As a reminder from Unit 1, for accounting purposes, each business form is separate from other business entities and from its owner(s).
A sole proprietorship is an unincorporated business owned by one single person and often managed by that same person. Sole proprietors include physicians, lawyers, electricians, and other people in business for themselves. Many small service businesses and retail establishments are also sole proprietorships. Some characteristics of a sole proprietorship are:
- No legal formalities are necessary to organize such businesses, and usually business operations can begin with only a limited investment (called Capital).
- A sole proprietorship does not pay taxes on profits at the business level but instead pays taxes based on the company’s earnings on the owner’s personal income tax.
- The business owner is personally liable for all debts of his or her company. This is called unlimited liability. Creditors can take and use your personal assets to cover the company’s outstanding business debt if the company does not have enough money to pay debt.
- A sole proprietor can take money out of the business any time he or she wants which is recorded in an contra-equity account called Drawing or Withdrawals.
A partnership is an unincorporated business owned by two or more persons associated as partners. Often the same persons who own the business also manage the business. Many small retail establishments and professional practices, such as dentists, physicians, attorneys, and many CPA firms, are partnerships. The characteristics of a partnership include:
- As with a sole proprietorship, if the company cannot pay its debts the partners personal assets can and will be used to pay off the debt. See how this unlimited liability is even riskier in the case of a partnership. Each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If, through mismanagement by one of your partners, the partnership is forced into bankruptcy, the creditors can go after you for all outstanding debts of the partnership.
- Another fun one is mutal agency. This means partners can sign contracts on behalf of the company with or without the other partner’s knowledge or approval. This makes the unlimited liability part very scary!
- Partneship agreements can be written or verbal, yes, verbal! Any partner contributions are recorded in their own Capital account.
- As with a sole proprietorship, the business itself does not pay taxes. Instead, the earnings of the company are divided between the partners using an agreed upon rate and the earnings are taxed on each partner’s personal income tax.
- A partnership has a limited life meaning that when the partners change for any reason, the existing partnership ends and new one must be formed.
- Partners can take money out of the business when they want. This is recorded in each partner’s Withdrawal or Drawing account.