2.1 Introduction

Construction contracting companies, like other business entities, can be established and operated as different forms of business enterprises. Each of the different forms of business ownership that a construction company owner may choose has associated benefits and drawbacks. For a business owner, the form of business ownership he selects is a momentous decision, and one that should engage the input and consulting services of business, tax, and legal experts. All of the variations and all of the complexities involving various forms of business ownership cannot be discussed here. However, this chapter will provide an overview of some of the advantages, disadvantages, and considerations inherent in the most common forms of business ownership, especially as they relate to ownership and operation of construction firms.

2.2 Alternative Forms

The typical forms of business ownership for construction contracting companies are the individual proprietorship, the partnership, and the corporation. Some of these basic forms of ownership have subsets or variations of the form they may take. A company owner's selection of the proper type of ownership for the business entity involves a great many considerations and is a matter that merits careful analysis and deliberative decision making. Each form of business organization has its own financial, taxation, and legal implications, all of which must be thoroughly investigated and understood. The selection of the ownership type that is most advantageous and appropriate for an owner's particular circumstances is a critically important business decision. As noted previously, this decision should only be made with the assistance and input of legal counsel, tax specialists, and business consultants when a new business is established or when consideration is being given to changing the form of ownership of an existing business concern.

2.3 Construction Contracting Firms

The construction industry is one of the easiest of businesses to enter. Any interested person can get started with little or sometimes no capital investment. There are many large firms in the construction industry in the United States, but the large firms are far outnumbered by small and medium-size companies. Family-owned businesses that work close to home are the general rule.

There are approximately 700,000 business firms in the United States that classify themselves as being construction contractors of one type or another. At any point in time, about 75 percent are individual proprietorships, 5 percent are partnerships, and 20 percent are corporations. Thus, it is easy to see that a large majority of construction firms are small businesses. However, it is also true that most of the very large construction firms in the United States, those that perform an annual volume of construction work of $100 million or more, are corporations.

2.4 The Individual Proprietorship

The simplest form of ownership of a business entity is the individual proprietorship, also called sole ownership. Forming a sole proprietorship is the easiest and least expensive procedure for establishing and administering a business. Additionally, this form of business ownership enjoys a maximum degree of freedom from government regulation. No legal procedures are needed to go into business as a sole owner, except the obtaining of required insurance, registration with appropriate tax authorities and municipal and state government, and, in some jurisdictions, becoming licensed as a contractor. The owner has the choice of operating the business under his or her own name or under an assumed company name. In some jurisdictions, an assumed company name must be registered with a designated public authority, as a “doing business as (dba)” concern.

In this type of ownership, the proprietor owns and operates the business, provides the capital, and furnishes all of the necessary equipment and property. As the sole manager of the enterprise, the owner can make any and all decisions for the business unilaterally and can act immediately. Title to property used in the business may be held in the name of the proprietor or in the name of the firm, if they differ. All business transactions and contracts are made in the owner's name.

This mode of doing business has many advantages to offer, including potential tax advantages as compared to other business types, as well as simplicity of organization and freedom of action. Other than the usual obligation to complete its outstanding contracts and to settle its financial obligations, there are no legal formalities barring termination of the business.

As an individual proprietor, however, the owner is personally liable for all debts, obligations, and responsibilities of the business, to the entire extent of his personal fortune. This unlimited liability extends to personal assets, even though they may not be directly involved in the business. Although management in a sole proprietorship is immediate and direct, the owner alone must bear all of the burdens and responsibilities that accompany this function, or must hire the talent needed to assist in operating the business. A proprietorship has no continuity in the event of the death of the owner, unless there is a direction in the proprietor's will that the executor continue the business until it can be taken over by the person to whom the business is bequeathed. In the case of the sickness or absence of the proprietor, the business may suffer severely unless there is a competent person or persons available to assume the management and operation of the business enterprise. Entrepreneurs who form proprietorships can raise money for business purposes only through personal contribution, by borrowing, or through the sale of company assets. This is in contrast to other options that are available for raising capital in other forms of business ownership. The owner must pay income taxes and other taxes at normal individual rates on the full earnings of the business, whether or not such profits are actually withdrawn from the business. Such earnings are added to the owner's income from other sources, and tax is computed on the whole.

It can be seen that the sole proprietorship form of business ownership has both advantages and disadvantages for the owner. As will be discussed in the sections that follow, the same is true of other forms of business ownership as well.

2.5 The General Partnership

A general partnership is an unincorporated association of two or more persons who, as co-owners, conduct a business for mutual profit. The principal benefits to be gained by such a merger are the concentration of assets and personal credit, equipment, facilities, and individual talents of the partners into a common course of action for a common purpose. The pooling of the financial resources of each of the partners results in the increased financial capacity and increased bonding capacity of the business. This, in turn, results in the possibility of a greater scope and volume of construction operations than would be possible for the partners acting individually.

