Forms of Business Ownership
Site: | Saylor Academy |
Course: | BUS101: Introduction to Business |
Book: | Forms of Business Ownership |
Printed by: | Guest user |
Date: | Sunday, October 13, 2024, 8:04 PM |
Description
Review this overview of the various forms of business ownership, including advantages and disadvantages, to learn about some of the factors that go into deciding which form is best for any given situation. No hard and fast formula helps an entrepreneur pick the proper form. However, there are some important considerations, such as risk, taxes, transferability, and even image. After you read, complete the concept check questions about the different types of business structures: sole proprietorship, partnership, and corporations.
Introduction
Learning Outcomes
After reading this chapter, you should be able to answer these questions:
- What are the advantages and disadvantages of the sole proprietorship form of business organization?
- What are the advantages of operating as a partnership, and what downside risks should partners consider?
- How does the corporate structure provide advantages and disadvantages to a company, and what are the major types of corporations?
- What other options for business organization does a company have in addition to sole proprietorships, partnerships, and corporations?
- What makes franchising an appropriate form of organization for some types of business, and why does it continue to grow in importance?
- Why are mergers and acquisitions important to a company's overall growth?
- What current trends will affect the business organizations of the future?
EXPLORING BUSINESS CAREERS
Jessica MacLean
Sole Proprietor
In most any elementary school classroom, at least one child's answer to the question, "What do you want to do with your life?" will be, "A lawyer". One of the most popular careers, lawyers are powerful figures in society, shaping our laws and ensuring that we adhere to them. Their prominence and power have led to the stereotype of rich, career-driven lawyers, often leaving no room in our minds for those who truly want to bring justice to the world. However, Jessica MacLean, a lawyer focusing primarily on women's rights, is quick to say that, as with many stereotypes, that is only one side of the story. "I know because I lived that - I was on my way to being a successful corporate lawyer. But I realized what I was doing and how different that was from why I'd started practicing. So I walked away from it all to start my own practice".
Nervous about the prospect of private practice, she has chosen to operate as a sole proprietorship for now. Sole proprietorships are easy to set up for people who want to work on their own, prefer direct control of the business, and desire the flexibility to sell the business or close the doors at any time. "For me, it's the best choice because I am not responsible for or to anyone else. I can easily dissolve the business if I find it is not proceeding how I'd planned. More positively, too, if it does succeed, I know that success is due to my hard work.
Indeed MacLean's law career was not always in corporate law. She turned her sights toward law after a gender and communications professor at DePaul University suggested her argumentative style might be an asset in that profession. "She said I needed to tone it down for class - that the other students seemed afraid to speak up - but then asked if I'd ever considered being a lawyer". MacLean, who had always been interested in issues of justice and legality surrounding women, took her professor's advice and made the leap into law.
While in law school, she clerked for the city of Chicago in their department of personnel's sexual harassment office and volunteered for the Cook County state's attorney's office in the domestic violence division. The cases she worked on were emotionally trying. Despite the difficulty of the cases, she was drawn to them, compelled by the people she helped and the change she was able to effect. After school, she continued in related practice, working first for the Cook County state's attorney's office.
After several years with the state's attorney's office, she needed a change. It was then that MacLean decided to work for a corporation, a form of business that you will learn about in this chapter. "Why did I switch to corporate law? I think I was burnt out, to some extent. It's so hard to work on those cases, day after day. I needed to see if I would be better somewhere else".
Having enjoyed the rewards of working with the state's attorney's office and a corporation and being a sole proprietor, in 2014 MacLean joined a limited liability partnership (LLP, a form of business that you will learn about in this chapter) firm in Chicago. As her needs changed, the form and type of business organization she has worked for has changed also.
This chapter discusses sole proprietorships, as well as several other forms of business ownership, including partnerships and corporations, and compares the advantages and disadvantages of each.
With a good idea and some cash in hand, you decide to start a business. But before you get going, you need to ask yourself some questions that will help you decide what form of business organization will best suit your needs.
Would you prefer to go it alone as a sole proprietorship, or do you want others to share your burdens and challenges in a partnership? Or would the limited liability protection of a corporation, or perhaps the flexibility of a limited liability company (LLC), make more sense?
There are other questions you need to consider too: Will you need financing? How easy will it be to obtain? Will you attract employees? How will the business be taxed, and who will be liable for the company's debts? If you choose to share ownership with others, how much operating control would they want, and what costs would be associated with that?
