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Partnership or Proprietorship: Which One Is Right for Your Small Business Endeavors?

One of the biggest decisions for an entrepreneur is whether to take the journey alone or to team up with a partner. As with any business decision, both paths have their own risks and rewards.

The Basics

A proprietorship is by definition a single business owner. The proprietor can hire employees and managers to run the business, but ultimately, the proprietor has final say in any decisions and owns all of the profits.

A partnership is a business consisting of two or more owners. Each partner gets an equal vote in business decisions and an equal share of the profits unless the partnership agreement says otherwise.

Business Strategy

Most proprietorships start out as a single person with an idea. The proprietor invests their own time and money into turning the idea into a profitable business. Sole proprietorships are best when the proprietor wants to remain 100 percent in charge and keep all of the profits.

The downside to a proprietorship is that it's harder for a single person to grow a business on their own. They might lack the time, expertise or money to quickly grow the business. Not having a second opinion on important decisions can potentially lead to poor decisions.

Partnerships allow people with a shared idea to team up or a proprietor to bring in someone who has needed time, expertise or money. Even though the profits are split, a strong partnership may be able to grow much larger than a proprietorship. While partnerships risk disagreements over key business decision, careful selection of partners and a strong partnership agreement can overcome this disadvantage.

Legal Structure

Most proprietorships are unregistered businesses with no special legal structure. Any profits earned by the business are earned by the owner, and any debts owed by the business are also owed by the owner. For added legal protection, many sole proprietors consider converting to a single-owner corporation or LLC.

Partnerships are similar to proprietorships in that the partners have rights to their share of the profits and are each personally responsible for the partnership's debts. Partnerships also have the option of converting to a corporation or LLC. There are also two special kinds of partnerships.

  • Limited partnerships protect partners who don't actively run the business (i.e., passive investors) from being personally responsible for partnership debts.
  • Limited liability partnerships establish a separate business entity similar to a corporation or LLC. All partners have limited personal liability for partnership debts as long as certain conditions are met.

Taxes

Both proprietorship and partnership income is taxed as individual income. There is no business income tax. Instead, a proprietor pays state and federal income taxes on the net profit of the proprietorship. Similarly, each partner pays state and federal income taxes on their share of the partnership's net profit.

In addition to income taxes, proprietors and partners pay self-employment taxes on their share of the profits. Limited partners who do not actively participate in operating the partnership do not pay this tax.

Corporations and LLCs have a different tax structure that may reduce the proprietor's or partner's personal taxes. However, the corporation or LLC may have to pay separate business income taxes in what's known as double taxation.

Raising Capital

Proprietors have three options for raising capital.

A sole proprietorship cannot sell shares of ownership without changing to a different form of business.

Partners have the same options as a proprietorship plus they can sell shares of ownership. This requires the partners to agree to give up a portion of their share to the new partner in exchange for the new partner's investment.

Paperwork

Unlike corporations and LLCs, proprietorships and partnerships generally don't need to file special paperwork with the state. However, there are a few exceptions:

  • If you do business under a name other than your own (e.g., "Anytown Plumbing" instead of "John Smith"), you need to file a fictitious name registration. This lets the government know who owns the business.
  • Your specific business activity may require a license from the state or local government.

Partnerships may need to file a business registration if they are a:

  • Limited partnership
  • Limited liability partnership
  • General partnership with unequal ownership or voting rights
  • Special type of partnership as provided under state law. This is often required for certain professions such as doctors and lawyers.

If a proprietor or partnership needs to register its name, acquire a license or file a business registration, it will often need to file a renewal form each year and pay an additional fee.

Requirements vary widely by state, so be sure to check with a local lawyer.

Changing the Form of Business

As a business grows, it may be a wise move to convert to an LLC, corporation or other form of business for tax benefits. This can help add personal liability protection or make it easier to bring in new investors.

A proprietor can make this decision at any time just like any other business decisions. In a partnership, the partners would decide by a majority vote unless the partnership agreement specifies otherwise.

Making the Decision

When deciding whether a proprietorship or partnership is right for you, evaluate how the pros and cons of each form match up with your own business goals. It's also a good idea to set up a meeting with your legal and financial advisors to help you make an informed decision.

 


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