The private sector is made up by the different businesses in an economy. Both unincorporated businesses and incorporated businesses exist in the private sector, that part of the economy which is owned and controlled by individuals, either directly or through share ownership.
An unincorporated business includes sole traders and partnerships. These businesses do not have a separate legal identity from its owners which means that the owners are legally responsible for the activities of the business. The owners are the business. The owners have unlimited liability for all debts of the business.
An incorporated business includes a private limited company, a public limited company and a holding company (either registered as a private limited company or a public limited company). These businesses have a separate legal identity from its owners which means that the company and not the owners (shareholders) is legally responsible for all the activities of the business. The owners of an incorporated business have limited liability for any debts caused by the business.
There are four distinct and important differences between the two forms of unincorporated business organization and limited companies. These are: legal ownership, liability, continuity and risk.
1st difference between unincorporated businesses and incorporated businesses: Legal personality
As an unincorporated business, sole traders and partners are not recognized in law as having a legal identity separated from that of them – they are the business and do not have legal personality. It means that if the products sold by them are dangerous, either a sole trader or a partnership may be taken to court.
As an incorporated business, a company is recognized in law as having a legal identity separate from that of its owners. This means that if the products sold by a company are found to be harmful, the company itself may be taken to court but not the owners. A company can be sued and it can itself sue other people and other companies in courts.
But, this does not take legal responsibilities away from the managers, for example, if they knowingly produce contaminated products or continue trading when their company is illiquid (being unable to pay its creditors), they will also be legally responsible. They must still act ethically, in accordance with the business aim and business objectives, and operate within the law set by the government.
2nd difference between unincorporated businesses and incorporated businesses: Liability for debts
Owners of unincorporated businesses have unlimited liability which means that the owners themselves are responsible for all the debts of the company. If the business goes bankrupt owing money, the owner will have to pay all the debts of the business, even if it means having to sell all personal possessions such as a house or a car.
Owners of incorporated businesses such as PepsiCo or Goldman Sachs have limited liability which means that the owners (shareholders) of a company are only responsible for the debts of the company up to the amount of money they have invested. If the company goes bankrupt owing money, the shareholders will only lose the amount they have invested in the company. Hence, all shareholders benefit from the advantage of limited liability – if the company fails, they will not lose their total wealth as shareholders by needing to sell personal possessions to pay for the debts of the company.
Nobody can make any further claims against shareholders, should the company fail. Therefore, people are more likely to invest in private limited companies and public limited companies because they have limited liability and therefore their personal processions are protected. This makes it easier for private limited companies and public limited companies to raise capital for expansions.
And the risk of the company failing to pay its debts is now transferred from investors to creditors who lend money or sell raw materials to the company.
3rd difference between unincorporated businesses and incorporated businesses: Continuity
In an unincorporated business, should anything happen to the owner(s) (sole trader or partners), the business will cease trading and cannot continue as a separate entity from that owner(s). The business will die together with its owner(s).
In incorporated businesses, the death of a single shareholder or director does not lead to any breaks in ownership or dissolution of a business. The ownership will continue through the inheritance of the shares. The ownership of companies is divided into small units called shares which people buy to own a part of the business. It is possible to buy either just one share or to completely control the company by owning more than 50% of the shares.
4th difference between unincorporated businesses and incorporated businesses: Risk
Unincorporated business ownership has greater legal and financial risks for owners than incorporated businesses. This is because of two reasons. First, owners and the business have the same legal identity. If, for example, a customer is injured as a result of using a faulty product made by the business, then the owners of the business are legally responsible and may be sued for damages.
Second, owners have unlimited liability for business debts. If the business fails and has unpaid debts, then the owners may have to use their personal wealth to pay these debts. Sole traders have high risk of failure (unlimited liability and limited finances of one owner to overcome obstacles) and partnership has medium risk of failure (unlimited liability, but can have many owners, so may have more finance available to deal with obstacles).
These risks are removed for the owners of incorporated businesses such as private limited companies or public limited companies because of two reasons. First, owners and the company have separate legal identities from each other. If customers are seriously injured by a good sold by an incorporated business, then they can sue the company for damages and not the owners. Second, owners have limited liability for all business debts. This means that if the company fails, the owners do not have to use their personal wealth to pay any debts.
The only financial risk that owners of incorporated businesses have is that they can lose all of the money they paid for their shares. Private limited company has medium to low risk (limited liability, many owners, ability to invite extra shareholders into the company to gain extra finance), and a public limited company has low risk of failure (limited liability, many owners, ability to access finance through share issues on the stock exchange).
