Question

Q1. Describe the legal forms of business organization.

Q2. Discuss business taxes and their importance in financial decisions.

Q3. What are the two primary activities of the financial manager that are related to the firm’s balance sheet?

Answer 1

2) Business Tax

A tax on business income is called business tax as defined by United States Internal Revenue Service. A person does'nt have to show a profit every year to qualify as a business owner. As long as his/her primary purpose is to make money, he/she should qualify as a business (even if he/she shows a loss when first starting out, and even afterward, depending on the circumstances). Business can be conducted from home, full-time or part-time, as long as it is being worked upon regularly and continuously. A person can have more than one business at the same time. However, if an individual's primary purpose is something other than making a profit—for example, to incur deductible expenses or just to have fun—the IRS may find that activity as a hobby rather than a business. If the individual's venture earns a profit in three out of five consecutive years, the IRS presumes that he/she has a profit motive. The IRS and courts look at the tax returns for each year the person claims to be in business to see whether he/she turned a profit.

As per the new tax laws starting 2018, . all C corporations are subject to a single flat tax rate of 21%. However, the vast majority of smaller businesses aren’t organized as C corporations. Instead, they are “pass-through entities.” This includes sole proprietorships, limited liability companies, partnerships, and S corporations. Their rates can now be higher than the 21% rate for C corporations-under the new tax law.

As per the IRS, the taxes depend upon the businesses being operated. There are also different types of taxes depending on various business activities, like selling taxable products or services, using equipment, owning business property, being self-employed versus having employees. These are the basic following types of business taxes :-

1. Income taxes. All businesses must pay tax on their income; that is, the business must pay tax on the profit of the company (the income of the business less deductible expenses). How that tax is paid depends on the form of the business.
   According to the IRS, all businesses except partnerships must file an annual income tax return. Partnerships file an information return. The form used depends on how the business is organized. The federal income tax is a pay-as-you-go tax. The individual must pay the tax as he/she earns or receives income during the year. An employee usually has income tax withheld from his or her pay. If the business owner do not pay his/her tax through withholding, or do not pay enough tax that way, he might have to pay an estimated tax. If the person doesnt pay estimated tax , he may pay any tax due. Some states require businesses to pay income tax depending on the legal structure of the business.
2. Estimated taxes. Generally, an individual has to make quarterly estimated tax payments to cover income tax on income not subject to withholding and self-employment tax. If his/her estimated payments fall short of the annual tax liability, the person may have to pay a penalty.

3. Self-Employment Tax - The IRS imposes self-employment taxes to contribute to social security and Medicare of a person who works for himself. Some taxpayers find this to be a benefit because the coverage provides them with benefits for retirement, disability and hospital insurance, and also pays benefits to a survivor in the case of death of the payee. Self-employment tax is 15.3 %. 12.4 % of that tax goes to Social Security. The IRS defines a self-employed person as "one who carries on a trade or business as a sole proprietor or independent contractor, a member of a partnership that carries on a trade or business, or a person who is otherwise in business for themselves."

4. Employment Taxes - An employer must pay employment taxes to cover Social Security and Medicare taxes, federal income tax withholding, and federal unemployment tax (FUTA) for its employees. The employer pays half of the expense of the Social Security and Medicare tax out ofhis/ her own pocket and deducts the other half from the employees' paycheck. The employer covers all the cost of the FUTA. States also require that businesses with employees pay state employment taxes to cover workers' compensation insurance and unemployment insurance.

5. Excise Tax - The federal government levies excise tax for certain types of businesses, depending on what they sell or manufacture, the kind of business they operate, the kinds of equipment and products they use, and whether they receive payment for certain services. These include environmental taxes, communications and air transportation taxes, fuel taxes, and taxes on the first retail sale of heavy trucks, trailer and tractors.

Some other taxes a business might have to pay are :-

• Sales Tax on Products and Services Sold in Certain States - Businesses don't directly pay sales tax on products and services they sell. But if the business operates in a state that has state income tax, one must set up a system to collect, report, and pay state sales tax. Merchants in most states are required to collect sales tax and pay it to the state department of revenue. Specific products and services are sales-tax eligible, depending on state laws. Money must be collected from customers, reported, and paid on a regular basis. sellers. Online sellers also now have to pay certain sales taxes.

• Property Tax on Business Property - If the business owns real property (real estate), like a building, then the business must pay property tax to the local taxing authority, which is usually the city or county where the property is located. The tax is based on assessed value, same as for personal property like a house.

• Gross Receipts Tax on Businesses in Some States - Some states, like Nevada and Texas, impose a gross receipts tax on businesses instead of a state income tax. Sole proprietorships are usually exempt from paying gross receipts taxes, but not from state income tax. Corporations and LLCs are most likely to pay gross receipts taxes.

• Franchise Taxes - Some states charge franchise taxes to corporations based on the value of the company. Sole proprietorships are not typically subjected to a franchise tax.

• Dividend Tax on Corporate Shareholders - If you are an owner of a corporation, you are a shareholder. That means you pay income taxes on income you receive from dividends.

