Business Organizations

types of business organizations:

1. sole proprietorship: a single individual, who typically tends to also be its

manager, owns 100% of the business.

Disadvantages:

* individual has unlimited liability, if the business goes

bankrupt the owner may end up losing even 100% wealth while paying off all
creditors.

* difficult to raise capital as there is no required financial reporting. Outside

investors will have no idea about how well or badly the company is performing. Also
the life of sole proprietorships may be limited to the life of the owner. No one
may be willing to take over the ownership of the sole proprietorship after the
owner's death.

Advantages:

* Taxation: The owner does not have to pay corporate taxes. She will have to pay
taxes at the personal income tax rate.

2. Partnership: Two or more individuals come together to form a partnership.

> All advantages and disadvantages of sole proprietorship apply to partnerships

also. Partners are subject to unlimited liability and will also find it difficult
to raise capital. There are taxed at personal income tax rates.

3. Corporation: solves the two disadvantages of sole proprietorships and

partnerships, namely unlimited liability and difficulty to raise capital. Owners
of corporations are subject to limited liability, that is, they can lose only how
much they have invested in the company and nothing more. Further, corporations have
to externally release financial statements periodically. So outside investors know
the financial health of the company at any point in time. This makes raising
capital for the company much easier than sole proprietorships and partnerships.

Disadvantages:

However, corporations have their own disadvantages. The shareholders of a

corporation are its owners Since there are usually thousands or even millions of
shareholders in a corporation they appoint managers to take care of the day to day
operations of the corporation. The managers are agents acting on behalf of the
shareholders. This leads to what are called agency problems where the managers act
in their own interests rather than in the owner's best interest. Sole
proprietorships and partnerships typically do not have agency problems as the
owners are also their managers. An example of agency problem is managers using the
companies� money to buy themselves an expensive vacation home which will not held
any financial benefits to the owners.

Solutions:

There are ways to solve this agency problem. A common one is to make managers part
owners in the company by offering them shares as part of their compensation
package. Since the managers are now owners them interest is aligned with other
owners and so they will work in all owner's best interests.
Another disadvantage of a corporation is double taxation. The corporation pays
taxes from its profits at corporate tax rates. If it pays dividends to its
shareholders, then these dividends (?????)are also taxed. In some countries, the
company pays a dividend distribution tax. In other countries, shareholders are
taxed at the personal tax rate on any dividends earned. Either way, the same stream
of cash flow companies' profits is taxed twice. Remember that this is not the case
with sole proprietorships and partnerships, where the owner managers are taxed at
the personal income tax rate.