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2: Alternative Forms of Business Organizations

  • Page ID
    12747
  • Learning Objectives

    After completing this chapter, you should be able to: (1) know the different forms of business organizations; (2) compare the advantages and disadvantages of alternative types of business organizations; and (3) identify how alternative forms of business organizations can influence a firm’s ability to achieve its financial goals and objectives.

    To achieve your learning goals, you should complete the following objectives:

    • Learn about the advantages and disadvantages of a sole proprietorship.
    • Study the characteristics of firms best suited to be organized as sole proprietorships.
    • Learn about the advantages and disadvantages of partnerships.
    • Study the characteristics of firms best suited to be organized as partnerships.
    • Learn about the advantages and disadvantages of C corporations and S corporations.
    • Study the characteristics of firms best suited to be organized as C corporations and S corporations.
    • Learn about the advantages and disadvantages of a Limited Liability Company (LLC).
    • Study the characteristics of firms best suited to be organized as LLCs.
    • Learn about the advantages and disadvantages of a cooperative.
    • Study the characteristics of firms best suited to be organized as cooperatives.
    • Learn about the advantages and disadvantages of a trust.
    • Study the characteristics of firms best suited to be organized as trusts.

    Introduction

    The way a business is organized influences its ability to reach its goals and objectives. This chapter focuses on legal forms of business organizations that are widely used in the U.S. These include sole proprietorships, general and limited partnerships, limited liability corporations (LLCs), S corporations, and C corporations. Partnerships, LLCs, and C corporations are found across a wide spectrum of business types and sizes. LLCs are becoming increasingly important in the production agricultural sector, particularly with multi-generation family businesses. In family businesses, legal business structures which facilitate intergenerational transfer of assets has become particularly important.

    Characteristics of businesses organizations that influence the ability of a firm to reach its goals and achieve its mission include: 1) who makes the management decisions; 2) how much flexibility does it have in its production, marketing, consumption, and financing activities; 3) its liability exposure; 4) its opportunities for acquiring capital; 5) how the life of the business is defined; 6) how the death of its owners affects the firm; 7) methods available for transferring the current owners’ interest to others; and 8) Internal Revenue Service definitions of business profits and their taxation. Thus, the way a firm is legally organized provides the framework to make financial management decisions.

    Sole Proprietorship

    The sole proprietorship is a common organization form especially used by small businesses. A sole proprietorship is a business that is owned and operated by a single individual. Most sole proprietorships are family-owned businesses. The advantages of the sole proprietorship organization include:

    1. It is easy and inexpensive to form and operate administratively (simplicity);
    2. It offers the maximum managerial control; and
    3. Business income is taxed as ordinary (personal) income to the owner.

    The disadvantages of the sole proprietorship include:

    1. It is difficult to raise large amounts of capital;
    2. There is unlimited liability;
    3. It is difficult to transfer ownership; and
    4. The company has a limited life that is linked to the life of the owner.

    Sole proprietorships are typically organized informally and require relatively little paperwork to begin operations. It is the most simple among the alternative business organizations to understand and use. To begin operation, the individual declares himself/herself to be a business. In many cases, a license will be required to operate the business, but often the business begins simply by “opening its door.” The day-to-day operations of the firm are also organized informally and may be administered as the owner desires, subject to legal and tax restrictions. For example, certain taxes must be paid by specific dates. The vast majority of regulations small businesses face are independent of the legal form of the business. Metrics such as business size, number of employees, and location determine which regulations business face.

    Since sole proprietorships are owned by a single individual, this form of business organization offers the maximum management control. In small firms, the owner of the business is often involved in all aspects of the business: purchasing, inventory control, production, sales, accounting, personnel and customer relations, as well as financial and general management. While the large amount of owner control can be a strength in small firms, it often turns out to be a disadvantage as firms begin to grow and the owner is no longer able to manage all aspects of the business. The owner must then hire competent staff to manage specific aspects of the business.

