1. CHOOSING YOUR FORM OF BUSINESS AND FINANCING

In organizing your business enterprise, you should consider all of the legal forms for operation that are available to you.

The ones most generally used are the sole proprietorship, partnership, corporation and, of late, the form of business which allows a corporation to elect to have its stockholders taxed directly. Variations of these forms include limited partnerships, joint stock companies, joint ventures, syndicates and trusts. This book, however, will discuss only the three basic forms of organization and the new stockholder's election provision.

SOLE PROPRIETORSHIP

The simplest form of business organization is the sole proprietorship. Choosing this form makes you and you alone the boss. You do not share profits with others. This is the form giving you the greatest freedom of action. You are not bound by restrictions of corporate charter, or partnership agreement. Read the following list of advantages of this form of operation. Apply your own factual circumstances to this list and see if this is the proper form for your contemplated enterprise.

ADVANTAGES OF OPERATING AS A SOLE ROPRIETOR

Minimum legal organization requirements.

It affords the greatest amount of privacy—one person is sole owner.

It gives greatest personal contact with customers, employees, etc.

It permits relative freedom from government control.

No income tax levy on business (but on owner only).

It often has very real social security and income tax advantages.

But this form of operation does have disadvantages. Read the following list and again check whether this form of operation is correct for you.

DISADVANTAGES OF OPERATING AS A SOLE PROPRIETOR

Unlimited personal liability for your business debts.

Death or disability of the proprietor means termination of the business. Natural limitations of the ability and energy of a single individual restrict the size and growth of the enterprise. Your personal life, domestic or economic, affects the durability and stability of your organization. Your credit line is limited to your personal credit standing.

Now that you have read the above lists and matched them with your personal circumstances, you should have some idea of whether the sole proprietorship form is suitable for your enterprise. Assuming that you have decided in favor of this form of operation, continue reading this chapter. If for some reason you have decided against this form of operation, skip the rest of this section and continue on to page 17.

Financing. Your business needs capital for two main purposes— to acquire fixed assets and for working capital. The latter is the operating capital you use for salaries and wages, for purchasing supplies and inventory, and for extending credit to your customers. If at this time you do not have a good idea of what your capital requirements will be, address your specific inquiries to The Small Business Administration in Washington, D. C. The SBA has a great volume of statistics available on business financing requirements for enterprises similar to your own and they will be glad to furnish these to you.

Your first source of capital is, of course, your personal funds that you have set aside for your projected investment. But you may find you are in immediate need of more capital in order to purchase your fixed assets or to commence your operations.

You may borrow money on a debt basis from many varied sources. You may borrow from a relative or personal friend and give him a note. You can approach your local bank, speak to the loan officer and determine what type of bank loan is available to you. You may apply to small-loan companies as a source of capital. Many governmental agencies exist for the purpose of aiding the small businessman at the commencement of his operations or at times of stress. In addition, you can make inquiries to the following as a source of loans: factoring companies, commercial credit companies, sales finance companies, insurance companies, equipment manufacturers, wholesalers and suppliers, corporations seeking affiliates, branches, or outlets and community industrial development groups.

Whatever your source of borrowed money, it is important that your requirements are satisfied at the least possible cost to you. This necessitates "shopping" for your borrowed money.

To give specific figures on what you should pay for loans is difficult. The charges vary tremendously (all the way from 1% a year for commercial paper houses, which make loans solely to large corporations, to 42% a year for some small-loan companies). In comparing prices, always reduce each to a percent per year effective interest rate on the average amount of the loan. This will avoid the pitfall of the many different ways in which companies quote their interest rates. Also, be wary of excessive investigation charges, service charges, minimum deposit requirements and collection charges on delinquent accounts. These are all part of your cost of borrowing money.

If you borrow directly from a relative or friend and he requires a note, mortgage or any other type of security, be sure to consult with your attorney before signing any such instrument. Assuming the best of intentions on the part of such lender, your entire future credit standing may be affected by your having given him an excessive amount of security, i.e., tieing up your assets.

Bank Loans—Mortgages. A bank is a highly recommended source for borrowing money. If in the past you have maintained good banking relations, you will experience no difficulty in obtaining reasonable loans. If you are locating in a new area be sure to establish a personal contact with your local bank as soonas possible. You will usually find your banker eager and able to offer you sage business advice, of course in the hope of securing your bank business.

