Prior to beginning work on this assignment, review Chapters 28, 29, and 30 of the textbook, as well as the articles on Changing Legal Structure

Sole Proprietorships and Partnerships 28

Beginning with this chapter, we will explore the most common forms of business organization in order to understand their fundamental makeup and examine the benefits and liabilities of structuring a business under each distinct form of business organization. One of the first deci-

sions that must be made by anyone seeking to establish a new business is what organizational form to choose. The most common types of business organizations are:

1. Sole proprietorships; 2. Partnerships; 3. Limited partnerships; 4. Corporations; and 5. Limited liability companies (LLCs).

As we will see, each type of business organization offers certain benefits as well as drawbacks that should be carefully weighed before deciding which form is best suited to the new venture. Table 28.1 provides a comparison of the different types of business entities. The requirements for starting a business under each of the available forms of business organization vary widely. For example, individuals who start a business under their own name alone or in traditional partnerships will have very few organizational formalities, whereas those who wish to organize a new business as a limited partnership, corporation, or limited liability company (LLC) will need to strictly follow the requirements of their state’s limited partnership, corporation, or LLC acts. Consult the office of the secretary of state in your location for registration requirements.

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Table 28.1: Business entity comparison

Sole Proprietorship General Partnership Limited Partnership

TYPE OF ENTITY SOLE PROPRIETORSHIP PARNERSHIP CORPORATION

DEFINED A business owned and run by one person.

An association of two or more people for a profit.

An entity that is created by permission of the state whose ownership is represented by shares of stock.

ADVANTAGES No meetings; run the business by yourself; no disagreements with others about how to run the business; liable only for own mistakes.

Have two or more people to help in running the business and share the liability. Have others to discuss the business plan with and share ideas for the business.

Limited liability of the owners and tax advantages.

DISADVANTAGES Taxed on income like regular income; have all of the liability; have no one else to contribute ideas.

Taxes. The profits of the partnership are taxed as personal income on each partner’s individual tax return, but the entity must file Form 1065 with the IRS.

Expensive and complicated to create; must follow state rules and comply with state and federal filing laws.

WHO OWNS The sole proprietor. The partners. The shareholders.

HOW FORMED Many states require a business certificate to be filed at the county clerk’s office; some also require an EIN (federal) number.

Many states require a business certificate to be filed at the county clerk’s office; as between the partners, the agreement can be informal and oral.

Preincorporators must file Articles of Incorporation with the secretary of state; state must issue charter. Other forms required. If public, must comply with federal and state law regarding the initial issuance of shares of stock.

WHO OPERATES The sole proprietor. The general partners, but they can turn over day- to-day management to a managing partner.

The corporate officers.

LIABILITY OF OWNERS

The sole proprietor’s assets, personal and business-related, are all subject to a lawsuit.

All the partner’s assets (personal and business) are subject to a lawsuit.

Liability is limited to one’s investment (i.e., in shares of stock).

HOW TAXED As personal income on Form 1040.

Income is reported on Form 1040 as personal income and paid at the personal rate, but the partnership also has to file Form 1065.

At the state’s corporate rate.

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28.1 Sole Proprietorships

The oldest and simplest form of business organization is the sole proprietorship. Under this form of business organization, the owner of a business personally oper- ates and is solely responsible for all aspects of the enterprise. A sole proprietor who

is hired by another to perform services may also be an independent contractor. An indepen- dent contractor usually performs one job and works at his or her own discretion. Thus, if ABC Corporation hired Fisher Painting, a sole proprietorship owned by Martha Fisher, Martha would be both a sole proprietor and an independent contractor. (For other employ- ment issues relating to sole proprietorships, see Chapter 21, Establishing the Employment Relationship, and Chapter 27, Principal–Agency Law.)

Formation of a Sole Proprietorship

The greatest benefit of the sole proprietorship form of business organization is that few formalities are required for its formation. To a certain extent, people wishing to go into business for themselves in a business that carries their own name can start the enterprise at any time without the need to seek state or local approval.