As Table 4.1 illustrates, sole proprietorships are the most popular form of business ownership, accounting for 72 percent of all businesses, compared with 10 percent for partnerships and 18 percent for corporations. Because most sole proprietorships and partnerships remain small, corporations generate approximately 81 percent of total business revenues and 58 percent of total profits.
Most start-up businesses select one of these major ownership forms. In the following pages, we will discover the advantages and disadvantages of each form of business ownership and the factors that may make it necessary to change from one form of organization to another as the needs of the business change. As a company expands from small to midsize or larger, the form of business structure selected in the beginning may no longer be appropriate.
Source: Rice University, https://openstax.org/books/introduction-business/pages/4-introduction
This work is licensed under a Creative Commons Attribution 4.0 License.
Going It Alone: Sole Proprietorships
- What are the advantages and disadvantages of the sole proprietorship form of business organization?
Jeremy Shepherd was working full-time for an airline when, at the age of 22, he wandered into an exotic pearl market in China, searching for a gift for his girlfriend. The strand of pearls he handpicked by instinct was later valued by a jeweler back in the States at 20 times what he paid for it. Jeremy cashed his next paycheck and hurried back to Asia, buying every pearl he could afford. Founded in 1996, his company Pearl Paradise was brought online in 2000. Shepherd chose the sole proprietorship form of business organization - a business that is established, owned, operated, and often financed by one person - because it was the easiest to set up. He did not want partners, and low liability exposure made incorporating unnecessary.
Fluent in Mandarin Chinese, Japanese, and Spanish and immersed in Asian culture, Shepherd believed the internet was the way to market his pearls. Offering a wide range of pearl jewelry through 14 websites worldwide, his company sells as many as 1,000 items per day. The recent addition of an exclusive Los Angeles showroom allows celebrity customers to shop by appointment. With $20 million in sales annually, PearlParadise.com is the industry leader in terms of sales and volume.
Comparison of Forms of Business Organization | |||
---|---|---|---|
Form | Number | Sales | Profits |
Sole Proprietorships | 72 percent | 4 percent | 15 percent |
Partnerships | 10 percent | 15 percent | 27 percent |
Corporations | 18 percent | 81 percent | 58 percent |
Advantages of Sole Proprietorships
Sole proprietorships have several advantages that make them popular:
- Easy and inexpensive to form. As Jeremy Shepherd discovered, sole proprietorships have few legal requirements (local licenses and permits) and are not expensive to form, making them the business organization of choice for many small companies and start-ups.
- Profits all go to the owner. The owner of a sole proprietorship obtains the start-up funds and gets all the profits earned by the business. The more efficiently the firm operates, the higher the company's profitability.
- Direct control of the business. All business decisions are made by the sole proprietorship owner without having to consult anyone else.
- Freedom from government regulation. Sole proprietorships have more freedom than other forms of business with respect to government controls.
- No special taxation. Sole proprietorships do not pay special franchise or corporate taxes. Profits are taxed as personal income as reported on the owner's individual tax return.
- Ease of dissolution. With no co-owners or partners, the sole proprietor can sell the business or close the doors at any time, making this form of business organization an ideal way to test a new business idea.
Disadvantages of Sole Proprietorships
Along with the freedom to operate the business as they wish, sole proprietors face several disadvantages:
- Unlimited liability. From a legal standpoint, the sole proprietor and the company are one and the same, making the business owner personally responsible for all debts the company incurs, even if they exceed the company's value. The owner may need to sell other personal property - their car, home, or other investments - to satisfy claims against the business.
- Difficulty raising capital. Business assets are unprotected against claims of personal creditors, so business lenders view sole proprietorships as high risk due to the owner's unlimited liability. Owners must often use personal funds - borrowing on credit cards, second-mortgaging their homes, or selling investments - to finance their business. Expansion plans can also be affected by an inability to raise additional funding.
- Limited managerial expertise. The success of a sole proprietorship rests solely with the skills and talents of the owner, who must wear many different hats and make all decisions. Owners are often not equally skilled in all areas of running a business. A graphic designer may be a wonderful artist but not know bookkeeping, how to manage production, or how to market their work.
- Trouble finding qualified employees. Sole proprietors often cannot offer the same pay, fringe benefits, and advancement as larger companies, making them less attractive to employees seeking the most favorable employment opportunities.
