Download MODULE 3a - CLSU Open University

MODULE 3
FORMS OF BUSINESS ORGANIZATIONS
Legal Structure of the Different Forms of Business Organization
Once an entrepreneur has conceptualized a commercially viable technology or product,
he should begin to conceptualize the proper business form in which to pursue product
development. The selection of the most advantageous form of legal organization involves
weighing many practical and legal considerations.
The most important distinctions among the available forms of business include -- cost
and formality of organization, transferability of ownership interests, continuity of existence,
management, and control, ability to obtain capital and credit, method of participation in profits,
vulnerability to personal liability, and taxation of the enterprise.
In general, the available forms of business include the sole proprietorship, the general
partnership, the limited partnership, and the corporation. Each of these forms of business
enterprise is recognized in the State of Michigan and are generally adaptable to the specific
needs of a start-up or emerging business. The impact of certain of these important considerations
among the available forms of business is discussed below.
The sole proprietorship is a simple form of business enterprise which is the most widely
used. The distinguishing characteristic of a sole proprietorship is that it is owned and managed
by one person. The individual proprietor has the ultimate responsibility and authority for all
decisions affecting the business. Generally, no legal formalities are necessary to create an
enterprise in this form. With the exception of a very nominal filing and publication cost
associated with an assumed name certificate, there are no state or local taxes or fees payable for
the privilege of organizing as a sole proprietorship. Sole proprietors are personally liable for the
debts of the proprietorship.
A general partnership is created by agreement, either oral or written, and the relations
of the partners are governed by that understanding. Partners typically agree to share in the
profits, losses, and assets of the partnership. Apart from the agreed upon duties and liabilities of
the partners, a fiduciary relationship also exists between the partners. Each partner is personally
liable for the debts of the partnership, a feature which makes this business form undesirable to
many entrepreneurs.
A limited partnership is similar to a general partnership in certain respects and similar
to a corporation in others. A limited partnership is a business form in which, by complying with
certain statutory requirements, one or more of the partners has only limited liability for
partnership debts and obligations. The price for this liability protection is a limitation on
participation in management.
A corporation is a legal entity created under a particular business statute. The entity may
be owned by one or more shareholders, who, in turn, may be natural persons or other legal
entities. A corporation is regarded, in law, as having a personality and existence entirely distinct
from that of its owners. Accordingly, shareholders are generally not liable for corporate
obligations. However, the statutory formalities concerning the formation and operation of a
corporation must be strictly observed. Failure to properly follow corporate formalities may cause
the shareholders to become personally liable for the obligations of the corporation.
Continuity of Existence
The sole proprietorship terminates by law upon the death of the sole proprietor, with very
few exceptions. Estate planning documents for the sole proprietor may grant the heirs of the sole
proprietor the right to continue the business.
The death or withdrawal of a general partner, or the expiration of the term of the general
partnership, will dissolve the partnership. Continuation of the partnership following such events
may be dealt with, however, in the partnership agreement. Since a partnership is generally a
"voluntary" association, any general partner who no longer desires to be associated with the
partnership may withdraw and force dissolution. Dissolution of a partnership, as a general rule,
requires winding up of its affairs and a liquidation of the partnership's assets.
The relationship between the general partner and limited partner in a limited partnership
is different than that of a general partnership. If there is at least one general partner, the death or
withdraw of another general partner in a limited partnership will not result in a termination of the
partnership. Moreover, a limited partner, as a passive investor, is like a shareholder of a
corporation and his withdrawal or death will not affect the continuity of the partnership.
The corporation is the most suitable form of business if continuity is desired. The Articles
of Incorporation can provide for perpetual existence and, as a result, the corporation can continue
without interruption upon the death or withdrawal of any of its shareholders, officers, or
directors.
Transferability of Ownership Interest
Since a sole proprietor owns his business directly, his ownership interest may be
transferred at any time. The ownership interest of a general partner receives different treatment.
A general partner's interest in the partnership is an intangible interest that includes his
proportionate share of assets and liabilities. This intangible interest may be assigned or
transferred freely.
Unless otherwise provided in the partnership agreement, the ownership interest in a
limited partnership held by a limited partner is freely transferable. Depending upon the
circumstances under which a limited partnership interest was obtained, securities laws may limit
the otherwise free transferability of this ownership interest.
Shareholders' interests in a corporation are evidenced by share certificates, which are
generally freely transferable. The corporation permits the greatest flexibility in the transfer of
ownership interests. However, as is the case with limited partnerships, securities laws may
otherwise restrict the transferability of shares.
Capital and Credit Requirements
The sole proprietor is limited to his own personal resources in his ability to obtain loans
to capitalize his enterprise. For general partnerships, the partners' contributions of cash or
property will constitute the initial capital investment. The general partnership is, from a practical
standpoint, equally as limited in the sources available for obtaining funds. In order to borrow
money, partners typically must pledge their personal assets as collateral.
Limited partnerships often obtain capital from the contributions of limited partners. In
this sense, the capital infusion mechanism of a limited partnership is analogous to that of a
corporation. A pledge of partnership assets may be sufficient for borrowings, although general
partner guarantees are not uncommon.
The corporation's ability to attract capital and facilitate credit is another strong advantage
for this legal form. The corporate financial structure lends itself to a wide variety of securities
such as debt and equity instruments. The sale of shares in a corporation is a relatively convenient
mechanism for capital formation.
Tax Considerations
The laws regarding taxation of sole proprietorships may be an advantage in many
instances. All business income or loss is treated as the individual's income or loss and taxed
accordingly. Similarly, a general partnership pays no federal income tax. Each general partner is
required to declare his share of partnership income or loss on his individual tax return.
For the most part, limited partnerships are treated like general partnerships for tax
purposes, with tax events proportionately passing through to general and limited partners. This is
one reason that limited partnerships are a favored form of enterprise to conduct certain types of
tax sensitive business activities.
Unlike sole proprietorships, a corporation files its own tax return. A disadvantage to the
corporate form is that "double taxation" may occur since income received by the corporation will
be taxed at the corporate level and, if distributed to its shareholders as dividends, will be taxed
again for their personal income tax reporting purposes. There are several methods which can be
employed to minimize the impact of this double taxation such as salaries to officers, loans from
shareholders, and a Subchapter S election (whereby the corporation elects not to be taxed at the
corporate level and instead to have its income channeled through directly to its shareholders).
Cooperatives. The basic reason for having cooperatives as a form of economic enterprise
in an economy is to help people work together and move forward in a collective way.
Cooperatives are considered to be the best form of economic enterprise because they are capable
of seeking a balanced adjustment between collective spirit and individual rights.
Cooperation means getting things done with collective effort. The benefit of cooperatives
is that they combine the wealth and resources of many individuals and harness them in a united
way. To help achieve this, however, cooperatives should be structured so that individual interest
does
not
dominate
collective
interests.
Individual
dominance
can
adversely affect the welfare of different social groups and the environment.
Essence of cooperatives
Cooperatives as a form of economic enterprise involve getting things done between free human
beings with:
(i) equal rights;
(ii) equal human prestige (and mutual respect for each other);
(iii) equal locus standing (eg, legal standing) so that everyone's welfare is considered.
This is called "coordinated cooperation" and is needed for equilibrium and equipoise in
social life. A socio-economic system should be based on coordinated cooperation not
subordinated cooperation.
"Subordinated cooperation" involves people doing something individually or collectively,
but at the same time keeping themselves under other peoples' supervision or control. This can
degenerate the moral fabric of an enterprise and should be avoided when structuring cooperative
business enterprises.
Conclusion
In summary, an entrepreneur should carefully evaluate these and other important
considerations when choosing to form a business enterprise. An informed choice should enable
flexibility in raising capital, address investors' tax needs, and provide liability protection
whenever possible.
Advantages and Disadvantages of Each Form of Business Organization
Sole Proprietorship
A form of business organization owned and managed by a single individual.
Advantages
Disadvantages
ease of formation
unlimited liability
low start-up costs
difficulty raising capital
less administrative paperwork than some
lack of continuity in business organization
other organizational structures (such as
in the absence of the owner
incorporation)
owner in direct control of decision making
minimal working capital required
tax advantages to owner
all profits to owner
Partnership
A partnership is an agreement in which two or more persons combine their resources in a
business with a view to making a profit. In order to establish the terms of the business and to
protect partners/shareholders in the event of disagreement or dissolution of the business, a
partnership/shareholders agreement should be drawn up, usually with the assistance of a lawyer.
Partners share in the profits according to the terms of the agreement.
Advantages
Disadvantages
ease of formation
unlimited liability (for general partners)
low start-up costs
lack of continuity
additional sources of investment capital
divided authority
broader management base
hard to find suitable partners
possible development of conflict between
partners
Corporation
A corporation is a legal entity that is separate from its owners, the shareholders. No
shareholder of a corporation is personally liable for the debts, obligations or acts of the
corporation. Directors, officers and insiders can bear some liability for their involvement with
the corporation. A corporation can be formed at either the federal or provincial level.
Advantages
Disadvantages
limited liability
closely regulated
specialized management
most expensive form to organize
ownership is transferable
charter restrictions
continuous existence
extensive record keeping necessary
separate legal entity
double taxation of dividends
possible tax advantage (if you qualify for
small business tax rate)
easier to raise capital
Cooperative
A co-operative is a corporation organized by people with similar needs to provide
themselves with goods or services, or to make joint use of their available resources to improve
their income. Their business structure ensures:

