Types of Business Organizations 120

Corporate Finance PowerPoint presentation. In this presentation, we will discuss types of business organizations, including the corporation, partnership, and sole proprietorship Get ready, it’s time to take your chance with corporate finance types of business organizations. Now, as we go through here, note that we’re focusing in on corporate finance, and therefore on the corporate type of business organization, but many of the concepts that we will learn will be applicable to all types of business organizations. Therefore, we want to have a general idea of the different main kind of components or main types of business organizations. So those will include a sole proprietorship, partnership, and a corporation.


So we’ll go through the general differences between these items. Also note that there’s going to be some types of organizations that are put together oftentimes primarily for tax purposes, such as an S corporation called flow through corporations LLCs, we’re not going to get into a lot of detail on those, we want to look at the major differences in terms of this course, between the different major components or major types of corporations, those being a sole proprietorship, partnership, and the corporate form the form that we will be focusing in on of course, the corporate form.



So a sole proprietorship is going to be a smaller type of organization, it’s going to be owned by one person, right, we have one person ownership, typically for a sole proprietor, note that the sole proprietor is very common, there’s more sole proprietors than any other type of business. But of course, when you look at the complete revenue, the revenue that’s going to be generated as a total of say that us, then the corporate form in terms of revenue, would be the largest in terms of number of organizations, sole proprietorships, would be larger. So then we have the advantages of a sole proprietorship, if you’re going into business yourself, and you’re thinking, what type of business entity should I start with? Many people will start with and it’s a good idea, oftentimes to start with a sole proprietorship, why, because this decision making process is going to be fast. And the cost to set up and operate is low. So in other words, with the decision making process, oftentimes people have a decision making process of, you know, do we want do I want to set up as a sole proprietor or do I want to try to get a partnership type of organization to be going together?



In other words, if I’m going to work with other people, do I want to to try to be a sole proprietor and basically work with them as contractors or employees, or possibly as a partner, or something like that to build the company. Notice, if you only have one decision making process and one decision maker, if you’re the one with the vision and the company, and you’re and you’re putting that vision together, it can actually be easier than then if you have multiple different people, that that you’re going to have to clear the decision with, right. So it’s often said, in other words, that two heads are better than one a committee is better than an individual, but also it can be difficult to move forward when you have different people with different visions as to how to move forward. So when a small organization is better, and you have someone that has a really solid clear vision of where they’re going, it can actually be really useful for them, they can they can manage a small business and be able to, to move forward faster that way, whereas a corporation, a large corporation has a large committee is going to have a lot of different people with a lot of different inputs, a lot of compromise.



And a lot it’s going to could be confusing if they don’t have the standard mission as to where they’re going. And if they’re not all going kind of in the same direction. So it’s also going to be cheap to to make to put up a sole proprietorship, basically, from a federal standpoint, all you have to do is start doing business, right, and the government sees you as a sole proprietorship, if you’re generating revenue, then the IRS is going to want their their portion of it. Now, obviously, you want to make sure that you’re in compliance with regards to local licensing and things like that for whatever business that you happen to be in. But from a federal standpoint, to set up a sole proprietorship really easy, you basically start making money, and then you have to, then you owe some of that money to the government, including the IRS if you’re in the US, and that would be for the federal taxes.



Now, it’s also really easy to pay the taxes because typically as compared to other types of businesses, because you’re going to fill out just another form on your, your 1040 form called a Schedule C, which will basically be an income statement, and you don’t even have a balance sheet or anything like that to do so it’s going to be a much more simple process to fill out the tax return, at least in terms of the number of forms that will be included. Typically a lot cheaper if you hire a tax, you know someone to to do that. Also, there’s no setup costs with regards to really setting up the organization except the setup process you might need for local, you know, local business license or something like that. But to set up as opposed to setting up like a corporation. Which you have to go through a process to set up and typically pay for that process to set up, it’ll be faster and easier to set up and less costly to do that, the disadvantages are going to include the unlimited liability to the owner. So notice there’s no real distinction, the business is not separate from the owner, we’re going to keep the bookkeeping separate all the time from the owner.



