Business Structures

A business is initiated by a founder(s) who possesses significant know-how or expertise. The founder may, nevertheless, lack the skills to manage the business as it grows. Moreover, the founders may lack the capital to grow their business. They may, therefore, outsource capital from private channels. This is what occasions the institution of different business structures.

Business Structures

A business structure describes how a business is organized, influencing day-to-day operations. A business structure is determined by four factors:

1. Legal Identity: Describes the legal relationship between the owner(s) and the business.
2. Business Liability: Indicates the level of liability an individual assumes dues to a business’ actions or debts. The levels of liability can be described as limited or unlimited.
3. Owner-Operator Relationship: Describes the relationship between the owner(s) of a business and the management.
4. Taxation: Describes the tax regime applicable to a business structure.

Types of Business Structures

Considering the above factors, we now discuss the following business structures:

1.  Sole Proprietorship (or Sole Trader)

In a proprietorship, the owner raises the business capital and fully controls business operations. Moreover, the owner benefits fully from financial returns and assumes all the business risks.

A good example would be a plumber.

General Features of Sole Trader

• The owner operates it.
• The business is not a legal identity; hence it is considered as an extension of the owner.
• The owner keeps all the financial returns and bears all risks.
• Profits generated by the business are taxed as personal income.
• It is simple and flexible to operate.
• Financing is solely from the owner.
• Business growth depends on the financial ability and risk appetite of the owner. 

2.  General Partnership

In the general partnership business structure, there are at least two owners (partners) whose roles and responsibilities are stated in the partnership agreement. Unlike a sole proprietorship, there are multiple sources of funds, and the returns and risks are shared.

Good examples are professional service businesses such as law and accounting firms.

General Features of General Partnership

• The business is operated by partners.
• It has no legal identity since ownership is set in the partnership agreement.
• All business risks and business liabilities are shared by the partners.
• Business returns are shared by the partners, and profits are taxed like personal income.
• Capital and expertise are provided to the partners.
• Business growth depends on the ability of the partners to finance and the level of their risk appetite.

3. Limited Partnership

In a limited partnership, partners are divided into two:

1. At least one general partner (GP) has unlimited liability and is responsible for managing the business.
2. Limited partners (LPs) have, as the name suggests, limited liability. This means that their losses are capped at their investment amounts in the limited partnership.

The limited partners earn a share profit that is usually lower than that of the general partners. General partners earn more, given their managerial position in the business.

Examples of limited partnerships are private equity funds, real estate, and hedge funds.

General Features of Limited Partnerships

• Capital contributions and expertise are provided by the partners.
• The general partner manages the business and has unlimited liability.
• Limited partners do not have business control and have limited liability.
• All partners are entitled to a share in returns, where profits are taxed as personal income.
• Business growth depends on the financial capabilities of the GPs and LPs, risk appetite, and the competence and integrity of the GP(s). 

4. Corporation (or Limited Liability Company)

A corporation is an advanced type of limited partnership in which the business owners have limited liability. Further, it is noteworthy that a corporation has higher access to capital and expertise. This facilitates its quick growth. As such, a corporation is the preferred business structure for larger companies. Indeed, a corporation is a dominant business structure globally in terms of revenue and asset values.

A corporation goes by different names depending on the jurisdiction within which it operates. For instance, it is referred to as a limited company in the UK and a limited liability company (LLC) in the US. In US LLCs, distributions to the owners and corporate profits are taxed.

Examples of corporations are regional stock exchanges and national or multinational conglomerates.

Types of Corporations

Corporations are divided into nonprofit, public for-profit, and private for-profit.

Nonprofit

Nonprofit corporations are established for such purposes as the promotion of public health, religious benefits, or charitable missions. They are usually not driven by profits. Nonprofits are the same as for-profits since they, too, have a board of directors and can have paid employees.

In contrast to for-profit, nonprofits lack shareholders and do not pay dividends. Moreover, nonprofits do not pay taxes.

Nonprofits can generate profits when they are managed well. In this case, all profits are reinvested back into the mission of the corporation.

Examples of nonprofits include Harvard University and Asian Development bank.

Public and Private For-profits

The majority of corporations are formed to make profits for the owners. By engaging in any legal business, for-profit corporations are profit-motivated from inception. For-profit corporations can be private or public, depending on the number of shareholders (in some countries), and whether the corporation is listed on a stock exchange, among other factors.

