One of the most basic decisions that all businesses confront is how to choose a legal form of organization. This decision has very important financial implications because how a business is organized legally influences the risks that the firm’s owners must bear, how the firm can raise money, and how the firm’s profits will be taxed.
The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. More businesses are organized as sole proprietorships than any other legal form. However, the largest businesses are almost always organized as corporations. Even so, each type of organization has its advantages and disadvantages.
Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own profit. About 73 percent of all businesses are sole proprietorships. The typical sole proprietorship is small, such as a bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the wholesale, retail, service, and construction industries.
Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The proprietor raises capital from personal resources or by borrowing, and he or she is responsible for all business decisions. As a result, this form of organization appeals to entrepreneurs who enjoy working independently.
A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of the business are the entrepreneur’s responsibility, and creditors can make claims against the entrepreneur’s personal assets if the business fails to pay its debts.
Partnerships
A partnership consists of two or more owners doing business together for profit. Partnerships account for about 7 percent of all businesses, and they are typically larger than sole proprietorships. Partnerships are common in the finance, insurance, and real estate industries. Public accounting and law partnerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership.
Corporations
A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are; corporations account for nearly 90 percent of total business revenues.
Although corporations engage in all types of businesses, manufacturing firms account for the
largest portion of corporate business receipts and net profits.
The owners of a corporation are its stockholders, whose ownership, or equity, takes the form of either common stock or preferred stock. Unlike the owners of sole proprietorships or partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not personally liable for the firm’s debts.
Their losses are limited to the amount they invested in the firm when they purchased shares of stock. Stockholders expect to earn a return by receiving dividends—periodic distributions of cash—or by realizing gains through increases in share price.
Because the money to pay dividends generally comes from the profits that a firm earns, stockholders are sometimes referred to as residual claimants, meaning that stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive what they are owed. If the firm does not generate enough cash to pay everyone else, there is nothing available for stockholders.
The stockholders (owners) vote periodically to elect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures.
Most importantly, the board decides when to hire or fire top managers and establishes compensation packages for the most senior executives. The board consists of “inside” directors, such as key corporate executives, and “outside” or “independent” directors, such as executives from other companies, major shareholders, and national or community leaders.
Outside directors for major corporations receive compensation in the form of cash, stock, and stock options. This compensation often totals $100,000 per year or more.
The president or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board of directors. The CEO reports periodically to the firm’s directors.
Other Limited Liability Organizations
A number of other organizational forms provide owners with limited liability. The most popular are limited partnership (LP), S corporation (S corp), limited liability company (LLC), and limited liability partnership (LLP).
Each represents a specialized form or blending of the characteristics of the organizational forms described previously. What they have in common is that their owners enjoy limited liability, and they typically have fewer than 100 owners.
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