Creating a Tax Entity The first step in starting a sole proprietorship is to open a bank account so that the busi- ness can receive money and pay debts, either with checks or electronically. To open a business account, the bank will require a federal tax identification number (TIN). This nine-digit number could be the proprietor’s Social Security number or an employer iden- tification number (EIN) that the IRS assigns the business (in the format 12-3456789) and is used for filing tax returns. (All the information to obtain the federal tax number can be found at GovServices, http://www.taxid-gov.us.)

All sole proprietors do not need to set up an EIN. If a sole proprietorship does not have employees, it is not required to have an EIN. In fact, the IRS generally prefers that sole proprietors use their Social Security number. However, employers with one or more part- time or full-time employees, no matter how small their business, must have one. Also, if they plan to use an EIN to differentiate between personal and business finances, they should have an EIN before applying for business permits. In addition, if they pay subcon- tractors or others for services valued at more than $600 in a calendar year, they may need to get an EIN. Anyone who registers as a limited liability company, corporation, partner- ship, or joint venture must have an EIN.

Before a sole proprietor can collect any money from sales, the state tax division will require that the business register for permission to collect sales tax. This process may take months, so planning ahead is essential. Once the federal TIN and state tax collection permission have been acquired, there are no other formalities to go through before business can begin.

Licensing Some types of businesses require licenses to do business, such as bars (liquor license) or real estate firms. So a sole proprietorship must comply with all state and federal regula- tions applicable to business concerns. While there may be few formalities for actually forming the business, it is not as simple as simply setting up a lemonade stand.

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Doing Business As Persons who wish to do business under an assumed name must apply for a permit from the appropriate state office in their state (typically the secretary of state’s office) and pay a nominal fee for the privilege of doing business under a trade name. The primary purpose of this requirement is to prevent different persons from doing business under the same name in the same area, which might cause consumers confusion, and to have on record the names and addresses of the owners of these businesses so that they may be readily found and held accountable for any civil or criminal transgressions. Thus, Rick Carpenter generally needs no special permission to start a carpentry business under the name Rick Carpenter or Rick Carpenter’s Carpentry Service, but he would need to get what is com- monly termed a Doing Business As (DBA) certificate from the appropriate office in his state if he wanted to call his business Good Homes Carpentry, Expert Carpentry Works, or any other assumed name.

Benefits of Sole Proprietorships

As already discussed, there are few formalities to launch a sole proprietorship, and as a result, persons starting a business often choose this form to begin with. Other types of businesses, such as limited partnerships, corporations, and LLCs, require the drafting and filing of specific forms and approval from government officials before the business can get off the ground—a process that requires an investment of time and money to complete.

Autonomy If you ask a sole proprietor what the other greatest advantage is to this form of business, he or she will most likely reply that it is not having to share the management with anyone else. The sole proprietor does not have to ask for anyone’s permission, wait for votes or meetings, or seek others’ approval. Business decisions can occur quickly. Partnerships and corporations, on the other hand, require the members to reach a consensus and, in the case of corporations, sometimes onerous formalities before major business decisions (e.g., the sale of substantial portions of the assets of the business or the acquisition of business property) can be made. These processes can interfere with the smooth operation of some businesses and make instituting major changes slow and often tedious.

Freedom From Vicarious Liability of Co-Owners Just as important as the autonomy that the sole proprietorship permits the business owner is the freedom from liability for the negligent acts or bad business decisions of oth- ers. General partners in a partnership are deemed to be agents of the partnership and of one another under the common law of partnership (see Chapter 27 for a full treatment of principal–agency law). Thus, if there are partners A, B, and C, and only C is negligent, A and B will also be liable. In a corporation (discussed in Chapter 30), directors and officers of a corporation are deemed to be agents of the corporation they serve.

Under the law of agency, principals can be bound by the authorized acts of their agents and are liable for the negligent acts of their agents committed during the course of the agency. Thus, partners in a partnership can be held liable for contracts entered into on

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behalf of the partnership by any other partner as well as for the negligent acts of any part- ner that injures a third party. Likewise, a corporation can be held liable for the authorized acts of its officers and directors, as well as their negligence. Sole proprietors, however, need never worry about being responsible for the bad judgment, negligence, or bad faith of a co-owner, since they are the only owners; they are responsible only for their own acts and for the acts of their agents.

