Types of Business Organizations
Three principal types of
organizations have developed as ways of owning and operating business
enterprise.
In general, business entity or
organizations are:
- Sole proprietorship
- Partnerships
- Corporations
Let us discuss these concepts
starting with the simplest form of business organization, the single or sole
proprietorship.
Sole Proprietorship
A sole proprietorship is a business
wholly owned by a single individual. It is the easiest and the least expensive
way to start a business and is often associated with small storekeepers,
service shops, and professional people such as doctors, lawyers, or
accountants. The sole proprietorship is the most common form of business
organization and is relatively free from legal complexities.
One major disadvantage of sole
proprietorship is unlimited liability since the owner and the business are
regarded as the same, from a legal standpoint.
Partnerships
A partnership is a legal association
of two or more individuals called partners and who are co-owners of a business
for profit. Like proprietorships, they are easy to form. This type of business
organization is based upon a written agreement that details the various
interests and right of the partners and it is advisable to get legal advice and
document each person’s rights and responsibilities.
There are three main kinds of
partnerships
- General partnership
- Limited partnership
- Master limited partnership
General Partnership
A business that is owned and operated
by 2 or more persons where each individual has a right as a co-owner and is
liable for the business’s debts. Each partner reports his share of the
partnership profits or losses on his individual tax return. The partnership
itself is not responsible for any tax liabilities.
A partnership must secure a Federal
Employee Identification number from the Internal Revenue Service (IRS) using
special forms.
Each partner reports his share of
partnership profits or losses on his individual tax return and pays the tax on
those profits. The partnership itself does not pay any taxes on its tax return.
Limited Partnership
In a Limited Partnership, one or more
partners run the business as General Partners and the remaining partners are
passive investors who become limited partners and are personally liable only
for the amount of their investments. They are called limited partners because
they cannot be sued for more money than they have invested in the business.
Limited Partnerships are commonly
used for real-estate syndication.
Master Limited Partnership
Master Limited Partnerships are
similar to Corporations trading partnership units on listed stock exchanges.
They have many advantages that are similar to Corporations e.g. Limited
liability, unlimited life, and transferable ownership. In addition, they have
the added advantage if 90% of their income is from passive sources (e.g. rental
income), then they pay no corporate taxes since the profits are paid to the
stockholders who are taxed at individual rates.
Corporations
The Corporation is the most dominant
form of business organization in our society. A Corporation is a legally
chartered enterprise with most legal rights of a person including the right to
conduct business, own, sell and transfer property, make contracts, borrow
money, sue and be sued, and pay taxes. Since the Corporation exists as a
separate entity apart from an individual, it is legally responsible for its
actions and debts.
The modern Corporation evolved in the
beginning of this century when large sums of money were required to build
railroads and steel mills and the like and no one individual or partnership
could hope to raise. The solution was to sell shares to numerous investors
(shareholders) who in turn would get a cut of the profits in exchange for their
money. To protect these investors associated with such large undertakings,
their liability was limited to the amount of their investment.
Since this seemed to be such a good
solution, Corporations became a vibrant part of our nation’s economy. As rules
and regulations evolved as to what a Corporation could or could not do,
Corporations acquired most of the legal rights as those of people in that it
could receive, own sell and transfer property, make contracts, borrow money,
sue and be sued and pay taxes.
The strength of a Corporation is that
its ownership and management are separate. In theory, the owners may get rid of
the Managers if they vote to do so. Conversely, because the shares of the
company known as stock can sold to someone else, the Company’s ownership can
change drastically, while the management stays the same. The Corporation’s
unlimited life span coupled with its ability to raise money gives it the
potential for significant growth.
A Company does not have to be large
to incorporate. In fact, most corporations, like most businesses, are
relatively small, and most small corporations are privately held.
Some of the disadvantages of
Corporations are that incorporated businesses suffer from higher taxes than
unincorporated businesses. In addition, shareholders must pay income tax on
their share of the Company’s profit that they receive as dividends. This means
that corporate profits are taxed twice.
There are several different types of
Corporation based on various distinctions, the first of which is to determine
if it is a public, quasi-public or Private Corporation. Federal or state governments
form Public Corporations for a specific public purpose such as making student
loans, building dams, running local school districts etc. Quasi-public
Corporations are public utilities, local phones, water, and natural gas.
Private Corporations are companies owned by individuals or other companies and
their investors buy stock in the open market. This gives private corporations
access to large amounts of capital.
Public and private corporations can
be for-profit or non-profit corporations. For-profit corporations are formed to
earn money for their owners. Non-profit Corporations have other goals such as
those targeted by charitable, educational, or fraternal organizations. No
stockholder shares in the profits or losses and they are exempt from corporate
income taxes.
Professional Corporations are set up
by businesses whose shareholders offer professional services (legal, medical,
engineering, etc.) and can set up beneficial pension and insurance
packages.Limited Liability Companies (LLCs as they are called) combine the
advantages of S Corporations and limited partnerships, without having to abide
by the restrictions of either. LLCs allow companies to pay taxes like
partnerships and have the advantage of protection from liabilities beyond their
investments. Moreover, LLCs can have over 35 investors or shareholders (with a
minimum of 2 shareholders). Participation in management is not restricted, but
its life span is limited to 30 years.
Subchapter S Corporation
Subchapter S Corporation, also known
as an S Corporation is a cross between a partnership and a corporation.
However, many states do not recognize a Subchapter S selection for state tax
purposes and will tax the corporation as a regular corporation.
The flexibility of these corporations
makes them popular with small-and medium-sized businesses. Subchapter S allows
profits or losses to travel directly through the corporation to you and to the
shareholders. If you earn other income during the first year and the
corporation has a loss, you may deduct against the other income, possibly
wiping out your tax liability completely subject to the limitations of Internal
Revenue Service tax regulations.
Subchapter S corporations elect not
to be taxed as corporations; instead, the shareholders of a Subchapter S
corporation include their proportionate shares of the corporate profits and
losses in their individual gross incomes. Subchapter S corporations are
excellent devices to allow small businesses to avoid double taxation. If your
company does produce a substantial profit, forming a Subchapter S Corporation
would be wise, because the profits will be added to your personal income and
taxed at an individual rate. These taxes may be lower than the regular
corporate rate on that income.
To qualify under Subchapter S, the
corporation must be a domestic corporation and must not be a member of an
affiliated group. Some of the other restrictions include that it must not have
more than 35 shareholders – all of who are either individuals or estates.
Subchapter S corporations can have an unlimited amount of passive income from
rents, royalties, and interest. For more information on the rules that apply to
a Subchapter S corporation, contact your local IRS office.
Limited Liability Company
Limited Liability Companies (LLCs as
they are called) combine the advantages of S Corporations and limited
partnerships, without having to abide by the restrictions of either. LLCs allow
companies to pay taxes like partnerships and have the advantage of protection
from liabilities beyond their investments. Moreover, LLCs can have over 35
investors or shareholders (with a minimum of 2 shareholders). Participation in
management is not restricted, but its life span is limited to 30 years.
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