Question

Businesses are created in one of several organizational structures, or forms. Before launching any new business, an essential step is to decide which business structure (sometimes called business form) is most favorable for the business and its owners. Jo, Maddy, and Taylor recognize the significance and implications for choosing an appropriate business structure for PI.

A priority goal for all the owners is to minimize legal risks and liabilities, as well as tax liabilities, for the owners and the business.   They understand that a business organizational structure can achieve this goal, and can define their managerial roles and responsibilities clearly to satisfy their interests and maximize their areas of expertise.

The owners agree that weighing and balancing advantages and disadvantages for the company and its owners is the heart of the process of choosing a business structure for PI. The owners have met privately to discuss business structures. They are now ready to meet with BCA for further analysis, negotiation, and a decision regarding the PI business structure.

To assist in this process, Pat and Gale asked you to assess several business structures and their characteristics, advantages and disadvantages for PI and the owners. Those structures are:

Partnerships (all types)

S Corporation

General Corporation

Limited Liability Company

Evaluate and synthesize this information, and do the following. Label all parts.

A. Create a comparison chart  that shows the four business structures and compares and contrasts each type of structure. You may use the chart format in the hyperlink above, or create a similar chart, or create an excel chart.

B.  Write a memo to PI owners:

recommending a business structure for PI that best minimizes tax and personal liability for the new business and its owners

explaining and justifying your recommendation, specifically and in detail.

Memorandum format:

Memorandum

TO:                  Pat Braden, Gale Roth

FROM:            (your name)   

RE:                 Painted Images - Recommended Business Structure

DATE:               

Double space; 12-point Arial or Times Roman font

Answer 1

Advantages of a partnership include that:

two heads (or more) are better than one
your business is easy to establish and start-up costs are low
more capital is available for the business
you’ll have greater borrowing capacity
high-calibre employees can be made partners
there is opportunity for income splitting, an advantage of particular importance due to resultant tax savings
partners’ business affairs are private
there is limited external regulation
it’s easy to change your legal structure later if circumstances change.

Disadvantages of a partnership include that:

the liability of the partners for the debts of the business is unlimited
each partner is ‘jointly and severally’ liable for the partnership’s debts; that is, each partner is liable for their share of the partnership debts as well as being liable for all the debts
there is a risk of disagreements and friction among partners and management
each partner is an agent of the partnership and is liable for actions by other partners
if partners join or leave, you will probably have to value all the partnership assets and this can be costly.

Characteristics

Number of Persons. There are at least two partners if the business is of ordinary nature than minimum partner are 2 and maximum is 20. While in case of banking organization minimum are 2 and maximum number of partners is 10.

Management and Control. In partnership business organization all the partners can take part in managing the business. However, they may elect any one of them as their representative in partnership agreement.

Unlimited Liability of Partners. Partners Liability is unlimited, if facing insolvency the assets are not sufficient to fulfill the liabilities then creditors have the right reserved to sue the partners. Liabilities if any, must be considered as the liabilities of the partners according to legal status of business. It means in case of insolvency of the business, their personal properties can be sold for the recovery of all its debts.

Taxation. It enjoys the tax advantages over other forms of business organizations. For the purpose of income tax owners and business are treated as same thing. Income from its operations is treated as the personal income of the partners. There all are personally liable to pay the tax to the government, if income becomes taxable.   

Flexibility. It is less flexible as compare to sole proprietorship due to more owners, more resources and difference of opinion among the partners.Characteristics of S Corporation

Distributions

Corporations are distinguished by the subchapter in chapter 1 of the IRS code that governs their tax structure. The so-called S corps do not pay corporate taxes, but rather they transfer income, losses, deductions and credits to their shareholders in transactions called distributions. Distributions are reported by the corporation on K-1 forms and are reported on the stockholders’ personal income tax returns. S corps file annual federal tax returns reporting income and distributions; they must also file annual reports and tax returns as required in the state or states where they are chartered and in which they operate.

Structure

S corps may not have more than 100 stockholders -- a married couple counts as one stockholder -- nor may they have partnerships, C corporations or nonresident aliens as stockholders. Individuals, trusts and estates may hold stock in S corps. Certain financial institutions, insurance companies and import-export companies are ineligible to become S corps. A potential S corp must be chartered as a corporation, LLC or partnership within one of the 50 United States. When a corporation elects to function as an S corp, each shareholder must agree to the election, sign the application to the IRS, and agree on a fiscal year for the corporation.

