PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 8 pdf

PART TWO PLANNING AND FORECASTING 225 8 CHOOSING A BUSINESS FORM Richard P. Mandel THE CONSULTING FIRM Jennifer, Jean, and George had earned their graduate business degrees to- gether and had paid their dues in middle management positions in various large corporations. Despite their different employers, the three had maintained their friendship and were now ready to realize their dream of starting a con- sulting practice. Their projections showed modest consulting revenue in the short term offset by expenditures for supplies, a secretary, a small library, per- sonal computers, and similar necessities. Although each expected to clear no more than perhaps $25,000 for his or her efforts in their first year in business, they shared high hopes for future growth and success. Besides, it would be a great pleasure to run their own company and have sole charge of their respec- tive fates. THE SOFTWARE ENTREPRENEUR At approximately the same time that Jennifer, Jean, and George were hatching their plans for entrepreneurial independence, Phil was cashing a seven-figure check for his share of the proceeds from the sale of the computer software firm he had founded seven years ago with four of his friends. Rather than rest on his laurels, however, Phil saw this as an opportunity to capitalize on a com- plex piece of software he had developed in college. Although Phil was con- vinced that there would be an extensive market for his software, there was 226 Planning and Forecasting much work to be done before it could be brought to market. The software had to be converted from a mainframe operating system to the various popular mi- crocomputer systems. In addition, there was much marketing to be done prior to its release. Phil anticipated that he would probably spend over $300,000 on programmers and salespeople before the first dollar of royalties would appear. But he was prepared to make that investment himself, in anticipation of retain- ing all the eventual profit. THE HOTEL VENTURE Bruce and Erika were not nearly as interested in high technology. Directly fol- lowing their graduation from business school, they were planning to construct and operate a resort hotel near a popular ski area. They had chosen as their location a beautiful parcel of land in Colorado owned by their third partner, Michael. Rich in ideas and enthusiasm, the three lacked funds. They were cer- tain, however, that they could attract investors to their enterprise. The loca- tion, they were sure, would virtually sell itself. THE PURPOSE OF THIS CHAPTER Each of these three groups of entrepreneurs would soon be faced with what might well be the most important decision of the initial years of their busi- nesses: which of the various legal business forms to choose for the operation of their enterprises. It is the purpose of this chapter to describe, compare, and contrast the most popular of these forms in the hope that the reader will then be able to make such choices intelligently and effectively. After discussing the various business forms, we will revisit our entrepreneurs and analyze their choices. BUSINESS FORMS Two of the most popular business forms could be described as the default forms because the law will deem a business to be operating under one of these forms unless it makes an affirmative choice otherwise. The first of these forms is the sole proprietorship. Unless he or she has actively chosen another form, the individual operating his or her own business is considered to be a sole pro- prietor. Two or more persons operating a business together are considered a partnership (or general partnership), unless they have elected otherwise. Both of these forms share the characteristic that for all intents and purposes they are not entities separate from their owners. Every act taken or obligation as- sumed as a sole proprietorship or partnership is an act taken or obligation as- sumed by the business owners as individuals. Choosing a Business Form 227 Many of the rules applicable to the operation of partnerships are set forth in the Uniform Partnership Act, which has been adopted in one form or another by 49 states. That Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” Notice that the defini- tion does not require that the individuals agree to be partners. Although most partnerships can point to an agreement between the partners (whether written or oral), the Act applies the rules of partnership to any group of two or more persons whose actions fulfill the definition. Thus, the U.S. Circuit Court of Ap- peals for the District of Columbia, in a rather extreme case, held, over the de- fendant’s strenuous objections, that she was a partner in her husband’s burglary “business” (for which she kept the books and upon whose proceeds she lived), even though she denied knowing what her husband was doing at nights. As a re- sult of this status, she was held personally liable for damages to the wife of a burglary victim her husband had murdered during a botched theft. In contrast, a corporation is a legal entity separate from the legal identities of its owners, the shareholders. In the words James Thurber used to