Chapter 4 Selecting a Form of Business Ownership

Advantages and Disadvantages of Sole Proprietorships

As sole owner, you have complete control over your business. You make all important decisions, and you’re generally responsible for all day-to-day activities. In exchange for assuming all this responsibility, you get all the income earned by the business. Profits earned are taxed as personal income, so you don’t have to pay any special federal and state income taxes.

Figure 4.2

Sole proprietors enjoy complete control but also face increased risks.

© 2010 Jupiterimages Corporation

For many people, however, the sole proprietorship is not suitable. The flip side of enjoying complete control, for example, is needing to supply all the different talents that may be necessary to make the business a success. And if you die, the business dissolves. You also have to rely on your own resources for financing: in effect, you are the business, and any money borrowed by the business is loaned to you personally. Even more important, the sole proprietor bears unlimited liabilityLegal condition under which an owner or investor is personally liable for all debts of a business. for any losses incurred by the business. As you can see from Figure 4.3 "Sole Proprietorship and Unlimited Liability", the principle of unlimited personal liability means that if the company incurs a debt or suffers a catastrophe (say, getting sued for causing an injury to someone), the owner is personally liable. As a sole proprietor, you put your personal assets (your bank account, your car, maybe even your home) at risk for the sake of your business. You can lessen your risk with insurance, yet your liability exposure can still be substantial.

Figure 4.3 Sole Proprietorship and Unlimited Liability

The Partnership Agreement

The impact of disputes can be lessened if the partners have executed a well-planned partnership agreement that specifies everyone’s rights and responsibilities. The agreement might provide such details as the following:

• Amount of cash and other contributions to be made by each partner
• Division of partnership income (or loss)
• Partner responsibilities—who does what
• Conditions under which a partner can sell an interest in the company
• Conditions for dissolving the partnership
• Conditions for settling disputes

Unlimited Liability and the Partnership

Figure 4.4 "General Partnership and Unlimited Liability" shows that a major problem with partnerships, as with sole proprietorships, is unlimited liability: each partner is personally liable not only for his or her own actions but also for the actions of all the partners. In a partnership, it may work according to the following scenario. Say that you’re a partner in a dry cleaning business. One day, you return from lunch to find your establishment on fire. You’re intercepted by your partner, who tells you that the fire started because he fell asleep while smoking. As you watch your livelihood go up in flames, your partner tells you something else: because he forgot to pay the bill, your fire insurance was canceled. When it’s all over, you estimate the loss to the building and everything inside at $1.2 million. And here’s the really bad news: if the business doesn’t have the cash or other assets to cover losses, you can be personally sued for the amount. In other words, any party who suffered a loss because of the fire can go after your personal assets.

Figure 4.4 General Partnership and Unlimited Liability

Limited Partnerships

Many people are understandably reluctant to enter into partnerships because of unlimited liability. Individuals with substantial assets, for example, have a lot to lose if they get sued for a partnership obligation (and when people sue, they tend to start with the richest partner). To overcome this defect of partnerships, the law permits a limited partnershipPartnership made up of a single general partner (who runs the business and is responsible for its liabilities) and any number of limited partners., which has two types of partners: a single general partner who runs the business and is responsible for its liabilities, and any number of limited partners who have limited involvement in the business and whose losses are limited to the amount of their investment.

Advantages and Disadvantages of Partnerships

The partnership has several advantages over the sole proprietorship. First, it’s relatively inexpensive to set up, and it subjects you to few government regulations. Second, it brings together a diverse group of talented individuals who share responsibility for running the business. Third, it makes financing easier: The business can draw on the financial resources of a number of individuals. The partners not only contribute funds to the business but can also use personal resources to secure bank loans. Fourth, continuity needn’t be an issue because partners can agree legally to allow the partnership to survive if one or more partners die. Finally, partners pay taxes at the income tax rate for individuals; they don’t pay any special taxes.

Figure 4.5

Partnerships can have many advantages, but there are disadvantages to consider as well.

