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► Listen from source (IPFS) In this presentation, we will discuss business forms and business structures. At the end of this we will be able to:
• List types of business forms
• Describe pros and cons of being a sole proprietor type of business form
• Explain the meaning of a partnership
• Describe what a partnership agreement is
When considering going into business or just thinking about business in general, it can be a bit overwhelming when we think about all the different types of formations that can be used to create a business and run the business formation. We're going to go through a list of few of these formations, and then we'll discuss some of the pros and cons. Before we do, however it's important to note that there's a lot of similarities between the different types of business formations the major goal being principally the same that we want to separate the business from the personal. From a bookkeeping side, we do that no matter what type of formation we have. The business has different objectives than the personal. We're going to separate out the business objectives and at least track them in a separate formation so that we can see what the performance is of the business
The business objective is typically revenue generation or at least to track the revenue to have one indication of how well we are doing at our business goal, the business objective, whatever we do for the business. To do that we need to have a separate record of the business versus the personal.
No matter what type of formation we have we are generally going to do that. We're going to separate everything out on the business side. We're going to try to track it business separate from personal and achieve business objectives one of those being revenue generation.
Where some of the differences come into play are when we talk about the different people involved in owning a business whether that be one individual or multiple individuals. When we have multiple individuals then the complexity it becomes more complex of course regarding how we deal with those multiple individuals. How do we allocate for one thing the revenue between those multiple individuals?
The other thing that's different and one of the innovations that happened within business that really kind of helped business to grow in many ways is the concept of a corporation. The concept of a corporation means that we have a separate legal entity. We actually give this corporation, this piece of paper, this non-human thing human characteristics such as the ability to own property. What that really does one of the main things it does is it removes some of the personal liability that would be involved for people that are involved in a corporation and investing in corporations really allowing people to invest in corporations without having their personal liability or their personal assets at risk. That's going to be a huge innovation in order for people to use capital and for new ideas to be put in place and be able to construct businesses and actually get capital from people that have the funds to invest in something but don't want to take on that added liability risk that would go beyond their initial investment to their personal resources in the case of problems. That separate legal type of entity then is great however it does come at some rigidity in terms of how the corporation is run and the structure of the corporation the typical type of C corporation.
Many of the other type of entities try to blend some of these advantages of a corporation and partnership. Some of these other types of entities we include limited liability company, limited liability partnership, and S corporation.
Many of these entities are just variations on the concepts, their mixes in some way between a general partnership very flexible type of partnership there's a lot of different things we can do with a partnership agreement and the C corporation which has the benefit of being a separate legal entity and therefore providing liability protection. However, it not being as flexible as a partnership it being a bit more rigid. These other types of entities we look into I really variations trying to get some benefit on both sides of flexibility of a partnership and the liability protection of a corporation being the principal thing of a corporation.
When we think about the three main types of entities, you can think of it kind of like a color wheel that has the main three components and then a blending of those really is going on for these other types of entities. We think of a sole proprietorship which is a one individual. We think of a general partnership which is multiple individuals but has a really a lot of flexibility in terms of how they maneuver and then within and then we have the corporation which is going to be a separate legal entity but a bit more rigid. Then if we blend and mix a bit in between especially the partnership and the corporation we end up with things like limited liability companies, S corporations. We could have a limited liability partnership and so on and so forth.
First, we're going to start off with the sole proprietorship because it's going to be the most common type of business formation in the United States by far. By far most businesses are sole proprietors. If we think about the amount of revenue generated, then the amount of revenue would be highest typically by corporations. However, if we're thinking about just the number of business entity forms the sole proprietor has the greatest number by far. Why? Because it's the easiest to form. That's going to be one of the major benefits as the sole proprietorship. All we really have to do to start a sole proprietorship is start acting like a business. If we start generating revenue. If we start acting in a way that we are doing businesses and generating revenue and acting for that revenue, not in essence a hobby, but trying to actually generate revenue from it then we're really acting as a sole proprietorship and as a consequence the government sees us as a sole proprietorship and we have to do things such as report our business earnings on our taxes, not in a separate tax return however. It's not like we have to file return for separate entity. We generally have to file a Schedule C which we would then attached to the form 1040. The fact that we don't file a separate entity return is an indication of one of the benefits and one of the weaknesses of a sole proprietor and that is that from a legal standpoint the business isn't a separate legal entity and therefore we report it basically on our 1040 with just another schedule to it. The problem with that is that if we were to get sued or something as a sole proprietor then it may be more likely that they could go after not just the revenue that we generated from the business or the business assets but possibly after the personal assets. We don't have as much of a door differentiation from a legal standpoint in terms of what is it that is our business entity or business entity lives and our personal entity and therefore from a liability perspective someone is more likely to be able to go after personal asset personal resources rather than just the business resources.
