In this section, we examine different forms of business organizations: sole proprietorships, partnerships, corporations, and limited-liability companies.
1. Sole Proprietorships
A sole proprietorship is a firm owned and operated by one individual. No separate legal entity exists. There is one principal in the business who has total control over all export-import operations and who can make decisions without consulting anyone. The major advantages of sole proprietorships are as follows:
- They are easy to organize and simple to control. Establishing an export-import business as sole proprietorship is simple and inexpensive and requires little or no government approval. At the state level, registration of the business name is required, while at the federal level, sole proprietors need to keep accurate accounting records and attach a profit or loss statement for the business when filing individual tax returns (schedule C, Internal Revenue Service Form 1040). They must operate on a calendar year and can use the cash or accrual method of accounting.
- They are more flexible to manage than partnerships or corporations. The owner makes all operational and management decisions concerning the business. The owner can remove money or other assets of the business without legal or tax consequences. The owner can also easily transfer or terminate the business.
- Sole proprietorships are subject to minimal government regulations compared to other business concerns.
- The owner of a sole proprietorship is taxed as an individual, at a rate lower than the corporate income tax rate. Losses from the export-import business can be applied by the owner to offset taxable income from other sources. Sole proprietors are also allowed to establish tax-exempt retirement accounts (Cheeseman, 2006a; Mallor, Barnes, Bowers, and Langvardt, 2013).
The major disadvantage of running an export-import concern as a sole proprietorship is the risk of unlimited liability. The owner is personally liable for the debts and other liabilities of the business. Insurance can be bought to protect against these liabilities; however, if insurance protection is not sufficient to cover legal liability for defective products, or debts, judgment creditors’ next recourse is the personal assets of the owner. Another disadvantage is that the proprietor’s access to capital is limited to personal funds plus any loans that can be obtained. In addition, very few individuals have all the necessary skills to run an export- import business, and the owner may lack certain skills. The business may also terminate upon the death or disability of the owner.
A partnership is an association of two or more persons to carry on as co-owners of a business for profit. “Persons” is broadly interpreted to include corporations, partnerships, or other associations. “Co-ownership” refers to a sharing of ownership of the business and is determined by two major factors: share of the business profits and management responsibility. The sharing of profits creates a rebuttable presumption that a partnership exists. The presumption about the existence of a partnership is disproved if profits are shared as payment of a debt, wages to an employee, interest on a loan, or rent to a landlord.
Example: Suppose Gardinia Export Company owes Kimko Realty $10,000 in rent. Gardinia promises to pay Kimko Realty 20 percent of its business profits until the rent is fully paid. Kimko Realty is sharing profits from the business but is not presumed to be a partner in the export business.
Although a written agreement is not required, it is advisable for partners to have some form of written contract that establishes the rights and obligations of the parties. Since partnerships dissolve upon the death of any partner that owns more than 10 percent interest, the agreement should ascertain the rights of the deceased partner’s spouse and that of surviving partners in a way that is least disruptive of the partnership.
A partnership is a legal entity only for limited purposes, such as the capacity to sue or be sued, to collect judgments, to have title of ownership of partnership property, or to have all accounting procedures in the name of the partnership. Federal courts recognize partnerships as legal entities in such matters as lawsuits in federal courts (when a federal question is involved), bankruptcy proceedings and the filing of informational tax returns (profit and loss statement that each partner reports on individual returns). The partnership, however, has no tax liability. A partner’s profit or loss from the partnership is included in each partner’s income tax return and taxed as income to the individual partner (Cooke, 1995; Cheeseman, 2006b; Mallor et al., 2013).
Partners are personally liable for the debts of the partnership. However, in some states, the judgment creditor (the plaintiff in whose favor a judgment is entered by a court) must exhaust the remedies against partnership property before proceeding to execute against the individual property of the partners.
What are the duties and powers of partners? The fiduciary duty that partners owe the partnership and the other partners is a relationship of trust and loyalty. Each partner is a general agent of the partnership in any business transaction within the scope of the partnership agreement. For example, when a partner in an import business contracts to import merchandise, both the partner and the partnership share liability unless the seller knows that the partner has no such authority. In the latter case, the partner who signed the contract will be personally liable but not the partnership. A partner’s action can bind the partnership to third parties if his or her action is consistent with the scope of authority, that is, expressed or implied authority provided in the partnership agreement (Cheeseman, 2006a; Mallor et al., 2013).