What kind of loans can you make? A sole proprietor will often make a "character loan''' A character loan is actually an unsecured loan made without collateral and based upon your general integrity, business standing, management ability and earning capacity.

Closely associated with this type of loan is the "line of credit." This is an advance commitment by your banker to lend you money up to a certain maximum. The line of credit is on a revolving basis so that you can have more than one loan out at a given time as long as you keep within the agreed-upon maximum. This will also save you in interest cost in comparison with a similar loan equal to the maximum sum required at any one time.

You may be able to make a "term loan" This is a loan repayable according to an agreement between a lender and borrower over a period of more than one year. One advantage of this loan is that your repayment schedule can be scaled to fit your earning power.

You may also make loans secured by the pledge of accounts or notes receivable. Such loans may either be made on a notification or a non-notification basis. On the notification basis, the bank tells those who owe you money that it is lending it to you on the security of your accounts receivables, and the bank also undertakes to secure payment directly from them.

On the non-notification basis, the bank does not inform your debtors about the loan. They remit to you in the usual way and you pay back the loan to the bank. The charges on this type of loan are usually higher on account of the greater risk to the bank.

Your bank may also be willing to negotiate a loan with you on the security of a bill of lading for your inventory located in warehouses.

For the purchase of heavy equipment, you may be able to get an equipment loan from the bank using installment notes receivable as collateral, or you can discount these notes with a bank or finance company. You may also get an equipment loan by giving a mortgage on personal property as the form of security.

Finally, in your consideration of banks as a source of funds, you may be able to obtain loans by pledging the cash value of your life insurance policy or of any stocks or bonds that you may own. You may also receive a loan on the strength of an endorsement made by a co-signer, surety or guarantor acceptable to the bank.

Loan Companies. Small-loan companies operate under state regulations and licenses, and are also known as personal finance companies or consumer finance companies. In many states the maximum amount of any one loan is limited by local law. It also is important to remember that the rate of charge for small loans is necessarily higher than for large business loans. It is, of course, advisable that you secure the advice of an attorney before commiting yourself on any loan documents.

Governmental Assistance—FHA; SB A, etc. The Small Business Administration is authorized by Congress "to purchase the obligations of and to make loans to any business enterprise." It provides a lending hand where the necessary financial assistance is not otherwise available on reasonable terms.

The SBA may make loans to business enterprises directly or in cooperation with banks or other lending institutions. You should exhaust your other usual means of obtaining credit before making application to the SBA. This is because, as a matter of policy, the SBA emphasizes "participation" loans in which the agency assumes a part of the loan made by a private lending institution.

Factoring. Factors specialize in buying outright accounts receivable. The factoring company is available for advice as to what trade credit you should extend. Here is how a factor works: he advances funds on a short-term basis, usually expecting to convert the purchased receivables into cash within 30 to 50 days. Factors charge interest and usually a fee or commission. Interest varies between five and six percent. The commission may be as much as two percent of the sales cashed. Be alert to the high cost involved in factoring. For example, if you pay a two percent commission each month the effective commission is 24 percent for the year. Weigh this consideration against the credit and collection services offered by factoring.

Establishing a Credit Line. You will find as you venture into the business world that your most important asset is your credit. You should work and work hard to establish a sound credit standing. Here are some points as to what you can do to improve your credit position:

Make a personal contact with a credit officer of your local bank.

Open a business regular checking account.

It is only on the basis of the activity of a regular checking account that a bank will give credit information to your suppliers, customers, etc. Special checking accounts and savings accounts while important in their own right do not furnish you with a credit standing.

It might be advisable to make frequent small loans even when you don't need them—and repay them on or before the due date. Do this with reasonable discretion so as not to incur heavy interest costs. You will find that over a period of years you will have gained a fine reputation for reliability with the lending institution. In addition, all interest charges that you pay on business or personal loans are tax deductible.

Be careful how you use equity and mortgage financing. To secure a bank loan when a good part of your assets are tied up under long-term mortgages or liens is extremely difficult, regardless of how favorable your financial statements look.

Pay your bills on time. Credit agencies and lending institutions have access to much information concerning your daily business operation. Falling behind in your bill payments and being involved in collection actions do not enhance your credit standing.

