15 How are businesses legally organized?

The prior Question used a variety of terms for various ways to organize a business. This chapter addresses why businesses are organized differently from a general perspective. Later Questions will address several of these varieties in business forms more specifically.

Three questions are typically at the heart of how businesses choose to legally organize themselves. (1) How will capital be raised? (2) How will liability be shared? And, (3) How will we be taxed? Answering these questions leads to selection of a particular legal form for the organization, such as a corporation, an LLC, an S-Corp., and so on. What is often less considered are the legal duties that come into being after the business takes that form. We will briefly note how the answers to (1), (2), and (3) guide selection of a business form, but we will then turn our attention primarily to the question of the legal duties arising from these entities.

In a sole proprietorship, in which an individual runs a business by themselves with no other legal formalities, it may be difficult to raise capital because giving another an ownership stake is difficult. Rather, financing would come in the form of a loan to the individual themselves, in their name. Then, if the business suffers a loss, it is borne by that individual, with no liability shield. The proprietor’s personal assets could be lost. The same was true of a general partnership, when two or more people began running a business for profit–both partners suffered from unlimited personal liability, but now for their own and their partner’s actions. These two problems: unlimited personal liability and difficulty in raising capital, led to creation of the corporation early in the history of the United States, building off earlier English counterparts. A corporation allowed the accumulation of massive amounts of capital by selling stock, and liability was limited to the amount of capital contributed. Early corporations (considered in the next Question) had to have a specific public purpose to qualify for these privileges.

The corporation suffered from one distinct disadvantage. As a separate legal entity from the owners, it was also taxed separately from its owners. The result was double taxation: once at the corporate level, and another when profits were distributed through dividends to the owners. This problem led to the creation of additional legal forms: the LLC or limited liability company had the liability shield of the corporation paired with the possibility of individual taxation like in a sole proprietorship or a partnership, and an S-Corp allowed stock to be raised in limited ways while preserving taxation advantages.

Finally, the limited partnership was a long special case. In a limited partnership, general partners would manage the business and retain personal liability, while limited partners would contribute funds but not run the day-to-day operations. Limited partner liability would be limited to their investment, much like the stock contributed by a stockholder in a corporation.