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16.1 Selecting a Legal Form for a Business

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Describe the three primary legal forms available for a business in the United States.
  2. Discuss the advantages and disadvantages of incorporating a business rather than maintaining it as a sole proprietorship or partnership.
  3. Explain the double taxation that is inherent in operating a corporate organization.
  4. Describe the impact that issuing capital stock has on a corporation.

Creating a Corporation

Question: In the United States, businesses and other organizations must operate as one of three legal forms.Over the decades, a number of variations of these legal forms have been allowed, each with its own particular characteristics. For example, limited liability companies (LLC) and limited liability partnerships (LLP) are hybrids that exhibit characteristics of both partnerships and corporations and are permitted to exist in certain states. A proprietorshipA business created, owned, and operated by a single individual; business is not legally separate from its owner; it is also referred to as a sole proprietorship. has a single owner whereas a partnershipAn unincorporated business created, owned, and operated by more than one individual; the business is not legally separate from its owners. is started and owned by two or more parties. In both of these cases, establishing the business is often an unstructured process. For example, a partnership can be created by a mere handshake or other informal agreement.

The third legal form of organization is a corporationAn organization that has been formally recognized by the state government as a separate legal entity so that it can sell ownership shares to raise money for capital expenditures and operations., which is brought into existence by means of a formal request made to a state government. Incorporation creates a separate entity, one that is owned by a group of stockholders. The number of owners is usually not relevant in the operation of a corporation. Because corporations are the dominant legal form (at least monetarily) in the United States, they have been the primary emphasis throughout this text. Numerically, more proprietorships and partnerships do exist but virtually every business of any size operates as a corporation. How is a corporation established, and what characteristics make it attractive?

 

Answer: Organizers only need to satisfy the incorporation process in one state regardless of their entity’s size. To start, they submit articles of incorporation to that government along with any other necessary information.A list of the typical contents of the articles of incorporation can be found at “Articles of Incorporation,” http://en.wikipedia.org/wiki/Articles_of_Incorporation. Rules, regulations, and requirements vary significantly so that these procedures are more complicated in some states than others. For example, many well-known businesses are incorporated in Delaware because of the traditional ease of the laws in that state.

After necessary documents have been filed and all other requirements met, the state government issues a corporate charter that recognizes the organization as a legal entity separate from its owners. This separation of the business from its owners is what differentiates a corporation from a partnership or proprietorship. Following incorporation in one state, the entity is then allowed to operate in any other state.

As mentioned in an earlier chapter, ownership of a corporation is physically represented by shares of stock that are issued to raise funds. In general, these shares are referred to as capital stock and the owners as shareholders or stockholders. For example, by December 31, 2010, Nucor Corporation had issued approximately 375 million of these shares to its stockholders. Unless restricted contractually, capital stock can be exchanged freely. After being issued by a corporation, shares can be resold dozens or even hundreds of times. Operations are usually unaffected by these ownership changes. Information about the current market price of most stocks as well as considerable other information about thousands of businesses can be found at sites such as http://www.google.com/finance and http://www.yahoo.com/finance.

Thus, a corporation is able to continue in existence even after owners die or decide to switch to other investments. In partnerships and proprietorships, capital stock does not exist. Consequently, transfer of an ownership interest is much more complicated. Partnerships and proprietorships often operate only for as long as the original owners are willing and able to continue being actively involved.

As a result of the legal separation of ownership and business, shareholders have no personal liability for the debts of the corporation.When money is loaned to a corporation, especially one that is either new or small, the lender might require the owners to guarantee the debt personally. Unless such a guarantee is made, the debt is that of the corporation and not the members of the ownership. An owner of a share of Nucor Corporation is not responsible for any of the liabilities of that company. Thus, the maximum loss a shareholder can suffer is the amount contributed to the corporation (or paid to a previous owner) in acquiring capital stock. The limited liabilityA legal characteristic associated with the ownership of a corporation whereby the maximum amount of money that can be lost is the owner’s capital investment; an attribute of a corporation that does not exist with the ownership of proprietorships or partnerships. offered by a corporation is one of the primary reasons for its popularity.

In contrast, the owners of a partnership or proprietorship are liable personally for all business debts. No separation exists between the business and ownership. For example, a partner or proprietor could invest $1,000 but wind up losing almost any amount of money if funds are borrowed by the business that cannot be repaid. Such potential losses are especially worrisome in a partnership because of the legal concept of mutual agencyA characteristic of a partnership whereby any partner can obligate other partners to an agreement without their direct consent; does not have a parallel in corporate ownership. where each partner serves as an agent for the entire organization. Thus, a partner can obligate the partnership and, if the debt is not paid when due, the creditor can seek redress from any partner. This possibility of unlimited losses typically restricts the number of potential investors because most people have a strong preference for being able to quantify the amount of risk they face.

The Double Taxation of Corporations

Question: Ownership shares of most corporations can be transferred. Thus, the life of an incorporated business can extend indefinitely as one owner leaves and another arrives. Caswell-Massey Co. is a perfect example. It has been in operation now for over 250 years. According to the corporate Web site (http://www.caswellmassey.com/about/about.aspx), “Before there was the United States of America, there was Caswell-Massey, the original purveyor of the finest personal care products and accessories and America’s oldest operating retailer. The company was founded in Newport, Rhode Island, by Scottish-born Dr. William Hunter in 1752.”