The shares of a public for-profit are usually listed on a stock exchange. In contrast, private for-profit companies do not trade on a stock exchange. Instead, they run on buyer-seller agreements and transactions.

More on Corporations

Legal Identity of a Corporation

When a corporation is formed, articles of incorporation to a regulatory authority are filled. As such, a corporation is considered a legal entity that is unique and separate from its owners. Being a legal entity implies that a corporation has the rights and responsibilities of an individual. As such, it can participate in activities such as signing contracts, hiring employees, suing, being sued, borrowing and lending money, paying taxes, and initiating investments.

Established corporations are subject to regulatory jurisdictions in which they conduct business, list their securities, and are incorporated.

Notable activities that regulatory bodies mostly concentrate on include:

• Registration of public companies.
• Financial and non-financial reporting and disclosure.
• Corporation’s capital market activities. 

Owner-operator Separation of a Corporation

A notable feature of a corporation is owner-operator separation; the business owners and managers are independent of one another. In other words, the business owners are excluded from the company’s day-to-day operations.

The owners elect a board of directors to run the business. The board, then, hires the CEO and other senior managers to oversee the day-to-day operations of the corporation. The board of directors is under obligation to conduct business that aligns with the owner’s interest; otherwise, the owners may enact change through voting rights linked to their share.

In addition to adhering to the owner’s interests, the board is expected to consider the interests of other stakeholders such as employees, creditors, customers, suppliers, regulators, and members of the society in which the corporations operate.

Owner-operator separation of a corporation allows corporations to easily access capital financing. This is because capital is the only requirement for one to become one of the owners. As such, the owners can leverage greater resources to run the business.

Business Liability of a Corporation

The risks in a corporation are shared among all owners. However, owners have limited liability. This implies that the maximum loss owners can incur is the amount of their investment in the business. Moreover, returns are shared by the owners through equity claims proportional to their respective shares.

There is no contractual obligation for the repayment of the ownership claim. Nevertheless, the owners have a residual claim on the corporation’s cash flows and assets after liabilities have been settled.

Capital Financing of a Corporation and Types of Capital Providers

Corporations access capital financing through capital providers. These are individuals and entities that are willing to finance a company in return for the company’s issued securities. The issued securities raise two types of capital:

• Ownership capital (equity): This is the money invested by a corporation’s owners in return for the company’s ownership (they become shareholders).
• Borrowed capital (debt): Money borrowed from lenders (bondholders). The bondholders exchange their capital for issued debt securities with no ownership entitlement.

Capital providers include corporations, family offices, governments, and individuals.

Taxation of a Corporation

Corporations are subject to the tax authority and tax codes outlining the issuer’s tax reporting, payment, and status. Tax regimes on corporations vary from country to country.

In the majority of countries, corporations are taxed directly on their profits. Moreover, shareholders may be taxed on their dividends (double taxation of corporate profits). However, in some countries, shareholders are not taxed if the corporations had initially paid taxes on the dividends distributed.

General Features of a Corporation

• A corporation is a separate legal entity.
• Dividends (distributions) paid to the owners are taxed as personal income.
• Corporations have unlimited opportunities to access capital, hence unlimited capital potential.
• Owner-operator separation allows for higher and diverse resourcing with significant risk control.
• In some countries, corporations are tax disadvantaged due to double taxation of corporate profits.
• Business liability is shared among multiple owners with limited liability.

Question

Which of the following statements is most likely correct regarding business structures?

1. Sole trader and general partnerships business structures both have a legal identity.
2. The taxation regimes for sole traders and corporations are different.
3. Corporate bondholders and shareholders have different claims on a corporation in exchange for the capital they provide.

Solution

The correct answer is C.

Corporate bondholders and shareholders are the capital providers of a corporation. Corporate bondholders provide debt capital while the shareholders provide equity capital. The bondholders provide debt capital in exchange for issued debt securities with no ownership entitlement. On the other hand, aside from returns, shareholders are entitled to the ownership of the company.

A is incorrect. Sole trader (sole proprietorship) and general partnerships do not have a legal identity. The business structures are considered as an extension of the owner (sole proprietorship) or partnership agreement (general partnerships).

B is incorrect. The tax structures in both sole trader and corporation are comparable because, in both business structures, profits are taxed as personal income.