Differences Between Sole Proprietorship, Partnership & Corporation

Choosing the right legal structure for your new business is an important decision you must make early in the planning process. The type of legal structure you select will affect your ability to raise capital, your liability for taxes and your protection from lawsuits. Your main business entity options are sole proprietorship and the variations of partnerships and corporations.

A sole proprietorship is the easiest entity to form because it is not a legal entity and requires no paperwork. It has no separate existence apart from the owner. Legally, the business and the owner are the same. There are no costs required to set up a sole proprietorship except for usual business licenses required of all businesses. When tax time comes, your business income and losses are declared on your personal tax return. You are also personally liable for the debts of your business. If your business is sued, regardless of reason, you are personally liable for judgments against the business. The sole proprietorship works best when there's only one owner. It is inappropriate if you plan to raise capital for the business by taking on partners or investors.

The Internal Revenue Service recognizes several types of partnerships for tax purposes. General and limited partnerships are the two most common. In general partnerships, each general partner has unlimited personal liability for partnership debts and shares management of the business. Limited partnerships have both general and limited partners. Limited partners are usually passive investors who are not actively involved in the business. Their personal liability is limited to the amount of capital they invested in the partnership. Profits and losses are distributed among the partners on a proportionate basis. They, in turn, report their share of the profits and losses on their personal tax returns.

Corporations are separate legal entities created under state law with legal rights and liabilities detached from the corporation owners. They can enter into legal contracts. They can sue and be sued. The corporate structure facilitates raising capital by selling shares of stock to investors. Shareholders are usually protected from the financial and legal liabilities of the corporation. However, major creditors typically require personal guarantees from owners of small-business corporations. The two most common types of corporations recognized by the IRS are C corporations and S corporations. C corporations pay taxes on profits. If profits are distributed to shareholders, shareholders must declare the dividend income on their personal taxes. The IRS allows S corporations to pass profit and losses to shareholders. As with partnerships, shareholders report income and losses on their personal tax returns.

Each of the major business entities has advantages and disadvantages in terms of legal, financial and management issues that will affect the long-term viability of your business. It's recommended that you obtain competent advisers to help you weigh the pros and cons of each business entity to select the most appropriate structure to help rather than hinder your long-term success.