Chapter 4 - Which Form of Organization Is Best for You?

Size importance and relative potential sales of existing restaurant organizations | Individual ownership – definition | organizational procedure | partnership agreements | advantages and disadvantages | Corporation – definition organizational procedure | advantages and disadvantages | Three rules for profitable decision

There are three basic forms of organization through which a food service operation may be initially organized and operated. Most of the 195,200 restaurants in the United States are organized as individ­ual proprietorships. This number is followed closely by the partnership form of organization. The corporate form of organization is at present a very small percentage of the number of food service operations.

Bulletin R. 22, 1954, Bureau of Census reported:

195,128  eating places in the United States, 1 eating place for each 800 population (est.)
141,000  individual proprietorships accounted for over 50% of the restaurant industry's sales
35,000 partnerships accounted for over 21% of the restaurant industry's sales
16,000 corporations accounted for approximately 30% of the restaurant industry's sales
240 individual establishments have sales of over 3½ million dollars annually
18,000  individual establishments have sales of over $1,000,000 but less than $5,000,000 annually

Two interesting observations may be made at this point based on the information shown above.

1.  The restaurant industry is overcrowded and highly competitive. In order to make $3,000 annually, there should be 1,400 people for every restaurant. At present over 154,000 establishments have less
than $50,000 annual sales.

2.  Where energy, skills, training, and personalities, can be com­bined in one organization as in partnerships or corporations, the
organization has a better chance to prosper. Partnerships and corporations comprise about 26% of the total eating establishments and ac­count for over 51% of sales. Partnerships comprise approximately 17% of the total eating establishments but account for 21% of total industry sales. Although corporations are less than 9% of the total eating establishments, they account for 30% of sales.

Each of the three forms of organization have certain distinct ad­vantages and disadvantages and require careful study before a definite choice is made. The decision to operate as sole owner, with a partner, or to corporate, involves consideration of the total resources of the prospective owner of a business and the selection of an organization that is specifically designed to supplement the owner's assets without adding undesirable features that remain fixed in the organization formed. Usually a certified public accountant and a lawyer should be retained to aid the owner in making a proper decision.

INDIVIDUAL PROPRIETORSHIP

Definition

When a business is organized so that one person has control of the assets of the business, sole power to make management decisions af­fecting the operation of the business, and unlimited liability for any claims against the business, the organization is known as individual proprietorship.

Organizational Procedure

The individual proprietorship differs from both the partnership and corporate forms in not requiring contracts or complicated legal pro­cedures to organize. The prospective owner of the restaurant finances the purchase of the business assets, registers the trade name of the restaurant at the recording office, and receives the necessary license or licenses and permits to operate his restaurant.

Advantages and Disadvantages

The advantages of organizing the business as an individual pro­prietorship are as follows:

1. The individual proprietorship can be organized without formal permission.

2.  This form of organization provides the owner with absolute con­trol of the operation. He can select his own menu items, labor force and equipment; decide on the promotion, accounting systems, investment, type of service that he wants to initiate; has complete freedom of operation with no interference from partners or stockholders.

3.  The sole owner of an operation does not have to divide his profits with others.

4.  As a single owner of an operation all the data regarding profits, costs, methods of operation can be kept private.

5.  In contrast to a corporation, the sole owner is not required to pay excess profit tax, capital stock tax, transfer tax, tax on retained earnings; nor is he taxed twice on income of the business.

6. In contrast to the corporation and the partnership form of organization, the individual proprietorship can be dissolved easily or sold.

The disadvantages of the sole proprietorship are as follows:

1. The sole owner must bear all the responsibility of operation.

2.  He has unlimited liability regarding any claim on the business. The liability includes not only his business but also his personal assets.

3. Initial capital requirements are greater for the individual proprietorship than for either the partnership or the corporate form of organization.

4.  Credit is more difficult to obtain. Creditors have recourse on the business and personal assets of only one person.

5.  Since one person's time and energy are limited, he must either develop a large operation capable of bearing the cost of executive or managerial aid or he must devote most of his total time and energy to the operation.

6. There is no division of skills or abilities in the proprietorship. The owner can depend only on himself to be a host, an accountant, a
purchasing agent, a cook and a personnel manager.

PARTNERSHIP DEFINITION

The partnership is a contractual association of two or more persons to carry on as co-owners of a business for profit.

