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Business Associations/Corporations
University of San Diego School of Law
Wonnell, Christopher T.

1. Introduction
– Valuation of a Business
i. Net Asset Value Method – look to balance sheet (aka accounting statement) “snapshot”
1. Assets – Liabilities = Net Worth (aka Equity)
a. Assets
i. determine according to GAAP
1.lower of a) cost after depreciation or b) mkt value
a. so if mkt value is higher, so replacing equip would be higher than cost after depreciation, need to adjust GAAP values to current mkt values
i. adjusting upward for unrealized appreciation – would make clear the higher asking price for biz
ii. cash, inventory, fixed assets (building, equipment), intangibles (patent), “blue sky”(goodwill)
b. Buying a Business – should insert a warranty into deed that values are in accord with GAAP
ii. “Capitalizations of Earnings” Method – look to income statement “motion picture” – based on earning power
1. Step 1 – determine amount of earnings – what is the business capable of making?
a. Net returns each year = $16,000
b. CAUTION – don’t forget to take into account business owner’s salary. (e.g. if owner took $12,000 salary, net earnings are $4,000 = 16,000-12,000)
2. Step 2 – determine rate of return on the investment
a. net returns/purchase price (e.g. $4,000/$20,000 = 20%)
iii. Comparison Ratios – should one buy the business?
1. A higher risk should be taken only if there is a corresponding high rate of return
2. Current Ratio
a. Current Assets (cash on hand) : Current Liabilities (money owing due within next year)
b. This needs to be at least 1:1
i.if assets are less than liabilities (i.e., 1:2), then bad
3. Debt to Equity Ratio
– Choice of Business Forms
i. Considerations
1. The Five Fingers
a. Limited Liability
b. Duration/Continuity of Interest
c. Transferability
d. Centralized Management (less important in modern application)
e. Cost and Anonymity (less important in modern application)
ii. Business Forms
1. Proprietorship
a. Formation – No filing
b. Duration – at will of sole proprietor
c. Liability – Proprietor has unlimited liability
d. Simplicity – Yes
e. Management – Sole proprietor has full control
f. Taxation – not a taxable entity, sole proprietor pays income tax & takes bus. exp. deducts
g. Cost of Formation – none
h. Raising Equity Capital – Only when proprietor invests money into it
i. Transferability of interest – no.
2. General Partnership (GP)
a. Formation – no filing req’d. Default business form. At least two partners
b. Duration – Dissolved with partner’s death or withdrawal (unless otherwise agreed)
i. if multiple partners, remaining can continue partnership minus dead or w/drawn partner
1. liabilities cease once w/drawn
c. Liability – Partners have unlimited personal liability
i. Uniform Partnership Act – each partner incurs liability for partnership as long as acting within scope of apparent authority (third person believed through partner’s conduct that the partner had the authority to act on behalf of the partnership)
d. Simplicity – yes
e. Management – Each partner has equal voice, regardless of unequal contributions (unless otherwise agreed)
f. Taxation – Not a taxable entity. Income/Loss passed through to partners equitably – ind returns and rates
g. Cost of Formation – none
h. Rasing equity capital – contributions of partners or addition of new partners
i. Transferability – No.
j. No 5 finger attributes
3. Limited Liability Partnership (LLP)
a. Formation – File registration with State designated official. (In CA, LLP registration available only to architects, attorneys, accountants)
i.not available in all states
b. Liability – each partner’s liability is limited to their interests in the partnership. Personal liability does not exceed the firm’s assets. No joint and several liability
i. only 5-finger attribute – limited liability
4. Traditional Limited Partnership (LP)
a. Formation – file a registration with designated state official. 2 or more partners, at least one general partner
b. Duration – Dissolved with partner’s death or withdrawal (unless otherwise agreed) – same as LLP
c. Liability – General Partner has unlimited personal liability. Limited Partner’s liability limited to the extent of their interest in the partnership
i. Under the ULPA 303 situations that cause limited partner to have general partner liability
1. if limited partner takes part in controlling the business; or
2. if through the actions of a limited partner, a third party reasonably believes the partner is a general partner
d. Simplicity – yes
e. Management – General Partners manage, limited partners are passive
f. Taxation – Not a taxable entity. Income/Losses flow through to partners equitably – ind returns and rates
g. Cost of Formation – filing fee
h. Raising Equity Capital – Contribution from partners or adding new partners
i. Transferability of interest – no
5. Limited Liability Limited Partnership
a. recognized in fewer than half the states (and not in CA)
b. Register with state official
c. Liability – general partners have limited liability
6. Limited Liability Companies
a. Formation – Filing with state official. One or more members
i. Limitations – in CA, business does not qualify if req’d to license under business and professional code
ii.formed under statutory steps
b. Duration – Sometimes limited by state law
c. Liability – Liability of members only to the extent of their investment in the company (except in cases where alter ego applies aka piercing the corporate veil) liability to debts and obligations of LLC
d. Simplicity – more formal than a sole proprietorship and less than a corporation
e. Management – In accord with an operating agreement developed by members
f. Taxation- Not a taxable entity. Income/Losses passed through to members – ind returns and rates
i. Can “check the box” and be taxed as a corporation
g. Cost of Formation – Filing fee with the state
h. Raising Equity Capital – Possible to sell interests, subject to the operating agreement
i. Transferability of Interests – yes, if in accord with the Operating Agreement
j. can’t have any more than 2 of top 4 5-finger attributes
7. The Corporation
a. Formation – Filing with state official required
i. S-corporations
1. no mo

b. tax is paid on the amount realized and a deduction is allowed for the adjusted basis
i. amount realized – amount of the sale. purchase property for $100k and sell 5 years later for $150k. Amount realized is $150k
ii. Basis – amount invested. e.g. in example above, $100k
iii. Stepped-up and Adjusted basis
1. stepped up basis: if inherited the asset, stepped-up basis is fair market value at time of inheritance
2. substituted basis: if asset is a gift, donee takes donor’s basis in the asset
3. adjusted basis: for appreciation or depreciation.
a. if spend $10k improving $100k property, adjusted basis = $110k
b. if $100k property depreciates by $15k, adjusted basis = $85k
iv. Gain = amt realized – adjusted basis
1. so, 150 – 110 = $40k
2. Tax rate on Capital Gains is maximum 15% whether capital asset belongs to an individual, partnership, corporation or otherwise.
iv. Business Tax Planning Concerns and Solutions
1. If know business will show losses, at least at first:
a. remember – no tax consequences to convert to a corporation, but heavy tax burden to dissolve a corporation
b. Option #1 the S-corporation
i. can “check the box” and be taxed as a partnership, thus losses pro-rata to individuals
1.each shareholder take percentage of loss into their income returns and could use to set-off their income and reduce their exes
ii. must meet all of the reqs of an S-corp (no non-resident aliens or non-citizens, no more than 75 shrhldrs, cannot have more than 1 class of stock outstanding – unless only difference b/t classes of stock is voting rights: must have equal financial rights)
c. Option #2 the LLC
i. taxed as a partnership, thus partners take losses pro-rata into their individual returns
1. limitations to liability and more flexibility
ii. good if exceed max shareholder number or want overseas investors
iii. moreover, less formalities in business operations
d. Option #3 the partnership forms
i. tax flows through to individual investors as long as do not check the box.
2. Will the losses be able to offset individual’s income? (the “passive activity rule”)
a. Purpose – to curb abusive tax shelters
b. Is an individual’s activity passive?
i. if individual materially participates in the activity, then no
ii. if the individual is a limited partner, then automatically yes
c. If the activity is passive
i. it may be used to offset gains from other passive activities
if the individual has no gains from passive activities