8.1: Types of Business Ownership

Chapter 8 Learning Objectives

• To gain an understanding of different forms of ownership.
• Sole Proprietorship
• Partnerships
• Corporations
• To understand the advantages of each form of ownership.
• To understand the disadvantages of each type of ownership.
• Able to understand job functions and job descriptions
• Understand how to assemble and train a restaurant staff.

“By putting the employee first, the customer effectively comes first by default, and in the end, the shareholder comes first by default as well.”
Richard Branson

Sole Proprietorship

In a sole proprietorship, one person owns and operates for their benefit. The owner may operate the business alone or with other people. All assets of the business belong to a sole proprietor, including, for example, computer infrastructure, any inventory, equipment and/or retail fixtures, as well as any real estate owned by the business. Subsequently, a sole proprietor has unlimited liability for all obligations incurred by the business, whether from operating costs or judgments against the business.

Partnership

General partnership

A general partnership is a partnership in which partners share equally in both responsibility and liability. In the commercial and legal sense, a general partnership (the basic form of partnership), refers to an association of persons or an unincorporated company with the following major features:

• Created by a legal agreement with proof of existence.
• Formed by two or more persons
• The owners are all personally liable for any legal actions and debts the company may face.

Partnerships have certain default characteristics relating to both (a) the relationship between the individual partners and (b) the relationship between the partnership and the outside world. The former can generally override the agreement between the partners, whereas the latter generally may not. The assets of the business are owned on behalf of the other partners, and they are each personally liable, collectively and individually, for business debts, taxes, or legal liability. For example, if a partnership defaults on a payment to a creditor, the partners' personal assets are subject to attachment and liquidation to pay the creditor.

By default, profits disperse equally among the partners. However, a partnership agreement will almost invariably provide for the manner in which partners share profits and losses. Each general partner is the agent of the partnership. Therefore, if that partner is apparently carrying on partnership business, all general partners are usually liable for his dealings with third persons.

By default, a partnership will terminate upon the death, disability, or even withdrawal of any one partner. However, most partnership agreements provide for these types of events, with the share of the departed partner usually purchased by the remaining partners in the partnership.

Each general partner has an equal right to participate in the management and control of the business. A majority of the partners, and disagreements of extraordinary matters decide disagreements, in the ordinary course of partnership business, and amendments to the partnership agreement require the consent of all partners. However, in a partnership of any size the partnership agreement will provide for elected individuals to manage the partnership along the lines of a company board.

Unless otherwise provided in the partnership agreement, no one can become a member of the partnership without the consent of all partners, though a partner may assign his share of the profits and losses and right to receive distributions and transferable interest (Smiddy and Cunningham, 2010).

Limited Partnership

A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners (GPs), there are one, or more, limited partners (LPs). It is a partnership where only one partner is required to be a ‘general partner’.

The GPs are, in all major respects, in the same legal position as partners in a conventional firm, i.e. they have management control, share the right to use partnership property, share the profits of the firm in predefined proportions, and have joint and individual liability for the debts of the partnership.

As in a general partnership, the GPs have actual authority, as agents of the firm, to bind all the other partners in contracts with third parties that are in the ordinary course of the partnership's business. As with a general partnership, an act of a general partner, which is not apparently for carrying on the ordinary course of business, requires consent of all partners. The limited partnership's activities binds the limited partnership only if the act has the authorization of all the other partners.

Like shareholders in a corporation, limited partners have limited liability. This means they have no management authority and are only liable on debts incurred by the firm to the extent of their registered investment. The GPs pay the LPs a return on their investment (similar to a dividend), the nature and extent of which is evident in the partnership agreement. General Partners thus carry more liability, and in cases of financial loss, the GPs will be the ones, which are liable.

LP members are subject to the same alter-ego 'piercing' theories as corporate shareholders. However, it is more difficult to pierce the LP veil because LPs do not have a great many formalities to maintain. So long as the LP and the members do not co-mingle funds, it would be difficult to pierce its veil.

When the partnership comes together, or the composition of the firm is changing, LPs are generally required to file documents with the relevant state registration office. LPs must also explicitly disclose their LP status when dealing with other parties, so that such parties are on notice that the individual negotiating with them carries limited liability. It is customary that the notepaper, other documentation, and electronic materials issued to the public by the firm will carry a clear statement identifying the legal nature of the firm and listing the partners separately as general and limited. Hence, unlike the GPs, the LPs do not have inherent agency authority to bind the firm unless they are subsequently held out as agents (and so create an agency by estoppel); or acts of ratification by the firm create ostensible or questionable authority (Smiddy and Cunningham, 2010).