© 2010 Jupiterimages Corporation

Still, there are some negatives. First, as discussed earlier, partners are subject to unlimited liability. Second, being a partner means that you have to share decision making, and many people aren’t comfortable with that situation. Not surprisingly, partners often have differences of opinion on how to run a business, and disagreements can escalate to the point of actual conflict; in fact, they can even jeopardize the continuance of the business. Third, in addition to sharing ideas, partners also share profits. This arrangement can work as long as all partners feel that they’re being rewarded according to their efforts and accomplishments, but that isn’t always the case.

While the partnership form of ownership is viewed negatively by some, it was particularly appealing to Ben Cohen and Jerry Greenfield. Starting their ice cream business as a partnership was inexpensive and let them combine their limited financial resources and use their diverse skills and talents. As friends they trusted each other and welcomed shared decision making and profit sharing. They were also not reluctant to be held personally liable for each other’s actions.

Ownership and Stock

Corporations are owned by shareholdersOwners of a corporation. who invest money in the business by buying shares of stockShare of ownership in a corporation.. The portion of the corporation they own depends on the percentage of stock they hold. For example, if a corporation has issued 100 shares of stock, and you own 30 shares, you own 30 percent of the company. The shareholders elect a board of directorsGroup of people who are legally responsible for governing a corporation., a group of people (primarily from outside the corporation) who are legally responsible for governing the corporation. The board oversees the major policies and decisions made by the corporation, sets goals and holds management accountable for achieving them, and hires and evaluates the top executive, generally called the CEO (chief executive officer). The board also approves the distribution of income to shareholders in the form of cash payments called dividendsEarnings distributed to stockholders..

Benefits of Incorporation

The corporate form of organization offers several advantages, including limited liability for shareholders, greater access to financial resources, specialized management, and continuity.

Drawbacks to Incorporation

Like sole proprietorships and partnerships, corporations have both positive and negative properties. In sole proprietorships and partnerships, for instance, the individuals who own and manage a business are the same people. Corporate managers, however, don’t necessarily own stock, and shareholders don’t necessarily work for the company. This situation can be troublesome if the goals of the two groups differ significantly. Managers, for example, might be more interested in career advancement than the overall profitability of the company. Stockholders might care about profits without regard for the well-being of employees.

Another drawback to incorporation—one that often discourages small businesses from incorporating—is the fact that corporations are costly to set up. Additionally, they’re all subject to levels of regulation and governmental oversight that can place a burden on small businesses. Finally, corporations are subject to what’s generally called “double taxation.” Corporations are taxed by the federal and state governments on their earnings. When these earnings are distributed as dividends, the shareholders pay taxes on these dividends. Corporate profits are thus taxed twice—the corporation pays the taxes the first time and the shareholders pay the taxes the second time.

Five years after starting their ice cream business, Ben Cohen and Jerry Greenfield evaluated the pros and cons of the corporate form of ownership, and the “pros” won. The primary motivator was the need to raise funds to build a $2 million manufacturing facility. Not only did Ben and Jerry decide to switch from a partnership to a corporation, but they also decided to sell shares of stock to the public (and thus become a public corporation). Their sale of stock to the public was a bit unusual: Ben and Jerry wanted the community to own the company, so instead of offering the stock to anyone interested in buying a share, they offered stock to residents of Vermont only. Ben believed that “Business has a responsibility to give back to the community from which it draws its support.”Fred Chico Lager, Ben & Jerry’s: The Inside Scoop (New York: Crown Publishers, 1994), 91. He wanted the company to be owned by those who lined up in the gas station to buy cones. The stock was so popular that one in every hundred Vermont families bought stock in the company.Fred Chico Lager, Ben & Jerry’s: The Inside Scoop (New York: Crown Publishers, 1994), 103. Eventually, as the company continued to expand, the stock was sold on a national level.

Hybrids: S-Corporations and Limited-Liability Companies

To understand the value of S-corporations and limited-liability companies, we’ll begin by reviewing the major advantages and disadvantages of the three types of business ownership we’ve explored so far: sole proprietorship, partnership, and corporation. Identifying the attractive and unattractive features of these three types of business ownership will help us appreciate why S-corporations and limited-liability companies were created.

