Businesses are operated as sole proprietorships, partnerships, or corporations. Table 1 indicates that over 70% of all U.S. firms are proprietorships, but they account for only 6% of total sales in the United States. At the other extreme, about one firm in five is incorporated, but corporations generate 90% of all revenues. Over the last two decades, both partnerships and corporations have fallen as a percent of the total number of business firms, and partnership profits as a percent of total profits have dropped by two-thirds while corporate profits as a percent have risen. Sole proprietorship sales as a percent of total have fallen by 40% but sole proprietor profits have remained constant as a percent of the total.

 

The message seems to be that a first step toward success is to incorporate. Then why do nearly 14 million or so sole proprietorships exist? The answer comes from an examination of the strengths and weaknesses of each type of organization.

Sole Proprietorships

Establishing a sole proprietorship often requires little more than declaring, “I am in business.”

A sole proprietorship is a firm owned and operated by one individual.

Major advantages are a proprietorship’s relative (a) ease of organization, (b) flexibility, (c) control by the owner, and (d) freedom from government regulation.

 

Sole proprietors, however, suffer from some major drawbacks. Size is limited by the proprietor’s initial wealth and credit standing and by business profits over time. Capital accumulation tends to be a slow process. Proprietors normally perform most management functions, and such firms lack permanence:—they cannot outlive their owners.

 

The greatest disadvantage, however, is a proprietor’s unlimited liability, that is, legal obligations to pay for debts or damages. Nearly all a proprietor owns, including personal assets (e.g., savings and cars), may be sold to pay a firm’s debts if it fails or is held liable for damages in a lawsuit. More is at risk than an owner’s investment, although insurance can guard against the financial risks of some legal hazards.

Partnerships

Pooled resources in a partnership can expand the resource base that limits sole proprietorships.

Partnerships are businesses formed by two or more people combining their resources.

Partnerships are easy to establish, relatively simple to control, allow some specialized management, and are subject to relatively few regulations. Many doctors, for example, operate in partnerships. This permits them to share office expenses and reduces the need for every doctor to be on-call to patients 24 hours a day and 7 days a week.

 

A major problem arises because partnership debts are joint and each partner incurs unlimited personal liability for a firm’s debts. A dishonest or incompetent partner can cost you all you own since you are responsible not only for your own actions, but the actions of your partner as well. Shared ownership can also create discord about policies, decreasing personal control—a vital issue for many entrepreneurs. Other drawbacks are that resources for growth tend to remain quite limited, and partnerships automatically dissolve upon the withdrawal or death of any partner.

Corporations

The loss of entrepreneurial control that occurs when a sole proprietor takes on partners escalates tremendously when even more people (e.g., stockholders, professional managers, and government) come into the picture because an entrepreneur decides to incorporate. Incorpo-rating a firm requires submitting a charter to a state government outlining the intended line of business and specifying how the firm will be financed and governed.

Corporations are firms sanctioned by state laws and considered legal entities separate and distinct from their owners.

Once corporations are formed, numerous special taxes and regulations hinder their operations.

 

Then why are firms ever incorporated? A major reason is that corporations excel at raising financial capital because they can sell common stocks (ownership shares) and bonds (corporate IOUs). Combined with undistributed profits, these funds facilitate acquisition of economic capital. Another major corporate advantage is the limited liability of stockholders, which means that owners of a corporation cannot lose more than they paid for stock. Other assets of individual stockholders are not jeopardized if the firm fails. Without limited liability, few individuals could (or would) invest in stock of modern corporations.

 

Other advantages include potential stability and permanence; corporations do not shut down when a stockholder dies. A final advantage is that corporations can hire highly specialized management. However, large corpora- tions are often controlled by their top managers because stock is so widely spread that individual stockholders have little influence on business policies. This yields potential gains for corporate managers but poses major disadvantages for stockholders.

 

The divorce of ownership from managerial control opens up opportunities for fraud, so strict accounting and reporting requirements govern corporate life and add to business costs. Because corporations are viewed as fruitful sources of tax revenue, some of corporate income is subject to double taxation: corporations pay taxes on their incomes, and then, if some after-tax income is distributed to stockholders, these dividends are taxed again at the individual’s personal income tax rate.

 

Other Forms of Enterprise

Proprietorships, partnerships, and corporations dominate production, but other types of organizations exist. Producer cooperatives share profits from marketing such things as handicrafts or farm outputs. Consumer cooperatives share savings achieved by buying in quantity. Cooperatives are flourishing in China and Eastern Europe, primarily because many Chinese and Eastern Europeans, while recognizing the shortcomings of state enterprises, don’t yet feel ready to launch purely private business firms. Cooperatives may be an intermediate step on the road toward capitalism.

 

Nonprofit corporations operate most hospitals, private schools, public radio and TV stations, and charities (standard corporations are run for profit—a purpose inconsistent with the goals of most people who operate charities). Closely held corporations and limited partnerships are intended to secure tax advantages and limited liability for family-owned businesses or partnerships. Many doctors, dentists, and lawyers who would normally be considered as sole proprietors operate as professional corporations. These professional corporations are treated as corporations for tax purposes but do not allow for unlimited liability. Society has determined that the services of these individuals would be the subject of serious incentive problems if their liability to their clients (patients) were limited.

 

Still other minor organizational forms abound, varying in their specifics by the state laws governing them. Determining how a firm will be legally organized is only one step for an entrepreneur. Securing business funding is another hurdle in establishing a firm.