So we think about the business as separate when we’re trying to make decision making processes. But from a legal standpoint, the business is not a separate entity, if it’s a sole proprietor, and therefore, if someone Sue’s the business, you don’t have that kind of dividing line between the business and the owners, and therefore they could go after, say, for example, the owners assets might be something that they could go after, even if they’re suing basically the business. Whereas if you have a corporation that might be a little bit different, you might not be able to have the exposure of your personal assets. So there’s pros. And so that’s going to be one of the major cons, you may be able to counter that with something like insurance, so liability insurance and whatnot, it’s going to be one way to deal with that, or possibly setting up some other form, which would be more complex and typically more costly, in order to deal with that liability protection issue, which might be something like an S corporation, or a limited liability company. And then there’s less financing options to generate capital investment.



So if you’re a sole proprietorship, and you’re you’re getting into a business that doesn’t need a lot of money upfront, a lot of capital upfront, in order to get into the business than a sole proprietors not is a good thing is a good way to go. Because you can get in there with with a little capital. But if you’re putting if you’re getting into something which requires money up front, then it’s going to be a little bit more difficult to get the money as a sole proprietorship, because you have no past history on which to get a loan from the bank. And it’s going to be harder to generate the revenue possibly, whereas if you’re a corporation or something, maybe you can, you can have equity or issue stocks or something like that, which might make it easier to get the capital to in order to start the business to put the capital investment down to move forward. A partnership is the next most common type of organization is going to be very similar to the sole proprietorship, but now you have two or more partners involved.



So you can have some of the same kind of characterization, we have the advantages still, including the decision making process is still relatively fast. Cost of setup and operate is still low. In other words, you can think of the partnership as basically being a sole proprietorship with two or more people. So if you’re two or more people, in essence, and you just start doing business together, you have two or three people and you just start doing business, you start generating revenue. Once again, from a from a federal government standpoint, you’re seeing as a partnership, and any revenue that you generate, you’re responsible for basically, you know, reporting that revenue with regards to taxes and paying the IRS for it. So the setup process again, is going to be fairly straightforward. Now, however, with a partnership, it’s going to be a little bit more difficult for the decision making process as well.



Because now if you have two or more people, then the you know, you got you got the decision making process, you have more of a committee now that you’re gonna have to make the decisions with so as long as they’re all lined up in the same direction, then then that’s gonna that’s going to be good if you’re a sole proprietor, however, and you’re thinking about, do I want to set up my business as a partnership? Or? Or do I want to set up my business as a sole proprietor with contractors and employees and you got to consider if you take on a partner, then of course, you’re going to have to make sure that your goals are in alignment. So that so that you’re moving forward in the same direction, as you move forward, as you get more people involved than again, that that goal, that mission of everybody being kind of on the same page gets more difficult to do when you get to the corporation, that’s going to be something that’s that’s always of concern to the corporation, where is everybody in alignment with the mission with the objectives with the goals of the corporation?



Now, it’s also going to be more complex with basically profit sharing agreements, how are you going to shoot? So you want to make sure when you’re a partnership, you got to think about Okay, well, the revenue generation What if one partner puts more time in it than another partner? How are we going to deal with the splitting up of the revenue generation it might be an even split, but it may well not be in a partnership can be very flexible in the form of the of the split. But again, just like any type of partnership, if there’s not good communication with setting up that those type of agreements, if people aren’t on the same page, if people have different expectations and are moving forward and are not understanding why other people aren’t acting the way, the way they thought they would act in terms of the revenue splitting, then that’s going to cause a problem.



So these things are typically going to need to be laid out with articles of the partnership. And again, they’re not really required from for just setting up a partnership. You can just make a partnership start making money. But if you want the partnership to Last, then you’re typically going to need to to line those out and make them as as clear, transparent as possible. So everybody’s on the same page. So it is a bit more complicated. But in terms of legal setup, it’s going to be very, very similar for setting up the legal process. You when you do the file the tax return, you typically do need to file another return because now you have a partnership, but it’s going to flow through all the revenue is going to flow through to the sole proprietorship. So again, it should it The idea is it’s going to be kind of as easy as a sole proprietorship, but a partnership.