all members have an equal say (one vote per member, regardless of the number of
shares
held);

open and voluntary membership;

limited interest on share capital;

surplus is returned to members according to amount of patronage.
There is no requirement to incorporate as a co-operative in order to run your business
collectively and cooperatively. However, it is illegal in Ontario to use the word "co-operative" in
connection with the name of an enterprise unless the group is incorporated under the Cooperative Corporations Act.
Advantages
Disadvantages
owned and controlled by members
longer decision making process
democratic control: one member, one vote
requires members to participate for success
limited liability
extensive record keeping necessary
profit distribution (surplus earnings) to
possibility of development of conflict
members in proportion to use of service;
between members
surplus may be allocated in shares or cash
less incentive to invest additional capital
Source: Canada-Ontario Business Service Centre
Activity 3
Let us review some concepts we have learned in this Module. Answer the questions
before you proceed to the Module 4.
1. Enumerate the four general types of Business Organizations.
a. ___________________
b. ___________________
c. ___________________
d. ___________________
2. Differentiate the four types of Business Organizations. Cite its advantages and
disadvantages of each. Use a matrix to show the advantages of each form.
3. Visit one cooperative near your area. Talk to any of its officers and inquire the
following:
a. Type of cooperative (credit, production, consumers, etc)
b. Set of Officers
c. Date of establishment
d. What are their objectives
e. Financial standing (try to get their financial statements)
f. Marketing Practices
g. Organizational Management
h. Socio-economic impact of the cooperative in the area.