Operation

S corps conduct business in the same ways as other corporations; they must pay salaries and withhold unemployment, individual income and Social Security insurance taxes for employees. Although wages are subject to withholding, distributions to shareholders are not. Ordinary business expenses, employee benefits and officer and owners’ retirement funds count as for any other corporation, but dividends earned from stock held by the corporation may not be deducted by the corporation -- it must be passed along to shareholders -- and charitable deductions are not limited for an S corp. Any losses may be carried forward and applied piecemeal over a 20-year period.

Considerations

Although the tax benefits and pass-through features make S corps attractive, some states do not fully recognize them and tax them as they do C corporations. Many states levy annual report filing fees or franchise fees that, for a very small company, might mitigate the apparent advantages of an S corp. The only way to tell if the S corp is right for your business is to consult with a professional CPA who can tell you about your state’s corporate regulations and which type of organization will best fit your company.

S corporation advantages

The advantages of an S corporation often outweigh any perceived disadvantages. The S corporation structure can be especially beneficial when it comes time to transfer ownership or discontinue the business. These advantages are typically unavailable to sole proprietorships and general partnerships. S corporation advantages include:

Protected assets. An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities of the corporation. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.
Pass-through taxation. An S corporation does not pay federal taxes at the corporate level. (Most—but not all—states follow the federal rules. View the Ongoing Corporation Requirements page of our state guides to see if your state recognizes the federal S corporation election.) Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns. This can be extremely helpful in the startup phase of a new business. (A corporation that does not elect S corporation status and accumulates passive income is at risk of being classified as a personal holding company.)
Tax-favorable characterization of income. S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.
Straightforward transfer of ownership. Interests in an S corporation can be freely transferred without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity.) The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
Cash method of accounting. Corporations must use the accrual method of accounting unless they are considered to be small corporations. (A small corporation has gross receipts of $5,000,000 or less.) S corporations, however, usually don't have to use the accrual method unless they have inventory.
Heightened credibility. Operating as an S corporation may help a new business establish credibility with potential customers, employees, vendors and partners because they see the owners have made a formal commitment to their business.

S corporation disadvantages

An S corporation may have some potential disadvantages, including:

Formation and ongoing expenses. To operate as an S corporation, it is necessary to first incorporate the business by filing Articles of Incorporation with your desired state of incorporation, obtain a registered agent for your company, and pay the appropriate fees. Many states also impose ongoing fees, such as annual report and/or franchise tax fees. Although these fees usually are not expensive, and can be deducted as a cost of doing business, they are expenses that a sole proprietor or general partnership will not incur.
Tax qualification obligations. Mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status. Although this is relatively rare, and usually can be remedied easily, it is still an issue that is not a factor with other business forms.
Calendar year. An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.
Stock ownership restrictions. An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights. Also, there cannot be more than 100 shareholders. Foreign ownership is prohibited, as is ownership by certain types of trusts and other entities.
Closer IRS scrutiny. Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.
Less flexibility in allocating income and loss. Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement. Also, the necessary accumulated adjustment account can be cumbersome to maintain, requiring input from an accounting professional. (Note: C corporation shareholders ordinarily can't deduct any losses at all, unless their stock becomes worthless or is sold at a loss.)
Taxable fringe benefits. Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation.Characteristics of General Corporation
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Five Main Characteristics of a Corporation in Accounting

by Daphne Adams
[The corporate operating structure is highly favored by outside investors.]

There are many forms of business associations, corporations being one of them. A corporation is a legal entity which has its own rights and obligations. This means that corporations have their own legal personality that makes them separate from their owners. With regards to accounting, five unique features distinguish corporations from other forms of business associations.

Limited Liability

Stockholders, who are owners of the corporation, are not liable for its debts or acts. The premise of separate legal entity means that the no one represents or acts on behalf of the company as it represents itself. In instances where a corporation is being wound up, the shareholders are only liable up to the unpaid amounts of their shares.

Perpetual Life

In accordance to the going concern principle of accounting, corporations have an endless life. A corporation exists indefinitely, up to the foreseeable future. There is no connection between the life of a corporation and that of its members. There is a continuous succession of stakeholders (employees, shareholders, managers and debtors).

Transferability of Ownership

Shares of corporations, whether private or public, are transferable from one person to the other. By transferring shares, the ownership of the corporation also changes hands. Transfer of ownership is accomplished simply by selling and buying of shares at the prevailing market prices. Transfer transactions do not interfere with the corporation’s operations. The share certificate represents a legal title to ownership.

