HS. E3.

4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

Business Organizations Reading Assignment

The three basic types of business organizations are sole proprietorship, partnership, and corporation.
Choosing the right kind of organizational structure can be an important factor in the future success of a
business. Each type of business organization has costs (often called disadvantages) and benefits (often
called advantages). There is no perfect or “one size fits all” business organization. Each has its own
benefits and costs. If you looked at the number of businesses operating in the United States, the majority
would be sole proprietorships – but they are very small businesses and often homebased with very
limited sales. Some may even be hobbies or personal services, such as your lawn mowing business or
your friend’s babysitting services. Few companies are partnerships because of the difficulty in managing
them. That means the vast majority of business activity today is conducted by corporations – both
publicly and privately-held. Not all corporations are “big business”. They may be the local diner, a local
plumber, your dentist, your mom’s accounting business or your dad’s tire shop. Being a corporation has
nothing to do with size. It generally is related to limiting an individual’s liability to protect their personal
assets.

• Each type of business organization has benefits and costs

• While most businesses in the U.S. would be classified a “sole proprietorship”, they tend to be
small, homebased businesses with limited services and sales

• The vast majority of business sales and business activity is produced by corporations

• Corporations may be publicly or privately-held

• Liability, financing and taxes are key factors in deciding which business organization is best

Sole Proprietorship
A sole proprietorship simply means there is one owner of the business. These tend to be very small
businesses, often based in a home office – and they generally have few sales or market-shares. In terms
of numbers, there are more sole proprietorships than any other type of business form – however, they
only account for about 10% of all business activity (sales, production) in the U.S. One of the biggest
advantages of a sole proprietorship is having total control over a business and the decisions made.
However, that can also be one of the biggest disadvantages. While it sounds fun to make all decisions, it
can become complicated or overwhelming – especially for someone with limited experience. A sole
proprietor also receives all income from the business and that income is taxed as personal income. Sole
proprietorships are easy to start and relatively easy to close down because there’s few legal requirements
and only one person making those choices. Remember, that one person has all the responsibility – even
when things go wrong or not as planned. Due to the limited structure and assets, it is usually very
difficult to find start-up funds for a sole proprietorship.

Sole Proprietorship

• One owner

• Tend to be small with no employees

1|Page
HS. E3.4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

Benefits

• One person

• Receives all benefits, profits and income

• Easy to start and easy to close down

Costs

• Responsible for all decisions and all debts

• Unlimited liability

• Difficult to get start-up or expansion financing

• Income/profits taxed at personal income rates, not business rates

Partnership
A partnership means a business has two or more owners. They may have equal responsibilities in the
daily operations of the business or they may have an agreement where one has more responsibility than
the others. The manner in which the partnership is structured depends upon the individuals involved and
their motivation for being part of it. Partnerships have the smallest number and market share of the
three types of business organizations. Sole proprietorships and partnerships are relatively simple forms
of business organizations with little, if any, legal structure. Partnerships are also relatively easy to start
and close down, as long as everyone involved agrees. With a partnership, one or more people are part of
the business and can be part of the decision-making process. The role each person plays is determined
by the partners themselves. Some may invest money in the business while others may invest time and
energy – or they may share everything equally. Partnerships can be helpful if they have different areas of
expertise. For example, if one partner is great at accounting and the other is great at marketing, they can
take on responsibilities that best match their skills. However, they still need to agree or work together to
build a successful business. Then, what happens when one person decides to leave or passes away? The
other partner (or partners) must figure out how to handle that.

