FORMS OF BUSINESS ENTERPRISE

Financial management is not restricted to large corporations: It is necessary in all forms and sizes of businesses. The three major forms of business organization are the sole proprietorship, the partnership, and the corporation. 

These three forms differ in a number of factors, of which those most important to financial decision-making are:

■ The way the firm is taxed.

■ The degree of control owners may exert on decisions.

■ The liability of the owners.

■ The ease of transferring ownership interests.

■ The ability to raise additional funds.

■ The longevity of the business.

Sole Proprietorships

The simplest and most common form of business enterprise is the sole proprietorship, a business owned and controlled by one person—the proprietor. Because there are very few legal requirements to establish and run a sole proprietorship, this form of business is chosen by many individuals who are starting up a particular business enterprise. The sole proprietor carries on a business for his or her own benefit, without participation of other persons except employees. The proprietor receives all income from the business and alone decides whether to reinvest the profits in the business or use them for personal expenses.

A proprietor is liable for all the debts of the business; in fact, it is the proprietor who incurs the debts of the business. If there are insufficient business assets to pay a business debt, the proprietor must pay thedebt out of his or her personal assets. If more funds are needed to operate or expand the business than are generated by business operations, the owner either contributes his or her personal assets to the business or borrows. 

For most sole proprietorships, banks are the primary source of borrowed funds. However, there are limits to how much banks will lend a sole proprietorship, most of which are relatively small.

For tax purposes, the sole proprietor reports income from the business on his or her personal income tax return. Business income is treated as the proprietor’s personal income.

The assets of a sole proprietorship may also be sold to some other firm, at which time the sole proprietorship ceases to exist. Or the life of a sole proprietorship ends with the life of the proprietor, although the assets of the business may pass to the proprietor’s heirs.

Partnerships

A partnership is an agreement between two or more persons to operate a business. A partnership is similar to a sole proprietorship except instead of one proprietor, there is more than one. The fact that there is more than one proprietor introduces some issues: Who has a say in the day-to-day operations of the business? Who is liable (that is, financially responsible) for the debts of the business? How is the income distributed among the owners?

How is the income taxed? Some of these issues are resolved with the partnership agreement; others are resolved by laws. The partnership agreement describes how profits and losses are to be shared among the partners, and it details their responsibilities in the management of the business.

Most partnerships are general partnerships, consisting only of general partners who participate fully in the management of the business, share in its profits and losses, and are responsible for its liabilities. Each general partner is personally and individually liable for the debts of the business, even if those debts were contracted by other partners.

A limited partnership consists of at least one general partner and one limited partner. Limited partners invest in the business but do not participate in its management. A limited partner’s share in the profits and losses of the business is limited by the partnership agreement. In addition, a limited partner is not liable for the debts incurred by thebusiness beyond his or her initial investment.

A partnership is not taxed as a separate entity. Instead, each partner reports his or her share of the business profit or loss on his or her personal income tax return. Each partner’s share is taxed as if it were from a sole proprietorship.

The life of a partnership may be limited by the partnership agreement.

For example, the partners may agree that the partnership is to exist only for a specified number of years or only for the duration of a specific business transaction. The partnership must be terminated when any oneof the partners dies, no matter what is specified in the partnership agreement.

Partnership interests cannot be passed to heirs; at the death of any partner, the partnership is dissolved and perhaps renegotiated.

One of the drawbacks of partnerships is that a partner’s interest in the business cannot be sold without the consent of the other partners.

So a partner who needs to sell his or her interest because of, say, personal financial needs may not be able to do so. Another drawback is the partnership’s limited access to new funds.

Short of selling part of their own ownership interest, the partners can raise money only by borrowing from banks—and here too there is a limit to what a bank will lend a (usually small) partnership.

In certain businesses—including accounting, law, architecture, and physician’s services—firms are commonly organized as partnerships.

