Question

What are the alternative forms of business organization? What are the advantages and disadvantages of each?.

Answer 1

The alternative forms of business organization & their respective advantages & disadvantages :-

Most production and distribution activities are carried out by millions of people in different parts of the country by constituting various kinds of organizations. These organizations are based on some form of ownership.
Business organization is the single-most important choice an entrepreneur will make regarding his company.
Aligning the business goals to the business organization type is the first & foremost important step. Which organizational form is most appropriate can be influenced by tax issues, legal issues, financial concerns, cost of formation, operational costs and personal concerns.  

The alternative forms of business organisation are :-

1) Sole Proprietorship :

Sole proprietorship or individual entrepreneurship is a business concern owned and operated by one person. The sole proprietor is a person who carries on business exclusively by and for himself. He alone contributes the capital and skills and is solely responsible for the results of the enterprise. In fact sole proprietor is the sole decision maker of all matters pertaining to his business subject only to the general laws of the land and to such special legislation as may affect his particular business.

The sole proprietorship is a common organization form especially used by small businesses. Most sole proprietorships are family-owned businesses.

Advantages :-

• It is easy and inexpensive to form and operate administratively (simplicity).
  Sole proprietorships are typically organized informally and require relatively little paperwork to begin operations. It is the most simple among the alternative business organizations to understand and use. To begin operation, the individual declares himself/herself to be a business. In many cases, a license will be required to operate the business, but often the business begins simply by “opening its door.” This type of businesses do pay some taxes but they are free of many other legal obligations regarding metrices such as business size, number of employees, and location determine which regulations business face.
• Since sole proprietorships are owned by a single individual, this form of business organization offers the maximum management control. In small firms, the owner of the business is often involved in all aspects of the business: purchasing, inventory control, production, sales, accounting, personnel and customer relations, as well as financial and general management.
• Business income is taxed as ordinary (personal) income to the owner.
  No corporate income taxes. Any income realized by a sole proprietorship is declared on the owner’s individual income tax return.
• All profits are subject to the owner.
• Very few requirements for starting—often only a business license.
• Personal Touch – The proprietor can maintain personal contacts with his employees and clients. Such contacts help in the growth of the enterprise.
• Ease of formation and dissolution - Establishing a sole proprietorship can be as simple as printing up business cards or hanging a signboard announcing the business. Taking work as a contract carpenter or freelance photographer, for example, can establish a sole proprietorship. Likewise, a sole proprietorship is equally easy to dissolve.

Disadvantages :-

• It is difficult to raise large amounts of capital - The business is restricted by the financial resources available to the owner. This can restrict the startup of the business as well as its growth over time. In many cases, substantial cash outlays are required to make the capital purchases (land, facilities, equipment, cars, offices) to start the business and to provide initial overhead expenses (salaries, wages, supplies) until the business gets going. Further, it frequently takes two or three years before the business begins to show a profit. The owner of the business has to obtain these funds using his/her own equity (funds owned by the individual) and/or by borrowing funds, and borrowing requires collateral in the form of owner equity The amount that can be borrowed depends on the level of equity as well as the projected cash flow generated by the business. The profits from the business are taxed as personal income to the owner.
• Sole proprietorships are subject to unlimited liability which means that the liability for business debts extends beyond the owner’s investment in the firm. For example, if the sole proprietorship is unable to cover its debts and obligations, creditors have the right to collect the personal assets that are not part of the business or other businesses of the owner. The owner may be forced to liquidate assets, such as a personal savings account, personal home, or other personal assets just to cover the firm’s obligations.
• Limited Skills - Since one man is responsible for the entire business and he/she can't be expert in all areas (production, marketing, finance, personnel etc.). Hence there is no scope of specialiization and the decsions might not be balanced.
• Uncertain Life – The life of proprietorship depends upon the life of the owner. The owner may sell assets from the business to another sole proprietorship or business. However, if the business is not terminated prior to the death of the owner, then after the proprietor’s death, the assets remaining in the firm will be distributed according to the owner’s will or comparable instrument.

Therefore, sole proprietorship is suitable in the following cases:

• Where small amount of capital is required e.g., sweet shops, bakery, newsstand, etc.
• Where quick decisions are very important, e.g., share brokers, bullion dealers, etc.
• Where limited risk is involved, e.g., automobile repair shop, confectionery, small retail store, etc.
• Where personal attention to individual tastes and fashions of customers is required, e.g., beauty parlour, tailoring shops, lawyers, painters, etc.
• Where the demand is local, seasonal or temporary, e.g., retail trade, laundry, fruit sellers, etc.
• Where fashions change quickly, e.g., artistic furniture, etc.
• Where the operation is simple and does not require skilled management.

