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Forms of Business Organizations and Some of Their Characteristics

Prepared by David M. Saxowsky and Terry W. Knoepfle

Businesses can be organized in a variety of ways based on state law and the goals of the business owner(s). This page provides an overview of select characteristics of several common forms of business ownership.

Sole Proprietorship

• Simplest form of business ownership
• One owner who makes the investment, makes the decisions, takes the risks, and enjoys the profits or suffers the losses.
• Very few formal requirements to start operating the business.
• All of the business' assets are owned by the sole proprietor and all business debts are obligations of the proprietor; the owner's personal (or nonbusiness) assets can be used (can be taken through a court proceeding), if necessary, to pay obligations owed to creditors of the business.
  • The owner may provide some of the other business assets, such as land, labor, capital and expertise, or the owner may acquire these by renting land, hiring staff, borrowing capital, and buying technology or information.  The owner may also manage some risks through the purchase of insurance, but the risk that the business incurs a net operating loss is borne solely by the business owner.
• The owner decides whether to use any of the business' income or profit for personal or nonbusiness purposes. Profit the owner does not withdraw from the business can be used to expand the business; in that case, the owner's return for investing in and operating the business is not cash, but ownership in a growing business.
• Earnings from the business are taxed as income to the business owner (26 U.S.C. §61(a)(2) and §62(a)(1)); earnings also are subject to self-employment tax (26 U.S.C. §1402(a)).

Partnership

• Business with two or more owners.
  • For example, "Partnership" means an association of two or more persons to carry on as coowners a business for profit ... (N.D.C.C. §45-13-01(19))
• Each partner invests in the business, shares decision making and management of the business, and shares the risks, profits, and losses in equal proportion (unless they have agreed to a different split; e.g., the partner who contributes 75% of the business' assets will be considered as owning 75% of the partnership, and entitled to that portion of the business' profit, as well as bear that portion of the liabilities).

• Partners may develop a legal document (a partnership agreement) that sets forth their relationship to one another; each partner's contributions, responsibilities, and authorities could be set forth in the partnership agreement.
  • For example, "Partnership agreement" means the agreement, whether written, oral, or implied, among the partners concerning the partnership... (N.D.C.C. §45-13-01(20))
• Assets used in the partnership business can be owned by the partners or by the partnership; assets owned by the partners but used by the partnership business would be considered a contribution by the partner who owns the assets.
  • Of course, a partnership can also acquire the use of others' assets by renting land, borrowing capital, buying technology or information, etc.

   

• Partners are personally liable for the business' debts if the business' assets are inadequate to pay the business' debts.
• Partners are personally liable for partnership obligations even if the partner did not participate in the business transaction; as long as the creditor thought or had reason to believe the representative of the business was acting on behalf of the partnership, the resulting obligation is the responsibility of the partnership and each partner.
• Co-owners of a business will be treated as partners even though they do not have a partnership agreement if they act as if they are partners; that is, they will be personally liable for unpaid partnership obligations; creditors are the ones who will raise the issue of an implied partnership -- when one of the business owners cannot pay and the creditors want to collect from another business owner, the creditors will argue that the business was a partnership (even though the owners never established the business as a partnership), and that each partner is personally liable for any of the business' unpaid obligations.
  • This is why the definition of a partnership is so critical; a partnership (and its associated responsibilities) can arise from your actions. If others perceive your actions as "co-owning a business," you will be treated as co-owning the business.

   

• The partners decide if they will take some of the business' income or profit for their personal or nonbusiness use. If the partners have a partnership agreement, the conditions for removing cash from the business may already be set forth in that document. Similar to a sole proprietor, profit the partners do not withdraw can be used to expand the business and the partners' return is not cash, but ownership in a growing business.
• These partnerships are often referred to as a general partnership to distinguish it from other forms of partnerships (explained subsequently).
• An example of partnership legislation is North Dakota Century Code (N.D.C.C.) 45-13 to 45-21.
• Earnings from the business are taxed as income to the business owners; earnings also are subject to self-employment tax (26 U.S.C. §1402).
  • The partnership does not pay income tax; instead, the partnership's profit is allocated to the partners (the business owners) and they report their share of the partnership profit as part of their individual income (26 U.S.C. §701).

Corporation

• An entity that is legally separate from its owner or owners.
  • For court cases that recognize corporations are defined as entities separate from their owners/shareholders, see Jablonsky v. Klemm, 377 N.W.2d 560 (N.D. 1985) and First Interstate Bank of Fargo v. Larson, 475 N.W.2d 538, (ND 1991).
• The business is owned by shareholders, which may be as few as one shareholder or as many as several thousand shareholders.
• The business owns its assets and is responsible for its obligations; if the corporation's assets are not enough to pay its debts, the creditors will go unpaid.
  • Shareholders generally contribute assets to the corporation in exchange for corporate stock; that is, a share in the ownership of the business.
  • Like a sole proprietorship and partnership, a corporate can acquire the use of others' assets by renting land, borrowing capital, buying technology or information, etc.

