The non-entity
A sole proprietorship is the business of an individual who has decided not to carry his business as a separate legal entity, such as a corporation, partnership or limited liability company (LLC). This kind of business is not a separate entity, but any time a person regularly provides services for a fee, sells things at a flea market or engage in any business activity whose primary purpose is to make a profit, that person is a sole proprietor.
Furthermore, if s/he engages in business activity to make a profit or generate income, the IRS requires that the operator file a separate Schedule C (Profit or Loss From a Business) with his/her annual individual income tax returns. The Schedule C summarizes total income and expenses from particular sole proprietorship business.
As the sole proprietor of a business you have unlimited liability, meaning that if your business cannot pay all the liabilities it has incurred, those creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this, but it’s an enormous financial risk because if their sole proprietorship is sued for failure to pay its bills, they will be personally liable for the liabilities which the business would otherwise be responsible for if, for example, that business was some type of corporate or partnership entity.
Owner’s equity
A sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements in order to maintain a record of how his business is doing. Banks usually require financial statements from sole proprietors who apply for loans. A partnership needs to maintain a separate capital or ownership account for each partner; but the total profit from such a firm is allocated into capital accounts, as spelled out in the partnership agreement.
Although sole proprietors don’t have separate invested capital from retained earnings like corporations do, they still need to keep these two separate accounts for owner’s equity – not only to track the business – but for the benefit of any future buyers of that business. It is for this reason that some business owners choose to create partnerships or limited liability companies (LLCs) even though they are unwilling to go as far as a corporation.
The partnership
A partnership is often referred to as a firm, and is best described as an association of a group of individuals working together in a business or professional practice. While corporations have rigid rules about how they are structured, partnerships and limited liability companies allow the division of management authority, profit sharing and ownership rights among the owners to be very flexible.
Partnerships fall into two categories. The first is a General Partnership which is subject to unlimited liability, but if the business cannot pay its debts, creditors can demand payment from the general partners’ personal assets. General partners have the authority and responsibility to manage the business and serve in capacities similar to the officers of a corporation such as president, vice-president, treasurer and other such positions.
The LLC
Limited partners escape the unlimited liability that the general partners have because they are not responsible, as individuals, for the liabilities of the partnership. They members, some of whom are junior partners, with ownership rights to profits from the business, but they generally do not participate in the day-to-day or high-level management of the business. A partnership must have one or more general partners.
Limited liability companies are becoming more prevalent among smaller businesses. Think of an LLC as if it was a corporation in terms of the limited liability feature; but as a partnership in terms of the flexibility when dividing profit among the owners. The advantage of a LLC over other types of ownership is its flexibility in how profit and management authority are determined. This can have a downside in the sense that the owners must enter into very detailed agreements about how the profits and management responsibilities are divided. It can get very complicated and generally requires the services of a lawyer to draw up the agreement(s).
Not share-based entities
A partnership or LLC agreement specifies how profits will be divided among the owners. While stockholders of a corporation receive a share of profit that is directly related to how many shares they own, a partnership or LLC does not have to divide profit according to how much each partner invested. Invested capital consists only of those factors used in allocating and distributing profits.
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