Cost Savings There are significant financial advantages for the sole proprietorship in terms of tax sav- ings and lower administrative costs. Unlike most corporations, the sole proprietorship does not pay federal, state, or local income taxes as a business entity; instead, all income earned by the business is taxed as simple income to the owner. This means that if the business makes $250,000, then that figure is reported on the sole proprietor’s tax return as income (on a Schedule C form). Because bookkeeping and legal formalities for the business are simplified, the administrative costs are usually lower than for other forms of business organization. For example, the sole proprietorship often has less need for legal and accounting services compared with other business organizations.

Drawbacks of Sole Proprietorships

While there are many benefits rooted in the simplicity of the sole proprietorship, a num- ber of tangible drawbacks stem from this form of business organization. Chief among these is the unlimited personal liability of the sole proprietor for all debts incurred by the business. The sole proprietorship is not recognized as a separate entity from its owner; as a consequence, the debts of the business are deemed to be the personal debts of the owner, and the sole proprietor has unlimited personal liability for all the debts, contractual obli- gations, and legal judgments the business incurs. If the business fails, its owner not only can lose the capital invested in the business but can also face the prospect of having his or her personal assets raided to satisfy business debts if the business assets are insufficient to cover business debts. Consequently, the business failure of a sole proprietorship often means personal bankruptcy.

Another downside of the sole proprietorship is that the owner must rely solely on his or her own assets and expertise in running the business, including dealing with profits and losses. While the business owner need not share profits or consult with others on business decisions, neither can the sole proprietor count on others to lend their expertise, share business losses, or shoulder part of the responsibilities for the business’s daily operation. Such assistance can be obtained in the form of hiring employees, but individuals who draw a salary are seldom as committed to the enterprise or as motivated to ensure its success as those whose fortunes are tied directly to the success or failure of the business. Further, the lack of co-owners of a business enterprise can be a particularly important drawback when the business owner needs to raise capital to expand or to cover extraor- dinary expenses.

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Property Status and Transferability of Sole Proprietorships

A sole proprietorship is considered personal property (see also Chapter 19). As such, it can be transferred in whole or in part at any time by its owner through sale or testamentary gift (through a will). If a business concern that is organized as a sole proprietorship is sold or otherwise transferred by its owner, its nature can change, depending on both the terms of its transfer and the wishes of the new owners. A sole proprietorship transferred to a single person who continues to run the business as a sole proprietor, for example, retains its previous status, whereas one transferred to two or more persons as joint own- ers becomes a partnership. A sole proprietorship can also be reorganized as a corporation if its new owner so desires. The type of business organization can also be changed by a present owner by reorganizing the business from a sole proprietorship to a partnership, corporation, or any other business organization recognized by the state.

Termination of the Sole Proprietorship

If there are few formalities for starting a sole proprietorship, there are none for ending one. The sole proprietorship can terminate as a business concern at any time at the will of its owner. Alternatively, it can end by operation of law—upon the death, incapacity, or bankruptcy of the owner. Consistent with this business form, when the business ends, its owner will remain personally liable for the completion of any outstanding contracts and for meeting any other outstanding business obligations. If the business ends owing to the death or incapacity of its owner, the owner’s estate or guardian will be responsible for paying creditors out of estate funds.

28.2 Partnerships

When two or more people wish to start a business together, the sole proprietor- ship is not a viable entity, and they must consider another form. One of the more popular (and less expensive) businesses to begin is a partnership. There are two

types of partnerships: general partnerships (discussed here) and limited partnerships (dis- cussed in Chapter 29).

Partnership law differs from state to state, but all states have adopted (in one form or another) the Uniform Partnership Act (UPA). Because there are 50 different states, you need to consult individual state law to ascertain the most current version. All states define partnership as “an association of two or more persons to carry on as co- owners a business for profit . . . .” (§ 101(6) Uniform Partnership Act (1997)). Any time that two or more individuals are engaged in a business as co-owners with the intent to make a profit, a partnership arises automatically (de jure, or by law), and the rights and responsibilities of each partner will be dictated by the law of partnership in the state where the partnership was formed.