    Additionally, the business is restricted by the financial resources available to the owner. This can restrict the startup of the business as well as its growth over time. In many cases, substantial cash outlays are required to make the capital purchases (land, facilities, equipment, cars, offices) to start the business and to provide initial overhead expenses (salaries, wages, supplies) until the business gets going. Further, it frequently takes two or three years before the business begins to show a profit. The owner of the business has to obtain these funds using his/her own equity (funds owned by the individual) and/or by borrowing funds, and borrowing requires collateral in the form of owner equity The amount that can be borrowed depends on the level of equity as well as the projected cash flow generated by the business. The lack of available financial capital for starting and expanding the business is a major drawback in the sole proprietorship. The profits from the business are taxed as personal income to the owner.

    Sole proprietorships are subject to unlimited liability which means that the liability for business debts extends beyond the owner’s investment in the firm. For example, if the sole proprietorship is unable to cover its debts and obligations, creditors have the right to collect the personal assets that are not part of the business or other businesses of the owner. The owner may be forced to liquidate assets, such as a personal savings account, a vacation home, or other personal assets just to cover the firm’s obligations.

    Another disadvantage of a sole proprietorship is that it has a limited life that corresponds to life of the owner. The owner may sell assets from the business to another sole proprietorship or business. However, if the business is not terminated prior to the death of the owner, then after the proprietor’s death, the assets remaining in the firm will be distributed according to the owner’s will or comparable instrument. When the owner dies, the business is terminated.

    Partnerships

    A general partnership is a business that is owned and operated by two or more individuals. The partners contribute to the business, share in management, and divide any profit. Partnerships are usually created by written contract among the partners, but they can be legally recognized even without a written agreement. If the partnership owns real property, the partnership agreement should be filed in the county where the property is located.

    Advantages of partnerships include:

    1. They are easy and inexpensive to form and operate administratively;
    2. They have the potential for large managerial control;
    3. Business income is taxed as ordinary (personal) income to the owner; and
    4. A partnership may be able to raise larger amounts of capital than a sole proprietorship.

    The disadvantages of a general partnership include:

    1. Raising capital can still be a constraint;
    2. There is unlimited liability;
    3. It is difficult to transfer ownership; and
    4. The company has limited life.

    The advantages and disadvantages of a general partnership are similar to the sole proprietorship. Partnerships are generally easy and inexpensive to set up and operate administratively. Partnership operating agreements are critical. Like sole proprietorships, profit allocated to the partners is based upon their share in the business.

    Managerial control resides with the partners. This feature can be an advantage or disadvantage depending on how well the partners work together and the level of trust in each other. Control by any one partner is naturally diluted as the number of partners increases. Partnerships are separate legal entities that can contract in their own name and hold title to assets

    The challenge to partnerships extends beyond possible conflicts with the partners. Divorce and other disputes may threaten the survival of the partnership when a claimant to a portion of the business’s assets demands his/her equity.

    Unlimited liability remains a strong disadvantage for a general partnership. All partners are liable for the debts of the firm. Due to this unlimited liability, the risks of the business may be spread according to the owners’ equity rather than according to their interests in the business. This risk becomes an actual obligation whenever the partners are unable to satisfy their shares of the business’s obligations.

    Increasing the number of partners can increase the amount of capital that can be accessed by the firm. More partners tends to mean more financial resources and this can be an advantage of a partnership compared to a sole proprietorship. Still, it is generally difficult for partnerships to raise large amounts of capital—particularly when liability is not limited.

    Ownership transfer and limited life continues to be a problem in partnerships; however, it may be possible to build provisions into the partnership that will allow it to continue operating if one partner leaves or dies. In some cases, parent-child partnerships can ease the difficulties of ownership transfer.

    A limited partnership is another way businesses can organize. Limited partnerships have some partners (limited partners) who possess limited liability; limited partners do not participate in management of the firm. There must be at least one general partner (manager) who has unlimited liability. Because of the limited liability feature for limited partners, this type of business organization makes it easier to raise capital by adding limited partners. These limited partners are investors and make no management decisions in the firm.