Taxation tends to influence the decision of businesses at all levels, it affects their financing decision, investment decision and dividend decision.
High taxes can influence business decisions in several ways:

• They can reduce the number of business formations by discouraging those who might otherwise form new businesses.
• They can also slow down the rate at which small businesses are able to grow by making it difficult for them to finance a rapid expansion,
• they can weaken the desire and the ability of small businesses to survive as independent enterprises by making the gains from a merger look more attractive than the income to be derived from continued operation.
• A high marginal tax rate will be a disincentive for business while a lower one will be an incentive to work.
• Complex corporate taxation structure deters foreign investors, curbs entrepreneurship, drives out local investors and results in deadweight losses due to tax avoidance costs and tax compliance costs.  Friendly taxation, on the other hand, stimulates entrepreneurship, encourage local and foreign investors organization.
• Since businesses can deduct expenses of running a business for getting tax advantage, the company may make a purchase within a given year in order to get the tax benefit for that year. Businesses can also take depreciation on certain property, to get tax benefits. This can impact how and when new items are purchased.
• The biggest impact on taxes on business decisions, however, normally focuses on how the business is structured. There are several ways in which businesses can be structured, each of which have different tax impacts. A sole proprietor is taxed as an individual. For partnerships and limited liability companies (LLCs) the individual members of the organization can also claim business profits and losses on personal tax returns.
• More complex business structures, have different tax structures. S-corporations and C-corporations allow for different deductions and the business generally files taxes separately and then pays a salary.

3) Two primary activities of finance manager are making investments and financing decisions.

Investment decisions :- In the investments area, the Financial Manager is responsible for defining the optimal size of the company. For the finance manager,  it is important to have a market study in place and be clear on the objectives that the company needs to meet. It is important to have properly studied the demand, technology and equipment, financing methods and human resources available. The manager must also analyze whether the resources adapt to the optimal size desired for the company. If they don’t, it is necessary to define the types of assets that the company must acquire, or otherwise sell or get rid of, in order to achieve efficient resource management.

The manager needs to intelligently allocate capital to long term assets so as to get maximum yield in future. It is also known as capital budgeting. Following are the two aspects of investment decision :-

1. Evaluation of new investment in terms of profitability
2. Comparison of cut off rate against new investment and prevailing investment.

While considering a new investment proposal it is important to take into consideration both expected return and the risks involved.
Investment decision also involves decisions of using funds which are obtained by selling those assets which become less profitable and productive. It is wise to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR).

Financing Decisions:- It is important to make wise decisions regarding when, where and how should a business acquire funds. Funds can be acquired through many ways. Essentially, a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes which not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds and have significant tax benefits since the interest paid is tax deductible.
A sound financial structure is one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other ways to acquire funds. The Financial Manager can also design a mixed financing strategy for efficient financial management which is called the company’s “financing mix”. Sometimes the company can benefit from a combination of short and long term financing.

1) All businesses do have some legal configuration that defines the rights and liabilities of the participants in the business’s ownership, control,  lifespan and financial structure. The form of business determines which income tax return form to file and the company’s and owner’s legal liabilities.

Following are the different legal forms of business organisations:-

1. Sole proprietorship - Majority of small businesses/entrepreneurships start out as sole proprietorships. These businesses usually are owned by one individual who has day-to-day responsibility for running the business. Sole proprietors can be independent contractors, freelancers or home-based businesses.
   Advantages :-
   Easy to establish.
   Full control over all business decisions.
   Owner keeps all the profit
   Profits are taxed only once.
   The business is easy to dissolve, if desired.
   It is the easiest and least expensive form of ownership to organize
   Disadvantages :-
   There is unlimited liability if anything happens in the business. The owner's personal assets are at risk including the personal home, car etc.
   It is limited in raising funds and the owner might have to acquire consumer loans.
   There is no separate legal status.
   Limited skills & knowledge available to run and grow the business.

2. Partnerships :- In a partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal partnership deed/agreement that establishes how decisions will be made, how profits will be shared, how disputes will be resolved, how future partners will be admitted to the partnership, or what steps will be taken to dissolve the partnership when needed.
   Advantages :-
   It is easy to establish
   Separate legal status gives limited liability protection.
   Profits are taxed only once.
   Different partners come with different skill sets & knowledge which add value to the business.
   Multiple sources of capital
   Risks are spread among partners
   Minimum govt regulations
   Disadvantages :-
   Partners are jointly and individually liable for other partners’ actions.
   Profits must be shared with the partners.
   Decision making is divided giving rise to conflicts
   -Business can suffer if the detailed partnership agreement is not in place.

3. Corporations

   A corporation is considered by law to be a unique entity, separate from those who own it. A corporation can be taxed, sued and enter into contractual agreements. The corporation has a life of its own and does not dissolve when ownership changes.There are three types of corporations: C-corporation, S-corporation and Limited Liability Company.

A C-corporation is taxed separately from its owners. It gives the owners limited liability, which can encourage more risk-taking and potential investment.  In regards to transfer of ownership, shareholders can sell their shares. Capital is easier to raise through the sale of stock.
However, it is subject to double taxation. (Corporation and shareholder earnings are taxed. It can be costly to form. They pay corporate taxes at a different time than other forms of business.

An S-corporation, also known as subchapter S-corporation, offers the owners limited liability. S-corporations do not pay income taxes; the earnings and profits are treated as distributions. The shareholders must report their income on individual income tax returns. Stockholders are limited to individuals, estates or trustees. Stockholders are limited to citizens or residents of the United States.

A limited liability company or LLC is a hybrid business structure that provides the limited legal liability of a corporation and the operational flexibility of a partnership or sole proprietorship. However, the formation is more complex and formal than that of a general partnership. This entity type requires insurance in case of a suit. It is the most common business structure and is specifically created for small businesses. Can have an unlimited number of owners.