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The contractual provisions contained in the agreement define the relationship as well as the rights and responsibilities the partners owe to one another. In the absence of a partner- ship agreement, or in cases in which the partnership agreement fails to define key rights and responsibilities, the state’s common law of partnership (and, where applicable, the state’s partnership act) will define these rights and obligations.

Formation of a Partnership

Like the sole proprietorship, the partnership form of business organization does not require specific formalities for its creation. Oral and written agreements to enter into a partnership are generally equally binding. A partnership can also arise by operation of law even absent a specific agreement: Any voluntary association by two or more persons to conduct a business for profit as joint owners automatically results in the creation of a partnership by operation of law, whether or not the joint owners specifically intended it. This holds true if two people start to sell a product but decide between themselves that they are not partners or they don’t consider themselves a partnership.

One would think that people contemplating going into business together would want to put their understanding in writing. That way, if any disputes or misunderstandings arose, the agreement could serve as a guide. In far too many cases, however, partners do not execute a written partnership agreement. This may be because of the cost of hiring an attorney, or mere laziness or aversion to discussing the minutiae of the agreement. It may also result from the partnership being a close family relation or friend with whom they don’t foresee conflict. Whatever the reason, it is a poor excuse, because forming an agreement is easy and the forms are available online. The consequences of not setting forth the terms of the partnership can be dire—the loss of the business, personal debt, and damaged personal relationships. It pays to be ready for the worst (dissolution, divorce, creditors, and personal problems of a partner) in order to protect the interests of all parties involved. See Figure 28.1 for a sample partnership agreement.

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Figure 28.1: Sample partnership agreement

PARTNERSHIP AGREEMENT

AGREEMENT made July 4, 2012, between Wendy Uhlinger of 100 Bucolic Dr., Slippery Rock, PA 16057-1014 and

Enrique Garcia of 10 Country St., Newton, NJ 07860.

1. NAME AND BUSINESS.

The parties hereby form a Partnership under the name of W&E Computer Consulting to engage in the business of

providing general computer consulting services and computer hardware and software sales. The principal office of the

business shall be in One Technology Drive, Middletown, NY 10940.

2. TERM.

The Partnership shall begin on August 4, 2012, and shall continue until terminated as herein provided.

3. CAPITAL.

The capital of the Partnership shall be contributed in cash by the partners as follows: $50,000 (Fifty thousand dollars)

by each partner. A separate capital account shall be maintained for each partner. Neither partner shall withdraw any

part of his capital account. Upon the demand of either partner, the capital accounts of the partners shall be maintained

at all times in the proportions in which the partners share in the profits and losses of the Partnership.

4. PRINCIPAL PLACE OF BUSINESS.

The principal office of the business shall be in One Technology Drive, Middletown, NY 10940.

5. BUSINESS AND PURPOSE.

The business and purposes of the Partnership are to manage, and operate, a computer consulting and repair

business, or interest therein.

6. WITHDRAWAL OF CAPITAL CONTRIBUTION.

Except as specifically provided in this Agreement, or as otherwise provided by and in accordance with law to the extent

such law is not inconsistent with this Agreement, no Partner shall have the right to withdraw or reduce his or her

contributions to the capital of the Partnership.

7. PROFIT AND LOSS.

The percentages of Partnership Rights and Partnership Interest of each of the Partners shall be as follows:

Partner 1: 50%

Partner 2: 50%

8. LOSSES.

Net losses shall be borne equally by them. A separate income account shall be maintained for each partner. Partner-

ship profits and losses shall be charged or credited to the separate income account of each partner. If a partner has

no credit balance in his income account, losses shall be charged to his capital account.

9. TAXATION.

For purposes of Sections 702 and 704 of the Internal Revenue Code of 1954, or the corresponding provisions of any

future federal internal revenue law, or any similar tax law of any state or jurisdiction, the determination of each

Partner’s distributive share of all items of income, gain, loss, deduction, credit, or allowance of the Partnership for any

period or year shall be made in accordance with, and in proportion to, such Partner’s percentage of Partnership

Interest as it may then exist.

10. DISTRIBUTION OF PROFITS.

Generally, gross cash distribution, in proportion to Partners’ percentages of Partnership interest, will be made based

on the scheduled payments of processors or within 60 days of payments being made.

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11. OPERATING EXPENSES.

