- - AGRICULTURAL CORE CURRICULUM - - (CLF1000) Advanced Core Cluster: AGRICULTURAL BUSINESS MANAGEMENT (CLF1250) Unit Title: Management Functions _____________________________________________________________________________ (CLF1254) Characteristics of Individual Time Years Proprietorships, Partnerships, 4 Hours 3 / 4 and Corporations _____________________________________________________________________________ Topic Objectives: Upon completion of this lesson, the student will be able to: Learning Outcome #: (C-3) - Distinguish among the main characteristics of individual proprietorships, partnerships, and corporations. Special Materials and Equipment: References: Downey, W. David, & Erickson, Steven P. (1987). AGRIBUSINESS MANAGEMENT (2nd ed). New York: McGraw-Hill. Downey, W. David (1982). AGRIBUSINESS MANAGEMENT INSTRUCTOR MANUAL. New York: McGraw-Hill. Erickson, Steven P. (1981). AGRIBUSINESS MANAGEMENT STUDY GUIDE. New York: McGraw-Hill. Resources: Farm Credit Services (resources on marketing, management, sales, etc.), 375 Jackson Street, P.O. Box 64949, St. Paul, MN 55614 Telephone: (612) 221-0600. U.S. Internal Revenue Service. (Current tax year). Farmer's Tax Guide. Evaluation: Unit Exam TOPIC PRESENTATION: CHARACTERISTICS OF INDIVIDUAL PROPRIETORSHIPS, PARTNERSHIPS, AND CORPORATIONS. A. Choice of the Form of Business Organization 1. Factors Influencing the Choice of Business Organization: a. Cost and Ease of Starting 1) Are there any "hidden" costs of this form? Attorney fees? Filing fees? 2) Are there one-time or annual costs? b. Capital 1) How much capital is needed to make the business run properly? 2) Where will it come from? 3) What is the ease of bringing in new creditors? 4) How do creditors feel? c. Taxes 1) Does this business form receive favored treatment from the Internal Revenue Service? 2) How are investment credit and capital gains taxed by this business form? d. Profit Distribution 1) How are profits distributed? 2) Are all profits removed from the business or are some profits reinvested in the business? e. Transfer and Continuity 1) How easy will it be to pass on part or all of the business to family members? 2) How easy is it to bring in new investors, whether family or outsiders? 3) What happens if the firm's top person dies? How does leadership continue? f. Secrecy 1) Are accounts open to the public? 2) What is the amount of government involvement? What influence do regulatory agencies have on the day-to-day management choices? g. Risk 1) To what extent is the firm financially liable for its management's actions? 2) Do investors lose all their money if the firm files for bankruptcy? 3) Are the owners' personal assets safe from business creditors? h. Objectives 1) What are the goals of the individual firm? Stay small or expand? 2) How many owners will there be? ____________________________________________________________ ACTIVITY: 1. Design a chart to show how the forms of business structure would be rated for each of the factors that must be considered in selecting an organizational form. Use "+" if the factor is an advantage for the given structure and use "-" if it is a disadvantage. If the factor could be either, depending on circumstances, indicate by using "+/-". Include comments where appropriate. ____________________________________________________________ B. Single Proprietorship 1. Definition: "Owned by one individual who has exclusive control over decisions." 2. This is the largest, oldest, and simplest form of business. 80-85% of all U.S. businesses are single proprietorships; however, only 10-15% of total dollar business volume is transacted within this form. 3. This form of business is very simple and easy to start; it provides ownership satisfaction (100% profits), flexibility, and is subject to few regulations. 4. Advantages of Single Proprietorships a. Economical and Easy to Start b. Tax Advantage (at less than $75,000/year) c. Complete Control d. 100% Profits e. Secrecy f. Ease of Exit 5. Disadvantages of Single Proprietorships a. Unlimited Liability b. All Capital and Credit must be Obtained by Proprietor Alone c. Lack of Management Depth d. Potential Lack of Continuity e. Taxed at Individual Rates 6. Further Considerations Regarding the Single Proprietorship Form for an Agribusiness a. Any profit/loss belongs to the owner and must be reported on the owner's income tax return, usually on Schedule C, Income (or Loss) from a Business or Profession, Form 1040. 1) As a general rule, once a sole proprietorship begins to generate more than $75,000/year in taxable income, consider incorporating in order reduce taxes. b. There is favorable treatment regarding unemployment taxes by the IRS. c. Funds may be shifted in and out of the business account or assets may be withdrawn from the business with few tax, legal, or other limitations. d. A major disadvantage is that there are no significant tax benefits regarding group term life insurance benefits, long-term disability insurance coverage, and medical insurance or medical expense reimbursement. e. There is virtually no difference in the tax treatment of self-employed (Keogh) plans of sole proprietorships and partnerships, as compared with corporate retirement plans. C. General Partnership (Uniform Partnership Act) 1. Definition: "An association of two or more persons to carry on as co-owners of a business for profit." a. A general partnership may be viewed as an extended proprietorship; most of the advantages/disadvantages of sole proprietorships also apply to partnerships. b. More can be accomplished by pooling talents, resources, abilities, etc. c. Advantages of a General Partnership 1) Greater Resources 2) Increased Management Depth 3) Expansion Possible 4) Increased Financial Strength 5) Fairly Easy to Start 6) Secrecy (Details of business are shared only with partner(s).) 