Certificate of Conducting Business Under An Assumed Name with Secretary of State. Right of Survivorship Document – Says what will happen in case of your death To end business – Liquidate assets, pay off debts, and walk away.

8. Sole Proprietorship Summary Control: You’ve got it all Flexibility: It’s your decision (alone) Liability: You’ve got it all Longevity: Nobody lives forever… Capital: Your money, bank debt, and trade credit Taxation: Once, but not many breaks Bureaucratic BS: Almost none Cost: Very little

9. Partnership • Use if more than one person’s capital (including human capital) is involved • Agreement can be oral or written, but non-idiots put it in writing • Terminates with the death of any partner in most states – Can use “Key Person” insurance to provide for the continuation of the partnership • Liability is joint and several unless there are limited partners

10. Partnership Taxes Form 1040 with proportional share of partnership income Form 1065: US Partnership Return of Income (PDF) Schedule K-1: Partner’s Share of Income Credits, Deductions, etc. (PDF) Each partner calculates and files an estimated tax Quarterly vouchers and payments

11. Types of Partnerships General Partnership • Partners are equally liable (joint and several) • Partners share workload and decision making • Operates on a calendar year • Generally cash-based accounting

12. Types of Partnerships Limited Partnership • One or more partners are merely investors and do not participate in running the business or making decisions. • Limited partners have share of ownership but liability is limited to the amount of the investment • Must have at least one general partner • Limited liability attracts equity investors, thus increasing the availability of capital.

13. Partnership Legal Stuff The partnership name and information about the partners must be filed Written partnership agreement is optional Estate planning (what happens when a partner dies) is essential, but complicated All personal assets of all general partners are at risk Partnership terminates with the death of any partner unless partnership agreement specifies otherwise

14. Partnership Summary Control: Shared between the partners Flexibility: Now it’s a committee... Liability: Joint and several Longevity: Nobody lives forever… Capital: Partners’ money and some debt Taxation: Once, but not many breaks Bureaucratic BS: Some - Partnership agreements, more stringent records Cost: Very little

15. Corporations • Most difficult and costly to set up • Provides specific benefits to the owners • Separate legal entity – provides limited liability for all owners • Best access to capital markets • Easiest in which to transfer ownership • Income is taxed twice – once at the corporate level and once at the personal level – but otherwise gets very favorable tax treatment • Most closely scrutinized by the US Government and (if publicly traded) by the SEC

16. The Corporate Form • Ownership The shareholders (also known as stockholders or equity holders) are the owners of the corporation. • Control Ultimate control rests with the shareholders, but the managers control the day to day operations. • Risk Bearing While all parties associated with the corporation bear risk, shareholders bear all residual risk.

17. Flow of Control in a Corporation Shareholders Board of Directors Managers

18. Corporation Taxes VERY complicated and constantly changing Owners (shareholders) file a Form 1040 for personal tax with dividend income included The corporation files a Form 1120 (PDF) – US Corporation Income Tax Return – if gross receipts, or total income, or total assets are over $500,000 or if several other conditions are not met (see instructions) Form 1120A (short form) (PDF) if all three are under $500,000 and other conditions are met.

19. Constitutional Protections for Corporations • Right to due process and equal protection: Corporations enjoy the right to equal protection and due process of law under the Fourteenth and Fifth Amendments to the U.S. Constitution and under similar provisions of most state constitutions. • Freedom of speech: Absent some narrowly drawn restrictions serving compelling state interests, corporations have the right to express themselves on matters of public importance whether or not those issues "materially affect" corporate business.

20. Constitutional Protections for Corporations • Right to counsel: While a corporation cannot be imprisoned, a criminal action can result in fines and other penalties that could harm shareholders, officers, and other persons. Thus, a corporate criminal defendant has a Sixth Amendment right to counsel. But note, because a corporation faces no risk of incarceration, it has no right to appointed counsel if it cannot afford to retain private counsel. • No privilege against self-incrimination: Corporations have no privilege against self-incrimination (e.g. to prevent disclosure of incriminating corporate records).

21. Piercing the Corporate Veil Creditors may attempt to recover money from shareholders if: • The business was initially underfunded or “thinly capitalized” • The owners failed to treat the business as a separate entity themselves: • Fail to use Inc. or Corp or LLC in dealings • Co-mingle assets or funds • Fail to keep good records and hold meetings

22. Forming a Corporation What do you need? • $50 (In Mississippi) to file Articles of Incorporation • Company name (unique) • Directors • Business address • [Federal Tax ID] • [Corporate Charter]

23. Need Help? • Small Business Development Center (link) • Small Business Administration (link) • Mississippi Secretary of State (link) • Incorporate USA (link) • Company Corporation (link)

24. Corporation Summary Control: LOTS of cooks Flexibility: Now it’s a BIG committee... Liability: Limited personal liability Longevity: Nobody lives forever… So what? Capital: Best access of all forms Taxation: Twice, but many deductions and breaks (may be eliminated or reduced) Bureaucratic BS: Lots and lots and lots and… Cost: Can be substantial

25. Subchapter S Corporation Owners retain limited liability Taxed as a partnership - eliminates double taxation and makes it easier for owners to be compensated All profits are taxed and distributed annually

26. Subchapter S Corporation A corporation can elect S-Corp status within 75 days of formation if: • It is a domestic corporation (i.e., it operates in the state in which it is franchised • There is only one class of stock • It has 75 or fewer stockholders • All stockholders are US citizens or resident aliens • There are no subsidiaries

27. Limited Liability Company (LLC) Owned by “members” who may run the company or appoint managers to do it. Can have as few as one manager. Members and managers have limited liability Taxed like a Subchapter S Corporation without having to conform to the S Corp restrictions Limited liability can make it harder to raise capital - may require personal guarantees

28. Limited Liability Company (LLC) Becoming one of the most popular structures for small businesses because of its simplicity, but there are many statutory formalities that must be followed, so compliance can impose a large expense. If you expect to go public in the future, this form poses several large problems.

29. Limited Liability Partnership (LLP) Also called a Professional Corporation Used primarily by those who render professional services - lawyers, accountants, doctors, architects, social workers, etc. Some tax advantages - possible tax shelter Unlike a limited partnership, all partners can have limited liability and still be active participants. Limited liability may not be all that limited. Personal guarantees are commonly required for unsecured loans.

30. Selection Considerations • Will you need to sell ownership to raise equity? • How willing are you to dilute your ownership? • How risky is the business? • How important is transferability of ownership? • Are you in a high personal tax bracket? • Do you expect losses for some time? • Is “Inc” worth something to the company’s image?

31. Notes on sources for this presentation This presentation is based on and includes material provided in: • Chapter 2 slide presentation for Corporate Finance by Emery and Finnerty (Prentice Hall) • Small Business Financing: How and Where to Get It, published by CCH Inc, 1998 • Ready or Not, Get Set Go; by Hamilton and Taylor – published by Professional Prodigy, Inc • MyCorporation.com • Aswath Damodaran: Corporate Finance Theory and Practice – John Wiley & Sons

32. Professor’s Disclaimer I have no original thoughts. Therefore, every piece of material in this presentation most likely came from someone else. None of it is my personal work. Sources are listed on the previous slide.