Three Basic Forms of Business Organization

Mar 6, 2020

In the United States, most business enterprises are organized as sole proprietorships, partnerships, or corporations. Generally accepted accounting principles can be applied to the financial statements of all three forms of organization.

Sole Proprietorships

An unincorporated business owned by one person is called a sole proprietorship. Often the owner also acts as the manager. This form of business organization is common for small retail stores, service businesses, and professional practices in law, medicine, and accounting. In fact, the sole proprietorship is the most common form of business organization in our economy.

From an accounting viewpoint, a sole proprietorship is regarded as a business entity separate from the other financial activities of its owner. From a legal viewpoint, however, the business and its owner are not regarded as separate entities. Thus, the owner is personally liable for the debts of the business. If the business encounters financial difficulties, creditors can force the owner to sell his or her personal assets to pay the business debts. While an advantage of the sole proprietorship form of organizations is its simplicity, this unlimited liability feature is a disadvantage to the owner.

Partnerships

An unincorporated business owned by two or more persons voluntarily acting as partners (co-owners) is call a partnership. Partnerships, like sole proprietorships, are widely used for small businesses. In addition, some large professional practices, including CPA firms and law firms, are organized as partnerships. As in the case of the sole proprietorship, the owners of a partnership are personally responsible for all the debts of the business. From an accounting standpoint, a partnership is viewed as a business entity separate from the personal affairs of its owners. Creditors of an unincorporated business often ask to see the personal financial statements of the business owners, as these owners ultimately are responsible for paying the debts of the business. A benefit of the partnership form over the sole proprietorship form is the ability to bring together larger amounts of capital investment from multiple owners.

Corporations

A corporation is a type of business organization that is recognized under the law as an entity separate from its owners. Therefore, the owners of a corporation are not personally liable for the debts of the business. The owners can lose no more than the amounts they have invested in the business---a concept known as limited liability. This concept is one of the principal reasons that corporations are an attractive form of business organization to many investors.

Ownership of a corporation is divided into transferable shares of capital stock, and the owners are called stockholders or shareholders. Stock certificates are issued by the corporation to each stockholder showing the number of shares that he or she owns. The stockholders are generally free to sell some or all of these shares to other investors at any time. This transferability of ownership adds to the attractiveness of the corporate form of organization, because investors can more easily get their money out of the business. Corporations offer an even greater opportunity than partnerships to bring together large amounts of capital from multiple owners.

There are many more sole proprietorships and partnerships than corporations, but most large businesses are organized as corporations. Thus, corporations are the dominant form of business organization in terms of dollar volume of business activity.

Limited Liability Company (LLC)

In the United States, a limited liability company is a business entity type that provides a partnership or sole proprietorship with the limited liability protection of a corporation, creating the best of both worlds for business owners. By forming an LLC, only the LLC is liable for the debts and liabilities incurred by the business — not the members. The members liability is limited to the personal interest they have invested in the company thus protecting the personal assets of the individual member that are separate from the LLC. LLCs have rapidly become one of the most popular business structures for new and small businesses, largely because they are considered to be simpler and more flexible than a corporation. When you form an LLC, your business becomes its own legal entity, with separate debts and legal matters.

For most small businesses, a limited liability company offers the right mix of personal asset protection and simplicity. Unlike sole proprietorships and partnerships, LLCs can protect your personal assets if your business is subject to legal action. Unlike corporations, LLCs are relatively easy to form and maintain.

How to report ownership equity in the balance sheet for each form of business organization

Assets and liabilities are presented in the same manner in the balance sheet of all three types of business organizations. Some differences arise, however, in the presentation of the ownership equity.

Sole Proprietorships A sole proprietorship is owned by only one person. Therefore, the owner’s equity section of the balance sheet includes only one items—the equity of the owner. However, the owner’s equity can be broken down into three accounts to record different types of equity transactions:

Owner’s Equity: 

• Retained Earnings – represents the accumulation of net income earned over the business’ existence.
• Owner’s Contributions – used to record the capital contributions made by the owner.
• Owner’s Draws - used to record the capital withdrawals made by the owner.

Partnerships A partnership has two or more owners. Accountants use the term partners’ equity instead of owners’ equity and usually lists separately the amount of each partner’s equity in the business. Similar to the sole proprietorship, the partner’s equity can also be broken down into three accounts, for each partner, to record different types of equity transactions:

Partner 1 Equity:

• Partner 1 Retained Earnings
• Partner 1 Contributions
• Partner 1 Draws

Partner 2 Equity:

• Partner 2 Retained Earnings
• Partner 2 Contributions
• Partner 2 Draws

Total Partners' Equity:

• Partners' Retained Earnings
• Partners' Contributions
• Partners' Draw

Corporations In a business organized as a corporation, it is not customary to show separately the equity of each stockholder. In the case of large corporations, this clearly would be impractical because these businesses may have several million individual stockholders (owners). Owners’ equity (also referred to as stockholders’ equity or shareholders’ equity) is presented in two amounts:

Owners’ Equity:

• Capital stock – represents the amount that the stockholders originally invested in the business in exchange from shares of the company’s stock.
• Retained earnings – the balance represents the total net income of the corporation over the entire lifetime of the business, less all of the dividends to its stockholders (a dividend is a distribution of profits to stockholders). In short, retained earnings represents the earnings that have been retained by the corporation to finance growth.

Your business structure affects how much you pay in taxes, your ability to raise money, the paperwork you need to file, and your personal liability. You'll need to choose a business structure before you register your business with the state. Most businesses will also need to get a tax ID number and file for the appropriate licenses and permits.

Choose carefully. While you may convert to a different business structure in the future, there may be restrictions based on your location. This could also result in tax consequences and unintended dissolution, among other complications. Consulting with business counselors, attorneys, and accountants can prove helpful.

If you need help deciding which business structure is best for you and setting it up, we can help … contact us.

Check out these helpful resources offered by the U.S. Small Business Administration.