3. Limited Partnerships
A limited partnership is a special form of partnership that consists of at least one general (investor and manager) partner and one or more limited (investor) partners. The general partner is given the right to manage the partnership and is personally liable for the debts and obligations of the limited partnership. The limited partner, however, does not participate in management and is liable only to the extent of his or her capital contribution. Any person can be a general or limited partner, and this includes natural persons, partnerships, or corporations. Limited partners have no right to bind the partnership in any contract and owe no fiduciary duty to that partnership or the other partners due to the limited nature of their interest in the partnership.
Whereas a general partnership may be formed with little or no formality, the creation of a limited partnership is based on compliance with certain statutory requirements. The certificate of limited partnership must be executed and signed by the parties. It should include certain specific information and be filed with the secretary of state and the appropriate county to be legal and binding. The limited partnership is taxed in exactly the same way as a general partnership. A limited partner’s losses from an export-import business could be used to offset income generated only by other passive activities, that is, investments in other limited partnerships (passive loss rules). They cannot be used against salaries, dividends, interest, or other income from portfolio investments. Both types of partnership can be useful in international trade. They bring complementary assets needed to distribute and/or commercialize the product or service. The combination of skills by different partners usually increases the speed with which the product/service enters a market and generally contributes to the success of the business. Limited partners may also be useful when capital is needed by exporters or importers to prepare a marketing plan, expand channels of distribution, increase the scope and volume of goods or services traded, and so on. However, potential exists for conflict among partners unless a partnership agreement exists that eliminates or mitigates any sources of conflict. If limited partners become involved in marketing or other management decisions of the export-import firm, they are considered general partners and, hence, assume unlimited risk for the debts of the partnership (Anderson and Dunkelberg, 1993; Cheeseman, 2006a; Mallor et al., 2013).
A corporation is a legal entity separate from the people who own or operate it and is created pursuant to the laws of the State in which the business is incorporated. Many export-import companies prefer this form of business organization due to the advantage of limited liability of shareholders. This means that shareholders are liable only to the extent of their investments. These companies can be sued for any harm or damage they cause in the distribution of the product, and that incorporation limits their liability to the assets of the business. Other advantages of incorporation are free transferability of shares, perpetual existence, and ability to raise additional capital by selling shares in the corporation. However, most of these companies are closely held corporations; that is, shares are owned by few shareholders who are often family members, relatives, or friends and are not traded on national stock exchanges.
Export-import corporations as legal entities have certain rights and obligations: they can sue or be sued in their own names, enter into or enforce contracts, and own or transfer property. They are also responsible for violation of the law. Criminal liability includes loss of a right to do business with the government, a fine, and any other sanction.
If an export-import company that is incorporated in one state conducts intrastate business (transacts local business in another state), such as selling merchandise or services in another state, it is required to file and qualify as a “foreign corporation” to do business in the other state. Conducting intrastate business usually includes maintaining an office to conduct such business. Using independent contractors for sales, soliciting orders to be accepted outside the state, or conducting isolated business transactions do not require qualification to do business in another state. The qualification procedure entails filing certain information with the secretary of state, paying the required fees, and appointing a registered agent that is empowered to accept service of process on behalf of the corporation.
The process of forming a corporation (incorporating) can be expensive and time consuming. A corporation comes into existence when a certificate of incorporation, signed by one or more persons, is filed with the secretary of state. The corporation code in every state describes the types of information to be included in the articles of incorporation. Generally, it includes provisions such as the purpose for which the corporation is organized, its duration, and powers of the corporation.
Many businesses incorporate their companies in the state of Delaware even when it is not the state in which the corporation does most of its business. This is because Delaware has laws that are very favorable to businesses’ internal operations and management. It is even more ideal for companies that plan to operate with little or no surpluses or that have a large number of inaccessible shareholders, making it difficult to obtain their consent when needed.
