Chapter 6 BUSINESS FORMATION Choosing the Form that

LOOKING AHEAD • How are sole proprietorships and partnerships different? How are they different than corporations? • Why are corporations the most dominant form of business? • What are the different types of corporations and how are they different? • What are mergers & acquisitions? • What is the goal of mergers and acquisitions? • Why have limited liability companies become popular? • What are the advantages and disadvantages of franchising? © 2009 South-Western, a division of Cengage Learning 2

CHOICES, CHOICES Form of ownership affects: • Operation • Start-up Costs The form of ownership • Profit Distribution of a business is a • Taxes big decision. The “Big Three” is Becoming the “Big Four”: • Sole Proprietorship • Partnership • Corporation • Limited Liability Company © 2009 South-Western, a division of Cengage Learning 3

SOLE PROPRIETORSHIP: BUSINESS AT ITS MOST BASIC • Advantages: – Ease of Formation – Retention of Control – Pride of Ownership – Retention of Profits – Possible Tax Advantages © 2009 South-Western, a division of Cengage Learning • Disadvantages: – Limited Financial Resources – Unlimited Liability – Limited ability to attract and maintain talented employees – Lack of Permanence 4

MOST COMMON TYPES OF SOLE PROPRIETORSHIPS Category Examples Number of Proprietorships (thousands) Professional, Technical, and Scientific Services Law firms, accountants, architects, computer system designers, consultants 2, 752 Construction Residential construction, commercial construction, specialty contractors 2, 491 Retail Trade Car dealerships, restaurants, clothing stores, home & garden stores 2, 416 Other Services Automobile repair and body shops, laundries, personal services 1, 995 Health Care Physicians, dentists, chiropractors, psychologists, psychiatrists 1, 762 © 2009 South-Western, a division of Cengage Learning 5 Source for Table: “Sole Proprietorship Returns”, by Kevin Pierce Statistics of Income Bulletin, Summer, 2005, Figure A, p. 9; website: http: //www. irs. gov/pub/irs-soi/03 solp. pdf )

BUSINESS FORMS: COMPARING THE NUMBERS Total Number of Businesses by Form of Ownership (Millions) © 2009 South-Western, a division of Cengage Learning Total Net Income by Form of Ownership ($Billions) 6

PARTNERSHIPS: TWO HEADS CAN BE BETTER THAN ONE • Advantages: – Pooled Financial Resources – Shared Responsibilities • Disadvantages: – Unlimited Liability – Disagreements – Ease of Formation – Difficulty in withdrawing from agreement – Tax Advantages – Lack of Continuity © 2009 South-Western, a division of Cengage Learning 7

LIMITED PARTNERSHIPS Limited Partnership – includes at least one general partner and at least one limited partner Limited partners have limited liability. © 2009 South-Western, a division of Cengage Learning Limited Liability Partnership – All partners are actively involved but they have some form of limited liability. The amount of liability differs per state. 8

GENERAL VS LIMITED PARTNERSHIPS • General Partnerships – All partners have the right to participate in the management of the firm and share in any profits/losses. • Limited Partnerships – All partners contribute financially and share in the profits but the limited partner(s) cannot actively participate in management. © 2009 South-Western, a division of Cengage Learning 9

FAMILY LIMITED PARTNERSHIPS • Parents as general partners • Children as limited partners • Parents transfer assets to limited partners while still maintaining control, this strategy: – Reduces gift and inheritance taxes – Protects family assets from creditors and lawsuits • But watch out for the IRS – Family Limited Partnerships can attract tax auditors! © 2009 South-Western, a division of Cengage Learning 10

CORPORATIONS: AN ARTIFICIAL REALITY • A corporation is a legal entity, separate and distinct from its owners. • Corporations are owned by stockholders. • The Board of Directors establishes the mission and objectives. • The Board is elected by the stockholders to represent their interests. © 2009 South-Western, a division of Cengage Learning 11

CORPORATIONS • Advantages: – Limited Liability – Permanence – Easy to Transfer Ownership – Ability to Raise Capital • Disadvantages: – Expense/complexity of formation and operation – Double Taxation – Paperwork and Regulation – Conflicts of Interest – Specialized Management © 2009 South-Western, a division of Cengage Learning 12

OTHER TYPES OF CORPORATIONS: SAME BUT DIFFERENT • S Corporation • Closed Corporation •

COMPARING TYPES OF CORPORATIONS TYPE S Corp. KEY ADVANTAGE • IRS does not tax earnings separately. • Stockholders have limited liability. LIMITATIONS • No more than 100 stockholders • Stockholders must be US citizens or permanent residents Statutory • Not require to have a board or hold Close Corp. annual meetings. • Owners can participate in management while maintaining limited liability. • Limited number of stockholders. • Stockholders must offer shares to owner first before selling publicly • Not all states allow this corporation type • Earnings are exempt from federal and state income taxes. • Members/directors have limited liability • Contributions made by individuals © 2009 South-Western, a division of Cengage Learning are tax-deductible • May have dues paying members but no stockholders. • Can’t distribute dividends. • Can’t make political donations. • Must keep accurate records 14 to document tax-exemption. Nonprofit Corp.

LIMITED LIABILITY COMPANY: THE NEW KID ON THE BLOCK • Advantages: • Disadvantages: – Limited Liability – Franchise Taxes – Tax Pass-Through – Foreign Status in other States – Simplified Management and Operation – Flexible Ownership © 2009 South-Western, a division of Cengage Learning – State Law Differences – Limited to Select Industries 15

COMPARING BUSINESS FORMS HIGH DEGREE OF PERSONAL LIABILITY Sole Proprietorships LOW Partnerships LOW Corporations DEGREE OF COMPLEXITY AND PERPETUITY © 2009 South-Western, a division of Cengage Learning HIGH 16

CORPORATE RESTRUCTURING Mergers – two companies agree to a combination of equals. Acquisitions – when one firm buys another. Corporations look for: – Growth opportunities – Operational efficiencies – Competitive advantages © 2009 South-Western, a division of Cengage Learning 17

TYPES OF MERGERS AND ACQUISITIONS Type of Merger Horizontal Definition Objective Example Combine firms in same industry. • Increase size • Increase market power • Gain efficiency AT&T and SBC Vertical Combine companies • Provide tighter with buyer-seller integration and relationship. increase control Time Warner and Turner Broadcasting Conglomerate Combination of • Increase company’s unrelated companies. diversity. GE acquiring RCA © 2009 South-Western, a division of Cengage Learning 18

FRANCHISING: PROVEN METHODS FOR A PRICE • Not a form of ownership but an operation option. – – Subway Jiffy Lube 7 -Eleven Mc. Donalds • The franchisee uses the brand name, trademark and practices of the franchisor. © 2009 South-Western, a division of Cengage Learning 19

FRANCHISING • Advantages: • Disadvantages: – Less Risk – Costs – Training and Support – Lack of Control – Brand Recognition – Negative Halo Effect – Access to Funding – Growth Challenges Ben & Jerry franchises its Partner. Shops to non-profit corporations. © 2009 South-Western, a division of Cengage Learning – Restriction on Sale – Poor Execution 20

LOOKING BACK • What are the pros and cons of operating a business as a sole proprietorship? • What are the basic features of general partnerships, limited partnerships, and limited liability partnerships? • Why have corporations become the dominant form of business ownership? • How do S corporations, statutory closed corporations and nonprofit corporations differ from general corporations, and from each other? • How does a corporation restructure through mergers and acquisitions? • Why have limited liability companies become increasingly popular? • What are the advantages and disadvantages of franchising? © 2009 South-Western, a division of Cengage Learning 21