Ch 5: how to form a business
How you form your business can make a tremendous difference in your longterm success. The
three major forms of business ownership are (1) sole proprietorships, (2) partnerships, and (3)
corporations. Each has advantages and disadvantages that we’ll discuss.
It can be easy to get started in your own business. You can begin a lawn mowing service,
develop a website, or go about meeting other wants and needs of your community. A business
owned, and usually managed, by one person is called a sole proprietorship. That is the most
common form of business ownership.
Many people do not have the money, time, or desire to run a business on their own. When two or
more people legally agree to become co-owners of a business, the organization is called
Sole proprietorships and partnerships are relatively easy to form, but there are advantages to
creating a business that is separate and distinct from the owners. This is a corporation, a legal
entity with authority to act and have liability apart from its owners. The almost 5 million
corporations in the United States make up only 20 percent of all businesses, but they earn 81
percent of total U.S. business receipts
Advantages: 1) ease of starting and ending the business, 2) being your own boss, 3)pride of
ownership, 4) leaving a legacy, 5) retention of company profits, 6) no special taxes
1) Unlimited liability—the risk of personal losses. When you work for others, it is their
problem if the business is not profitable. When you own your own business, you
and the business are considered one. You have unlimited liability; that is, any
debts or damages incurred by the business are your debts and you must pay
them, even if it means selling your home, your car, or whatever else you own.
This is a serious risk, and undertaking it requires not only thought but also
discussion with a lawyer, an insurance agent, an accountant, and others.
2) Limited financial resources. Funds available to the business are limited to what the one
owner can gather. Since there are serious limits to how much money one person can
raise, partnerships and corporations have a greater probability of obtaining the financial
backing needed to start and equip a business and keep it going.
3) Management difficulties. All businesses need management; someone must keep
inventory, accounting, and tax records. Many people skilled at selling things or providing
a service are not so skilled at keeping records. Sole proprietors often find it difficult to
attract qualified employees to help run the business because often they cannot compete
with the salary and benefits offered by larger companies.
4) Overwhelming time commitment. Though sole proprietors say they set their own hours,
it’s hard to own a business, manage it, train people, and have time for anything else in life
when there is no one with whom to share the burden. The owner of a store, for example,
may put in 12 hours a day at least six days a week—almost twice the hours worked by a
nonsupervisory employee in a large company. Imagine how this time commitment affects
the sole proprietor’s family life. Many sole proprietors will tell you, “It’s not a job, it’s
not a career, it’s a way of lif4.” 5) Few fringe benefits. If you are your own boss, you lose the fringe benefits that often
come with working for others. You have no paid health insurance, no paid disability
insurance, no pension plan, no sick leave, and no vacation pay. These and other benefits
may add up to 30 percent or more of a worker’s compensation.
6) Limited growth. Expansion is often slow since a sole proprietorship relies on its owner
for most of its creativity, business know-how, and funding.
7) Limited life span. If the sole proprietor dies, is incapacitated, or retires, the business no
longer exists (unless it is sold or taken over by the sole proprietor’s heirs).
Being the sole proprietor of a company, like a dog-walking service, means making a major time
commitment to run the business, including constantly seeking out new customers and looking for
reliable employees when the time comes to grow.
. There are several types: (1) general partnerships, (2) limited partnerships, and (3) master
limited partnerships. In a general partnership all owners share in operating the business and in
assuming liability for the business’s debts. A limited partnership has one or more general
partners and one or more limited partners. A general partner is an owner (partner) who has
unlimited liability and is active in managing the firm. Every partnership must have at least one
general partner. A limited partner is an owner who invests money in the business but does not
have any management responsibility or liability for losses beyond his or her investment. Limited
liability means that the limited partners’ liability for the debts of the business is limited to the
amount they put into the company; their personal assets are not at risk.
One form of partnership, the master limited partnership (MLP), looks much like a corporation
(which we discuss next) in that it acts like a corporation and is traded on the stock exchanges
like a corporation, but is taxed like a partnership and thus avoids the corporate income
tax.5 Master limited partnerships are normally found in the oil and gas industry
Another type of partnership was created to limit the disadvantage of unlimited liability.
A limited liability partnership (LLP) limits partners’ risk of losing their personal assets to the
outcomes of only their own acts and omissions and those of people under their supervision. If
you are a limited partner in an LLP, you can operate without the fear that one of your partners
might commit an act of malpractice resulting in a judgment that takes away your house, car,
retirement plan, even your collection of vintage Star Wars action figures, as would be the case in
a general partnership. However, in many states this personal protection does not extend to
contract liabilities such as bank loans, leases, and business debt the partnership takes on; loss of
personal assets is still a risk if these are not paid. In states without additional contract liability
protections for LLPs, the LLP is in many ways similar to an LLC (discussed later in the chapter).
The UPA defines the three key elements of any general partnership as (1) common ownership,
(2) shared profits and losses, and (3) the right to participate in managing the operations of the
1. More financial resources. When two or more people pool their money and credit, it is
easier to pay the rent, utilities, and other bills incurred by a business. A limited
partnership is specially designed to help raise money. As mentioned earlier, a limited partner invests money in the business but cannot legally have management responsibility
and has limited liability.
2. Shared management and pooled/complementary skills and knowledge. It is simply much
easier to manage the day-to-day activities of a business with carefully chosen partners.