describe a unicorn, the corporation “is a mythical beast,” created by the state at the request of one or more business promoters upon the filing of a form and the payment of the requisite, modest fee. Thereupon, in the eyes of the law, the corpora- tion becomes for most purposes a “person” with its own federal identification number! Of course, one cannot see, hear, or touch a corporation, so it must in- teract with the rest of the world through its agents, the corporation’s officers and employees. Corporations come in different varieties. The so-called professional cor- poration is available in most states for persons conducting professional prac- tices, such as doctors, lawyers, architects, psychiatric social workers, and the like. A subchapter S corporation is a corporation that is the same as a regular business corporation in all respects other than taxation. These variations are discussed later. A fourth common form of business organization is the limited partner- ship, which may best be described as a hybrid of the corporation and the gen- eral partnership. The limited partnership consists of one or more general partners—who manage the business much in the same way as do the partners in a general partnership—and one or more limited partners, who are essen- tially silent investors with no control over business operations. Like the general partnership, limited partnerships are governed in part by a statute, the Uni- form Limited Partnership Act (or its successor, the Revised Uniform Limited Partnership Act), which has also been adopted in one form or another by 49 states. The limited liability company (LLC), is now available to entrepreneurs in all 50 states. The LLC is a separate legal entity owned by “members” who may, but need not, appoint one or more “managers” (who may but need not be mem- bers) to operate the business. A few states require that there be more than one member, but the trend is toward allowing single-member LLCs. An LLC is formed by filing an application with the state government and paying the 228 Planning and Forecasting pre scribed fee. The members then enter into an operating agreement setting forth their respective rights and obligations with respect to the business. Most states that have adopted the LLC have also authorized the limited liability partnership, which allows general partnerships to obtain limited liability for their partners by filing their intention to do so with the state. This form of business entity is normally used by professional associations that previously op- erated as general partnerships, such as law and accounting firms. COMPARISON FACTORS The usefulness of the five basic business forms could be compared on a virtu- ally unlimited number of measures, but the most effective comparisons will likely result from employing the following eight: 1. Complexity and cost of formation. What steps must be taken before your business can exist in each of these forms? 2. Barriers to operation across state lines. What steps must be taken to move your business to other states? What additional cost may be involved? 3. Recognition as a legal entity. Who does the law recognize as the operative entity? Who owns the assets of the business? Who can sue and be sued? 4. Continuity of life. Does the legal entity outlive the owner? This may be especially important if the business wishes to attract investors or if the goal is an eventual sale of the business. 5. Transferability of interest. How does one go about selling or otherwise transferring one’s ownership of the business? 6. Control. Who makes the decisions regarding the operation, financing, and eventual disposition of the business? 7. Liability. Who is responsible for the debts of the business? If the com- pany cannot pay its creditors, must the owners satisfy these debts from their personal assets? 8. Taxation. How does the choice of business form determine the tax payable on the profits of the business and the income of its owners? FORMATION OF SOLE PROPRIETORSHIPS Reflecting its status as the default form for the individual entrepreneur, the sole proprietorship requires no affirmative act for its formation. One operates a sole proprietorship because one has not chosen to operate in any of the other forms. The only exception to this rule arises in certain states when the owner chooses to use a name other than his own as the name of his business. In such event, he may be required to file a so-called d/b/a certificate with the local authorities, stating that he is “doing business as” someone other than himself. Choosing a Business Form 229 This allows creditors and those otherwise injured by the operation of the busi- ness to determine who is legally responsible. FORMATION OF PARTNERSHIPS Similarly, a general partnership requires no special act for its formation other than a d/b/a certificate if a name other than that of the partners will be used. If two or more people act in a way which fits the definition set forth in the Uniform Act, they will find themselves involved in a partnership. However, it is strongly recommended that prospective partners consciously enter an agree- ment (preferably in writing) setting forth their understandings on