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13.1 What Kind of Business Organizations Are There?

Learning Objectives

  1. Distinguish and define the principal ways of organizing a business.
  2. Consider liability and ethical responsibility as they relate to different forms of businesses.
  3. Sketch the organizational structure of a corporation.

Paramount Pictures

Movies from Paramount Pictures begin with an image of a mountain flashed onto the screen. That mountain, reputedly, was quick-sketched on a notepad by the company’s founder W. W. Hodkinson. Hodkinson got started in the movie business in the early 1900s when he opened a theater in Ogden, Utah. He shuffled films faster than his competitors (the town’s two other movie houses), and so came to dominate the local market. Soon he expanded to the big city of Salt Lake, then Los Angeles, and onward.

Looking to keep his enterprise growing, Hodkinson founded a company called Paramount to provide up-front money to cash-strapped movie producers. In exchange, he got exclusive rights to screen their work in theaters. Grateful for the help, for the trust, and above all for the cash, struggling moviemakers including Adolph Zukor, Samuel Goldfish (later Goldwyn), and Cecil B. DeMille signed on to the project in five-year deals. By 1915, they were all wealthier.

Now that they no longer needed his up-front money, Zukor and the rest started trying to squirm out of their deal. Having initially taken the risk to launch their careers, Hodkinson refused to let them go. So Zukor and friends hatched a plan. Pretending to have been faced down by Hodkinson, they not only embraced the deal they’d already inked, but they also extended it for twenty-five more years in exchange for a lump sum. They took that money, opened a line of credit, and began secretly buying Paramount stock. When they accumulated enough, they took it over, and in what would be a good premise for a revenge movie, they kicked Hodkinson out of his own company.

Types of Businesses

One lesson of Hodkinson’s story is that the way a business is organized is critically important. He left Paramount open to a financial sneak attack by not keeping the whole company in his name as a sole proprietorship. When he let shares go out—when he allowed others to buy part ownership in his enterprise—he was setting himself up for what happened. Of course it’s also true that he probably wouldn’t have had the money needed to get the enterprise going in the first place had he not gotten a capital injection from selling off pieces of ownership.

Every form of business organization comes with advantages and disadvantages, and the specific kinds of organization that may be formed are numerous and change from state to state. There are, however, a number of basic types:

  • Sole proprietorship
  • Partnership
  • Limited liability company
  • S corporation
  • Nonprofit organization
  • Corporation

A sole proprietorshipA business owned by a single individual. is the easiest kind of business to start. All you need to do is go down to the county courthouse and fill out a DBA, which is a form officially registering that you’re opening a business with the name you choose. DBA means doing business as, so Jan Jones can go register her company as JJ’s Midnight Movie House, and she doesn’t need to do anything more: her tax ID number for the business is just her Social Security number, and when she’s filling out her IRS forms, she counts her profits as income, just like a paycheck. Benefits of a sole proprietorship include the speed and ease of getting it going. Further, sole proprietors can take advantage of tax accounting fitted to business reality. If you’re Jan Jones and you sign contracts to pay $2,500 to rent a vacant warehouse along with the rights to show Paramount’s Mommie Dearest, and you receive $3,000 from ticket buyers, you don’t pay income tax on the whole $3,000, only on the $500 profit. Finally, sole proprietorships have the advantage of belonging to their owner: she can do whatever she wants with her company without fear of being taken over by someone else.

The main disadvantage of a sole proprietorship is that the company really is an extension of you, and you’re on the hook for whatever it does. So if you screen your movie and no one shows up, you can’t just call the whole thing a bad idea, declare bankruptcy, and walk away. Your lenders can sue you personally for the $2,500 you agreed to pay as JJ’s Midnight Movie House. Worse, if people do show up, but someone smokes in the theater, which starts a fire and causes injuries, those injured people can sue you personally, and maybe take everything you own. The fact that Jan Jones has to take full responsibility for what her company does is called unlimited liabilityThe owner’s or owners’ legal responsibility in the face of all claims made against a company.. That liability, finally, is legal, but it’s also clear that there’s an ethical dimension to the responsibility. While few assert that it’s morally wrong to fail in business, there is a reasonable objection to be made when those who fail try to avoid paying the cost.

A partnershipA business owned by more than one person. resembles a sole proprietorship. The main difference, obviously, is that there’s more than one owner: maybe there are two partners with 50 percent each, or one with 50 percent and then a group of smaller shareholders each owning 10 percent of the enterprise. The bookkeeping is pretty straightforward since profits are allotted in accordance with how great a share each partner owns. All partnerships must have, finally, at least one general partner who faces unlimited liability for the company’s actions. On the ethical front, responsibility starts getting murky as you move to multiple owners. If the theater burns down, and one individual partner had been assigned (and failed) the task of making sure there were a few fire extinguishers around, does that one partner bear the entire ethical burden of the injuries? Is it doled out in accordance with the percentage owned? What if one of the owners just kicked some money in as a favor to a friend, and wasn’t involved in the actual operation, does she bear any responsibility for what happened?