- Personal time commitment. Running a sole proprietorship business requires personal sacrifices and a huge time commitment, often dominating the owner's life with 12-hour workdays and 7-day workweeks.
- Unstable business life. The life span of a sole proprietorship can be uncertain. The owner may lose interest, experience ill health, retire, or die. The business will cease to exist unless the owner makes provisions for it to continue operating or puts it up for sale.
- Losses are the owner's responsibility. The sole proprietor is responsible for all losses, although tax laws allow these to be deducted from other personal income.
The sole proprietorship may be a suitable choice for a one-person start-up operation with no employees and little risk of liability exposure. For many sole proprietors, however, this is a temporary choice, and as the business grows, the owner may be unable to operate with limited financial and managerial resources. At this point, the owner may decide to take in one or more partners to ensure that the business continues to flourish.
CATCHING THE ENTREPRENEURIAL SPIRIT
Work-Life Balance Important in Small Business
According to a survey released by the Wells Fargo/Gallup Small Business Index, about two-thirds of small business owners are satisfied with how they balance their personal lives and work schedules, and the New York Enterprise Report survey found that they work twice as much as regular employees. The survey also found that 33 percent of small business owners work more than 50 hours per week, while 25 percent reported working over 60 hours per week. A survey by Gallup finds 39 percent of small business owners working over 60 hours per week.
The 2016 Annual Bank of the West Small Business Growth Survey found that 62 percent of the respondents reported the stress of ownership as worse than what they had originally imagined. At the same time, the same people indicated that being a small business owner puts them in charge of their destiny, offers freedom, and is more rewarding than ever imagined. Over two-thirds of small business owners, according to a survey, said they were satisfied with their personal work-life balance, and almost 90 percent said they were satisfied with being a small business owner in general. Dennis Jacobe, chief economist at Gallup, argues, "People see the benefits more closely tied to them when they’re the owner," he says. "Working hard and long is a natural aspect of the kind of people willing to start their own business".
But if employees have trouble balancing work and life, odds are they will have less confidence in you as a leader, a recent study shows. The study, which polled more than 50,000 U.S. workers from various markets including professional services, consumer goods, and financial services, found that employees who strike a positive balance between home and work were 11 percent more likely to praise their leaders’ ability to set a clear direction.
The Society for Human Resource Management’s (SHRM) research also shows work-life balance has a great impact on how employees feel about their leaders. Jennifer Schramm, a manager in SHRM’s workplace trends and forecasting research department, predicts that as companies try to maximize the productivity of each employee, work-life balance and the resulting employee satisfaction will become increasingly more important. And research shows that happy employees can yield happy returns for businesses.
Critical Thinking Questions
- Many small business owners expect their employees to be as committed and to work as hard as they do. How would you avoid falling into that trap while still demanding the best from your workers?
- As a small business owner, consider some strategies to ensure an appropriate work-life balance for your employees.
CONCEPT CHECK
- What is a sole proprietorship?
- Why is this a popular form of business organization?
- What are the drawbacks to being a sole proprietor?
Partnerships: Sharing the Load
- What are the advantages of operating as a partnership, and what downside risks should partners consider?
Can partnerships, an association of two or more individuals who agree to operate a business together for profit, be hazardous to a business's health? Let's assume partners Ron and Liz own a stylish and successful beauty salon. After a few years of operating the business, they find they have contrasting visions for their company. Liz is happy with the status quo, while Ron wants to expand the business by bringing in investors and opening salons in other locations.
How do they resolve this impasse? By asking themselves some tough questions. Whose view of the future is more realistic? Does the business actually have the expansion potential Ron believes it does? Where will he find investors to make his dream of multiple locations a reality? Is he willing to dissolve the partnership and start over again on his own? And who would have the right to their clients?
Ron realizes that expanding the business in line with his vision would require a large financial risk and that his partnership with Liz offers many advantages he would miss in a sole proprietorship form of business organization. After much consideration, he decides to leave things as they are.
For those individuals who do not like to "go it alone," a partnership is relatively simple to set up. Offering a shared form of business ownership, it is a popular choice for professional-service firms such as lawyers, accountants, architects, stockbrokers, and real estate companies.
