Differences Between Sole Proprietorship, Partnership, and Corporation

How a sole proprietorship works

A sole proprietorship is one of the easiest forms of business to start partially because it requires no filing of documents. If a single person starts a business and takes no further steps, they are automatically considered to be a sole proprietor. The Internal Revenue Service (IRS) considers a sole proprietorship as a pass-through entity, with all income or losses being reported through the owner's personal tax returns. However, a sole proprietorship also provides no liability protection for the owner. The owner is held personally liable for the business's debts and liabilities, placing his or her personal assets at risk. 

How a partnership works

A partnership is a business owned by two or more people. The three most common types of partnerships are general partnership, limited liability partnership, and limited partnership.

General partnerships

In a general partnership, each partner participates equally in the operation unless the partnership agreement says otherwise. The partners also share the profits or losses from the partnership equally. General partnerships also provide no personal liability protection for owners. Each partner is personally responsible for all the company's debts and liabilities, placing the partners' personal assets at risk.

Limited partnerships

With a limited partnership (LP), which needs a minimum of two members, there is one general partner with unlimited liability and the limited partner is only liable up to the amount they invested in the company. Say, if partner X is a limited partner who invests $20,000 into the business, and the business's debts are $80,000, then partner X's liability is capped at $20,000. The general partner is liable for that entire $80,000. The limited partners are also more silent members and aren't involved in day-to-day business activity.

Limited liability partnerships

In a limited liability partnership (LLP), each partner gets personal liability protection and neither is solely responsible for partnership debts. Each owner's actions are separate from the others and therefore one partner is not responsible for the action or another. All partners can also manage the business, unlike a limited partnership. This structure is usually reserved for professional disciplines like law firms or medical practices.

Creating a written partnership agreement is the best way to lay the groundwork for your business and minimize disputes while ensuring personal liability protection.

How a corporation works

A corporation is a legal entity that is separate from its owners, called shareholders. The shareholders do not necessarily operate the business. Instead, the shareholders elect a board of directors who then elects the corporation's officers to operate the business. Depending on the corporation, shareholders may also serve as officers.

This business structure provides complete personal liability protection to its owners and the personal assets of shareholders are not subject to the liabilities of the corporation. It's also held to higher compliance requirements, like the creation of corporate bylaws and regular board and shareholder meetings.

Sole proprietorships, partnerships, and corporations each provide distinct advantages and disadvantages depending on the number of owners, type of taxation, and liability you desire for your business. As you think about forming your own company, you can do research on your own, consult an attorney, or request the aid of an online legal service provider.

​​Sole proprietorships vs. partnerships vs. corporations

Learning the key differences between these business structures is essential to making an informed choice for your business.

Creation

Creating each type of structure involves different formalities and steps.

• Creating a sole proprietorship requires no formal steps. You're automatically a sole proprietor the day you open shop.
• Your business is automatically created as a general partnership if you have two or more owners who agree to start a business. However, to create a limited partnership (LP) or limited liability partnership (LLP), you must complete a formal application (generally a certificate of formation or certificate of partnership) with the state's Secretary of State. Some states even mandate creating a partnership agreement and publishing a formal notice in newspapers.
• Forming a C corporation requires filing articles of incorporation with the state where the corporation will conduct business. Formation of a corporation also involves creating company bylaws and a shareholder agreement, issuing stock certificates, and appointing a board of directors. These additional steps can make it more expensive to form a corporation. 

Dissolution

Dissolution is the formal process of ending one's business operations. Financial difficulties, market shifts, death of the owner(s), or disagreements between partners are all reasons why a business might decide to cease operations.

• The dissolution process for a sole proprietor is straightforward. They just need to tell everyone you are "done" and pay off any pending debts. The business's shelf life is tied to the owner. Therefore, if a sole proprietor decides to shut shop or dies, the business ends with them.
• General partnerships are also relatively easy to dissolve, especially if both partners agree to end their business activities. They have to inform employees and creditors (if any) about their plans and pay final taxes. However, dissolving an LP or LLP, may require filing of dissolution papers and putting a formal notice in the newspaper.
• A corporation has a complicated and extensive dissolution process. It first requires approval from the shareholders, then the filing of a final tax return and a certificate of dissolution with the state authorities. Corporations have a completely independent life separate from its shareholders. Therefore, even in the case a shareholder leaves the company or sells their shares, the corporation continues to exist.

LegalZoom can help with accurate filing of dissolution for your business. If this process isn't done properly, you might continue to be on the hook for business taxes and annual reports.

Taxes

Each operating business has to report and pay taxes, the difference is in which taxes one has to pay and how income is reported.

• Sole proprietorships are pass-through entities. Much like a limited liability company, a sole proprietor's business earnings and expenses are reported on their personal taxes. The applicable personal income tax rate depends on the business earnings.
• Partnerships are also pass-through entities for tax purposes. Each general partner has to pay self employment taxes on income earned (limited partners are exempt).
• Corporations are a separate legal entity, and therefore must pay corporate taxes on profits. After taxes, profits are distributed as dividends to shareholders who then pay personal income tax on the dividends. It's common for corporations to face double taxation. For instance, a C corp must first pay corporate tax on profits, and then again when dividends are paid to shareholders (which is disclosed through their personal tax returns). The corporate tax varies by state.
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• A corporation, if it meets the IRS's requirements, may select alternative tax treatment. An S corporation status allows a corporation to pass profits or losses directly to shareholders, avoiding taxation at the corporate level. S corporations provide shareholders with the same limited liability status of corporations.

Liability

One notable difference between the three types of business structures is the level of legal protection each provides.

