S-Corp, Sole Proprietorship, LLC, Scratching your head?In this blog series I break down the different forms of business organizations to help you decide. Lets start with the General Partnership and Sole Proprietorship...
The type of organization that a business decides to operate as has profound implications for the health and future of the organization. In this series I will discuss 6 business organization types.
For each business organization type I will give a brief description and address key characteristics such as liability, income taxes, continuity of the organization, control, profit retention, location, and convenience or burden.
Sole Proprietorship
A sole proprietorship organization is one where a single owner owns all of the business. He/She manages, operates and leads his business, and therefore enjoys a level of autonomy not found in other types of business organizations. In fact 73% of all businesses are sole proprietorship's, with 90% being made up of single individual operations and less than 8% have more than 8 employees. First let us discuss the advantages of operating a sole proprietorship.
It is a relatively easy process to start a sole proprietorship because there is no need to hire a lawyer or register with the federal government. Simplicity is an advantage but you may need a state permit and some cities require a business license in order to operate if you operate under a fictitious name. As an owner you call the shots and have no one other than yourself to answer to. You make the decisions that affect your business. You manage the day to day operation as well as its growth. You do not have to discuss the merits of your business choices or seek agreement with a partner before you act. As a result of single management of your business you reap all of the rewards and profits. It is clear why this type of organization is popular.
Liability
While a sole proprietor has the advantage of reaping all the rewards for their efforts,
conversely they also are liable for all the failures. There is not a partner to share or corporation to shield one from the effects of poor business decisions. Debts are solely the responsibility of the owner as are any legal judgments. Because legally the business and the owner are indistinguishable from one another if an accident or misfortune were to occur while operating the business the owners personal assets would be in jeopardy.
Income Taxes
Income taxes are levied to the individual not the business as a separate entity. A 1040 form is used. Business expenses and write offs can be used to offset the individuals tax burdens.
Continuity of the organization
With a sole proprietorship the owner is the business, therefore if the owner dies or can no longer continue the business, the business ceases to exist.
Control, profit retention
The sole proprietorship is controlled by the individual owner. Profits are retained by the individual and become the personal income of the individual.
Location
The business must operate where the individual resides, because the individual is indistinguishable from the business.
General partnership
“A partnership is an unincorporated association of two or more co-owners who carry on a business for a profit. (Beatty,Samuelson, 2007, page 756).” Unlike a sole proprietorship where a single individual runs the business, a general partnership brings two or more individuals together along with their talents, skills and assets for the purpose of operating a profitable business.
Liability
When a partnership is formed it is recommended that a written contract be drafted and signed by the parties, although a verbal agreement will be observed by law. In the contract each partner’s exact percentage of ownership should be detailed. For instance in a dual partnership fifty percent ownership is typical, and this distinction coincides with the personal liability of each partner. One partner can make decisions on behalf of the business such as awarding or signing contracts’, making capital investments or acquiring financing, and the other partner will be liable for these decisions. Each partner in the business shares personal liability with the personal assets of each partner exposed.
Income taxes
Because partnerships are not a taxable entity, the business does not itself pay any taxes. Instead profits are divided between the partners, and these partners pay taxes on the divided income. Any investments in capital or debts incurred by the business can be used to offset tax liability of the individual equal to the percentage of ownership. This a advantage over corporations which pay a 35% tax rate and then the shareholders get a special dividend tax of 15%. This is known as double taxation.
Longevity or continuation of the business
If a partner in a general partnership quits, the partnership must decide whether to pay the exiting partners share of the value of the partnership or quit the business. This is where a written agreement can be invaluable. In the written agreement there should be a provision for valuing a partner’s share of the business in the event of death or disassociation. Likewise in the unfortunate case of a partner’s death, heirs may inherit the value of the deceased partners share, but no place in the partnership.
Control
Partners all share an equal role in the management of the firm. This is rarely an issue when a partnership is kept small, but larger partnerships can be difficult to manage effectively and this can be a disadvantage.
Profit Retention
Profits are divided evenly between partners and become personal assets and income.
Location
Partnerships can operate in more than one state. They must register and comply with state requirements for filing.
Next up the Limited Partnership and C-Corp.
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