Thus, sole proprietorship is a common form of organisation in retail trade, professional firms, household and personal services. It accounts for the largest number of business establishments in India, in spite of its limitations.

2) Partnerships :-

A general partnership is a business that is owned and operated by two or more individuals. The partners contribute to the business, share in management, and divide any profit. Partnerships are usually created by written contract among the partners, but they can be legally recognized even without a written agreement. If the partnership owns real property, the partnership agreement should be filed in the county where the property is located.

These come in two types: general and limited.
In general partnerships, both owners invest their money, property, labor, etc. to the business and are both 100% liable for business debts. General partnerships do not require a formal agreement—partnerships can be verbal or even implied between the two business owners.

Limited partnerships require a formal agreement between the partners. They must also file a certificate of partnership with the state. Limited partnerships allow partners to limit their own liability for business debts according to their portion of ownership or investment.

Advantages :-

• The advantages and disadvantages of a general partnership are similar to the sole proprietorship. Partnerships are generally easy and inexpensive to set up and operate administratively. Partnership operating agreements are critical. Like sole proprietorships, profit allocated to the partners is based upon their share in the business.
• Managerial control resides with the partners. Control by any one partner is naturally diluted as the number of partners increases. Partnerships are separate legal entities that can contract in their own name and hold title to assets.
• Business income is taxed as ordinary (personal) income to the owner.
• Shared resources provides more capital for the business.
• Similar flexibility and simple design of a proprietorship.
• Inexpensive to establish a business partnership, formal or informal.

• Specialisation and Balanced Approach: The partnership form enables the pooling of abilities and judgment of several persons. Combined abilities and judgment result in more efficient management of the business.

• Protection of Minority Interest: No basic changes in the rights and obligations of partners can be made without the unanimous consent of all the partners. In case a partner feels dissatisfied, he can easily retire from or he may apply for the dissolution of partnership.

• Capacity for Survival: The survival capacity of the partnership firm is higher than that of sole proprietorship. The partnership firm can continue after the death or insolvency of a partner if the remaining partners so desire.

• Business Secrecy: It is not compulsory for a partnership firm to publish and file its accounts and reports.

Disadvantages :-

• Unlimited liability - All partners are liable for the debts of the firm. Due to this unlimited liability, the risks of the business may be spread according to the owners’ equity rather than according to their interests in the business.
• Increasing the number of partners can increase the amount of capital that can be accessed by the firm. More partners tends to mean more financial resources and this can be an advantage of a partnership compared to a sole proprietorship. Still, it is generally difficult for partnerships to raise large amounts of capital—particularly when liability is not limited.
• Ownership transfer and limited life is a problem in partnerships; however, it may be possible to build provisions into the partnership that will allow it to continue operating if one partner leaves or dies.
• One difficulty occurs if the limited partners wish to remove their equity from the firm. In this instance, they must find someone who is willing to buy their share of the partnership. In some cases, this may be difficult to do. Another difficulty is that the Internal Revenue Service (IRS) may tax the limited partnership as a corporation if it believes the characteristics of the business organization are more consistent with the corporate form of business organization.

• Lack of Harmony: The success of partnership depends upon mutual understanding and cooperation among the partners. Continued disagreement and bickering among the partners may paralyse the business or may result in its untimely death.

• Non-Transferability of Interest: No partner can transfer his share in the firm to an outsider without the unanimous consent of all the partners. This makes investment in a partnership firm non-liquid and fixed.

Examples of partnerships :- small scale industries, wholesale and retail trade, and small service concerns like transport agencies, real estate brokers, professional firms like chartered accountants, doctor’s clinics or nursing homes, attorneys, etc.

3) Corporations :-

A corporation is a legal entity separate from the owners and managers of the firm. Three fundamental characteristics distinguish corporations from proprietorships and partnerships: (1) the way they are owned and managed, (2) their perpetual life, and (3) their legal status separate from their owners and managers.

A corporation can own property, sue and be sued, contract to buy and sell, and be fined—all in its own name. The owners usually cannot be made to pay any debts of the corporation. Their liability is limited to the amount of money they have paid or promised to pay into the corporation.

Ownership in the corporation is represented by shares on the equity and profit stream of the firm.

The two most common types of claims on the equity of the firm are common and preferred stock. The claims of preferred stockholders takes preference over equity claims of common stockholders in the event of the corporation’s bankruptcy. Preferred stockholders must also receive dividends before other equity claims.

Corporations are probably the dominant form of business organization in the United States.

Public corporations are owned by shareholders who elect a board of directors to oversee primary responsibilities. Along with standard, for-profit corporations, there are charitable, not-for-profit corporations.

Large corporations are usually organized as Subchapter C corporations.

