2.

1 • Business Structures 41

2. They are subject to relatively few government rules and regulations.

3. Taxation on sole proprietorships is far simpler than on other organizational forms. There are no separate
taxes associated with a sole proprietorship, as there are with corporations. Sole proprietors simply report
all their business income and losses on their personal income tax returns.
4. Controlling responsibilities of the firm are not divided in any way. This results in less complicated
managerial decisions and improved timeliness of necessary corrective actions.

However, despite the ease of their formation and these stated advantages, proprietorships have four notable
shortcomings:

1. A sole proprietor has unlimited personal liability for any financial obligations or business debts, so in the
end, they risk incurring greater financial losses than the total amount of money they originally invested in
the company’s formation. As an example, a sole proprietor might begin with an initial investment of
$5,000 to start their business. Now, let’s say a customer slips on some snow-covered stairs while entering
this business establishment and sues the company for $500,000. If the organization loses the lawsuit, the
sole proprietor would be responsible for the entire $500,000 settlement (less any liability insurance
coverage the business might have).
2. Unlike with a corporation, the life of the business is limited to the life of the individual who created it. Also,
if the sole proprietor brings in any new equity or financing, the additional investor(s) might demand a
change in the organizational structure of the business.
3. Because of these first two points, sole proprietors will typically find it difficult to obtain large amounts of
financing. For these reasons, the vast majority of sole proprietorships in the United States are small
businesses.
4. A sole proprietor may lack specific expertise or experience in important business disciplines, such as
finance, accounting, taxation, or organizational management. This could result in additional costs
associated with periodic consulting with experts to assist in these various business areas.

It is often the case that businesses that were originally formed as proprietorships are later converted into
corporations when growth of the business causes the disadvantages of the sole proprietorship structure to
outweigh the advantages.

Partnerships
A partnership is a business structure that involves a legal arrangement between two or more people who
decide to do business as an organization together. In some ways, partnerships are similar to sole
proprietorships in that they can be established fairly easily and without a large initial investment or cost.

Partnerships offer some important advantages over sole proprietorships. Among them, two or more partners
may have different or higher levels of business expertise than a single sole proprietor, which can lead to
superior management of a business. Further, additional partners can bring greater levels of investment capital
to a firm, making the process of initial business formation smoother and less risky.

A partnership also has certain tax advantages in that the firm’s income is allocated on a pro rata basis to the
partners. This income is then taxed on an individual basis, allowing the company to avoid corporate income
tax. However, similar to the sole proprietorship, all of the partners are subject to unlimited personal liability,
which means that if a partnership becomes bankrupt and any partner is unable to meet their pro rata share of
the firm’s liabilities, the remaining partners will be responsible for paying the unsatisfied claims.

For this reason, the actions of a single partner that might cause a company to fail could end up bringing
potential ruin to other partners who had nothing at all to do with the actions that led to the downfall of the
company. Also, as with most sole proprietorships, unlimited liability makes it difficult for most partnerships to
raise large amounts of capital.
42 2 • Corporate Structure and Governance

Corporations
The most common type of organizational structure for larger businesses is the corporation. A corporation is a
legal business entity that is created under the laws of a state. This entity operates separately and distinctly
from its owners and managers. It is the separation of the corporate entity from its owners and managers that
limits stockholders’ losses to the amount they originally invest in the firm. In other words, a corporation can
lose all of its money and go bankrupt, but its owners will only lose the funds that they originally invested in the
company.

Unlike other forms of organization, corporations have unlimited lives as business entities. It is far easier to
transfer shares of stock in a corporation than it is to transfer one’s interest in an unincorporated business.
These factors make it much easier for corporations to raise the capital necessary to operate large businesses.
Many companies, such as Microsoft and Hewlett-Packard, originally began as proprietorships or partnerships,
but at some point, they found it more advantageous to adopt a corporate form of organization as they grew in
size and complexity.

An important disadvantage to corporations is income taxes. The earnings of most corporations in the United
States are subject to something referred to as double taxation. First, the corporation’s earnings are taxed;
then, when its after-tax earnings are paid out as dividend income to shareholders (stockholders), those
earnings are taxed again as personal income.