The parties agree, either orally or in writing, to share in the profits and losses of a joint enterprise. A written partnership agreement, spelling out the terms and conditions of the partnership, is recommended to prevent later conflicts between the partners. Such agreements typically include the name of the partnership, its purpose, and the contributions of each partner (financial, asset, skill/talent). It also outlines the responsibilities and duties of each partner and their compensation structure (salary, profit sharing, etc.). It should contain provisions for the addition of new partners, the sale of partnership interests, and procedures for resolving conflicts, dissolving the business, and distributing the assets.
There are two basic types of partnerships: general and limited. In a general partnership, all partners share in the management and profits. They co-own the assets, and each can act on behalf of the firm. Each partner also has unlimited liability for all the business obligations of the firm. A limited partnership has two types of partners: one or more general partners, who have unlimited liability, and one or more limited partners, whose liability is limited to the amount of their investment. In return for limited liability, limited partners agree not to take part in the day-to-day management of the firm. They help to finance the business, but the general partners maintain operational control.
There are also limited liability partnerships (LLP), which are similar to a general partnership except that partners are not held responsible for the business debt and liabilities. Another type is a limited liability limited partnership (LLLP), which is basically a limited partnership with addition of limited liability, hence protecting the general partner from the debt and liabilities of the partnership.
Advantages of Partnerships
Some advantages of partnerships come quickly to mind:
- Ease of formation. Like sole proprietorships, partnerships are easy to form. The partners agree to do business together and draw up a partnership agreement. For most partnerships, applicable state laws are not complex.
- Availability of capital. Because two or more people contribute financial resources, partnerships can raise funds more easily for operating expenses and business expansion. The partners' combined financial strength also increases the firm's ability to raise funds from outside sources.
- Diversity of skills and expertise. Partners share the responsibilities of managing and operating the business. Combining partner skills to set goals, manage the overall direction of the firm, and solve problems increases the chances for the partnership's success. To find the right partner, you must examine your own strengths and weaknesses and know what you need from a partner. Ideal partnerships bring together people with complementary backgrounds rather than those with similar experience, skills, and talents. In Table 4.2 you'll find some advice on choosing a partner.
- Flexibility. General partners are actively involved in managing their firm and can respond quickly to changes in the business environment.
- No special taxes. Partnerships pay no income taxes. A partnership must file a partnership return with the Internal Revenue Service, reporting how profits or losses were divided among the partners. Each partner's profit or loss is then reported on the partner's personal income tax return, with any profits taxed at personal income tax rates.
- Relative freedom from government control. Except for state rules for licensing and permits, the government has little control over partnership activities.
Perfect Partners |
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Picking a partner is both an art and a science. Someone may have all the right credentials on paper, but does that person share your vision and the ideas you have for your company? Are they a straight shooter? Honesty, integrity, and ethics are important, because you may be liable for what your partner does. Be prepared to talk about everything, and trust your intuition and your gut feelings - they're probably right. Ask yourself and your potential partner the following questions - then see how well your answers match up:
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Table 4.2
Disadvantages of Partnerships
Business owners must consider the following disadvantages of setting up their company as a partnership:
- Unlimited liability. All general partners have unlimited liability for the debts of the business. In fact, any one partner can be held personally liable for all partnership debts and legal judgments (such as malpractice) - regardless of who caused them. As with sole proprietorships, business failure can lead to a loss of the general partners' personal assets. To overcome this problem, many states now allow the formation of limited liability partnerships (LLPs), which protect each individual partner from responsibility for the acts of other partners and limit their liability to harm resulting from their own actions.
- Potential for conflicts between partners. Partners may have different ideas about how to run their business, which employees to hire, how to allocate responsibilities, and when to expand. Differences in personalities and work styles can cause clashes or breakdowns in communication, sometimes requiring outside intervention to save the business.
- Complexity of profit sharing. Dividing the profits is relatively easy if all partners contribute equal amounts of time, expertise, and capital. But if one partner puts in more money and others more time, it might be more difficult to arrive at a fair profit-sharing formula.
- Difficulty exiting or dissolving a partnership. As a rule, partnerships are easier to form than to leave. When one partner wants to leave, the value of their share must be calculated. To whom will that share be sold, and will that person be acceptable to the other partners? If a partner who owns more than 50 percent of the entity withdraws, dies, or becomes disabled, the partnership must reorganize or end. To avoid these problems, most partnership agreements include specific guidelines for transferring partnership interests and buy–sell agreements that make provision for surviving partners to buy a deceased partner's interest. Partners can also purchase special life insurance policies designed to fund such a purchase.