7) Easy to Manage d. Disadvantages of a General Partnership 1) Partners Dependent on One Another 2) Profits Shared 3) Taxed at Individual Rate 4) Transfer/Continuity Problems 5) Unlimited Liability 6) Divided Authority 7) Potential Personal Conflicts Among Partners e. Further Considerations Regarding the General Partnership Form for an Agribusiness Owner/Manager 1) A partnership usually terminates when any one partner dies or withdraws from the partnership. Under the laws of most states, bankruptcy of a partner or the partnership itself will cause the dissolution of the partnership, regardless of any agreement. 2) A written partnership agreement is a sound business practice for partners that, at a minimum, spells out such basic issues as: a) How much and what kind of property will each partner contribute to the venture? b) What value will be placed on the contributed property? c) How will profits and losses be divided among the partnership? d) When and how will profits be withdrawn? e) How will partners be compensated for their services to the partnership, or for making capital available to the partnership? f) How will changes in ownership of interests in the partnership will be handled? 3) A written partnership agreement should be prepared by an attorney and reviewed by a tax accountant before it is put into effect. 4) Partnerships are a bit like marriages: They usually start out with a great deal of trust and have a high breakup rate. 5) Like marriages, it has also been said, partnerships are easy to get into, requires a lot of patience and understanding to live with, and are often costly and painful to get out of. 6) Each partner is an agent for the partnership and can do anything necessary to operate the business, such as: a) Hire employees b) Borrow money c) Enter into contracts on behalf of the partnership 7) Each partner has personal liability for the debts, taxes, and other claims against the partnership. If the partnership's assets are not sufficient to pay creditors, the creditors can satisfy their claims out of any individual partner's personal assets. 8) Partnerships must file federal and usually state information returns (Form 1066 is the federal form), but pay no income tax. Instead, each partner's share of income/loss, tax credits, etc. is reported on the information sheet and Schedule E on the individual tax return. 9) Like a sole proprietor, a partner is not considered an employee of the partnership for income tax and payroll tax purposes. D. Limited Partnership (governed under Uniform Limited Partnership Act) 1. Definition: "The association of two or more people as owners of a business in which some partners contribute money or ownership capital to the partnership without incurring the full legal liability of a general partner." 2. Limited partnerships have some of the benefits of both partnerships and corporations. 3. They are often used to attract investors who have "risk capital" but don't want personal liability. 4. One or more of the partners are general partners and one or more partners is a limited partner. a. General Partner--answerable to the public, has unlimited liability b. Limited Partner--contributes capital, shares in profits, but does not participate in management or operations, and liability is limited to individual investment 5. Advantages of Limited Partnerships a. Capital contribution from limited partner(s) b. Limited liability for limited partner c. Estate planning tool 6. Disadvantages of Limited Partnerships a. Outside creditors may be wary b. More highly regulated than either sole proprietorships or partnerships c. Cannot use limited partner's management abilities d. Taxed as partnerships 7. Further considerations of a Limited Partnership for the Agribusiness Manager/Owner. a. The limited partnership form of business organization is more regulated than ordinary general partnerships. b. The limited partner risks only his/her investment but must allow one or more general partners to exercise control over the business. c. If the limited partner becomes involved in the partnership's operations, he/she may lose the protected status as a limited partner. d. State law requires certain formalities for limited partnerships, usually filing a certificate of limited partnership with Secretary of State or other state or county offices. e. Limited Partnerships also REQUIRE a written partnership agreement. J. Corporation 1. Definition: "An artificial 'legal being' endowed by law with the powers, rights, liabilities, and duties of a natural person." A corporation's assets are controlled by the business entity itself, not be the owners (stockholders) directly. 2. A corporation as a "legal being" is a legal concept only. 3. The corporation is treated as an individual in the eyes of the law; it can sue and be sued, it has unlimited life, it can own property in its own right, and receives its life from a state charter. 4. The agreement to incorporate must be in writing, must be filed in the state where the corporation is chartered, and must be approved by the state government. The articles of incorporation, bylaws, and a record of owner investment must be maintained by the corporation. 