10.6: Legal Forms of Business
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Making a profit is a key goal for the overwhelming majority of firms. How a firm’s owners benefit from profits and suffer from losses varies across different legal forms of business. Below we illustrate how profits and losses are treated within different business forms.
|Treatment of Profits and Losses within Different Business Forms|
|A sole proprietorship is owned by one person. The firm and its owner are treated interchangeably—the owner is the only beneficiary of any profits and is personally responsible for any losses and debts. Most sole proprietorships are small, but entrepreneur James Cash Penney operated JCPenney as one for many years after buying out his two partners.|
|In a partnership, two or more partners jointly own the firm. A successful partnership requires trust because profits and losses are shared and because each partner is accountable for the actions of others. Partnerships are a common business form for dental practices and law offices.|
|A corporation such as Southwest Airlines separates ownership and management by issuing ownership shares that are publicly traded in stock markets. Shareholders do not directly receive profits or absorb losses, but profits and losses tend to be reflected in whether the firm’s stock price rises or falls. Shareholders can also benefit from profits in the form of dividends. Most large companies are C corporations with multiple stockholders. A disadvantage of this business form is double taxation: taxes are paid on corporate profits and on any dividends that corporate pays to stockholders, at their personal tax rate. An S corporation is limited to 100 stockholders and is more for smaller companies. It does not have double taxation. Taxes are paid on profits distributed to stockholders at their personal tax rate.|
|A limited liability company (LLC) can be thought of as a hybrid of a corporation and partnership. Like in a corporation, owners are not accountable for the firm’s debts. A winner of a legal judgement against an LLC, for example, cannot claim the personal assets of the LLC’s owners. LLC’s also enjoy the management flexibility of partnerships. For federal tax purposes, an LLC must choose to be treated as a corporation, a partnership, or a sole proprietorship. Many architectural and consulting firms are organized as LLCs.|
Choosing a Form of Business
The legal form a firm chooses to operate under is an important decision with implications for how a firm structures its resources and assets. Several legal forms of business are available to executives. Each involves a different approach to dealing with profits and losses (Table 10.9).
There are three primary considerations that firms should take into account when deciding which legal form of business should be chosen. These are:
- How taxes are handled
- How liability of the owners is handled
- How easy to set up and operate the entity
There are five basic forms of business entities:
- Sole Proprietorship
- S Corporation
- Limited Liability Company—LLC
A sole proprietorship is a firm that is owned by one person. From a legal perspective, the firm and its owner are considered one and the same. On the plus side, this means that all profits are the property of the owner (after taxes are paid, of course). On the minus side, however, the owner is personally responsible for the firm’s losses and debts. This presents a tremendous risk. If a sole proprietor is on the losing end of a significant lawsuit, for example, the owner could find his personal assets forfeited. Most sole proprietorships are small and many have no employees. In most towns, for example, there are a number of self-employed repair people, plumbers, and electricians who work alone on home repair jobs. Also, many sole proprietors run their businesses from their homes to avoid expenses associated with operating an office. Along with the disadvantage of personal liability for the owner, sole proprietorships enjoy two advantages. Taxes on profits are assessed at the owner’s personal tax rate. Also, this is the easiest form of business to set up and operate.
In a partnership, two or more partners share ownership of a firm. A partnership is similar to a sole proprietorship in that the partners are the only beneficiaries of the firm’s profits, but they are also responsible for any losses and debts. Partnerships can be especially attractive if each person’s expertise complements the others. For example, an accountant who specializes in preparing individual tax returns and another who has mastered business taxes might choose to join forces to offer customers a more complete set of tax services than either could offer alone.