The advantages of a C corporation include :-

1. There is limited liability.
   This limited liability feature means that as a shareholder, one’s personal assets beyond the investment in the corporation can’t be taken to satisfy the corporation’s debts or obligations.
2. Ownership can easily be transferred by selling shares in the corporation.
3. The corporation has an unlimited life because when an owner dies, the ownership shares are passed to his/her heirs. The common separation of ownership and management in large corporations helps to ease the ownership transfer as the firm management process never ceases.
4. It may be possible to raise large amounts of equity capital.
5. Investors in large corporations don’t have to become involved in management of the firm.

The disadvantages of a C corporation include :-

1. Corporations are more expensive and complicated to set up and administer than sole proprietorships or partnerships. Corporations require a charter, must be governed by a board of directors, pay legal fees, and meet certain accounting requirements. Apart from the relatively high setup cost, the primary disadvantage of the corporate form of business is that income generated by the corporation is subject to double taxation.
2.   If the corporation pays dividends to the shareholders, those payments are subject to corporate-level income tax. And, qualifying dividends (and most United States Corporation dividends come under this) are taxed at capital gains rates and not the individual’s top marginal tax rate.
3. Corporate operations are costly
4. Start a corporate business requires complex paperwork
5. Regulatory restrictions - Corporations are typically more closely monitored by governmental agencies, including federal, state, and local. Complying with regulations can be costly.
6. Since the managers do not own the firm but control the resources of the firm, may use them for their own benefit. For example, top management may build extravagantly large headquarters and buy fleets of jets and limousines for transportation. If less were spent on perquisites, then the income of the corporation would be higher. Higher income allows higher dividends to be paid to the owners (shareholder).
7. Higher organizational and operational costs - Corporations have to file articles of incorporation with the appropriate state authorities. These legal and clerical expenses, along with other recurring operational expenses, can contribute to large budgets.
8. The (potential) self-serving behavior by management running contrary to the interests of stockholders is an example of a principal-agent problem. One way to combat this problem is to hire auditors to monitor the use of firm resources.

Many small businesses, including farms, use the C corporation structure and operate much like partnership.

C corporations and S corporations -

there are two types of for-profit corporations for federal tax law purposes:

• C corporations: What we normally consider “regular” corporations that are subject to the corporate income tax
• S corporations: Corporations that have filed a special election with the IRS. They are not subject to corporate income tax. Instead, they are treated similarly (but not identically) to partnerships for tax purposes.

Subchapter S Corporations have limited liability protection, but the income for the business is only taxed once as ordinary income to the individual.

There are restrictions on what type of firms can be organized as Subchapter S corporations. It must meet several requirements: (1) cannot have more than 100 shareholders; (2) may have only one class of stock; (3) cannot have partnerships or other corporations as stockholders; and (4) may not receive more than 20 percent of its gross receipts from interest, dividends, rents, royalties, annuities, and gains from sales or exchange of securities. In agriculture, these restrictions usually mean that only family or closely-held farm businesses can achieve Subchapter S status.

Federal income tax rules for Subchapter S corporations are similar to regulations governing partnerships and sole proprietors. However, corporations may provide certain employee benefits that are tax deductible like accident and health insurance, group life insurance, and certain expenditures for recreation facilities etc.

There is greater continuity for businesses organized under Subchapter S than for sole proprietorships or partnerships. Upon the death of shareholders, their shares of the corporations are transferred to the heirs and the Subchapter S election is maintained.

4) Limited Liability Company :-

An LLC is a separate entity, like a corporation, that can legally conduct business and own assets. The LLC must have an operating agreement which regulates its business activities and the relationship among its owners (referred to as members). There are no restrictions on the number of members. LLCs are subject to disclosure, record keeping, and reporting requirements that are similar to a corporation.

Advantages :

• Limits liability to the company owners for debts or losses
• The profits of the LLC are shared by the owners without double-taxation
• The LLC is similar in most respects to the Subchapter S corporation. The primary differences are: 1) the LLC has less restrictive membership requirements; and 2) the LLC is dissolved in the event of transfer of interest or death unless members vote to continue the LLC.

Disadvantages:

• Ownership is limited by certain state laws
• Agreements must be comprehensive and complex
• Beginning an LLC has high costs due to legal and filing fees

5) Farm Business Organization Types in US Agriculture :-

The USDA defines a farm as a place that generates at least $1,000 value of agricultural products per year.

6) Cooperatives :-

A cooperative is a business that is owned and operated by member patrons with all profits going to member patrons. The profits are usually redistributed over time in the form of patronage refunds. Cooperatives often operate as profit making organizations much the same as other forms of business organization. Agricultural cooperatives generally have a different federal income tax status.