Setting up a business in the US isn’t very difficult. All you need is a business name, a business account, some customers and maybe a website to get going. However, for most small business owners, the question arises as to what type of legal structure or entity they want to construct their business upon. The decision, based on the business needs, determines and directly impacts the small business taxation method, payroll management, liabilities and profit distribution of a business.
Among the four commonly known business entities, sole proprietorship, partnership, LLC and corporate, the simplest ones are sole proprietorship and partnership. In fact, according to data, the US has approximately 73 percent of businesses registered under sole ownership.
What is Sole Proprietorship?
Any business owned by a single individual – or spouses according to some state laws – is known as a sole proprietorship. The assets, liabilities, profits and losses are the sole owner’s concerns. A sole proprietor may have a team to work for him, but they have full autonomy of the business’s operations and management.
What is Partnership?
As the name says, a partnership business is formed when two or more individuals invest their capital to earn profit through a venture. In the US, partnerships account for seven percent of all businesses and generate almost five percent of the revenue in the economy.
Although the legal matters and taxation of a partnership business are not much different from a sole proprietorship business, it is important to keep in mind that a partnership essentially translates into a division of power, assets, and profits. Similarly, all the partners are equally liable for the business’s losses. However, there are two types of partnerships:
Limited Partnership: One partner is known as the managing partner, and the other is a sleeping partner. The managing partner handles the business, and limited partners are bound from actively partaking in business’s operations.
General Partnership: The most common type of partnership is a general partnership that allows two or more partners to invest and operate a business mutually. Both the partners are also equally liable and eligible for profits and losses.
What is Better Among Both Structures?
In essence, there is no comparison of the two through which one can be regarded as superior over the other. Businesses throughout the United States must weigh in on their business model, operations, hierarchy, and the functional aspects of running a business. It is for a business owner to decide which type of entity they want to form. However, by hiring a reliable consultant, credible guidance can be acquired on which entity a business should choose.
Similarities and Differences
To make things simpler, here is a list of key similarities and differences between the two business structures. Although there are similarities, the difference between the two business structures is worth keeping in mind when deciding which type of business you want to choose for yourself.
Both sole proprietorship and partnership businesses are not mandated by the government laws to register the business. That means both these business entities do not require paperwork and documentation at the government level. However, it is a good idea to document the terms and conditions of the partnership through a partnership agreement to avoid any foul play in the future.
Both the business structures make the owner or owners personally liable to the business’s financial matters. That means if the business goes bankrupt, a creditor may go after personal assets such as a car, home and property of the single owner of a proprietorship or multiple owners of a partnership owned business.
Whether you are a sole proprietor or co-own a business with a partner, the taxes for your business will be paid from your personal tax ID. Both sole proprietorship and partnership are termed “pass-through entities,” meaning that the business’s earnings pass through to the owners, who are then liable to pay taxes on the business’s behalf.
In the case of a sole proprietary, your business’s profits and loss will be accounted for within your personal taxes, and you will pay accordingly. For a partnership owned business, the multiple partners would reflect their earnings, profits and losses in their personal tax record and file it as their income.
To ensure that accounting and tax matters are diligently dealt with, and no discrepancy on personal or business tax is shown, it is wise to get help from a certified tax specialist.
A proprietor is the whole sole owner of a business, and every decision is made with their discretion. Although some state laws allow spouses to co-own a proprietary business, the decision making power in a single owner business lies with the very individual who runs the business. This means that a partnership takes away the autonomous power from the individual, and decisions become a mutual consultation matter amongst the partners.
The same goes for operations and management of the business run and managed by multiple stakeholders. Ideally, this is an efficient method of doing business with each individual assigned a specific managerial task as per their expertise. In less ideal situations, this can become a nightmare for businesses if the partners do not draw a framework to follow for management and operations.
As mentioned earlier, a partnership business makes all the partners equally liable to the business’s losses. However, this also means a mutual liability as all partners are liable for a partner’s actions, taken on behalf of or within the means of the business.
For example, if a partner is found guilty of transporting narcotics in a company-owned vehicle, all partners can be charged and tried with the possession of narcotics. Similarly, if a partner is involved in money laundering, vandalism, or misdemeanors, all the co-owners are prone to be held accountable for one individual’s actions.
