Forms of Business Organization

Module 4: Forms of Business Organization

LEARNING OBJECTIVES
After studying this module, you should be able to:
1. Explain the basic legal forms of business organizations such as, sole proprietorship,
partnership and corporation.
2. Know the advantages and disadvantages of adopting the
a. Sole proprietorship
b. Partnership
c. Corporation form of business organization
3. Determine the form of business organization most adaptable to an enterprise.

FORMS OF BUSINESS ORGANIZATION

THE ORGANIZATION OF THE BUSINESS FIRM

The business firm is an entity designed to organize raw materials, labor, and machines with the
goal of producing goods and/or services. Firms
1. purchase productive resources from households and other firms,
2. transform them into a different commodity, and
3. sell the transformed product or service to consumers
For business firms engaged in retail or trading activities, transforming purchased goods into a
different commodity does not necessarily take place.
Every society, no matter what type of economy it has, relies on business firms to organize resources
and transform them into products. In market economies, most firms choose their own price, output
level, and methods of production. They get the benefits of sales revenues, but they also must pay
the costs of the resources they use.
Business firms can be organized in one of three ways: as a proprietorship, a partnership, or a
corporation. The structure chosen determines how the owners share the risks and liabilities of the
firm and how they participate in making decisions.
Forms of Business Organization

LEGAL FORMS OF BUSINESS ORGANIZATION

PROPRIETORSHIP
A sole proprietorship is a business owned by a single person who has complete control over
business decisions. This individual owns all the firm's assets and is responsible for all its liabilities.
More businesses are sole proprietorship than any form of business organization. From a legal point
of view, the owner of a proprietorship is not separable from the business and is personally liable
for all debts of the business. From an accounting prospective, however, the business is an entity
separate from the owner (proprietor). Therefore, the financial statements of the business present
only those assets and liabilities pertaining to the business.
The owner cannot be paid salary or wages from the business. Instead, the owner may withdraw
funds or other property from the business. These withdrawals are treated as reduction of owner's
equity or financial interest of the owner in the business. The business itself does not pay any
income taxes. The income or loss of the business is reported on the owner's personal income, tax
return on a supporting schedule.

Among the advantages of a sole proprietorship are:

1. Ease of entry and exit
A sole proprietorship requires no formal charter and is inexpensive to form and dissolve.

2. Full ownership and control.

The owner has full control, reaps all profits and bears all losses.

3. Tax savings
The entire income generated by the proprietorship passes directly to the owner. This may
result in a tax advantage if the owner's tax rate is less than the tax rate of a corporation.

4. Few government regulations

A sole proprietorship has the greatest freedom as compared with any form of business
organization.
Major disadvantages of the proprietorship form include:
1. Unlimited liability
The owner is personally liable or responsible for any and all business debts. Thus, the
owner's personal assets can be claimed by the creditors if the firm defaults on its
obligations.

2. Limitations in raising capital

Fund-raising ability is limited. Resources may be limited to the assets of the owner and
growth may depend on his or her ability to borrow money.
Forms of Business Organization

3. Lack of continuity
Upon death or retirement of the owner, the proprietorship ceases to exist.

Therefore, the proprietorship may be an ideal form of business organization when the following
conditions exist:
 The anticipated risk is minimum and adequately covered by insurance.
 The owner is either unable or unwilling to maintain the necessary organizational
documents and tax returns of more complicated business entities.
 The business does not require extensive borrowing.

PARTNERSHIP
A partnership is a legal arrangement in which two or more persons agree to contribute capital or
services to the business and divide the profits or losses that may be derived therefrom. Partnership
may operate under varying degrees of formality. For example, a formal partnership may be
established using a written contract known as the partnership agreement which is filed with the
Securities and Exchange Commission.
Partnership may be either general or limited.
A general partnership is one in which each partner has unlimited liability for the debts incurred by
the business. General partners usually manage the firm and may enter into contractual obligations
on the firm's behalf. Profits and asset ownership may be divided in any way agreed upon by the
partners.
A limited partnership is one containing one or more general part9ers and one or more limited
partners. The personal liability of a general partner for the firm's debt is unlimited while the
personal liability of limited partners is limited to their investment. Limited partners cannot he
active in management.

