Choosing a Form of Business

The legal form a firm chooses to operate under is an important decision with implications for how a firm structures its resources and assets. Several legal forms of business are available to executives. Each involves a different approach to dealing with profits and losses (Figure 9.10 "Business Forms").

There are three basic forms of business. A sole proprietorshipA firm that is owned by one person. is a firm that is owned by one person. From a legal perspective, the firm and its owner are considered one and the same. On the plus side, this means that all profits are the property of the owner (after taxes are paid, of course). On the minus side, however, the owner is personally responsible for the firm’s losses and debts. This presents a tremendous risk. If a sole proprietor is on the losing end of a significant lawsuit, for example, the owner could find his personal assets forfeited. Most sole proprietorships are small and many have no employees. In most towns, for example, there are a number of self-employed repair people, plumbers, and electricians who work alone on home repair jobs. Also, many sole proprietors run their businesses from their homes to avoid expenses associated with operating an office.

In a partnershipA legal form of business wherein two or more partners share ownership of a firm., two or more partners share ownership of a firm. A partnership is similar to a sole proprietorship in that the partners are the only beneficiaries of the firm’s profits, but they are also responsible for any losses and debts. Partnerships can be especially attractive if each person’s expertise complements the others. For example, an accountant who specializes in preparing individual tax returns and another who has mastered business taxes might choose to join forces to offer customers a more complete set of tax services than either could offer alone.

From a practical standpoint, a partnership allows a person to take time off without closing down the business temporarily. Sander & Lawrence is a partnership of two home builders in Tallahassee, Florida. When Lawrence suffered a serious injury a few years ago, Sander was able to take over supervising his projects and see them through to completion. Had Lawrence been a sole proprietor, his customers would have suffered greatly. However, a person who chooses to be part of a partnership rather than operating alone as a sole proprietor also takes on some risk; your partner could make bad decisions that end up costing you a lot of money. Thus developing trust and confidence in one’s partner is very important.

Most large firms, such as Southwest Airlines, are organized as corporations. A key difference between a corporationA legal form of ownership wherein shares of ownership are publicly traded in stock markets, and management is performed by professional executives. on the one hand and a sole proprietorship and a partnership on the other is that corporations involve the separation of ownership and management. Corporations sell shares of ownership that are publicly traded in stock markets, and they are managed by professional executives. These executives may own a significant portion of the corporation’s stock, but this is not a legal requirement.

Another unique feature of corporations is how they deal with profits and losses. Unlike in sole proprietorships and partnerships, a corporation’s owners (i.e., shareholders) do not directly receive profits or absorb losses. Instead, profits and losses indirectly affect shareholders in two ways. First, profits and losses tend to be reflected in whether the firm’s stock price rises or falls. When a shareholder sells her stock, the firm’s performance while she has owned the stock will influence whether she makes a profit relative to her stock purchase. Shareholders can also benefit from profits if a firm’s executives decide to pay cash dividends to shareholders. Unfortunately, for shareholders, corporate profits and any dividends that these profits support are both taxed. This double taxation is a big disadvantage of corporations.

A specialized type of corporation called an S corporationA special type of corporation wherein the firm’s profits and losses are reported on owners’ personal tax returns in proportion with each owner’s share of the firm. avoids double taxation. Much like in a partnership, the firm’s profits and losses are reported on owners’ personal tax returns in proportion with each owner’s share of the firm. Although this is an attractive feature, an S corporation would be impractical for most large firms because the number of shareholders in an S corporation is capped, usually at one hundred. In contrast, Southwest Airlines has more than ten thousand shareholders. For smaller firms, such as many real-estate agencies, the S corporation is an attractive form of business.

A final form of business is very popular, yet it is not actually recognized by the federal government as a form of business. Instead, the ability to create a limited liability company (LLC)A form of ownership that is granted in state laws wherein owners are not personally responsible for debts that the LLC accumulates (like in a corporation) and the LLC can be run in a flexible manner (like in a partnership). is granted in state laws. LLCs mix attractive features of corporations and partnerships. The owners of an LLC are not personally responsible for debts that the LLC accumulates (like in a corporation) and the LLC can be run in a flexible manner (like in a partnership). When paying federal taxes, however, an LLC must choose to be treated as a corporation, a partnership, or a sole proprietorship. Many home builders (including Sander & Lawrence), architectural businesses, and consulting firms are LLCs.