3.16: Forms of Doing Business
Learning Outcomes
- Describe the legal implications of a business’ organization on its accounting
As we discussed in the prior section, most small businesses are organized functionally. As a business grows, it tends to gravitate toward a divisional structure, often landing somewhere between the two. In addition to the formal and informal internal structure, however, there is a legal side to the business organization.
Many small businesses in the United States are classified as sole proprietorships, which, just like it sounds, means that one person is the owner and is responsible for all the debts and is the beneficiary of all the profits. A sole proprietorship can have employees, can secure debt, buy assets, sell goods and services, and do anything that any business does. It can even grow large, with revenues in the hundreds of millions of dollars, but that kind of volume is rare is a sole proprietorship, because it takes more business acumen and attention to grow to that size than a single person, even a talented individual, possesses.
The single biggest drawback to a sole proprietorship is that the legal liability for debts and lawsuits (suppose someone slips and falls in your store) lies with the owner. A sole proprietor is not separate from the business, and so the owner’s personal assets are at risk if the business gets into trouble. The proprietor is the business. However, a sole proprietorship is easy to set up, simple to run, and the profits flow through the business to the owner, reported on the proprietor’s Federal and state income tax returns as self-employment income, and is then subject to both the employer and employee portion of Federal payroll taxes, in addition to Federal income tax. The tax issue could be a benefit or a burden, depending on the tax rates on the other forms of doing business.
Adding an additional owner, or two, or even more, transforms a sole proprietorship into a partnership. A general partnership looks for tax purposes much like a sole proprietorship, with the added challenge of splitting profits and losses between partners. There’s no steadfast legal rule on how that is done—it’s up to the partners to figure that out and account for it. There is one additional legal issue worth noting with a general partnership; any general partner may make a business decision (or blunder) that binds all of the general partners. Thus, the idea of the limited partnership was born. Limited partners are sometimes called silent partners, because they invest their money in the business but have no say in how it is run, thus they are sheltered from the general partnership liabilities and decisions. In addition, any time a partner comes on board or leaves, legally the old partnership dissolves and a new one has to be formed, and often a new partner can only be admitted upon approval of the existing partners, making continuity of the partnership sometimes problematic. That’s why every partnership should have a written agreement covering a wide variety of terms, such as admitting a new partner, divvying up profits and losses, distribution to the owner, and dissolution.
Most large companies though are incorporated. The word incorporated literally means “embodied.” In order to form a corporation, the owners file articles of incorporation with a state government and an artificial person is created. A corporation is a separate legal entity, able to buy and sell property, to be sued and to sue others, and to engage in business and commerce. Because it is a separate legal entity run by a board of directors who then delegate the day to day business to the “C suite” of leadership (CEO, CFO, etc.), owners are protected from debts, illegal acts, lawsuits, and all the myriad challenges that sole proprietors and general partners face in running a business. Corporate owners, called shareholders or stockholders, simply invest money in the business in exchange for a return on that investment. Profits are reported and taxed at the corporate level, If the corporation pays out profits to shareholders, the shareholders report that income as taxable (so it is, in essence, taxed twice). Distributions of profits from a corporation are called dividends.
In addition to these three basic forms of doing business, there are a myriad of alternatives and variations, the most notable of which is the Limited Liability Company (LLC). An LLC is much like a partnership. The partners are usually called members, and the LLC can elect to be taxed as a partnership is, with the profits reported on the partner’s individual income tax returns, or as a corporation, where the profits are taxed at the corporate level and distributions to members are dividends that are taxed again at the individual level. Of course, if an LLC or a corporation decides to retain income in the company for operating purposes and future growth and expansion, the double taxation is not an issue. The same holds true for S-Corporations, which are small corporations (100 shareholders or less) that elect to be taxed as a partnership. Other forms of ownership include Professional Service Corporations (PSC), Co-op for farms, factories, and even apartment buildings, and Publicly Traded Partnerships (mostly oil and gas companies.) In addition, some firms, like Kahn Academy, the Red Cross, and many colleges and private school, apply for and are granted to be exempt from tax. These not-for-profit entities have no shareholders, since they are held in the public trust, and the excess of revenues over expenditures have to stay in the organization to further the exempt purpose, like education, health, and social justice. However, most businesses can be categorized into one of the three main categories: corporation, partnership, and sole proprietorship.
| Organization Type | Number of Organizations in U.S. |
|---|---|
| C-Corporations and S-Corporations | 3.9 million |
| Partnerships | 0.7 million |
| Sole Proprietors | 0.9 million |
But why would an investor buy shares of stock in a corporation if the business was not paying out earnings in the form dividends? The answer is growth—specifically, growth in the price of the stock on the open market.
Take FaceBook for example. Mark Zuckerberg started FaceBook in his dorm room in 2004 with no real capital and a single, informal partner—his roommate Eduardo Saverin. As the site grew in popularity, Zuckerberg and Saverin formalized their arrangement by registering in Florida as a Limited Liability Company.
As investors came on board, the company incorporated, still keeping it’s highly centralized management style and functional organizational structure. The initial public offering of stock (IPO) on May 18, 2012 generated $16 billion, with shares selling at just over $38 each. The proceeds from the IPO went directly into the company coffers to fund future expansion, but subsequent trading of those shares of stock issued are between investors who are banking on FaceBook’s continued success (if they are buying) or who are taking their gains and profits (if they are selling). Just under six years later, the stock was trading at a high of over $190 a share. An investor who purchased $10,000 worth of stock during the IPO could have sold that stock in early 2018 for $50,000, making a $40,000 profit for an annualized return on investment of over 32%.
Of course, not every company boasts grand gains. Even the most astute investors lose money on some stocks. That’s why the accounting information that these publicly traded companies provide to the marketplace in the form of quarterly and annual reports is so important. Investors, lenders, and vendors extending credit are relying on that information to make informed judgments and rational financial decisions.
Below is a summary of forms of business ownership and organization:
| Organization by Type | Sole Proprietorship | General Partnership | Limited Partnership | Limited Liability Company (LLC) | C-Corporation | S-Corporation |
|---|---|---|---|---|---|---|
| Ownership | One person | Two or more | At least one general partner plus or one or more limited partners | One or more members | Virtually unlimited number of shareholders | No more than 100 stock holders |
| Capital | Generally comes from personal assets of owner | Generally comes from personal assets of owners and ability to borrow | Limited partners generally provide capital | Members provide capital, limited ability to borrow | Capital can be raised by selling shares on the open market, also debt issuance | Members provide capital, limited ability to borrow |
| Liability | Owner liable for all legal obligations | Partners are jointly and severally liable | General partners are jointly and severally liable but limited partners are not | Members are not liable for LLC legal obligations | Corporation is a separate legal entity. Shareholders are not personally liable for corporate obligations | Corporation is a separate legal entity. Shareholders are not personally liable for corporate obligations |
| Taxation | Net income taxed at the personal level | Net income taxed at the personal level | Net income taxed at the personal level | Can elect to be taxed as a partnership or a corporation | Net income taxed at the corporate level | Net income taxed at the personal level |
| Distributions to owners from profits | Not taxed | Not taxed | Not taxed | Depends on tax election | Taxed as dividends | Not taxed |
| Other | Easy to form and account for, no continuity | Relatively easy to form and account for, some continuity | More difficult to form and account for, some continuity | More difficult to form and account for, some continuity | Most difficult to form and account for, generally continuous | More difficult to form and account for, some continuity |
Practice Questions