Investors are able to move into and out of corporate investments quickly. In addition, the availability of limited liability restricts potential losses to the amounts invested. These characteristics help explain the immense popularity of the corporate form in the United States. However, a significant number of partnerships and proprietorships continue to be created each year. If no problems existed, incorporation would be the only practical option. What disadvantages are associated with the corporation form?

 

Answer: Incorporation is often a time-consuming and costly legal process. However, in most states, proprietorships and partnerships can be created informally with little effort. Owners of many small businesses may feel that the creation of a corporation is more trouble than it is worth. Furthermore, corporations are often more susceptible to a plethora of government regulations.

The most obvious problem associated with corporations is the double taxationA negative feature associated with the corporate form; corporate earnings are taxed when earned by the business and then taxed again when distributed to owners in the form of dividends. of income. As noted, proprietorships and partnerships are not deemed to be separate entities. Therefore, the owners (but not the business) must pay a tax when any income is generated. However, the income is taxed only that one time when earned by the business.

For a proprietorship, Form 1040 Schedule C is an income statement attached to the owner’s individual income tax return to include the business’s profit or loss. A partnership does file its own tax return on Form 1065, but that is merely for information purposes; no income tax is paid. Instead, the various business revenues and expenses are assigned to the partners for inclusion on their individual tax returns. Any eventual conveyance of this income from the business to the owner does not create a second tax.

In contrast, as separate legal entities, corporations pay their own taxes by reporting all taxable income on Form 1120.Tax rules do allow smaller corporations to file their income taxes as S corporations if certain guidelines are met. S corporations follow virtually the same tax rules as partnerships so that income is only taxed one time when initially earned. However, when any dividends are eventually distributed from those earnings, this transfer is also viewed as taxable income to the stockholders. Income is taxed once when earned by the corporation and again when distributed to the owners. Critics have long argued that the conveyance of the dividend is not a new earning process. To mitigate the impact of this second tax, the U. S. Congress has established a maximum tax rate of 15 percent on much of the dividend income collected by individuals. This rate is considerably lower than that applied to most other types of income (such as salaries). Whether that reduced tax rate for dividends should continue at 15 percent or be raised or lowered is the subject of intense political debate.

To illustrate, assume that income tax rates are 30 percent except for the 15 percent tax on dividends. A proprietorship (or partnership) earns a profit of $100. For this type business, the $100 is only taxable to the owner or owners when earned. Payment of the resulting $30 income tax ($100 × 30 percent) leaves $70 as the remaining disposal income. Any distribution of this money to an owner has no impact on taxes. The government has collected $30.

If a corporation reports income of $100, a tax of $30 is assessed to the business so that only $70 remains. This residual amount can then be conveyed to owners as a dividend. However, if distributed, another tax must be paid, this time by the stockholder. The second income tax is $70 times 15 percent, or $10.50. The owner is left with only $59.50 ($70.00 less $10.50) in disposal income. The government has collected a total of $40.50 ($30.00 plus $10.50). The increase in the amount taken by the government is significant enough to reduce the inclination of many owners to incorporate their businesses.

Test Yourself

Question:

James Erskine and Pamela White are starting a new business. They are trying to determine whether to go to the trouble of incorporating or simply shake hands to form a partnership. Which of the following is a reason to create a partnership?

  1. Partnerships can raise large amounts of money more easily than corporations.
  2. Partnerships offer limited liability for their owners.
  3. Partnerships are not subject to double taxation of income.
  4. Partnerships are more likely to have a continuous life than a corporation.

Answer:

The correct answer is choice c: Partnerships are not subject to double taxation of income.

Explanation:

Because ownership of a corporation is viewed as separate from the business, capital shares can be issued to raise money—often large sums. These shares allow frequent changes in ownership that provides an easy way for a business to exist beyond the life of the original owners. Corporations provide only limited liability for their owners, a major reason for their popularity. However, partnerships are not subject to the same double taxation effect as corporations. The owners save money.

Key Takeaway

Legally, businesses can be created to function as corporations, partnerships, or sole proprietorships. Corporations are formed by meeting the legal requirements of an individual state. In contrast, partnerships and proprietorships can be started with little formal activity. A corporation differs from these other two forms because it is an entity legally separate from its ownership. Because of that separation, the maximum possible loss for the stockholders in a corporation is limited to the amount invested. Without that separation, owners of a partnership or proprietorship face the risk of unlimited liability. Ownership shares of a corporation (capital stock) are issued to raise money for operations and growth. In many cases, these shares can be readily sold by one owner to the next, often on a stock exchange. The ability to buy and sell capital shares enables a corporation to raise funds and have a continuous life. Disadvantages associated with the corporate form include the cost and difficulty of incorporation and government regulation. The double taxation of corporate income (which is not found with partnerships and sole proprietorships) is often the biggest drawback to incorporation. This second tax effect results because dividends are taxed to the recipients, although a reduced rate is often applied.