Back to the Basics: Choosing the Right Entity For Your New Business: Part 1: Sole Proprietorships and Partnerships
There are many considerations when you start a business: refining your products and services, developing your sales and marketing strategies to attract customers, securing a lease, and hiring employees. Because it can directly affect the other aspects of your business formation, one of the most important first steps in forming a business is organizing the business using the proper legal entity. To help you understand the issues and help you choose the right type of entity for your new business, we will discuss the various business types, including their pros and cons. Today’s post will cover sole proprietorships and partnerships, our next post will cover LLCs and corporations, and our final post will consider limited liability partnerships.
The Sole Proprietor
A sole proprietorship is a business owned and controlled by a single individual or, in Washington, a married couple. The upside of this entity is that it is easy to form and operate. The downside is that sole proprietors are personally liable for the debts of and claims against their business. If something goes awry with a customer of the business, if the business defaults on a contract, or if the business’ negligence or acts cause damage to another, the sole proprietor’s personal assets (including personal bank accounts, cars, home, etc.) are at risk.
It doesn’t take anything formal to set-up a sole proprietorship. Basically, if you are doing business and your business is not one of the other types of entities, then your business is a sole proprietorship and your personal assets are at risk. Anytime you are doing business in Washington, you are required to obtain a master business license from the Department of Revenue, as well as obtain any necessary local business licenses. Sole proprietors must report their business income and expenses on their individual tax returns.
A sole proprietorship may make sense if you have few personal assets or lack the capital to operate a limited liability. However, in most cases it makes sense to choose a different type of entity to help limit your liability.
The General Partnership
The legal definition of a general partnership is “an association of two or more individuals to carry on as co-owners a business for a profit.” In other words, anytime more than one person joins together to execute an idea with the intent of making money, it’s a partnership. So when your child and his friend decide to run a lemonade stand on the corner, they have likely formed a partnership. It may be helpful to think of a partnership as two sole proprietorships joining together, or as a “multiple proprietorship.”
No formal paperwork is required to form a general partnership. In fact, many partnerships are formed accidentally or without the intent of the partners. Once formed, each partner is an agent of the partnership for purposes of its business, which means that each partner’s actions while carrying on the partnership’s business will generally bind the partnership. Each partner has a right to share the profits and losses and a right to participate in the management of the business. Additionally, each partner is jointly and severally liable for all debts and obligations of the partnership—in other words, if something goes wrong, each partner will be liable for the full amount of damages that result.
The partnership form was once popular, but is generally disfavored because it can be incredibly risky. Practically speaking, when you form a partnership (absent agreement otherwise) you give any and all of your partners the ability to bind you (via the partnership) to obligations without your explicit consent. Perhaps more importantly, if the partnership defaults on its obligations, your personal assets are at risk even if you didn’t necessarily participate in the decision making or explicitly agree to be bound.
Formal partnership terms are usually contained in a written partnership agreement; however, a written partnership agreement is not required (though we always advise drafting one). Again, anytime you are doing business in Washington, you are required to obtain a master business license from the Department of Revenue, as well as obtain any necessary local business licenses. Partnerships must file an annual “information return” with the IRS, and the individual partners must report their business income and expenses on their individual tax returns.
A sole proprietorship or partnership may be the right entity for your business, but it is unlikely. Both forms do not limit the owners’ liability. And limiting liability is an important consideration for all business owners. Though probably less important, operating your business as a sole proprietorship or partnership can also indicate to customers, vendors, suppliers, contractors, etc. that your business isn’t “as serious” as one with LLC, Inc., etc. attached to the name. Particularly if you are entering into contracts, have a “public” place of business, or have employees, you will likely want to choose a different type of entity.
Stay tuned for Part 2 of this post, which will include details about the two most popular entities for forming a business: the LLC and the corporation.
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