It is important to understand the tax environment within which the financial manager operates because few business decisions are unaffected by tax considerations. This chapter presents a brief overview of the major elements of the tax structure affecting financial planning and financial decision making. Providing a detailed description of the Internal Revenue Code or guidance relative to the preparation of tax returns is well beyond the scope of this book. The objective here is only to provide a brief sketch of the most important points of the tax system and an understanding of the necessary connection between financial planning and tax planning.
There are three basic forms of business ownership in the United States: the sole proprietorship, the partnership, and the corporation. Each form of ownership has various advantages and disadvantages. Perhaps the greatest advantage of the sole proprietorship, which is the most frequently encountered form of organization in terms of total numbers of businesses, is the ease with which it is formed. As the name implies, the sole proprietorship is owned and operated by a single individual. Formation of a sole proprietorship is extremely simple, and the profit earned by the proprietor is normally treated as ordinary income for tax purposes. The principal disadvantage of a sole proprietorship is that the owner is solely liable for all obligations of the business. Thus, if the business is sued, the owner is solely responsible for any liability resulting from the outcome of the suit.