Sole Proprietorship vs Partnership: Everything You Need to Know
It constitutes the similarities and differences you must consider when choosing between these two types of legal entity for your business.8 min read
Sole proprietorship vs partnership constitutes the similarities and differences you must consider when choosing between these two types of legal entity for your business. By definition, a sole proprietorship consists of just one person while a partnership can have anywhere from two to 100 owners. It's important to understand the advantages and disadvantages of each business type before registering an official business entity.
Definitions of Sole Proprietorship and Partnership
A type of business in which one person serves as an owner and operator is known as a sole proprietorship. Partnerships are formed with two or more people who conduct the business operations and share in the losses and profits. A sole proprietor must shoulder business liability alone while in a partnership liability is shared. When it comes to raising capital, the scope is limited with sole proprietorships and relatively high with partnerships. Partnerships are also more regulated than sole proprietorships. The Indian Partnership Act of 1932 lays out specific regulations for partnerships, where there is no statute for sole proprietors. Speaking of requirements, registration for a sole proprietorship isn't necessary and is up to the partners in a partnership.
Sole Proprietorship: A Choice for Solo Entrepreneurs
A sole proprietor, also known as the sole trader, is the person who owns and runs the business. The alternate name for sole proprietorship is sole tradership. The fewer people you have running a business, typically, the easier it is to run. It is by far the simplest and most convenient form of business. Another perk is that you have complete control over the entire business. The best part is there are no legal requirements when setting up a sole proprietorship. It just starts up automatically with your first business transaction.
The biggest disadvantage is that no legal distinction exists between the business and the individual. Therefore, the individual is personally liable for any obligations or debts incurred by the business because there is no protection or limitation when it comes to your personal assets. In summary, a sole proprietorship is very simple, the record keeping is minimal, and it doesn't subject itself to legal formalities. It also is eligible for tax benefits since the income from the business becomes the owner's personal income. One disadvantage is if the business owner dies or is not able to run the business, the business and business owner's livelihood also comes to an end.
Partnership: An Enterprise for Two (or More)
Each state varies, but in general no federal regulations govern the process of partnership formation. All partnerships should initially start as an agreement that is drafted by an attorney. This way everything is spelled out to prevent misunderstandings and conflicts down the road.
Just like sole proprietorships, partnerships are not necessarily an entity that is independent of the individual. All partners contribute with paid-in capital and therefore become liable for any debts incurred by the business. Even though expenses and income are filed as a business, each partner will pay taxes separately. There's an invisible legal relationship between the partners that goes unnoticed with those doing business with the firm. The key elements of a partnership are the agreement between the owners of the business, sharing of profit and loss, and an outline of each partner's responsibilities.
There are various types of partnerships just as there are various types of partners. Some of the different partnerships include general partnership, partnership at will, limited liability partnership, and particular partnerships. The different types of partners include active partner, nominal partner, sleeping partner, incoming partner, sub partner, outgoing partner, and partner for profits. Partnerships and partners can be dissolved at any time, especially if one or more partners retire, becomes insolvent, or dies. Then the remaining partners can continue on with their own agreement.
Options with More Liability Protection
Several business entities are among the most popular with smaller business owners, including LLCs and S corps. Both of these provide liability protection, so you don't lose your house or car, if the business is unable to pay off its debts.
A corporation is one of the most popular forms of business. It is also a separate entity from the owners. One or more business owners may become shareholders in the corporation. Registration is required in every state where that the corporation plans to do business.
Documents are not required when filing a partnership or sole proprietorship. Businesses must file articles of incorporation or certificate of formation to form a corporation legally. Fees vary from state-to-state when filing articles of incorporation. Partnerships and sole proprietorships are not required to file articles of incorporation.
Liability differs with the various forms of businesses. Partners and sole proprietors are liable for all debts that a business incurs, meaning that the possibility exists of the owners losing their personal assets, such as cars and homes, if the business has insufficient funds. Corporations, however, provide business owners with liability protection, although limited, against business obligations and losses which will protect their personal assets if the company goes bankrupt. Corporation owners are liable for any outstanding debts up to the amount invested in the company.
Taxation also varies depending on the type of business formed. Sole proprietorships and partnerships are considered pass-through entities. These entities report their losses and profits on their own personal tax return. Partnerships and sole proprietorships aren't required to file business-related taxes with the IRS. Corporations can be liable to double taxation when the business pays taxes on the corporation's profits on the business level and shareholders pay on income as a result of the business on their own personal return.