5. Corporations may issue two types of stock: a. Common Stock 1) Voting stock/vote/share 2) More risk than preferred stock, price and returns 3) Often purchased for price appreciation 4) No guaranteed returns b. Preferred Stock 1) No voting rights 2) Less risk 3) Purchased for returns 4) Have claims on assets similar to creditors 6. In the corporation a. Stockholders elect the board of directors b. Directors supervise the corporation 1) Hire management 2) Adopt policy 3) Evaluate progress c. Management supervises employees 7. Advantages of Incorporation a. Can attract capital by selling stock b. Generally stockholders are not liable for claims against the corporation beyond their original investment c. Continuous existence (not terminated by death of individual members) d. Potential for more depth of management and for specialization e. Easy transfer of ownership f. Some tax related favorable deductions from IRS 8. Disadvantages of Incorporation a. Must apply for charter from state b. Sale of stock is regulated c. Incorporation is costly (and legal fees must be paid) d. Franchise tax must be paid e. Double taxation f. Highly regulated and lack of secrecy 9. Further Considerations of Incorporation for the Agribusiness Manager/Owner a. The main reason most businesses incorporate is to limit the personal liability of the owners for the debts, taxes, and other liabilities of the business to the amount of their investment. b. An owner may lose unlimited liability if courts determine that it is a "thin corporation," i.e., a corporation that capitalizes too thinly with equity capital (owner's money) as compared to debt capital (borrowed money). c. Failure to observe corporate formalities and the separate legal existence of the corporation may result in unlimited liability; this is called "piercing the corporate veil" by the courts. d. Legal fees are usually between $500-$1000 for even for simple incorporation; if it is necessary to obtain a permit from the state to issue stock or securities, legal fees can be much higher. e. There will be recurring costs, often including annual franchise or corporate income taxes, and federal corporate income taxes. f. Many corporate actions must or should be formalized by board of directors' resolutions or shareholders' meetings, and must be recorded in written form in the corporate minute books, which takes valuable time. K. Sub-chapter S Corporation 1. Definition: "A closely held corporation for which Subchapter S of the Internal Revenue Code makes it possible for the owners of the corporation to elect to be taxed as individuals rather than as a corporation." 2. Small operations may choose an "S" corporation which may be closed to outsiders. 3. Subchapter S corporations (usually referred to as "S Corporations" are no different than any other corporation under state law in terms of corporate law requirements, limited liability of shareholders, or any other aspect other than for tax treatment. 4. Advantages of S Corporations a. Limited liability b. Employee benefit (owner can be an employee which reduces taxable income) c. Costs/ease - still need attorney d. Taxes are lower than corporate rates e. Transfer/continuity (existence separate from owners) f. Simplified meetings and bylaws 5. Disadvantages of S Corporations a. May not protect all personal assets in business b. More expensive to operate c. Costs to incorporate d. Meetings must be held and minutes taken 6. Further Considerations of an S Corporation for the Agribusiness Manager/Owner a. To qualify for S corporation treatment, a corporation must meet the following requirements: 1) It must be a U.S. domestic corporation. 2) No shareholders can be non-resident alien individuals. 3) All shareholders must be individuals. 4) The corporation can have only one class of common stock, and no preferred stock. 5) There cannot be more than 35 shareholders (husband-wife counted as one). 6) The corporation cannot be a member of an affiliated group of corporations. 7) If more than 25% of the gross receipts during three successive tax years are from passive sources, the corporation will not qualify as an S corporation for subsequent tax years. 8) In order to become an S Corporation, a company that meets the above requirements must file an election on Form 2553 with the IRS. _____________________________________________________________ ACTIVITY: 1. Assign students to visit particular agribusiness firms in the community. Pass out Handout #1 for the students to complete upon visiting the manager of the business. 2. Review Handout #2. Summarize the key characteristics of the various legal forms of business organizations. This handout may be used as a summary of information about the characteristics of diffedrent forms of business. _____________________________________________________________ Handout #1 TYPE OF AGRIBUSINESS OWNERSHIP You are to visit the business assigned to you to determine the type of ownership of that business. Complete the following information about the business after you have visited with the manager of the business. Name of the Business: __________________________________________________ Type of ownership: ________ Sole Proprietorship ________ Partnership ________ Limited Partnership ________ Corporation ________ S Corporation ________ Franchise Why was the business organized under this type of ownership? What are the advantages of this type of ownership for this business? What are the advantages of this type of ownership for this business? What are the disadvantages of this type of ownership for the above business? Handout #2 SUMMARY OF THE KEY CHARACTERISTICS OF THE VARIOUS LEAGAL FORMS OF BUSINESS ORGANIZATION* This section provides