Read Chapter 4 - Forms of Business Ownership

Brief Overview

Chapter 4 focuses on specific forms of business organization and introduces a number of basic terms and definitions. The greater part of this chapter is devoted to the three most common forms of business ownership—the sole proprietorship, the partnership, and the corporation.

We discuss the advantages and disadvantages of each form, using Figures 4-1 and 4-2 to emphasize the relative proportions ranked by headcount and sales revenue for each form within the total business community. Then, we outline the process of incorporation and examine the role of a corporation’s board of directors. Next, we discuss S corporations, limited-liability companies, and other special forms of business ownership. Examples from actual corporations illustrate various patterns of corporate growth through mergers and acquisitions.

The three most common forms of business ownership in the United States are sole proprietorships, partnerships, and corporations.

SOLE PROPRIETORSHIPS. A sole proprietorship is a business that is owned (and usually operated) by one person. It is the simplest form of business ownership and the easiest to start. There are approximately 24.1 million sole proprietorships in the United States. (See Figure 4-1.) They account for 72 percent of the country’s business firms. As shown in Figure 4-2, sole proprietorships account for about $1.3 trillion, or about 4 percent of total annual sales.

Advantages of Sole Proprietorships

Ease of Start-Up and Closure. Registering the name of the business and obtaining licenses and permits are the only legal requirements to start a business; this does not require an attorney.

Pride of Ownership. The amount of time and hard work that the owner invests in a sole proprietorship is substantial, and the owner deserves a great deal of credit for assuming the risks and solving the problems associated with operating sole proprietorships.

Retention of All Profits. All profits earned by a sole proprietorship become the personal earnings of its owner. Thus, the owner has a strong incentive to succeed.

No Special Taxes. The sole proprietorship’s profits are taxed as personal income of the owner. Thus, sole proprietorships do not pay the special state and federal income taxes that corporations do.

Flexibility of Being Your Own Boss. The sole owner of a business is completely free to make decisions about the firm’s operations. A sole proprietor can move a shop’s location, open a new store, or close an old one.

Disadvantages of Sole Proprietorships

Unlimited Liability. Unlimited liability is a legal concept that holds a business owner personally liable for all of a business’s debts. If the business fails, the sole proprietor’s personal property including savings and other assets can be seized to pay creditors

Lack of Continuity. Legally, the sole proprietor is the business. If the owner retires, dies, or is declared legally incompetent, the business essentially ceases to exist.

Lack of Money. Banks, suppliers, and other lenders are often unwilling to lend large sums to sole proprietorships. The limited ability to borrow can prevent a sole proprietorship from growing.

Limited Management Skills. The sole proprietor often is the sole manager—in addition to being the sole salesperson, buyer, accountant, and, on occasion, janitor. The business can suffer in the areas in which the owner is less knowledgeable.

Difficulty in Hiring Employees. The sole proprietor may find it hard to attract and keep competent help. Potential employees may feel that there is no room for advancement in a firm whose owner assumes all managerial responsibilities.

Beyond the Sole Proprietorship. The major disadvantage of a sole proprietorship is the limited amount that one person can do in a workday. One way to reduce the effect of this disadvantage is to have more than one owner.

The U.S. Uniform Partnership Act defines a partnership as a voluntary association of two or more persons to act as co-owners of a business for profit. There are approximately 3.4 million partnerships in the United States, accounting for about $5.1 trillion in sales receipts each year. (See Figures 4-1 and 4-2.) However, partnerships represent only about 10 percent of all American businesses.

Types of Partners

General Partners. A general partner is a person who assumes full or shared responsibility for operating a business.

General partners are active in day-to-day business operations, and each partner can enter into contracts on behalf of all the others. He or she assumes unlimited liability for all debts, including debts incurred by any other general partner without his or her knowledge or consent.

To avoid future liability, a general partner who withdraws from the partnership must give notice to creditors, customers, and suppliers.

