Partnerships have fewer regulatory controls than corporations

Options for Organizing a Business

Chapter 4

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Learning Objectives

4-1 Define and examine the advantages and disadvantages of the sole proprietorship form of organization.

4-2 Identify two types of partnership and evaluate the advantages and disadvantages of the partnership form of organization.

4-3 Describe the corporate form of organization and cite the advantages and disadvantages of corporations.

4-4 Define and debate the advantages and disadvantages of mergers, acquisitions, and leveraged buyouts.

4-5 Propose an appropriate organizational form for a startup business.

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Figure 4.1 Comparison of Sole Proprietorships, Partnerships/S Corporations, and C Corporations

Source: Scott Greenberg, “Pass-Through Businesses: Data and Policy,” Tax Foundation, January 17, 2017, https://taxfoundation.org/pass-through-businesses-data-and-policy/ (accessed April 10, 2018)

Access the text alternative for these images.

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Table 4.1 Various Forms of Business Ownership

Structure Ownership Taxation Liability Use

Sole Proprietorship One owner Individual income taxed Unlimited Owned by a single individual/easiest way to conduct business

Partnership Two or more owners Individual owners’ income taxed Somewhat limited Easy way for two individuals to conduct business

Corporation Any number of shareholders Corporate and shareholder taxed Limited Legal entity with shareholders or stockholders

S Corporation Up to 100 shareholders Taxed as a partnership Limited Legal entity with tax advantages for restricted number of shareholders

Limited Liability Company Unlimited number of shareholders Taxed as a partnership Limited Avoid personal lawsuits

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Every student of business should be aware that there are three primary forms of organizing a business, whether it is a traditional “brick and mortar” organization, or a virtual corporation that does business exclusively through the Internet.

The three primary forms of business that we will examine are Sole Proprietorship, Partnership, and Corporation. This table compares a sole proprietorship, a partnership, a corporation, an S corporation and an LLC as they relate to ownership, taxation, liability and use. All businesses must select a form of organization that is most appropriate for their owners and the scope of their business.

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Sole Proprietorships 1

Businesses owned and operated by one individual

Most common form of business organization in the United States

Typically employ fewer than 50 people

Comprise nearly three-quarters of all U.S. businesses

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Sole proprietorships, businesses owned and operated by one individual, are the most common form of business organization in the United States. Common examples include many retailers such as restaurants, hair salons, flower shops, dog kennels, and independent grocery stores.

Sole proprietorships are typically small businesses employing fewer than 50 people constitute approximately three-fourths of all businesses in the United States. It is interesting to note that women business owners are less likely to get access to credit than their male counterparts. In many areas, small businesses make up the vast majority of the economy.

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Sole Proprietorships 2

Advantages of Sole Proprietorships

Ease and cost of formation

Secrecy

Distribution and use of profits

Flexibility and control of the business

Government regulation

Taxation

Closing the business

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The major advantages of a sole proprietorship are:

Forming a sole proprietorship is relatively easy and inexpensive.

They make possible the greatest degree of secrecy; minimizes the possibility of competitors gaining trade secrets.

All profits belong exclusively to the owner.

The owner has complete control over the business allowing them to respond quickly to changing business conditions.

Sole proprietorships have the most freedom from government regulation.

Taxes are considered personal income and are taxed at individual tax rates.

It can be dissolved easily.

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Sole Proprietorships 3

Disadvantages of Sole Proprietorships

Unlimited liability

Limited sources of funds

Limited skills

Lack of continuity

Lack of qualified employees

Taxation

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The major disadvantages of a sole proprietorship are:

The owner has unlimited liability in meeting the debts of the business.

Sources of external funds are difficult to find so it is more difficult to obtain funds to start or expand a sole proprietorship.

The owner must have many diverse skills such as management, marketing, finance, accounting, bookkeeping, and personnel management.

The survival of the business is tied to the life of the owner and his or her ability to work.

Qualified employees are hard to find as it is difficult for small proprietors to pay competitive wages and benefits offered by large competing corporations.

Wealthy sole proprietors pay a higher tax rate than they would under the corporate form of business.

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POLLING QUESTION

Colleen wants to start a crafting business as a side job and is considering forming it as a Sole Proprietorship. In your opinion, what disadvantages should she be most concerned about?