Organizational Procedure

To organize a partnership two or more persons who have the legal capacity to become partners must agree to carry on, for certain considerations, a business operation for profit. Although the partnership agreement can be either oral or written, expressed or implied, the agreement is based upon a contract and therefore should be in writing. Because there are so many points covered in a partnership agree­ment that are points of dispute, the contract should be drawn up by an attorney and examined by a qualified accountant. Among the im­portant points to be covered by the contract, called the articles of partnership, are the following:

1.  The partnership name, the names of the partners, and a de­scription of their special duties.

2. The date when the contract shall become effective and the date when it will terminate.

3.  The nature and place of business.

4.  The amount of capital to be contributed by each partner.

5.  The type of records to be kept.

6.  The dates when the books are to be closed and the profits are to be divided.

7.  A detailed description of intention of the partners regarding the amount and distribution of salaries or profits.

8.  The amount of drawings to be allowed each partner and the interest, if any, upon these withdrawals.

9.  The method of dividing losses.

10.The method of settling disputes and the provisions for arbitra­tion in the event of disputes.

11. Provisions regarding death of a partner.

12. A detailed description of the conditions under which the partnership will be dissolved or a partner be permitted to withdraw.

Advantages and Disadvantages

The advantages of a partnership arrangement are as follows:

1. There is an immediate pooling of skills, training, experience, and abilities.

2. The partnership can obtain more credit than an individual proprietorship.

3.  More capital is available when two or more form a partnership than when either one of the partners attempts to operate as a sole owner.

4. The partnership contrasted with the corporate firm does not pay excess profit tax, capital stock tax, transfer tax, tax on accumulated earnings and is not taxed twice on income of business.

5.  The time and energy required to operate a business are shared by the partners.

The disadvantages of a partnership form of organization are as follows:

1.  Each partner may be held liable for all the debts of the partner­ship. As a principal in the partnership and as an agent of the partner­ ship all the business and personal assets of a partner (except those personal assets specifically exempted under the bankruptcy laws) may be claimed by creditors.

2. Each partner has the right to make contracts binding the partnership. This right can be a dangerous one to the total partnership relation.

3.  Control of the operation is divided. In most partnership agree­ments there is a division of power which may interfere or create dis­putes in the normal running of the operation.

4.  Profits are divided in partnerships.

5.  Death of one partner ends the partnership relation.

6.  Unless all contingencies are clearly written out in the articles of partnership, a partnership is difficult to dissolve.

7. The partnership creates difficulty in either trade or division of assets in case of dissolution.

8.  Very difficult to sell partnership interest.

CORPORATION DEFINITION

The corporation is an organization of human and physical assets created as a legal entity by law, and empowered to operate a business under a special name and within the limitations of its charter with the capacity of perpetual continuity as a business.

Organizational Procedure

After the necessary planning and promotion of the new business, the first step is that of selecting the state from which a charter granting life and entity to the corporation will be obtained. Considerations such as taxes, legal restrictions, and attitude of the state will be important points in arriving at a decision.

After selecting the state of incorporation, the incorporators prepare and file an application for a charter with the proper public officials such as the Secretary of State and the County Auditor. This applica­tion is called the certificate of incorporation and contains all the infor­mation that is to constitute the charter for the corporation.

Because the content of this certificate is governed by the laws of the state of incorporation, generalization is difficult. In most cases, the certificate of incorporation includes the name, principal office, purpose or purposes, description of total and classes of capital stock, names of incorporators and directors, amount of paid-in capital, and other charter provisions of the corporation.

If the law is complied with and the filing fee is paid, a charter is issued or a copy of the articles of incorporation serves as a charter. Following the incorporation, the incorporators or original shareholders adopt the bylaws, elect directors and officers and are legally ready to do business.

This description of corporate organizational procedure is not in­tended as a portrayal of the ease with which a corporation may be organized. The purpose of the description is to present a broad general view of the important procedures necessary to the formation. Real­istically, formation of an effective corporation requires not only a knowledge of finance but also a knowledge of law and of business management.

Advantages and Disadvantages

The advantages of a corporate form of business organization are as follows:

1.  Limited liability of the owners. The liability of the stockholders is ordinarily limited to the par value of shares. In most cases the stated value of the shares shown in the articles of incorporation and on the stock certificate means very little. Under normal circumstances the corporation's creditors can obtain satisfaction for their claims only out of such property as the corporation may own.

2. The stability and permanence of the corporation differs from both the individual proprietorship and the partnership. The proprietor­ ship begins and ends at the will of the owner or at his death. Partner­ ship can be brought to an end by the death, withdrawal, bankruptcy, or legal disability of any single partner. The partnership interest can­ not be transferred to another by gift or by will.

In most states, on the other hand, a corporation can receive a charter giving perpetual life. In the states which do limit the life period, the life of the charter may be easily and indefinitely prolonged by renewal of the charter.

3.  Ease of transferring ownership interests. In the partnership because of the personal relation of the partners and the possibility of injury to creditors, the sale of ownership rights is very difficult. The owner of a share in a corporation, on the other hand, may transfer his interest whenever and to whomever he pleases.