Partners give each other free time from the business and provide different skills and
perspectives. Some people find that the best Page 125partner is a spouse. Many husband-
and-wife teams manage restaurants, service shops, and other businesses. 7
3. Longer survival. Partnerships are more likely to succeed than sole proprietorships because
being watched by a partner can help a businessperson become more disciplined. 8
4. No special taxes. As with sole proprietorships, all profits of partnerships are taxed as the
personal income of the owners, who pay the normal income tax on that money. Similarly,
partners must estimate their taxes and make quarterly payments or suffer penalties for
1. Unlimited liability. Each general partner is liable for the debts of the firm, no matter who
was responsible for causing them. You are liable for your partners’ mistakes as well as
your own. Like sole proprietors, general partners can lose their homes, cars, and
everything else they own if the business loses a lawsuit or goes bankrupt.
2. Division of profits. Sharing risk means sharing profits, and that can cause conflicts. There
is no set system for dividing profits in a partnership, and they are not always divided
evenly. For example, if one partner puts in more money and the other puts in more hours,
each may feel justified in asking for a bigger share of the profits.
3. Disagreements among partners. Disagreements over money are just one example of
potential conflict in a partnership. Who has final authority over employees? Who hires
and fires employees? Who works what hours? What if one partner wants to buy expensive
equipment for the firm and the other partner disagrees? All terms of the partnership
should be spelled out in writing to protect all parties and minimize
misunderstandings. 9 TheMaking Ethical Decisions box offers an example of a difference
of opinions between partners.
4. Difficulty of termination. Once you have committed yourself to a partnership, it is
not easy to get out of it. Sure, you can just quit. However, questions about who
gets what and what happens next are often difficult to resolve when the
partnership ends. Surprisingly, law firms often have faulty partnership
agreements and find that breaking up is hard to do. How do you get rid of a
partner you don’t like? It is best to decide such questions up front in the
partnership agreement. Figure 5.3 gives you ideas about what to include in
A conventional (C) corporation is a state-chartered legal entity with authority to act and
have liability separate from its owners—its stockholders.Stockholders are not liable for
the debts or other problems of the corporation beyond the money they invest in it by
buying ownership shares, or stock, in the company. They don’t have to worry about
losing their house, car, or other property because of some business problem—a
significant benefit. A corporation not only limits the liability of owners but often enables
many people to share in the ownership (and profits) of a business without working there or having other commitments to it. Corporations may choose whether to offer
ownership to outside investors or remain privately held.
1) Limited liability. A major advantage of corporations is the limited liability of their
owners. Remember, limited liability means that the owners of a business are
responsible for its losses only up to the amount they invest in it.
2) Ability to raise more money for investment. To raise money, a corporation can sell shares
of its stock to anyone who is interested. This means that millions of people can own part
of major companies like IBM, Apple, and Coca-Cola, and smaller corporations as well. If
a company sells 10 million shares of stock for $50 a share, it will have $500 million
available to build plants, buy materials, hire people, manufacture products, and so on.
Such a large amount of money would be difficult to raise any other way.
Corporations can also borrow money by obtaining loans from financial institutions like
banks. They can also borrow from individual investors by issuing bonds, which involve
paying investors interest until the bonds are repaid sometime in the future.10You can read
about how corporations raise funds through the sale of stocks and bonds in Chapter 17.
3) Size. “Size” summarizes many of the advantages of some corporations. Because they can
raise large amounts of money to work with, big corporations can build modern factories
or software development facilities with the latest equipment. They can hire experts or
specialists in all areas of operation. They can buy other corporations in different fields to
diversify their business risks. In short, a large corporation with numerous resources can
take advantage of opportunities anywhere in the world.
But corporations do not have to be large to enjoy the benefits of incorporating. Many
doctors, lawyers, and individuals, as well as partners in a variety of businesses, have
incorporated. The vast majority of corporations in the United States are small businesses.
4) Perpetual life. Because corporations are separate from those who own them, the death of
one or more owners does not terminate the corporation.
5) Ease of ownership change. It is easy to change the owners of a corporation. All that is
necessary is to sell the stock to someone else.
6) Ease of attracting talented employees. Corporations can attract skilled employees by
offering such benefits as stock options (the right to purchase shares of the corporation for
a fixed price).
7) Separation of ownership from management. Corporations are able to raise money from
many different owners/stockholders without getting them involved in management. The
corporate hierarchy in Figure 5.5 shows how the owners/stockholders are separate from
the managers and employees. The owners/stockholders elect a board of directors, who
hire the officers of the corporation and oversee major policy issues. The
owners/stockholders thus have some say in who runs the corporation but have no real
control over the daily operations.
1. Initial cost. Incorporation may cost thousands of dollars and require expensive lawyers
and accountants. There are less expensive ways of incorporating in certain states (see the
following subsection), but many people do not have Page 130the time or confidence to go
through this procedure without the help of a potentially expensive lawyer.
2. Extensive paperwork. The paperwork needed to start a corporation is just the beginning. A
sole proprietor or partnership may keep rather broad accounting records. A corporation, in
contrast, must keep detailed financial records, the minutes of meetings, and more. As noted in Figure 5.4, many firms incorporate in Delaware or Nevada because these states’
business-oriented laws make the process easier than it is in other states.
3. Double tax