Business Entities: Study Notes
UNIT FOUR | Business Entities
Learning Objectives
After studying this chapter, students who have mastered the material will be able to:
Articulate the factors that business owners should consider when selecting a business entity.
Identify the advantages and drawbacks of the sole proprietor form of entity.
List the choices available to capitalize a sole proprietorship.
Explain how proprietorships are managed and taxed.
Describe the impact of terminating a sole proprietorship.
Recognize the role of franchises in business.
Overview of Business Entities
All business ventures operate under a legally recognized form of business entity.
Important for business owners and managers to understand the structure, advantages, and risks associated with each form of entity to effectively manage potential liability.
Most states recognize at least six forms of business entities.
This chapter focuses specifically on the most basic form: the sole proprietorship, with further details on other forms covered in subsequent chapters.
Choosing a Business Entity
The best choice of business entity is primarily driven by:
Risk
Tax implications
Operational objectives of the owner(s)
Type of business operations contemplated
Choosing an appropriate business entity is crucial for startup entrepreneurs and managers initiating additional ventures.
Each form has advantages, drawbacks, and legal consequences for the principals (owners) of the business.
Factors for Choosing a Business Entity
Formation:
Ease of formation and maintenance
Number of principals required
Annual filings or fees and formalities that must be followed
Liability:
Extent of personal liability for debts and liabilities of the entity
Example: If Khan, a consultant, entered into a lease and could not pay, would Landlord have a claim against Khan's personal assets?
Capitalization:
How the entity will fund its operations
Can principals sell ownership rights to raise capital?
Taxation of income:
Treatment of the entity by tax authorities
Will taxes be paid by the entity or passed through to the principals?
Management and operation:
How and by whom will the business be operated?
Duties owed by principals to the business and each other?
Profit and loss distribution methods
Continuation of operations if a principal leaves.
Table 27.1: Common Forms of Business Entities
Sole Proprietorship:
One-person entity with debts and liabilities being personal debts of the principal.
Partnerships:
General: Two or more share profits and losses; debts are personal liabilities for general partners.
Limited: Limited partners have limited liability.
Limited Liability Partnerships (LLPs):
Protection from personal liability for partnership debts.
Limited Liability Companies (LLCs):
Ongoing venture with favorable tax treatment and limited liability for members.
Corporations:
Business with ownership (stock) where owners typically have no personal liability for debts.
Evolution of the Entity
Choice of business entity varies based on business type and associated liabilities.
Initial choice isn't permanent; principals can change it as needed.
Example: Zhang running a dorm business might start as a sole proprietorship but might transition to an LLC as operations expand.
Key Takeaways
Best entity choice influenced by risk, tax, operational goals, and business type.
Each entity has its own set of advantages and drawbacks.
Entities can evolve based on business changes.
Sole Proprietorships
Easiest ownership entity to form; low cost and minimal maintenance requirements.
Generally requires a simple state filing and no annual filings.
Suitable for low-revenue start-up businesses.
Proprietors can file for a DBA (Doing Business As) certificate for a trade name.
Liability of Proprietor:
Sole proprietors face unlimited personal liability for business debts and liabilities.
Example: Redfern of Redfern Catering could be personally liable for debts exceeding business assets (e.g., $50,000 in liabilities with only $5,000 in business assets).
Case 27.1: Lewis v. Moore
Facts: Moore sold a property to Lewis with future percentages of profits linked to her sole proprietorship, Moore Media.
The court ruled that Lewis had no ownership interest since Moore Media did not have a separate legal existence as a sole proprietorship.
Words of the Court: A sole proprietorship is solely the owner conducting business for profit with no separate legal identity.
Capitalization of Sole Proprietorships
Limited options for raising capital:
Use of personal resources
Debt financing from personal loans or commercial loans
Table 27.2: Capital options for sole proprietors discussed.
Taxation
Sole proprietorships avoid corporate taxation; income/loss reported directly on the owner's tax return and taxed at the individual rate.
Example: $1,000 income taxed at the sole proprietor’s individual rate of 12%.
Management and Organization
No restrictions on the number of employees or locations.
Sole discretion for business operations and decisions lies with the proprietor.
Sole proprietorships can later transition to other entity types if desired.
Termination of Sole Proprietorships
Can be terminated either voluntarily or by operation of law (e.g., death or personal bankruptcy).
Case 27.2: Biller v. Snug Harbor Jazz Bistro of Louisiana
The court ruled the sole proprietorship terminated upon Brumat’s death, and the LLC formed later was a distinct entity; thus, it held no successor liability.
Franchising as a Business Method
Franchises are arrangements for distribution utilizing a contractual relationship rather than a standalone business entity.
Federal Trade Commission (FTC) regulations ensure full disclosure of information to potential franchisees, supplemented by state regulations.
Additional Considerations
Umbrella insurance can cover gaps in liability coverage for sole proprietors, particularly useful against potential excess claims due to inadequate primary coverage.