Each general partner customarily makes a contribution of capital and shares in the management of the business to an extent defined in the partnership agreement. Profits or losses are usually allocated in the same proportion as the percentage of ownership. If no agreement is made in this regard in the articles of partnership, however, each partner receives an equal share of the profits or bears an equal share of the losses, regardless of the amount invested.

For most purposes, a partnership is not generally recognized by the law as being an entity separate from the partners. For example, a partnership pays no income tax, although it must file an information return. However, a partnership can operate under a company name and for certain purposes a partnership is recognized as a separate legal entity. In many jurisdictions, for example, a partnership can own property, can have employees, and can sue or be sued as a partnership business entity.

The Internal Revenue Service has ruled that bona fide members of a partnership are not employees of the partnership. Rather, such persons are deemed to be self-employed individuals whose remuneration is not subject to the Federal Unemployment Tax Act, the Federal Insurance Contributions Act, or to income tax withholding.

Partners usually receive drawing accounts against anticipated earnings, or annual salaries that are considered to be operating expenses of the partnership enterprise. In any event, partners must individually pay annual income taxes at the normal individual rates on their salaries, as well as on their allocated shares of the partnership profits. This holds true whether or not the funds that represent partnership profits are actually withdrawn.

A partner's share of the profits in a partnership can be assigned. However, an individual partner cannot sell or mortgage partnership assets. Neither can a partner sell, assign, or mortgage an interest in a functioning partnership without the consent of the other partners. Partners act as fiduciaries for the business entity and commensurately have an obligation to act in good faith toward one another.

2.6 Establishing a Partnership

State laws regarding partnerships are not entirely uniform, although most states have adopted the Uniform Partnership Act more or less verbatim. In the formation of a partnership, it is customary and advisable to draw up written articles of partnership, even though it is true that a binding partnership can, in certain instances, be formed by oral agreement.

It is always advisable to obtain the services of an attorney to assist in the preparation of the articles of partnership, which is a contract between the partners. In addition to statutory requirements, these articles may include almost anything the partners believe to be desirable. It is usual that articles of partnership, signed by the parties concerned, contain complete and explicit statements concerning the rights, responsibilities, and obligations of each partner. Although such articles must be individually tailored for each specific business partnership, the following list illustrates some of the types of provisions that are typically included in partnership agreements:

• Names and addresses of the partners.
• Business name of the partnership.
• Nature of the business with any limitations thereof.
• Location of the business.
• Date on which business operations will commence.
• Contribution of each partner in the form of capital, equipment, property, contracts, goodwill, services, and the like.
• Division of responsibilities and duties between partners.
• Statements requiring partners' full-time attention to partnership affairs.
• Division of ownership as it affects allocation of profits and losses.
• Voting strength of each partner.
• Drawing accounts or salaries of the partners.
• Any restriction on the management authority of individual partners.
• Specification of the requirement for majority or unanimous decision on management questions.
• Payment of expenses incurred by a partner in carrying out partnership duties.
• Rental or other remuneration for use of a partner's personal property, or for the provision of personal services.
• Arbitration of disputes between partners.
• Requirements relating to record-keeping and inventories.
• Right of each partner to full and complete access to all books of accounts of the partnership, as well as to all business audits.
• Rights and responsibilities of the individual partners upon dissolution of the partnership.
• Procedure in the event of an incapacitating disability of a partner.
• Rights and powers of surviving partners, such as option to purchase the interest of a deceased or withdrawing partner.
• Provision for final accounting of the business in the event of death, retirement, or incapacity of any partner.
• Provision as to whether the executor or spouse of a deceased partner is to continue as a partner.
• Termination date of the partnership agreement, if any.

Unless there is specific agreement to the contrary, general partners are expected to devote full time to the affairs of the partnership. Partners cannot normally withdraw capital from the partnership unless provision for this possibility has been set forth in the partnership agreement. It is typical that by mutual consent of all of the partners, any provision of a partnership agreement can be modified or deleted or new provisions can be added at any time.

2.7 Liability of a General Partner

A general partner is liable for all of the debts of a partnership. This truism is based on two legal principles. First, each general partner is defined to be an agent of the partnership, and therefore can bind the other partners in the normal course of business without express authority. Second, partners are individually liable to creditors for the debts of the partnership. The implications of these two points will be further discussed in the paragraphs that follow.

Agency exists when one party, called the principal, authorizes another, who is called the agent, to act for the former in certain types of defined business or commercial transactions. An agency relationship exists by agreement, and an agent can be designated by the principal to conduct any business or to take any action that the principal might lawfully take. The principal is liable for all contracts made by the agent while the agent is acting within the scope of his actual or apparent authority. The principal is also responsible for nonwillful torts (civil wrongs) that the agent may commit in the furtherance of the principal's business.