Generally, operating expenses will be shared at the time those expenses are realized in proportion to Partners’

percentages of Partnership interest. While each purchase will not require an accounting of Partnership interest,

reimbursement to the payor, based on share, will be resolved every 30 days.

12. SALARIES AND DRAWINGS. Neither partner shall receive any salary for services rendered to the Partnership.

Each partner may, from time to time, withdraw the credit balance in his income account.

13. INTEREST. No interest shall be paid on the initial contributions to the capital of the Partnership or on any subse-

quent contributions of capital.

14. MANAGEMENT OF THE PARTNERSHIP BUSINESS.

14. A. All decisions respecting the management, operation, and control of the Partnership business and determi-

nation made in accordance with the provisions of this Agreement shall be made based upon a majority share of

the Partnership in favor of the decision. Majority owner Partner 1 has the full intention of increasing the responsibil-

ity and stake of Partner 2’s management, operation, and control of the Partnership. Succession of such powers

will take place, at first on a day-to-day basis. Later, based on performance, a management agreement will be

incorporated into this Partnership.

14. B. Nothing herein contained shall be construed to constitute any Partner or the agent of another Partner,

except as expressly provided herein, or in any manner to limit the Partnership to the carrying on of their own

respective businesses or activities. Any of the Partners, or any agent, servant, or employee of any of the Partners,

may engage in and possess any interest in other businesses or ventures of every nature and description, indepen-

dently or with other persons, whether or not, directly or indirectly, in competition with the business or purpose of

the Partnership, and neither the Partnership nor any of the Partners shall have any rights, by virtue of this Agree-

ment or otherwise, in and to such independent ventures or the income or profits derived therefrom, or any rights,

duties, or obligations in respect thereof.

14. C. The Partners shall devote to the conduct of the Partnership business so much of their respective time as

may be reasonably necessary for the efficient operation of the Partnership business. That will include a significant

amount of time during peak sales season in Partnership business. At this time, both partners expect to contribute

approximately 2,500 hours annually. To the extent that partners cannot devote adequate time to the business due

to health, outside ventures, jobs, or other reasons, said partner will be responsible for finding replacement labor

and covering the costs of said labor.

15. BANKING.

All funds of the Partnership shall be deposited in its name in such checking account or accounts as shall be

designated by the partners. All withdrawals therefrom are to be made upon checks signed by either partner.

16. BOOKS.

The Partnership books shall be maintained at the principal office of the Partnership, and each partner shall at all times

have access thereto. The books shall be kept on a fiscal year basis, commencing August 1 and ending July 31, and

shall be closed and balanced at the end of each fiscal year. An audit shall be made as of the closing date.

17. VOLUNTARY TERMINATION.

The Partnership may be dissolved at any time by agreement of the partners, in which event the partners shall proceed

with reasonable promptness to liquidate the business of the Partnership. The Partnership name shall be sold with the

other assets of the business. The assets of the Partnership business shall be used and distributed in the following

order: (a) to pay or provide for the payment of all Partnership liabilities and liquidating expenses and obligations;

(b) to equalize the income accounts of the partners; and (c) to discharge the balance of the income accounts of the

partners.

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Agency Rights and Duties of Partners

When partners act within the scope of their authority, they are agents of the partnership and of each other. As such, they bind the partnership to any contracts they enter into on the partnership’s behalf within the regular course of business. As is true of all agents, partners have fiduciary duties to the partnership and to each other. As co-owners of the business, partners also have the interests of principals in the enterprise; since each partner is both an agent and a principal of the partnership, each partner also owes every other partner the duties of a fiduciary. As such, partners must place partnership interests above their own personal gain and must execute their duties as partners with the utmost good faith. (See Chapter 27 for a list of fiduciary duties of agents and principals.) Table 28.2 illustrates these relationships.

18. DEATH.

Upon the death of either partner, the surviving partner shall have the right either to purchase the interest of the

decedent in the Partnership or to terminate and liquidate the Partnership business. If the surviving partner elects to

purchase the decedent’s interest, he shall serve notice in writing of such election, within three months after the death

of the decedent, upon the executor or administrator of the decedent, or, if at the time of such election no legal

representative has been appointed, upon any on