But in practice, it’s actually somewhat more complex to deal with a partnership just because of the the profit sharing split in the fact that you’re gonna have to file the separate tax return and deal with the flow through means you’re, you’re more likely to need more help with a partnership to go through just the maintenance of it, including tax preparation at the end of the year, then possibly you would with a sole proprietorship, where everything can be basically be reported on one, Schedule C. Now, the disadvantages still include that unlimited liability to the owners. So the owners of the partnership are now limited. And that becomes a larger problem as well. Again, if you’re thinking about being a sole proprietorship, or a partnership, if you’re thinking about do I want to be a sole proprietor, and I want to then hire some people, as contractors or employees, or do I want to bring them in as partners, if you bring them in as partners, now they are agents of the partnership.



So the decisions that they then make your liability liable for, right they can make, they can make decisions about loans and this kind of thing, as an agent of the Partnership for which you have you have liability too. So there’s actually, you could think of some more written, you know, there might be more risk involved in that you want to make sure that you’re dealing with, again, partners that are all on the same page for the partnership, so that that the unlimited liability again, that’s something that’s on the sole proprietorship and partnership. So for example, if the partnership got sued, or something like that, then it’s not just limited to the assets in the company, as it might be or should be, or is more likely to be for like a corporation, or something with a with a corporate shield. But But you don’t have that same kind of, you know, defense or block against against liability.



Now, you could deal with that, just like with the sole proprietorship by buying liability insurance and making sure that you have enough insurance that you think will cover any kind of problem for it. Or you can think about moving from a partnership to something that will have more of a corporate kind of distinction, corporate shield, hopefully. And that would be something like a limited liability company, or an S corp or two options before moving up to the standard, you know, C Corp, so small partnerships, sole proprietorships, if they want to increase their liability protection, might think about an S corp, or an LLC, rather than going to a full Corporation because of the added, you know, downsides which we’ll talk about of a corporation that are often, you know, not necessary for a small company. But remember, that’s going to add, that’s going to add complication, in terms of maintenance in the company, if it’s if you move up to an S corp, or an LLC, and processing things like the tax returns and whatnot, there’s also less financing options to generate capital investment.



So if you’re like a sole proprietorship, and you’re trying to generate capital in order to implement your business, then one of your options might be that that you take on partners, but again, when you take on partners, you’re giving up some of the some of the equity in the business some decision making within within the business, in order to generate the capital, as opposed to if you got a loan or something like that, if you get a loan, you got to pay the interest, but then you’re not then you’re able to kind of move forward with whatever decisions you’re making, as the owner of the company. Also note, you could have like a limited partner. So you could set up a partnership where one one partners is a limited partner. So they’re not, they’re not a partner that’s actively involved in the partnership, but they’re involved simply for an investment in the partnership. So that’s a limited liability partner that you would have, and they are someone that typically will then have more liability protection, because they’re not actively involved in the day to day operations with the business and therefore if the business was sued, then they would have their investment at risk if the partner if the business goes down, but less liability with regards to them personally.



So a partnership can be set up where you have general partners and like a limited partner, the limited partner having more protection. Then we have corporations and when we think about corporations, we’re typically think about like normal corporations, which are c corporations as opposed to S corporations, which I mentioned before S corporation. are like a flow through type of entity. So most large companies are going to be what would be called C corporations. And that would be like the normal thing that most people would be thinking. When you say corporations, the major innovation with a corporation is it’s going to be a separate legal entity. In other words, it’s an entity in and of itself. In essence, you’re giving the corporation this thing that was created with like paper and pencil, you know, this article, you’re giving them kind of rights, similar to what humans would have, including owning property and having some longevity. In other words, the corporation living beyond any particular owner, or having the ability or capability to do so unlike a partnership, or a sole proprietor, so it’s created through the articles of incorporation, articles, lists, rights and limitations of the entity, the owners or the shareholders.



So when you think about the standard Corporation, when you set up the corporation, you’re going to basically break the ownership into standardized chunks, those being shares, and then you can issue out the shares. This is really useful, because that’s, and it’s really a lot different than something like a partnership. So a partnership, there’s advantages and disadvantages to both of them note, a partnership, like you have a lot of flexibility, if you have three partners or something like that, and one partner works a lot more in the business and the other partner doesn’t work in the business that much but has more capital investment or something like that, you can break up the profit sharing in different kinds of ways, one person getting 60% or and whatnot, 6040 or something like that. And you can have you can break up have different options in terms of how you’re going to run the profit share, and especially in terms of how you’re going to be distributing the revenue for a partnership and a corporation, you don’t have that kind of flexibility. But what you do have is a standardization of the units of ownership within the corporation.