Further to the definitions discussed earlier, a general agent is one empowered to transact all of the business of his principal. In a partnership, each full member of the partnership is a general agent of the partnership itself and has complete authority to make binding commitments, enter into contracts, and otherwise act as an agent for his fellow partners within the scope of the business. Additionally, under the agency principle, communication to any one partner is considered to be notice to all. These provisions are subject, of course, to any limitations that may be set forth in the partnership agreement.

In most states, the responsibility of a partner for the contractual obligations of the partnership is joint with that of the other partners, which means that all of the partners are necessarily parties to any contractual action. Liability of a partner for torts committed by the partners in the ordinary conduct of business affairs is joint and several. This means that in any such tort action, every member of the firm is individually liable, and the injured party can proceed against all of the parties jointly or against whichever of the partners he chooses.

Each partner assumes unlimited personal liability to third persons for the claims, contracts, and debts of the partnership. If any one partner is not able to pay his proper share of company liabilities, creditors can force the remaining partners to pay the share of the first. A creditor of a partner can attach that partner's interest in the profits of the business but cannot proceed against the property of the partnership unless the partnership is being dissolved.

It should be apparent from the foregoing discussion that careful judgment should be exercised, both in the decision to form a partnership and in the selection of business partners. Each general partner accepts unlimited financial responsibility for the acts of the other partners, and each general partner underwrites the debts of the enterprise to the full extent of his personal fortune. If a partner withdraws from a going partnership, he remains personally liable for the partnership obligations outstanding as of the date of his withdrawal. To protect himself from future partnership debts, the retiring partner should give personal notice to firms doing business with the partnership, and should publish public notice of his departure. In most states, the withdrawing partner can discharge himself of all liability by means of an agreement to that effect between himself, the firm's creditors, and the partners continuing the business.

2.8 Dissolution of a Partnership

One of the major weaknesses of the partnership form of business organization is its automatic dissolution upon the death of one of the partners. However, this possibility can be circumvented by making provision in the partnership agreement that the business will continue and that the surviving partners will purchase the decedent's interest. Dissolution of a partnership may also come about as the result of bankruptcy, or through a legal provision called a duration provision in the original partnership agreement, or through the decision of a partner to withdraw, the insanity of a partner, a court of equity decree, or the mutual consent of all parties to the partnership. Dissolution is not a termination of the partnership per se, but rather is simply a restriction of the authority of the partners to those activities that are necessary for the conclusion of the business. Dissolution of the partnership has no effect on the outstanding debts and obligations of the enterprise.

Voluntary dissolution of a partnership is often accomplished by a written agreement between the partners. This agreement provides that the partners will undertake to complete all contracts in progress, to settle company affairs, and to pay all partnership obligations from the proceeds and assets of the business.

In the settlement of the debts of a partnership, outside creditors enjoy a position of first priority. If partnership assets are insufficient to satisfy the outstanding obligations of the partnership, then the partners must personally pay the difference. After all of the creditors have been satisfied, remaining partnership assets are used to repay any loans or advances that may have been made by partners above and beyond their capital contributions. Only after all loans and advances of this kind have been repaid, can there be a return to the partners of their capital investments. If additional partnership assets remain thereafter, these are treated as profits, and are distributed in accord with the provisions of the original partnership agreement. When a partnership dissolves and construction contracts are involved that may require considerable time for their completion, the clearing of partnership accounts is often subject to lengthy delays, pending the payment of all debts, receipt of all accounts receivable, and discharge of all of the construction contract obligations of the partnership.

2.9 Subpartnership

A general partner in a partnership can enter into an agreement with an outsider, who is called a subpartner. This can be completed by a written agreement whereby the subpartner will share in some designated way in the general partner's profits or losses as derived from the business activities of a partnership enterprise. The subpartner is not a member of the firm, and consequently he or she performs no active function in the partnership, has no voice in the management, and has no contractual relationship with the partners, other than the one with whom he made the profit-or-loss-sharing arrangement in the subpartnership agreement. Because the subpartner has contracted to participate only in the individual partner's share, he is not personally liable to the creditors of the partnership.

2.10 The Limited Partnership

In a general partnership, each of the general partners is a recognized member of the firm, is active in its management, and has unlimited liability to its creditors, as discussed in the preceding sections. A limited partner is one who contributes cash or property to the business and then commensurately shares in the profits or losses of the enterprise. However, the limited partner does not, and in fact cannot, provide any services, nor have any voice or vote in matters of management of the firm.

Unlike the general partners, limited partners are liable for partnership debts only to the amount of their investments in the partnership. This is true, however, only as long as their names are not used as part of the firm name, and they do not participate in management.

