Backup of Corporations

8/6/2019 Backup of Corporations

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FINANCIAL ACCOUNTING AND VALUATIONBasics

Analysis

Notes Assumptions built into GAAP

A. Business enterprise is viewed as an accounting unit separate and distinct from its

owners.

1. Regardless of whether or not the business enterprise has a separate legal existence

B. Business is a going concern and will continue in operation for the foreseeable future.

C. Firms are generally required to apply the same accounting concepts, standards, and

procedures from one period to the next.

D. Firms are supposed to disclose all material information

E. Firms are supposed to follow a conservatism principle that profits not be anticipated

and that probable losses be recognized as soon as possible.

F. Simply put, there are different ways to account for different items.

1. Choices people make regarding GAAP might be entirely legitimate without being

manipulative.

2. Example: If your company buys a building, you should list that building as an asset.

But how much should you record it as being worth? The amount you paid? What if you

got a really good deal and bought it at half of its true market value, should you then

record the market value of the building instead of its cost? How should you record

changes in the value of the building over time?

Three-Stage Process for producing Financial Statements for Public Companies

A. Recording and controls

1. Company records in its books information concerning every transaction in which it

is involved.

B. Auditing

1. Company, sometimes with the help of independent public accountants, verifies the

accuracy of the information it has recorded.

C. Accounting

1. Company classifies and analyzes the audited information and presents it in a set of

financial statements.

D. Problems in process

1. Can be manipulated at each stage


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2. Private companies do not always go through process

a. Expensive, time consuming, and not mandated by law.

Basic Categories of Financial Statements

A. Balance sheet

B. Income statement

C. Statement of cash flows

I. The Corporate Balance Sheet: snapshot of the business

A. The balance sheet is a picture of the business at a particular moment in time

B. The fundamental equation of financial accounting

1. The balance sheet is in balance total assets are equal to total liabilities plus total

equity.

Left Side of Equation Right Side of Equation

Equation: (Total) ASSETS = (Total) LIABILITIES + (Total) EQUITY

a. (Assets): property, both tangible and intangible, owned by the firm

b. (Liabilities): amounts that the firm owes to others, whether pursuant to written

evidence of indebtedness or otherwise.

c. (Equity): the accounting value of the interest of the firms owners; reflects the value

of the owners residual interest, assuming (which is almost never the case) that all assets

could be sold for their balance sheet values and that all liabilities will be paid in full.

i. Includes the value of the property (including money) the owners contribute when

they organize the firm.

ii. Since owners bear the risk of the firms operations, equity increases thereafter

whenever the firm earns a profit.

iii. Since owners bear the risk of the operation, equity decreases thereafter

whenever the firm incurs a loss.

iv. Equity also increases whenever the owners contribute additional property

(including money) to the firm and decreases whenever the owners withdraw property

(including money) from the firm.


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Equation Restated

Left Side = Right Side

(Where the Money Went) = (Where the Money Came From)(How money was spent or used) = (Money borrowed and owed to others) + (Stock issued and capital raised)

Assets = Liabilities + Equity

(all the property owned by the firm) = (amount the firm owes to others) + (owners residual interest (measured as

the owners initial contribution of property and capital + or - any p rofit or loss incurred, and + or - any additional

property or capital contributed to the f irm), assuming that all assets can be sold for their balance sheet values and that

all liabilities will be paid in full)

C. Cost principle: historic cost provides the best basis for recording a transaction, because

it can be determined objectively and is verifiable.

D. Managers/investors/creditors interested in two basic categories of information:

1. Data about a firms financial status at a given time,

a. Including data about the make up of its assets and its liabilities

i. E.g., how much cash does it have, how much merchandise? Due dates of

liabilities (must they be paid tomorrow or in five years?)

2. Information about the results of the firms operations over some period of time

a. Whether the decline in equity was due to a loss from operations or to other causes

II. Assets on the balance sheet

A. Listed in the balance sheet in the order of their liquidity

1. Cash

2. Assets the firm expects to convert to cash in the reasonably near future

3. Other assets, such as plant and equipment, that the firm uses in its business long-term

B. Current Assets

Includes cash and other assets which in the normal course of business will be converted

into cash in the reasonably near future, generally within one year of the date of the

balance sheet.

1. Cash: the money in the till and money in demand deposits in the bank

i. Demand deposit: a bank deposit that the depositor may withdraw at any time without

prior notice to the bank.