S-Corporation

In 1970, Karen and Mike Tocci, avid go-kart racing fans, bought a parcel of land in New Hampshire so their son, Rob, and his son’s friends could drag race in a safe environment. The Tocci’s continued interest in racing resulted in their starting a family-run business called Shannon Dragway. Over time, the business expanded to include a speedway track and a go-kart track and was renamed New Hampshire Motorsports Complex. In selecting their organization form, the Tocci’s wanted to accomplish two main goals: (1) limit their personal liability; and (2) avoid having their earnings taxed twice, first at the corporate level and again at the personal level. An S-corporation form of business achieved these goals. They found they were able to meet the following S-corporation eligibility criteria:

• The company has no more than 100 shareholders
• All shareholders are individuals, estates, or certain non-profits or trusts
• All shareholders are U.S. citizens and permanent residents of the U.S.
• The business is not a bank or insurance company
• All shareholders concur with the decision to form an S-corporation

Deciding to operate as an S-corporation presented the Tocci’s with some disadvantages: They had no flexibility in the way profits were divided among the owners. In an S-corporation, profits must be allocated based on percentage ownership. So if an owner/shareholder holds 25 percent of the stock in the S-corporation, 25 percent of the company profits are allocated to this shareholder regardless of the amount of effort he or she exerts in running the business. Additionally, the owners had to follow a number of formal procedures, such as electing a board of directors and holding annual meetings. Finally, they were subjected to heavy recordkeeping requirements. Despite these disadvantages, the Tocci’s concluded that on balance the S-corporation was the best form of organization for their business.

Limited-Liability Company

In 1977, Wyoming was the first state to allow businesses to operate as limited-liability companies. Twenty years later, in 1997, Hawaii was the last state to give its approval to the new organization form. Since then, the limited-liability company has increased in popularity. Its rapid growth was fueled in part by changes in state statutes that permit a limited-liability company to have just one member. The trend to LLCs can be witnessed by reading company names on the side of trucks or on storefronts in your city. It is common to see names such as Jim Evans Tree Care, LLC, and For-Cats-Only Veterinary Clinic, LLC. But LLCs are not limited to small businesses. Companies such as Crayola, Domino’s Pizza, Ritz-Carlton Hotel Company, and iSold It (which helps people sell their unwanted belongings on eBay) are operating under the limited-liability form of organization.

In many ways, a limited-liability company looks a lot like an S-corporation. Its owners (called members rather than shareholders) are not personally liable for debts of the company, and its earnings are taxed only once, at the personal level (thereby eliminating double taxation). But there are important differences between the two forms of organizations. For example, an LLC:

1. Has fewer ownership restrictions. It can have as many members as it wants—it is not restricted to a maximum of 100 shareholders.
2. Its members don’t have to be U.S. residents or citizens.
3. Profits do not have to be allocated to owners based on percentage ownership. Members can distribute profits in any way they want.
4. Is easier to operate because it doesn’t have as many rules and restrictions as does an S-corporation. It doesn’t have to elect a board of directors, hold annual meetings, or contend with a heavy recordkeeping burden.

As the approach used to allocate profits is very important (item 3 above), let’s spend a few minutes going over an example of how the profit allocation process works. Let’s say that you and a business partner started a small pet grooming business at the beginning of the year. Your business partner (who has more money than you do) contributed $40,000 to start-up the business and you contributed $10,000 (so your partner’s percentage ownership in the business is 80 percent and yours is 20 percent). But your business partner has another job and so you did 90 percent of the work during the past year. Profit for the first year was $100,000. If your company was set up as a S-corporation, you would be required to allocate profits based on percentage ownership. Under this allocation scheme $80,000 of the profits would be allocated to your business partner and only $20,000 would be allocated to you. This hardly seems fair. Under the limited-liability form of organization you and your partner can decide what is a “fair” allocation of profits and split the profits accordingly. Perhaps you will decide that you should get 70 percent of the profits (or $70,000) and your business partner should get 30 percent (or $30,000).

