- Examine special types of business ownership, including S-corporations, limited-liability companies, cooperatives, and not-for-profit corporations.
In addition to the three commonly adopted forms of business organization—sole proprietorship, partnership, and regular corporations—some business owners select other forms of organization to meet their particular needs. We’ll look at several of these options:
- Limited-liability companies
- Not-for-profit corporations
Hybrids: S-Corporations and Limited-Liability Companies
To understand the value of S-corporations and limited-liability companies, we’ll begin by reviewing the major advantages and disadvantages of the three types of business ownership we’ve explored so far: sole proprietorship, partnership, and corporation. Identifying the attractive and unattractive features of these three types of business ownership will help us appreciate why S-corporations and limited-liability companies were created.
Attractive and Unattractive Features of Corporations
What feature of corporations do business owners find most attractive? The most attractive feature of a corporation is limited liability, which means that the shareholders (owners) cannot be held personally liable for the debts and obligations of the corporation. For example, if a corporation cannot pay its debts and goes bankrupt, the shareholders will not be required to pay the creditors with their own money. Shareholders cannot lose any more than the amount they have invested in the company.
What feature of corporations do business owners find least attractive? Most would agree that the least attractive feature of a corporation is “double taxation.” Double taxation occurs when the same earnings are taxed twice by the government. Let’s use a simple example to show how this happens. You’re the only shareholder in a very small corporation. This past year it earned $10,000. It had to pay the government $3,000 corporate tax on the $10,000 earned. The remaining $7,000 was paid to you by the corporation in the form of a dividend. When you filed your personal income tax form, you had to pay personal taxes on the $7,000 dividend. So the $7,000 was taxed twice: the corporation paid the taxes the first time and you (the shareholder) paid the taxes the second time.
Attractive and Unattractive Features of Sole Proprietorships and Partnerships
Now let’s turn to the other two types of business ownership: sole proprietorship and partnership. What feature of these forms of business organization do owners find most attractive? The most attractive feature is that there is no “double taxation” with proprietorships and partnerships. Proprietorships and partnerships do not pay taxes on profits at the business level. The only taxes paid are at the personal level—this occurs when proprietors and partners pay taxes on their share of their company’s income. Here are two examples (one for a sole proprietorship and one for a partnership). First, let’s say you’re a sole proprietor and your business earns $20,000 this year. The sole proprietorship pays no taxes at the “business” level. You pay taxes on the $20,000 earnings on your personal tax return. Second, let’s say you’re a partner in a three-partner firm (in which each partner receives one-third of the partnership income). The firm earns $90,000 this year. It pays no taxes at the partnership level. Each partner, including you, pays taxes on one-third of the earnings, or $30,000 each. Notice that in both cases, there is no “double taxation.” Taxes were paid on the company earnings only once—at the personal level. So the total tax burden is less with sole proprietorships and partnerships than it is with corporations.
What feature of sole proprietorships and partnerships do business owners find least attractive? And the answer is…unlimited liability. This feature holds a business owner personally liable for all debts of his or her company. If you’re a sole proprietorship and the debts of your business exceed its assets, creditors can seize your personal assets to cover the proprietorship’s outstanding business debt. For example, if your business is sued for $500,000 and it does not have enough money to cover its legal obligation, the injured party can seize your personal assets (cash, property, etc.) to cover the outstanding debt. Unlimited liability is even riskier in the case of a partnership. Each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If, through mismanagement by one of your partners, the partnership is forced into bankruptcy, the creditors can go after you for all outstanding debts of the partnership.
How would you like a legal form of organization that provides the attractive features of the three common forms of organization (corporation, sole proprietorship and partnership) and avoids the unattractive features of these three organization forms? It sounds very appealing. This is what was accomplished with the creation of two hybrid forms of organization: S-corporation and limited-liability company. These hybrid organization forms provide business owners with limited liability (the attractive feature of corporations) and no “double taxation” (the attractive feature of sole proprietorships and partnerships). They avoid double taxation (the unattractive feature of corporations) and unlimited liability (the unattractive feature of sole proprietorships and partnerships). We’ll now look at these two hybrids in more detail.