One of the main disadvantages of a corporation as a form of business organization is that its profits are subject to double taxation. Tax is imposed by federal and state governments on profits earned by the company, and, later, those profits are taxed as income when distributed to shareholders. Companies often avoid this by increasing salaries and bonuses for their owners and reporting substantially reduced profits. In this way, the income will be subject to tax when the owners or shareholders receive it rather than at the corporate level.
It is important that export-import companies maintain a separate identity from that of their owners. This includes having a separate bank account, preparing export/distributor contracts in the name of the company, holding stockholders meetings, and so on. In circumstances in which corporations are formed without sufficient capital or when there is a nonseparation of corporate and personal affairs, courts have disregarded the corporate entity. The implication of this is that shareholders may be found personally liable for the debts and obligations of the company. The corporate entity is also disregarded in cases in which the corporation is primarily used to defraud others and for similar illegitimate purposes, such as money laundering, trading in narcotics, or funneling money to corrupt officials (bribery).
Directors and officers of export-import companies owe a duty of trust and loyalty to the corporation and its shareholders. Directors and officers must act within their scope of authority (duty of obedience) and exercise honest and prudent business judgement (duty of care) in the conduct of the affairs of the corporation. In the absence of these, they could be held personally liable for any resultant damages to the corporation or its shareholders. Breach of duty of obedience and care by directors and officers of an export-import company could include one or more of the following:
- Investment of profits: Investing profits from export-import operations in a way that is not provided in the articles of incorporation or corporate bylaw
- Corporate decisions: Making export-import decisions without being adequately informed, in bad faith, and at variance with the goals and objectives of the company.
5. S Corporations
The Subchapter S Revision Act of 1982 divides corporations into two categories: S corporations and C corporations, that is, all other corporations. If an export company elects to be an S corporation, it has the best of advantages of a corporation and a partnership. Similar to a corporation, S corporations offer the benefits of limited liability but still permit the owner to pay taxes as an individual, thereby avoiding double taxation. One advantage of paying taxes at the level of the individual shareholder is that export-import companies’ losses can be used to offset shareholders’ taxable income from other sources. It is also beneficial when the corporation makes a profit and when a shareholder falls within a lower income tax bracket than the corporation. However, the corporation’s election to be taxed as an S corporation is based on the following preconditions (Mallor et al., 2013):
- Domestic entity: The corporation must be a domestic entity, that is, it must be incorporated in the United States.
- No membership in an affiliated group: The corporation cannot be a member of an affiliated group (not part of another organization).
- Number of shareholders: The corporation can have no more than seventy-five shareholders.
- Shareholders: Shareholders must be individuals or estates. Corporations and partnerships cannot be shareholders. Shareholders must also be citizens or residents of the United States.
- Classes of stock: The corporation cannot have more than one class of stock.
- Corporate income: No more than 20 percent of the corporation’s income can be from passive investment income (e.g., dividends, interest, royalties, rents, annuities).
Failure to maintain any one of these conditions will lead to cancellation of the S corporation status. Another election after cancellation of status cannot be made for five years.
6. Limited-Liability Companies
This form of business organization combines the best of all the other forms. It has the advantages of limited liability and no restrictions on the number of owners or their nationalities (as is the case of S corporations). It is taxed as a partnership, and, unlike limited partnerships, it does not grant limited liability on the condition that the members refrain from active participation in the management of the company. To be taxed as a partnership, a limited- liability company (LLC ) can possess any of the following attributes: two or more persons as associates, objectives to carry on business and divide gains, limited liability, centralized management and continuity, and free transferability of interests (Cheeseman, 2006b; Mallor et al., 2013). Such a company can be formed by two or more persons (natural or legal) and its articles of incorporation filed with the appropriate state agency. Limited-liability companies provide the advantage of limited liability, management structure (participation in management without being subject to personal liability), and partnership tax status. It has become a popular form of business for subsidiaries of foreign corporations as well as small-scale and medium-size businesses (August, 2004) (Table 3.1).
Source: Seyoum Belay (2014), Export-import theory, practices, and procedures, Routledge; 3rd edition.