BADM 336 - Chapter 7
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T/F: Most states and communities require businesses that sell goods, and in some cases services, to collect sales tax and submit the tax to the proper state authorities. If you're obligated to collect sales tax, you must get a permit from your state. Most states have online portals that make it easy to obtain a sales tax permit.
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T/F: On the local level, there are two categories of licenses and permits that may be needed. The first is a permit to operate a certain type of business (child care, barber shops and salons, automotive repair, and hotels and motels). The second category is permits for engaging in certain types of activities.
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T/F: One of the most important things the founders of an entrepreneurial venture can do is establish a strong ethical culture for their firms This must be prioritized and worked on at all stages during the development of a business. Everyone involved with a start-up plays an important role in developing a strong ethical culture for their firm.
nondisclosure agreement
binds an employee or another party (such as a supplier) to not disclose a company's trade secrets.
Common stock
is issued more broadly than preferred stock. The common stockholders have voting rights and elect the firm's board of directors. The common stockholders are typically the last to get paid in the event of the liquidation of the corporation; that is, after the creditors and the preferred stockholders.
Preferred stock
is typically issued to conservative investors who have preferential rights over common stockholders in regard to dividends and to the assets of the corporation in the event of liquidation.
C corporation
legal entity that, in the eyes of the law, is separate from its owners. In most cases, the corporation shields its owners, who are called shareholders, from personal liability for the debts and obligations of the corporation.
buyback clause
legally obligates departing founders to sell to the remaining founders their interest in the firm if the remaining founders are interested. In most cases, the agreement also specifies the formula for computing the dollar value to be paid.
liquid market
meaning that the stock can be bought and sold fairly easily through an organized marketplace.
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T/F: Most businesses do not require a federal license to operate, although some do. Seemingly simple businesses sometimes require more licenses and permits than one might think.
articles of incorporation
A corporation is formed by filing _____________with the secretary of state's office in the state of incorporation. These typically include the corporation's name, purpose, authorized number of stock shares, classes of stock, and other conditions of operation. In most states, corporations must file papers annually, and state agencies impose annual fees. It is important that a corporation's owners fully comply with these regulations.
double taxation
A corporation is taxed as a separate legal entity. In fact, the "C" in the title "C corporation" comes from the fact that regular corporations are taxed under subchapter C of the Internal Revenue Code. A disadvantage of corporations is that they are subject to ___________ which means that a corporation is taxed on its net income and, when the same income is distributed to shareholders in the form of dividends, is taxed again on shareholders' personal income tax returns. This complication is one of the reasons that entrepreneurial firms often retain their earnings rather than paying dividends to their shareholders. The firm can use the earnings to fuel future growth and at the same time avoid double taxation. The hope is that the shareholders will ultimately be rewarded by an appreciation in the value of the company's stock
Federal Employee Identification Number (normally called the Employer Identification Number or EIN)
A tax identification number used when filing various tax returns. All businesses, other than sole proprietorships that do not have employees, are required to obtain this. A business' EIN is similar to an individual's social security number. It is used by the IRS to track the business for tax compliance purposes.
Advantages: -Owners are liable only for the debts and obligations of the corporation up to the amount of their investment. -The mechanics of raising capital is easier. -No restrictions exist on the number of shareholders, which differs from subchapter S corporations. -Stock is liquid if traded on a major stock exchange. -The ability to share stock with employees through stock options or other incentive plans can be a powerful form of employee motivation. Disadvantages: -Setting up and maintaining one is more difficult than for a sole proprietorship or a partnership. -Business losses cannot be deducted against the shareholders' other income. -Income is subject to double taxation, meaning that it is taxed at the corporate and the shareholder levels. -Small shareholders typically have little voice in the management of the firm.
C Corporation: Advantages & Disadvantages
The first is to ask someone who is running a similar business, and they will usually be able to point you in the right direction. The second is to contact the secretary of state's office in the state where the business will be launched. In most cases, they'll be able to help you identify the federal, state, and local licenses that you'll need. The third is to use one of the search tools available online.
