Chapter 5 How to Form a Business 1 Basic Forms of Business Ownership a Sole Proprietorship A business owned and usually managed by one person i Most common form of business ownership ii Advantages 1 Ease of Starting and Ending The Business Only need to buy necessary equipment and potentially acquire a permit or license 2 Being Your Own Boss 3 Pride of Ownership You deserve and receive all the credit 4 Leaving a Legacy Pass down business to other generations 5 Retention of Company Profits 6 NO SPECIAL TAXES All profits are taxed as the personal income of the owner and the owner pays the normal income tax on that money a Do pay self employment tax for social security Medicare purposes 1 Unlimited Liability Risk of Personal Loss Any debts or damages incurred by the business are your own and you must pay them even if that means selling personal assets 2 Limited Financial Resources Funds are limited to what you have 3 Management Difficulties Someone must keep inventory accounting and tax records 4 Overwhelming Time Commitment 5 Few Fringe Benefits No paid health insurance no pension plan no sick leave no iii Disadvantages vacation pay etc 6 Limited Growth Expansion is slow 7 Limited Life Span Business dies if owner dies b Partnership Two or more people legally agree to become co workers i General Partnership All owners share in operating the business and in assuming liability for the business s debts 1 General Partner Owner who has unlimited liability and is active in managing firm ii Limited Partnership One or more general partners and one or more limited partners 1 Limited Partner Invests money in the business but does not have any management responsibility or liability for losses beyond the debts of the business a Limited Liability Liability is limited to the amount partner puts into the iii Master Limited Partnership MLP Looks much like a corporation but is taxed like a company personal assets are not sacrificed partnership avoids income tax iv Limited Liability Partnership LLP Limits partner s risk of losing their personal assets 1 In some states this does not extend to assets such as bank loans leases and business debts if these are not paid then you become liable for them v Advantages 1 More Financial Resources Two or more people are able to pool money credit 2 Shared Management Pooled Knowledge Skills 3 Long Survival 4 NO SPECIAL TAXES All profits are taxed as personal income vi Disadvantages 1 Unlimited Liability 2 Division of Profits 3 Disagreements Among Partners 4 Difficulty of Termination Who gets what assets of the company once it is terminated c Corporation A legal entity with authority to act and have liability apart from its owners i Only make up 20 of all businesses but earn 81 of all business receipts ii Conventional Corporation C State chartered legal entity with authority to act and have liability separate from its owners or stockholders iii Advantages 1 Limited Liability Responsible for losses up to what you invest in it 2 Ability to Raise More For Investment Can sell shares of stock to anyone who is interested as long as it is public or can borrow from individual investors who buy bonds or loans from financial institutions 3 Size Have large amounts of money to work with so can buy large amounts of resources 4 Perpetual Life Corporations are separate from those who own them 5 Ease of Ownership Change Sell stocks to someone else 6 Ease of Attracting Talented Employees 7 Separation of Ownership from Management Raise money from different stockholders w o having to involve them in the business iv Disadvantages 1 Initial Cost 2 Extensive Paperwork 3 Double Taxation Corporate income is taxed twice a 1 Pays tax on income before it can distribute dividends to stockholders b 2 Stockholders pay income tax on the dividends 4 Two Tax Returns File a corporate tax return and an individual tax return 5 Size Hard to respond quickly to market changes 6 Difficulty of Termination 7 Possible Conflict with Stockholders and Board of Directors v S Corporation Unique government corporation that looks like a corporation but taxed like a sole proprietorship and partnerships 1 Qualifications a No more than 100 shareholders makes ownership small b Shareholders are individuals or estates who are citizens or permanent residents of U S c Have only one class of stock d Derive no more than 25 of income from passive sources 2 If you lose your S status you may not operate under it again for at least five years vi Limited Liability Companies LLC Similar to an S corporation but without the special eligibility 1 Advantages a Limited Liability b Choice of Taxation Can choose to be taxed as partnerships or as 2 Disadvantages corporations c Flexible Ownership Rules d Flexible Distributions of Profit Losses e Operating Flexibility a No Stock Ownership is non transferable b Limited Life Span c Fewer Incentives d Taxes Must pay self employment taxes e Paperwork 2 Corporate Expansion Mergers Acquisitions a Merger The result of two firms joining to form one company i Vertical Merger Joins two firms operating in different stages of related businesses ii Horizontal Merger Joins two firms in the same industry and allows them to diversify or expand iii Conglomerate Merger Unites firms in completely unrelated industries in order to diversify their products business operations and investments b Taking a Firm Private Management or a group of stockholders obtain all the firm s stock for themselves by buying it back from other stockholders c Leveraged Buyout LBO An attempt by employees management or a group of investors to buy out the stockholders in a company primarily by borrowing the necessary funds d Acquisition One company s purchase of the property and obligations of another company 3 Franchises a Franchise Agreement An Arrangement whereby someone with a good idea for a business sells the rights to use the business name and sell a product or service to others in a given territory i Franchisor A company that develops a product concept and sells others the rights to make and ii Franchise The right to use a specific business s name and sell its products or services in a given sell the products territory iii Franchisee A person who buy a franchise b Advantages i Management Marketing Assistance ii Personal Ownership iii Nationally Recognized Name iv Financial Advice Assistance v Low Failure Rate c Disadvantages i Large Start Up Costs ii Shared Profit Royalty Fees Franchisor demands either a large share of the
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