Carry adequate insurance protection. Before someone makes a loan to you on the strength of your fixed assets as collateral, the lender would be interested in knowing that his collateral would be protected, and that he would be repaid in case of disaster.

How a Sole Proprietorship is Taxed. A sole proprietor's business operations are considered an integral part of the owner's activities. The tax law does not treat a proprietorship as a separate taxpayer or even as a separate tax reporting unit. The income of a proprietorship is included as part of all the income earned by theproprietor. But although the proprietorship is neither a separate tax-paying nor tax-reporting unit, the proprietor's business income is figured separately from his other income. Business income is reported on a separate schedule, called Schedule C, that accompanies the individual tax return, Form 1040. The resulting net profit (or loss) is then added (or subtracted from as the case may be) the proprietor's other income.

When a sole proprietor's business losses exceed his other income, he can carry back the loss as a net operating loss deduction against income of three prior years. If the loss is not eliminated by the income of the prior years, then the remaining loss can be carried forward as deduction against income of five later years. A loss applied to previous years gives a refund of back taxes. A loss applied to later years reduces taxes for those years.

Example: In 1961 a sole proprietor suffers a business loss of $65,000. His nonbusiness income is $5,000. He now has a net operating loss of $60,000 which he can deduct from the income of the following years:

PERSONAL TAX

YEAR	INCOME	DEDUCTION	TAX RESULT

1958	$10,000	$10,000	Tax refund
1959	7,500	7,500	Tax refund
1960	8,500	8,500	Tax refund
1962	5,000	5,000	No tax due
1963	6,000	6,000	No tax due
1964	8,000	8,000	No tax due
1965	10,000	10,000	No tax due
1966	12,500	12,500	Tax reduction

PARTNERSHIP

An acceptable definition of a partnership is an agreement between two or more persons to carry on a business for a purpose and for profit. Read through the following lists containing the advantages and disadvantages of this form of business enterprise. Check these lists against your own factual circumstances in order to determine whether this form of operation is best for you.

Two or more persons are co-owners. This in itself can broaden your scope of operations as compared with a sole proprietorship. You are not limited by the maximum ability and energy of a single individual which would restrict the size and growth of your enterprise.

Credit may be obtained by reliance upon the credit standing of two or more people. This should increase your ability to obtain needed capital.

Ease of formation. The partnership has no charter limitation; rather, the limitation is self-imposed by agreement among the partners.

The partnership form is relatively free from government control.

There is no income tax lavy on the partnership, only upon the individual partners.

DISADVANTAGES OF THE PARTNERSHIP FORM

Each partner has unlimited liability for the debts of the partnership.

Each partner can bind the partnership and the individual partners when acting within the scope of business. (Note: a partner can obtain insurance against this type of liability.)

The partnership automatically terminates upon the death, withdrawal, bankruptcy or legal declaration of insanity of any one partner.

There can be great difficulties in removing a partner from a partnership.

There is the possibility of lack of unanimity among the partners and resulting serious complications if a deadlock should occur.

The partnership interest is not readily marketable. This is due to the fact that the characteristic of a partner is a personal relationship to the partnership.

Some of the disadvantages of a partnership form may be overcome by the hybrid form of operation known as the limited partnership. It has the advantage of limiting the liability of those who do not wish to be general partners to the cash investment made by each. Creditors must be notified of the limited liabilityset out in the partnership articles. Consult with your attorney before entering into a partnership or a limited partnership agreement.

Remember: in the absence of specific written agreement between partners, the law defines the rights and obligations between them. Your partnership agreement (in writing, of course) should include at least the following:

The kind of business to be conducted.

The amount to be invested by each partner.

Precise mention of the division of profits and losses.

The powers and duties of each partner.

The compensation, if any, to be paid to each partner.

The partners' drawings.

Division of assets and other matters in case of dissolution.

Duration of the partnership, and the manner in which it is to be dissolved.

The withdrawal of partners and the admission of new partners. The manner in which differences of opinion are to be settled - you might provide for formal arbitration. Finally, anything else of importance around which some future dispute may center.
Remember: do not consent to habitual violations of any part of your partnership agreement unless you want to lose those rights permanently.

