Types of Business Organizations

You may recall from your introductory accounting course that the type of business organization in which you are affiliated will have ramifications or advantages and disadvantages. Let’s begin with a refresher.

Businesses have the option to organize in four ways:

1. Sole Proprietor
2. Partnership
3. Corporation
4. LLC/LLP

Now, take a look at each type of organization in order to understand it in terms of corporate finance.

Sole Proprietor

In the United States, the most popular type of business organization is the sole proprietor. This is where an individual decides to open up a business on her own. Some of the advantages of opening up as a sole proprietor would include sole decision maker, ease of starting up the business and infinite possibility of one’s individual income. Disadvantages of creating a sole proprietorship would include unlimited liability, lack of other owners/partners, and difficulty for the sole owner to manage both her business as well as personal affairs.

Partnership

A partnership is where two or more individuals decide to form a joint venture. Partnerships include general partners (responsible for all day-to-day business activities) and can include limited partners. A limited partner is only responsible for what they put into the joint venture, ie. funds, advice, etc. A limited partner is not normally responsible for the daily activities of a partnership. An advantage of a partnership is the pooling of assets as well as having at least two individuals involved in the partnership decision making process. A disadvantage can be if the partners no longer want to work with one another and wish to dissolve the partnership. When this occurs, each partner is financially liable, both with the firm’s monies and their personal finances. Also upon dissolve, the firm must shut down. Neither partner can continue with the firm unless the business is reorganized. The partnership agreement should include, amongst other items, procedures for how a possible dissolution of the partnership can take place.

Corporation

A corporation is considered a separate legal entity. In the United States, most business is done through corporations. The main advantage for forming a corporation is separate liability. The main disadvantage of forming a corporation is double taxation. The earnings are taxed at both the owner’s level and then again at the corporate level. There are two types of corporations: “C” corp and a “S” corp. The most prevalent type of corporation, in the United States, is the “C” corp. This type of corporation enjoys the benefits of special tax deductions and is a separate entity concerning tax liability. The “S” corp, on the other hand, passes its losses and gains of income through their personal returns but this allows the owner to avoid double taxation. The “S” corp also allows for some special tax considerations to take place; however, we will not be doing a full analysis of the different types or business organizations in this course.

If you would like more information concerning this topic, check out this Khan Academy video or visit the IRS Web site.

LLC/LLP

A rather popular type of business organization (and fairly new) is the LLC/LLP. LLC stands for "limited liability company" and the LLP stands for "limited liability partnership." They are both hybrids of both the corporation and partnership types of business organizations.

With that said, the LLC and LLP both offer the advantage of limited liability in which the owners are not personally financially liable for the firm's shortcomings. But the firm must be dissolved in the event of death or bankruptcy. Also, if you want to go public with your newly-acquired firm, the LLC/LLP would not be the correct option.

Regardless of which type of business organization the owners choose, financial management is critical to the overall success of the firm.

Agency Relationship and Potential Problems

An agency relationship develops when a third party is hired to represent another party in a certain business transaction. In order to create a successful agency relationship, the two parties must have trust and confidence in one another. For example, an agency relationship exists when a real estate broker is hired by a homeowner to market his real property. Another example of agency would be when a corporation hires a lawyer to represent it in either a legal or business transaction.