The choice of which type of organizational form is best is a matter of deciding the scope of the firm and the nature of ownership. In the United States, there are three primary organizational forms: the sole proprietorship, the partnership, and the corporation. Each of these has its own set of advantages and disadvantages but the corporation is clearly the choice for large ventures.
The sole proprietorship is an organizational structure in which a single individual owns the firm and all it assets and is responsible for all of the organization’s liabilities. In fact, the owner has unlimited liability meaning that the entire personal wealth of the owner is at risk. However, the sole proprietorship is not a taxable entity. Income from the organization is simply added to the owner’s personal income to determine taxable income. Sole proprietorships are easy to establish and dissolve representing the simplest type of organizational structure.
A partnership is similar to a sole proprietor except that two or more owners lay claim to the organization. General partnerships are those in which all partners have unlimited liability. This includes any liability taken on by other members of the partnership. Profits and losses are usually shared in proportion to the capital contributions of each partner. Just like a sole proprietorship, income from the organization is reported directly on each owner’s personal income tax.
One of the problems with partnerships occurs when one partner either leaves the organization or dies. At this point the partnership is dissolved which can be frustrating when there are several or many partners. Some states allow limited partnerships in which limited partners are owners along with the general partners. Limited partners provide capital and share in the profits of the organization. However, liabilities are limited to the amount of capital each limited partner provides. Often, limited partners may sell their share of the partnership eliminating the need to dissolve the partnership if a limited partner dies.
A corporation (from Latin “corpus”, literally “body”) is considered to be a person who is completely separate from its owners. Owners are known as shareholders because they own only a share or part of the organization. Like a person, corporations may own property and assets, take on debt to finance operations, and sell shares to raise money. The corporation enjoys four major advantages that, when combined, make this type of organization attractive for large ventures.
Owner liability is limited to the loss of the value of shares held. Owners’ entire wealth is not in jeopardy if the corporation goes bankrupt or ceases operation. The most an owner can lose is the value of the investment from buying shares of the corporation. The owners of sole proprietors and partnerships can lose more than just the value of the business.; their entire wealth is on the line.
When owners die, shares of the corporation can be willed to family members or other entities just like any other asset. A corporation can theoretically live forever as long as it remains profitable.
Transferability of Ownership
Selling ownership of a corporation is simply a matter of selling shares to a buyer willing to pay the price of the shares. Exchanges, such as the New York Stock Exchange, are markets created for the purpose of selling shares of corporations. Selling a sole proprietorship or partnership is a far more involved process which usually necessitates legal representation, contracts, and valuation procedures.
Access to Capital
The permanent nature of corporations makes capital easier to acquire as lenders do not have to worry about the death of its owners. Corporations are far more flexible in their ability to take on debt.
The corporation does have one major disadvantage. Income made by the corporation is taxed twice. The first taxation occurs because the corporation is considered to be a person and, therefore, is taxed accordingly. Then, the income gained through ownership of the corporation is taxed as personal income in the owners’ income tax. This double taxation dilutes the profitability of the corporation and makes ventures that much more risky because they cost more. Essentially, corporations must get a greater return on investments to cover the corporation’s taxes while still maintaining profitability to shareholders.
Clearly, corporations have some major advantages over the other two organizational forms Limited liability, permanency, transferability of ownership, and easier access to capital make corporations the best choice when large ventures are planned.