The use of this business form may be attributed primarily to state laws, regulations of the industry, and certifying organizations meant to keep practitioners in those fields from limiting their liability.

Corporations

A corporation is a legal entity created under state laws through the process of incorporation. The corporation is an organization capable of entering into contracts and carrying out business under its own name, separate from it owners. To become a corporation, state laws generally require that a firm must do the following: (1) file articles of incorporation, (2) adopt a set of bylaws, and (3) form a board of directors.

The articles of incorporation specify the legal name of the corporation, its place of business, and the nature of its business. This certificate gives “life” to a corporation in the sense that it represents a contract between the corporation and its owners. This contract authorizes the corporation to issue units of ownership, called shares, and specifies the rights of the owners, the shareholders.

The bylaws are the rules of governance for the corporation. The bylaws define the rights and obligations of officers, members of the board of directors, and shareholders. In most large corporations, it is not possible for each owner to participate in monitoring the management of the business. For example, at the end of 2001, Emerson Electric Co. had approximately 33,700 shareholders. It would not be practical for each of these owners to watch over Emerson’s management directly. Therefore, the owners of a corporation elect a board of directors to represent them in the major business decisions and to monitor the activities of the corporation’s management. The board of directors, in turn, appoints and oversees the officers of the corporation. Directors who are also employees of the corporation are called insider directors; those who have no other position within the corporation are outside directors or independent directors. In the case of Emerson Electric Co., for example, there were 18 directors in 2002, six inside directors and 13 outside directors. Generally it is believed that the greater the proportion of outside directors, the greater the board’s independence from the management of the company. The proportion of outside directors on corporate boards varies significantly. For example, in 2002 only 44% of Kraft Foods’ board are outsiders, whereas 89% of Texas Instrument’s board is comprised of outside directors.

The state recognizes the existence of the corporation in the corporate charter. Corporate laws in many states follow a uniform set of laws referred to as the Model Business Corporations Act.3 Once created, the corporation can enter into contracts, adopt a legal name, sue or be sued, and continue in existence forever. Though owners may die, the corporation continues to live. The liability of owners is limited to the amounts they have invested in the corporation through the shares of ownership they purchased.

Unlike the sole proprietorship and partnership, the corporation is a taxable entity. It files its own income tax return and pays taxes on its income. That income is determined according to special provisions of the federal and state tax codes and is subject to corporate tax rates different from personal income tax rates.

If the board of directors decides to distribute cash to the owners, that money is paid out of income left over after the corporate income tax has been paid. The amount of that cash payment, or dividend, must also be included in the taxable income of the owners (the shareholders).

Therefore, a portion of the corporation’s income (the portion paid out to owners) is subject to double taxation: once as corporate income and once as the individual owner’s income.

The dividend declared by the directors of a corporation is distributed to owners in proportion to the numbers of shares of ownership they hold. If Owner A has twice as many shares as Owner B, he or she will receive twice as much money.

The ownership of a corporation, also referred to as stock or equity, is represented as shares of stock. A corporation that has just a few owners who exert complete control over the decisions of the corporation is referred to as a close corporation or a closely-held corporation. A corporation whose ownership shares are sold outside of a closed group of owners is referred to as a public corporation or a publicly-held corporation.

Mars Inc., producer of M&M candies and other confectionery products, is a closely-held corporation; Hershey Foods, also a producer of candy products among other things, is a publicly-held corporation.

The shares of public corporations are freely traded in securities markets, such as the New York Stock Exchange. Hence, the ownership of a publicly-held corporation is more easily transferred than the ownership of a proprietorship, a partnership, or a closely-held corporation.

Companies whose stock is traded in public markets are required to file an initial registration statement with the Securities and Exchange Commission (SEC), a federal agency created to oversee the enforcement of U. S. securities laws. The statement provides financial statements, articles of incorporation, and descriptive information regarding the nature of the business, the debt and stock of the corporation, the officers and directors, any individuals who own more than 10% of the stock,     among other items.