It is important to note that after recognizing this problem of double taxation, Congress created the S
corporation, designed to aid small businesses in this area. S corporations are taxed as if they were
proprietorships or partnerships and are exempt from corporate income tax. In order to qualify for S
corporation status, a company can have no more than 100 stockholders. Thus, this corporate form is useful for
relatively small, privately owned firms but precludes larger, more diverse organizations. A larger corporation is
often referred to as a C corporation. The vast majority of small corporations prefer to elect S status. This
structure will usually suit them very well until the business reaches a point where their financing needs grow
and they make the decision to raise funds by offering their stock to the public. At such time, they will usually
become C corporations. Generally speaking, an S corporation structure is more popular with smaller
businesses because of the likely tax savings, and a C corporation structure is more prevalent among larger
companies due to the greater flexibility in raising capital.

Hybrids: Limited Liability Corporations and Partnerships

Another form of business organization is the limited liability corporation (LLC). This type of business
structure has become a very popular type of organization. The LLC is essentially a hybrid form of business
that has elements of both a corporation and a partnership. Another form of organizational structure is
something called a limited liability partnership (LLP), which is quite similar to the LLC in structure and in
use. It is very common to see LLPs used as the organizational form for professional services firms, often in
such fields as accounting, architecture, and law. Conversely, LLCs are typically used by other forms of
businesses.

Similar to corporation structures, LLCs and LLPs will provide their principals with a certain amount of liability
protection, but they are taxed as partnerships. Also, unlike in limited partnerships, where a senior general
partner will have overall control of the business, investors in an LLC or LLP have votes that are in direct
proportion to their percentage of ownership interest or the relative amount of their original investment.

A particular advantage of a limited liability partnership is that it allows some of the partners in a firm to limit
their liability. Under such a structure, only designated partners have unlimited liability for company debts;
other partners can be designated as limited partners, only liable up to the amount of their initial contribution.
Limited partners are typically not active decision makers within the firm.

Some important differences between LLCs and LLPs are highlighted in Table 2.1.

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 2.1 • Business Structures 43

Limited Liability Corporation Limited Liability Partnership

Advantages Disadvantages Advantages Disadvantages
Fewer restrictions on eligibility (only one Only certain
member allowed; can be professional, professions
although some states disallow professionals) eligible
Personal protection as well
Limited
as protection from
Usually more personal liability protection protection from
negligence of other
partners’ actions
partners
Earnings
Must file taxes
included in
Flexibility in taxation Earnings taxed just once as pass-
members’
through entity
personal taxes

Table 2.1 Advantages and Disadvantages of LLCs and LLPs

LLCs and LLPs have gained great popularity in recent years, but larger companies still find substantial
advantages in being structured as C corporations. This is primarily due to the benefits of raising capital to
support long-term growth. It is interesting to note that LLC and LLP organizational structures were essentially
devised by attorneys. They generally are rather complicated, and the legal protection offered to their
ownership principals may vary from state to state. For these reasons, it is usually necessary to retain a
knowledgeable lawyer when establishing an organization of this type.

Obviously, when a company is choosing an organizational structure, it must carefully evaluate the advantages
and disadvantages that come with any form of doing business. For example, if an organization is considering a
corporation structure, it would have to evaluate the trade-off of having the ability to raise greater amounts of
funding to support growth and future expansion versus the effects of double taxation. Yet despite such
organizational concerns with corporations, time has proven that the value of most businesses, other than
relatively small ones, is very likely to be maximized if they are organized as corporations. This follows from the
idea that limited ownership liability reduces the overall risks borne by investors. All other things being equal,
the lower a firm’s risk, the higher its value.

Growth opportunities will also have a tremendous impact on the overall value of a business. Because
corporations can raise financing more easily than most other types of organizations, they are better able to
engage in profitable projects, make investments, and otherwise take superior advantage of their many
favorable growth opportunities.

The value of any asset will, to a large degree, depend on its liquidity. Liquidity refers to asset characteristics
that enable the asset to be sold or otherwise converted into cash in a relatively short period of time and with
minimal effort to attain fair market value for the owner. Because ownership of corporate stock is far easier to
transfer to a potential buyer than is any interest in a business proprietorship or partnership, and because
most investors are more willing to invest their funds in stocks than they are in partnerships that may carry
unlimited liability, an investment in corporate stock will remain relatively liquid. This, too, is an advantage of a
corporation and is another factor that enhances its value.

LINK TO LEARNING

Amazon
Most people are surprised to learn than Amazon, the largest online retailer, is set up as an LLC.