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2. Marketable securities: securities purchased with cash not needed for current

operations.

i. Many firms use their surplus cash to purchase very liquid securities such as

commercial paper and treasury bills, with a view to generating interest income.

ii. Some firms also purchase publicly traded debt and equity securities.

iii. Many small businesses, such as PT, keep their short term investments exclusively in

cash, and do not own marketable securities.

iv. The value of marketable securities must be reported at their fair market value,

rather than cost. mark to market

aa. This is because the vaule can readily be determined.

bb. Fluctuations in the value of marketable securities are recorded as income or loss

on the income statement.

cc. Where the market prices for instruments cannot be readily determined,

management is required to make a good faith estimate of the price.

3. Accounts receivable: amounts not yet collected from customers to whom goods have

been shipped or services delivered.

a. Must be adjusted by deducting an allowance (or reserve) for bad debts, reflecting

the fact that some customers will not pay their bills.

i. Usually computed on the basis of past experience.

ii. How long have the accounts been due?

iii. How quickly are they being paid?

b. Firms that subject goods subject to a right of return and record their sales net of an

allowance for returns face similar problems. (i.e. college bookstore)

i. I the people to whom they are selling or the products they are selling change

significantly, past experience may not be an accurate indicator of future results.

c. Whenever a firm increases its allowance for bad debts, it must record the increase as

a charge against income identified as a bad debt expense

d. Notes or loans receivable: somewhat analogous to accounts receivable and often

represent very large portion of the assets of firms engaged in financing businesses.

i. Relatively small percentage differences in such firms allowances for bad debts

often will have a major impact on their reported earnings.

4. Inventory: goods held for use in production or for sale to customers.

a. GAAP requires inventory to be valued at the lower of cost or market.

b. Value firm reports for inventory significantly affects balance sheet and income


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statement.

c. Cost of Goods Sold (COGS): items sold from inventory, often represents a firms

single largest expense.

d. Specific identification method: used by firms that hold a relatively small number of

identifiable items in inventory. This practice values each inventory item at cost, unlessits market is lower than cost, and compute COGS by adding up the actual cost of all

inventory items sold during the relevant period.

i. Each inventory item= the lower value of cost and market

ii. impractical for most firms, especially large ones

e. Alternative COGS method:

i. Add the firms purchases during a reporting period to the value of their inventory at

the start of the period (called the opening inventory)

ii. Subtract the value of their closing inventory at the end of an accounting period byconducting a physical count to determine the number of items present.

iii. Three ways to compute closing inventory:

aa. average cost method, which visualizes inventory as sold at random from a bin;

bb. First in, first out (FIFO) method, which visualizes inventory flowing in pipeline

cc. Last in, first out (LIFO) method, which visualizes inventory as being added to

and sold from the top of a stack.

5. Prepaid expenses:payments a firm has made in advance for services it will receive inthe coming year. (i.e., the value of ten months of a one-year insurance policy that a firm

purchased and paid for two months before the year ended).

a. Deferred charges: reflect payments made in the current period for goods or services

that will generate income in subsequent periods.

i. E.G., advertising to introduce a new product.

ii. Firms sometimes inflate their reported profits by recording as deferred charges

payments that should be charged against current income because they are unlikely to

produce future benefits.

C. Fixed Assets (or property, plant and equipment): the assets a firm uses to conduct its

operations (as opposed to assets it holds for sale).

1. When a firm acquires a fixed asset, it records the asset on its balance sheet at cost.

a. This means that the balance sheet value of the fixed asset remains constant over

time, set at the historic cost of the asset.


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2. Depreciation expense: because the firm uses fixed assets to generate revenue, the firm

must charge a portion of the fixed assets cost against the revenues received during the

period the fixed asset is in use.

a. Can be computed using any number of formulas.

b. Is reflected by regular and periodic charges against income over the useful life of theasset in question.

c. It reduces reported income even though it does not reflect any current outlay of cash

i. The cash was spent when the asset was acquired.

d.Allowance for depreciation or accumulated depreciation: all depreciation expenses

accrued with respect to a firms fixed assets must be added up and recorded, on the

asset side of the balance sheet, then subtracted from the cost of the firms fixed assets

Policy I. Perspective and most useful financial statements

A. Owner/manager

1. Most useful financial statements are those that come as close as possible to

presenting the objective truth about the firms financial status and the results of its

operations.