the many issues which will arise in such an arrangement. Principal among these are the investments each will make in the business, the allocation and distribution of profits (and losses), the method of decision making (i.e., majority or unanimous vote), any obligations to perform services for the business, the relative com- pensation of the partners, and so on. Regardless of the agreements that may exist among the partners, however, the partnership will be bound by the ac- tions and agreements of each partner—as long as these actions are reasonably related to the partnership business, and even if they were not properly autho- rized by the other partners pursuant to the agreement. After all, third parties have no idea what the partners’ internal agreement says and are in no way bound by it. CORPORATIONS In order to form a corporation, in contrast, one must pay the appropriate fee and must complete and file with the state a corporate charter (otherwise known as a Certificate of Incorporation, Articles of Incorporation, or similar name in the various states). The fee is payable both at the outset and annually thereafter (often approximately $200). A promoter may form a corporation under the laws of whichever state she wishes; she is not required to form the corporation under the laws of the state in which she intends to conduct most of her business. This partially explains the popularity of the Delaware corpo- ration. Delaware spent most of the last century competing with other states for corporation filing fees by repeatedly amending its corporate law to make it increasingly favorable to management. By now, the Delaware corporation has taken on an aura of sophistication, so that many promoters form their com- panies in Delaware just to appear to know what they are doing! In addition, it is often less expensive under Delaware law to authorize large numbers of shares for future issuance than it would be in other states. Nevertheless, the statutory advantages of Delaware apply mostly to corporations with many stockholders (such as those which are publicly traded) and will rarely be sig- nificant to a small business such as those described at the beginning of this 230 Planning and Forecasting chapter. Also, formation in Delaware (or any state other than the site of the corporation’s principal place of business) will subject the corporation to addi- tional, unnecessary expense. It is thus usually advisable to incorporate in the company’s home state. The charter sets forth the corporation’s name (which cannot be confus- ingly similar to the name of any other corporation operating in the state) as well as its principal address. The names of the initial directors and officers of the corporation are often listed. Most states also require a statement of corpo- rate purpose. Years ago this purpose defined the permitted scope of the cor- poration’s activities. A corporation which ventured beyond its purposes risked operating “ultra vires,” resulting in liability of its directors and officers to its stockholders and creditors. Today virtually all states allow a corporation to de- fine its purposes extremely broadly (e.g., “any activities which may be lawfully undertaken by a corporation in this state”), so that operation ultra vires is gen- erally impossible. Still directors are occasionally plagued by lawsuits brought by stockholders asserting that the diversion of corporate profits to charitable or community activities runs afoul of the dominant corporate purpose, which is to generate profits for its stockholders. The debate over the responsibility of directors to so-called corporate “stakeholders” (employees, suppliers, cus- tomers, neighbors, and so forth) currently rages in many forms but is normally not a concern of the beginning entrepreneur. Corporate charters also normally set forth the number and classes of eq- uity securities that the corporation is authorized to issue. Here an analysis of a bit of jargon may be appropriate. The number of shares set forth in the charter is the number of shares authorized, that is, the number of shares that the di- rectors may issue to stockholders at the directors’ discretion. The number of shares issued is the number that the directors have in fact issued and is obvi- ously either the same or smaller than the number authorized. In some cases, a corporation may have repurchased some of the shares previously issued by the directors. In that case, only the shares which remain in the hands of sharehold- ers are outstanding (a number obviously either the same or lower than the number issued). Only the shares outstanding have voting rights, rights to receive dividends, and rights to receive distributions upon full or partial liqui- dation of the corporation. Normally, we would expect an entrepreneur to au- thorize the maximum number of shares allowable under the state’s minimum incorporation fee (e.g., 200,000 shares for $200 in Massachusetts) and then issue only 10,000 or so, leaving the rest on the shelf for future financings, em- ployee incentives, and so forth. The charter also sets forth the par value of the authorized shares, another antiquated concept of interest mainly to accountants. The law