Chapter 27 Choice of Business Entity and Sole Proprietorships

Chapter 27: Choice of Business Entity and Sole Proprietorships

Principals: Individuals entitled to the profits of a business based on their percentage of ownership.

Formation:
- How easy is the entity to form and maintain?
- Must there be more than one principal?
- What annual filings or fees are required?
Liability:
- To what extent are the principals personally liable for debts and other contract or tort liabilities of the business entity itself?
Capitalization:
- How will the business entity fund its operations?
- May the principal(s) sell ownership rights in the business to raise capital?
Taxation of income:
- How will tax authorities treat the entity?
- Will the entity itself pay taxes, or are the taxes passed through to the principals?
Management and operation:
- How, and by whom, will the business venture be operated?
- Will the principals be involved in the day-to-day operations of the business?
- What duties do the principals owe to the business and to each other?
- How will profits and losses be split?
- If a principal decides to leave the business entity, may the remaining principals continue to operate?

The appropriate choice of business entity varies widely depending on the type of business and nature of liabilities associated with its activities.
Those engaged in self-funded business activities with low liability do not require protection or flexibility offered by more complex forms of entity.
The initial choice of entity is not permanent; it can be changed by principal(s) as the business evolves or necessity demands.

Sole proprietorship: One-person entity where debts and liabilities of the business are also personal debts and liabilities of the principal.
Partnerships:
- General: Two or more principals agreeing to share profits and losses; personal liability for debts.
- Limited: Limited partners have limited liability; general partners bear full personal liability.
Limited liability partnership (LLP): Offers heightened liability protection for debts and liabilities.
Limited liability company (LLC): Ongoing business with favorable tax treatment and limited liability.
Corporation: One or more principals invest money for stock ownership; principals generally have no personal liability for debts.

Sole proprietorship: A one-person entity where debts and liabilities are also personal debts and liabilities of the principal.
Easiest single-person ownership entity to form and maintain.
Requires only a minimal fee with straightforward filing requirements.
Typically requires no annual filings.
- If conducting under a trade name, the proprietor must file a doing business as (DBA) certificate.
- A DBA name may also be known as a fictitious name.

Ease of formation and maintenance: Primary advantages include low start-up costs and minimal filing requirements, making it accessible for individuals.

Liability: The main drawback is the complete lack of protection for personal assets against unpaid debts and liabilities of the business.

Held: The Tennessee Court of Appeals affirmed the trial court’s decision in favor of Moore, ruling that Moore, as a sole proprietor, was free to dissolve her entity at any time. The court stated that Moore had 100 percent ownership of her business.

Private loan: Negotiated directly with family or friends, paid back over a specific term with interest.
Commercial loan: From a commercial lender, interest tied to market rates and secured with collateral.
Commercial line of credit: Allows withdrawals against a predetermined limit instead of the full loan at once.
Unsecured credit: High-interest credit accounts (e.g., credit cards) that do not require collateral.

Sole proprietorships are not subject to corporate income taxation; they do not file a tax return for the business.
The principal reports business income on their individual tax return, paying taxes at their individual rate with possible deductions for losses.

Figure 27.2: How Sole Proprietorship is Taxed: A principal reports $1,000 in business income at an individual tax rate of 12%, thus paying/deducting taxes as part of their individual tax bill.

Not restricted in terms of employees and can operate in multiple locations.
Proprietor has full discretion and authority for all business decisions.
Sole proprietorships do not have oversight committees (e.g., boards of directors) or need for agreements among principals.
Can be converted to another form of entity by the proprietor at will.

Termination occurs either by:
- An express act of the principal.
- Operation of law (e.g., death or bankruptcy of principal).
Although the proprietor can sell business assets, the ownership interest cannot be transferred to heirs via gift or estate.

Held: Court affirmed that Snug Harbor, LLC continued operating despite the former owner's death; however, the former sole proprietorship ceased upon the owner's death, necessitating the formation of a new entity (LLC).

Formation: Low start-up costs, minimal filing; one-person entity.
Liability: All debts and liabilities are personal liabilities of the proprietor, putting all personal assets at risk.
Capital: Proprietors rely on personal assets or loans for capital.
Taxes: Business income is taxed as part of the proprietor's individual income tax return.
Management: One-person entity.

A franchise is a method of conducting business through a contractual relationship rather than as a separate entity.
Federal Statutes' Definition: A commercial relationship granting the right to operate a business using a franchisor’s trade name or to sell their branded goods.
The franchisor, a proven entity, assists franchisees with financial support, supplies, and training to ensure success.

Federal Trade Commission (FTC) regulates franchisors, ensuring full disclosure of information before franchisee investment.
State Regulation: Many states enforce individual franchise rules and disclosure requirements, often requiring registration with state regulatory agencies for oversight.