B. Lawyers

1. Adversarial proceedings produce financial information that often represents a

subjective and self-serving picture of the opposing partys financial situation.

2. Non-adversarial deal makers need to understand the business fully to add value to

the clients transactions.

II. Generally Accepted Accounting Principles

1. Often represent controversial judgments and policy preferences of a group of highly-

qualified accounting professionals.

2. Goal of GAAP conventions is to resolve potential policy choices as o the most

appropriate method of presenting financial information, given the frequent impossibilityof providing truly accurate and reliable information at reasonable cost.

III. There is no such thing as objective truth in accounting!!!

IV. People naturally will want to present financial information that suits their interests.

V. Managers often view GAAP not as a standard to be met, but as an obstacle to be


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overcome.

VI. The goal of financial statements is to convey information by constructing a plausible

story about the value and risks of a business.

A. However, financial statements alone rarely tell the whole story.

Ultimate Goal: Helping your client ask the right questions

Cases

Arguments Buyer considering acquisition of private company

A. Preliminary questions

1. Who prepared the financial statements?

2. What did the person preparing the statements do?

3. Did a third party review the financial statements that were prepared?

a. If financial statements have been audited, a signed audit opinion would

accompany the financial statements.

Business

Basics for

Law

students

I. Basic functions of Accounting

A. Keeping track of transactions as they occur

B. Reporting of results of operations on a periodic basis

C. Continuous process that permits transactions that are numerous, large, and complex to be

recorded on a routine basis.

II. Fundamental premises of balance sheet

1. Business is a distinct entity

2. All entries must be in terms of dollars

3. Balance sheet must balance

4. Every transaction that a business enters into must be recorded in at least two ways if the

balance sheet is to continue to balance

5. Balance sheet records a situation at one instant in time.

6. The bottom line of a balance sheet, is not itself a meaningful figure, because transactions

such as a bank loan that do not affect the real worth of the business to the owners may

increase or decrease the bottom line.

III. Accounting for Profits and losses

Income = revenue - expenses

A. Profit and loss items are reflected on the balance sheet as changes in the owners equity

B. Balance sheet is a snapshot

1. Static concept showing the status of a business at a particular instant in time


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C. Income statement is a motion picture

1. Describes the results of operations over some period of time: daily, monthly, quarterly, or

annually.

2. Serves as the bridge between the balance sheet at the beginning of the period and the

balance sheet at the end of the period.

a. This is true because positive income items (revenues) increase owners equity, while negative

income items (expenses) reduce owners equity.3. Most investors and creditors look first at the bottom line of the income statement when

evaluating financial statements, because the income statement reflects the operations of the

business.

D. Premises of profit and loss and accounting periods

1. Assumes the continuing existence and activity of the business enterprise

2. Each business must adopt a fiscal or accounting period and must report the results of

operations for that period as a separate accounting unit.

3. In determining the results of operations during an accounting period, some kind of logical

relationship must be created between the revenues and expenses that are taken into accountin determining profit or loss for that period.

a. Costs allocable to the creation of revenue should be matched with that revenue.

b. Other costs arising from the passage of time are allocated to the accounting period on the

basis of that time and not the time of receipt.

4. Some principles must be established as to when revenue is realized.

a. Usual rule is that revenues are realized when the business becomes unconditionally entitled

to their receipt, not when payment is received.

i. In the case of the contract for the sale of goods, for example, revenue may be realized when

the goods are shipped, not when the contract was formed or when payment was made.

ii. Property of the business that may have appreciated in market value does not give rise to

revenue until the gain in value is realized by sale or disposition of the property.

iii. This concept is known as accrual accounting, and most businesses follow it.

IV. Journal Entries: systematic recordation of every transactionA. Each transaction is recorded in a business journal to reflect both sides of the entry.

1. Businesses do not normally create a new balance sheet after each transaction

B. Debits and Credits

1. Debit means left hand side of equation

2. Credit means right hand side of equation

3. A debit journal entry increases left-hand items on the balance sheet and decreases right-


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hand items, while a credit journal entry reduces left-hand items and increases right-hand

items.

C. Income statement may be viewed as part of the right-hand side of the balance sheet, so

journal entries are also used to enter transactions involving the income statement.

1. Revenue items are credits

2. Expense items are debits

V. The balance sheet

A. Left-hand side: Assets categories

1. Current assets

2. Non-Current assets

B. Current assets

1. Consist of cash plus other assets that normally may be expected to be turned into cash

within a year (or, in a few cases, in a longer period constituting the businesss normal

operating cycle):

2. Cash:

Includes not only funds on deposit in checking accounts, but also cash equivalents.