   

• Shareholders are not responsible for the corporation's unpaid debts (referred to as limited liability) unless the shareholder has agreed to be responsible, or the shareholder has done something that can be remedied only by the shareholder assuming the corporation's debt (such as the shareholders using the corporation to defraud creditors).
  • For example, see Jablonsky v. Klemm, 377 N.W.2d 560 (N.D. 1985).
• The inability of creditors to use shareholders' personal assets to pay corporate obligations forces lending institutions, when evaluating a loan application from the corporation, to consider only the corporation's assets and not the shareholders' personal assets. This limitation could reduce the amount of borrowed capital shareholders can attract to their business.
  • In the situation of a corporation with a small number of shareholders, a lending institution may require that shareholders with extensive personal assets or shareholders of a large portion of the corporation's shares agree to be personally liable for the corporation's unpaid obligations before the lender will agree to extend credit to the corporation. This is an example of how shareholders agree to assume responsibility for the corporation's obligations; but on the other hand, without the limit on liability, one has to consider whether potential shareholders would be willing to invest in the business.

   

• Shareholders are entitled to a portion of the corporation's assets only after all creditors of the corporation have been paid; that is, if the corporation was to cease operating, sell it assets, and pay its debts, the shareholders will receive only the cash that remains after all the debts have been paid.  If no assets remain after the creditors have been paid, the shareholders receive nothing; thus shareholders can "lose" their investment, or equity, in the corporation.

• Corporations must be explicitly formed; they do not exist until the necessary documents have been completed. 
• Some of the documents must be filed with the state or federal governments and thus become public information. The two most important documents for a corporation are the articles of incorporation and the by-laws. 
• Shareholders retain the decision making authority (even though the corporation may have hired managers to oversee day-to-day operations) and participate in proportion to the number of shares each shareholder owns; that is, each share of stock generally entitles the shareholder to one vote, the more shares an individual owns, the more authority that person has in managing the corporation.
• The number of shares a shareholder owns generally reflects the amount the shareholder has invested in the corporation.

 

• Corporations with many shareholders often elect a board of directors from among the shareholders who guide the managers in the daily operation. The board of directors is a means of regularly representing shareholders' interests to the hired mangers.

• If the corporation earns a profit, the board of directors can declare a dividend for the shareholders; that is, a cash payment to the shareholders in return for having invested in the company. This is similar to a sole proprietor or partners taking some of the business' profit for personal use.
• The corporation's articles of incorporation and by-laws often set forth a dividend policy to guide the board of directors in this decision. Dividends are usually paid on a per-share basis, thus a shareholder who owns more shares will receive a larger total dividend than a shareholder who owns fewer shares.
• The board of directors may decide to retain the corporation's profits in the business rather than pay it to shareholders as a dividend. Similar to a sole proprietorship and a partnership, the retained cash can be used to expand the business and the shareholders' return for investing in the corporation is not a cash dividend, but ownership in a growing company.

• Shareholders can sell their shares to other individuals; the value of the share is negotiated between the shareholder who wants to sell their interest in the business and the person who wants to become part owner of the corporation.
• Some corporations want to influence who can be a shareholder; to accomplish this, the corporation has to limit or control whether a current shareholder can sell to the person who is interested in buying the shares; laws generally prohibit corporations from preventing a shareholder from selling (because such a prohibition may block the shareholder from ever being able to liquidate the investment); a strategy that is often used by corporations that want to control who can be shareholders is to have the corporation retain the right to approve all transfers of shares before they are transferred, and to have a policy of buying shares from shareholders (at a market price) if the selling shareholder cannot find an acceptable buyer; such a strategy needs to be described in the articles of incorporation or by-laws.
• Some corporations have more than one class of shares with different rights and responsibilities; for example, a corporation may offer a preferred stock whereby the shareholders are entitled to be paid after all creditors have been paid but before the holders of common stock are paid and the holders of common shares are the last to be paid; in exchange for assuming this added risk, common shareholders will likely have more decision making authority than the holders of preferred shares and will be entitled to a disproportional share of the corporation's profit during times of extraordinarily high corporate earnings; the availability, rights and responsibilities of classes of shares must be set forth in the corporation's articles of incorporation.

• Example of legislation authorizing corporations is N.D.C.C. 10-19.1.
• Example of legislation prohibiting specified businesses from being organized as a corporation is N.D.C.C. 10-6.1 which defines and limits which corporations can own farmland or operate a farm business in North Dakota.

• C corporations are taxed as separate entities; dividends received by shareholders generally are taxed as "unearned income" even though the corporation does not deduct the dividend as an expense; this is where the concern about double taxation arises; in comparison, wages paid to employees are taxed as ordinary income to the employee and deducted as a business expense of the corporation; rent paid by corporations to asset owners is treated as "unearned income" and deducted as a business expense by the corporation; the different tax treatment of these various transactions sometimes leads shareholders in a closely-held corporation (a corporation with a small number of shareholders) to consider having several legal relationships with the corporation; e.g, investor, employee, and lessor.
• Earnings from S corporations are allocated among the shareholders who report the earnings as income on their individual income tax returns; these earnings are reported by the shareholders whether the income is distributed as a dividend to the shareholders or retained in the corporation.
• Corporations may have opportunities to treat employee benefits as business expenses.
• Corporations may have an opportunity to convert the shareholders' "earned income" to "unearned income" and thus reduce the amount of income subject to employment (e.g., social security) tax.