Depending on the nature of the business, licenses and permits may be required at the federal, state, and/or local levels. There are three ways for those leading a business to determine the licenses and permits that are necessary: The number-one rule is that if you are uncertain, ask. Severe penalties can be levied if you start running a business without the proper licenses in place.
Pressure to compromise organizational standards. This factor is an important warning sign of future workplace misconduct. Observed misconduct. Misconduct is the most basic indicator of the state of integrity in an organization. To what extent do employees follow the rules and live out the core values of organization? Report observed misconduct. This refers to whether employees report misconduct when they observe it, rather than remaining silent. Experience retaliation for reporting misconduct. (Employees getting the silent treatment or being exposed to verbal harassment, demotions, undesirable assignments, or even violence).
Four key metrics provide insight into the ethics environment of an organization:
Advantages: -Creating one is relatively easy and inexpensive compared to a corporation or limited liability company. -The skills and abilities of more than one individual are available to the firm. -Having more than one owner may make it easier to raise funds. -Business losses can be deducted against the partners' other sources of income. -It is not subject to double taxation Disadvantages: -Liability on the part of each general partner is unlimited. -The business relies on the skills and abilities of a fixed number of partners. Of course, similar to a sole proprietorship, the partners can hire employees who have additional skills and abilities. -Raising capital can be difficult. -Because decision making among the partners is shared, disagreements can occur. -The business ends at the death or withdrawal of one partner unless otherwise stated in the partnership agreement. -The liquidity of each partner's investment is low.
General Partnership: Advantages & Disadvantages
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T/F: Most legal disputes are the result of misunderstandings, sloppiness, or a simple lack of knowledge of the law. Legal snafus, particularly if they are coupled with management mistakes, can be extremely damaging to a new firm.
Business registration requirements Sales tax permits Professional and occupational licenses and permits
In most states, there are three different categories of licenses and permits that you may need to operate a business. Most states have start-up guides that walk you through the steps of setting up a business in the state.
Abusive or intimidating behavior among employees; lying to employees, customers, vendors, or the public; and decisions made or actions taken to benefit the employees (or friends or family of the employee) over the interests of the employees' organization.
In regard to observed misconduct, in the United States, the three highest incidents of observed misconduct were:
In strong ethical cultures, entrepreneurs, managers, and supervisors: -Communicate ethics as a priority -Set a good example of ethical conduct -Keep commitments -Provide info about what's going on -Support following organizational standards Employees also have responsibilities. The most important things employees can do to support a strong ethical culture in an organization are to: -Consider ethics in making decisions -Talk about ethics while completing their work -Set a good example of ethical conduct -Support following organizational standards
Leading by example is the most important thing any entrepreneur, manager, or supervisor can do to build a strong ethical culture in her or his organization.
Advantages: -Members are liable for the debts and obligations of the business only up to the amount of their investment. -The number of shareholders is unlimited. -An LLC can elect to be taxed as a sole proprietor, partnership, S corporation, or corporation, providing a great deal of flexibility. -Because profits are taxed only at the shareholder level, there is no double taxation. Disadvantages: -Setting up and maintaining one is more difficult and expensive. -Tax accounting can be complicated. -Some of the regulations governing LLCs vary by state. -Because LLCs are a relatively new type of business entity, there is not as much legal precedent available for owners to anticipate how legal disputes might affect their businesses. -Some states levy a franchise tax on LLCs—which is essentially a fee the LLC pays the state for the benefit of limited liability.
Limited Liability Company: Advantages & Disadvantages
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T/F: In all states, there are laws that require people in certain professions to pass a state examination and maintain a professional license to conduct business (barber, real estate agent). There are also certain businesses that require a state occupational license or permit to operate (plumbers, daycare centers).
Advantages: -Creating one is easy and inexpensive. -The owner maintains complete control of the business and retains all the profits. -Business losses can be deducted against the sole proprietor's other sources of income. -It is not subject to double taxation (explained later). -The business is easy to dissolve. Disadvantages: -Liability on the owner's part is unlimited. -The business relies on the skills and abilities of a single owner to be successful. Of course, the owner can hire employees who have additional skills and abilities. -Raising capital can be difficult. -The business ends at the owner's death or loss of interest in the business. -The liquidity of the owner's investment is low.
