Organizational Forms and Law
Pathways is incorporated as a privately held S corporation under Ohio law and subject to internal revenue service (IRS) provision for taxation of income. S corporations elect to pass corporate income, losses, deductions, and credit to their shareholders for federal tax purposes. Shareholders of S corporations report the flow of income and losses on their personal tax returns and are assessed at individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive incomes.
To qualify for S-corporation status, the corporation must meet the following requirements:
· Be a domestic corporation
· Have only allowable shareholders, which includes individuals, certain trusts, and estates, but not partnerships, corporations, or nonresident alien shareholders
· Have no more than 100 shareholders
· Have one class of stock
· Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
ESOP, which Pathways follows, is a tax-qualified retirement plan that enables a corporation to reward and motivate employees with ownership in the corporation. Available only to corporations, ESOPs provide a number of benefits, including significant tax advantages.
Pathways allocates its ESOP contributions to individual employees in proportion to their compensation. The contributions go into a trust account and employees become entitled to an increasing percentage of their accounts over time. Pathways employees’ ESOPs vest at five years of continued full-time employment. An ESOP employee who reaches the age of fifty-five and who has at least ten years of participation in the plan, has the option of diversifying his/her
ESOP account up to twenty-five percent of the value. This option continues until age sixty, at which time the employee has a one-time option to diversify up to fifty percent of his/her account.
The form of distribution of a privately held firm such as Pathways is governed by the corporate by-laws. Pathways makes the distribution in stock, giving the employees a “put option” on the stock for sixty days after the distribution. If the employee chooses not to sell at that time, the company must offer another put option for a second 60-day period starting one year after the distribution date. After this period the company has no further obligation to repurchase the shares.
Employees receive the vested portion of their accounts at termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.
If at the time of receiving their accounts there is no public market, the company must purchase the employee’s shares at their present valuation. The corporation is generally given the option of paying for the shares in a lump sum or in installments over a period of years.
As an S Corporation, Pathways is a corporation that elected to be taxed under Subchapter S of the Internal Revenue Code and received Internal Revenue Service (IRS) approval of its request for Subchapter S status. As a legal entity, the S Corporation is separate and distinct from the corporation’s owners, who are the stockholders.
Pathways gains several advantages from its S Corporation status. These advantages are
· As an S Corporation, the continuation and sustainability of the company is ensured because it cannot be impacted by the death of one or more stockholders.
· Distributing stock shares through the ESOP allows restructuring of corporate ownership without interruption of business operations.
· The Pathways S Corporation pays no income taxes and corporation income or loss is passed to stockholders.
· To the extent the corporate shield is maintained and other investments and savings of the stockholders are not at risk, the personal life of stockholders is simplified.
· Depending on the corporation’s business record and the policies and practices of prospective lenders, access to credit and the ability to secure needed resources is improved.
· Earnings representing return on investment (interest, rental payments, etc.) are not subject to self-employment tax as long as stockholder-employees receive adequate compensation for labor and management of the business.
The S Corporation status also has some disadvantages:
· Lenders may require personal guarantees from corporate officers as a condition of credit which negates to some extent the limits of liability.
· Disagreements among employee stockholders could impede the decision-making process of Pathways.
· The appreciated assets owned by Pathways could become significant income tax liabilities to shareholder-employees if the corporation is dissolved.
· • Employment benefits such as life insurance, health insurance, and housing costs are taxable income to Pathways’ stockholder-employees with two percent or more stock ownership.
Assignment 1: Discussion—Creative Entrepreneur
One of Pathways’ graphic designers is going to start his own design company. The parting is amicable and Pathways has already promised him two assignments. As an entrepreneur, the designer now has to make many managerial and financial decisions.
Examine this scenario and respond to the following:
· What organizational form should the designer choose for his venture?
· What are the legal, operational, and financial implications of the form you recommend?
Write your initial response in 2–3 paragraphs. Apply APA standards to citation of sources.
Book is Bagley, C. E. (2019). Managers and the Legal Environment: Strategies for the 21st century (9th ed.). Cengage Learning
Assignment 1 Grading Criteria
Recommended an organizational form based on a consideration of its legal, operational, and financial implications.
Contributed to the discussion, for example, made connections between points, drew conclusions from information presented, and suggested questions for further thought.
Expressed information and arguments clearly in writing and applied APA standards for editing.
Organizational forms are extremely important because they determine the managerial and financial dynamic of an organization or company. Choosing the right organizational form affects the business’ legal, operational, and financial aspects. A graphic designer at Pathways is going to start his own design company on his own. According to Bagley, “the
preferred form of ownership for real property today is the limited liability company, or LLC.” (Bagley, C. E., 2019)
LLC is the organizational form the designer should choose for his venture because legally an LLC limits personal liability because it is separate from its owners. Financially, if the graphic designer is in debt or loses money, his personal assets cannot be used to pay his business debt. Personal assets are protected even if an employee decides to sue for negligence. Even the operational implications of an LLC are less taxing. For example, an LLC does not have to hold annual meetings, and are usually not required to keep extensive records, unlike other corporations. (Haskins, J., 2020) Based on this information, I believe LLC is the employee’s best option.
Haskins, J. (2020, March 5). Advantages of an LLC. Retrieved from
Bagley, C. E. (2019). Managers and the Legal Environment: Strategies for the 21st century (9th ed.). Cengage Learning
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The graphic designer that left Pathways to start up his own company has many organizational forms to choose from. The graphic designer should choose to structure his company as a Limited Liability Company (LLC). In doing so, the entrepreneur “combines the tax advantages of a pass-through entity with the limited liability advantages of a corporation” (Bagley, 2019, p.579). The graphic designer is already promised work from Pathways, whose relationship remained positive though he decided to leave. Bagley highlights that “An LLC offers the advantages of both the limited partnership and the S corporation without their respective drawbacks” (Bagley, 2019, p.579). LLC’s are better than S-corporations in this situation because LLC’s have less “restrictions on shareholders and the ability to have more than one class of securities” (Bagley, 2019, p.579). Pathways is structured as an S-corporation which requires companies to “have one class of stock” (Case Study, 2011). An LLC is better than a sole proprietorship in that it takes most of the liability away from a graphic designer, who under a sole proprietorship would be personally liable for all of the companies’ “debts, contract obligations, and tort liabilities” (Bagley, 2019, p.576).
In order for a graphic designer to reap the full benefits of the LLC, it is imperative that the operating agreement is “tailored to the individual company and the needs of its members” (Bagley, 2019, p.579). Like Pathways S-corporation, LLC’s do not pay income taxes itself. One key benefit of the LLC is “Unless a business is organized as a corporation under state law or is publicly held, the IRS’s “check the box” regulations permit the founders to decide whether the entity is to be taxed as a corporation or a pass-through entity. State-law corporations and publicly traded entities are always taxed as corporations. Accordingly, LLCs are not taxed at the firm level unless they elect to be taxed as corporations” (Bagley, 2019, p.580). This is beneficial in that it gives the graphic designer the flexibility of choosing its method of taxation for the company.
Bagley, C. E. (2019). Managers and the Legal Environment: Strategies for the 21st century (9th ed.). Cengage Learning.
2011, Organizational Forms and Law. Miami International University of Arts and Design, Law Policy & Ethics in Design and Media Arts.
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