requires only that the corporation not issue shares for less than the par value, but it can, and usually does, issue the shares for more. Thus, typical par values are $0.01 per share or even “no par value.” Shares issued for less than par are watered stock, subjecting both the directors and holders of such stock to liability to other stockholders and creditors of the corporation. Choosing a Business Form 231 Corporations also adopt bylaws, which are not filed with the state but are available for inspection by stockholders. These are usually fairly standard docu- ments describing the internal governance of the corporation and setting forth such items as the officers’ powers and notice periods for stockholders’ meetings. LIMITED PARTNERSHIPS As you might expect, given the limited partnership’s hybrid nature, the law re- quires both a written agreement among the various general and limited part- ners and a Certificate of Limited Partnership to be filed with the state, along with the appropriate initial and annual fees. The agreement sets forth the part- ners’ understanding of the items discussed earlier regarding general partner- ships. The certificate sets forth the name and address of the partnership, its purposes, and the names and addresses of its general partners. In states where the Revised Uniform Limited Partnership Act has been adopted, it is no longer necessary to reveal the names of the limited partners, just as the names of cor- porate stockholders do not appear on a corporation’s incorporation documents. LIMITED LIABILITY COMPANIES The LLC is formed by filing a charter (e.g., a Certificate of Organization) with the state government and paying a fee (usually similar to that charged for the formation of a corporation). The charter normally sets forth the entity’s name and address, its business purpose, and the names and addresses of its managers (or persons authorized to act for the entity vis-à-vis the state if no managers are appointed). The same broad description of the entity’s business which is allowable for modern corporations is acceptable for LLCs. The members of the LLC are also required to enter into an operating agreement that sets forth their rights and obligations with regard to the business. These agreements are generally modeled after the agreements signed by the partners in a general or limited partnership. OUT OF STATE OPERATION OF SOLE PROPRIETORSHIPS AND PARTNERSHIPS Partly as a result of both the Commerce clause and Privileges and Immunities clause of the U.S. Constitution, states may not place limits or restrictions on the operations of out-of-state sole proprietors or general partnerships that are different from those placed on domestic businesses. Thus, a state cannot force registration of a general partnership simply because its principal office is lo- cated elsewhere, but it can require an out-of-state doctor to undergo the same licensing procedures it requires of its own residents. 232 Planning and Forecasting OUT OF STATE OPERATION OF CORPORATIONS, LIMITED PARTNERSHIPS, AND LIMITED LIABILITY COMPANIES Things are different, however, with corporations, limited partnerships, and LLCs. As creations of the individual states, they are not automatically entitled to recognition elsewhere. All states require (and routinely grant) qualification as a foreign corporation, limited partnership, or LLC to nondomestic entities doing business within their borders. This procedure normally requires the completion of a form very similar to a corporate charter, limited partnership certificate, or LLC charter, and the payment of an initial and annual fee simi- lar in amount to the fees paid by domestic entities. This requirement, inciden- tally, is one reason not to form a corporation in Delaware if it will operate principally outside that state. Much litigation has occurred over what consti- tutes “doing business” within a state for the purpose of requiring qualification. Similar issues arise over the obligation to pay income tax, collect sales tax, or accept personal jurisdiction in the courts of a state. Generally these cases turn on the individualized facts of the particular situation, but courts generally look for offices or warehouses, company employees, widespread advertising, or negotiation and execution of contracts within the state. Perhaps more interesting may be the penalty for failure to qualify. Most states will impose liability for back fees, taxes, interest, and penalties. More important, many states will bar a nonqualified foreign entity from access to its courts and, thus, from the ability to enforce obligations against its residents. In most of these cases, the entity can regain access to the courts merely by pay- ing the state the back fees and penalties it owes, but in a few states access will then be granted only to enforce obligations incurred after qualification was achieved, leaving all prior obligations unenforceable. RECOGNITION OF SOLE PROPRIETORSHIPS AS A LEGAL ENTITY By now it probably goes without saying that the law does not recognize a sole proprietorship as a legal entity separate from its owner. If Phil, our computer entrepreneur, were to choose this form, he would own all the company’s assets; he would be the plaintiff in any suits it brought, and he would be the defendant in any suits brought against it. There would be no difference between Phil, the individual, and Phil, the business. RECOGNITION OF PARTNERSHIPS AS A LEGAL ENTITY A general partnership raises more difficult issues. Although most states allow partnerships to bring suit, be sued, and own property in the partnership name, this does not mean that the partnership exists for most purposes separately from [...]