Learn all about proprietorships, partnerships, and limited liability companies in just a few minutes! Fabio Ambrosio, CPA, instructor of accounting at the Central Washington University, walks through the characteristics of proprietorships, partnerships and limited liability companies.
Characteristics of Proprietorships
A proprietorship can be set up with few legal forms to file or restrictions, but the owner has unlimited liability.
Corporations generate the majority of total business dollars annually. However, sole proprietorships, partnerships, and limited liability companies make up the majority of small businesses in the United States. A proprietorship is a business organization owned by one individual. Also known as a sole proprietorship, a proprietorship is the easiest business to start because there are no legal forms to file and no legal restrictions to follow. One of the major drawbacks of this type of business entity is that the owner is completely liable for any debts or legal claims that may arise against the business.
For example, a proprietor may enter into a contract and is later found liable for damages to a creditor in the amount of $200,000. Even if the net worth of the business is only $100,000, the owner can be forced to use his or her house as collateral to pay the debt incurred by the business. Creditors can seize personal assets to satisfy a claim against a sole proprietorship.
Also, the proprietorship is not a separate taxable entity and therefore is not taxed as one. The income or loss of the company is passed through to the owner, who then reports this information on their individual income tax return. This information is reported on a separate form, Schedule C, at tax time.
The life of the proprietorship relies on the life of the owner. When the owner retires or dies, the business ceases to exist. The owner is also limited in their ability to raise capital for the business. These funds are usually raised through personal resources or borrowing.
Characteristics of Partnerships
A partnership is not a separate taxable entity, and it has a limited life with unlimited liability for its general partners.
A partnership (or general partnership) is a business entity that is owned by two or more people with the goal of generating a profit. Because partnerships are moderately complex to form, an attorney is sometimes used in the formation and agreement process. A partnership agreement is a formal document that contains an outline of how a partnership will work. Elements in the outline may include the amounts that the partners have invested, the duties and rights of each partner, how income and losses will be distributed, how partners will be admitted to or withdrawn from the partnership, as well as other terms of agreement.
Common Characteristics of General Partnerships
| Unlimited liability | Similar to proprietorships, partners are completely liable for any debts or legal claims that may arise against the business. (There are some other forms of partnerships that may not have unlimited liability.) |
| Not taxable | The partnership is not a separate taxable entity and is not taxed as one. The income or loss of the company is reported on form 1065, and then each partner is provided with form K-1, which breaks down their individual share of the income and losses. This information is reported on their individual income tax returns. The IRS uses form 1065 to check that income is reported by the individual partners. |
| Limited life | Similar to a proprietorship, the life of the general partnership relies on the life of the owners. When one of the owners retires or dies, the business ceases to exist. When a new partner is admitted, the partnership dissolves. Each change in ownership requires dissolution of the old partnership and formation of a new one. |
| Capital limitations | Partnerships are limited in their ability to raise capital. These funds are usually raised through personal resources or borrowing. |
| Partnership property | Partnerships are in a unique position in that property that is invested by an individual partner becomes the joint property of all the owners upon formation. |
| Mutual agency | The concept of mutual agency is a unique characteristic of a general partnership that says each partner is an agent and is allowed to act on behalf of the partnership in business deals. This also means any liabilities created by an individual partner in the name of the business become the liabilities of all the partners. |
| Income and losses | Income and losses are distributed to the partners according to the guidelines of their partnership agreement in proportion to the partners' ownership. In the event that the agreement does not clearly outline distribution, income and losses are shared equally. |
In a partnership each partner has their own capital account, which is the equity account for each individual partner. Partners retain a separate capital account to easily show their interest in the organization. With mutual agency, each partner may act on behalf of the partnership. Thus, trust is required among partners, and the business and personal relationships of partners are often closely related.
Characteristics of Limited Liability Companies (LLCs)
A limited liability company (LLC) is popular for small businesses, in part, because of its limited liability for owners.
A limited liability company (LLC) is a company treated as a partnership or sole proprietorship for tax purposes but that provides limited liability for its owners. Because LLCs are moderately complex to form, an attorney is sometimes used in the formation and agreement process. An operating agreement is a formal document that contains an outline of how an LLC will operate. The outline may include similar elements found in a partnership agreement, such as invested amounts, distribution of income and losses, and how members will be admitted to or withdrawn from the LLC. However, unlike the partnership agreement, it may also include a continuity clause to stipulate whether the business will continue if current owners withdraw or new members sign up.
Common Characteristics of Limited Liability Companies
| Limited liability | One of the most attractive components of an LLC is limited liability for its members. Therefore, the members are only liable for their investment in the organization, similar to corporations. |
| Not taxable | An LLC with two or more owners typically elect to be treated as a partnership. Therefore, the LLC is not a separate taxable entity and is not taxed as one. The income or loss of the LLC is reported on form 1065. Each member is provided with form K-1, which breaks down their individual share of income and losses. This information is reported on their individual income tax returns. The IRS uses form 1065 to check that income is reported by the individual members. A single-member LLC is a disregarded entity that reports on Form 1040, Schedule C. |
| Unlimited life | Unlike a proprietorship or partnership, the life of the LLC does not rely on the life of its members. Most LLC agreements will include a continuity clause that states that the business will continue even if current members withdraw or new members sign up. |
| Capital limitations | LLCs are moderately limited in their ability to raise capital. Because of their limited liability, these entities are attractive to potential investors, allowing LLCs to have more access to capital than a traditional partnership. |
| Income and losses | Similar to a partnership, income and losses are distributed to the members according to the guidelines of their operating agreement. In the event that the agreement does not clearly outline distribution, the income and losses are shared in proportion to the members' ownership. |
LLCs have the unique ability to operate as either a manager-managed or a member-managed organization. In manager-managed LLCs, only certain authorized members may bind the LLC to legal contracts. Therefore, some members share in the income of the LLC without having to help manage the day-to-day functions of the LLC. In a member-managed LLC, however, each individual member can legally bind the LLC to legal contracts, similar to the partners in a partnership.