Business partnerships are often compared to marriages. As with a marriage, choosing the right partner is critical. So if you are considering forming a partnership, allow plenty of time to evaluate your and your potential partner's goals, personality, expertise, and working style before joining forces.
CONCEPT CHECK
- How does a partnership differ from a sole proprietorship?
- Describe the four main types of partnerships, and explain the difference between a limited partner and a general partner.
- What are the main advantages and disadvantages of a partnership?
Corporations: Limiting Your Liability
- How does the corporate structure provide advantages and disadvantages to a company, and what are the major types of corporations?
When people think of corporations, they typically think of major, well-known companies, such as Apple, Alphabet (parent company of Google), Netflix, IBM, Microsoft, Boeing, and General Electric. But corporations range in size from large multinationals with thousands of employees and billions of dollars in sales to midsize or even smaller firms with few employees and revenues under $25,000.
A corporation is a legal entity subject to the laws of the state in which it is formed, where the right to operate as a business is issued by state charter. A corporation can own property, enter into contracts, sue and be sued, and engage in business operations under the terms of its charter. Unlike sole proprietorships and partnerships, corporations are taxable entities with a life separate from their owners, who are not personally liable for its debts.
When launching her company, Executive Property Management Services, Inc., 32-year-old Linda Ravden realized she needed the liability protection of the corporate form of business organization. Her company specialized in providing customized property management services to mid- and upper-level corporate executives on extended work assignments abroad, often for three to five years or longer. Taking care of substantial properties in the million-dollar range and above was no small responsibility for Ravden's company. Therefore, the protection of a corporate business structure, along with carefully detailed contracts outlining the company's obligations, were crucial in providing Ravden with the liability protection she needed - and the peace of mind to focus on running her business without constant worry. Note that an LLC does not provide unlimited protection; you can still get in trouble for such things as mingling personal and business funds.
MANAGING CHANGE
Pacific Sun's Golden Glow
It all started as a little surf shop in 1980 in Newport Beach, California. It wasn't called PacSun then. It wasn't even all that different from other shops carrying surfboards and wax, except for one thing. The founders had a better idea.
During Southern California's wet, cool winters, the beaches got empty, and the surf store business went dry. Where did everyone go? To the mall, of course. Their idea - to be the first surf shop to move into California's popular mall locations - worked. The company soon grew to 21 stores, selling such popular name brands as Billabong, Gotcha, CatchIt, Stussy, and Quiksilver, as well as its own private-label brands.
What began as a little surf shop became a leading mall-based specialty retailer in the fast-growing surf, skate, and hip-hop apparel markets. With close to a thousand stores in the United States and Puerto Rico and sales topping $1 billion, how did the founders make the leap from selling and waxing surfboards to being a major player in the youth apparel market? How has Pacific Sunwear of California, Inc. (http://www.pacsun.com) succeeded when thousands of other clothing companies failed?
"We listen and we change," says the CEO of Pacific Sun. "The kids have the answers, so we listen to get the trends, the solutions, and find out what we are doing right". To remain on the cutting edge of teen tastes, the company hosts an open house every Wednesday at its corporate headquarters in Anaheim, California, where vendors present their wares to PacSun's savvy team of buyers. Being able to distinguish between short-lived fads and actual trends is important when making merchandise choices. The company's focus on "active brand management" is what kept its sales climbing.
The founders' philosophy had served their business well. In 1993, the 60-store company sold stock to the public. It had grown to over 1,000 stores in 50 states and Puerto Rico, with 12,000 employees. The company's PacSun stores cater to a completely different customer than its d.e.m.o. hip-hop stores. In April 2006, PacSun launched its third concept, One Thousand Steps, a footwear store.
With changing trends and online shopping challenges facing many brick-and-mortar retailers, companies such as Wet Seal and Quicksilver filed for bankruptcy in 2015, and PacSun filed for bankruptcy in April 2016. At the time of bankruptcy filing, the company had 593 PacSun stores employing approximately 2,000 employees. In September 2016, PacSun emerged from the bankruptcy after it cut debt and closed stores. The company also turned over all of its stock to the private equity firm Golden Gate Capital, its senior lender.