Sole Proprietorship: Advantages & Disadvantages
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T/F: It is important for an entrepreneur to select an attorney as early as possible when developing a business venture. It is critically important that the attorney be familiar with start-up issues and that he or she has successfully shepherded entrepreneurs through the start-up process before. It is not wise to select an attorney just because she is a friend or because you were pleased with the way she prepared your will. For issues dealing with intellectual property protection, it is essential to use an attorney who specializes in this field, such as a patent attorney, when filing a patent application.
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T/F: It's a judgment call as to whether to hire a lawyer to do your legal work, utilize a service such as LegalZoom, RocketLawyer, or Nolo, or pursue a blended approach. A blended approach might involve hiring an attorney to obtain legal advice (such as determining your form of business ownership) and then utilizing one of the online services to prepare the documents and file them with the appropriate governmental agencies on your behalf.
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T/F: A corporation is governed by a board of directors, which is elected by the shareholders.
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T/F: A final advantage of organizing as a C corporation is the ability to share stock with employees as part of an employee incentive plan. Because it is easy to distribute stock in small amounts, many corporations, both public and private, distribute stock as part of their employee bonus or profit-sharing plans. Such incentive plans are intended to help firms attract, motivate, and retain high-quality employees.
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T/F: A sole proprietorship is not a separate legal entity. For tax purposes, the profit or loss of the business flows through to the owner's personal tax return document and the business ends at the owner's death or loss of interest in the business. The sole proprietor is responsible for all the liabilities of the business, and this is a significant drawback. If a sole proprietor's business is sued, the owner could theoretically lose all the business's assets along with personal assets. The liquidity of an owner's investment in a sole proprietorship is typically low. It is usually difficult for a sole proprietorship to raise investment capital because the ownership of the business cannot be shared. Unlimited liability and difficulty raising investment capital are the primary reasons entrepreneurs typically form corporations or limited liability companies as opposed to sole proprietorships.
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T/F: Along with maintaining a strong ethical culture, it is also important that a firm is willing to say "We're sorry" when it makes a mistake in that doing so is an important part of operating in a fair, trustworthy, and savvy manner.
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T/F: An additional advantage of the subchapter S corporation pertains to self-employment tax. By electing the subchapter S corporate status, only the earnings actually paid out as salary are subject to payroll taxes. The ordinary income that is disbursed by the business to the shareholders is not subject to payroll taxes or self-employment tax.
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T/F: Choosing a legal entity is not a one-time event. As a business grows and matures, it is necessary to periodically review whether the current form of business organization remains appropriate.
piercing the corporate veil
T/F: If the owners of a corporation don't file their annual paperwork, neglect to pay their annual fees, or commit fraud, a court could ignore the fact that a corporation has been established and the owners could be held personally liable for actions of the corporation. This chain of effects is referred to as
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T/F: If two or more people start a business, they must organize as a partnership, corporation, or limited liability company. Partnerships are organized as either general or limited partnerships.
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T/F: In addition to obtaining the proper licenses and permits, if you plan to use a fictitious name for your business, you'll need to obtain a fictitious business name permit (regulations vary depending on location).
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T/F: Organizations should also set standards that govern employees' behavior beyond what can be expressed via a code of conduct. Four of the most common ethical problem areas that occur in an organization are human resource ethical problems, conflicts of interest, customer confidence, and inappropriate use of corporate resources. Policies and procedures should be established to deal with these issues. Firms are increasingly partnering with others to achieve their objectives. Entrepreneurial ventures should be vigilant when selecting their alliance partners.
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T/F: Sole proprietorships are the most prevalent (widespread) form of business organization. The two most important advantages of a sole proprietorship are that the owner maintains complete control over the business and that business losses can be deducted against the owner's personal tax return. Setting up a sole proprietorship is cheap and relatively easy compared to the other forms of business ownership. The only legal requirement, in most states, is to obtain the appropriate license and permits to do business. If the business will be operated under a trade name (e.g., West Coast Graphic Design) instead of the name of the owner (e.g., Sam Ryan), the owner will have to file an assumed or fictitious name certificate with the appropriate local government agency. This step is required to ensure that there is only one business in an area using the same name and provides a public record of the owner's name and contact information.