Under the Uniform Limited Partnership Act, which has been adopted by most states, a limited partnership may be formed by two or more persons, at least one of whom must be a general partner. A contract is drawn up between the partners that clearly defines the individual duties and financial obligations of each of the partners. Additional stipulations in this contract may include the length of time the agreement remains in effect and the date by which the contributions of each limited partner are to be returned.

In addition, state statutes provide that a limited partnership certificate must be signed and filed with a designated public office, and this partnership certificate must be published as required by state statute. The operation of a limited partnership, like its establishment, must be conducted in strict accordance with the laws of the state in which it is formed. The partnership is not automatically dissolved by the death of a limited partner, as is the case in a general partnership.

The limited partnership is used principally as a means of raising capital for a business enterprise. It is a means for an investor to contribute money into a business while maintaining immunity from any personal liability. The limited partner is not a creditor of the business, but rather is considered to be an owner of a share of the firm. The limited partner is entitled to a share of the profits of the firm while the business is operational, and to a return of capital and undistributed profits upon its dissolution.

By contrast, the obtaining of new investment capital for a business enterprise by bringing in additional general partners can result in serious problems with regard to company control and decision making, due to the fact that each of the new general partners shares in the management of the company. The addition of a limited partner may also be preferable to borrowing the desired funds from a bank or from another source. In this regard, however, one who lends money to the partnership can be in a better position than a limited partner. A lender to whom a firm is in debt can possibly exert some control over the firm, whereas for a limited partner, any show whatsoever of management input or interference can result in the loss of the limited partner's immunity from personal liability. Moreover, a lender enjoys a higher priority in the event of dissolution of a partnership than does a limited partner.

It is to be noted that high corporate income tax rates have generated considerable interest in limited partnerships as an organizational alternative to the corporate form of business ownership. As noted earlier, a limited partner is considered to be an investor in a company rather than a stockholder. Income from a partnership is taxed only at the individual investor's rate, rather than being taxed at both the corporate and individual levels as it is for stockholders. Limited partners, like the stockholders in a corporation, do not have personal liability for company debts and obligations.

A relatively recent development, publicly traded master limited partnerships (MLPs) have been developed and utilized, some of which are listed on the major security exchanges. This form of organization serves principally as a capital pooling technique where small companies or individual investors can pool their resources to initiate large projects. A sponsoring corporation normally serves as the general partner in an MLP.

2.11 The Corporation

A corporation is an entity, created by law, that is composed of one or more individuals united into one body under a special or corporate name. While there are several different classifications of corporations, including public and private, profit and nonprofit, quasi-public, and foreign and domestic corporations, the discussion here will consider only the private form of corporation that a contractor would establish for ordinary business and profit motives.

Corporations have certain privileges and duties, enjoy the right of perpetual succession, and are regarded by the law as being business entities that are separate and distinct from their owners. A corporation is authorized to conduct business in the name of the corporation, and can own and convey real and personal property, can enter into contracts, and can incur debts in its own name and on its own responsibility. It can also file suit and can be sued in its corporate name.

The principal advantages of this form of business organization are the limited liability of its owners (who are the stockholders), the perpetual life of the company, the relative ease of raising capital, the easy and workable provision for multiple ownership, and the economic benefit that owners pay taxes only on profits (dividends) actually received. In a corporation, unlike in a partnership, the owners (shareholders) can also be employees.

A corporation is formed under the provisions of state law, by a prescribed number of shareholders filing a certificate of “articles of incorporation” with the appropriate administrative department of state government. The corporation comes into being upon receipt of its corporate charter from the state of domicile, that is, the state where its charter is registered. The powers of a corporation are limited to those that are enumerated in its charter, along with those that are reasonably necessary to implement its declared purpose. The provisions of the corporate charter are usually structured so as to be very broad in nature, in order that the new corporation will be authorized to perform the many different functions that may become necessary or desirable for the business entity in future years.

These charter provisions also include the drawing up of corporate bylaws that pertain to the day-to-day conduct of the business of the corporation. Acts of the corporation are governed and controlled by its articles of incorporation, as well as by its bylaws and the applicable state law.

Corporations are regulated by the various states, with each of the several states having a corporation code that prescribes the formal process that must be followed by the organizers in order to obtain a charter. These legal requirements differ somewhat from one state to another, and it is always important to secure competent legal guidance when establishing a new corporation or when modifying an existing corporation. In any case, as organizers proceed toward obtaining a corporation charter from the state, they find that fees must be paid and substantial quantities of information must be filed with the proper state officials. Additionally, a series of detailed requirements must typically be satisfied regarding the incorporators' residence and financial structure.

A corporation is dissolved by the surrender or expiration of its charter. Dissolution of a corporation merely means that the corporation ceases to exist. State laws govern the means by which the business affairs of a dissolved corporation must be settled.

