A sole proprietorship business is the most basic form of carrying on business. It is not a business entity in itself. The business activity is considered one in the same with the entrepreneur. A general partnership (or “partnership”, as it is commonly called), in contrast, is a formally-recognized, business entity.
In this article, we discuss the primary characteristics of each form of business and compare their differences. The points of comparison include formation, ownership, control, personal liability, compensation, and taxation.
Forming a Sole Proprietorship and General Partnership
A sole proprietorship business arises when a single individual carries on any type of commercial activity with the purpose of generating a profit or loss. In this way, an individual may form a business without even realizing that she has done so. A general partnership arises similarly to the sole proprietorship business. The difference is that a general partnership requires two or more individuals carrying on a commercial activity together for an intended profit or loss. The individuals must share the profits in some percentage. For example, if one of the individuals receives the profits, while the other individual receives an assured amount or hourly wage, then there is no partnership. This would be considered a sole proprietorship business with the second individual acting as an employee. Again, the general partners may not even realize that they have formed a business. The general partnership arises by default. Like the sole proprietorship business, there is no filing or registration requirements for general partnership to exist.
Who Owns a Sole Proprietorship Business and General Partnership?
As previously stated, a sole proprietorship business is one in the same with the individual who organizes or initiates the commercial activity. If the sole proprietor business grants and ownership interest to anyone else (either intentionally or inadvertently), the sole proprietorship business would convert into a general partnership. For example, if the sole proprietor agreed to share profits with anyone, this would likely constitute sharing an ownership interest.
A general partnership is owned by the general partners. As discussed, the general partnership consists of two or more individuals carrying on a commercial activity with the intention of sharing profits or losses. It does not matter the percentage ownership of each partner. One partner could own 99% of the business, while another partner owns 1%. The business is still a general partnership. The partners often lay out the percentage of ownership in a business partnership agreement. When you form a business, and the partners carry on business without specifically outline the percentage ownership of each partner, then the default rule is equal ownership.
Who Controls a Sole Proprietorship and General Partnership?
The sole proprietor controls all activity of the sole proprietorship business. Even if employees carry on all of the commercial activity, the sole proprietor still retains complete control. The same applies to the partners is a general partnership. When you form a business, the partners often establish the authority of the partners in the business partnership agreement. If no specific authority is outlined, the default rule is that all partners have equal control of the partnership – regardless of the percentage of ownership. When a partner is dealing with third parties, she has the apparent authority to act on behalf of the partnership in any fashion, regardless of what limitations exist in the business partnership agreement. This only changes when third parties specifically have notice of the partner’s limited authority.
Are Owners of Sole Proprietorship Business and General Partnership Personally Liable?
The major downside of carrying on as a sole proprietorship business or general partnership regards the personal liability of the owners for the debts or obligations of the business. Both forms of business, the sole proprietorship business and general partnership may incur debts as part of operations. A particularly scary debt is the potential liability resulting from a legal actions against the business. If the business becomes subject to any debt, the sole proprietor or general partners are personally responsible for that debt. So, if the business becomes subject to collections and is not able to pay the debt, the creditor can go after the personal assets of the owners. This applies regardless of the percentage ownership interest of general partners. When you form a business, the only thing the sole proprietor or general partners can do to limit their personal liability exposure is to purchase business insurance.
It is worth noting that other forms of business entity, such as a limited liability company and a corporation offer personal liability protections to the business owners.
How Are Owners and Employees of a Sole Proprietorship and General Partnership Compensated and Taxed?
Profits or losses of the sole proprietorship and general partnership flow directly through the business entity to the owners. The owners do not receive a salary. They receive a draw from company earnings. The sole proprietor will report the business operations (revenue and expenses, profits and losses) on her personal income tax return. The calculation of profits and losses from the revenues and expenses are calculated in a schedule to the form 1040. The general partnership must file its own tax return in which it calculates revenues and expenses. This is just an informational return, as the partnership does not pay taxes itself. The partnership then prepares forms K-1 to disburse to the partners. This form identifies the percentage of profits or losses to which the partners are entitled. The partners report this amount on their personal income tax returns.
LawTrades Knows Business Entities
Selecting the appropriate business entity through which to carry on business is an extremely important decision. Don’t organize your business partnership agreement without first understanding the characteristics of a business entity that could affect many aspects of operations. Let the legal professionals at LawTrades help you form a business. They are experienced experts who can provide the advice and guidance that you need.