ENTREPRENEURSHIP

Dr. Jean Dautrey NEU Business School

CHOOSING THE LEGAL FORM

OF
BUSINESS ORGANIZATION
 When a business is launched, a form of
legal entity must be chosen…
 There is no single form of business
organization that works best in all
situations…
 Each business organization involves
trade-offs
So, What are the legal structure alternatives
for business?
 Legal structure alternatives for business….
1. Sole Proprietorship
2. Partnership
3. Limited Liability Company
4. Corporation (C, Subchapter S, or
Nonprofit)

 Choosing the right structure depends upon…

 Legal and tax ramifications
Legal Forms of Organization
1. Sole Proprietorship
 This is the simplest form of business
ownership…
 It involves one person and that
person and the business are
essentially the same

 Setting up a sole proprietor is cheap

and relatively easy compared to other
forms of business ownership
 The only legal requirement is to obtain
the appropriate licenses and
permits to do business…
 Severe penalties can be levied for
starting running a business without
the proper licenses and permit in place
So, what kind of licenses and permits are
required to operate?
 Businesses selling goods and services
are required to have a sales tax
permit and collect sales tax

 People in certain professions are required

to pass an examination and maintain a
professional license to conduct business
(tattoo artists, barbers, real estate
agents…)
 Certain businesses require an
occupational license or permit to
operate (plumbers, daycare centers,
trucking companies….)

 If you plan to sell alcohol you will need a

permit and a liquor license
 If your business involves preparing food,
a health permit is required
 If the business handles hazardous
substances or sells and/or stores
highly flammable material a fire
permit is required

 In some cases, a street vendor

permit or a side-walk café permit
may also be required
 If you plan to use a fictitious name
for the business, you will need to
obtain a fictitious name permit…
 You should obtain the appropriate
internet domain name at the
same time to make sure it is
available
 A sole proprietorship is not a separate
legal entity. It is not a legal person…
 The sole owner is responsible for all
the liabilities of the business.

 If the sole proprietor’s business is sued…

 The owner could theoretically lose all
the business’s assets along with
personal assets
Recall from earlier that…
 There are two kinds of persons…
1. Natural persons – real human beings as
distinguished from legal persons (legal
personhood acquired at birth)
2. Legal persons – corporations or limited
liability companies treated at law as if they
were persons.
 Legal personhood is acquired when the
company is incorporated (registered) in
accordance with the law
Every natural or legal person receives…
 An estate at birth in which there will
be more and more property as that
person grows. The estate includes…
 What you own (a watch, a car, a
house, a bank account…) and…
 What you owe (credit cards, loans…

 The difference is your net worth

So, if for example…
 You set up a coffee shop and register
it as a legal person, then…
 Any property used in relation to the
company will belong to that
company’s estate
 The debts incurred by that company
can only be paid with property taken
from the company’s estate
 The reason the law has created two
kinds of persons is to encourage
business risk taking…
 Since a person is not liable for the
debt of another person (unless
he/she agreed to it by contract)
 A natural person is NOT liable for
the debt of a legal person
 In other words, since your coffee shop
and you are two separate legal
entities (two separate persons)…
 Unless agreed upon, a creditor
cannot access the estate you have
as a natural person (e.g. the car you
own) to…
 Pay the loan on the car owned by the
company you own (the legal person)
For tax purposes…
 The profit or loss of the business flows
through to the owner’s personal tax
and…
 The business ends at the owner’s death
or if he/she loses interest in the
business
 Most sole proprietorships are lifestyle
entrepreneurs…
 Sole proprietorships are a poor choice for an
aggressive entrepreneurial firm….
 The liquidity of an owner’s investment in a
sole proprietorship is usually low
 It is usually difficult for a sole proprietorship
to raise investment capital
 Unlimited liability and difficulty raising capital are
the primary reasons entrepreneurs typically
form…
 Corporations or limited companies as opposed
to sole proprietorships
 If the business will be operated under a
trade name (e.g. Hanoi Graphic Design)
instead of the name of the owner, the owner
will have to …
 File a certificate with the appropriate
government agency so as to ensure that
there is only one business using the same
name and…
 Provide a public record of the owner’s
name and contact information…
Advantages of Sole Proprietorship
 Easy and inexpensive to create
 100% of ownership + profits stay with the
owner
 Complete decision-making authority for
the owner who maintains complete control
 Income is taxed only at the owner’s
personal income tax rate (no double
taxation)
 No major reporting requirements exist
 Easy to dissolve
Disadvantages of Sole Proprietorship
 Owner has unlimited liability for all claims
against the business-all debts must be paid
from the owner’s assets
 The business relies on the skills and
liabilities of a single owner to be successful
 Difficult for the owner to raise debt
capital
 Survival of the business depends upon the
owner
2. Partnerships
 If two or more people start a
business, they must organize as…
 A partnership
 A corporation or…
 A limited liability company
 A partnership is formed when two or
more people agree to share the
assets, liabilities, profits of a business