2.12 The Foreign Corporation

A business corporation that is created within a certain state and under the laws of that specific state, is known as a domestic corporation. In all other states, this corporation is considered to be a foreign corporation. The state of incorporation is frequently chosen by the organizers of the corporation, not on the basis of the location of work to be performed by the company, but rather because of its more favorable corporation laws. The incorporated contractor that wishes to extend its operations beyond the borders of its state of incorporation must apply for and receive certification to do business as a corporation within each additional state. Usual requirements for the certification of a foreign corporation are the filing of a copy of the corporate charter, the designation of a local state resident as an agent for the service of process, and the payment of a filing fee.

The acts of a foreign corporation within another state are considered to be unlawful until the corporation has become certified to do business as a corporation in that state. Hence, the contractor that is incorporated must exercise great care to comply with the corporation laws of those states in which it does business. Failure to be properly certified as a foreign corporation in a state may very well render construction contracts unenforceable and may eliminate the right of lien. Additionally, an uncertified foreign corporation typically will not have access to the state courts.

A foreign corporation is, of course, subject to the statutory controls of the state within which it does business. For example, if franchise taxes or income taxes are levied on businesses of that state, the foreign corporation must also pay such taxes in accordance with its total amount of business in the state.

2.13 Stockholders

The ownership of a corporation resides in shares of stock that entitle the owners thereof to a portion of the business profits and also to the net assets of the corporation upon its liquidation. This does not mean that shareholders own the corporate assets because the corporation itself holds legal title to its own property. However, each share of stock represents a share in the ownership of the corporation. Under the laws of most states, all of the stock of a corporation can be owned by a single individual, and in this case, as well as for all stockholders when there is more than one, the courts recognize a clear distinction between the individual and his corporation.

Ordinarily, shares of stock in a corporation are freely transferable, and this is in fact one of the advantages of incorporation. Stock certificates are negotiable instruments that may be transferred by endorsement and delivery in the same manner as promissory notes.

It is commonplace that the shares of stock in a corporation are held by a small group, such as the members of a family or a select group of business associates. In this way, control of the company is maintained within a select group. Such a corporation whose stock is not available to the public is referred to as a closed corporation or a closely held corporation. By contrast, when corporate stock is available to the general public, the company is referred to as a publicly owned or public corporation.

In the case of stockholders who wish to maintain a select group who can own stock, a restriction on the ownership or transfer of the stock of the corporation can be accomplished by stamping the nature of the restriction directly onto the face of the stock certificate. Another method by which stock ownership can be restricted to a small or select group, is to provide in the bylaws that before stockholders can sell their stock to an outside party, they must first offer their stock for sale back to the corporation, that is, the current stockholders.

When a corporation is established, its articles of incorporation will authorize the issuance of a certain dollar value of stock, which is called the authorized capital stock. The actual capital stock is the dollar amount that has actually been paid to the corporation for its outstanding stock. The actual capital stock value does not necessarily equal the amount of the authorized capital stock.

The stock that is issued by the corporation may take the form of common stock or preferred stock, or both common and preferred stock may be issued. Preferred stock is subject to less risk for the stockholder than is common stock because it has a certain defined preference as to dividends distribution, as well as distribution of assets upon liquidation of the corporation. However, preferred stock usually carries no voting privileges with regard to the matters of electing the leadership, and voting on the conduct of some of the business of the corporation.

Common stock, while it does not carry the preferential distribution of dividends and assets of preferred stock, generally entitles its owners to one vote per share. Additionally, common stock often provides at least the possibility of greater ultimate profits to its owners.

Stockholders, those who own both preferred and common stock in the corporation, have certain rights and privileges that are based on the state statutes of the state where the corporate charter resides, and as set forth in the language of the charter of the corporation. Additional rights and privileges accrue from the terms of stock ownership as stipulated on the stock certificate. These stockholder rights typically include the preemptive right to subscribe new stock issues, to carry out reasonable inspection of the corporation's books and records, to bring suit against the corporation, to share proportionately in declared dividends, to receive a share of the net assets of the corporation upon dissolution, to elect officers and members of the board of directors of the corporation, as discussed below, and to enact bylaws.

The profits earned by a corporation are subject to federal and state taxes at the corporate tax rate. Such taxes are paid by the corporation as a business enterprise, before any profits can be distributed as dividends to the stockholders. Following the distribution of dividends resulting from the corporate profits, the stockholders are then taxed individually on any such dividends which are distributed on a cash basis. Such double taxation is considered by many to be one of the greatest drawbacks associated with the corporate form of business. Because a corporation cannot deduct dividend payments to its stockholders as business expense deductions for tax purposes, both the corporation and its shareholders pay taxes on the same income.

