When starting a business, one of the first considerations an entrepreneur should think about is the type of entity they will use to form their business. The type of entity a business owner utilizes determines the structure of their business, but not the purpose for which the business is formed.
The type of entity that a business is formed under is an important choice that will have an impact on many business issues, including the allocation of control and taxation. Two of the most common types of entities utilized by small business owners are sole proprietorship and partnerships. In determining whether a sole proprietorship or partnership is the best option when forming a new business, owners must take into consideration the characteristics of each type of entity.
What Is a Sole Proprietorship?
A sole proprietorship may be the best choice when a person wants to form a business on their own and maintain complete control over its management without outside interference. In California, a sole proprietorship is a business that is owned by an individual and is unregistered with the state of California. When forming a sole proprietorship, there are no formal documents that must be completed and filed by the sole proprietor with the state, making it an inexpensive option for new business owners with limited capital. The sole proprietor has exclusive control over the management and operation decisions surrounding the business. However, the control of the business enjoyed by the sole proprietor comes at the expense of personal liability. Sole proprietors are personally labile for all business debts and obligations that are incurred during the business’s existence. Thus, the owner will be personally liable any judgments entered against it by the court. Finally, the sole proprietorship will end at either the choice of the sole proprietor or at their death.
What is a General Partnership?
When a group of people desire to start a business that allows every individual owner to maintain control over the business, a general partnership may be a good option. General partnerships are treated similarly to sole proprietorships but is formed by two or more persons instead of a single individual. A partnership is defined as an agreement between two or more people to carry on a business for profit. The agreement between two persons to enter a partnership does not need to be in writing; a handshake is sufficient. Unlike, limited liability companies, each general partner to the agreement is jointly and severally labile for the obligations of the partnership, except for obligations that arose before the person became a partner to the business. When drafting a formal partnership agreement, the parties should outline the contributions of each partner, how the profits of the business will be divided, how the partners are to share in the losses, the length of the partnership, and the division of assets and liabilities upon dissolution of the partnership. The partners may also agree to the contribution amount required from each party to the agreement. The contributions from each partner will act as capital for the use of the partnership in carrying out its business.
Additionally, the agreement may limit the purpose of the business. For example, if the parties to the agreement wish to limit the business to the sale of cars, they should make this known at the time the agreement is made, preferably in writing. If no formal agreement is drafted, an at-will partnership is created, and the partners will share in the profits and losses equally.
Sole Proprietorship vs Partnership
One significant difference between a sole proprietorship and a partnership is the ability to limit the authority of a person to manage and control the business. As discussed above, in a sole proprietorship, the sole proprietor, as an individual owner, may act unilaterally as an agent of the business, and their power may not be limited by any other person. Conversely, in a partnership, each partner is an agent of the business and may act to legally bind the business, but that authority may be limited by a majority vote of all the partners to the agreement. If the partnership is only between two persons, the authority of any partner may not be limited by the other. Upon dissolution of the partnership, absent an express agreement, each partner will share equally in the profits, after each has been repaid his contributions.
How Are Business Entities Taxed?
Finally, tax issues are a major consideration when forming any business entity. Sole proprietorships and partnerships are treated similarly under federal and state tax laws. Both sole proprietorships and partnerships enjoy flow-through taxation. Flow-through taxation mean that the business is considered a non-entity and the owners must file all the profits and losses of the business on their personal income statements. The flow-through tax treatment of sole proprietorships and partnerships is different from the flow-through tax treatment of corporations. Corporations are subject to double taxation, while sole proprietors and partnerships are taxed once at the personal level. For example, corporate profits are first taxed at the corporate rate and then taxed as personal income when paid out to shareholders as dividends. On the other hand, sole proprietorships and partnerships are not taxed as businesses, and the individual owners will file a tax return that includes the profits of the business and may personally deduct any business losses. Even though both a partnership and sole proprietorship will not file or pay taxes on their profits, a partnership will still file an information return with the IRS, informing the agency of the business profits and losses for the tax year in question. Accordingly, both sole proprietorships and partnerships are a good tool to avoid double taxation and maximize an owner’s yearly income from the use of their business’s profits and losses.
At DuFord Law, our business law practice provides assistance to individuals who want to form any type of business. Ultimately, the determination of whether a sole proprietorship or partnership is the right type of entity for your business will depend on a closer analysis of your desired business structure, the type of business you are entering, and plans for future growth. Consulting with an experienced attorney and tax professional will ensure that you make a guided and informed decision when choosing the type of entity to form your business in the ever changing business and tax law landscape.