 Partnerships are organized as either

1. General partnerships or
2. Limited partnerships
1. General Partnerships
 A general partnership is a form of business
organization where two or more people…
 Pool their skills, abilities, and resources
to run a business

 The primary advantage is that the business is not

dependent on a single person for its survival
and success (in most cases, partners have equal
say in how the business is run)
 Most partnerships have a partnership
agreement which is a legal document that…
 Details the responsibilities and the
ownership shares of the partners
involved with an organization

 The business created by a partnership ends at the

death of withdrawal of a partner unless…
 Otherwise stated in the agreement
 Similar to a sole proprietorship, the
profit or loss of the business flows
through to the partner’s personal tax…
 The portion flowing to each partner’s
individual tax return is based on their
percentage of ownership

 The partnership files an informational tax

return only
 A partnership agreement defines the
relationship between partners in terms
of…
 Business responsibilities
 Profit sharing
 Transfer of interest

 It is a binding contract between partners

Structuring an Effective Partnership Agreement
Advantages of a General Partnership

 Same advantages as sole proprietorships

 Shared risk of doing business
 Shared partner clout with multiple
financial statements
 Shared ideas, expertise, decision
making
 Partners receive pass-through earnings
and losses taxed at their personal tax
rates
Disadvantages of a Partnership
 Partners are personally liable for all business
debts and obligations.
 Individual partners can bind the partnership
contractually.
 Partnership dissolution results when a partner
leaves or dies
 Partners can be sued individually for the full
amount of partnership debt.
 Raising capital can be difficult
 Because decision making among the partners is
shared, disagreements can occur
2. Limited Partnerships
 A limited partnership is a modified form
of a general partnership
 The major difference is that a limited
partnership includes two classes of
owners…
 General partners and…
 Limited partners
 There are no limits on the number of either
class
 Similar to a general partnership, the
general partners are liable for the
debts and obligations of the partnership
but…
 The limited partners are liable only
up to the amount of their investment…
 They also may not exercise any
significant control over the
organization
 A limited partnership is usually formed
to…
 Raise money or…
 Spread out the risk of a venture
without forming a corporation

 Limited partnerships are common in real estate

development, motion picture ventures, and oil
and gas exploration
 As is the case with general partnerships,
most limited partnerships have a limited
partnership agreement that sets
forth…
 The rights and duties of the general
and limited partners along with…
 The details of how the partnership will
be managed
3. Limited Liability Company
 A limited liability company (LLC) is a
privately held company which
incorporate under strict guidelines.