Advantages of a partnership include among others the following:

1. Ease of formation
Forming a partnership may require relatively little effort and low start-up costs.

2. Additional sources of capital

A partnership has the financial resources of several individuals.

3. Management base
A partnership has a broader management base or expertise than a sole proprietorship.

4. Tax implication
Forms of Business Organization

A partnership like a proprietorship does not pay any income taxes. The income or loss of
the business is distributed among the partners in accordance with the partnership and each
partner reports his or her portion whether distributed or not on personal income tax return.

Disadvantages of partnership are:

1. Unlimited liability
General partners have unlimited liability for the debts and litigations of the business.

2. Lack of continuity
A partnership may dissolve upon the withdrawal or death of a general partner, depending
on the provisions of the partnership.

3. Difficulty of transferring ownership

It is difficult for a partner to liquidate or transfer ownership. it varies with conditions set
forth in the partnership agreement.

4. Limitations in raising capital

A partnership may have problems raising large amounts of capital because many sources
of funds are available only to corporations.

CORPORATION
A corporation is an artificial being created by law and is a legal entity separate and distinct from
its owners. This legal entity may own assets, borrow money and engage in other business entities
without directly involving the owners. In many corporations, owners who are also called
shareholders do not directly manage the firm. Instead they select managers designated as the Board
of Directors to run the firm for them. The Board of Directors is authorized to act in the corporation's
behalf.
The incorporation process is initiated by filing the articles of incorporation and other requirements
with the Securities and Exchange Commission (SEC). The articles of incorporation include among
others the following:
 Incorporators
 Name of the corporation
 Purpose of the corporation
 Capital stock
 Authorized shares
After the corporation is legally formed, it will then issue its capital stock. Ownership of this stock
is evidenced by a stock certificate. The corporate bylaws which are rules that govern the internal
Forms of Business Organization

management of the company are established by the board of directors and approved by the
shareholders. These bylaws may be amended or extended from time to time by shareholder.

Advantages of a corporation are:

1. Limited liability
Shareholders are liable only to the extent of their investment in the corporation. Thus,
shareholders can only lease what they have invested in the firm's shares, not any other
personal assets. However, limited liability is not all-encompassing. Government may pass
through the corporate shield to collect unpaid taxes. Also, it is not uncommon for creditors
to require that major shareholders personally co-sign for credit extended to the corporation.
Thus, upon default by the business, the creditors may sue both the corporation and
shareholders who have co-signed.

2. Unlimited life
Corporations continue to exist even after death of the owners.

3. Ease in transferring ownership

Shareholders can easily sell their ownership interest in most corporations by selling their
stock without affecting the legal form of business organizations. The ability to sell stock
provides corporations with a stronger financial base and the capital needed for expansion.

4. Ability to raise capital

Corporations can raise capital through the sale of securities such as bonds to investors who
are lending money to the corporations and equity securities such as common stock to
investors who are the owners.

Disadvantages of a corporation include:

1. Time and cost of formation
Registration of public companies with the SEC may be time-consuming and costly.

2. Regulation
Corporations are subject to greater government regulations than other forms of business
organizations. Shareholders can not just withdraw assets from the business. They can only
receive corporate assets when dividends are declared and these amounts may be subject to
limits imposed by law.

3. Taxes
Corporations pay taxes on income they have earned. The complexity of the subject of
taxation demands the advice of a qualified tax accountant.
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The need of large businesses for outside investors and creditors is such that, the corporate form
will generally be the best for such firms. We focus on corporations in the chapters ahead because
of the importance of the corporate form not only locally but also world economies. Also, a few
financial management issues, such as dividend policy are unique to corporations. However,
businesses of all types and sizes need financial management, so the majority of the subjects we
discuss hear on any form of business.

References:
Cabrera, M. B. (2013). Financial Management: Principles and Applications
Comprehensive Volume