Division of Assets and Profits
As is the case with liabilities and losses, a partnership divides the assets and profits of the business as well. In some cases, both the partners invest equal capital together to initiate a business and thus mutually own the return on investment. In other cases, a partnership ratio is 60/40 or 70/30, making one partner eligible for a higher share of the profit than the other.
A framework about these details should be drafted at the start of a partnership to make sure that the partners have clarity regarding the distribution of profit and assets. You can also outsource the management of financial records to bookkeeping services to ensure transparency.
Advantages of Sole Proprietorship
Both sole proprietorship and partnership businesses indeed have their own set of advantages and disadvantages, but for any business to thrive, it is essential to fully divulge in details and make informed decisions.
The first and foremost upside of a proprietorship is the autonomy that comes with it. This means that the sole owner is neither accountable nor answerable to anyone for their decisions for the company. This also means that there’s a minimal chance of conflict within the organization.
Often in businesses, a leak of important secrets turns out to be detrimental for the business’s wellbeing. Sole owners, however, don’t have to worry about secrecy as they are responsible for sharing any information of value with anyone other than themselves.
No documentation, no registration, no paperwork. Forming a sole proprietorship is the simplest way of starting a business and requires no additional legal procedures. However, it is essential for business owners to acquire the required permits and licenses if the State law mandates it for the industry they are stepping into.
As a sole owner of a business, you have the authority to decide when to take days off, when to go on vacations, or how to go about employee’s remunerations and policies. This benefit of sole proprietorship goes away the moment a business becomes a partnership, and multiple people call the shots. The freedom and convenience of a sole proprietorship is unmatched in other business structures.
Disadvantages of Sole Proprietorship
Like everything else, the prospect of freedom, simplicity and autonomy in sole proprietorship comes with its fair share of downsides. Here’s a list of disadvantages you need to consider before opting for this business structure.
If a single individual owns a business, it solely relies on that individual’s life and wellbeing. Such a business’s future will be uncertain if something happens to the owner. In a partnership, the business can continue to run after the death of a partner and the family of a deceased partner can either withdraw investment or receive profits from the ongoing business.
A sole proprietorship makes the owner the sole bearer of the liabilities and losses. This poses a higher risk in contrast to a divided or limited risk per se in a partnership. By forming a partnership, all partners can minimize risks by mutually designating assets and savings for the business from each partner’s personal assets.
More people mean more money on the table, meaning more money to fuel the growth of a business. Sole proprietors often fail to achieve success due to limited resources and investment. While some look up to creditors for assistance, many hesitate to borrow money against an uncertain and risky business. This prevents small sole proprietary businesses from growing into large scale businesses.
Advantages of Partnership
In essence, most benefits that sole proprietorship offers are eliminated in a partnership structure and become disadvantages. However, there are some advantages that only come from a partnership and do not necessarily mean a disadvantage for the opposite model.
The same way a barber isn’t meant to mow the lawn and a fashion designer doesn’t know how to weave a fabric; each individual brings their own set of expertise to the business. If a partnership is formed, an efficient working order can be formed through which the business’s operations improve and translate into a better customer experience.
Across the US, there are many mom and pop shops which never grow into large supermarket chains. This is because of the lack of branding by the two people who can only run day-to-day operations. By opting for a partnership, one can include branding and marketing of the business in the plan and help the business grow larger than a small-scale startup. Maybe, one of the partners suggests a business idea, and over the years, it transforms into an industry standard.
As discussed, a sole proprietorship makes the single owner vulnerable to all risks and losses. This is also true when it comes to managing the workload, which sometimes becomes quite hectic. By having partners on board, your business has multiple resources to rely on, and one person is not meant to do it all and burnout. This also allows partners to take breaks without worrying about the business’s discontinuation, as the other partners keep the company running efficiently.
Which Structure Should You Opt for?
Depending on your business size, needs and model, you can decide what kind of business entity you should form. If you are ambitious and keen on turning your small scale business into a large conglomerate, then opting for a partnership model is a great idea to kick start your venture. However, if your vision is to efficiently operate a small business with the flexibility and liberty a sole proprietorship offers, then that’s well to float your boat.
In case you are looking for guidance regarding business formation and which entity to choose from, you can reach out to us, at Advance Tax Defense and Accounting, in West Palm Beach, Florida. We are a consultancy firm that assists small businesses and large enterprises with entity selection, bookkeeping, payroll management as well as taxation.