 Combines the limited liability

advantages of the corporation with…
 The tax advantages of the
partnership..
 Characteristics of LLCs…
 No minimum number of people
required to form
 Owners are called members
 Shares of ownership are called
interests
 Members may elect to manage the LLC
themselves or may hire managers to
manage it
Advantages of LLCs
 Income tax and liability pass through to members
 Exhibits all 4 characteristics of a corporation:
1. Limited liability
2. Continuity of life
3. Centralized management
4. Free transferability of interests
 No limit on number of members or status
 LLC’s may actually possess wholly owned
subsidiary corporations
 Not limited to one class of stock
Disadvantages of LLCs
 Setting up and maintaining a LLC is complex
and expensive
 Formation filing fee is obligatory
 Consensus is difficult if there are many
members
 It is not a separate tax-paying entity
 Members must file quarterly tax statements
 Can be obliged to register with the SEC
 Allows inclusion of foreign investors
4. Corporations
 A corporation is a separate legal
entity organized under the authority of
the state.
 Corporations are organized as
either…
1. C Corporations (public/private)
2. S Corporations
1. C Corporations
 A C corporation is separate legal entity that
in most cases shields its owners
(shareholders) from personal liability for
the debts and obligations of the corporation
(Can only lose the money they invest)

 Governed by a board of directors elected by

the shareholders
 In most instances, the board hires officers to
oversee the day-today management
 It is usually easier for a C corporation
to raise investment capital than a
sole proprietorship or a partnership…

 It is also easier to allocate partial

ownership interests in a corporation
through the distribution of stock
 Most C corporations have two
classes of stock….
1. Preferred stock
2. Common stock

 Common stock is issued more

broadly than preferred stock
 Establishing a C corporation is more
complicated than a sole proprietorship,
a partnership or a LLC
 Formed by filing articles of
incorporation with a government
agency
 They typically include name, purpose
classes of stock, conditions of
operations, termination, etc…
 It is important that a corporation’s
owners fully comply with these
regulations…

 If they fail to comply, they could be

held personally liable for actions of
the corporation (“piercing the
corporate veil’)…
 A corporation is taxed as a separate legal
entity…
 The “C” in the title comes from the fact that
regular corporations are taxed under sub-chapter
C of the internal revenue service (IRS)
 Subject to double taxation. Taxed on...
 Its net income and…
 Shareholders taxed on their personal
income when that income is distributed to
shareholders in the form of dividends
 This is one of the reasons
entrepreneurial firms often retain
their earnings rather than…
 Pay dividends to their shareholders

 Another advantage of C corporations is the

ease of transferring stock..
 As public corporations, they enjoy a liquid
market for their stock
 It is much more difficult to sell
stock in a closely held
corporation as the voting stock is
held by…
 A small number of individuals
and very thinly or infrequently
traded
Private Corporation
 Private corporation = one in which
all the shares are held by…
 A few shareholders, such as
management or family members and…
 Are not publicly traded

 The vast majority of C corporations are private

corporations
 The stock in both closely held
corporations and private
corporations is fairly illiquid as…
 It typically is not easy to find a
buyer for the stock
 Another advantage of a C corporation
is the ability to share stock with
employees as part of an employee
incentive plan (e.g. vested shares..)

 Such plans are intended to help firms

attract, motivate, and retain high-
quality employees
 Stock options provide employees the
option or right to buy a certain number
of shares of their company’s stock at…
 A stated price over a certain period
of time

 Powerful inducement for employees to

exert extra effort in the hopes of
positively affecting the stock price
Advantages of C Corporations
 Limited liability for owners
 Capital can be raised through sale of stock
 Ownership is transferable
 Enjoys status and deference in business
circles
 Employee access to retirement funds, defined-
contribution, profit-sharing and stock option
plans
 The entrepreneur can hold personal assets
which can be leased back to the corporation
for a fee
Disadvantages of C Corporations

 More complex to organize

 Subject to more governmental
regulations
 Cost more to create
 Stockholders do not receive benefit
of losses
 Ownership control passes to the
board of directors
2. S Corporations
 A subchapter S corporation (S
corporation) combines the advantages
of a partnership and a C corporation in
that….
 The profits and losses of the business
are not subject to double taxation
 Owners are not subject to personal
liability for the behavior of the
business
 Because of these advantages, many
entrepreneurial firms start as sub-
chapter S corporations…