When considering the sole proprietorship, we have got to weigh the pros and cons of liability protection and ease of formation and be more careful when we're doing business as a sole proprietorship and possibly try to cover ourselves with things like liability insurance.
Clearly one of the benefits of a sole proprietorship is that the owner of the business has complete control over that business and can make decisions quickly as they see fit going for and that can be really beneficial when we're talking about a small business that wants to move quickly. When we get to something like a partnership then of course we have to negotiate within the partnership which could be a good thing we have more people to discuss and get good ideas with, but it's also could be more difficult to move forward in that we have to have some type of agreement of course between the individuals involved to move forward on any particular decisions. Whereas a sole proprietor the individual can move forward with whatever they think is the best move for the business. When we go to a corporation of course then we're going to have more of a hierarchical structure which could make it a little bit more difficult at times to move forward and move quickly. When we're talking about a small business oftentimes they're weighing the pros and cons of being a sole proprietor limited liability protection of some other types of business entities and the benefits and cons of being something like a partnership in having more people involved in the decision-making process.
In terms of a partnership versus the sole proprietor that the question is oftentimes should a small business take on a partner or should possibly a small business take on employees to help or contractors to help out the business. If they take on contractors, then they still remain in control of the business and ultimately making business decisions and then pay for work to help them. If they take on a partner, then of course now you have decision-making power within the business and you need to be able to work through how you are going to move forward with the business and be able to negotiate that process going forward. However, if you have a partnership it's often easier for people to contribute capital. If someone's going to contribute money into the business, then they're probably going to want some type of ownership percentage. That's going to be one of the benefits of a corporation versus of sole proprietor as well. A corporation to buy stocks in a company is going to have some more type of power to have decision-making.
The next type of business entity we will discuss is a partnership. A partnership will be very similar to a sole proprietor in that we have that revenue generation goal and objective of a business. However, here we're going to have two or more individuals involved in the carrying out of the business and some form of profit sharing between those two individuals. It's important to note that a partner could be someone other than an individual. In other words, we could have a business entity such as a corporation or some other business entity included in a partnership as one of the two or more individuals involved in the partnership.
A partnership is going to be easy to form typically as well as with. Two individuals are getting together and earning revenue generating revenue then in essence like a sole proprietor there they are now a partnership basically because they have that business objective of generating revenue and now they have that profit sharing a perspective in that they're dividing up the profits in some way.
Partnerships are going to have a similar problem in that we're don't have the same type of level of a separate legal entity from the partners. The partners still have some of the liability problems in terms of not being a separate legal entity as the sole proprietor and therefore are more vulnerable to things like a lawsuit not only being able to go over after the business assets but possibly the partner assets as well.
Although the partnership is not a separate legal entity and we still have that liability issue between the individual partners and the partnership itself we do think about the decision making from the partnerships for the most part to be from an entity rather than individual partners. In other words, the owners of the partnership can make agreements binding agreements that would bind not only them, but there are other partners that are involved within the partnership. Therefore, we have this type of agency problem or this type of agency representation in that either of the partners can make decisions that will be binding in terms of the joint assets of the business as well as create liabilities for the business. That's where the partners need to be careful and be able to understand that the individuals involved both partners can make decisions, and those decisions may be binding not only to the individual that made them but of course to the partnership as an entity.
The most common way to set up a partnership is to have a partnership agreement to have the partners meet and set up some type of agreement between the parties. If a partnership does not do this may basically act as a partnership and have profit sharing, we could still say well they're basically a partnership from a legal perspective. However, meeting has an agreement on the partnership is the best way to set up a partnership. It's possible to do that with an oral agreement however it's best typically to put things in writing. The more defined the partnership agreement is the better it is typically for the individuals the partners involved because then they have a better idea of what is expected. At the minimum we would want to say what the profit sharing will be of the partnership agreement. It does not necessarily need to be a 50/50 split. It could differ substantially and that's one of the huge benefits of a partnership agreement. We are able to say hey if one individuals working a lot more than the other individual then we may want the profit sharing to be split in such a way that it would favor that individual. If one individual puts a lot more capital into the business to start the business, then it would make sense for the profit share and possibly to go to that individual at least for a time.
There's also a lot of different types of variations that we can put into the profit-sharing agreement for a partnership. Variations such as some type of guaranteed return on the capital to compensate the individual who put in capital investment, a lot of money to start the partnership, or some other type of assets, to start up the business. We could include something like having a distribution for the work done, a type of salary a or a type of compensation that would be guaranteed as part of the revenue distribution when we divide up the revenue for someone who is putting in more service more work towards the business. There is a lot of flexibility with a partnership in terms of how that partnership agreements can work and how the profit sharing within it can be set up.