Be exceedingly careful in the choice of your partners. Their power to obligate the partnership is exceedingly broad. Your partners' acts may cause you to lose not only your investment, but your private property as well.

As a partner, you must observe three cardinal rules in your relations with your other partners:

Do not engage in any competing business without their consent.
Do not use the partnership business or property for your own profit or advantage.
Follow THE GOLDEN RULE—Do unto others as you would like them to do unto you.

Remember also that your rights as an individual partner are dictated by law and do not include these rights:

To do anything that would make it impossible to carry on business, e.g., disposing of the chief partnership asset.

To dispose of the partnership's good will.

To make an assignment for the benefit of creditors.

To confess a judgment against the partnership.

Taxation. The partnership as such does not pay a tax. It merely files an annual information return with the Treasury. This tells the Treasury the proportionate share of losses or profits earned by each partner. The partnership computes its net income (even though it pays no tax) in a manner similar to an individual.

Partnerships are not entitled to a personal exemption, credits for dependents or the standard deduction given individuals. But partners are allowed all of these in making their own returns.

A partner's proportionate share of the partnership profits or losses is part of his gross income. He reports the income even though, in fact, it has not yet been distributed. The partner reports his partnership income even though he is on a cash basis while the partnership is on an accrual basis, or vice versa.

A partnership's tax year may be different from that of the partner. Then the partner includes in his own tax year his share of the partnership income for the partnership tax year which ends in his tax year. For example, one partner has a tax year ending December 31. The partnership year ends June 30. The partner includes in his December 31 tax return the partnership earnings for the period ending June 30.

It is important to note that certain partnerships may be taxed as if they were corporations. Depending upon the circumstances, this may either be advantageous or disadvantageous, so consult your tax advisor.

Financing. The problems of financing the partnership entity are quite similar to those of the sole proprietorship. (See pages 12 to 17.) Of course, your credit standing is enhanced by the fact that there are more people in the enterprise upon whom creditors can rely.

CORPORATION

The corporation is a separate legal entity and possesses many characteristics which render it extremely advantageous as a legal form of business:

ADVANTAGES OF THE CORPORATE FORM

Limited financial liability for stockholders. A stockholder's liability is limited to the ount of his stock investment in the corporation.

Continuity of the corporation is unaffected by death or transfer of stock shares by any or all stockholders.
Ease in financing. The corporate form makes it easier to obtain capital by means of either debt or equity financing.

Transferability of ownership can more readily be accomplished with the corporate form as opposed to any other. A shareholder need only sign over his stock certificates to another individual to accomplish this transfer.

DISADVANTAGES OF THE CORPORATE FORM

More governmental control than any other business form.

More taxation requirements than any other business form, e.g., filing fees, excess profits tax, excise taxes, etc.

Income tax levied upon corporate profits and, in addition, upon other property when passed as dividends to stockholders.

Difficulty of expansion into other states. A corporation is often severely burdened by formal legal requirements of registration and taxation for doing business in states in addition to its state of incorporation.

Your corporate charter must be a carefully drafted document. The corporation is strictly limited in the exercise of its powers to those stated in its charter. Consult with your attorney upon incorporating. Draft a charter with the broadest possible corporate powers even going beyond those powers you might reasonably anticipate your corporation will need currently.

If you are to be a director of your company, remember you are acting in the capacity of a fiduciary. That means your actions are strictly governed by the corporate charter and by-laws of the corporation. If you wish to deviate from these in any way take care to see that they are amended. In your fiduciary capacity you should, above all, be certain not to use your position to obtain any unfair advantages or to make secret profits or commissions out of any business transaction engaged in by your corporation.

You should not unlawfully borrow money from the corporation or authorize loans to other directors, officers or stockholders.

Be sure that corporate dividends are paid only out of profits and that the capital structure of the corporation is not impaired.

Suppose you have a disagreement with the action taken by the majority of directors. You must explicitly note your dissent upon the minutes of the corporate records. Otherwise you will be liable along with the other directors for any action taken.

Financing—Use of Debt and Equity Financing. A corporation can raise capital through the use of debt financing (bonds) or equity financing (stocks). Sometimes debt financing is preferable. A corporation is allowed a deduction for interest paid on bonds. But there is no deduction for dividends declared on stock. The corporation can also usually pay off the bonds without any tax liability to the corporation or the bondholders. But if you redeem stock without changing the relative interest of shareholders, your payments might be taxed as dividend distributions. This same theory does not apply to bond redemptions.

