One of the most important decisions you will make when setting up your accounting practice is deciding what kind of legal structure your company will be. Are you a sole proprietor or do you have a partner? Do you need to incorporate?
To help you choose the right legal structure for your accounting practice, or to clear up whether the status you have now is the best one for your firm, below is an explanation of each legal structure for businesses.
Differences Between Sole Proprietorship, Partnership, & Corporation
There are several options from which to choose when selecting a structure for your business. A sole proprietorship is an unincorporated entity that does not exist apart from its sole owner . A partnership is two or more people agreeing to operate a business for profit. A corporation is a legal entity -- a "person" in the eyes of the law -- existing separate and apart from its owners. Ease of formation, management, protection from personal liability and taxation are some factors business owners should consider in choosing a business structure.
There are no formalities involved in creating a sole proprietorship that will operate under the owner's name, other than obtaining licenses or permits related to the trade or profession of the owner. For example, a plumber or electrician might have to obtain a license. An in-home day care provider might need to meet certain inspection requirements. A sole proprietor using fictitious name for the business must file an assumed name certificate with the state or local government. The sole proprietor has exclusive control over management decisions and operations, reports all profits and losses on her personal income tax return and is personally liable for business debts and obligations. When the sole proprietor dies or stops doing business, the company no longer exists.
Two or more people agreeing verbally or in writing to operate a business for profit constitutes a general partnership. If a general partnership operates under a fictitious name, the partners must register it with the state or local government. Each partner has the right to participate in the management of the business and to share equally in profits and losses, however, partners may agree in writing to an unequal allocation of management control and profits and losses. Partners and sole proprietors have the same exposure to personal liability. A creditor of the partnership sues the partners individually and, if successful, may collect from the personal assets of any or all of the partners. Also, like a sole proprietorship, each partner reports his share of business profits and losses on his personal tax return. Absent a partnership agreement that states otherwise, the partnership will end if one partner withdraws or dies.
A general partner signing a partnership agreement and filing a certificate of limited partnership with the state forms a limited partnership. Unlike a general partnership that has only one class of partners, limited partnerships have at least one general partner and one or more limited partners. As in a general partnership, limited and general partners share profits and losses that they then report on their personal income tax returns. The advantage for a limited partner is that unlike general partners, a limited partner’s liability is restricted to the money she invested in the business and does not extend to her personal assets as long as she does not participate in management of the business.
A corporation is created by filing articles of incorporation with the state in which the company will be doing business. The filed articles contain information about the new corporation including its street address, the number of shares of stock the corporation may issue and the type of business it will conduct. Corporations are owned by shareholders who do not participate in their management or operation, and instead elect a board of directors to handle management responsibilities. Officers, such as a president and vice-president, are appointed by the board to oversee day-to-day operations. It is common for a small corporation to have only one shareholder who is the sole officer and director. Corporations are legal entities separate and apart from the shareholders, so they can sue and be sued in their own name. This protects the personal assets of the shareholders from liability for corporate obligations and debts. The death or withdrawal of a shareholder will not end the company's existence.
Corporations pay taxes on their profits. If they then distribute those profits to shareholders in the form of dividends, the shareholders pay taxes on that income as well. Corporations that meet certain IRS requirements, including having no more than 100 shareholders, can file for S corporation status which allows them to pass income and losses through to the shareholders, similar to a partnership, while allowing them the limited liability of a corporation.