When considering a capital contribution or the generation of capital from a partnership the partners themselves often will put in an initial investment or possibly investments in the future within the partnership which we would call capital contributions so that the partnership can then use those capital contributions to achieve the goal of revenue generation. As a partner puts the capital contribution money or other resources other assets into the business the expectation is to generate revenue and then the partnership has some claim to that assets that they put into the business will have to divided up the business in essence owing that those resources back to the business in some way shape or form hopefully through the generation of revenue and the dividing of the profit sharing. We need to track the amount that is owed to the partners as we move through the partnership agreement in terms of both capital contributions and the revenue generation that could either be distributed to the partners when we generate revenue, or it can be put back into the business and used to help facilitate the growth of the business for the objective the goal of future revenue generation.
When considering a variation of a partnership where we have a limited partner we're going to have one or more individuals that are partners but have limited liability in that they're not making the decisions typically of the day to day negotiations of the partner and therefore we can think of them more as a type of partner that is contributing capital oftentimes in order to generate revenue but not being involved in the day-to-day management of the partnership and therefore there's granted a more of a liability protection for those partners.
We can see the concept of why we would want this type of limited partner in a partnership agreement. If a partnership for example is looking to generate. They have a good idea, but they don't have a capital, don't have the money, they may want to take on a limited liability partner who does have some money and have some faith in the individuals to generate revenue and are willing to give that money to the partnership for revenue generation. However they would be taking on more risk if they were subject to liability beyond that initial investment and that's going to be one of the benefits of a limit liability partner who could then put in money but not be involved in the day-to-day transactions and therefore not be as liable as general partners in terms of their personal resources their personal assets in the case of some kind of problem like towards, wrongful acts, negligence, or misconduct committed by another partner within the partnership.
Next type of entity we will discuss is a corporation a standard C corporation and the C corporation the big innovation here is that the C corporation will be considered a separate legal entity and therefore be able to take on some human characteristics such as being able to enter into agreements and own assets and take on liabilities these being things of course that typically we would think about in terms of individuals having those types of rights. If we attribute those to a business, we have similar types of advantages we saw with something like a limited partner in that a business can then I get resources generate capital from more people who would like to invest in the business and help the business to grow but who would be skeptical to do so if the business was going to generate personal liability for them beyond that initial investment. We can all see this when we think about our 401k plans and the money that we invest. We would be much more skeptical to take money out of our checking account and put it into a fund that would be tracking stock to be corporate stock owners to own stock if having done so would expose us not only to the loss of that initial investment but to loss to our personal resources such as our house or something like. That that would very be a very limiting concept. The ability for a corporation to generate capital through issuing stock and then having some kind of authority or power ownership of the business without exposing the personal resources is going to be a huge benefit to the business.
A corporation will have owners in the form of stockholders. The idea of a corporation to have this separate legal entity would be that there's going to be some layers regarding how the corporate structure will be set up. The major benefit of the corporation is that it is a separate legal entity providing that liability protection also comes at some costs as well and the costs include the fact that a corporation is typically a bit more expensive to form and a corporation is typically going to have some more rigidity in terms of how to have the profit sharing agreement and how to set things up.
For example, the partnership we have a partnership agreement that has a lot of flexibility in terms of profit sharing in particular. Whereas a corporation we have corporate stock in the corporation and the stock has to be in essence all the same for the most part. When we talk about common stock, the common stock needs to be the same. That's the point of it. We can have separate individuals that own more or less common stock, but we can't have the common stock the normal stock the common stock has different characteristics from one to the other. They all need to be the same form of common stock whereas in a partnership agreement we can assign different types of profit-sharing agreements to the different partners, so the flexibility is something that is lost a bit regarding the profit sharing in a corporation.
It can also be more expensive to form a corporation. Corporations can also be subject to double taxation as well, meaning tax often happens on the corporate level when earnings are made and then when the earnings go from the corporation to the individuals, the stockholders, we call that a dividend and rather than being just a distribution as it would if we're talking about a sole proprietor which would not be taxable we could tax it at the point in time it was earned out on a sole proprietor when we give it from the corporation to an individual because there's separate legal entities or in part because there's separate legal entities the dividend is often taxed as well. In other words, the revenue that we had is taxed two times. That can be a huge downfall of the corporation, a huge problem. We have this great benefit of being able to generate capital, but you have this problem of possibly having a double taxation.
Other types of entities, the concept of a limited liability company, the concept of an S corporation, are types of entities that try to have the best of both worlds, to try to be a separate legal entity in terms of being able to more easily generate capital and to be able to have liability protection. However also having more flexibility in terms of how they're going to have their profit sharing and of course try to remove the idea of the deble taxation and the way that would happen is to have a flow-through type of entity we're although we report it as a separate legal entity we in essence have it flow through to the individual tax returns and basically be taxed on the individual level rather than it being taxed first at the corporate level and then again on the individual level in the form of distribution.
Rather than having that double form of taxation we would have the original income generated from something like an S corporation that would flow through to the individual tax return at the point of generation, not the point of distributed.