Corporate financing is a complex problem. Advice should be obtained from attorneys, accountants and bankers. The problem is especially obvious because of the many diverse ways to finance. There are over a dozen major different types of stock a corporation can issue. Each type, in turn, is subject to variation.

Taxation. A corporation income tax is payable each taxable year on the taxable income of every corporation. The tax consists of a normal tax and a surtax. The normal tax is 30% of taxable income. The surtax is 22% on the amount of taxable income that exceeds $25,000.

Corporate taxation is complex. Competent legal and accounting advice must be obtained. However, the prospective incor-porator should be aware of certain pitfalls relating to corporate taxation.

For example, in operating a family corporation, beware of becoming a personal holding company. The evil associated withthis classification is the arbitrary high surtax rate (75% to 85% ). Your motives and intentions are immaterial, once you fall within this classification. Be sure to obtain legal advice if you are contemplating incorporation in a family situation.

An additional warning to you as a prospective incorporator is the tax on accumulated earnings. This special tax is imposed on corporations when surplus is accumulated for the purpose of helping stockholders avoid the payment of a tax on dividends. The penalty tax is intended by the government to force a distribution of corporate earnings.

STOCKHOLDER ELECTION TO REPORT CORPORATE INCOME

You can now have all the legal advantages of a corporation and avoid corporate tax reporting. The election can be used as long as it reduces taxes—for as little as one year—or indefinitely. How the election works. You, as a stockholder, agree to report on your personal tax return as dividends your share of the corporation's taxable income. However, you cannot reduce this type of dividend income by the dividend exclusion, the dividend credit or the retirement income credit. But you can report your share of corporate capital gains on your Schedule D as capital gains. You can also use your share of corporate operating losses to reduce your other personal income. If the loss exceeds your income, you can use the excess as a net operating loss carryover to other years as if you were a sole proprietor or partner. But you cannot carry back to years before 1958. Nor can you deduct capital losses incurred by the company.

In addition to reporting your share of company income or loss, you also adjust your cost or basis for the stock. You increase yur basis by the corporation's income you report, whether or not distributed to you. However, when this income is distributed, you reduce your basis.

You also reduce basis by company losses you report. If these reduce your basis to zero, further losses are used to decrease any debts the corporation owes you. When the cost basis of your stock and debts has been eliminated, you cannot deduct any further corporate losses on your return. These are completely wasted unless you make a further investment in your company.

The corporation files an information return instead of itsregular corporate return. It does not have to pay any tax for the years the election is in force.

Who can make the election? If your company meets the following tests you can make the election:

Stock test. Your company is a domestic corporation which is not a member of an affiliated group and has

No more than 10 stockholders, all of whom must agree to the election. Where stock is held jointly, you must commit the joint owners as one stockholder.
Stockholders which are either individuals or estates.
No non-resident alien stockholders.
One class of stock. You cannot make the election if your company has common and preferred stock outstand ing. As long as only common is outstanding, you can take advantage of the election. But you lose the election when you issue preferred.

Income test. You cannot make an election in a company which has gross annual receipts of more than (1) 20 percent from rents, royalties, dividends, interest, annuities, and sales or exchanges of securities. This test bars the election to most corporations earning substantial rental income. Or (2) 80 percent from sources outside of the United States. Watch for these two income tests even if you qualify for the election. Your election is automatically terminated if your company's receipts ever come within the above two tests.

How to make the election. You make an election by filing Form 2553 with the district director of the district in which the corporation files its tax return. You also attach o Form 2553 statements from all of the stockholders consenting to the election.

Make sure the form is filed on or before the end of the first calendar month of the taxable year you want the election to be effective.

Example: Your corporation reports on a calendar year. You want the election to be effective in 1962. File Form 2553 and the statements of the stockholders' consents on or before January 31, 1962. The earliest you can file these papers is the month before the first calendar month. Here, this is December, 1961.

When a new stockholder enters the company, also make sure that he quickly consents to the election. If he doesn't, the election will automatically terminate. Here are the rules: If an election has been made before the first day of the corporation's taxable year, a new shareholder entering the corporation on or before this first day must file his consent not later than the last day of the first calendar month.