Now, let’s look at the fourth item—ease of operation. It is true that S-coporations have to deal with more red tape and paperwork and abide by more rules (such as holding annual meetings) than do limited-liability companies. Plus they are more complex to set up. But this does not mean that setting up and operating a limited-liability company is a breeze and should be taken lightly. One essential task that should be carefully attended to is the preparation of an operating agreement. This document, which is completed when the company is formed (and can be revised later), is essential to the success of the business. It describes the rights and responsibilities of the LLC members and spells out how profits or losses will be allocated.

We have touted the benefits of limited liability protection for an LLC (as well as for regular corporations and S-corporations). We now need to point out some circumstances under which an LLC member (or shareholder in a corporation) might be held personally liable for the debts of his or her company. A business owner can be held personally liable if he or she:

• Personally guarantees a business debt or bank loan which the company fails to pay
• Fails to pay employment taxes to the government that were withheld from workers’ wages
• Engages in fraudulent or illegal behavior that harms the company or someone else
• Does not treat the company as a separate legal entity. For example, uses company assets for personal uses

As personal loan guarantees are the most common circumstance under which an LLC member is held personally liability for the debts of his or her company, let’s explore this topic some more by asking (and answering) two questions:

1. What is a loan guarantee? It is a legal agreement made between an individual and a bank that says, “If my company does not repay this loan, I will.” It is the same thing as co-signing a loan.
2. Why would an LLC member give a bank a personal guarantee? Because it is often the only way a business can get a loan. Bankers understand the concept of limited liability. They know that if the company goes out of business (and the loan is not guaranteed), the bank is stuck with an unpaid loan because the LLC members are not personally liability for the debts of the company. Consequently, banks are reluctant to give loans to companies (particularly those just starting up) unless the loans are guaranteed by an owner.

A final note about hybrid forms of organization. In this section, we have looked at two organization forms that offer business owners limited liability and tax benefits. There are others not covered here such as Professional Limited-Liability Companies (PLLCs), which are set up by doctors, lawyers, accountants, etc. to provide professional services. And it is evident that the variations of organization forms available to businesses will continue to expand in the future.

Cooperatives

A cooperativeA business owned and controlled by those who use its services. (also known as a co-op) is a business owned and controlled by those who use its services. Individuals and firms who belong to the cooperative join together to market products, purchase supplies, and provide services for its members. If run correctly, cooperatives increase profits for its producer-members and lower costs for its consumer-members. Cooperatives are common in the agricultural community. For example, some 750 cranberry and grapefruit member growers market their cranberry sauce, fruit juices, and dried cranberries through the Ocean Spray Cooperative.Ocean Spray History (company Web site, about us, history), http://www.oceanspray.com/about/cranberry_history.aspx (accessed June 19, 2008). More than three hundred thousand farmers obtain products they need for production—feed, seed, fertilizer, farm supplies, fuel—through the Southern States Cooperative.Corporate information, Southern States Cooperative, http://www.southernstates.com/sscinfo/about (accessed June 19, 2008). Co-ops also exist outside agriculture. For example, REI (Recreational Equipment Incorporated), which sells quality outdoor gear, is the largest consumer cooperative in the U.S. with more than three million active members. The company shares its financial success each year with its members, who get a refund each year based on their eligible purchases.2006 REI Stewardship Report, http://www.rei.com/aboutrei/csr/2006/coop.html (accessed June 19, 2008).

Not-for-Profit Corporations

A not-for-profit corporationAn organization formed to serve some public purpose rather than for financial gain. (sometimes called a nonprofit) is an organization formed to serve some public purpose rather than for financial gain. As long as the organization’s activity is for charitable, religious, educational, scientific, or literary purposes, it should be exempt from paying income taxes. Additionally, individuals and other organizations that contribute to the not-for-profit corporation can take a tax deduction for those contributions. The types of groups that normally apply for nonprofit status vary widely and include churches, synagogues, mosques, and other places of worship; museums; schools; and conservation groups.