Structures among the different business types can be formal or informal. Corporations consist of directors, shareholders, employees, and officers. Corporations must also have at least one individual serving on the board of directors. The board of directors' main purpose is to allocate resources and increase the profits of the shareholders. Officer's responsibilities are to manage daily company activities and execute decisions made by the directors and shareholders. Partnerships and sole proprietors are set up with a more informal structure. Their structure doesn't require directors or officers. Sole proprietors have complete control over their business where corporations and partnerships have to share decisions and vote on issues related to the business.
Corporations have a few more formalities than sole proprietors and partnerships. The latter two have less paperwork and fewer requirements than a corporation. For example, corporations have to hold one meeting or more a year, while partnerships and proprietorships don't have to hold any meetings. Corporations must adhere to strict record keeping, especially financial, by keeping detailed ledgers, while partnerships and sole proprietorships aren't required to submit annual reports or keep financial statements. Corporations must file legal documents in the state in which it was created. In summary, corporations must hold shareholder and director meetings, record business meeting minutes, and have business decisions approved by the board of directors. If any of these formalities are not executed and maintained, the shareholders can lose their protection from any liability. Partnerships and sole proprietors can be run without the formality of structure and procedures.
Liability For Corporate Debts
Acts and liabilities can sometimes be passed from the corporation to its shareholders. A court can deem that as a possibility when it comes to justice, that the corporation should be disregarded as far as its liabilities and acts and be passed down to the shareholders. This is known as “piercing the corporate veil.”
Corporations Offer Self-Employment Tax Savings
Income from sole proprietors are vulnerable to self-employment taxes. Currently, this is 13.3% on the initial $106,800 income earned. With corporations, salaries, instead of profits, are such taxes required. This can save thousands of dollars a year.
Corporations Have Continuous Life
Corporations usually have a longer shelf life than partnerships and sole proprietors. A corporation doesn't typically dissolve when a shareholder, officer, or director dies. With sole proprietors and partnerships, the business usually comes to an end.
Corporations Make Raising Money Easier
A corporation has many ways to raise money, such as selling stock and creating new types of stocks. Preferred stock is just one type. This type of stock has different profit and voting characteristics where investors are not liable personally for any of the corporation's debts.
Transferring the Ownership Interests of a Corporation is Easier
The method of transferring the ownership of a business depends on its structure. Ownership of a corporation can be sold to third parties without disrupting its business operations. Partnerships and sole proprietors can't be sold as easily. Each of the licenses, assets, and permits have to be transferred individually. New tax ID numbers and bank accounts are also required.
Sole Proprietorships and Partnerships Cost Less to Establish
Partnerships and sole proprietorships don't cost as much as corporations do to establish and maintain. With sole proprietors and partnerships, there are yearly state fees, filing fees, and formation fees. The cost of corporations are offset by insurance costs that are lower.
Sole Proprietors and Partners are not Liable for Unemployment Insurance
There are also differences when it comes to unemployment insurance. Partners and sole proprietors do not have to pay this type of insurance tax while the corporation's shareholder-employee must pay this tax which is based on salary. Currently, this tax is figured by calculating 6.2 percent based on the initial $7,000 received of income. The maximum is $434 for each employee. If any other state unemployment taxes are paid, a 5.4 percent credit will lower the rate to .8 percent. The maximum per employee is $56.00 per year.
Advantages of an LLC
With sole proprietorships and partnerships, if assets can't meet the amount of debt, creditors may go after each business owner's personal assets, such as personal bank accounts, house, car, etc. With LLCs, the owners aren't usually liable for outstanding debts. The only time individuals of an LLC are liable is if an individual personally guarantees the debt, if the LLCs are mixed in with personal funds, if the LLC carries minimal insurance or capitalization, if the LLC doesn't pay its state taxes, and if it violates any other state law.
Easier for an LLC to Raise Money
There are many ways for an LLC to raise capital. It can sell memberships to new members and new membership classes can be created with different profit characteristics or voting.
Ease of Ownership Transfer
Ownership of an LLC is easily transferred. Interests may be sold to other parties, such as third parties, while not disrupting the operations of the business. Also with ownership transfer, tax ID numbers and newly acquired bank accounts are required.
Disadvantages of an LLC Compared to a Sole Proprietorship and a Partnership
An LLC does cost more to run and maintain than a partnership or sole proprietorship. This is because there are yearly state fees, filing fees, and formation fees. LLCs also don't require as many formalities as a corporation, however, more paperwork is still involved versus the partnership and sole proprietorships.
LLC owners should keep their personal records separate from the business in order to have some liability protection. Personal money should never be mixed in with the LLC's money.
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