... expected to invest enough money or property and obtain enough liability insurance to offset the kinds and amounts of liabilities normally encountered by a business in their industry Thus, the owner of a f leet of taxicabs did not escape liability by canceling his liability insurance and forming a separate corporation for each cab The court deemed each such corporation inadequately capitalized and, in a novel... the business individually—an administrative nightmare at best and possibly 236 Planning and Forecasting impractical in the case of nonassignable contracts, licenses, and government approvals Partnerships To discuss transferability in the context of a general partnership, one must keep in mind the difference between ownership of partnership assets as tenants in partnership and ownership of an individual’s... imagined earlier holding stockholder’s and director’s meetings in his shower, would be well advised to record the minutes in a corporate record book A third argument arises from a common mistake made by entrepreneurs Fearful of the expense involved in forming a corporation, they wait until they are sure that the business will get off the ground before they spring for the attorneys’ and filing fees In. .. dividend and interest income generated by his investments, thus effectively rendering $100,000 of that income tax free One can strongly argue, therefore, that the form in which one should operate one’s business is dictated in part by the likelihood of its short-term success and the presence or absence of other income f lowing to its owner EXHIBIT 8. 3 Corporate federal income tax rates Marginal tax... can easily eliminate the partnership and the limited partnership Phil is clearly the sole owner of his enterprise and will not brook any other controlling persons In addition, his plan to finance the enterprise with earnings from his Choosing a Business Form 257 last business eliminates the need for limited partner investors Almost as easily, Phil can eliminate the sole proprietorship since it would... From a tax point of view, this plan also changes a nondepreciable asset (land) into deductible rent payments for the business As their next move, the three may 2 58 Planning and Forecasting decide to form an entity to construct and own the hotel building, separate from the entity that manages the ongoing hotel business This plan would convert a rather confusing real estate/operating venture into a pure... liability by incurring substantial losses and ultimately dissipating its initial capitalization A second argument used by creditors to reach stockholders for personal liability is failure to respect the corporate form This may occur in many ways The stockholders may fail to indicate that they are doing business in the corporate form by leaving the words “Inc.” or “Corp.” off their business cards and stationery,... noncompetition, and accountability as it does upon agents with respect to their principals Corporations There can be much f lexibility and complexity in the allocation of control in the partnership form, but not nearly so much as in the corporate form Many EXHIBIT 8. 1 Principal and agent Principal Governed by: Principal Express, Apparent Authority, and Scope of Employment Agreement and Fiduciary Principles... other income The net effect of this is that the sole proprietor will pay tax on the income from this business at his highest marginal rate, possibly as high as 39.1% (in 2001), depending upon the amount of income received from this and other sources (see Exhibit 8. 2) In Phil’s case, for example, if his software business netted $100,000 in 2001, that amount would be added to the substantial interest and. .. circumstances can vote their shares totally in their own self-interest, directors must use their best business judgment and act in the corporation’s best interest when making decisions for the 242 Planning and Forecasting corporation At the very least, the director must keep informed regarding the corporation’s operations, although he or she may in most circumstances rely on the input of experts hired by the corporation, . PART TWO PLANNING AND FORECASTING 225 8 CHOOSING A BUSINESS FORM Richard P. Mandel THE CONSULTING FIRM Jennifer, Jean, and George had earned their graduate business degrees to- gether and had paid. LLC is formed by filing an application with the state government and paying the 2 28 Planning and Forecasting pre scribed fee. The members then enter into an operating agreement setting forth their. (preferably in writing) setting forth their understandings on the many issues which will arise in such an arrangement. Principal among these are the investments each will make in the business, the