Limited partnerships are distinct from limited liability partnerships, in which all partners have limited liability. In some jurisdictions, the limited liability of the LPs is contingent on their not participating in management.

Corporation

A corporation is a separate legal entity that incorporate either directly through legislation or through a registration process established by law. Incorporated entities have legal rights and liabilities that are distinct from their employees, shareholders and members, and may conduct business as either a profit -seeking business or not-for-profit. Most jurisdictions now allow the creation of new corporations through registration. Registered corporations have legal personality and shareholder ownership whose liability is limited to their investment. Shareholders do not typically actively manage a corporation; shareholders instead elect or appoint a board of directors to control the corporation in a fiduciary capacity (Courtney, 2002).

In the United States, corporations form under laws of a state or the District of Columbia. Procedures vary widely by state. Some states allow formation of corporations through electronic filing on the state's web site or very quickly. All states require payment of a fee (often under 200 dollars) upon incorporation. Corporations receive a "certificate of incorporation" by most states upon formation. Most state corporate laws require the basic governing instrument to be either: the ‘certificate of incorporation’, or formal ‘articles of incorporation’. Many corporations also adopt additional governing rules known as bylaws. Most state laws require at least one director and at least two officers, all of whom may be the same person. Generally, there are no residency requirements for officers or directors (Pettet, 2005). Two corporation forms that are applicable to the hospitality operation.

C’ Corporation

C corporation refers to any corporation that, under United States federal income tax law, is taxed separately from its owners. A class C corporation is distinguished from an S corporation, which generally does not pay a separate tax. Most major companies (and many smaller companies) are C corporations for U.S. federal income tax purposes.

‘S’ Corporation

S corporations are ordinary business corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379). S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.

Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. However, with modern incorporation statutes makes the establishment of a corporation relatively easy. Firms that traditionally run as partnerships, or sole proprietorships, often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form; this is particularly true of firms established prior to the advent of the modern limited liability company. Therefore, taxation of S corporations resembles that of partnerships (Pettet, 2005). S corporations are also useful to guard the rights of intellectual property and are often used within an LLC corporation.

Like partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions occur. Thus, income is taxable at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation have tax-free distribution to the extent that the distributed earnings undergo previous taxation. In addition, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation. Unlike a C corporation, an S corporation is not eligible for a dividends received deduction and is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions (Pettet, 2005).

In order to make an election for status as an S corporation, the corporation:

• Must be a liability entity (a domestic corporation which has elected to be taxed as a corporation).
• Must have only one class of stock.
• Must not have more than 100 shareholders.
• Must have shareholders that are U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and tax-exempt corporations, notably 501(c) (3) corporations, can be shareholders.
• Must have profits and losses allocated to shareholders in proportion to each one's interest in the business.

General Corporate Benefits

Protection of personal assets

One of the most important legal benefits is the safeguarding of personal assets against the claims of creditors and lawsuits. Sole proprietors and general partners in a partnership are personally and jointly responsible for all the liabilities of a business such as loans, accounts payable and legal judgments. In a corporation, however, stockholders, directors, and officers typically are not liable for the company's debts and obligations. They are limited in liability to the amount they have invested in the corporation. For example, if a shareholder purchased $100 in stock, no more than $100 can be lost. Corporations and limited liability corporations (LLCs) may hold assets such as real estate, cars or boats. If a shareholder of a corporation is personally involved in a lawsuit or bankruptcy, these assets should be under corporate protection. A creditor of a shareholder of a corporation or LLC cannot seize the assets of the company. However, the creditor can seize ownership shares in the corporation, as they are under personal asset consideration (Pettet, 2005).

Transferable ownership

Ownership in a corporation or LLC is easily transferable to others, either in whole, or in part. Some state laws are particularly corporate-friendly. For example, the transfer of ownership in a corporation incorporated in Delaware is not required to be filed or recorded (Courtney, 2002).

Retirement funds and taxation

Retirement funds and qualified retirements plans, such as a 401(k), are achievable more easily. In the United States, corporations are taxable at a lower rate than individuals are. In addition, they can own shares in other corporations and receive corporate dividends 80% tax-free. There are no limits on losses a corporation may carry forward to subsequent tax years. A sole proprietorship, on the other hand, cannot claim a capital loss greater than $3,000 unless the owner has offsetting capital gains (Courtney, 2002).