There are more than 1.6 million not-for-profit organizations in the United States.“Non-profit organization,” Wikipedia, http://en.wikipedia.org/wiki/Non-profit_organization (accessed June 19, 2008). Some are extremely well funded, such as the Bill and Melinda Gates Foundation, which has an endowment of approximately $60 billion.Carol J. Loomis, “Warren Buffett Gives Away His Fortune,” Fortune, June 25, 2006, http://money.cnn.com/2006/06/25/magazines/fortune/charity1.fortune (accessed June 19, 2008). Others are nationally recognized, such as United Way, Goodwill Industries, Habitat for Humanity, and the Red Cross. Yet the vast majority are neither rich nor famous, but nevertheless make significant contributions to society.

Mergers and Acquisitions

Though they are often used as if they’re synonymous, the terms merger and acquisition mean slightly different things. A mergerThe combination of two companies to form a new company. occurs when two companies combine to form a new company. An acquisitionThe purchase of one company by another with no new company being formed. is the purchase of one company by another with no new company being formed. An example of a merger is the merging in 2005 of US Airways and America West. The combined company, the nation’s fifth largest carrier, flies under the US Airways name but is headquartered in Tempe, Arizona, the home of America West. It was hoped that the merger would help the combined airlines better compete with discount rivals Southwest and JetBlue.Dan Reed and Barbara De Lollis, “America West, US Airways Merger Goes for a Tight Fit,” USA Today, May 19, 2005, http://www.usatoday.com/money/biztravel/2005-05-19-merger_x.htm (accessed June 20, 2008). An example of a recent acquisition is the purchase of Reebok by Adidas for $3.8 billion.Theresa Howard, “Adidas, Reebok lace up for run at Nike,” US Today, August 3, 2005, http://www.usatoday.com/money/industries/manufacturing/2005-08-02-adidas-usat_x.htm (accessed June 20, 2008). The deal will give Adidas a stronger presence in North America and will help the company compete with rival Nike. Though Adidas still sells shoes under the Reebok brand, Reebok as a company no longer exists.

Motives behind Mergers and Acquisitions

Companies are motivated to merge or acquire other companies for a number of reasons, including the following.

Gain Complementary Products

Figure 4.7

Do you think by acquiring Reebok, Adidas has had an impact on Nike’s command of the running shoe market?

© 2010 Jupiterimages Corporation

Acquiring complementary products was the motivation behind Adidas’s acquisition of Reebok. As Adidas CEO Herbert Hainer stated in a conference call, “This is a once-in-a-lifetime opportunity. This is a perfect fit for both companies, because the companies are so complementary….Adidas is grounded in sports performance with such products as a motorized running shoe and endorsement deals with such superstars as British soccer player David Beckham. Meanwhile, Reebok plays heavily to the melding of sports and entertainment with endorsement deals and products by Nelly, Jay-Z, and 50 Cent. The combination could be deadly to Nike.”Theresa Howard, “Adidas, Reebok lace up for run at Nike,” US Today, August 3, 2005, http://www.usatoday.com/money/industries/manufacturing/2005-08-02-adidas-usat_x.htm (accessed June 20, 2008).

Hostile Takeover

What happens, though, if one company wants to acquire another company, but that company doesn’t want to be acquired? You can end up with a very unfriendly situation. The outcome could be a hostile takeover—an act of assuming control that’s resisted by the targeted company’s management and its board of directors. Ben Cohen and Jerry Greenfield found themselves in one of these unfriendly situations: Unilever—a very large Dutch/British company that owns three ice cream brands—wanted to buy Ben & Jerry’s, against the founders’ wishes. To make matters worse, most of the Ben & Jerry’s stockholders sided with Unilever. They had little confidence in the ability of Ben Cohen and Jerry Greenfield to continue managing the company and were frustrated with the firm’s social-mission focus. The stockholders liked Unilever’s offer to buy their Ben & Jerry’s stock at almost twice its current market price and wanted to take their profits and run. In the end, Unilever won; Ben & Jerry’s was acquired by Unilever in a hostile takeover. Despite fears that the company’s social mission would end, this didn’t happen. Though neither Ben Cohen nor Jerry Greenfield are involved in the current management of the company, they have returned to their social activism roots and are heavily involved in numerous social initiatives sponsored by the company.