Small Scale. The corporate structure, which became tremendously popular in the nineteenth century, separates a business from its owners so that it can go on even when owners die or sell their shares. In the eighteenth century, however, few businesses continued to exist separately from the people who owned and operated them. Some partnerships lasted only as long as a particular venture, and merchants could belong to several partnerships simultaneously. These were fairly easy to form and manage because all businesses were small in scale, and they were organized simply. Even the largest had only a few employees. In addition to the owner himself there were a few clerks and perhaps an apprentice or two. There was no need for the sophisticated systems that characterize modern business corporations. Bookkeeping was simple and was done by the owners or their clerks. Nor was there much need for business service providers, other than some lawyers and a few insurance associations. So although colonial merchants performed a wide array of activities, they did not work too hard by modern standards. Letters were the primary form of communication, but merchants wrote only a few of these a week. And although large-scale importers dealt with many different customers, they usually had a core group of customers numbering only between ten and forty. In the countryside, stores handled fewer than twenty sales per day, and most of these were for only a few items.
Importance of Trust. The businesses of the period were frequently owned and operated by people who were related by blood or marriage. Family and religious connections were especially important for people who worked in long-distance trade. There were many risks to doing this type of business, and merchants had to be reasonably certain that their trading partners were reliable. Merchants extended large amounts of credit to each other, and creditors had to be confident that their debtors would pay bills when they came due. They had to be sure that distant merchants would not shortchange them or adulterate the merchandise. Although standards for measurement and quality could be enforced among people living in the same town or village, there were no mechanisms for doing so among merchants living in different places. Terms such as hogshead, barrel, and bale had various meanings depending on the country or port. Merchants also had to be confident that their trading partners would do a good job in packing and handling the merchandise so that breakage and loss were kept to a minimum. Because merchants could seldom accompany their cargoes to distant ports, they relied on trusted agents or ship captains to dispose of the goods for them. These individuals worked on a commission basis, earning between 3 to 10 percent of the total profit. Commission agents had autonomy to make decisions because prices in faraway ports could rise or drop unexpectedly, and slow communication prevented these agents from checking with their clients before responding to sudden developments.
Apprenticeships. The apprenticeship system was another way of cultivating trusting relationships. Several revolutionary leaders served as apprentices in their youth. For example, as a young man on the Caribbean island of Nevis, Alexander Hamilton, who later became the country’s first secretary of the Treasury, was apprenticed to Nicholas Cruger, who ran a general store. Apprentices often were related to the merchants for whom they worked or were recommended by someone the merchant knew. The young men lived in the merchants’ homes and became an extension of their families. Apprentices learned how to write business letters, maintain accounts, keep the workplace tidy, and a variety of other routine tasks. When the apprentice was ready, the merchant entrusted him with more responsibility, such as accompanying a cargo to its destination and selling the goods on behalf of his employer. The most able apprentices accumulated enough capital to set up business for themselves. Some of them became junior partners of their firm, eventually taking over when the senior partner retired. A few spent time in distant ports as resident agents for their firms before returning home to set up their own businesses.
The Quaker Network. Quakers, or the Society of Friends, as they called themselves, became successful overseas traders because they could rely on fellow members of their sect to transact business for them. The Quakers had established Pennsylvania in 1681-1682, and they dominated Philadelphia’s economic life until the Revolution. The Society of Friends had a strong tradition of mutual aid and community as well as a shared
sense of being a “peculiar people” who were different from their non-Quaker neighbors. So it was only natural for Quakers to rely on one another in their business dealings and to set up businesses with relatives and other members of their sect. Quaker merchants frequently combined trading voyages with religious visits to other communities of the Society of Friends. They developed commercial, religious, family, and personal relationships throughout the entire north Atlantic trading economy that stretched from Nova Scotia in the north to Curacao in the Caribbean and east to the European cities of Hamburg and Lisbon. In London the Philadelphia Friends dealt almost exclusively with fellow Quakers. Some of the most prominent Quaker merchants in the Atlantic trading community were related by marriage to leading Quaker families in Philadelphia. Among these were the Hills in Madeira, Portugal, the Lloyds in London, the Callenders in Barbados, the Wantons in Newport, and the Franklins in New York. The Society of Friends became less prominent in the merchant community after the Revolution. But for nearly a century their farflung business networks allowed Philadelphia Quakers to conduct trade with greater confidence, and this gave them a competitive advantage over other colonial merchants.