Limited liability companies (LLC) and S corporationsCompanies usually owned by a limited number of individuals that provide some legal protections to owners for claims made against the company. are very similar. They’re both hybrids of partnerships and corporations. From the partnership side they take the tax structure. Called pass-through taxationA tax regime where the profits (or losses) of a company are passed through to the owners who are responsible for declaring and paying taxes—the company itself pays no taxes., profits are divided among the partners or shareholders. Then those individuals pay taxes on the money like it’s income, a normal paycheck. What these two take from the corporate side—and the main reason people form an LLC or an S corporation—is that the enterprise’s legal status provides some protection against liability lawsuits. If you, Jan Jones, and a few others form an LLC and the theater burns and people get injured, you may get out without losing all you have. Creditors and lawyers for the injured will be able to sue the company and probably take any money left in the till, but they’ll have a harder time trying to take your personal car or the house you live in. Specific rules, it’s important to note, vary depending on the business and the location, but both options are typically limited to a certain number of participants.

On the responsibility front, this is the pressing ethical question: If the theater burns down for an LLC, the owners will likely enjoy some legal protection. Does that protection, however, extend to the ethics? Is there any difference in terms of moral responsibility between a partnership operating a burning theater and an LLC?

Nonprofit corporationsCorporations formed to serve a charitable or civic cause that are exempt from taxes and channel income back into the cause they’re formed to serve. exist in a class by themselves. Usually formed to serve a charitable or civic cause, they don’t have to pay taxes since they don’t make profits: they spend all their income promoting the cause they’re set up to serve. The operators of nonprofits often enjoy complete protection from liability claims. What about the ethics? If a nonprofit screens Mommie Dearest to raise money for the cause of orphans, and the theater burns, does the fact that the entire endeavor was arranged for the public good provide moral protection from guilt when people get hurt?

Technically, what most of us mean when we use the term corporationA legally independent business that protects its owners from all liability claims made against the company. is a C corporation (as opposed to an S corporation). One financial difference between the two is that a C corporation is taxed twice. First, the government takes a chunk of the corporation’s profits before they’re distributed to the company’s owners, who are all those individuals holding shares. Then when the shareholders get their part, each must pay taxes on it again. Another difference is that C corporations are not limited in terms of number of shareholders. Finally, most of the corporations that people are familiar with are publicA corporation with shares available for purchase by the general public., meaning that the company’s shares are available for purchase by anyone with the money to spend. There are, it should be noted, private corporationsA corporation with share allocation limited to a group or single person. (and the similar “closely held” corporations) where share allocation is limited to a group or single person, but again, most of the commonly referenced incorporated companies are listed for public sale in places including the New York Stock Exchange, and you or I may become partial owners. In fact, and as the story of W. W. Hodkinson teaches, if we get enough money, we can buy the shares to take over the business.

Corporations step away from easier-to-form partnerships by providing protection to owners against liability claims. In the case of C corporations, that protection is significant. In many cases, the protection is total: completely insulated from liability, shareholders can lose their investment if the company does something it shouldn’t and gets sued, but their personal possessions are completely safe. This is the case, for example, with the mega movie chain Regal Cinemas. The price of one share of that company today was $13.77. If you buy that, then no matter what the company does tomorrow, the most you could possibly lose is a little under $15. No one likes to lose $15, but still, there’s a very large freedom from responsibility here. If Regal tries to save some money (and therefore boost its share price and your profit) by intentionally not charging their fire extinguishers, and on the day a blockbuster gets released ten theaters in various states burn with accompanying human suffering and a major number of deaths, the company may go bankrupt under a flood of lawsuits and justifiable public outrage. But you, one of the owners, would be out three $5 bills.

Corporations play a very large role in business ethics for two reasons. First, their independence from their specific owners opens questions about who—if anyone—should take moral responsibility for what the corporation does. Second, because corporations today have grown so large and powerful, because they touch all our lives in so many ways so often, the ethical questions they raise become hard to avoid. Both these dimensions of the modern corporation, the ethical ambiguity and the potentially huge size, relate to the history of the institution.

A Very Brief History and Description of the Corporation

Exxon Mobil’s market value is around $450 billion. Just to compare, the GDP of Portugal—the total value of all goods and services produced in the country each year—is about $250 billion (when converted to US dollars). Walmart’s revenues are climbing above $375 billion, which is a full third of the total revenues (in the form of taxes) collected by the US federal government from individuals. If Walmart were a sovereign nation, it would be China’s fourth largest export market. Less abstractly, the size and penetration of the Ford Motor Company can be felt just by going out on the street and watching their products pass by. And if you go to a movie from Paramount, or laugh for a while with the Comedy Channel, or check out music videos on MTV, you’re patronizing the behemoth called Viacom.