    One difficulty occurs if the limited partners wish to remove their equity from the firm. In this instance, they must find someone who is willing to buy their share of the partnership. In some cases, this may be difficult to do. Another difficulty is that the Internal Revenue Service (IRS) may tax the limited partnership as a corporation if it believes the characteristics of the business organization are more consistent with the corporate form of business organization.

    In production agriculture, family limited partnerships serve a number of objectives. For example, parents contemplating retirement may wish to maintain their investment in a farm business but limit their liability and be free of management concerns. To reduce their liability exposure and be free of managerial responsibilities, parents can be limited partners in a business where younger family members are the general partner.

    The joint venture is another variation of the partnership, usually more narrow in function and duration than a partnership. The law of partnership applies to joint ventures. The primary purpose of this form or organization is to share the risks and profits of a specific business undertaking.

    Corporations

    A corporation is a legal entity separate from the owners and managers of the firm. Three fundamental characteristics distinguish corporations from proprietorships and partnerships: (1) the way they are owned and managed, (2) their perpetual life, and (3) their legal status separate from their owners and managers.

    A corporation can own property, sue and be sued, contract to buy and sell, and be fined—all in its own name. The owners usually cannot be made to pay any debts of the corporation. Their liability is limited to the amount of money they have paid or promised to pay into the corporation.

    Ownership in the corporation is represented by small claims (shares) on the equity and profit stream of the firm.

    The two most common types of claims on the equity of the firm are common and preferred stock. The claims of preferred stockholders takes preference over equity claims of common stockholders in the event of the corporation’s bankruptcy. Preferred stockholders must also receive dividends before other equity claims. The preferred stockholders’ dividends are usually fixed amounts paid at regular intervals that rarely change. In most cases, preferred stock has an accumulated preferred feature. This means that if the firm fails to pay a dividend on preferred stock, at some point in time the corporation must make up the payment to its preferred stockholders holders before it can make payments to other equity claims.

    Common stock equity claims are the last ones satisfied in the event of the corporation’s bankruptcy. These are residual claims on the firm’s earnings and assets after all other creditors and equity holders have been satisfied. Although it appears that common stock holders always get the “leftovers,” the good news is that the leftovers can be substantial in some cases because of the nature of the fixed payments to creditors and other equity holders.

    Large corporations are usually organized as Subchapter C corporations.

    The advantages of a C corporation include:

    1. There is limited liability;
    2. The corporation has unlimited life;
    3. Ownership is easily transferred; and
    4. It may be possible to raise large amounts of capital.

    The disadvantages of a C corporation include:

    1. There is double taxation; and
    2. It is expensive and complicated to begin operations and to administer.

    Seeing Double

    Earnings from the corporation are taxed using a corporate tax rate. When earnings are distributed to the shareholders in the form of dividends, the earnings are taxed again as ordinary income to the shareholder. For example, suppose a corporation, whose ownership is divided among its 3000 shareholders, earns $1,000,000 in taxable profits for the year and is in a flat 40-percent tax bracket. Profits per share equal $1,000,000/3000—or $333.33. The corporation pays 40% of $1,000,000—or $400,000—in taxes to the government. Taxes per share equal $400,000/3000—or $133.33.

    Now suppose the corporation distributes its after-tax profits to its 3,000 shares in the form of dividends. Each shareholder would receive a dividend check of $600,000/3,000 = $200. The $200 dividend income received by each shareholder would then be taxed as ordinary personal income. If all the shareholders were in the 30-percent tax bracket, then each would pay 30% of $200 or $60 in taxes, leaving each shareholder with $140 in after-tax dividend income.

    So what is the total tax rate paid on corporate earnings? Dividing the taxes paid by the corporation and the shareholder by the profit per share, the total tax rate is ($133.33+$60)/$333.33 = 58%, a higher rate than would be paid on personal income of the same amount.