Large sums of money are not normally left idle for event short periods of time. In most

publicly held companies, temporarily excess funds are conservatively invested short-term in

riskless securities that are usually not subject to swings in value. Such investments may

include Treasury Bills or notes, certificates of deposit, commercial paper, bankers

acceptances, and so-called money market accounts

3. Marketable Securities

Includes longer term investments. Businesses may have excess or idle cash available for

longer periods of time that may be temporarily invested in longer-term marketable

securities. The funds may be set aside for business purposes such as long-term capital

improvements or real eastate acquisition, or they may simply be excess cash that the

company does not want to distribute to shareholders in the form of dividends.

4. Accounts receivable

Amounts due from customers. Accounts receivable typically arise from the sale of goods

on credit. An allowance for bad debts (sometimes more elegantly referred to as an

allowance for doubtful accounts) is subtracted from accounts receivable. The amount of

this item is usually estimated based on the prior collection history of the business.

5. Inventories

Include several types of goods needed by the business in production of its end product:

raw materials, partially finished goods in process of manufacture, and finished goods ready

for shipment. The inventory of a retail operation may consist almost solely of finished

goods. There are several methods of reporting inventory, and the choice can be

controversial.


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C. Non-current Assets

Consist of all assets that are not classified as current and include a variety of quite

different items.

1. Fixed assets

are traditionally defined as property, plant, and equipment. Such items are usually

recorded at historical cost; plant and equipment is depreciated over its expected life.Hence, the negative item, accumulated depreciation, appears as an offset. This negative

item is the total of all prior deductions for depreciation in earlier years. The truck in the

simple illustration used earlier to describe basic bookkeeping techniques is an example of

depreciable equipment. Land is a fixed asset that is not depreciable.

2. Prepayments and Deferred Charges

are also sometimes described as pre-paid charges. Discussed below in connection with

the concept of accrual.

3. Intangible assets

Fall into various categories. Traditional intangible assets (those that are usually not

controversial from the standpoint of accounting principles) include patents, trademarks,

and franchises. These intangible assets are reported at acquisition or development cost.The presence of other intangible assets, particularlygoodwill, capitalized organizational

cost, or capitalized research and development costs on a balance sheet are a warning sign

for careful analysis. These assets may reflect only balancing entries for prior transactions.

For example, if a company buys a bundle of assets for more than the sum of their

individual fair market values, the excess may be entered as goodwill.

Whether or not the purchase was desirable, not much weight can be given to goodwill as

an asset. It is unclear on the face of the balance sheet what Goodwill $25,000 entry

represents; it is unlikely, however, that it is an asset in any realistic sense of the word.

4. Other Assets

May include a variety of interests (e.g., debts owed to the company that mature in more

than one year, minority interests in other businesses, and the like). Companies in

specialized fields may include additional asset items or different breakdowns of traditional

items.

D. Liabilities

In the accounting sense are obligations that probably will need to be paid in an amount

that can reasonably be estimated when the balance sheet is prepared. Material litigation or

claims that do not qualify as liabilities in this sense do not appear on the balance sheet

itself but should be referred to in the accompanying notes to the financial statements ascontingent liabilities.

E. Current Liabilities

Are those expected to be satisfied out of current assets, usually including all liabilitiesthat will become due in the coming year. Their relationship to current assets can be an

important one for evaluating the financial strength of the business. The most common

current liabilities are usually broken down and listed separately:

1. Accounts payable

Are amounts owed to suppliers based on deliveries of supplies and raw materials on

credit.


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2. Notes payable

Are amounts due to banks and other lenders in connection with loans that mature

during the following 12 months. The portion of a long-term loan payable in installments

that is due to be paid within 12 months is also included within notes payable.

3. Accrued Expenses Payable

Is a catchall for amounts owed to other creditors that do not fall within the categories ofaccounts or notes payable. It may include amounts owed to employees for wages and

salaries on the date of the balance sheet; interest on open accounts not reflected as

promissory notes; amounts owed to federal, state, or local governments for taxes; fees owed

to attorneys; insurance premiums; required pension plan contributions; and a variety of

other current liabilities. Because accountants are conservative and interested in matching

costs with revenues, accrued expenses payable may include items that are not yet

enforceable legal liabilities.