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T/F: Some codes of conduct are very specific. Other codes of conduct set out more general principles about an organization's beliefs on issues such as product quality, respect for customers and employees, and social responsibility. In all cases, codes of conduct are intended to influence people to behave in ways that are consistent with a firm's ethical orientation.
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T/F: Some of the terminology used for an LLC differs from the other forms of business ownership. For example, the shareholders of an LLC are called "members," and instead of owning stock, the members have "interests."
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T/F: Some states require all new businesses to register with the state. The purposes of the document are to (1) register the business, (2) place the business on the radar screen of the tax authorities, and (3) make sure the business is aware of and complies with certain regulations, such as the need to withhold state and federal taxes from employees' paychecks.
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T/F: The LLC is more flexible than a subchapter S corporation in terms of number of owners and tax-related issues. An LLC must be a private business—it cannot be publicly traded. The LLC is rather complex to set up and maintain, and in some states the rules governing the LLC vary. Members may elect to manage the LLC themselves or may designate one or more managers (who may or may not be members) to run the business on a day-to-day basis. The profits and losses of the business may be allocated to the members any way they choose.
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T/F: The business created by a partnership ends at the death or withdrawal of a partner, unless otherwise stated in the partnership agreement. General partnerships are typically found in service industries. In many states, a general partnership must file a certificate of partnership or similar document as evidence of its existence. Similar to a sole proprietorship, the profit or loss of a general partnership flows through to the partner's personal tax returns. If a business has four general partners and they all have equal ownership in the business, then one-fourth of the profits or losses would flow through to each partner's individual tax return.16 The partnership files an informational tax return only.
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T/F: The ease of transferring stock is another advantage of corporations. If a corporation is listed on a major stock exchange, such as the New York Stock Exchange or the NASDAQ, an owner can sell shares at almost a moment's notice. This advantage of incorporating, however, does not extend to corporations that are not listed on a major stock exchange
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T/F: The primary advantage of a general partnership over a sole proprietorship is that the business isn't dependent on a single person for its survival and success. In fact, in most cases, the partners have equal say in how the business is run. Most partnerships have a partnership agreement, which is a legal document that is similar to a founders' agreement.
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T/F: The primary disadvantage of a general partnership is that the individual partners are liable for all of the partnership's debts and obligations. If one partner is negligent while conducting business on behalf of the partnership, all the partners may be liable for damages. It is typically easier for a general partnership to raise money than a sole proprietorship simply because more than one person is willing to assume liability for a loan. One way a general partnership can raise investment capital is by adding more partners. Investors are typically reluctant to sign on as general partners, however, because of the unlimited liability that follows each one.
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T/F: The primary disadvantages of a subchapter S corporation are restrictions in qualifying, expenses involved with setting up and maintaining the subchapter S status, and the fact that a subchapter S corporation is limited to 100 shareholders.27 If a subchapter S corporation wants to include more than 100 shareholders, it must convert to a C corporation or a limited liability company.
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T/F: Vesting ownership in company stock is another topic most founders' agreements address. The idea behind vesting is that when a firm is launched, instead of issuing stock outright to the founder or founders, it is distributed over a period of time, typically three to four years, as the founder or founders "earn" the stock. Vesting keeps employees motivated and engaged and also solves a host of potential problems that can result if employees are given their stock all at once.
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T/F: While hiring an attorney is advisable, it is not the only option available for researching, preparing, and filing the necessary forms to get a business up and running legally. Most business owners can do much of the preliminary work on their own, and they rely on an attorney for guidance and advice. If you're particularly tight on money and feel as though you can handle portions of the legal process on your own (which is not generally recommended but may apply in some cases), there are online companies that can help you with the necessary forms and filings
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T/F: it is important that a business choose a name that facilitates rather than hinders how it wants to differentiate itself in the marketplace.