Limited Partners. A limited partner is a person who contributes capital to a business but who has no management responsibility or liability for losses beyond his or her investment in the partnership.

The general partner(s) collect fees and receive a percentage of the profits. Limited partners receive a portion of the profits and tax benefits.

Special rules apply to limited partnerships intended to protect customers and creditors who deal with them.

The Partnership Agreement. Articles of partnership are an agreement listing and explaining the terms of the partnership. (See Figure 4-3.) When entering into a partnership agreement, partners would be wise to let a neutral third party assist.

ADVANTAGES AND DISADVANTAGES OF PARTNERSHIPS

Advantages of Partnerships

Ease of Start-Up. Partnerships are relatively easy to form. As with sole proprietorships, legal requirements are often limited to registering the name of the business and purchasing licenses or permits.

Availability of Capital and Credit. Because partners can pool their funds, a partnership usually has more capital available than does a sole proprietorship. This, coupled with the general partners’ unlimited liability, can form the basis for a better credit rating.

Personal Interest. General partners are very concerned with the operation of the firm, perhaps even more so than sole proprietors; they are responsible for the actions of all other general partners, as well as for their own.

Combined Business Skills and Knowledge. Partners often have complementary skills. The weakness of one partner in a certain area may be offset by another partner’s strength in that area.

Retention of Profits. As in a sole proprietorship, all profits belong to the owners of the partnership.

No Special Taxes. Like a sole proprietor, each partner is taxed only on his or her share of the profits.

Disadvantages of Partnerships

Unlimited Liability. Each general partner is legally and personally responsible for the debts, taxes, and actions of any other partner, even if that partner did not incur those debts or do anything wrong. Limited partners, however, risk only their original investment. Today, many states allow partners to form a limited-liability partnership (LLP) in which a partner in the business may have limited-liability protection from legal action resulting from the malpractice or negligence of the other partners.

Management Disagreements. Most of the problems that develop in a partnership involve one partner doing something that disturbs the other partner(s). When partners disagree about decisions, policies, or ethics, distrust may build to the point where it is impossible to operate the business successfully.

Lack of Continuity. A partnership is terminated if any one of the general partners dies, withdraws, or is declared legally incompetent.

Frozen Investment. It is easy to invest money in a partnership, but it is sometimes quite difficult to get it out. The partnership agreement should outline the procedure for buying out a partner.

CORPORATIONS. A corporation (or C-corporation) is an artificial person created by law, with most of the legal rights of a real person. There are approximately 5.9 million corporations in the United States. Corporations comprise about 18 percent of all businesses, but they account for 82 percent of all sales revenues. (See Figures 4-1 and 4-2.)

Corporate Ownership. The shares of ownership of a corporation are called stock, and those who own the shares are called stockholders.

A closed corporation is a corporation whose stock is owned by relatively few people and is not bought and sold on security exchanges.

An open corporation is a corporation whose stock is sold to the general public and can be purchased by any individual.

Forming a Corporation. The process of forming a corporation is called incorporation. Most experts recommend that a lawyer should be consulted when beginning the incorporation process. (See Table 4-1 for some aspects that may require legal help.)

Where to Incorporate. A business is allowed to incorporate in any state it chooses. Most small and medium-sized businesses are incorporated in the state where they do the most business. Some states are more hospitable than others and offer fewer restrictions and other benefits to attract new firms.

An incorporated business is called a domestic corporation in the state in which it is incorporated.

In all other states where it does business, it is called a foreign corporation.

A corporation chartered by another government and conducting business in the United States is an alien corporation.

The Corporate Charter. Once a home state has been chosen, the incorporators submit articles of incorporation to the secretary of state. A corporate charter is a contract between the corporation and the state in which the state recognizes the formation of the artificial person that is the corporation and usually includes the following:

a) Firm’s name and address

b) Incorporators’ names and addresses

c) Purpose of the corporation

d) Maximum amount and types of stock to be issued

e) Rights and privileges of stockholders

f) Length of time the corporation is to exist