Risk and Insurance. Another way to decrease the risks in overseas trade was to spread it among several partners, each of whom took a fractional interest in a ship or cargo. That way an accidental loss would not ruin any one merchant but would instead be shared among all of the partners. Insurance was yet another way of dealing with risk, and it was already fairly common by the end of the colonial period. Merchants could buy it from government-approved English firms or from fellow merchants, who usually formed a partnership for each separate policy. Merchants about to embark on a venture went to a broker, usually a fellow merchant, who wrote a policy and set a premium. The policy was then signed by other merchants who agreed to underwrite a portion of the venture. Rates varied depending on the circumstances. Shipping along the colonies’ Atlantic coastline was deemed relatively safe, so premiums were only 1 or 2 percent of the value of the goods. In contrast, insurance for vessels involved in the African trade cost 8 or 9 percent, and premiums during wartime were even higher. In 1757 a group of Philadelphia merchants formed the colonies’ first formal insurance association. Thomas Willing, who later became the first president of the Bank of North America, led the effort, and other merchants soon imitated it. By 1783 these associations supported a semimonthly paper reporting on insurance news. Yet most American merchants had limited resources, so they were unable to insure large ventures. It was only in 1792 that the Insurance Company of North America was incorporated in Philadelphia with a capitalization of $600,000.
Business and Government. The colonists did not accept the concept of laissezfaire, which held that businesses function best when left alone by the government. That idea became more popularly accepted only in the nineteenth century. Instead colonists expected governments to be involved in nearly all areas of private economic behavior. This mixed economy, as it would later be called, had a long history. The settlement of the colonies had been a mix of private initiative and public incentives. The British government gave trading monopolies and land grants to private investors, who then recruited settlers such as those who came on the Mayflower. Mercantilism, practiced by all of the great European powers, was also based on the idea that governments should direct the flow of trade and regulate the economic activities of colonies. Mercantilism operated through government regulations that by the mid eighteenth century controlled a wide array of colonial products. The provincial and municipal colonial governments also regulated economic activities. Responding to public demand, they established town markets and passed regulations that maintained the just price of certain goods. These governments guaranteed the right of people to make contracts with each other, granted licenses to shopkeepers and peddlers, administered land sales, operated schools and land banks, and printed money. They taxed their residents to pay for roads, bridges, and wharves or required able-bodied men to help build them. In this way colonial governments helped to increase trade by linking farms, villages, and towns. Sometimes these governments even passed measures that discriminated against British merchants. For example, Virginia passed a law that favored locally owned vessels despite the strong protest of British traders. The protection provided by the Virginia assembly encouraged colonial capital to stay in local hands.
Arthur H. Cole, “The Tempo of Mercantile Life in Colonial America,” Business History Review, 33 (1959): 277-299;
Frederick B. Tolles, Meeting House and Counting House: The Quaker Merchants of Colonial Philadelphia, 1682-1763 (Chapel Hill: University of North Carolina Press, 1948).
One of the first critical decisions to be made when forming a new company is the formal structure that the business will take. The formal structure of the business impacts issues such as liability, ownership, operating strategy, and taxation. Four different business structures are discussed below: partnership, corporation, subchapter S, and limited liability corporation (LLC).
A partnership is a business association where two or more individuals (or partners) share equally in profits and losses. As is the case with a sole proprietorship, partners have full legal responsibility for the business (including debts against the business). Persons entering into this type of business need a partnership agreement detailing how much each partner owns of the business, how much capital each person will contribute, and the percentage of profits to which they are entitled; how company decisions will be made; if the company is open to new/additional partners, and how they can join; and in what cases and how the company would be dissolved.
In a general partnership, all partners are liable for actions made on the company's behalf, including decisions made and actions taken by other partners. Profits (and loss) are shared by all partners, as are company assets and authority.
A limited partnership is a similar business arrangement with one significant difference. In a limited partnership, one or more partners are not involved in the management of the business and are not personally liable for the partnership's obligations. The extent to which the limited partner is liable is thus “limited” to his or her capital investment in the partnership.
In a limited partnership agreement, several conditions must be met, the most important of which is that a limited partner or partners have no control or management over the daily operations of the organization. At least two partners, and one or more of the general partners, must manage the business and are liable for firm debts and financial responsibilities. If a limited partner becomes involved in the operation of the partnership, he or she stands to lose protection against liability. In addition, a limited partnership agreement, certificate, or registration has to be filed, usually with the secretary of state, but this varies by state. Such an agreement generally
includes the names of general and limited partners, the nature of the business, and the term of the limited partnership or the date of dissolution. Since limited partnerships are often used to raise capital, the agreement has a set term of duration. Individual states may also have additional limited partnership requirements.
The most frequent use of the limited partnership agreement has been as an investment, removing the limited partner from financial liability but raising capital through his or her investments or contributions. Limited partnerships are common in real estate investments and, more recently, in entertainment business ventures.
Partnerships are not required to file tax returns for the company, but individual partners do have to claim their share of the company's income or loss on personal tax returns. The Internal Revenue Service (IRS) governs limited partnerships for tax purposes. IRS guidelines restrict limited partnership investments to 80 percent of the total partnership interests. (See IRS Revenue Procedure 92-88 for information governing limited partnerships.) Limited partnerships are also taxable under state revenue regulations.
