Explain the legal forms a business can take and what each means for its owners
The idea
A sole proprietorship offers full control and unlimited personal liability, with profits taxed once as the owner's income. A general partnership spreads capital and labour but leaves each partner liable for the whole; a limited partnership confines that exposure to the limited partners' contributions while the general partner retains it. A corporation gives shareholders limited liability, perpetual existence and transferable ownership, at the cost of separating ownership from control and, in many jurisdictions, double taxation of distributed profits.
Formulas
Cash to the shareholder after double taxation
cash = P × (1 − t_c) × (1 − t_d)
- P
- the profit earned before any tax
- t_c
- the corporate tax rate
- t_d
- the tax rate on dividends
A company taxed as its own entity pays tax on profit, then the shareholder pays again on the dividend. Pass-through forms are taxed once.
A practice question
What liability does a sole proprietor bear?
- Unlimited personal liability - correct
- Liability capped at the business's assetsWhy not: That separation requires a distinct legal entity, which a sole proprietorship does not have.
- No liabilityWhy not: The proprietor and the business are the same person in law, so the obligations are personal.
A sole proprietorship is a business owned by one person, and it is not a separate legal entity. So in law the owner is the business, and its debts are the owner's debts. If the business owes $200,000 and cannot pay, creditors can claim the owner's personal assets, such as savings or a house. Rule: unlimited liability means personal assets stand behind business debts. Full control and full exposure come together.
A harder one
In a general partnership, what is each partner's exposure?
- Limited to the capital each partner contributedWhy not: That is a limited partner's position, and it requires a limited partnership.
- Limited to their agreed percentage share of the debtsWhy not: Profit share governs how gains are divided, not how far liability extends.
- Liability for the whole of the partnership's debts - correct
A general partnership is a business owned by two or more people who all share in running it. Rule: each partner is personally liable for all of the partnership's debts, not just a share. For example, if the partnership owes $500,000 and only one partner has assets, creditors can pursue that partner for the full amount. That partner must then seek contributions from the others. A limited partnership exists to cap the exposure of those who supply only capital.
The hardest tier
Why does separating ownership from control create a cost even when managers are honest?
- Because managers must be paid salaries and bonusesWhy not: An owner-manager is also paid for the work, so pay alone is not the cost created by the separation.
- Because shareholders delegate operating decisions to managersWhy not: Delegation is how the separation works; the cost arises from monitoring and aligning incentives.
- Because monitoring and incentive costs consume value - correct
When owners hire managers, the managers' interests may differ from the owners', even if the managers are completely honest. Owners therefore spend money to monitor them (audits, boards) and to line up incentives (share-based pay), and some gap remains. Idea: agency costs = monitoring costs + incentive costs + leftover loss. For example, a manager who owns no shares may prefer a safe, comfortable strategy over a riskier one with a higher return. These costs are the price of the corporate form, not evidence of misconduct.
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