Capacity to Contract

Corporations have full legal capacity to enter into contractual agreements on their own behalf. Having full contractual capacity means that legal proceedings instituted against the firm are upon the corporation and not the management or the employees. Legal proceedings brought forward by the corporation are also in the corporation’s name.

Centralized Management

Regardless of the type of corporation, whether sole, aggregate, statutory or chattered, there is a centralized management system. Shareholders do not manage the day-to-day operations of the corporation, instead appointed mangers act as stewards over the corporation's business. Unlike other business associations where owners manage the affairs, it is impossible for shareholders to do so due to their lack of skill and geographic dispersion.
A corporation is a legal entity, organized under state laws, whose investors purchase shares of stock as evidence of ownership in it. The advantages of the corporation structure are as follows:

Limited liability. The shareholders of a corporation are only liable up to the amount of their investments. The corporate entity shields them from any further liability.
Source of capital. A publicly-held corporation in particular can raise substantial amounts by selling shares or issuing bonds.
Ownership transfers. It is not especially difficult for a shareholder to sell shares in a corporation, though this is more difficult when the entity is privately-held.
Perpetual life. There is no limit to the life of a corporation, since ownership of it can pass through many generations of investors.

The disadvantages of a corporation are as follows:

Double taxation. Depending on the type of corporation, it may pay taxes on its income, after which shareholders pay taxes on any dividends received, so income can be taxed twice.
Excessive tax filings. Depending on the kind of corporation, the various types of income and other taxes that must be paid can require a substantial amount of paperwork.
Independent management. If there are many investors having no clear majority interest, the management team of a corporation can operate the business without any real oversight from the owners.

Benefits of an LLP
There are numerous benefits to be had from trading through an LLP -

Limited liability protects the member’s personal assets from the liabilities of the business. LLP’s are a separate legal entity to the members.
Flexibility. The operation of the partnership and distribution of profits is determined by written agreement between the members. This may allow for greater flexibility in the management of the business.
The LLP is deemed to be a legal person. It can buy, rent, lease, own property, employ staff, enter into contracts, and be held accountable if necessary.
Corporate ownership. LLP’s can appoint two companies as members of the LLP. In an LTD company at least one director must be a real person.
Designate and non-designate members. You can operate the LLP with different levels of membership.
Protecting the partnership name. By registering the LLP at Companies House you prevent another partnership or company form registering the same name.

This is not an exhaustive list but covers some of the key benefits on an LLP.
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Disadvantages of an LLP
As with all formats of business there will be disadvantages as well as advantages. the following may be considered disadvantageous in some cases.

Public disclosure is the main disadvantage of an LLP. Financial accounts have to be submitted to Companies House for the public record. The accounts may declare income of the members which they may not wish to be made public.
Income is personal income and is taxed accordingly. There may be tax advantages in registering as a company, but this will depend on your personal circumstances.
Profit can not be retained in the same way as a company limited by shares. This means all earned profit is effectively distributed with no flexibility to hold over profit to a future tax year.
An LLP must have at least two members. If one member chooses to leave the partnership the LLP may have to be dissolved.
Residential addresses were historically recorded at Companies House. Whilst the use of ‘service addresses’ now allows for home addresses to be kept out of public view, any address previously supplied to Companies House is still part of the public record unless you pay for the records to be suppressed. For many businesses this is not a problem. However, there are some examples where this may not be desired. Consider solicitors and partners of law firms that may not want their home address so freely available if their work involves sensitive cases.

Characteristics of an LLP:

1. LLP is governed by the Limited Liability Partnership Act 2008, which has come into force with effect from April 1, 2009. The Indian Partnership Act, 1932 is not applicable to LLP.

2. LLP is a body incorporate and a legal entity separate from its partners having perpetual succession, can own assets in its name, sue and be sued.

3. The partners have the right to manage the business directly, unlike corporate shareholders.

4. One partner is not responsible or liable for another partner’s, misconduct or negligence.

5. Minimum of 2 partners and no maximum limit.

6. Should be ‘for profit’ business.

7. The rights and duties of partners in an LLP, will be governed by the agreement between partners and the partners have the flexibility to devise the agreement as per their choice. The duties and obligations of Designated Partners shall be as provided in the law. 8. Limited liability of the partners to the extent of their contributions in the LLP. No exposure of personal assets of the partner, except in cases of fraud.

9. LLP shall maintain annual accounts. However, audit of the accounts is required only if the contribution exceeds Rs. 25 lakh or annual turnover exceeds Rs. 40 lakh. A statement of accounts and solvency shall be filed by every LLP with the Registrar of Companies (ROC) every year.