So if you break down the corporation into standard unit standard shares, and all those shares are the same, they can act kind of like dollars do in the economy. And you can basically they’re easily tradable in that way. So when you’re talking about a corporation, starting, you’re going to you’re going to have the investors that are going to be purchasing shares, the corporation issues those shares, to the investors, the shares represent an equal unit of ownership. So one individual then can own multiple shares. And that would give them a larger ownership. But each of those shares, just like each dollar would be the same unit. And therefore you have that kind of breakout, that’s going to be one of the major differences. That’s kind of like the equity section that we’re thinking about, between a corporation, and a and a sole proprietorship or partnership, that ability to be able to issue the corporate shares. And that kind of standard type of way. And for them to be tradable, is one of the things that are allow the corporation to generate capital through the issuance of the corporate stock, which is less easy to do, it’s less easy to generate capital in that way. Through equity investments for a partnership or a, a sole proprietorship, shareholders have limited liability, and that’s gonna be one of the major components.



So even if you think about investments from a normal kind of someone just investing in the stock market investing like a 401k, or something like that, then they’re going to have basically shares that they’re going to be putting money into, they have ownership of the corporation, although if you if you’re thinking about an individual that’s buying shares to a large company like apple or something like that, the amount of shares they have are small, therefore, their voting power, in terms of of the of the company is small, because they have a limited amount of shares compared to the total shares out there. However, the corporation is going to be kind of shielded, they’re shielded against personal liability, if something happened to the corporation.



So if you own stock in Apple, for example, and Apple then gets sued, and Apple somehow I don’t know how this would possibly be possible, but someone sued them for more than the company actually has. Then the people that sued them can’t say, hey, Apple couldn’t pay all the money, you own Apple, I want your house, right? They can’t really do that. Because because of the the thing that leads them to not be able to do that is generally this idea of the corporation being a separate legal entity. You’re basically saying, Hey, I’m just the owner, you’ve got to sue Apple, like they’re a person, you got to take it from them not, you can’t come out to my house, you got it, you got to sue Apple, right? And so the owners have that difference. Now, that’s going to be huge in terms of capital generation, of course, again, because now if they come if the corporation doesn’t have if you can invest in the corporation and have some kind of liability protection, then then you’re more likely the corporations more likely once again to be able to generate that capital through through capital investment.



Because the me if I’m putting money into Apple, I don’t I don’t have an exposure, I don’t feel exposed to Apple having a problem and then someone coming after my house that I have something about, about which I know nothing about, right? So so that safety allows more capital to be able to flow into corporations. Because of that structure, the life of the corporation is limited to the life of any is not limited to the life of any owner. So unlike a sole proprietorship or partnership with basically, structurally kind of reformats when an owner dies, the corporation will will live on can live past any owner. So the corporation is its own separate legal entity. So it’s been given rights like it like it’s a living thing, it issues the stock.



So if a stock owner dies, if the owner of the stocks die, then the stocks don’t die, the stocks just move on to wherever else they go, they’re just units of ownership, just like dollars, they would just move on to wherever the stocks are gonna go. So it is easy to distribute ownership and generate capital through stock issuance. So once again, we talked about the fact that now that we have the stocks, and we have the limited liability of the people that are investing in the stocks, by buying the stocks, you’re more likely to be able to generate capital in order to fund the operations of the company through the issuance of the stock. Note that if you talk about something like that, we talked about a partnership where you had a limited partner, it’s a similar kind of idea there with a partnership, if you’re saying hey, you’re a limited partner, you don’t have any, any, you’re not, you’re not making day to day decisions in the partnership, you’re just giving us money. And you’ll be and we’ll give you some return on that money. But part of the revenue generation, the fact that they’re not actively involved in the management of the company, is what will constitute basically a limited partner to be claimed as a limited partner and have a similar kind of, of protection now.