First, if a founder leaves the firm, the remaining founders may need the shares to offer to a replacement person. Second, if founders leave because they are disgruntled, the buyback clause provides the remaining founders a mechanism to keep the shares of the firm in the hands of people who are fully committed to a positive future for the venture.
The presence of a buyback clause is important for at least two reasons.
illiquid
The stock in both closely held and private corporations is fairly _______, meaning that it typically isn't easy to find a buyer for the stock.
Nondisclosure agreement Noncompete agreement
There are also two important written agreements that the majority of firms ask their employees to sign.
Avoid Undercapitalization If a new business is starved for money, it is much more likely to experience financial problems that will lead to litigation.9 A new business should raise the money it needs to effectively conduct business or should stem its growth to conserve cash. Most entrepreneurs have a goal of retaining as much of the equity in their firms as possible, but equity must often be shared with investors to obtain sufficient investment capital to support the firm's growth.
There are several steps entrepreneurs can take to avoid legal disputes and complications
It is important to meet all contractual obligations on time. This includes paying vendors, contractors, and employees as agreed and delivering goods or services as promised. If an obligation cannot be met on time, the problem should be communicated to the affected parties as soon as possible. Cash flow problems can send a company into a hole from which they will often not recover." Being forthright with vendors or creditors if an obligation cannot be met and providing the affected party or parties a realistic plan for repaying the money is an appropriate path to take and tends to maintain productive relationships between suppliers and vendors.
There are several steps entrepreneurs can take to avoid legal disputes and complications
Many business disputes arise because of the lack of a written agreement or because poorly prepared written agreements do not anticipate potential areas of dispute.10 Although it is tempting to try to show business partners or employees that they are "trusted" by downplaying the need for a written agreement, this approach is usually a mistake. Disputes are much easier to resolve if the rights and obligations of the parties involved are in writing.
There are several steps entrepreneurs can take to avoid legal disputes and complications
The cost of setting up and maintaining the legal form The extent to which personal assets can be shielded from the liabilities of the business Tax considerations The number and types of investors involved
There is no single form of business organization that works best in all situations. It is up to a firm's owners and their attorney to select the legal entity that best meets their needs. The decision typically hinges on several factors: It is important to be careful in selecting a legal entity for a new firm because each form of business organization involves trade-offs among these factors and because an entrepreneur wants to be sure to achieve the founders' specific objectives.
Choosing an attorney for a firm Drafting a founder's agreement Avoiding legal disputes
Those leading entrepreneurial ventures can also expect to encounter a number of important legal issues when launching and then, at least initially, operating their firm.
Lead by example Establish a code of conduct Implement an ethics training program
Three specific steps that an entrepreneurial start-up can take to build a strong ethical culture.
public corporations
a corporation that is listed on a major stock exchange, such as the New York Stock Exchange or the NASDAQ, in which owners can sell their shares at almost a moment's notice. These stockolders enjoy a liquid market for their stock.
general partnership
a form of business organization in which two or more people pool their skills, abilities, and resources to run a business.
sole proprietorship
a form of business organization involving one person, and the person and the business are essentially the same.
limited liability company (LLC)
a form of business organization that is rapidly gaining popularity in the United States. The concept originated in Germany and was first introduced in the United States in the state of Wyoming in 1978. As with partnerships and corporations, the profits of an LLC flow through to the tax returns of the owners and are not subject to double taxation. The main advantage of the LLC is that all partners enjoy limited liability. The LLC combines the limited liability advantage of the corporation with the tax advantages of the partnership.
limited partnership
a modified form of a general partnership. The major difference between the two is that this partnership includes two classes of owners: general partners and limited partners. There are no limits on the number of general or limited partners permitted. Similar to a general partnership, the general partners are liable for the debts and obligations of the partnership, but the limited partners are liable only up to the amount of their investment. The limited partners may not exercise any significant control over the organization without jeopardizing their limited liability status. It is usually formed to raise money or to spread out the risk of a venture without forming a corporation.
Mediation
a process in which an impartial third party (usually a professional mediator) helps those involved in a dispute reach an agreement. At times, legal disputes can also be avoided by a simple apology and a sincere pledge on the part of the offending party to make amends.
corporation
a separate legal entity organized under the authority of a state. They are organized as either C corporations or subchapter S corporations.
