FORMS OF BUSINESS ORGANIZATION
Large firms in the United States, such as Ford and General Electric, are almost all
organized as corporations. We examine the three different legal forms of business
organization—sole proprietorship, partnership, and corporation—to see why this is so.
Each of the three forms has distinct advantages and disadvantages in terms of the life of
the business, the ability of the business to raise cash, and taxes. A key observation is that,
as a firm grows, the advantages of the corporate form may come to outweigh the
disadvantages.
Sole Proprietorship
A sole proprietorship is a business owned by one person. This is the simplest type
of business to start and is the least regulated form of organization. Depending on where
you live, you might be able to start up a proprietorship by doing little more than getting a
business license and opening your doors. For this reason, there are more proprietorships
than any other type of business, and many businesses that later become large
corporations start out as small proprietorships.
The owner of a sole proprietorship keeps all the profits. That’s the good news. The
bad news is that the owner has unlimited liability for business debts. This means that
creditors can look beyond business assets to the proprietor’s personal assets for
payment. Similarly, there is no distinction between personal and business income, so all
business income is taxed as personal income.
The life of a sole proprietorship is limited to the owner’s life span, and, it is important
to note, the amount of equity that can be raised is limited to the amount of the proprietor’s
personal wealth. This limitation often means that the business is unable to exploit new
opportunities because of insufficient capital. Ownership of a sole proprietorship may be
difficult to transfer because this transfer requires the sale of the entire business to a new
owner.
Partnership
A partnership is similar to a proprietorship, except that there are two or more
owners (partners). In a general partnership, all the partners share in gains or losses, and
all have unlimited liability for all partnership debts, not just some particular share. The
way partnership gains (and losses) are divided is described in the partnership agreement.
This agreement can be an informal oral agreement, such as “let’s start a lawn mowing
business,” or a lengthy, formal written document.
In a limited partnership, one or more general partners will run the business and have
unlimited liability, but there will be one or more limited partners who will not actively
participate in the business. A limited partner’s liability for business debts is limited to the
amount that partner contributes to the partnership. This form of organization is common
in real estate ventures, for example.
The advantages and disadvantages of a partnership are basically the same as those
of a proprietorship. Partnerships based on a relatively informal agreement are easy and
inexpensive to form. General partners have unlimited liability for partnership debts, and
the partnership terminates when a general partner wishes to sell out or dies. All income
is taxed as personal income to the partners, and the amount of equity that can be raised
is limited to the partners’ combined wealth. Ownership of a general partnership is not
easily transferred, because a transfer requires that a new partnership be formed. A
limited partner’s interest can be sold without dissolving the partnership, but finding a
buyer may be difficult.
Because a partner in a general partnership can be held responsible for all
partnership debts, having a written agreement is very important. Failure to spell out the
rights and duties of the partners frequently leads to misunderstandings later on. Also, if
you are a limited partner, you must not become deeply involved in business decisions
unless you are willing to assume the obligations of a general partner. The reason is that if
things go badly, you may be deemed to be a general partner even though you say you are
a limited partner.
Corporation
The corporation is the most important form (in terms of size) of business
organization in the United States. A corporation is a legal “person” separate and distinct
from its owners, and it has many of the rights, duties, and privileges of an actual person.
Corporations can borrow money and own property, can sue and be sued, and can enter
into contracts. A corporation can even be a general partner or a limited partner in a
partnership, and a corporation can own stock in another corporation.
Not surprisingly, starting a corporation is somewhat more complicated than
starting the other forms of business organization. Forming a corporation involves
preparing articles of incorporation (or a charter) and a set of bylaws. The articles of
incorporation must contain a number of things, including the corporation’s name, its
intended life (which can be forever), its business purpose, and the number of shares that
can be issued. This information must normally be supplied to the state in which the firm
will be incorporated. For most legal purposes, the corporation is a “resident” of that state.
The bylaws are rules describing how the corporation regulates its own existence.
For example, the bylaws describe how directors are elected. These bylaws may be a very
simple statement of a few rules and procedures, or they may be quite extensive for a large
corporation. The bylaws may be amended or extended from time to time by the
stockholders.
In a large corporation, the stockholders and the managers are usually separate
groups. The stockholders elect the board of directors, who then select the managers.
Management is charged with running the corporation’s affairs in the stockholders’
interests. In principle, stockholders control the corporation because they elect the
directors.
