Three Basic Legal Forms of Business Organizations
There are three basic legal forms of business organizations: the sole proprietorship, the partnership, and the corporation. Each form of legal organizations has unique characteristics that are important to consider when starting a business. The legal form chosen will make significant differences for things such as ownership, sources of financing, personal and financial risk, taxes, workload, buying or selling a business, and liability issues. A sole proprietorship is a business owned by a single individual. Sole proprietorships are the most common form of business organization.
An individual owns, manages the business and is responsible for all transactions and activities. There is no difference between the owner and the business legally. As a result, the owner not only retains the revenue and title to all of the business’s assets, he is also responsible for all losses and liabilities incurred. Although a sole proprietorship must comply with all required licenses and permits necessary for its type of business to operate legally, there is no legal requirement to start the business operation.
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Terminating a sole proprietorship can be done if the owner chooses to do so or upon the owner’s death. A partnership is very similar to a sole proprietorship, but with more than one owner. There are two types of partnerships: general partnerships and limited partnerships. In a general partnership, each partner is fully responsible and liable for the business and the acts of the partners. A partnership agreement dictates the relationship between the partners and can be either oral or written.
In a limited partnership, one or more of the partners has limited liability, restricted to the amount of capital they have invested in the partnership. Essentially, a limited partnership can allow a partner to have limited liability and purely be an investor if several conditions are met. These include the requirement that at least one partner must have unlimited liability, the limited partners may not be included in the name of the firm, and the limited partners can’t participate in managing the business. The third form of legal organization is the corporation.
A corporation is a legal entity, separate from its owners, with many of the rights of an individual including own or sell property, sue and be sued, and enter into contracts. Regardless of the legal separation, the owners of the corporation dictate the policies and direction of the company. The amount of ownership is reflected in the number of shares owned by its holder. The owners of the company elect a board of directors to represent stockholder interests, hire the corporate officers, and oversee the direction and guide major business decisions. The corporate officers manage and operate the day-to-day management of the company.
Shares in a corporation are easily transferable to a new shareholder and the shareholders liability is limited to their investment amount in the company. Lastly, if a shareholder dies or withdraws from the company, unlike a sole proprietorship, there is no impact to the continuity of the corporation. In summary, the three basic legal forms of business organization are sole proprietorships, partnerships (general or limited), and corporations. Each of these legal forms has characteristics that must be evaluated very carefully in order to determine the best type of business organization for a company.
1Keown, Arthur J., John D. Martin, J. William Petty, David F. Scott, Jr. Foundations of Finance. New Jersey: Pearson, 2008.