Unlimited liability

Limited sources of funds

Lack of continuity

Lack of qualified employees

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Student answers will vary. Students should consider the following points.

Unlimited liability: Any business owner runs the risk of being sued. If a sole proprietor is sued, the plaintiff could not only ask for assets from said business but also the owner’s own personal assets, i.e. house, car, pension etc. This can be troublesome when starting a new business.

Limited sources of funds: New business owners most often use their own funds to start the business. The challenge is that banks and other financing institutions only look to the owners assets to determine credit. If the sole proprietor does not have well-established or good credit, banks may charge higher interests rates on loans because it is a riskier investment.

Lack of continuity: If a sole proprietor becomes extremely ill or passes away, the business will become defunct. As the sole owner, the life expectancy of the business is directly merged with the sole proprietor.

Lack of qualified employees: It is challenging for a sole proprietor to pay the same wages or offer the same benefits as that of a larger company. For this reason, sole proprietors find if very challenging to recruit and keep highly skilled employees.

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Partnerships 1

A form of business organization defined by the Uniform Partnership Act as “an association of two or more persons who carry on as co-owners of a business for profit”

Least used form of business

Typically larger than sole proprietorships but smaller than corporations

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One way to minimize the disadvantages of a sole proprietorship and maximize its advantages is to have more than one owner. Most states have a model law governing partnerships based on the Uniform Partnership Act. This law defines a partnership as “an association of two or more persons who carry on as co-owners of a business for profit.” Partnerships are the least used form of business. They are typically larger than sole proprietorships but smaller than corporations.

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Partnerships 2

Types of Partnership

General partnership

Limited partnership

Master limited partnership (MLP)

Articles of Partnership

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There are two basic types of partnership: general partnership and limited partnership. A general partnership involves a complete sharing in the management of a business. In a general partnership, each partner has unlimited liability for the debts of the business. Professionals such as lawyers, accountants, and architects often join together in general partnerships.

A limited partnership has at least one general partner, who assumes unlimited liability, and at least one limited partner, whose liability is limited to his or her investment in the business. Limited partnerships exist for risky investment projects where the chance of loss is great. A master limited partnership (MLP) is a limited partnership traded on securities exchanges. MLPs have the tax benefits of a limited partnership but the liquidity (ability to convert assets into cash) of a corporation. Popular examples of MLPs include oil and gas companies and pipeline operators.

Articles of partnership are legal documents that set forth the basic agreement between partners. Most states require articles of partnership, but even if they are not required, it makes good sense for partners to draw them up.

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Partnerships 3

Advantages of Partnerships

Ease of organization

Availability of capital and credit

Combined knowledge and skills

Decision making

Regulatory controls

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When deciding if a partnership is the right ownership choice, advantages and disadvantages must be compared with those offered by other forms of business organization, and not all apply to every partnership.

The advantages of a partnership are:

Partnerships are easy to organize. Starting a partnership requires little more than drawing up articles of partnership.

Partnerships can pool financial resources of the partners. Partnerships have higher credit ratings due to the partner’s combined wealth.

Partners can specialize in their particular areas of expertise such as marketing, production, accounting or service.

Small partnerships can react more quickly to changes in the business environment than can large partnerships and corporations.

Government regulations are few.

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Partnerships 4

Disadvantages of Partnerships

Unlimited liability

Business responsibility

Life of the partnership

Distribution of profits

Limited sources of funds

Taxation of Partnerships

Quasi-taxable organizations

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The disadvantages of partnerships include:

(1) General partners have unlimited liability for the debts of the partnership, just as in a sole proprietorship.

(2) Partners are responsible for each others’ decisions and a bad decision by one partner can put the other partners’ personal resources at risk.

(3) A partnership is terminated when a partner dies or withdraws.

(4) It is difficult to sell a partnership interest at a fair price.

(5) The distribution of profits may not correctly reflect the amount of work done by each partner.

(6) Sources of funds available to a partnership are limited.

Partnerships are quasi-taxable organizations. This means that partnerships do not pay taxes when submitting the partnership tax return to the Internal Revenue Service. The tax return simply provides information about the profitability of the organization and the distribution of profits among the partners. Partners must report their share of profits on their individual tax returns and pay taxes at the income tax rate for individuals.

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POLLING QUESTION

Which of the following is NOT an advantage of a Partnership?