Different Small Business Ownership Formats Have Pros, Cons

Many small businesses are formed each year in California, but more of these new firms fail than succeed – particularly in tough economic times.

Certainly an important component to running a successful small business is to determine what business form is most suitable for you and your venture. Here are some very basic pros and cons to operating your new business as a sole proprietorship, partnership, limited partnership and corporation.

• A sole proprietorship is probably the oldest and simplest way of doing business. This form of doing business is exactly what the term implies – an individual entrepreneur who engages in business for him or herself. The owner of a sole proprietorship business has the power or control over all decisions, such as who to hire, who to fire, what to sell and when to sell. A sole proprietor does not need the permission of anyone else to sell or close up shop.

A sole proprietorship is also personal responsible for all payments of the business’s debts, taxes, which includes the wages of all employees. Generally, anyone who works for a sole proprietor is an employee and also can be considered an agent of the owner or the principal.

If an employee, which is known as the agent, causes some wrongdoing or damage while in the course and scope of his or her employment, the owner or principal personally may be liable for the damages caused by that employee.

Sole proprietorships can be operated under a person’s own name or under a fictitious business name. Specific statements about the fictitious name must be filed and published in order to be valid.

• A partnership is a business that is owned by two or more people. A general partnership can be operated by oral or written agreement. However, a written agreement provides more specific and detailed operating rules and usually addresses such things as dividing profits and losses and what to do if a partner dies or leaves the business. A partnership can be set up so that the profits and losses are split on an equal basis or on another percentage that the partners agree upon.

Partnership agreements are advisable in order to custom-tailor the specific circumstances of your particular business.

If not otherwise agreed upon by law, the partners share equally in the profits as well as the losses of a business.

Each partner is personally liable for the debts and taxes of the partnership. If the assets of the partnership are not enough to satisfy the business’s debts, individual and personal assets of the partners can be used to satisfy any of those debts.

If a partnership is terminated, each partner is entitled to receive his share of the partnership property after all debts are paid. The biggest risk of partnership – specifically a general partnership – is that of unlimited partnership liability that an individual partner assumes when he or she becomes a party to this type of business setting.

If one partner in the partnership leaves the business or cannot afford to pay his or her share of the debts, the remaining partners may become liable for the entire amount owed by the general partnership.

Each partner may be personally responsible for all of the business actions done by any of the other partners who act on behalf of the general partnership.

Most small-business general partnerships don’t need to be registered. If the partnership business has employees, they are only entitled to his or her agreed-upon salary and have no interest in the partnership business itself.

• Limited partnerships require an agreement in writing and requires the filing of a certificate with the secretary of state’s office. In a limited partnership there are two types of partners; general and limited.

The general partner(s) of a limited partnership is responsible for the actual operation and management of the business.

The limited partner(s), however, is allowed to invest in the business, but does not participate in its management. Because of this limited decision-making ability, the limited partner enjoys limited liability. If the business fails, the only thing the limited partner can lose is his or her capital investment already committed to the business.

The general partner(s) has the same liability as a partner in a general partnership as I described earlier.

• Incorporating your business is one of the best ways to reduce personal liability to a sole proprietor or partner. If the business fails, the personal assets of the owners of the corporation are not exposed if the corporate formalities are properly observed.

There are additional advantages for tax planning that can be obtained even if the small business is operating as a corporation. For example, a corporation can be set up as a Sub-Chapter S corporation in which profits and losses of the corporation go through to the corporate owners.

If incorporated, a business does not have to end upon the death of one of the owners. A corporate form allows the business to continue and may make the sale of the business easier. Other types of corporations in California are closely-held corporations, professional corporations, and nonprofit corporations, which take far more space to explain than we have today.

There are a vast number of advantages and disadvantages in operating a business entity in one of the above-mentioned business forms.

It usually is a good idea in business related matters to consult with your attorney, a certified public accountant and even a business friend for advice.

Jim Testa is senior partner of the San Marcos-based law firm of Testa & Associates, LLP and may be reached at 760-891-0490.