In this four-part series, we'll examine the different ways to structure your small business, comparing the various advantages and disadvantages of each

 

Part I - Sole Proprietorship/General Partnership

 


by Reed Richardson

The first and most common small business structure that many entrepreneurs choose is a sole proprietorship. This is the simplest and cheapest way to start a business and involves little more than hanging out your shingle and paying a few nominal fees to obtain a business or retail sales tax license. (A state-by-state list of business licensing agencies can be found at http://business.gov/register/licenses-and-permits .) For single-person start-ups, sole proprietorships remain quite popular and some businesses continue to maintain this structure even after they've hired staff and begun to bring in millions of dollars in annual revenue.

As for the advantages of a sole proprietorship, there are several:

Operations - Sole proprietorships don't require entrepreneurs to set up any complex organizational rules or governing bylaws as to how the business will be run. You can simply make decisions as you normally would since all the power and responsibility rests with you, the owner. From a legal perspective, the owner and the business are considered the "same entity" and for many entrepreneurs, who typically start their businesses because they didn't like taking orders from someone else, the ability to take their company in any direction they want is one of the primary advantages.

Tax - Filing taxes becomes much simpler in a sole proprietorship structure as well. All business revenues, expenses, and profits are recorded on a simple two-page 1040 Schedule C form. (For a list of potential IRS forms needed, go to http://irs.gov/businesses/small/index.html.) With a more straightforward filing come tax time, sole proprietorships often choose a correspondingly simple and less expensive accounting process. In addition to saving time and money in terms of filing, sole proprietorships also offer a couple of important tax breaks when it comes to family members.

The first of these involves employing a sole proprietor's minor children. It's a little-known fact that they can be hired without triggering any payroll taxes. In fact, this tax break is something of a win-win, as your children do not have to pay any income taxes on earnings of up to $5,000 a year, while you can save your business up to $2,000 a year on self-employment and income taxes if you pay your children that salary out of your business's profits.

Health Benefits - The other important benefit of sole proprietorships deals with health benefits, specifically health reimbursement accounts (HRAs). HRAs are employer-sponsored plans that pay back employees for medical expenses as well as health insurance deductibles and co-payments. Normally, sole proprietors, like general partners, and S-Corporation shareholders, are prohibited from participating in HRAs. However, if the sole proprietor's spouse is a legitimate employee of the business, he or she can participate in an HRA and, thanks to a loophole in the tax code, such coverage can include that person's dependents and spouse, who just so happens to be the business's sole proprietor. So by doing this, a married sole proprietor can reap the health insurance benefits of an HRA as well as claim the expenses of both self-employment and income tax deductions, potentially saving thousands of dollars a year. (For more on the potential savings of using this HRA tax loophole, check out this discussion on the TaxTalk section of the National Association of the Self Employed website: http://nase.org/knowledgecenter/myconsultants/taxtalk/10-05-25/Tax_Deductions_and_Hiring_Your_Spouse.aspx .)

 

Sole proprietorships do have some notable downsides, however. These disadvantages are particularly important if an entrepreneur has concerns about losing his or her personal assets in the venture or if in the future he or she might want to raise significant amounts of outside capital to grow the business.

 


Personal Liability - One of the major disadvantages of sole proprietorships is that they do not protect the owner from personal liability. So, if a business incurs large operating expenses or faces a lawsuit settlement that cannot be paid, the sole proprietor's personal assets-home, car, personal savings, etc.-can be targeted by creditors to pay off the debts. This represents a significant risk on the part of a sole proprietor and, as a result, has led to the rise of two other business entities-limited liability partnerships (LLPs) and limited liability companies (LLCs)-that legally shield the personal assets of entrepreneurs from business debts. (For a more in-depth explanation of the legal liability issues involved with sole proprietorships, check out http://smallbusiness.findlaw.com/business-structures/sole-proprietorship/sole-proprietorship-basics.html .)

Raising Capital/Adding Partners - Sole proprietorships tend to rely heavily on outside loans (debt-based funding) or the personal assets of the owner for capital. For start-up entrepreneurs who are seeking to raise significant amounts of capital through equity funding, however, it is often difficult to keep sole proprietor status. That's because most equity partners will require some sort of ownership stake or power-sharing arrangement if they are making a significant investment. To accommodate these changes, it is a good idea to have a lawyer draw up a partnership agreement that spells out the new terms and responsibilities of the business partners.

 

To keep things simple, the new business owners can opt for forming another type of structure called a general partnership, which is similar in many ways to a sole proprietorship. In general partnerships, very few company bylaws and financial documents are needed since most state laws assume that the stakes are evenly divided among each partner, unless otherwise specified. In addition, the business is typically not taxed as a separate entity and all gains and losses are routed directly through to the individual partners' personal tax returns, similar to how sole proprietorships treat profits. And because payroll isn't required for general partnerships if a company consists entirely of partners and has no employees, the paperwork requirements are often much simpler than that of a corporation.
However, general partnerships suffer from the same liability risks as sole proprietorships since the partners remain jointly and individually liable for any debts or judgments against the company. Also, many state laws mandate that if any one of the partners leaves or dies, the business partnership-just as with a sole proprietorship-immediately dissolves, which can make succession planning more difficult and legally tenuous. For this reason, equity lenders tend to seek out small businesses that are structured as LLPs/LLCs or those that have already incorporated.

Be sure to come back next week for Part II in our business organization series, which deals with the pros and cons of the LLC structure.