When there is more than one — a Partnership?

When there is more than one participant, you can’t be a sole proprietor.  That goes for husband and wife also, except in some special circumstances.  Like a sole proprietorship, a partnership is easy to form and without a lot of red tape.  You do need an agreement, which also makes good business sense!  The biggest downside is that you have unlimited liability not only for your actions, but for the actions of the other partners.

Partnerships are not taxed, but do have their own informational tax return — a form 1065.  The form 1065 reports the income and expenses for the partnership and divides the items among the partners based on the partnership agreement.  Each partner is given a K-1 with his/her share of the income/loss to be reported on various lines of their individual tax return.   The form 1065 can be quite complicated and should be prepared by a qualified tax preparer — another expense.  Partners pay self-employment tax on the income rather than being employees with a W-2.

Fringe benefits are generally not deductible for partners, and the options for fringe benefits and retirement plans are much the same as for sole-proprietors.

A partnership interest can be transferred and continue after the demise of a partner depending on the partnership agreement.  Also, if an LLC is comprised of more than one member, a partnership is the default entity if no other choice is made.  More about this when we get to LLCs.

Sole Proprietorship – Oldie but a Goodie

Sole proprietorship isn’t as popular as in the old days — those days before LLC’s.  But as the LLC newness has worn off, people are taking another look at sole proprietorship.  More about it when we discuss the LLC, but some states (including KY) have established annual reporting requirements and annual fees associated with LLCs, including the single member variety.

The number one advantage to a sole propietorship is the ease and low cost of establishing.  Other than state and local registrations (and an EIN if you have employees), you just start doing business.  Also, it has the lowest administrative costs.  The business income is taxed to the owner on his or her individual tax return on a schedule C or if a farm, a schedule F.  No separate return to prepare.  The business owner is not an employee, and pays self-employment tax as opposed to social security/medicare tax.

The major disadvantage to a sole proprietorship is the unlimited liability (including business and personal assets) for debts and any lawsuits brought against the business.  Some risk can be covered by insurance, but depending on your situation,  you might be wise to discuss with an attorney.

Other disadvantages include, as the same implies, it can ONLY be you.  If you have a partner, then you can not be a sole proprietor.  In addition, It is difficult to transfer interest of a business where the owner is a sole proprietor.  Fringe benefits for the owner are generally not deductible.

For low cost and minimum red tape, it’s the sole proprietorship.

Choosing the “Right” Entity

Quite frequently, clients ask me, “What type of entity should I be?”  And my answer is always the same, “It depends.”

The type of entity that you choose to be affects each of these items:

  • Ease of formation
  • Taxation of income
  • Tax filing requirements
  • Administrative and legal costs
  • Fringe benefits available to you
  • Retirement plans available to you
  • Legal liability protection
  • Ease of selling all or a portion of an entity

And your choices are (I’ll cover each of these entity types in later posts):

  • Sole Proprietorship
  • Partnership
  • Regular Corporation
  • Sub-chapter S Corporation
  • Limited Liability Company (which then brings you to choosing one of the above)

To be better able to make a decision as you explore the different entities, here are some questions to ponder:

  • Is it just me or will others be involved in ownership of the business?
  • If there are losses, do I want to be able to take them against other income that I have?
  • Is the “cost” of set up crucial to me?
  • Do I have the funds, and is it important to be able to put a large part of the profit into a retirement plan?
  • What fringe benefits are important to me?  Am I being covered under another health insurance policy?
  • Will I have employees?
  • How capable am I with paperwork, or will I be hiring expertise?
  • Is passing the business on to future generations important to me?
  • Do I have plans or dreams to sell the business?
  • What are the possibilities of legal liability that can’t be covered by insurance?

The beginning is the time to clarify some of your intentions and choose the “right” entity.  Entities can be changed, and sometimes need to be changed.  But it’s so much smoother when you get it right the first time.