As its business took off, PacSun successfully made the leap from the small sole proprietorship form of business organization to corporate retailing giant. Facing changing trends and technologies, the firm hit a bump in the road and is working hard to reestablish. The company is indeed a thousand steps away from its humble beginnings.
- How did PacSun manage its evolution from a small, local business to a leading mall-based specialty retailer? What could be the reasons for its missteps resulting in the bankruptcy filing?
- What form of business organization might PacSun have chosen when it started, and what might have prompted it to change as it grew?
Corporations play an important role in the U.S. economy. As Table 4.1 demonstrated, corporations account for only 18 percent of all businesses but generate 81 percent of all revenues and 58 percent of all profits. Company type and size vary; however, when you look at the top companies by revenue in the United States or globally, they include many familiar names that affect our daily lives.
In the United States, according to Fortune magazine, the top three corporations in the 2017 were (1) Walmart Stores (revenue: $485.9 B), (2) Berkshire Hathaway (revenue: $223.6 B), and (3) Apple (revenue: $215.6 B), whereas Forbes magazine found that the top three corporations were (1) Berkshire Hathaway (revenue: $222.9B), (2) Apple (revenue: $217.5B), and (3) JPMorgan Chase (revenue: $102.5B). By comparison, the top three companies in 2017 according to the World Economic Forum were (1) Apple, (2) Alphabet, and (3) Microsoft. These corporations rise and fall on the various lists based on their revenue in a given year and how the organizations measure revenue and the time frames that they use.
The Incorporation Process
Setting up a corporation is more complex than starting a sole proprietorship or partnership. Most states base their laws for chartering corporations on the Model Business Corporation Act of the American Bar Association, although registration procedures, fees, taxes, and laws that regulate corporations vary from state to state.
- Selecting the company’s name
- Writing the articles of incorporation (see Table 4.3) and filing them with the appropriate state office, usually the secretary of state
- Paying required fees and taxes
- Holding an organizational meeting
- Adopting bylaws, electing directors, and passing the first operating resolutions
The state issues a corporate charter based on information in the articles of incorporation. Once the corporation has its charter, it holds an organizational meeting to adopt bylaws, elect directors, and pass initial operating resolutions. Bylaws provide legal and managerial guidelines for operating the firm.
Articles of Incorporation |
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Articles of incorporation are prepared on a form authorized or supplied by the state of incorporation. Although they may vary slightly from state to state, all articles of incorporation include the following key items:
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The Corporate Structure
As Exhibit 4.4 shows, corporations have their own organizational structure with three important components: stockholders, directors, and officers.
Stockholders (or shareholders) are the owners of a corporation, holding shares of stock that provide them with certain rights. They may receive a portion of the corporation’s profits in the form of dividends, and they can sell or transfer their ownership in the corporation (represented by their shares of stock) at any time. Stockholders can attend annual meetings, elect the board of directors, and vote on matters that affect the corporation in accordance with its charter and bylaws. Each share of stock generally carries one vote.
The stockholders elect a board of directors to govern and handle the overall management of the corporation. The directors set major corporate goals and policies, hire corporate officers, and oversee the firm’s operations and finances. Small firms may have as few as 3 directors, whereas large corporations usually have 10 to 15.
The boards of large corporations typically include both corporate executives and outside directors (not employed by the organization) chosen for their professional and personal expertise. Outside directors often bring a fresh view to the corporation’s activities because they are independent of the firm.
Hired by the board, the officers of a corporation are its top management and include the president and chief executive officer (CEO), vice presidents, treasurer, and secretary, who are responsible for achieving corporate goals and policies. Officers may also be board members and stockholders.
Advantages of Corporations
The corporate structure allows companies to merge financial and human resources into enterprises with great potential for growth and profits:
- Limited liability. A key advantage of corporations is that they are separate legal entities that exist apart from their owners. Owners’ (stockholders’) liability for the obligations of the firm is limited to the amount of the stock they own. If the corporation goes bankrupt, creditors can look only to the assets of the corporation for payment.
- Ease of transferring ownership. Stockholders of public corporations can sell their shares at any time without affecting the status of the corporation.
- Unlimited life. The life of a corporation is unlimited. Although corporate charters specify a life term, they also include rules for renewal. Because the corporation is an entity separate from its owners, the death or withdrawal of an owner does not affect its existence, unlike a sole proprietorship or partnership.