a thumbnail sketch or overview of some of the major advantages and disadvantages of sole proprietorships, partnerships, and corporations. Where there are differences between a general partnership and a limited partnership, or between a "regular" corporation and an S corporation, separate comments are shown for each. Otherwise the comments regarding partnerships apply to both general and limited partnerships, and the comments regarding corporations relate to both regular and S corporations. (a) Simplicity in Operation and Formation: Proprietorship Simplest to establish and operate. General Relatively simple, informal, but is usually Partnership desirable to have formal written agreement between partners. Limited More complex and expensive than other Partnership unincorporated forms of business to establish. Requires written agreement, filing of certificate. Managed by general partners only. Regular Requires most formality in establishment Corporation and operation, generally. S Corporation Same as regular corporation, but requires close oversight by a tax advisor, an additional cost. (b) Liability for Debts, Taxes, and Other Claims: Proprietorship Owner has unlimited personal liability. General Partners all have unlimited personal Partnership liability. Limited General partners are personally liable; Partnership limited partners are liable only to the extent of their investment, generally. Corporation Stockholders not generally liable for corporate debts, but often have to guarantee loans, as a practical matter, if corporation borrows money. Also, corporate officers may be liable for failure to withhold and pay over to IRS, withholding taxes on employees' wages. (c) Federal Income Taxation of Business Profits: Proprietorship Taxed to owner at individual current tax rates Partnership Taxed to partners at their individual tax rates. Regular Taxed to corporation at current corporate Corporation tax rate. S Corporation Taxed to individual owners at their individual rates (but certain gains are taxable to corporation as well). Similar to partnership. (d) Double Taxation if Profits Withdrawn from Business: Proprietorship No. Partnership No. Regular Yes (but not on reasonable compensation Corporation paid to owners who are employees of the corporation). Corporate dividends usually represent previously taxed profits. Dividends are taxable to the recipient but are not a tax deduction for the corporation S Corporation No, in general. (e) Deduction of Losses by Owners: Proprietorship Yes. Partnership Yes. Limited partner's deductions are subject to the complex passive activity rules. Regular No. Corporations carryover or carry back Corporation initial losses to offset past or future profits, if any. S Corporation Yes, in general, for federal tax purposes But not for state tax purposes in all states. Loss for a shareholder limited to investment in stock plus amount loaned to the corporation and the complex passive activity rules may apply. (f) Social Security Tax on Earnings of Owner from Business: Proprietorship Self-employment earnings are additionally taxed, in 1991, 12.4% for Oldage-survivors; Disability Insurance (OASDI) up to 53,400 and 2.9% for medicare up to $125,000. Partnership Each partners share of "self emplyment earnings is taxed as in the proprietorship, Corporation As of 1991 the owner/employee of the corporation has withheld and pays out of his paycheck 6.2% for old-age, survivors disability insurance (OASDI) up to $53,400. for 1991, and 1.45% for medicare up to $125,000. The corporation also pays, these same amounts as its share of the social security tax. (g) Unemployment Taxes on Earnings of Owner from Business: Proprietorship None. Partnership None. Corporation Yes. State and federal unemployment taxes apply to salaries paid to owners. (Some states exempt a sole stockholder.) (h) Retirement Plans: Proprietorship Plans, SEP, and KEOGH Deductions, other features now generally the same as for corporate pension and profit sharing plans. Partnership Same as for sole proprietorships. Regular Corporate retirement plans no longer significantly better than Keogh plans. Deduction limits same now as for Keogh. But participants can borrow from plan. (i) Tax Treatment of Medical, Disability, and Group-Term Life Insurance on Owners: Proprietorship Partially deductible, and part of medical expenses may be an itemized deduction on owner's tax return, including medical insurance premiums. 25% of medical insurance on owner now allowed as a business expense. Partnership See proprietorship, above. Regular Corporation is able to deduct corporation medical insurance premium or reimbursements paid under medical reimbursement plan Generally not taxable to the employee, even if employee is an owner. Similar treatment for disability and group-term life insurance plans. S Corporation Effective as of 1983, fringe benefits for 2% shareholders not deductible by corporation (same as for partnership or proprietorship). (j) Taxation of Dividends Received on Investments Proprietorship Dividends received on stock investments are fully taxable to owner. Partnership Dividends taxable to individual partners. See partnership, above. Regular Dividends are taxable to the corporation. However, 70% of the dividends received are generally free of federal income tax (unless stock is purchased with borrowed money), an important tax advantage. Affilated corporations dividends receive special treatment. S Corporation Dividends taxable to individual shareholders of the S corporation, as in the case of a partnership. 12/12/91 BF/sg #%&C