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The Financial Position of the Investor




There are any number of subtle legal distinctions among these three types of business firms and any number of variants of them, but for our purposes the crucial difference among the three is that if an individual is one of the owners of a corporation that individual’s wealth (above what has been invested in the corporation) is not subject to claim by creditors of the corporation. If an individual is an owner or part-owner of the proprietorship or partnership, then any debts of the business firm become the individual’s debts. Any creditor of the partnership can sue any owner for full payment of the debt, leaving it to that owner to collect from his or her co-owners, if they have any assets themselves. It is clear that the corporate form of business has marked advantages over the partnership form in raising funds from perspective owners, simply because of the limits that are placed on the owner’s liability for debts of the corporation.

This accounts for which British corporations are identified, that is, by a “Limited “ or “Ltd.” after the corporate name, as in the British Steamship Lines, Ltd. Corporations have limited liability for their owners; as owner can lose only what he has invested in the firm, and no more. However the owner of a proprietorship or the co-owner of a partnership is legally liable for all of the debts of the business, and co-owners can lose substantially more than the investment made in the business itself. On the other hand, the status of a public company is shown by the letter’s “Plc” after its name. This is short for “public limited company”. In practice, however, the real difference between the two arises from the fact that limited ownership companies cannot raise money by selling shares, in contrast to public companies which can do so by issuing shares and bonds to be offered for sale on the Stock Exchange.  

It might appear that the limited liability property of the corporate form insures that every business will be organized as a corporation. Things are not quite so simple.

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Advantages and Disadvantages of Various Business Forms

The basic advantages and disadvantages of the corporate form versus the proprietorship or partnership can be summarized in terms of the following matters:

1. Ease of organization;

2. Ease of raising equity (ownership) capital;

3. Ease of raising debt capital;

4.  Tax status;

5. Life span of the business.

Ease of Organization

To form a partnership, one simply goes into business. With a partnership, articles of agreement as to partnership duties, responsibilities, and sharing of profits are usually signed in order to avoid future disagreements and lawsuits, but this is not legally required. In order to incorporate, articles of incorporation must be filed with a state government and applications made to states in which the corporation will do business. This requires legal assistance as well as various fees. It is considerably easier to begin business as a proprietorship or partnership than as a corporation.  

Ease of Raising Equity Capital

 Ease of raising equity capital is the major advantage of a corporation. It is much easier to persuade someone to invest in your business as a co-owner if that individual knows the most that can be lost is what has been invested rather than having all of the individual assets subject to claim for business debts, as occurs with proprietorship or partnership.

Ease of Raising Debt Capital

 Clearly the other side of the coin so far as raising investment funds is concerned is the problem of borrowing money, that is, raising debt capital. Lenders should be less willing to lend to a firm with limited liability for its owners (a corporation) than to one where the personal assets of the owners are subject to claim. Thus, everything else being equal, corporations find it harder to raise debt capital than, say, proprietorships.

Tax Status

Average and Marginal Income Tax Rates

An important distinction to keep in mind concerning the income tax is the distinction between the average income tax rate and the marginal income tax rate. The average income tax rate is equal to total income taxes due divided by income; and the marginal income tax rate is equal to the change in income taxes due divided by the corresponding change in income. Thus the average income tax rate tells us what fraction of income is paid out in income taxes while the marginal income tax rate tells us how much additional income tax must be paid if income goes up by $1. Ours is a progressive personal income tax structure, by which we mean that the average personal income tax rate rises with income and the marginal rate rises with income as well. Note that with the average tax rate increasing with income, the marginal tax rate is higher than the average tax rate.

Proprietorship Income

Income earned by a proprietorship is income of the owner so far as the Internal Revenue Service (IRS) is concerned.

Partnership Income

Similarly, income earned by a partnership is split among the partners according to the income sharing rules of the partnership and is then treated as personal income for each of the individual owners by the IRS. Thus any income earned by a proprietorship or partnership is subject to the usual income tax rates, ranging up to 70 percent for the highest income group.