    One of the primary strengths of the corporate form of business organization is that the most the owners of the firm (shareholders) can lose is what they have invested in the firm. This limited liability feature means that as a shareholder, one’s personal assets beyond the investment in the corporation can’t be taken to satisfy the corporation’s debts or obligations.

    Ownership can easily be transferred by selling shares in the corporation. Likewise, the corporation has an unlimited life because when an owner dies, the ownership shares are passed to his/her heirs. The common separation of ownership and management in large corporations helps to ease the ownership transfer as the firm management process never ceases.

    The easy transfer of ownership, separation of management and ownership, and limited liability features of a corporation combine to create a business structure that is designed to raise large sums of equity capital. Investors in large corporations don’t have to become involved in management of the firm. Their risk is limited to the amount of funds invested in the firm, and their ownership interest can be transferred by selling their shares in the firm.

    Corporations are more expensive and complicated to set up and administer than sole proprietorships or partnerships. Corporations require a charter, must be governed by a board of directors, pay legal fees, and meet certain accounting requirements. Despite the relatively high setup cost, the primary disadvantage of the corporate form of business is that income generated by the corporation is subject to double taxation.

    However, there is a limit on corporate earnings that are double-taxed. The corporation may pay reasonable salaries, and these are deducted from the corporation’s profits. Therefore, salaries paid to corporate workers and operators are not taxed at the corporate level. In some cases, the corporation’s entire net profit may be offset by salaries to the owners so that no corporate income tax is due. On the other hand, if the corporation pays dividends to the shareholders, those payments are subject to corporate-level income tax. However, the individual does not have to pay self-employment tax on the dividends. And, qualifying dividends (and most United States Corporation dividends can fit into this definition) are taxed at capital gains rates and not the individual’s top marginal tax rate. Finally, dividends paid to a shareholder that actively participates in the business are not subject to either the 0.9 percent Medicare surtax on earnings or the 3.8 percent tax on net investment income that are levied on higher-income taxpayers.

    Another disadvantage of corporations has to do with the fact that the managers do not own the firm. Managers, who control the resources of the firm, may use them for their own benefit. For example, top management may build extravagantly large headquarters and buy fleets of jets and limousines for transportation. If less were spent on perquisites, then the income of the corporation would be higher. Higher income allows higher dividends to be paid to the owners (shareholder).

    The (potential) self-serving behavior by management running contrary to the interests of stockholders is an example of a principal-agent problem. Methods of dealing with the principal-agent exist. One way is to hire auditors to monitor the use of firm resources. Further, a corporation has a board of directors responsible for hiring, evaluating, and removing top management. Boards are often ineffective because they meet infrequently and may not have access to the information necessary to fulfill their responsibilities. Additional problems exist if management personnel also sit on the board of directors.

    Another way to deal with the principal-agent problem in corporations is to align the interests of management with those of shareholders. This is accomplished by basing the compensation of management on the value of the firm’s stock. A chief executive officer could receive stock options as a part of his/her compensation package. If the stock price rises, the value of the options increase, which benefits the manager financially. The shareholders also benefit when the stock price increases. Such an arrangement may reduce the principal-agent problem. However, very high executive compensation can often trigger criticism from external groups such as consumer or labor activists.

    Limitations of linking management’s compensation to the value of its stock have been illustrated by Enron and Tyco corporations. These corporations inflated the value of their stocks and eventually bankrupted themselves and lost the investments of their employees. It seems there is still a lot to be learned about aligning the interests of corporate managers and shareholders.

    Many small businesses, including farms, use the C corporation structure and operate much like partnership. This is frequently done for reasons of expensing and intergenerational transfer.

    The corporation will need to be “capitalized” by some level of equity funds from the shareholders. It is common practice among lenders to require personal guarantees by the owners of small corporations before providing funds to the business. This essentially eliminates the limited liability features for those shareholders. As one might expect, due to these difficulties, many small corporations are not able to generate large amounts of capital by simply selling ownership shares. As a result, many small corporations do not really receive the full benefits of corporate organization but are still subject to the disadvantages, namely double taxation.