The major difference between a partnership and a corporation is that the corporation exists as a unique and separate entity from its owners, or shareholders. A corporation must be chartered by the state in which it is headquartered. It can be taxed, sued, or entered into contractual agreements, and it is responsible for its own debts. The shareholders own the corporation, and they elect a board of directors to make major decisions and oversee corporate policy. The corporation files its own tax return and pays taxes on its income from operations. Unlike partnerships, which often dissolve when a partner leaves, a corporation can continue despite turnover in shareholders/ownership. For this reason, a corporate structure is more stable and reliable than a partnership.
Incorporating offers several major advantages over partnership. Sale of stock can help raise large amounts of capital significantly faster and shareholders are only responsible for their personal financial investment in the company. Shareholders have only limited liability for debts and judgments made against the company. And the corporation can deduct the cost of benefits paid to employees from corporate tax returns.
Forming a corporation costs more money than forming a partnership, including legal and regulatory fees, which vary depending on the state in which the business is incorporated. Corporations are subject to monitoring by federal and state agencies, and some local agencies. More paperwork related to taxes and regulatory compliance is required. Taxes are higher for corporations, particularly if it pays dividends, which are taxed twice (once as corporation income, then again as shareholder income).
Some small businesses are able to take advantage of the corporate structure and avoid double taxation. These companies must be small, domestic firms with seventy-five shareholders or less and only one class of stock, and all shareholders must meet eligibility requirements. If a company meets these requirements, they can treat company profits as distributions through shareholders' personal tax returns. This way the income is taxed to shareholders instead of the corporation, and income taxes are only paid once. Subchapter S corporations are also known as small business corporations, S-corps, S corporations, or tax-option corporations.
LIMITED LIABILITY CORPORATION
The limited liability corporation (LLC) structure combines the benefits of ownership with the personal protection a corporation offers against debts and judgments. One or more people can form an LLC, and business owner(s) can either choose to file taxes as a sole proprietorship/partnership or as a corporation. The process of forming an LLC is more extensive than a partnership agreement but still involves less regulatory paperwork than incorporation.
Major advantages offered by the LLC structure are:
- The business does not have to incorporate (or pay corporate taxes).
- One person alone can create an LLC.
- Owners can be compensated through company profits.
- Business losses can be reported against personal income.
Still, some may choose to file taxes as a corporate entity, particularly if owners want to keep corporate income within the business to aid its growth. According to the Small Business Administration, an LLC cannot file partnership tax forms if it meets more than two of the following four qualifications that would classify it as a corporation: (1) limited liability to the extent of assets; (2) continuity of life; (3) centralization of management; and (4) free transferability of ownership to interests. If more than two of these apply, the LLC must file corporation tax forms.
An LLC that chooses to be taxed as an S corporation can also do the following, which the traditional S corporation cannot:
- Have more than seventy-five business owners
- Include a nonresident alien as an owner
- Have either a corporation or a partnership as an owner
- Have more than 80 percent ownership in a separate corporate entity
- Have disproportionate ownership—ownership percentages that are different from each respective owner's investment in the business
- Have flow-through business loss deductions in excess of each respective owner's investment in the business
- Have owners/members who are active in the management of the business without losing limited personal liability exposure
Companies can change their business structure. Tax filing—and the subsequent tax payment—prompts many businesses to make decisions about restructuring their business. Owners may opt for a new structure due to changes to tax laws or in the business itself. In order to anticipate what changes in structure might be beneficial, companies should schedule an annual discussion about long-term business plans with an accountant and/or tax advisor.
SEE ALSO Entrepreneurship; Organizational Chart
“Choosing a Business Structure.” AccountingWEB.com, 22 Apr. 2008. Available from: http://www.accountingweb.com/cgibin/item.cgi?id=105002&d=883&h=884&f=882&dateformat=%25o%20%25B%20%25Y.
“Choosing the Best Ownership Structure for Your Business.” NOLO.com. Available from: http://www.nolo.com/resource.cfm/catid/5de04e60-45bb-4108-8d757e247f35b8ab/111/182/.
Gabriel, Michael Lynn. Everyone's Partnership Book. Available from: http://www.attorneyetal.com/Previews/Partnr.html.
Hynes, Dennis L. Agency, Partnership, and the LLC in a Nutshell. St. Paul, MN: West Publishing, 1997.
Mancuso, Anthony. LLC or Corporation?: How to Choose the Right Form for Your Business Entity. Berkeley, CA: NOLO, 2005.
Meier, David. “The Many Benefits of Forming an LLC: A Closer Look at Why This Legal Structure Can Be Good for Business.” Entrepreneur, 16 Aug. 2004. Available from: http://www.entrepreneur.com/article/0,4621,316656,00.html.
U.S. Small Business Administration. “Forms of Business Ownership.” Available from: http://www.sba.gov/starting_business/legal/forms.html.