Stock options
a special form of incentive compensation. These plans provide employees the option or right to buy a certain number of shares of their company's stock at a stated price over a certain period of time. The most compelling advantage of stock options is the potential rewards to participants when (and if) the stock price increases.
private corporation
all the shares are held by a few shareholders, such as management or family members, and are not publicly traded.
fictitious business name permit
allows a business to legally operate under a fictitious name, like Gold Coast Sea Food or Red Rock Bakery. Selecting a name for a business and obtaining a fictitious business name permit if needed is an important task, not only to comply with the law but because a business's name is a critical part of its identity and its branding strategy.
Sole proprietorships, partnerships, corporations, and limited liability companies
the most common legal entities from which entrepreneurs make a choice
subchapter S corporation
combines the advantages of a partnership and a C corporation. It is similar to a partnership in that the profits and losses of the business are not subject to double taxation. The subchapter S corporation does not pay taxes; instead, the profits or losses of the business are passed through to the individual tax returns of the owners. The S corporation must file an informational tax return. An S corporation is similar to a C corporation in that the owners are not subject to personal liability for the behavior of the business.
partnership agreement
details the responsibilities and the ownership shares of the partners involved with an organization.
Contact the local bar association and ask for a list of attorneys in your area who specialize in business start-ups. Interview several attorneys. Check references. Ask your prospective attorney whom he or she has guided through the start-up process before and talk to the attorney's clients. Select an attorney who is familiar with the start-up process. Make sure that the attorney is more than just a legal technician. Select an attorney who can assist you in raising money for your venture. Make sure your attorney has a track record of completing work on time. Talk about fees. If your attorney won't give you a good idea of what the start-up process will cost, keep looking. Trust your intuition. Learn as much about the process of starting a business yourself as possible.
guidelines to consider when selecting an attorney
code of conduct (or code of ethics)
is a formal statement of an organization's values regarding certain ethical and social issues. The advantage of having this is that it provides specific guidance to entrepreneurs, managers, and employees regarding expectations of them in terms of ethical behavior.
ethical dilemma
is a situation that involves doing something that is beneficial to oneself or the organization, but may be unethical.
founders' agreement (shareholders' agreement)
is a written document that deals with issues such as the relative split of the equity among the firm's founders, how individual founders will be compensated for the cash or the "sweat equity" they put into the firm, and how long the founders will have to remain with the firm for their shares to fully vest. If two or more people start a business, it is important that they have this.
shareholders
owners of a corporation who are shielded from personal liability for the debts and obligations of the corporation. In most instances, the board hires officers to oversee the day-to-day management of the organization. It is usually easier for a corporation to raise investment capital than a sole proprietorship or a partnership because the shareholders are not liable beyond their investment in the firm. It is also easier to allocate partial ownership interests in a corporation through the distribution of stock. Most C corporations have two classes of stock: common and preferred.
noncompete agreement
prevents an individual from competing against a former employer for a specific period of time.
limited partnership agreement
sets forth the rights and duties of the general and limited partners, along with the details of how the partnership will be managed and eventually dissolved.
-The business cannot be a subsidiary of another corporation. -The shareholders must be U.S. citizens. ---Partnerships and C corporations may not own shares in a subchapter S corporation. -Certain types of trusts and estates are eligible to own shares in a subchapter S corporation. -It can have only one class of stock issued and outstanding (either preferred stock or common stock). -It can have no more than 100 members. ---Husbands and wives count as one member, even if they own separate shares of stock. In some instances, family members count as one member. -All shareholders must agree to have the corporation formed as a sub chapter S corporation.
strict standards that a business must meet to qualify for status as a subchapter S corporation:
Ethics training programs
teach business ethics to help employees deal with ethical dilemmas and improve their overall ethical conduct. These can be provided by outside vendors or can be developed in-house.
Liquidity
the ability to sell a business or other asset quickly at a price that is close to its market value. (a company's ability to meet its short term obligations)
closely held corporation
the voting stock is held by a small number of individuals and is very thinly or infrequently traded.