    C corporations and S corporations. Any corporation is first formed under the laws of a particular state. From the standpoint of state business law, a corporation is a corporation. However, there are two types of for-profit corporations for federal tax law purposes:

    • C corporations: What we normally consider “regular” corporations that are subject to the corporate income tax
    • S corporations: Corporations that have filed a special election with the IRS. They are not subject to corporate income tax. Instead, they are treated similarly (but not identically) to partnerships for tax purposes.

    There is an alternative form of corporate business organization that is often more desirable from a small business perspective. Subchapter S Corporations have limited liability protection, but the income for the business is only taxed once as ordinary income to the individual (Wolters Kluwer. n.d.).

    There are restrictions on what type of firms can be organized as Subchapter S corporations. To do so, it must meet several requirements: (1) cannot have more than 100 shareholders; (2) may have only one class of stock; (3) cannot have partnerships or other corporations as stockholders; and (4) may not receive more than 20 percent of its gross receipts from interest, dividends, rents, royalties, annuities, and gains from sales or exchange of securities. In agriculture, these restrictions usually mean that only family or closely-held farm businesses can achieve Subchapter S status.

    Federal income tax rules for Subchapter S corporations are similar to regulations governing partnerships and sole proprietors. However, corporations may provide certain employee benefits that are tax deductible. Accident and health insurance, group life insurance, and certain expenditures for recreation facilities all qualify. However, these benefits may be taxable to the employees and subsequently to the shareholders.

    There is greater continuity for businesses organized under Subchapter S than for sole proprietorships or partnerships. Upon the death of shareholders, their shares of the corporations are transferred to the heirs and the Subchapter S election is maintained. Surveys suggest that the major reason farms incorporate is for estate planning. The corporate form allows for the transfer of shares of stock either by sale or gift. This is much easier than transferring assets by deed.

    Limited Liability Company

    The Limited Liability Company (LLC) is a relatively new form of business organization. An LLC is a separate entity, like a corporation, that can legally conduct business and own assets. The LLC must have an operating agreement which regulates its business activities and the relationship among its owners (referred to as members). There are no restrictions on the number of members or the members’ identities. LLCs are subject to disclosure, record keeping, and reporting requirements that are similar to a corporation.

    The attractive feature of the LLC is that all members obtain limited liability, but the entity is taxed as a general partnership. The LLC is similar in most respects to the Subchapter S corporation. The primary differences are: 1) the LLC has less restrictive membership requirements; and 2) the LLC is dissolved in the event of transfer of interest or death unless members vote to continue the LLC. Table 2.1 summarizes the primary characteristics of the business organizations discussed so far.

    Table 2.1. Comparison of Business Organizations
      Sole Proprietorship Partnership Limited Partnership S Corporation C Corporation Limited Liability Company
    ownership
    • single
    • individual
    • two or more individuals
    • two or more individuals
    • one or more general partners
    • legal person
    • max 35 shareholders
    • individuals
    • legal person
    • legal person
    • two or more members
    management decision
    • proprietor
    • partners
    • general partner
    • elected directors
    • management
    • elected directors
    • management
    • members
    • manager
    life
    • terminates at death
    • terminates at death
    • agreed term
    • terminates at death
    • perpetual or fixed
    • transfer stock
    • perpetual or fixed
    • transfer stock
    • agreed term
    • terminates at death
    transfer
    • assets
    • assets
    • assets
    • shares
    • shares
    • assets
    income tax
    • individual
    • individual
    • individual
    • individual
    • corporate
    • individual
    • individual
    liability
    • unlimited
    • unlimited
    • general partners unlimited
    • limited partners limited
    • limited
    • limited
    • limited
    capital
    • personal
    • loans
    • personal
    • loans
    • personal
    • loans
    • shareholders
    • bonds
    • loans
    • shareholders
    • bonds
    • loans
    • members
    • loans