Dividends can be paid only from earned surplus generated by the corporation, and may be declared only if such action does not impair the position of creditors to the corporation. Such dividends, or surplus distributions, are declared as a fixed sum per share of outstanding stock. This dividend payment is generally made quarterly, but may be declared at such intervals as decided upon by the board of directors of the corporation.

An outstanding advantage of the corporate form of business ownership, is the fact that each individual stockholder is immune from personal liability for corporate debts. With very few exceptions, shareholders have no personal liability for obligations of the corporation, and their responsibility is limited to their investment in the corporation's stock. An important exception to this generality sometimes occurs, however, when the stockholders in a closely held company may be required by the bonding company of the construction corporation to provide their personal guarantees for the debts of the corporation. (See Chapter 7 for more detailed discussion regarding bonding companies.) When this is the case, the shareholder's liability is not limited to the amount invested in the corporation.

A stockholder is not an agent of the corporation, and cannot act in any way for or on behalf of the organization. This also illustrates a difference between a stockholder in a corporation and a member of a partnership.

2.14 Corporate Directors and Officers

The voting shareholders of a corporation elect a board of directors that exercises general control over the business of the incorporated company and determines the overall policies of the corporation. The directors must conduct the affairs of the firm in accordance with its bylaws, and the members of the board are ultimately responsible to the stockholders. Directors have no authority to act individually for the corporation, and are not agents of the corporation, nor of the stockholders. Their powers may be exercised only through the majority actions of the board. Directors occupy the position of fiduciaries for the company, and are required to serve the financial interests of the corporation with prudence and reasonable care.

The articles of incorporation for an incorporated company will typically provide that there will be annual meetings of the shareholders, and defined periodic meetings of the board of directors. Minutes of these meetings must be kept and filed in accordance with the articles of incorporation, and in keeping with the laws of the state where the corporation is chartered. Failure to observe such required procedures can lead to serious problems in the event of claims or lawsuits against the corporation. For example, chronic disregard of corporate technicalities might result, for legal purposes, in the business being treated as a partnership or sole proprietorship rather than as a corporation.

The president, vice-president, secretary, and treasurer comprise the typical set of officers of the corporation. There may be other officers, as defined in the corporation charter and bylaws. These officers are usually appointed by the board of directors, and these are the people who have the responsibility of carrying out the everyday administrative and management functions of the company. The officers are empowered to act as agents for the corporation, in accordance with the agency concept discussed earlier in this chapter. The president is authorized to function for the firm in any proper way, including entering contracts, whereas the lesser officers generally have more limited authority. Officers also serve in the capacity of fiduciaries for the company, and may be held personally liable for corporation losses caused by their neglect or misconduct.

2.15 The S Corporation

If a corporation meets certain criteria specified by the Internal Revenue Service, it has the option of being taxed as a partnership rather than as a corporation. If such an election is made, the company is referred to as an S corporation. To be eligible, the corporation must meet certain criteria. It should be noted that none of the criteria for an S corporation restrict the size of business volume, profits, or capital.

Included among the required criteria for an S corporation are the following:

• The corporation must be defined as a closely held corporation having no more than 35 stockholders.
• All of the stockholders must be U.S. citizens, estates, or some specified trusts.
• There must be only one class of stock outstanding.
• Partnerships and other corporations cannot be shareholders.

An eligible corporation must elect to be treated as an S corporation and must make a filing with the Internal Revenue Service (IRS). Additionally, stockholders must consent by signing prescribed forms that are filed with the IRS. Once the taxation election is made, this S corporation status must continue until it is properly terminated. This may be done at any time by a majority vote of the stockholders. Once the S corporation designation is terminated, however, the corporation is not allowed to reelect S corporation status for five years, unless approved to do so by the IRS.

The stockholders in an S corporation enjoy the typical corporate benefits such as limited shareholder liability and the ability to easily transfer ownership. The use of an S corporation form of ownership can be especially beneficial in the following circumstances:

• In the early years of a business, when operating losses sometimes occur, and when substantial amounts of capital equipment must be acquired.
• When there is high company profitability with no additional capital needs.
• For family income tax planning.

The prime attraction of this form of company ownership is that profits or losses of the corporation are taxed directly on each stockholder's tax return instead of at the corporate level. Losses incurred by an S corporation, with some limitations, can be offset by the taxpayer who is a shareholder against taxable income from other sources. In contrast, as discussed earlier, a regular corporation pays taxes at the corporate level and then the stockholders must pay a second tax on any profits withdrawn as dividends. Additionally, S corporations are not subject to the penalty tax applied by the Internal Revenue Service when earnings are retained in a corporation beyond its reasonable needs. Also, the IRS cannot assert that unreasonably high compensation is being paid to an employee-shareholder of an S corporation.