F. Long-term liabilities

Liabilities due more than one year from the date of the balance sheet. The most

common kinds of long-term liabilities are mortgages on real property or bonds and

debentures that the company issues in order to raise working capital. The debenturesshown in Table 6.2 are unsecured debt obligations of ABC carrying a 5 percent interest

rate and not due for repayment for nearly 30 years. The payment date is so far in the

future that such a debt should realistically be viewed as part of the permanent

capitalization of the company.

G. Stockholders Equity

The balancing factor between assets and liabilities on the balance sheet. In the case of

partnerships or proprietorships, this part of the balance sheet may be titled owners

equity, or simplycapital or capital contributed by partners. Stockholders equity consists

of basically two parts: (1) the permanent non-debt capitalization of the business, and (2)retained earnings. Retained earnings is the accumulated income of the business (less any

distributions to owners). It is also the item that ensures that the balance sheet usually

contains the following categories:

1. Preferred stock:

Usually a stock with a prior (but limited) claim to distributions ahead of the common

shares. Preferred stock also usually has a prior (but limited) claim on liquidation. In the

case of the example company, no information is given on the balance sheet as to thedividend preference or liquidation preferences of this preferred stock.

2. Common stock

Represents the residual ownership of the corporation. In many states, it is customary to

assign a par value to common (and preferred) stock. Par value is an arbitrary amount, a

relic of earlier corporation practices. When par value is used, the virtually universal

practice is to specify a very low par value and to issue shares for a price higher than parvalue. Nevertheless, par value stock is entered as permanent capital on the balance sheet at

is aggregate par value, an item that is sometimes called stated capital. The excess amounts

that investors paid over par value when the stock was issued is shown separately asadditional paid in capital (APIC).

3. Retained earnings:

The accumulated income that the company has booked from operations and other

sources. When a company makes a sale of an item of inventory at a profit and then either


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holds the cash or uses it to purchase more inventory, the inventory account will go up by

the amount of the profit. Retained earnings is the default account into which the

difference between the assets and the right-hand side of the equation goes in such a

situation. And when the business has a loss, retained earnings is reduced. Thus, retained

earnings is in a sense a fudge factor. But it is important that the fudge factor reflects the

ability of the business to make profits over time. Retained earnings is the connection

between the balance sheet and the income statement.

Formulas describing relationship between balance sheet and income statement

Beginning equity + income - dividends + stock issued - stock repurchased = ending equity

Beginning capital + stock issued - stock repurchased = ending capital

Beginning retained earnings + revenues - expenses - dividends = ending retained earnings

Most important concept embedded in these formulas is that the owners equity

reported on the balance sheet will increase and decrease during the year by

revenues and expenses (income statement items).

In other words, if we record transactions according to the impact they have on

assets, liabilities, and owners equity, the changes to owners equity during the

year (excluding changes due to stock transactions and dividends) will be the income

statement

VII. The Income Statement

Revenues - expenses = net income

Bottom LinesSales - cost of goods sold = gross margin

Gross margin - operating expenses (expenses not directly allocable to the goods sold) =

operating profit

Operating profit + other income = total income(e.g., income from dividends, interest, or rent not connected with the entitys principal business)

total income - less interest on long-term debentures = income before provision for

income tax

income before provision for income tax - income tax = net income for year before

extraordinary items

Net income for year before extraordinary items - extraordinary items(non-recurring

items) - applicable taxes = net income for Year

Net Sales:

Means gross sales minus returns. One of the expenses deducted as other

expenses from net sales is depreciation. This reflects the portion of the

original purchase price of each depreciable asset that is allocated to the

current year as the cost of gradually using up that asset, and should be

distinguished from the accumulated depreciation item on the balance


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sheet, which represents all prior deductions for depreciation of all

depreciable property in the asset account.

VII. Other Statements accompanying balance and income

A. Statement of changes in retained earnings

Retained earnings at beginning of period + income for period - dividends declared = retained

earnings at end of period

1. Reflects notion that earnings for the accounting period in question should be

reduced by dividends declared during the period in computing the increment to

retained earnings form the start of the period.

B. Statement of Cash Flows

1. Reclassification of items that appear in the balance sheet and income

statement.