4. The corporate form of organization has a decided advantage over both the sole owner and the partnership organization in obtaining capital. Many people will risk small amounts of money in order to invest or speculate for big profits. This is so, especially in the organiza­tion that offers participation in ownership profits with little or no liability for claims against the owners.

5.  Professional management and control is provided in the corpo­rate form of organization. In contrast to the owner who is the sole arbiter of his business or to the partnership in which it is difficult to restrain partners to specific tasks, the corporation centralizes its man­agement in the board of directors who appoint professional officers to do the actual managing of the corporation.

6. A corporate form of organization can usually obtain credit easier than other forms of business organization.

7. Certain tax advantages are possible with the corporation. These advantages include:

(a) Employee stock holders can be included in profit sharing or pension plans of the company.

(b) Directors can control dividend payments, thus avoiding double tax.

(c) Can use tax money to build up working capital because taxes due can be paid the year following the period in which they were earned.

Disadvantages of corporate form of organization are as follows:

1.  A corporation may be difficult and expensive to start. The crea­tion of a corporation gives rise to a great deal of expense and effort. In some instances the formalities of incorporation, the legal expenses and other fees can be prohibitive.

2.  State and Federal regulations and restrictions affect the opera­tion of a corporation much more than other forms of business organizations. Because the corporation is created by the state, reports of the activities and finances of the business must be made at regular inter­vals. In addition, reports to federal and state governments for various tax purposes must be made, even if no tax liability exists. The corpora­tion's business activity is limited in terms of the approved certificate of incorporation and unless qualified, cannot do business outside of the state of its incorporation.

3.  Corporations seem to be singled out for several types of taxes that are not incurred by partnerships or individual proprietorships. The corporation must pay an incorporation tax or fee when it is organ­ized, a franchise tax annually, an accumulated earnings tax, a surtax on excess profits, a transfer tax, and a double tax on an income dis­tribution to its stockholders. The most serious aspect of taxation is that of double taxation. A corporation first pays income taxes on its profits, then the stockholders pay income taxes on the dividends they receive from these same profits.

The purpose of this chapter is to present enough basic considera­tions upon which a proper decision regarding the form of business organization can be made. Although the information on organizational procedures and advantages and disadvantages of the three basic forms of organization is complex, in reality a correct decision can be made if three rules are followed.

Three Rules for Correct Decision

The first rule is to know all the advantages and disadvantages of each form of organization and to realize that many of the disadvan­tages can be eliminated. For example, although a corporation pays an incorporation tax and an annual franchise fee, in most states these taxes are relatively small and unimportant. Double taxation on profits can be eliminated if the dividend policy is controlled. Tax on accumu­lated earnings can be avoided if the intent of the owner is to invest earnings so that the competitive position of the corporation is main­tained or to increase its operational efficiency. Surtax on corporate earnings can be avoided by dividing the single corporation into two corporations or the two corporations into three, four or five corpora­tions.

In a similar fashion certain other features of the partnership and individual proprietorship forms of business organization can be cir­cumvented. Partnership liability can be limited if a partnership asso­ciation or limited partnership is created. In this case the owners of the limited partnership are in the same position as corporate stockholders; that is, they will have no liability beyond the subscription price of their stock.

A sole owner can create a partnership by transferring partnership interest to other members of the family. He can make a gift of operating assets to the children, then have them make lease arrangements with his restaurant, charging him for the use of his assets.

The second rule is to analyze yourself and your requirements in terms of the form of organization. Basically, there are seven major factors to consider in relating the organization to you. The factors are: liability, division of profits, control of operation, span of time and energy, amount of training, financial resources, and transferability of business interests.

For example, if your personal assets are much greater than the pro­posed investment in business assets and you do not want to be held liable for business claims, the business must be organized as a corpora­tion. If your training, experience and financial resources are small, the business must be organized as a partnership or corporation. If you do not want to divide profits, establish a family partnership or an indi­vidual proprietorship. If you want absolute control of the operation, establish an individual proprietorship or a corporation. In the case of a corporation, you will need 51 percent of the common stock. If you do not desire to put in 18 hours a day in a small restaurant or your time and energy is limited, form a partnership or a corporation. If you plan to transfer your business interests in the future, form a corpora­tion or an individual proprietorship.

The third rule is to obtain the advice of a lawyer and an accountant. The lawyer's duties are to protect the owner's interests and to see that necessary forms are drawn up in full accordance with the legal require­ments of the state and according to the expressed or implied wishes of the owner. A qualified accountant will advise the owner in valuation of assets, and organization of the business so that excessive taxation is eliminated. Much of the difficulty of operation can be avoided by taking the proper steps before the business is organized. The greatest opportunities for tax savings arise when the business is being organized and when it is being sold.

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