Other Types of Business Ownership
In addition to the three commonly adopted forms of business organization—sole proprietorship, partnership, and regular corporations—some business owners select other forms of organization to meet their particular needs. We’ll look at several of these options:- S-corporations
- Limited-liability companies
- Cooperatives
- Not-for-profit corporations
Hybrids: S-Corporations and Limited-Liability Companies
To understand the value of S-corporations and limited-liability
companies, we’ll begin by reviewing the major advantages and disadvantages of
the three types of business ownership we’ve explored so far: sole
proprietorship, partnership, and corporation. Identifying the attractive and
unattractive features of these three types of business ownership will help us
appreciate why S-corporations and limited-liability companies were created.
Attractive and Unattractive Features of Corporations
What feature of corporations do business owners find most
attractive? The most attractive feature of a corporation is limited
liability, which means that the shareholders (owners) cannot be held personally
liable for the debts and obligations of the corporation. For example, if a
corporation cannot pay its debts and goes bankrupt, the shareholders will not
be required to pay the creditors with their own money. Shareholders cannot lose
any more than the amount they have invested in the company.
What feature of corporations do business owners find least
attractive? Most would agree that the least attractive feature of a
corporation is “double taxation.” Double taxation occurs when the same earnings
are taxed twice by the government. Let’s use a simple example to show how this
happens. You’re the only shareholder in a very small corporation. This past
year it earned $10,000. It had to pay the government $3,000 corporate tax on
the $10,000 earned. The remaining $7,000 was paid to you by the corporation in
the form of a dividend. When you filed your personal income tax form, you had
to pay personal taxes on the $7,000 dividend. So the $7,000 was taxed twice:
the corporation paid the taxes the first time and you (the shareholder) paid
the taxes the second time.
Attractive and Unattractive Features of Sole Proprietorships and Partnerships
Now let’s turn to the other two types of business ownership: sole
proprietorship and partnership. What feature of these forms of business
organization do owners find most attractive? The most
attractive feature is that there is no “double taxation” with
proprietorships and partnerships. Proprietorships and partnerships do not pay
taxes on profits at the business level. The only taxes paid are at the personal
level—this occurs when proprietors and partners pay taxes on their share of
their company’s income. Here are two examples (one for a sole proprietorship
and one for a partnership). First, let’s say you’re a sole proprietor and your
business earns $20,000 this year. The sole proprietorship pays no taxes at the
“business” level. You pay taxes on the $20,000 earnings on your personal tax
return. Second, let’s say you’re a partner in a three-partner firm (in which
each partner receives one third of the partnership income). The firm earns
$90,000 this year. It pays no taxes at the partnership level. Each partner,
including you, pays taxes on one-third of the earnings, or $30,000 each. Notice
that in both cases, there is no “double taxation.” Taxes were paid on the
company earnings only once—at the personal level. So the total tax burden is
less with sole proprietorships and partnerships than it is with corporations.
What feature of sole proprietorships and partnerships do business
owners find least attractive? And the answer is…unlimited
liability. This feature holds a business owner personally liable for all debts
of his or her company. If you’re a sole proprietorship and the debts of your
business exceed its assets, creditors can seize your personal assets to cover
the proprietorship’s outstanding business debt. For example, if your business
is sued for $500,000 and it does not have enough money to cover its legal
obligation, the injured party can seize your personal assets (cash, property,
etc.) to cover the outstanding debt. Unlimited liability is even riskier in the
case of a partnership. Each partner is personally liable not only for his or
her own actions but also for the actions of all the partners. If, through
mismanagement by one of your partners, the partnership is forced into
bankruptcy, the creditors can go after you for all outstanding debts of the partnership.
The Hybrids
How would you like a legal form of organization that provides the
attractive features of the three common forms of organization (corporation,
sole proprietorship and partnership) and avoids the unattractive features of
these three organization forms? It sounds very appealing. This is what was
accomplished with the creation of two hybrid forms of organization: S-corporation and limited-liability company.
These hybrid organization forms provide business owners with limited liability
(the attractive feature of corporations) and no “double taxation” (the
attractive feature of sole proprietorships and partnerships). They avoid double
taxation (the unattractive feature of corporations) and unlimited liability
(the unattractive feature of sole proprietorships and partnerships). We’ll now
look at these two hybrids in more detail.
