Business Entities Notes

Business Entities: Sole Proprietorship, Partnership, and Corporation

Overview

  • The accounting process is generally the same for all three major legal forms of business entities: sole proprietorship, partnership, and corporation.
  • Significant differences exist between these entities, impacting various aspects of their operations and financial management.

Sole Proprietorship

  • Definition: A business owned by one person.
  • Prevalence: Common among small businesses operated by a single individual.
  • Separate Entity Assumption:
    • Critical principle: the firm's financial records must be kept separate from the owner's personal records.
    • Importance: essential for accurately measuring the business's performance.
    • Mixing personal and business transactions makes it difficult to assess true business performance.
  • Advantages:
    • Simplest form to start.
    • No separate income tax: profits are included on the owner's individual income tax return.
    • The owner's income and the income of the business are combined to compute the total tax liability of the owner.
  • Disadvantages:
    • Limited lifespan: ceases to exist when the owner is unable or unwilling to continue the business.
    • Unlimited liability: the owner is legally responsible for all business debts and taxes.
    • Personal assets are at risk to cover business debts if the business cannot pay.

Partnership

  • Definition: A business owned by two or more people.
  • Common Use: Often used for professional service businesses (law firms, accounting firms, etc.).
  • Partnership Agreement:
    • A contract detailing:
      • Rights, obligations, and limitations of each partner.
      • Amount each partner contributes.
      • Each partner's percentage of ownership.
      • Each partner's share of profits and losses.
      • Duties each partner will perform.
      • Liability each partner has for the amounts owed by the business.
  • Advantages:
    • Greater knowledge and experience due to multiple partners.
    • No separate income tax: similar to sole proprietorships, partners include their share of profits on their individual tax returns.
  • Disadvantages:
    • Limited lifespan: dissolves upon the death or withdrawal of a partner (though a new partnership can be formed).
    • Unlimited liability: partners are individually and jointly responsible for the partnership's debts and taxes.

Corporation

  • Definition: A separate legal entity with potentially many owners (shareholders).
  • Ownership: Represented by shares of stock (stock certificates).
  • Types of Ownership:
    • Privately owned (closely held): ownership limited to a few individuals (e.g., family members); stock not traded on exchanges.
    • Publicly owned: stock is bought and sold on stock exchanges and over-the-counter markets.
  • Advantages:
    • Indefinite life: continues to exist even with changes in ownership.
    • Limited liability: stockholders are not personally responsible for the corporation's debts or taxes; they can only lose their investment.
  • Disadvantages:
    • Double taxation: corporate profits are taxed at the corporate level and then again when distributed to shareholders as dividends.

Taxation Summary

  • Sole Proprietorship:
    • Profits taxed at the individual level.
  • Partnership:
    • Profits taxed at the individual level (partners' share).
  • Corporation:
    • Double taxation: at the corporate level and at the individual shareholder level (dividends).