2. Purpose is to show how a company acquired cash and what it did with it.

CHOICE OF ORGANIZATIONAL FORM

Basics

Analysis

Notes I. Factors influencing the choice of organizational form

A. Need for limited liability

B. Free transferability of interests

C. Continuity of existence

D. Centralized management

1. How do the different forms handle majority and minority interests in decision making?

E. Costs

F. Access to capital

1. How does the choice of form affect the firms ability to raise capital?

G. Taxation

1. What are the tax implications of the choice?


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II. Basic issues that must be resolved by each organizational form

A. When does the investment begin and end?

B. What is the return on the investment?

C. Who manages the investment?

D. How can investors get out?

E. What are investors responsibilities to others?

Policy

Cases

Suppose Bud and Rudy plan to open a flower shop. Bud will run the shop Rudy will

put in the money. Whatever organizational form Rudy and Bud choose will notsignificantly affect how they conduct the business of selling flowers. The structuredetermines their legal relationship, their financial rights, their responsibilities forbusiness debts, and their tax liability.

Sole Proprietorship

A single individual, Rudy, owns the business assets and is liable for any businessdebts; Bud would be her employee. (Or Bud could be the proprietor and Rudy couldlend him money.) Proprietorships usually are small, with modest capital needs that

can be met from the owners resources and from lenders.

General Partnership

Bud and Rudy arrange to carry on the business while agreeing to sharecontrol and profits, thus automatically creating a partnership. As partners, they areeach individually liable for partnership obligations. The general partnership (GP) isprevalent in service industries- such as law, accounting, and medicine - where trustmust exist among the participants and capital needs are not great. (All states haveadopted a version of the Uniform Partnership Act (UPA 1914) or the more recent

Revised Uniform Partnership Act (RUPA 1997); and in the last decade all states havealso adopted limited liability partnership (LLP) statutes.)

Corporation Finance Cases and Materials


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Beginning owners equity + net income - dividends declared + stock issued - stock

repurchased= ending owners equity

Beginning capital + stock issued - stock repurchased= ending capital

Beginning retained earnings + revenues - expenses - dividends = ending retained

earnings

Owners equity reported on the balance sheet will increase and decrease during the

year by revenues and expenses (income statement items).

Income = revenues - expenses

Business basics for law students fourth edition Robert Hamilton and Richard a

booth, chapter 6 accounting and financial reporting


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Limited Partnership

Bud and Rudy organizes a limited partnership (LP) in which so-called limitedpartners provode capital and are only liable to the extent of their investment.General partners run the business and are fully liable for partnership debts. Sincelimited partners need not be general partners, Bud could be the general partner andboth of them limited partners. LPs combine tax advantages and limited liability.(Many states have adopted the Uniform Limited Partnership Act (ULPA 1916) or theRevised Uniform Limited Partnership Act (RULPA 1985); many states have alsoadopted limited liability limited partnership (LLLP) statutes.)

Limited Liability Company

Bud and Rudy form a limited liability company (LLC) -- a hybrid entitybetween a corporation and a partnership. Like a GP, the members of the LLC providecapital and manage the business according to their agreement; their interestsgenerally are not freely transferable. Like a corporation, members are notpersonally liable for debts of the LLC entity. (All states have LLC statutes; a UniformLimited Liability Company Act (ULLCA) was approved in 1996, but few states haveadopted it.)

Corporation

Bud and Rudy form a legal entity called a corporation. Shareholders providecapital, and directors and officers manage the business. Corporate participants arenot personally liable for corporate debts; only the corporation is liable. Corporationare the principal means of organizing businesses with complex organizationalstructures and large capital needs. The corporate form, however, works for any sizebusiness, including a one-person incorporated proprietorship. ( All states havecorporation statutes, many based on the Model Business Corporation Act (1984);but some important states, notably Delaware, have their own idiosyncratic statutes.)

Joint Venture

Basically a general partnership with a defined, limited-term objective.

Business Trust (or Massachusetts trust)


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Involves the transfer of investors property for their benefit. The investorsbeneficial interests are freely transferable, and the beneficiaries generally are notliable for trust debts.

Professional Corporation (as well as a professional LLC or professional LLP)

Allows specified professionals such as doctors, lawyers, and accountants, tolimit their vicarious liability without running afoul of ethical rules that prohibitprofessionals from practicing in the traditional corporate form.


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TAX IMPLICATIONS OF ORGANIZATIONAL CHOICEScenario Partnership Corporation

(1) Business makes moneyand distributes it.

The partnership acts as a taxconduit. Its income flows

through to its partners, whomust pay tax. Thus, tax is paid

only once. The partnership filesan informational tax returndisclosing relevant financial

information.