• A sole proprietorship and general partnership have no liability protection. Therefore, personal assets can be used to satisfy the business's debts, losses, and other financial obligations.
• In a limited partnership or limited liability partnership, at least one owner would typically have unlimited liability. Full protection for a partner is only possible if you set up a limited or limited liability partnership. The limited partner won't be accountable for the partnership's debts or losses beyond their investment amount.
• A corporation offers the highest level of protection, as all owners would have limited liability. A shareholder's personal assets are completely shielded from business assets and debts. 

How sole proprietorships and partnerships are similar

While their names suggest very different business models, sole proprietorships and general partnerships actually have quite a bit in common.

Easy to create

The individuals behind sole proprietorships and partnerships and the business entities themselves are legally one and the same. The law doesn't consider them to be separate as they do for corporations. So, as soon as an individual starts doing business, a sole proprietorship forms. 

Similarly, as soon as two or more people start doing business, they form a partnership. These entities require no additional paperwork, fees, or filing for formation. Automatic formation, of course, is much easier than writing and filing articles of incorporation, creating an LLC operating agreement form, and designating a registered agent.

Easy to dissolve

Because a sole proprietorship or general partnership is really the person or people behind the business, dissolving them is simple. If the general partners decide to split, or say a sole proprietor decides to go out of business, no additional paperwork is necessary. Rather than documenting the decision, the sole proprietor or partners simply cease doing business as they once did and pay any due taxes.

That being said, dissolving a limited or limited liability partnership may involve notifying business partners and the filing of dissolution papers with the Secretary of State. 

Simple taxes

Taxes are also quite straightforward for both a partnership and sole proprietorship. In a sole proprietorship, which is a pass-through entity, the owner claims their business losses and income on their personal tax returns rather than filing a separate tax return for the business.

Likewise, general partners must pay personal income taxes on their share of the business. While neither structure has to pay corporate taxes and therefore avoid double taxation, they don't escape paying self-employment taxes.

Simple business names

In most jurisdictions, sole proprietorships and partnerships operate under the names of their owners' legal names. For instance, the sole owner's name is Mary Foster, the company is also called Mary Foster. For partnership, the name would be under the general partners or limited partners' legal names.

However, a business can register a DBA, or a name they are "doing business as." Some jurisdictions refer to these as fictitious business names or assumed names. If a sole proprietorship wishes to operate under a fictitious name, the owner must complete the DBA filing with their jurisdiction. Say Mary Foster wants to run her business under the name Huber & Holly, she would need a DBA. Likewise, any partnerships, including limited partnerships, operating under a fictitious name must file to establish a DBA or assumed name.

No personal liability protection

The owners of sole proprietorships and general partnerships are liable for any lawsuits filed against their businesses. They are also liable for business debts. Being personally liable means that any damages awarded in a lawsuit or debts owed can come directly from the owner's personal assets; an owner of a sole proprietorship or partnership can lose their house, cars, jewelry, art, or any other valuable possession if their business runs into trouble.

Limited partners of an LP or LLP are only liable for their share of investment or or an amount stated in the partnership agreement.

Limited shelf lives

Because sole proprietorships and partnerships operate through the individual, they have limited shelf lives. A partnership or sole proprietorship does not live beyond the life of the owner of the business. Of course, if an owner of a sole proprietorship or partnership wishes to sell their business, it requires little effort, as they already own everything in their own name.

As you consider between setting up sole proprietorship, partnership and corporation, be aware that there are some issues you may want to ponder. Each type of business structure has its own advantages and disadvantages, but a well-informed business owner makes better choices than one who hasn't done their homework.

​FAQs

How do I choose from different types of business structures?

You need to consider the startup costs, legal risk, tax obligation, compliance requirements, business license requirements, funding needs, and personal liability protection before deciding on a business structure.

If raising funds, liability protection, and longevity of business are key priorities, then going for a corporation might make sense. However, it's the most complex structure to set up and manage, and you could face double taxation.

In a limited partnership or limited liability partnership, at least one owner would typically have unlimited liability. Full protection for a partner is only possible if you set up a limited liability partnership. In a sole proprietorship or general partnership, there is again unlimited liability for the owner.

A business attorney can help you evaluate which business entity will be best suited for your business.

Sole proprietorship vs. corporation: Which business structure is best for tax purposes?

From a tax savings standpoint, the best structure depends on your income, tax deductions available, and your state and local tax rates. One thing to know is that while a sole proprietorship provides the benefits of pass-through taxation, it means paying 15.3% in self-employment tax.

A corporation provides a protective wall for your personal assets in the event of bankruptcy, lawsuit, or financial loss, but it has a drawback—double taxation. However, with a corporation, you may be able to save on self-employment taxes. Ultimately, only a tax professional can help you decide on the best business structure based on your needs and financial goals. 

Is a sole proprietorship the same as an LLC?

No, a sole proprietorship is not a legal entity structure like an LLC, which creates a distinction between a person and their business. So, a sole proprietorship has unlimited personal liability, while an LLC doesn't. 

When you form an LLC, only business assets (not personal assets) are on the line to cover for business losses or debts. It's also easier to raise money through business loans or angel investors if you have a formal legal structure.

How long do partnerships last?

Unless there's a predefined end date in the partnership agreement, a partnership lasts until each partner decides to keep it going. The death of a partner can also result in the end of the partnership. However, the partnership can continue if the partnership agreement has a clause that gives the surviving partner the right to buy out the deceased's share. A business attorney can help you understand what a partner's death might mean for your business.

Can I change the business structure later?

Yes, it’s possible to change your business structure as your business grows and evolves. If you’re just starting a business and want to test the waters, consider establishing a sole proprietorship or general partnership before changing to a more formal entity like an LLC or corporation. Speak to a legal professional to understand the benefits, legal implications, risks, process, and costs associated with changing entity type.