Business Ownership Laws



Pre Reading Comment – Chapter 3

Book has good discussion of small business start up and the role of small business in job creation.  You may want to pay attention to this section to get some ideas for your business plan.


The other area to focus is on the identification of different types of business organizations



Business Plan

In your business plan you will need to identify the type of organization that you want your business to be, and why.



Lecture Notes


Lecture Summary

The key components of this lecture are:

  • The basic types of business organizations and some of the advantages and disadvantages of the various business types




Types of Business Organizations


In starting a business one needs to determine the legal form of the business that is most desirable.  There are differences in ease of creation, tax treatment and liability associated with each form of business organization.



Sole Proprietorship – The most common form of organization has the advantage of treating income/loss as personal income/loss of the owner (this can be an advantage for small business that often experience a loss).  These are also very easy forms of business to start.  The biggest disadvantage of a sole proprietorship is that unlimited liability of the business is treated as personal liability of the individual owner.  In other words to satisfy debts or lawsuits of the business the courts can take your house and personal savings.


General Partnerships - This is where multiple individuals are co-owners of the business.  An advantage of this form of business is that multiple individuals can invest and share in the management of the organization – this allows the organization to grow in size and complexity.


The biggest limitation of this form of organization is again unlimited individual liability for organizational debts.   In addition, managing the relationships between the partners can be a complex and time consuming process.


Limited Partnerships – Multiple individuals invest in and co-own the organization.  However some of the partners (limited partners) are not involved in the management of the organization and their liability is limited to the extent of their investment.  There are one or more general partners who manage the organization and who have unlimited personal liability.  While the early Dutch trading companies we referred to would not have called themselves limited partnerships this is what they were in today’s terminology


The creation of a partnership is not overly involved but does require the development of a partnership agreement between the partners addressing how the partners will mange the organization and their relationships.


Corporations -  These are business organizations that are a separate legal entity.  This means that for both tax and liability issues they are treated independently of the owners.  So owners in a corporation only have their investment in the company at risk – limited liability.   The creation of a corporate entity is more complicated and involved than the creations of a partnership or sole proprietorship. 


Depending on the type of corporation, there can be a double taxation issue.  This means that the profits of the corporation are taxed as corporate profits when they are earned and then taxed again as personal income when they are distributed to the owners.   


As a result of the limited liability associated with ownership, these corporations can much more easily raise investment capital by selling a share in the ownership of the business (shares of stock).


Some corporations are closely or privately held – meaning their ownership is control by a limited number of individuals and is not available for sale to the general public.   If you get involved in a privately held corporation you need to remember that generally speaking whoever controls 51% of the stock controls the corporation.  While state laws do provide some protection for minority stock holders, being a minority stock holder is generally considered a very weak position and one should be very careful about becoming a minority stockholder in a private corporation.


However, the vast majority of the larger corporations in the U.S. are publicly held with their ownership/stock sold or traded on open markets.  These organizations have the strongest separation of ownership and management.  The owners of the corporation are represented by a board of directors that is elected by the stockholders.  The board has authority to hire, direct, compensate and terminate the CEO and set policy on strategic direction and dividends.


Due to the nature of the control and ownership of these organizations, their existence is not dependent on any one individual and they can exist as long as they remain profitable.


Recently there have been problems with the managers of some corporations using the assets of the corporation for their personal benefit as opposed to acting in the best interest of the stockholders.  This has resulted in several large organizations going bankrupt, with the investors losing their money and the managers going to jail.  In response to these scandals the federal government has enacted the Sarbanes-Oxley Law that restricts the actions of managers of public traded corporations and significantly increases the record keeping and reporting requirements of these organizations.


Limited Liability Corporation – LLC


A relatively new form of business is the limited liability corporation.  These entities are treated as separate entities from the two or more individuals who formed them.  This provides liability protection for the owners of the LLC.  These forms of business are typically taxed as a partnership.  This is like a limited partnership – however the advantages of limited liability extent to all of the partners while the organizations is taxed at the often more desirable partnership level.



In addition to these forms of ownership is the possibility of franchising.  This is where one organization sells the right to use its name and trademark.  Franchise agreements also typically include lots of rules regarding the quality and price of goods and services that can be sold.  For example you could buy a franchise to operate a KFC Store – instead of starting your own restaurant from scratch.


Activity 1

What do you see as the advantages and disadvantages of being a franchisee?



In addition to the for-profit organization types we have discussed there are two more broad organizational options.


Governmental Entities – these are school districts, local, state and national government and most of the various entities created by these organizations (like our university).  These organizations are not for sale, are not focused on generating a profit and instead are focused on meeting the needs of the citizens as expressed through the electoral process.


Not-For-Profit   - Organizations that are established to pursue some societal good – that should be stated in their mission statement.  These entities can (and should) generate revenue in excess of their expenses to generate a “margin.”  However, unlike for-profit organizations, the profit is not ultimately returned to the owners; it is instead used to further the mission of the organizations.  These organizations are exempt from paying income tax and in some cases do not pay property tax.


Some not-for-profit organizations are also charities – often referred to as “501-c-3s” as a result of the tax code designation that created them.  To be a 501C3 requires meeting a test for serving the public good and results in contribution to the organization being deductible to the individual making the contribution.


Activity 2

Identify the advantages and disadvantages of using each of the six possible types of businesses.  Since the franchise model can be used with many of the previous models there will be some overlap in your analysis


Business Plan Activity:

Which organizational approach is best for your planned business?  Justify your decision in terms of the support you need (both financial and managerial) and the liability you are willing to assume.  You should also recognize that while you may want an organization that has limited or no liability, lenders may feel very different. How, for instance, would you attract lenders to your business when none of your personal property is at risk should you default on the loan?


Summary of Beyond the Book – expectations for the final


You should understand:


  • The relative advantages and disadvantages of each form of business ownership.