Businesses must be organized in order to effectively conduct their operations. This organization can run from simple to complex and depends greatly on the needs of the business owners to structure their liability and taxes. In this chapter, you’ll learn about the factors that go into organizing a business. Specifically, you should be able to answer the following questions:
- What are the available entity choices when conducting business?
- What are the factors that determine entity selection?
- What are the traditional entity choices, and how are they different from each other?
Many of you may be reading this chapter on a laptop or desktop designed and manufactured by Apple Inc. You may own a phone from Apple, or perhaps a portable music device. The company’s innovation, product development process, marketing capabilities in creating new and unthought-of markets, and ability to financially reward its owners are well known. While you might enjoy Apple products as a consumer, have you ever thought about Apple as a corporation? Its corporate headquarters in Cupertino, California (Figure 11.1 “Apple’s Headquarters in Cupertino, California”), is the physical embodiment of this entity we call a corporation, but what does that mean? It might surprise you to learn that this building, or rather the legal concept of the entity that occupies it, is more like you than you realize. For example, just like you, this entity can own property. This entity can enter into contracts to buy and sell goods. This entity can hire and fire employees. This entity can open bank accounts and engage in complex financial transactions. This entity can sue others, and can be sued in court. This entity even has constitutional rights, just like you. Unlike you, however, this entity does not breathe, does not bleed, and in fact may be immortal. And most unlike you, this entity has no independent judgment of its own, no moral compass or conscience to tell it the difference between right and wrong. In this chapter we’ll explore corporate entities such as Apple Inc. in detail. We’ll examine why human beings choose to organize into corporate entities in the first place, and why the law recognizes these entities for public policy purposes. We’ll start by looking at the factors that go into making a decision about entity choice, and then examine the available choices in detail.
Try to recall the basic function of a business. At its most fundamental level, a business exists to make a profit for its owners. In a capitalist market-driven economy, a business that fails to make a profit ultimately ceases to exist, overtaken by creditors and competitors. The need to make a profit is one truism that binds all businesses together, but beyond that, it’s hard to draw generalizations about business operations. The world of business is as varied as human experience itself, ranging from the neighborhood kids who shovel snow in the winter and sell lemonade in the summer, to the neighborhood pizza restaurant, to the small tool-and-die factory on the outskirts of town making machine tools, to the multinational corporation with hundreds of thousands of employees scattered throughout the globe. Some businesses make things in factories (manufacturers), other businesses sell things that other businesses make (retailers or franchisees), and still other businesses exist to help both the makers and sellers make and sell better (business consultants). Some businesses don’t make things at all, and instead profit by selling their services (think of an accounting or law firm, a house painting company, or a hotel) or by lending money at a higher rate of interest than it can borrow.
With this breadth and diversity, it’s not surprising that there is no “one size fits all” approach to choosing a business organization. When choosing what form of entity is best, business professionals must consider several factors. First, they have to consider how much it costs to create the entity and how hard it is to create. Some entities are easy to create, while others are more complicated and have ongoing maintenance requirements that are important to consider. Second, they have to consider how easy it is for the business to continue if the founder dies, decides to retire, or decides to enter a new business altogether. Third, they have to consider how difficult it might be to raise money to grow or expand the business. Fourth, they have to consider what sort of managerial control they wish to keep on the business, and whether they are willing to cede control to outsiders. Fifth, they have to consider whether or not they wish to eventually expand ownership to members of the public. Sixth, they must give some thought to tax planning to minimize the taxes paid on earnings and income. Finally, and most importantly, they have to consider whether or not they wish to protect their personal assets from claims, a feature known as limited liability.
It’s important to remember that choosing a business organization is different from what kind of business you run. For example, some businesses are known as franchises because they operate under a license agreement (contract) whereby they agree to follow certain standards set by the franchisor, purchase their goods from the franchisor, and maybe share either a royalty fee or percentage of profits with the franchisor. Franchises are a very common type of business (especially in the food and services industries), but there is no typical form of business for a franchise. Depending on the needs of the franchise owners, a franchise could be a sole proprietorship, a limited liability company (LLC), or a corporation. Similarly, we sometimes refer to “nonprofit organizations” such as universities or charities as separate legal entities. Although they are nonprofit, some of these enterprises can be very large, with complex operations that spread across borders (for example, the Red Cross or Doctors Without Borders). For tax purposes, nonprofits do not have to pay any taxes if they meet strict qualifications under IRS guidelines to become a “501(c)(3)” organization (named for the section of the Internal Revenue Code that grants nonprofit status), but from a legal perspective, these entities can also take on any number of forms, from sole proprietorships to corporations.
If you are ever in a position to start a new business venture, your focus is typically on growing revenue and cutting costs so that you can maximize profit. You may not be very concerned with entity choice at the outset, since so many other considerations are competing for your attention. Once an entity choice is made, however, it is difficult (but not impossible) to change to another selection. Since entity choice can have a profound effect on these considerations, it is important to gain a basic understanding of the available choices so that you, the business professional, can focus on the business fundamentals rather than legal or accounting details.
Business organizations are an important part of a business’s structure. Different organizations provide different advantages and disadvantages in creation cost and simplicity, ongoing maintenance requirements, dissolution and continuity, fundraising, managerial control, public ownership, tax planning, and limited liability. The type of business being conducted (for-profit, nonprofit, franchise) has little to do with the business organization in which the business is conducted. Many business organizations take the form of separate legal entities, which the law recognizes as nearly like persons for purposes of legal rights.
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