 However, there are strict standards that

a business must meet to qualify for status
as an S corporation…
1. The business cannot be a subsidiary
of another corporation
2. Can have only one class of stock issues
(either preferred or common)
3. Can have no more than 100
shareholders (husbands and wives count as
one member, even if they own separate share
of stock)
4. Shareholders must be U.S. citizens or
residents
5. Profits & losses must be allocated in
proportion to each shareholder’s interest
The Nonprofit Corporation
 A corporation established for charitable,
public, or religious purposes, or for
mutual benefit as recognized by federal
and state laws.
 Two distinct hurdles for nonprofit
operation and tax-exempt status:
1. Must meet state requirements for
being designated as a nonprofit
corporation and operating as such in a
given state
2. Must meet state requirements for
exemption from paying taxes by
forming a corporation that falls within
the IRS’s narrowly defined categories
 Advantages of the Nonprofit Corporation

 Attractive to corporate donors for

business expense deductions
 Can seek cash and in-kind contributions
of equipment, supplies, personnel
 Can apply for grants from government
agencies and private foundations
 May qualify for tax-exempt status
Disadvantages of the Nonprofit Corporation
 Profits cannot be distributed as dividends.
 Corporate money cannot be contributed to
political campaigns or used for lobbying.
 Entrepreneur gives up proprietary interest in
the corporation.
 Upon dissolution, all assets must transfer to
another tax-exempt nonprofit organization.
 Cannot make substantial profits from
unrelated activities.
 It must pay taxes on profits.
Professional Corporations
 Licensed service professionals’
corporation organized to provide
their services include…
 Limited liability company (LLC)
 Professional limited liability
company (PLLC)
 Limited liability partnership (LLP)
 Comparison of Forms of Business Ownership
Factor Sole General Limited C Corp. S Corp. LLC
Proprietsp Partnership Partnership
Number of 1 Unlimited Unlimited Unlimited Up to 100 Unlimited
owners number of number of number of
allowed general partners general & limited “members”
allowed partners allowed allowed

Cost of Low Moderate Moderate High High High

setting up &
Maintaining
Personal Unlimited Unlimited for all Unlimited for Limited to Limited to Limited to

4. Corporations
liability of partners general partners; amount of amount of amount of
owners limited partners investment investment investment
only to extent of
investment
Continuity of Ends at Death or Death or Perpetual Perpetual Typically
business death of withdrawal of withdrawal of limited to a
owner one partner general partner fixed amount
unless of time
otherwise
specified
Taxation Not a Not a taxable Not a taxable Separate No tax at No tax at
taxable entity; each entity; each taxable entity level; entity level if
entity; sole partner pays partner pays entity income/loss properly
proprietor taxes on his/her taxes on his/her is passed structured’
pays all share of income share of income through to income/loss is
taxes and can deduct and can deduct the passed
losses against losses against shareholders through to the
other sources of other sources of members
income income
 Comparison of Forms of Business Ownership
Factor Sole General Limited C Corp. S Corp. LLC
Proprietsp Partnership Partnership

Management Sole All partners Only general Board of Board of Members

control proprietor is share control partners have directors directors share control
in full equally, unless control elected by elected by or appoint
control otherwise the the manager
specified shareholders shareholders

Method of Must be
4. Corporations
Must be raised Sale of limited Sell shares of Sell shares of It is possible
raising raised by by general partnerships, stock to the stock to the to sell
capital sole partners depending on public public interests,
proprietor terms of depending on
operating the terms of
agreement the operating
agreement

Liquidity of Low Low Low High if Low Low

investment publicly
traded

Subject to No No No Yes No No
double
taxation
Thank you for your attention