The corporation is taxed on itsincome when earned. If the

corporation pays dividends to itsshareholders, the shareholders

must pay tax on the dividends--adouble tax.

(2) Business makes money,but retains it.

The partnerships income flowsthrough to the partners even ifretained in the business. But it

is taxed only once.

The corporation is taxed when itearns income. The tax on

shareholders is deferred until theincome is distributed or when

they sell their shares afterappreciation. Double tax is

unavoidable.

(3) Business loses money The partnerships losses flowthrough to the partners, whocan deduct them from other

income (or shelter theirincome). (There are some

limitations when the lossesarise for a partner who is not

active in the business--passivelosses.)

The corporation can deductordinary business losses onlyagainst income the business

generates. Sometimes, if there isinsufficient income in a year, thelosses can be carried forward or

back to other tax years.Shareholders can deduct lossesonly by selling their shares at a

loss and deducting capital losses.EXAMPLES

Case I (Low Income)

Bud and Rudys flower shop generates $150,000 in revenues and $110,000 in tax-deductibleexpenses during the first year, leaving $40,000 in taxable income. They share equally in after-taxearnings, the each are subject to tax rates for married individuals filing jointly, and they have noother income. (Assume the tax rates for 2002, disregarding the effect of exemptions and otherdeductions.)

Category Flow-through Entity CorporationTaxable income $40,000 $40,000

Entity tax None

Entity rate N/A 15%

Entity tax N/A $6,000

Amount for distribution $40,000 $34,000

Individual tax Flow-through Tax on dividends

Distribution to each owner $20,000 $17,000Individual rate $1,605 + 15% > $16,050 $1,605 + 15% > $12,000

Individual tax $2,198 $1,748

After-tax income $17,802 $15,252Total Tax(entity+individual) $4, 395 $9,495

Overall tax rates

Effective rate 11.0% 23.7%

Marginal rate 15.0% 27.8%


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D. Requirements for Subchapter S Corporation1. Must be a domestic corporation or LLC

2. There can only be one class of stock

3. No more than 100 individual shareholders, though certain tax-exempt entities

can be shareholders (i.e., employee stock ownership plans, pension plans, andcharities)

4. Shareholders must be U.S. citizens or residents (thus precluding nonresidentaliens or business entities)

E. If heavy losses are anticipated, the Subchapter S form may not be as desirable asan LLC or partnership.

1. S corporation shareholders can only write off losses up to amount of capital theyinvested (though the loss can be carried forward and recognized in future years).

Zeroing OutShareholder

Payments

Corporate tax in small, closely held C corporation can be zeroed out by paying

shareholders deductible compensation or interest. The effect is that tax is paid onlyat the shareholder level.

y Shareholder employees are paid salaries, bonuses, and contributions toprofit-sharing plans. Reasonable compensation is deductible by thecorporation from gross income in computing taxable income, whiledividends are not. If the compensation is not reasonable, i.e., not related tothe value of the services, the IRS can treat excess compensation asconstructive dividends and the corporation loses its deductions.

y Shareholder-lenders are paid deductible interest, rather than non-deductible dividends. The IRS will recharacterize debt as equity if itappears the contributions were at the risk of the business.


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BUSINESS ORGANIZATIONS (BASICS)

Organization

al form

Formation Financia

l

Manageme

nt

Voting Liquidit

y

Liability Tax Change

Partnerships

General

Partnership

(GP)

Association

*

Share

profits

Equal/agent Equal No Joint/several

*

Pass

throug

h

Unanimou

s

Limited

Liability

Partnerships

(LLP)

Association

* + filing*

Share

profits

Equal/agent Equal No Limited Pass

throug

h

Unanimou

s

Limited

Partnerships

Filing* Share

profits

Ltd-no

Genl-yes

Contract Ltd-yes

Genl-no

Ltd-limited

Genl-

joint/sev*

Pass

throug

h

majority

Corporations

C Corporation

Filing* Dividend

s

Board* Directors*

+

fundament

al

transaction

*

Yes Limited Entity* Majority*

S Corporation

Filing* Dividend

s

+salaries

Board Directors +

fundament

al

transaction

No

(agree)

Limited

(PCV*)

Pass

throug

h

majority

Limited Liability Company (LLC)

Member-

managed

Manager-

managed

*denotes a mandatory term

Backup of Corporations

Documents