All these businesses, along with the rest of the corporations on the Fortune 500 list and then the many that didn’t make the top tier, change our lives most every day. If you outfitted your dorm room or apartment at Walmart, it was a decision made by an executive buyer that determined the choices you’d have. If you’re thinking about voting this year, Jon Stewart at Comedy Central is doing all he can to guide the way you decide which lever to pull. If you go to see a concert next weekend, an MTV executive may have been the one who originally pulled that group out of obscurity. Publicly held corporations, all this means, aren’t just places where we go to work, or manufacturers that supply our necessities: they set the parameters and directions of our lives.

The first corporations extended directly from governments. In 1600, the English monarchy designated the British East India Company to manage international trade between the homeland and the Indian subcontinent. Shareholders did extremely well. By the 1800s, private enterprise was breaking away from tight governmental association; the corporation as we know it today began taking shape when individuals started claiming a right to freely associate for their economic benefit without direct governmental oversight and license.

Modern corporations are formed by a group of people who fill out the papers and register the name. Once it’s created, however, the business exists as a legally distinct entity. In the eyes of the law, it is

  • perpetual—it can survive even after its founders have passed away;
  • responsible—just like a person—in the narrow sense in that it holds specific legal obligations and rights.

In 1819, the US Supreme Court defined a corporation as “an artificial being, invisible, intangible and existing only in the contemplation of the law.”Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheat.) 518 (1819). This legal independence clears the way for owners (shareholders) to escape liability claims made against the corporation. Because the business stands on its own, because it is a “being,” all claims must be made against it, not the shareholders standing behind.

Corporations are structured in diverse ways, but the basic governing form starts with the shareholders electing a board of directorsIndividuals elected by shareholders who oversee a business and select the enterprise’s operating, day-to-day managers.. Walmart, for example, is governed by a fifteen-member board, which is elected each year. The board holds two main responsibilities. One is oversight; it keeps track of what’s going on and reports back to shareholders. The other responsibility is operational. The board selects individuals who’ll run the company on a day-to-day basis. Frequently, a chief executive officer (CEO)Selected by the board of directors, the CEO is responsible for managing a company’s daily operations. leads this team and is ultimately responsible for making sure Walmart is buying from suppliers at the lowest possible price, getting goods into the stores before stock runs out, and convincing customers to return and do more buying.

If the CEO and management team is good, there’s a decent chance the company will be successful and grow. Good leadership, however, can’t alone explain the megadimensions of today’s larger corporations. One critical element of the corporate structure that contributes to the size is the owner-as-shareholder model. The model allows businesses to collect large amounts of cash quickly. Simply by printing up and selling more shares, a corporation raises potentially huge sums. That capital can be reinvested in the business—maybe to build new Walmart stores in growing suburbs—and the corporation’s value goes up. It’s true that the original shareholders now own less of the company on a percentage basis (because there are more owners), but their shares are worth more because the company is worth more, so they’re unlikely to complain. As long as that virtuous cycle continues, well-run corporations can grow very quickly.

While all that growth is going on, the actual owners—shareholders—can be at home sitting in front of the TV. Many shareholders, actually, have almost no idea of what’s happening inside the company they partially own. With respect to business ethics, this adds another level of complexity to the question about who, if anyone, should be held morally responsible for what the corporation does. If you just go out in the street and ask a passerby, “Who do you think bears moral responsibility for what a company does?” the answer you’ll probably get is the owners. But in the case of corporations, they’re protected legally by a liability firewall, and now they’re also protected structurally by the fact that they—along with the multitude of other owners scattered all over the country and even the globe—aren’t necessarily involved in making the company’s operational decisions. These two factors combined have thrust this question to the forefront of questions about ethics in the economic world: can these artificial beings called corporations themselves have moral responsibilities to go along with their legal responsibility to operate within the law?

Key Takeaways

  • Businesses can be organized in various ways.
  • The way a business is organized affects economic questions about profits, legal questions about liability, and ethical questions about responsibility.
  • In sole proprietorships and partnerships, owners take economic, legal, and moral responsibility for what the company does.
  • In public corporations, owners are shielded from legal responsibility for the enterprise’s actions; the question about moral responsibility remains open.
  • The structure of corporations—the ability to sell shares publicly—is instrumental in their ability to grow economically.

Review Questions

  1. What are the main ways of organizing a business?
  2. What kind of business organization might be suitable for a plumber? Explain.
  3. Why might someone choose to organize as an LLC instead of a sole proprietorship?
  4. In legal terms, what is the relation between a corporation and those individuals who found the corporation?
  5. In what ways does the structure of a corporation protect its owners from absorbing ethical responsibility for the company’s actions?
  6. How can corporations raise money?