Many small business owners face a tough decision when starting a business. Will they start the business all on their own, or will they seek others to help in their venture? This ultimately comes down to whether they want to pursue a sole proprietorship or a partnership. In this article, we are going to dive into each of these classifications and discuss the good and the bad aspects of both.
What is a Sole Proprietorship?
A sole proprietorship is a one-person business that, unlike partnerships and other more complex business structures (corporations and LLCs), doesn’t have to register with the state in order to exist. If you are the sole owner of a business, you become a sole proprietor simply by conducting business.
Sole proprietorships are some of the most common forms of small businesses, mainly due to the numerous benefits they provide. Firstly, it is by far the easiest type of business to start, since most states do not require sole proprietors to register their business with their Secretary of State. There are also fewer regulations about having a board of directors (since it will just be you) and recorded meetings. Another obvious bonus is that you have no one to answer to but yourself, having the ability to set your own work schedule and routine. You also don’t have to share your profits with anyone (unless you hire employees, of course).
This sounds like a pretty sweet deal, but there are some downsides to a sole proprietorship. The biggest problem with sole proprietorships is that the business owner’s personal financials are tied directly to the business. This means that if the business goes bankrupt, so does the business owner. This makes a sole proprietorship a bit riskier. Along the same lines, any lawsuit brought against your business is also brought to you personally (meaning you are responsible for all the fees and costs associated with litigation). Sole proprietorships are also responsible for paying both income taxes and a self-employment tax (for Social Security and Medicare) on all profits of the business. This means that as the business becomes more profitable, you will end up owing even more in taxes.
What is a Partnership?
A partnership is a kind of business legal structure formed by the agreement between two or more individuals to carry on a business. Each partner is a co-owner, and each has invested in the business. A partnership, as different from a corporation is not a separate entity from the individual owners. In that sense, it’s more similar to a sole proprietorship because in both the business isn’t separate from the owners, for liability purposes. Also, don’t forget that are many types of structures under the umbrella of partnerships.
Learn here all the types of legal structures for businesses.
There are a lot of positives in most partnerships. While partnerships do have to pay taxes on any profits earned, the owners are not separately taxed for being self-employed. Partnerships can also be very fruitful due to the added knowledge, skills, and experience each partner can provide. Lastly, although they are harder to setup than sole proprietorships, partnerships are usually very easy to begin.
The downsides of a partnership should still be considered, however. One of the worst parts of a partnership is that you can possibly be held liable for something someone else has done. If someone sues a partner individually the other partner may not be brought in on the lawsuit, but if the sued partner cannot pay the full amount owed, the courts can take assets of the partner not involved in the lawsuit. There can also be some incredibly tricky situations that arise when one partner wants to dissolve the business and the others don’t. While you may not pay as many taxes in a partnership, you are still legally and somewhat financially tied to your partner(s).
Below is a breakdown of the pros and cons of each type of legal structure:
Full profits for owner
|No Self-Employment Taxes|
Financial dependence on partners
How do you establish a sole proprietorship or a partnership?
There aren’t complicated start-up requirements for establishing a sole proprietorship. You don’t have to take any formal or legal steps at the federal, state, or local level. However, there may be local registration, business license, or permit laws you need to comply with to make your business legitimate. All these may differ depending on your estate. You will need to contact your nearest Small Business Development Center (SBDC) to ask for those specific requirements. You can use this SBDC locator provided by the Small Business Administration.
It’s also recommended to file a trade name (a fictitious name), also known as DBA (“Doing Business As”). A DBA will allow to legally do business under that name instead of your personal name. Find out here if you need a DBA for your business. These days registering a DBA is easier than ever: you can do it online using LegalZoom.
Lastly, you also need to know about your income tax and business debt obligations because as a sole proprietor you are personally responsible for paying these debts.
The process is more complicated than in a sole proprietorship. These are the steps to follow:
- Register the business
You need to register your business with your state before it starts operating. This is usually done through your local Secretary of State office.
- Establish the business name
The business’s legal name is either the name given on your partnership agreement or the last names of the partners. If you’d like to operate under a name other than the business’s legal name, you’ll need to register a DBA (same as in a sole proprietorship).
- Obtain licenses and permits
The regulations for licenses and permits vary by industry, state, and locality.