So the partner, the limited partners could get capital investment, you’ll probably see TV shows and whatnot, where, you know, people are investing in small companies with regards to a limited partnership. But again, it’s kind of hard to value the limited partnership in some ways. Whereas if a corporation when you’re valuing corporate stock, it can be it can be because they’re all the same and units, you can kind of look at what the valuation is in terms of trading of stocks, at least for publicly traded stocks, you can see them trading, because they’re all the same in unit, then you can get a better idea of the value, sometimes just by the basically the market or the partnership can be a little bit more difficult. So then we had the possible double taxation. So the disadvantage of the corporation, we also we talked about the fact that if you’re a sole proprietorship or partnership, you may say, Hey, I don’t like this, this liability thing that I have here that I’m going to try to fix with, with insurance.



But maybe I want to set myself up as some other entity to kind of guard myself against the liability. Why don’t I set myself up as a corporation, a C corporation? Well, you could. But But typically, there’s disadvantages to a C corporation, which if you’re a smaller company, might not be worth the trouble. So there’s up that’s why these other flow through entities, quote, flow through entities are set up, which will typically be like us S corporation, or a limited liability company, which hopefully is the goal is to give some liability protection, while still having the flow through process. Now, what is the flow through process? Well, that’s to try to avoid this, this idea of double taxation. And that really stems from the idea that the corporation is a separate legal entity again. So if you’re saying hey, the corporation, we’re acting like this thing is piece of papers a person, it’s got a separate separate entity, a separate entity in and of itself. And if it gets to own property and live beyond the life of the owner, the will it should pay taxes, right?



So now you’re going to tax the corporation, the corporation actually pays tax, as opposed to the S corporation, or sole proprietorship, or S corporation, or limited liability company. Those two are flow through entities where you’ll do a separate tax return, but the actual revenue will flow through to the 1040 of the owners, whereas, so they’re not going to be taxed on the on the business level. Whereas the C corporation is so if you do a C corporation tax return, you’ll do the tax return and the corporation will owe so much money, and you’re going to have to pay that. What’s the problem with that? Isn’t it the same? Not really because also they tax, we could tax the dividends or the distributions. So if you ever invested in like apple or something, you’ll get dividends possibly, which are the earnings of the company that are now being distributed to you, which you’ll have to pay taxes on typically. So now the corporation got taxed when they earned the money, and they also got taxed when they distribute the money to the owners, which is what we call double taxation.



So if you’re a small company that’s you know, you don’t want it that’s a problem. Why’s that done in large companies? The general concept is that the company that when I invest in Apple, for example, I’m just associated with Apple. So it’s what they call a kind of like a passive investment. And therefore, that somehow justifies the idea that since I’m the owner, essence, I’m a passive owner, maybe, you know, that would somewhat be an argument as to why the company would be taxed, and then I would be taxed on the distribution. But in any case, that double taxation is a problem. And, and that’s one reason why smaller companies typically don’t don’t move directly to this to the C corporation, possibly it might go to one of these flow through entities, but large companies will typically have that have that issue with it with a double taxation, corporations will generally will generally cost more to create and maintain. So again, a C corporation is typically going to be the most you know complex entity to set up to set up and and maintain it. So it’s going to cost more for like accountants and tax and tax advisers and that kind of thing.



And so once again, if you’re a small company, then a sole proprietorship or partnership should be a sole proprietorship should be really the easiest type of format to to deal with in terms of tax preparation and yearly maintenance on it. A partnership is still fairly easy, but it adds it does have a good level of complexity, even though it’s easy to set up a partnership, because you just set one up, but you really shouldn’t have an art us articles of partnership, to set up the agreement of the partnership, and then the tax return gets more complex, because you can still need a separate tax return even though it’s a flow through tax return, and so on. And then if you move up to an S corporation, or an LLC, that gets more complex, but not as complex as a corporation, and the corporation will typically be more complex to maintain. So you’ve got those benefits with the corporation of the capital generation, and so on, and so forth. But you also have that those added costs related to the corporate form as well.



So as we move forward, then we’ll think about corporate finance, when we’re thinking about ratio analysis and whatnot, then those type of things many times will apply to any type of business entity. But when we get into particulars about financing options, such as financing through stock issuance, or through bond issuance, those are often things that are going to be more related to the corporate structure or larger companies in general than then to smaller companies and or structures of a sole proprietorship and partnership.


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