Partnership

• Two or more owners

• Tend to be small with few, if any, employees

Benefits

• Shared decision-making

• Can rely on partner’s expertise

• Relatively easy to start

Costs

2|Page
HS. E3.4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

• May have differences of opinions or disagreements

• Must decide what to do when one person wants to leave or close down

• Unlimited liability

• Difficult to get start-up or expansion financing

• Income/profit taxed at personal income rates, not business rates

Corporation
A corporation is somewhat different from a sole proprietorship or partnership. A corporation is a formal,
legal structure that takes on its own identity. In legal terms, it has similar rights and responsibilities as a
person has. While people often assume corporation means “big business”, that assumption is false.
Businesses of all sizes are incorporated, and they conduct about 80% of all business activity in the U.S.
Corporations are very different from the first two because they have a specific legal structure that must
comply with various rules and regulations. Because they are viewed similar to an individual in the eyes of
the law, the corporation itself is held responsible for the decisions made by employees, managers and/or
board of directors. Corporations require more money and time to start because of the need for legal
advice and paperwork. However, they tend to provide greater benefits for anyone who is serious about
opening a business. Corporations sell shares and are owned by the shareholders. Shares may be sold
publicly (using one of the stock market exchanges) or privately (often to friends and family members).

Publicly vs Privately-held Corporations

Corporations may be either public or private – and that decision depends on a variety of factors. While
both sell shares (stocks) to shareholders, the process for selling them is different. Publicly-held
corporations sell their share to the general public via stock exchanges like the New York Stock Exchange.
The board of directors determines which stock exchange and how many shares it wants to sell – and
often own the majority of shares in the company to maintain control. Publicly-held corporations are
regulated by the Securities Exchange Commission (SEC), which requires them to file quarterly financial
reports detailing their business activities. These reports are available to all shareholders and to members
of the general public. These reports provide information about the safety and soundness of the
company, information that is needed to help buyers and sellers make informed choices about their
investments. Privately-held companies are the opposite. Their stock is not traded in public stock
exchanges, even though it may be sold to investors or others outside the company. Because they are
privately-held, they are not regulated by the SEC and their reports are not available to the general public.
They are still regulated by laws in the states where they are set-up and chartered, and they do share
information about the company’s business activities with their shareholders. Publicly and privately-held
corporations come in all sizes and operate in most industries. Shareholders are owners in the company,
and their percentage of ownership is determined by the number of shares they own.

Corporation

• Legal entity that is similar to an individual in the eyes of the law

3|Page
HS. E3.4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

• May be large or small, with few or many employees

Benefits

• Legal entity that is held responsible for its decisions

• Ownership is separate and apart from the owner/shareholders

• Managed by a board of directors

• Owners/shareholders have “limited liability”

• Can be easier to get start-up and expansion financing

• Considered an “individual” and pays its own taxes at corporate tax rates

Costs

• Requires legal advice and fees to establish/maintain

• May be subject to more paperwork and state/federal regulations

• May have managers with absentee ownership

Three critical issues for businesses: liability, financing and taxes.

Liability

Definition: a company's legal financial debts or other obligations resulting from its daily business
operations

Liability may be a new concept for most students…. but it is extremely important for a business owner to
understand. Liability refers to the debt a business owes or another obligation it has. The most common
situation is the debts owed when a business experiences financial difficulty or fails. Supposed you owned
a lemonade stand and no one bought your lemonade. What would happen if you had borrowed money
to pay for the cups, the lumber to build the stand, the pitchers, and the lemons? You would still need to
repay the money you borrowed. Now Mom and Dad might say it’s okay, but a bank or credit card
company would not be that understanding. Now, what if someone got sick drinking your lemonade and
decided to sue you, you could be required to pay for their medical expenses or other costs. Even if found
innocent, you would have legal bills to pay. If you cannot pay your bills, the courts can take your personal
property. That may not be a big deal now, but what if your parents lost their home or their cars because
they couldn’t pay their bills when their business failed? In addition, there’s also the possibility of loss due
to disaster such as flood or fire. If not well insured, it could create financial problems. Unlimited liability
means that the owner’s personal assets can be used to pay for any debts of the business. Now, suppose
your lemonade stand was incorporated as World’s Best Lemonade Company. You owned $25 in shares,
your friend Sam owned $25 in shares, and your grandmother owned $25 in shares. That gives you $75 to
open the business. The most you could use lose – regardless of what happens – is $25. But your friend
Sam and your grandmother would also lose their $25. Even if World’s Best Lemonade Company owed
$1,000, you and your investors would be limited to a $25 loss each.