Corporation Income

Income of corporation is treated quite differently. Income of a corporation is subject to a federal corporate income tax, and to state corporate income taxes as well. The federal income corporate tax rate was a flat 47 % of all profits in excess of $25, 000 dollars per year, with a lower rate for profits less than $ 25,000. Moreover, when the corporation pays out income to its owners (to shareholders) in the form of dividends, income received by any owner is then subject to the personal income tax (federal and state). Thus corporate income is subject to double taxation: income is first taxed at the corporate level of the individual owner at the time that the corporation pays out such income to the owners. Clearly, if all corporate income after corporate income taxes were paid out to its owners (shareholders), then there would be an important tax disadvantage to the corporate form of organization as a business.

However, as is often the case, things are not quite what they seem. In fact, corporations can have major tax advantages over the partnership or the proprietorship form, because of the capital- gains tax laws. The International Revenue Code treats capital gains differently from ordinary income. A capital gain is the profit that one makes by selling an asset at a price higher than the price at which the asset was bought - for example, buying a share of stock at $10 and selling it for $25 produces a capital gain of $15. Long-term capital gains (gains from the sale of assets held longer then 6 months) are taxed by the IRS at roughly 40 percent of the corresponding income tax rate. Thus if the last dollar of income to you bears a (marginal) personal income tax rate of 60 percent, your capital- gain tax rate would be roughly 24 percent. If corporations follow the practice of reinvesting profits after corporate income taxes they sell their stock instead. To illustrate, consider the following example.

Example: capital-gains taxes and income taxes

Suppose that a corporation earns $ 100,00 in profits before taxes and that the corporation is owned by a single individual who is in the 70 percent marginal personal income tax bracket. For simplicity, take the corporate income tax rate as a flat 46 percent of corporate profits. We consider three cases, first, the corporation pays out all of its income after corporate taxes to the owner in dividends. Second, the corporation reinvests its after-tax income, which results in an increase in the market value of the corporation. The owner sells his ownership interest after six months and pays capital gains tax on the increase in the value of his ownership interest. Third, we consider the tax effects if the firm were organized instead as a proprietorship.

(1) Corporation pays out after tax-income as dividends

Profits of corporation Corporate income tax (-46% of $100,000) Corporate income after tax Dividends Personal income tax (-70% of $ 54,000) Income of owner after tax $100,000 - 46,000     $ 54,000 $ 54,000 -37,000   $ 16,200

 

Taxes have eaten up $63,000 of the original $100,000 of income.                        

(2) Corporation reinvests after-tax income, owner sells out ownership interest and pays capital-gains tax

Profits of corporation Corporate income tax (-46% of $100,000) Corporate income after tax  Reinvested earnings (increase in value of owner’s interest) Capital-gains tax (-70% of $ 54,000) Income of owner after tax   $100,000 - 46,000     $ 54,000     $ 54,000 -14, 560   $ 39,440

 

Taxes are now $60, 560 of the original %100,000 of income.

(3) Business organized as a proprietorship

Profits of business Personal income taxes (-70% of $100,000) Income of owner after taxes $100,000 -70,000   $ 30,000

 

As a proprietorship, taxes are $70,000 of the original $100,000 of income.

In summary, the price-tax income of $100,000 turns into an after-tax income to the firms owner of $16,200 if the firm is organized as a corporation with all income after taxes paid to the owner as dividends;$39,440 if the firm is organized as a corporation, with all income reinvested in the firm, the stock rising in value by the amount of reinvestment, and the owner paying capital-gains tax when selling out this increase in value; and $30,000 if the firm is organized as a proprietorship. Hence double taxation of income can be more than avoided, if the corporation reinvests its earnings, in such a case, there are tax advantages to organizing as a corporation rather than as a proprietorship or partnership.

Life Span of the Business

For the proprietorship, the firm has a lifetime that ends when the owner decides to disband the firm or dies. For the partnership, the firm ends as soon as any partner either dies or decides to leave the business. In contrast, the law treats the corporation as a legal person with a lifetime independent of the lives of its owners. Stockholders may sell their shares or may die while holding shares, but this has no effect on the life of the corporation. The corporation continues its existence until the owners decide to liquidate, or until the courts force liquidation of the firm. Clearly, this has important advantages when there are a number of persons who are co-owners of a business. If the business were organized as a partnership, there would be the expenses and inconveniences of rewriting the articles of partnership whenever an individual decides to leave the firm; these expenses are avoided in the case of the corporation.

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