From a practical standpoint, a partnership allows a person to take time off without closing down the business temporarily. Sander & Lawrence is a partnership of two home builders in Tallahassee, Florida. When Lawrence suffered a serious injury a few years ago, Sander was able to take over supervising his projects and see them through to completion. Had Lawrence been a sole proprietor, his customers would have suffered greatly. However, a person who chooses to be part of a partnership rather than operating alone as a sole proprietor also takes on some risk; your partner could make bad decisions that end up costing you a lot of money. Thus developing trust and confidence in one’s partner is very important. As with the sole proprietorship, the owners and the partnership are considered as one. Being personally liable for the debts and actions of the partnership and the partner(s) is certainly a downside, however setting up a partnership is relatively easy. Taxes are also paid at the partners individual rate, a tax advantage generally.
Most large firms, such as Southwest Airlines, are organized as corporations. A key difference between a corporation and a sole proprietorship or partnership is that corporations involve the separation of ownership and management. Corporations sell shares of ownership that are publicly traded in stock markets, and they are managed by professional executives. These executives may own a significant portion of the corporation’s stock, but this is not a legal requirement.
Another unique feature of corporations is how they deal with profits and losses. Unlike in sole proprietorships and partnerships, a corporation’s owners (i.e., shareholders) do not directly receive profits or absorb losses. Instead, profits and losses indirectly affect shareholders in two ways. First, profits and losses tend to be reflected in whether the firm’s stock price rises or falls. When a shareholder sells her stock, the firm’s performance while she has owned the stock will influence whether she makes a profit relative to her stock purchase. Shareholders can also benefit from profits if a firm’s executives decide to pay cash dividends to shareholders. Unfortunately, for shareholders, corporate profits and any dividends that these profits support are both taxed. This double taxation is a big disadvantage of corporations. Corporations (also called C corporations) are also the most difficult form of business to set up and have a number of regulations to comply with.
A specialized type of corporation called an S corporation is designed for smaller companies.. Much like in a partnership, the firm’s profits and losses are reported on owners’ personal tax returns in proportion with each owner’s share of the firm, so double taxation is avoided. Although this is an attractive feature, an S corporation would be impractical for most large firms because the number of shareholders in an S corporation is capped, usually at one hundred. In contrast, Southwest Airlines has more than ten thousand shareholders. For smaller firms, such as many real-estate agencies, the S corporation is an attractive form of business. S corporations also provide liability protection for their stockholders as C corporations do, and are easier to set up and operate than C corporations.
A final form of business is very popular, yet it is not actually recognized by the federal government as a form of business. Instead, the ability to create a limited liability company (LLC) is granted in state laws. LLCs mix attractive features of corporations and partnerships. The owners of an LLC are not personally liable for debts that the LLC accumulates (like in a corporation) and the LLC can be run in a flexible manner (like in a partnership). When paying federal taxes, however, an LLC must choose to be treated as a corporation, a partnership, or a sole proprietorship. Many home builders (including Sander & Lawrence), architectural businesses, and consulting firms are LLCs. The ease of setting up and operating an LLC is similar to a sole proprietorship or partnership.
|Taxes||Liability||Ease of Operation|
|Sole Proprietor||Personal tax return||Unlimited liability||Easiest|
|Partnership||Personal tax return||Unlimited liability||Easy|
|C Corporation||Double taxation||Limited liability||Hardest|
|S Corporation||Personal tax return||Limited liability||Hard|
|Limited Liability Company||Personal tax return||Limited liability||Moderate|
Finding the Right Business Structure [03:58]
The video for this lesson further explains the various forms of business ownership.
You can view this video here: https://youtu.be/A-Up-JUkaj0.
- The five major forms of business in the United States are sole proprietorships, partnerships, LLCs, and C and S corporations. Each form has implications for how individuals are taxed, the personal liability of the owners, and how resources are managed and deployed in the set up and operations.
- Why are so many small firms sole proprietorships?
- Find an example of a firm that operates as an LLC. Why do you think the owners of this firm chose this form of business over others?
- Why might different forms of business be more likely to rely on a different organizational structure?
John Deere. (2016, May 26). Finding the right business structure [Video]. YouTube. https://youtu.be/A-Up-JUkaj0.