Example: On December 18, 1961, you elect to report corporate income for 1962. On December 28, 1961, you sell part of your stock to your son. He must consent to the election by January 31, 1962. If he doesn't, your election is not effective.

If the new stockholder enters the corporation after the first day of the taxable year for which an election is effective, his consent must be filed within a 30-day period beginning on the date he became a stockholder.

Example: Same facts as above except you sell your son stock on January 18, 1962. He must file a consent by February 16, 1962. A late filing loses you the election.

To ensure the election, it may be advisable to provide a restrictive clause or agreement which would require new stockholders to consent to the election. The restriction might also be made part of the corporation's charter.

How the election is lost. The election does not have to be renewed each year. But it can be revoked or automatically termi nated under any one of these conditions:

All stockholders agree to revoke the election by filing a statement of revocation. If made before the close of the first month of the corporation's taxable year, the revocation is effective for that year. If made after that date, the revocation is not effective until the year following the year in which the revocation was filed.

Example: You only want the advantage of the election in 1961 and you want to return in 1962 to regular corporation reporting so you must file a revocation by January 31, 1962. A later filing will not be effective until 1963.
A new stockholder enters the corporation and does not consent to the election.
The company no longer meets the stock or income tests explained above; for example, the company receives more than 20 percent of its gross receipts from dividends or rents.

When the election is revoked or terminated, you cannot make another election until the fifth year following the year in which the election was revoked or terminated. That is, you have to wait at least four years for a second chance at an election.

However, you might get it sooner with Treasury permission.

ADVANTAGES AND DISADVANTAGES OF STOCKHOLDER REPORTING OF CORPORATE INCOME

Tax sheltered fringe benefits. Owners of unincorporated businesses do not benefit from tax sheltered fringe benefits available to stockholder executives. Now such owners can incorporate to benefit from qualified pension plans, sick pay exclusions, accident and health insurance, and still retain the tax advantages of unincorporated operation. Your company can buy you an accident and health insurance policy and deduct premium payments. A sole proprietorship or partnership cannot deduct premium payments covering its owners except for reimbursement of overhead. A corporation can also pay your medical expenses without creating taxed income for you.

Better timing of income distribution. If an electing corporation operates on a taxable year differing from that of its stockholders, it can time its distributions to cover two tax years.

Example: An electing corporation operates on a fiscal year ending January 31. Its five stockholders report income on a calendar year basis. By December 31, 1959, the electing corporation has earned $60,000. If it didn't distribute any of the $60,000, the entire amount would be taxable to the stockholders in 1960. The stockholders prefer to have the $60,000 spread over two of their tax years rather than have it all in 1960.

They accomplish this by paying a dividend of $30,000 on December 31, 1959. Thus, they have $30,000 taxable income from the electing corporation in 1959 and $30,000 in 1960when the corporate year ends. Undistributed corporate income on January 31, 1959, when the corporate year terminates, amounts to only $30,000 because of the previous distribution of $30,000.

Company business losses can be used to offset large personal business income.

Large nonrecurring capital gain can be passed to stockholders without double tax—that is, once to the corporation and again when the gain is distributed to stockholders in the form of dividends. This advantage also can facilitate liquidation of a company without having to meet more technical rules of liquidation to avoid the double tax.

Starting a new corporation with a fiscal year to postpone payment of taxes for a year. For example, you start your company with a fiscal year beginning February 1, 1960. You pick up income at the end of its year, January 31, 1961. Thus you do not have to report corporate income earned in 1960 until the due date of your personal 1961 tax return (April 15, 1962).

Increased charitable contribution deduction. By combining corporate giving with your own, you can increase your maximum yearly charitable giving.

Example: Jones, sole proprietor, has a business income of $50,000. He gives $17,000 to his church. But he can only deduct $15,000 because of the 30% limitation (30% of $50,000, or $15,000).

If Jones incorporates and elects to report corporate income, he and his corporation can deduct up to $16,750. His company gives up to 5% of $50,000, or $2,500; he can personally give up to 30% of $47,500, or $14,250. By coordinating his and his company's contributions, he gets an overall deduction.

1. CHOOSING YOUR FORM OF BUSINESS AND FINANCING

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