S-Corporation
In 1970, Karen and Mike Tocci, avid go-kart racing fans, bought a
parcel of land in New Hampshire so their son, Rob, and his son’s friends could
drag race in a safe environment. The Tocci’s continued interest in racing
resulted in their starting a family-run business called Shannon Dragway. Over
time, the business expanded to include a speedway track and a go-kart track and
was renamed New Hampshire Motorsports Complex. In selecting their organization
form, the Tocci’s wanted to accomplish two main goals: (1) limit their personal
liability; and (2) avoid having their earnings taxed twice, first at the
corporate level and again at the personal level. An S-corporation form of
business achieved these goals. They found they were able to meet the following
S-corporation eligibility criteria:
- The company has no more than 100 shareholders
- All shareholders are individuals, estates, or certain non-profits or trusts
- All shareholders are U.S. citizens and permanent residents of the U.S.
- The business is not a bank or insurance company
- All shareholders concur with the decision to form an S-corporation
Deciding to operate as an S-corporation presented the Tocci’s
with some disadvantages: They had no flexibility in the way profits were
divided among the owners. In an S-corporation, profits must be allocated based
on percentage ownership. So if an owner/shareholder holds 25 percent of the
stock in the S-corporation, 25 percent of the company profits are allocated to
this shareholder regardless of the amount of effort he or she exerts in running
the business. Additionally, the owners had to follow a number of formal
procedures, such as electing a board of directors and holding annual meetings.
Finally, they were subjected to heavy recordkeeping requirements. Despite these
disadvantages, the Tocci’s concluded that on balance the S-corporation was the
best form of organization for their business.
Limited-Liability Company
In 1977, Wyoming was the first state to allow businesses to
operate as limited-liability companies. Twenty years later, in 1997, Hawaii was
the last state to give its approval to the new organization form. Since then,
the limited-liability company has increased in popularity. Its rapid growth was
fueled in part by changes in state statutes that permit a limited-liability
company to have just one member. The trend to LLCs can be witnessed by reading
company names on the side of trucks or on storefronts in your city. It is
common to see names such as Jim Evans Tree Care, LLC, and For-Cats-Only
Veterinary Clinic, LLC. But LLCs are not limited to small businesses. Companies
such as Crayola, Domino’s Pizza, Ritz-Carlton Hotel Company, and iSold It
(which helps people sell their unwanted belongings on eBay) are operating under
the limited-liability form of organization.
In many ways, a limited-liability company looks a lot like an
S-corporation. Its owners (called members rather than shareholders) are not
personally liable for debts of the company, and its earnings are taxed only
once, at the personal level (thereby eliminating double taxation). But there
are important differences between the two forms of organizations. For example,
an LLC:
- Has fewer ownership restrictions. It can have as many members as it wants—it is not restricted to a maximum of 100 shareholders.
- Its members don’t have to be U.S. residents or citizens.
- Profits do not have to be allocated to owners based on percentage ownership. Members can distribute profits in any way they want.
- Is easier to operate because it doesn’t have as many rules and restrictions as does an S-corporation. It doesn’t have to elect a board of directors, hold annual meetings, or contend with a heavy recordkeeping burden.
As the approach used to allocate profits is very important (item
3 above), let’s spend a few minutes going over an example of how the profit
allocation process works. Let’s say that you and a business partner started a
small pet grooming business at the beginning of the year. Your business partner
(who has more money than you do) contributed $40,000 to start-up the business
and you contributed $10,000 (so your partner’s percentage ownership in the
business is 80 percent and yours is 20 percent). But your business partner has
another job and so you did 90 percent of the work during the past year. Profit
for the first year was $100,000. If your company was set up as a S-corporation,
you would be required to allocate profits based on percentage ownership. Under
this allocation scheme $80,000 of the profits would be allocated to your
business partner and only $20,000 would be allocated to you. This hardly seems
fair. Under the limited-liability form of organization you and your partner can
decide what is a “fair” allocation of profits and split the profits
accordingly. Perhaps you will decide that you should get 70 percent of the
profits (or $70,000) and your business partner should get 30 percent (or
$30,000).
Now, let’s look at the fourth item—ease of operation. It is true that
S-coporations have to deal with more red tape and paperwork and abide by more
rules (such as holding annual meetings) than do limited-liability companies.