Cooperative (traditional)

• A form of corporation but instead of ownership being based on how much capital a shareholder has invested in the business, ownership is shared by those who do business with the cooperative like corporations, the cooperative structure includes a board of directors who represent the shareholders, and hire managers who are responsible for the daily operation of the business.
• Each shareholder is entitled to one vote irrespective of how many shares the person has accumulated.

• Cooperatives often retain business profit for expansion purposes, rather than paying dividends.
• Generally, cooperative shares cannot be sold to other person; instead, the shareholder will receive cash from the cooperative for the value of the shares after the shareholder no longer does business with the cooperative; for many agribusiness cooperatives that serve farmers, this means the person retires from active farming.
• One philosophy is that cooperatives do not need to pay dividends to retain their shareholders because the shareholders benefit from the company by paying lower prices when they buy from the cooperative, receiving higher prices when they sell to the cooperative, or receiving their return in the form of a larger payout when they retire.

• Like a corporation, shareholders in a cooperative are not personally liable for unpaid cooperative obligations, unless the shareholder has agreed to be liable or imposing liability is a necessary remedy.
• Like a corporation, a cooperative does not exist until the necessary documents have been completed; the key documents are the articles of incorporation and the by-laws.

• Example of legislation authorizing a cooperative corporation is N.D.C.C. 10-15.
• Taxed similar to a corporation except that some ag cooperatives have an opportunity to qualify for alternative tax treatment (that is, dividend paid to members are a deductible expense for the cooperative thus avoiding the concern of "double taxation," but the cooperative must pay at least 20% of its dividends as cash to the members so they have enough cash to pay the income taxes on the full dividend).

Limited Partnership

• A form of partnership where some of the partners are not personally liable for the business' debts if the business' assets are inadequate to pay the business' debts.
• To be granted the protected status of a limited partner, the partnership must identify the limited partner(s) in a public document, not use the limited partner's name in the business' activities, the limited partner may not participate in managing the business, and the partnership must have at least one general partner who will manage the partnership and be personally responsible for debts that the partnership is unable to pay.
• Limited partners will lose their status if they participate in the management of the business; they then would be personally liable for the partnership's unpaid obligations (as if they were a general partner).
• Example of legislation authorizing limited partnership is N.D.C.C. 45-22.
• Earnings from the business are taxed as income to the business owners; "earned income" from the partnership also is subject to self-employment tax.

Limited Liability Company

• A relatively new business organization (has become available in most states during the past 25 years) which combines features of partnerships and corporations; that is, the investors are not prohibited from actively engaging in the management of the business but the investors are not liable for the business' unpaid debts except if they agreed to be personally liable, or it is a necessary remedy.
• A limited liability company (LLC) is different than a limited partnership because a member of a limited liability company will not be personally liable for the business debts even though the member has participated in managing the business.
• Generally taxed similar to a partnership.
• For IRS purposes, how do I classify a limited liability company? Is it a sole proprietorship, partnership or a corporation? (an IRS web page)
• Availability of LLCs has diminished the interest in general and limited partnerships.
• Example legislation for LLC is N.D.C.C. 10-32.
• An LLC must be explicitly formed.

• Different terminology is used to distinguish between an LLC and a corporation; for example, member rather than shareholders; organizer rather than incorporator; articles of organization rather than articles of incorporation; board of governors rather than board of directors, and membership interest rather than shares.

• An LLC can be formed with as few as one organizer and have as few as one member.
• Membership interest of an LLC is divided into financial rights and governance rights; this distinction allows the members to define which members are authorized to decide how the LLC is operated; that is, members with governance rights.
• Profits and losses of an LLC must be allocated among all members in proportion to the value of the contributions of the members; that is, all members must have financial rights.
• Cash, property, and services a member provides to the LLC in exchange for membership are considered a contribution.
• State law determines whether an LLC needs to be renewed or can last perpetually. State law determines whether an LLC must file an annual report with state government.
• Related link: Limited Liability Company 101

Limited Liability Partnership

• A relatively new development (perhaps the past 10 years) in which a partnership can publicly declare that none of its partners will be personally responsible for partnership obligations the partnership cannot afford to pay.
• This option probably spells the demise of general and limited partnerships.
• Example legislation for limited liability partnership is N.D.C.C. 45-22.
• This is a partnership and is taxed accordingly.

Closed Cooperative

• A modified cooperative in that shareholders are allowed to invest in the cooperative shares, similar to most corporations.
• A closed cooperative may limit itself to doing business only with its members; or if it does conduct business with non-members, the non-members do not become shareholders.
• Being a shareholder in a closed cooperative will likely include an obligation to do business with the cooperative; for example, the shareholders of a food processing cooperative may be limited to farmers who raise that crop, but the members may then be required (legally obligated) to deliver their crop to the cooperative.
• Closed cooperatives are nearly identical to corporations except that each shareholder is entitled to one vote irrespective of how much they have invested in the closed cooperative.
• Taxed as a cooperative.

Last updated February 11, 2008

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