Raising funds through sale of stock

A corporation can easily raise capital from investors through the sale of stock.

Durability

A corporation is capable of continuing indefinitely. The death of shareholders, directors, or officers of the corporation does not affect its existence.

Credit rating

Regardless of an owners' personal credit scores, a corporation can acquire its own credit rating, and build a separate credit history by applying for and using corporate credit.

Limited Liability Company

Limited Liability Company (LLC). A limited liability company (LLC) is a flexible form of enterprise that blends elements of partnership and corporate structures. An LLC is not a corporation; it is a legal form of ‘company’ that provides limited liability to its owners in the vast majority of United States jurisdictions. LLCs do not need to organize for profit. In certain states, businesses providing professional services that require a state professional license, such as legal or medical services, may not form an LLC but required to form a very similar entity called a Professional Limited Liability Company (PLLC).

A limited liability company (LLC) is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC, although a business entity, is a type of unincorporated association and is not a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is often more flexible than a corporation, and it is well suited for companies with a single owner (Courtney, 2002).

LLC members are subject to the same alter ego piercing theories as corporate shareholders. However, it is more difficult to pierce the LLC veil because LLCs do not have many formalities to maintain. So long as the LLC and the members do not commingle funds, it would be difficult to pierce this veil. Limited Liability Company members may in certain circumstances, also incur a personal liability in cases where distributions to members render the LLC insolvent. The following are some of the advantages and disadvantages of a limited liability company (Courtney, 2002):

LLC Advantages

• An LLC can elect to be taxed as a sole-proprietor, partnership, S corporation, or C corporation (as long as they would otherwise qualify for such tax treatment), providing for a great deal of flexibility.
• A limited liability company with multiple members that elects taxation as a partnership may specially allocate the members' distributive share of income, gain, loss, deduction, or credit via the company operating agreement on a basis other than the ownership percentage of each member so long as they meet certain Treasury regulations. S corporations may not specially allocate profits, losses and other tax items under U.S. tax law.
• Limited liability, meaning that the owners of the LLC, called "members", are not subject to some or all liability for acts and debts of the LLC depending on state shield laws.
• Much less administrative paperwork and record keeping than a corporation.
• Pass-through taxation (i.e., no double-taxation), unless the LLC elects to be taxed as a C corporation.
• Using default tax classification, profits undergo personal taxation at the member level, not at the LLC level.
• LLCs in most states are entities separate from their members.
• LLCs in some states can be set up with just one natural person involved.

LLC Disadvantages

Although there is no statutory requirement for an 'operating agreement' in most jurisdictions, members of a multiple member LLC who operate without one may run into problems. Unlike state laws regarding stock corporations, which provide for a variety of governance and protective provisions for the corporation and its shareholders, most states do not dictate detailed governance and protective provisions for the members of a limited liability company. Thus, in the absence of such statutory provisions, the members of an LLC must establish governance and protective provisions pursuant to an operating agreement or similar governing document.

• It may be more difficult to raise financial capital for an LLC as investors may be more comfortable investing funds in the better-understood corporate form with a view toward an eventual IPO (becoming a public company). One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation.
• Many jurisdictions levy a franchise tax or capital values tax on LLCs. The franchise tax can be an amount based on revenue, an amount based on profits, or an amount based on the number of owners or the amount of capital employed in the state, or some combination of those factors, or simply a flat fee.
• Some jurisdictions consider LLCs to be taxable entities, thus eliminating the benefit of flow-through taxes by subjecting members to double taxation. Typically, LLCs will choose taxation as a partnership to avoid double taxation, which occurs in corporations. This allows companies to distribute their income among members who then report it on their personal tax returns.
• While start up expense is relatively similar to a corporation, renewal fees such as annual reports may be higher in certain jurisdictions.
• The management structure of an LLC may be unfamiliar to many. Unlike corporations, they are not required to have a board of directors or officers. (This may be an advantage to some.)
• Taxing jurisdictions outside the US are likely to treat a United States LLC as a corporation, regardless of its treatment for US tax purposes, for example, a US LLC
• doing business outside the US, or a resident of a foreign jurisdiction is a member of a United States LLC.
• The principals of LLCs use many different titles such as member, manager, managing member, managing director, chief executive officer, president, and partner. As such, it can be difficult to determine who actually has the authority to enter into a contract on the LLC's behalf (Courtney, 2002).