- Tax deductions. Corporations are allowed certain tax deductions, such as operating expenses, which reduces their taxable income.
- Ability to attract financing. Corporations can raise money by selling new shares of stock. Dividing ownership into smaller units makes it affordable to more investors, who can purchase one or several thousand shares. The large size and stability of corporations also helps them get bank financing. All these financial resources allow corporations to invest in facilities and human resources and expand beyond the scope of sole proprietorships or partnerships. It would be impossible for a sole proprietorship or partnership to make automobiles, provide nationwide telecommunications, or build oil or chemical refineries.
Disadvantages of Corporations
Although corporations offer companies many benefits, they have some disadvantages:
- Double taxation of profits. Corporations must pay federal and state income taxes on their profits. In addition, any profits (dividends) paid to stockholders are taxed as personal income, although at a somewhat reduced rate.
- Cost and complexity of formation. As outlined earlier, forming a corporation involves several steps, and costs can run into thousands of dollars, including state filing, registration, and license fees, as well as the cost of attorneys and accountants.
- More government restrictions. Unlike sole proprietorships and partnerships, corporations are subject to many regulations and reporting requirements. For example, corporations must register in each state where they do business and must also register with the Securities and Exchange Commission (SEC) before selling stock to the public. Unless it is closely held (owned by a small group of stockholders), a firm must publish financial reports on a regular basis and file other special reports with the SEC and state and federal agencies. These reporting requirements can impose substantial costs, and published information on corporate operations may also give competitors an advantage.
Types of Corporations
Three types of corporate business organization provide limited liability.
The C corporation is the conventional or basic form of corporate organization. Small businesses may achieve liability protection through S corporations or limited liability companies (LLCs).
An S corporation is a hybrid entity, allowing smaller corporations to avoid double taxation of corporate profits as long as they meet certain size and ownership requirements. Organized like a corporation with stockholders, directors, and officers, an S corporation is taxed like a partnership. Income and losses flow through to the stockholders and are taxed as personal income. S corporations are allowed a maximum of 100 qualifying shareholders and one class of stock. The owners of an S corporation are not personally liable for the debts of the corporation.
A newer type of business entity, the limited liability company (LLC), is also a hybrid organization. Like S corporations, they appeal to small businesses because they are easy to set up and not subject to many restrictions. LLCs offer the same liability protection as corporations as well as the option of being taxed as a partnership or a corporation. First authorized in Wyoming in 1977, LLCs became popular after a 1988 tax ruling that treats them like partnerships for tax purposes. Today all states allow the formation of LLCs.
Table 4.4 summarizes the advantages and disadvantages of each form of business ownership.
Advantages and Disadvantages of Major Types of Business Organization | ||
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Sole Proprietorship | Partnership | Corporation |
Advantages | ||
Owner receives all profits. | More expertise and managerial skill available. | Limited liability protects owners from losing more than they invest. |
Low organizational costs. | Relatively low organizational costs. | Can achieve large size due to marketability of stock (ownership). |
Income taxed as personal income of proprietor. | Income taxed as personal income of partners. | Receives certain tax advantages. |
Independence. | Fundraising ability is enhanced by more owners. | Greater access to financial resources allows growth. |
Secrecy. | Can attract employees with specialized skills. | |
Ease of dissolution. | Ownership is readily transferable. | |
Long life of firm (not affected by death of owners). | ||
Disadvantages | ||
Owner receives all losses. | Owners have unlimited liability; may have to cover debts of other, less financially sound partners. | Double taxation because both corporate profits and dividends paid to owners are taxed, although the dividends are taxed at a reduced rate. |
Owner has unlimited liability; total wealth can be taken to satisfy business debts. | Dissolves or must reorganize when partner dies. | More expensive and complex to form. |
Limited fundraising ability can inhibit growth. | Difficult to liquidate or terminate. | Subject to more government regulation. |
Proprietor may have limited skills and management expertise. | Potential for conflicts between partners. | Financial reporting requirements make operations public. |
Few long-range opportunities and benefits for employees. | Difficult to achieve large-scale operations. | |
Lacks continuity when owner dies. |
Table 4.4
CONCEPT CHECK
- What is a corporation? Describe how corporations are formed and structured.
- Summarize the advantages and disadvantages of corporations. Which features contribute to the dominance of corporations in the business world?
- Why do S corporations and limited liability companies (LLCs) appeal to small businesses?