2.16 Employee Stock Ownership Plan (ESOP)

An employee stock ownership plan (ESOP) is a form of deferred compensation to employees, consisting of the employees investing in the stock of the employer corporation, with these investments funded by tax-exempt contributions made by the employer. The company employees pay no tax on their stock ownership until they withdraw their benefits from the plan, which usually occurs at the time of their retirement. This provides a tax-advantageous way by which to transfer ownership in a closely held corporation.

A company ESOP can provide benefits to both the employers and also to employees. While similar to some other stock bonuses or profit-sharing plans, an ESOP differs in that it invests its assets wholly or primarily in company stock.

Such a plan can be designed to accomplish different purposes, including the following:

• Promoting company growth by providing a new source of equity capital.
• Providing benefits for long-term employees.
• Allowing for the retirement of company owners.
• Accomplishing a change of company ownership.
• Retiring outstanding stock presently owned by stockholders.

By selling company stock to an ESOP trust, the employer determines the quantity of stock to be divested and the rate at which it will be sold to the employees. When an ESOP proposal is accepted by the firm's stockholders and board of directors, there are two ways in which the plan can be implemented. The choice of procedure depends on the purposes to be served by the plan.

One form of ESOP formation is for the corporation to make a series of periodic tax-deductible contributions to the trust, for the benefit of the participating employees. These company payments replace traditional profit-sharing distributions made to individual employees. Where the plan borrows no money from outside sources, such company payments are limited to 15 percent of total payroll.

The second form of ESOP formation is for the trust to obtain a third-party loan with which to buy the shares of stock offered. The loan is retired by a series of tax-deductible company contributions in a manner similar to that of the first procedure. Where funding is borrowed, the company payments cannot exceed 25 percent of covered payroll.

Under either of the procedures, the company is obligated to repurchase the shares of employees who retire, are disabled, die, or are terminated employment for specifically designated reasons. The shareholders of the sponsoring corporation can defer capital gains recognition when they sell their stock to an ESOP, provided that the ESOP owns 30 percent of the corporate stock and the seller reinvests the sale proceeds in securities of other domestic corporations.

An ESOP can be advantageous for some companies but can present serious problems for others. A privately held corporate firm must thoroughly understand all of the risks and drawbacks that can be involved. A wide range of issues must be carefully considered before making the decision to implement such a plan.

2.17 Limited Liability Company (LLC)

A relatively new form of business entity, the limited liability company (LLC), is coming into increasing usage. The LLC is a company formed by two or more members, with an LLC agreement executed among the members and written in conformity with the applicable state statute. This LLC agreement is much like a partnership agreement or a firm's articles of partnership.

An LLC can offer legal, tax, and economic advantages over the traditional forms of business ownership. An LLC is a statutory entity that combines the limited personal liability feature of a corporation and the partnership feature of taxation at the owner level.

An LLC is classified as a partnership for federal tax purposes. This form of company ownership offers distinct advantages over the S corporation and the limited partnership forms of ownership that attempt to have both limited liability and pass-through taxation. While an S corporation has both limited liability and pass-through tax advantages, it has many restrictions and pitfalls that an LLC does not have. An advantage that an LLC has over a general partnership is limited liability for its members. A limited partnership only partially overcomes the limited liability issue.

2.18 The Joint Venture

A joint venture is not an enduring form of business ownership like the others that have been discussed in this chapter. Rather, the joint venture is temporary form of ownership whereby two or more contractors unite and pool their resources, assets, and skills so as to perform a single construction project, and then go their separate ways again following completion of the project. A joint venture is a method of collaboration between contractors, which is defined as two or more separate and independent contractors uniting themselves into a single business entity for the performance of a single construction contract. The members of a joint venture can be sole proprietorships, partnerships, or corporations, but the joint venture itself is a separate business entity from the businesses owned by the participants in the joint venture.

Joint venture arrangements may be used when two or more contractors unite themselves into a single business for purposes of performing a project that none of them could perform alone. Sometimes complementary needs on the part of the contractors are the motivating force behind joint venture formation. For example, there may be a firm that is well established in a geographic location, with a proven record of performance for owners and architects in the area. This company has determined that it is not financially capable of performing a forthcoming project, or does not have the requisite bonding capacity. There may be another firm based in a different location that has the requisite size, financial capacity, and bonding capacity to perform the project, but is reluctant to submit a proposal because it is unfamiliar with the local owner and architect, and/or because this company is unfamiliar with matters such as labor availability, and availability of subcontractors and suppliers in the area where the project is to be built. These two companies may logically decide to form a joint venture, and to submit a proposal in the name of the joint venture concern, and if they are successful bidders, to perform the project as a joint venture.