    Cooperative

    A cooperative is a business that is owned and operated by member patrons. Generally, cooperatives are thought to operate at cost, with all profits going to member patrons. The profits are usually redistributed over time in the form of patronage refunds. Cooperatives often appear to operate as profit making organizations much the same as other forms of business organization. Agricultural cooperatives do not face the same anti-trust restrictions as non-cooperative businesses, and they enjoy a different federal income tax status. In most instances, the concepts and analysis techniques covered in this course will be relevant to financial management in cooperatives.

    Trusts

    A trust transfers legal title of designated assets to a trustee, who is then responsible for managing the assets on the beneficiaries’ behalf. The management objectives can be spelled out in the trust agreement. Beneficiaries retain the right to possess and control the assets of the trust and to receive the income generated by the properties owned by the trust. Beneficiaries hold the trust and personal property, rather than title to the assets. The legal status of certain types of land trusts are unclear in some states.

    Farm Business Organization Types in US Agriculture

    The USDA defines a farm as a place that generates at least $1,000 value of agricultural products per year. In 2007, farms generating between $1,000 and $10,000 of agricultural products made up 60% of the 2.2 million U.S. farms. Farms producing $500,000 or more in 2007 dollars generated 96% of the value of U.S. agricultural production.

    Table 2.2 shows the percentage of farms by organizational type and their share of aggregate agriculture product sales according to the 2007 Census of Agriculture. Sole proprietorships are the dominant form of business organization measured by farm count (86.5%) but have only 49.6% of the value of agricultural production. Partnerships and family corporations make up 20.8% of farms but have 43% of the value of agricultural production. Non-family corporations, part of the “other organization” category, accounted for 0.4% of farms and 6.5% of the value of agricultural production.

    Table 2.2. Farm Business Organization Types (USDA Census of Agriculture, 2007. Farms in US 1,925,300)
    Business Type % of Farms % of Cash Receipts
    Sole Proprietorships 86.5% 49.6%
    Partnerships 7.9% 20.9%
    Family Corporations[1] 3.95 22.9%
    Other[2] 1.2% 7.3%

    More generally, about 80 percent of all businesses (agriculture and non-agriculture) are organized as sole proprietorships while only around 10 percent of businesses are organized as corporations. Conversely, about 80 percent of business sales come from corporations while sole proprietorships account for only about 10 percent of business sales.

    So what have we learned? We learned that firms organize differently depending on the size, ability to manage, the need for internal versus external funding, and tax implications. Indeed, the need for different business organizations can be compared to the need for different kinds of transportation—it depends on where you are going.

    Summary and Conclusions

    Recognizing that we can offer financial management tools that meet a limited set of business organizations, we purposely focus in this text on small to medium-size businesses. As a result, we focus on firms that depend on internal capital and exercise the maximum control of the firm.

    Questions

    1. Discuss the advantages and disadvantages of organizing a business as a sole proprietorship versus a C corporation.
    2. Limited partnerships, limited liability companies, and Subchapter S corporations are also alternative forms of business organization. Discuss the advantages and/or disadvantages these organizations offer relative to sole proprietorships, general partnerships and C corporations.
    3. Approximately 85% of all farm businesses in the US are organized as sole proprietorships. Explain why the organization form of farm businesses in the U.S. is dominated by sole proprietorships.
    4. Pick an agricultural commodity or product that is produced in the food industry. Describe the different production, processing and marketing steps for the commodity or product and how they are typically coordinated.
    5. Can you explain in Table 2.2 why corporations tend to control more land than partnerships and sole proprietorships?
    6. What are the advantages or disadvantages of a family corporation compared to a regular corporation?

    1. More than 50% of the stock is owned by persons related by blood or marriage.
    2. Nonfamily farms, estates or trusts, grazing associations, American Indian Reservations, etc.