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Chapter 7Forms of Business Organization

and Personal Liability

Accounting and Finance for Entrepreneurs

EBD-301

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2BUSINESS ORGANIZATIONS

Decision Criteria Desired degree of personal liability The method of taxation of business profits

Principal Forms of Business Organization Sole Proprietorship Partnership S-corporation C-Corporations Limited Liability Company (LLC)

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3BUSINESS ORGANIZATIONS

In the early going for any new venture, the owners of a new business will be personally liable for all the obligations incurred by the business to its trade suppliers and to any lenders from whom they borrowed funds regardless of the form of business.

Sole proprietorships and partnerships will always be liable for all of the obligations incurred by the business

As businesses get larger, the corporate form is the preferred organizational form to limit personal liability

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4BUSINESS ORGANIZATIONS

Corporation Forms C-Corporation

Major draw back is the double taxation of business income

S-Corporation Avoids the double-taxation of business income

Critical Issue: Piercing the Veil of Limited Liability Owner/managers may face personal liability for debts of the

business if the business declares bankruptcy See: http://blogs.law.harvard.edu/corpgov/2014/03/27/the-

three-justifications-for-piercing-the-corporate-veil/

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5SOLE PROPRIETOR

Simplest form of business organization Unincorporated business owned by a single individual Owner and business treated as one tax entity

Owner files a form 1040, U.S. Individual Income Tax Return along Schedule C: Profit or Loss From Business

Schedule SE: Self-Employment Tax

Form 941 or 944: Employer’s QUARTERLY Federal Tax Return

Form 940: Employer's Annual Federal Unemployment (FUTA) Tax Return

IRS Publication 334 should be consulted for specific issues regarding filing and paying business taxes, accounting methods, computing profits (or loss), legal business expenses, self-employment taxes, several important issues, and frequently asked questions (FAQs).

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6SOLE PROPRIETOR

Business can be run full or part time important distinction; “trade or business is generally

activity carried on to make a profit.” Even an individual with a full time employment and

operating a business “on the side” is considered to be self-employed.

Hobby or Business? A hobby is an activity not engaged in for profit.

Major disadvantage: owner is personally responsible for all of the business’s liabilities.

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7PARTNERSHIP

An unincorporated business venture in which 2 or more individuals share the operation and profits of the business. IRS Publication 541 Partnerships is the reference document Partnership must file Form 1065 U.S. Return of Partnership

Income Each Partner must receive and file Schedule K-1 (Form

1065) along with their Form 1040 Each partner must file and pay self-employment tax and

pay roll taxes the same as sole proprietors

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8PARTNERSHIP

Two Categories of Partnerships General: GPs manage the company Limited: LPs are mainly investors

Personal Liability of Partners Partners are personally liable for the partnerships obligations and debt Each partner can act on behalf of the partnership – they can legally

encumber the partnership Limits to encumber must be spelled out in the partnership agreement

Limited Liability Partnership (LLP): Partners not liable for misdeeds of other partners. They are always liable for their own illegal acts.

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9LIMITED LIABILITY COMPANY

Formed under state statutes IRS Form 8832 is the key reference document

LLCs can elect to be taxed as corporations, partnerships, or as just simply on an individual’s Form1040

Filling form 8832 Entity Classification Election directs the IRS to treat and tax the LLC as a corporation. The LLC then files a form 1120 U.S. Corporation Tax Return

May also elect to be treated as a Disregarded Entity; A disregarded entity is an eligible entity that is treated as an entity not separate from its single owner for income tax purposes.

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10LIMITED LIABILITY COMPANY

An LLC may elect to be treated as a partnership for income tax purposes

File Form 1065 U.S. Return of Partnership Income

If Form 8832 is not filed, IRS will treat the LLC as an entity not separate from its owner (effectively the same as a sole proprietor)

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11S Corporations

Principal advantage of an S-corporation is the avoidance of the double taxation of profits. Maximum of 100 shareholders (owners) S-Corporations file a Form 1120-S S-corporations are exempt from taxation other than taxes on

certain capital gains and on passive income (rents, royalties) All profits pass directly to the owners – who report income on

their respective Form 1040 Owners must file a form 2553, Election by a Small Business

Corporation, to be taxed as an S-corporation.

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12C CORPORATIONS

Corporation is a legal form of organization of persons and material resources, chartered by the state for the purpose of conducting business Owned by the shareholders Business is governed by a Board of Directors

Officers are elected to run the business on a day-to-day basis

Business must abide by the laws and statutes of the state in which they are incorporated

C-Corps. May have an unlimited number of shareholders

May be public or privately held

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13C CORPORATIONS

Provides protection to its shareholders from the corporation’s liabilities

subject to the double taxation of profits As income to the corporation

As income to shareholders who receive dividends

State corporate regulations require; A Business Name

Certificate or Articles of incorporation along with Bylaws

Must hold annual meetings

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14C CORPORATIONS

C-Corps are the best way to protect personal assets C-Corps have better access to capital markets Must have an Employer Identification Number (EIN) C-Corps file a Form 1120

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15Caveats

The preceding discussions on organizational form and taxation issues should alert the budding entrepreneur to the importance of considerations affecting the management of the business.

The IRS is the first and best source of information and instructions on the use of various forms.

Business owners should also consult competent tax accountants about specific issues not readily found in IRS publications.

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