A joint venture enterprise begins with the preparation and execution of a joint venture agreement between the companies that are forming the joint venture. This contract will define and describe all of the elements of agreement between the two (or among each of the participants if there are more than two), including all aspects that have to do with how the joint venture will conduct its business operations. This is typically a very complicated matter, requiring expert legal counsel and tax counsel.

Among the elements of content of the joint venture agreement are matters such as definition of the aims and objectives of the enterprise, obligations and rights of each party, the specific responsibilities and contributions of the individual parties, the percentage interest of each participant, details regarding the advance of working capital by each party, limitations of liability, settlement of disputes among the co-venturers, and division of profits and losses. Also to be included are delineation with regard to which contractor will take the leadership role in project administration; the details of contract administration and project management; the conduct and oversight of accounting and purchasing; the procedure in case a co-venturer defaults on its commitments; and the manner of termination of the joint venture agreement. Certainly, there will also be definition and description of particulars regarding project administration, both in the office and in the field; use of equipment, scaffolding, and other resources of the several contractors; definitions regarding subcontractor selection, and subcontractor coordination and management; management and administration of requests for payment; and so on.

While the listing of matters to be considered in the previous paragraph is not intended to be comprehensive or complete, this cursory set of considerations serves to exemplify how many matters there are that need to be agreed upon and decided, and how complex the matter can be, of melding two or more companies into one functional but temporary business enterprise, capable of constructing a project for the mutual benefit of the co-venturers.

A joint venture serves to combine the resources, assets, and skills of the participating companies. Such a combination offers the multiple advantages of pooling construction equipment, estimating capabilities, office facilities, personnel, and financial and bonding capabilities. Each joint venturer participates in the conduct of the work and shares in any profits or losses in accordance with the joint venture agreement. Some of America's largest structures have been built by joint ventures. Hoover Dam, constructed by a joint venture of six companies, was an early example. Succeeding years have seen the formation and use of joint ventures develop into common practice in the construction industry.

An important consideration to be noted is that a joint venture can select its own accounting procedure for tax purposes, without regard to the methods used by the individual venture members. Prior to bidding, it may be necessary to obtain a contractor's license for the joint venture, to prequalify the joint venture for bidding, and to file a statement of intent to submit a joint venture proposal with the owner.

Usually, prior to the preparation and submittal of a proposal, the participants in the joint venture agreement will make a courtesy visit to the owner and architect-engineer for the project. They will present their joint venture agreement to the owner and the architect-engineer, and will typically make the joint venture agreement available for consideration by legal counsel of the owner. The intent is to provide full disclosure to the owner, to let the owner and architect-engineer know that the joint venture enterprise will be submitting a proposal, and to provide assurance that if selected to receive the construction contract, the joint venture will be fully prepared to satisfactorily perform the construction.

On bid day, the participating contractors will submit their proposal to the owner in the name of the joint venture business. The proposal will contain the names of all of the joint venture participants and will stipulate that all of the participants in the joint venture, jointly and severally, are directly bound to the owner for the performance of the contract. Each co-venturer is thereby individually liable for the performance of the entire contract and for the payment of all construction costs.

When the joint venture is selected to be the contract recipient, the business entity will, of course, enter a contract with the owner and will complete the project in accordance with all of the provisions of the contract documents, and will simultaneously fulfill all of the elements of their joint venture agreement among themselves. When the project has been completed and the joint venture agreement has been fulfilled, the participating contractors will again go their separate ways.

2.19 Summary and Conclusions

As was noted at the beginning of this chapter, there are numerous different forms of ownership for a construction company, and each has its own advantages and disadvantages. Further, it is noted that the summary of forms of business ownership presented here, and the accompanying discussion of advantages and disadvantages, is only a basic summation. A great many other details reside within the body of knowledge to be considered with regard to each form of ownership.

A company owner's selection of the proper type of ownership for the business entity that is the construction company involves a great many considerations and is a matter deserving of careful study and serious deliberation. It is recommended that this selection be made only after qualified input has been received from legal counsel, taxation experts, and business and financial consultants.

Chapter 2 Review Questions

1. What are the primary advantages of a limited partnership form of construction company ownership?
2. What is the difference between a public and a private corporation?
3. Define a joint venture contractor, and explain the rationale for the use of this form of business entity.
4. Define ESOP and explain its use.
5. What is the meaning and significance of the term foreign corporation?
6. State one key advantage and a key disadvantage to each of the following forms of construction business ownership: sole proprietorship, general partnership, limited partnership, corporation, S corporation.
7. Explain the rationale employed by those who argue that corporations are subject to double taxation.
8. About how many firms in the United States classify themselves as construction firms, and what is the most prevalent form of ownership of those companies?
9. Define and contrast the duties and responsibilities of the members of the board of directors of a corporation, and the officers of the corporation.
10. Define an LLC, and describe one key advantage to its usage.