4|Page
HS. E3.4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

Unlimited Liability: Sole Proprietor and Partnership

• Individuals are held responsible for all business activities and must pay any debts or
obligations of the business

• Individuals can be sued and possibly lose personal assets to cover those debts

Limited Liability: Corporation

• The corporation itself is held responsible for all business activities and any debts or
obligations.

• Individual shareholders loss is limited to the amount of money invested in the

corporation

Financing

Definition: Ability to borrow money to start or expand a business

Another important issue to consider is financing the business, either as a start-up or for expansion.
Financing is the ability to borrow money. Bankers and other potential lenders often view sole
proprietorships and partnerships as a “hobby” or high-risk because the owners often have little or no
experience owning and operating a business. As a result, the personal assets of individuals in a sole
proprietorship and partnership are the only source of money for them to use. That includes money in
their personal savings or retirement plan, personal loans which have higher interest rates or loans on
their credit cards which is some of the highest interest rates paid. On rare occasions, they may be able to
borrow money from family members, friends or a bank. Corporations have more options when they need
to obtain additional financing. They can choose to issue more stock to raise money, and they typically
find it easier to borrow money – through loans from various financial institutions such as banks, credit
unions and insurance companies. In addition, they could decide to issue corporate bonds.

Limited Options: Sole Proprietor and Partnership

• Relies more on individual/personal assets

• Often financed using credit cards, personal loans or personal savings

More Options: Corporation

• Can sell more stock to raise funds if needed

• Can borrow money based on its own assets, not those of the owners

Tax Issues

Tax rates and deductions vary for personal income tax and corporate/business income tax at both the
state and federal levels. Tax laws and issues can be complex to understand, which is why we have
professionals who specialize in law or accounting to help us make good decisions. However, we do know
there are some basic differences in how taxes affect business organizations. For example, tax law permits
corporations to deduct the full cost of employee benefits, such as medical insurance, thus reducing

5|Page
HS. E3.4 Explain the distinct types of business organizations and analyze the role of innovation and
entrepreneurship in a market economy.

corporate tax liabilities. But sole proprietorships and partnerships are not permitted to deduct these costs
directly from their business income (the costs may be partially deductible as an adjustment to income).
For some business owners, this is a major disadvantage of the sole proprietorship and partnership forms
of ownership. There may also be some differences at the state level, depending upon where the
corporation is chartered. In addition, corporate tax rates tend to be flat rates and less than personal
income tax rates at both the state and federal levels.

Sole Proprietor and Partnership

• Income/profits taxed as personal income

• Limited deductions for business expenses

Corporations

• Income/profits taxes as corporate/business income

• Increased options for deducting business expenses, including employee benefits

Directions: This reading has discussed the cost and benefits of three different types of business
organizations: sole proprietor, partnership and corporation. Following is a list of key factors that a new
owner(s) needs to consider when deciding what type of business organization is best for his or her
situation. Your assignment is to explain how two of these factors would be either a cost or benefit in each
of the three types of organizations.

1. The factor is the financial resources needed to start and expand a business. Decide whether this
factor is a cost or benefit to a sole proprietor, a partnership and a corporation, and give a brief
explanation for your answer.
2. Select one of the other factors listed, determine if it is a cost or benefit in each organization, and
briefly explain your answer.
• Their level of expertise starting and managing a business
• Their willingness to share decisions and profits with others
• The level of liability they are willing to accept
• The tax implications related to future income or profits from the business
• How long they want to stay involved in the business as either managers or
investors
• How concerned they are about what will happen to the business if they
decide to leave

6|Page