Plus they are more complex to set up. But this does not mean that setting up
and operating a limited-liability company is a breeze and should be taken
lightly. One essential task that should be carefully attended to is the
preparation of an operating agreement. This document, which is completed when
the company is formed (and can be revised later), is essential to the success
of the business. It describes the rights and responsibilities of the LLC
members and spells out how profits or losses will be allocated.
We have touted the benefits of limited liability protection for
an LLC (as well as for regular corporations and S-corporations). We now need to
point out some circumstances under which an LLC member (or shareholder in a
corporation) might be held personally liable for the debts of his or her
company. A business owner can be held personally liable if he or she:
- Personally guarantees a business debt or bank loan which the company fails to pay
- Fails to pay employment taxes to the government that were withheld from workers’ wages
- Engages in fraudulent or illegal behavior that harms the company or someone else
- Does not treat the company as a separate legal entity. For example, uses company assets for personal uses
As personal loan guarantees are the most common circumstance
under which an LLC member is held personally liability for the debts of his or
her company, let’s explore this topic some more by asking (and answering) two
questions:
- What is a loan guarantee? It is a legal agreement made between an individual and a bank that says, “If my company does not repay this loan, I will.” It is the same thing as co-signing a loan.
- Why would an LLC member give a bank a personal guarantee? Because it is often the only way a business can get a loan. Bankers understand the concept of limited liability. They know that if the company goes out of business (and the loan is not guaranteed), the bank is stuck with an unpaid loan because the LLC members are not personally liability for the debts of the company. Consequently, banks are reluctant to give loans to companies (particularly those just starting up) unless the loans are guaranteed by an owner.
A final note about hybrid forms of organization. In this section,
we have looked at two organization forms that offer business owners limited
liability and tax benefits. There are others not covered here such as Professional
Limited-Liability Companies (PLLCs), which are set up by doctors, lawyers,
accountants, etc. to provide professional services. And it is evident that the
variations of organization forms available to businesses will continue to
expand in the future.
Cooperatives
A cooperative
(also known as a co-op) is a business owned and controlled by those who use its
services. Individuals and firms who belong to the cooperative join together to
market products, purchase supplies, and provide services for its members. If
run correctly, cooperatives increase profits for its producer-members and lower
costs for its consumer-members. Cooperatives are common in the agricultural
community. For example, some 750 cranberry and grapefruit member growers market
their cranberry sauce, fruit juices, and dried cranberries through the Ocean
Spray Cooperative. More than three hundred thousand farmers obtain products
they need for production—feed, seed, fertilizer, farm supplies, fuel—through
the Southern States Cooperative. Co-ops also exist outside agriculture. For example, REI
(Recreational Equipment Incorporated), which sells quality outdoor gear, is the
largest consumer cooperative in the U.S. with more than three million active
members. The company shares its financial success each year with its members,
who get a refund each year based on their eligible purchases.
Not-for-Profit Corporations
A not-for-profit corporation
(sometimes called a nonprofit) is an organization formed to serve some public
purpose rather than for financial gain. As long as the organization’s activity
is for charitable, religious, educational, scientific, or literary purposes, it
should be exempt from paying income taxes. Additionally, individuals and other
organizations that contribute to the not-for-profit corporation can take a tax
deduction for those contributions. The types of groups that normally apply for
nonprofit status vary widely and include churches, synagogues, mosques, and
other places of worship; museums; schools; and conservation groups.
There are more than 1.6 million not-for-profit organizations in
the United States. Some are extremely well funded, such as the Bill and Melinda
Gates Foundation, which has an endowment of approximately $60 billion. Others are nationally recognized, such as
United Way, Goodwill Industries, Habitat for Humanity, and the Red Cross. Yet
the vast majority are neither rich nor famous, but nevertheless make
significant contributions to society.
Key Takeaways
- The S-corporation gives small business owners limited liability protection, but taxes company profits only once, when they are paid out as dividends. It can’t have more than one hundred stockholders.
- A limited-liability company (LLC) is similar to an S-corporation: its members are not personally liable for company debts and its earnings are taxed only once, when they’re paid out as dividends. But it has fewer rules and restrictions than does an S-corporation. For example, an LLC can have any number of members.
- A cooperative is a business owned and controlled by those who use its services. Individuals and firms who belong to the cooperative join together to market products, purchase supplies, and provide services for its members.
- A not-for-profit corporation is an organization formed to serve some public purpose rather than for financial gain. It enjoys favorable tax treatment.