- Create a partnership agreement
This is not legally required, but it’s safer to have one. Discuss with your partner(s) how decisions will be made, how partners will divide profits, how you will resolve disputes, how to change ownership, and how to dissolve the partnership if the situation arises.
How do you dissolve a sole proprietorship or a partnership?
You must notify the IRS as well as state and local tax authorities that you no longer operate the business. Also, keep records of final tax forms and close business accounts so interest does not continue to accrue.
Your partnership agreement should include a dissolution clause or terms of dissolution; this document may include specific dissolution procedures to be followed by the partners for specified circumstances.
In addition to your partnership agreement, you’ll need to check your state business laws, as the dissolution of partnerships is governed by state law. Your state’s Secretary of State office or website should provide information regarding the process that applies to a partnership dissolution (fees, forms, etc.)
Lastly, You’ll be required to file a statement of dissolution (in some states this is called a certificate of cancellation) with your state. It can take up to 90 days from the date you file the statement of dissolution for your partnership to be dissolved.
How do you file taxes as a sole proprietorship or as a partnership?
As a sole proprietor, you must report all business income or losses on your personal income tax return; the business itself is not taxed separately. The IRS calls this “pass-through” taxation because business profits pass through the business to be taxed on your personal tax return.
As a business, a partnership does not pay income tax. A partnership is also a “pass-through” entity: Profits and losses are passed through to the partners, who are responsible for including their share of the income on their personal tax return. However, partnerships do need to file an annual information return (Form 1065) to report income, deductions, gains, and losses for the business.
How do you get a business loan as a sole proprietorship or as a partnership?
For sole proprietors, usually, it’s easier to get a personal loan rather than a business loan. You can use a personal loan for eligible business purposes. To get approved, lenders will mainly base their decision on your personal credit history and income. Have in mind that the amounts in personal loans usually aren’t very high.
If you need more funds, you can also try to get a business loan. In this case, proof of DBA registration will be required. Have in mind that the business loan requirements vary from lender to lender, as well as the type of documents you’ll have to provide. While getting a business loan as a sole proprietorship may look like a daunting task if you turn to traditional banks, there are also more viable alternatives. Camino Financial is an alternative lender who provides small business loans to sole proprietorships. Their requirements are less strict than those in traditional banks and their process is fast and easy.
Again, the requirements will depend on your lender and the type of loan you need. But something will remain the same no matter what lender you approach: you’ll have to provide proof of how your business is structured. We have seen in the previous section that you’ll need proof of DBA registration; the case of a partnership, you’ll need to provide your business partnership agreement. This helps to establish your ownership of the business. Remember that your lender would like to be sure that they are dealing with the correct person when they are in the process of appraising your loan application.
The table below shows a breakdown at a glance of the features explained above:
How do you convert a sole proprietorship into a partnership?
If you are a sole proprietor of a business and have decided to share ownership with another party, you can convert the proprietorship into a partnership. One key document separates a sole proprietorship from a partnership: the partnership agreement, as we have seen above. All proposed owners must contribute to and agree with this document to form an official partnership. You should discuss, among others, includes the ownership percentage split (such as 60-40 or 70-30), partner responsibilities, investment from the new partner, if any, and the process of handling disputes. You must both agree on all points to form the partnership. Then, follow the steps indicated above to form a partnership.
To learn more on the subject, read the article Is it time to convert your sole proprietorship to a corporation or LLC?
If you have a sole proprietorship or a partnership and your business needs a cash infusion, consider taking a loan from Camino Financial. We are more flexible than traditional lenders when it comes to our requirements: mainly, we take into consideration the personal credit of the business owner and global cash flows. Among other benefits, Camino Financial is open to extending finance to borrowers with bad credit, and you don’t have to provide us with collateral.
These are the only documents we require from you:
- Your online application
- Last year of tax returns with reported business income (remember that you have to report taxes regardless of the legal structure of your business!)
- Proof of business registration (DBA registration or partnership agreement depending on your type of business, as seen above)
All you have to do to start is submitting your loan application. It will take only a few minutes, and you will receive an instant response informing you if you have been prequalified. Subsequently, one of our representatives will get in touch with you and guide you through the borrowing process.