A sole proprietorship essentially means that you are the business. You and your school operate as one entity. You are the sole owner (hence, the name sole proprietorship). The sole proprietorship is the simplest business form of operating your school.
The sole proprietorship is a popular and frequently used form of business organization. When your school is organized as a sole proprietorship, the business entity and your other affairs (personal and business) are merged together. As the proprietor, you own and control the business. From the standpoint of nearly all legal rights and responsibilities, your sole proprietorship business and you, as the proprietor, are considered to be one and the same.
When a business is owned and operated by a wife and husband, it is often not clear whether the operation is a sole proprietorship or a partnership. The distinction between a sole proprietorship and a partnership can be very important. If you have a sole proprietorship owned and operated by you and your spouse, ask your attorney to identify clearly the legal implications of the linkage between your personal and business affairs. Your attorney also can describe actions you can take to ensure that you have whatever the highest level of liability protection possible in your circumstances.
All debt incurred on behalf of the school is payable by you, the proprietor. Lenders customarily require signatures on debt agreements by both the proprietor and spouse (if any).
For business and financial management purposes, it is best to maintain completely separate records for your school and your family or household. To ensure you have documentation needed for income tax reporting purposes, it¹s highly recommended to use separate bank accounts and separate credit arrangements for your business and your family affairs.
If credit is used in your business operations, it¹s particularly important to maintain a separation of finances and records for your business unit and your household. Interest payments on personal debt are not a deductible expense for federal and state income tax purposes, while interest payments on business borrowing can be fully deductible.
When business and household costs are incurred jointly (for example, telephone bills when the telephone is used for personal and business calls, and travel using a personal auto for business purposes), allocate the respective portions to the business unit and the household. Then pay the business and personal amounts from the respective bank accounts. A relatively small investment of effort in bill paying and record keeping can ensure you have the data needed for filing and substantiating your income tax returns.
Advantages of the Sole Proprietorship
- In large part, the advantage of the sole proprietorship is in its simplicity and flexibility.
- A sole proprietorship can be established, modified, bought, sold, or terminated very quickly.
- No business planning or organizational arrangements are required when a sole proprietorship is established. Of course, that can also work to your detriment.
- A sole proprietorship involves minimal legal formalities and registration requirements to begin and maintain.
- A sole proprietor has total autonomy or decision-making authority.
- A sole proprietor enjoys all the income of the school.
- All school assets (equipment, inventory, property, etc) are owned by the sole proprietor.
Disadvantages of the Sole Proprietorship
- As a sole proprietor, you are personally responsible for all liabilities (losses, debts, expenses) created by the school. Therefore, the sole proprietor is personally responsible for all contracts and financial responsibilities created by the school including the actions of the school's employees. If there are any lawsuits against the school, you will be personally liable for any judgment. As such, your personal assets, such as your automobile, house and bank accounts are at risk of being seized by anyone obtaining judgment against your school.
- Income or loss from your school must be included with your other sources of income during the year. As a result, you may be subject to paying more income tax than if another method of conducting business is used. However, in some cases, the ability to apply losses to your personal income may be an advantage of a sole proprietorship, especially if there are other sources of income.
C-Corporation or an S-Corporation
Choosing the Structure That Fits Your Needs
The advantages of incorporating are many. Contrary to a sole proprietorship, a corporation separates you from the school. The incorporated school is an entity in and of itself. When a corporation is created, the shareholders do not own the business or the property belonging to the corporation. The business and the property are owned by the corporation and the corporation, in turn, is owned by the shareholders. In addition, the rights and liabilities of the corporation are not the rights and liabilities of the shareholders.
The fact that you can establish an entity that works and thinks for itself and, if used properly, will stand between you and may lawsuit settlements is the primary reason why you incorporate. However, it should be made clear that the corporate shield can be penetrated to expose the primary officers to liability. Record-keeping and annual corporate updates with your attorney and accountant are critical to maintaining the integrity of a corporation. There are two primary forms of incorporation. Generally, a corporation is a C-Corporation. The other form of corporation is the S-Corporation. Each is somewhat distinct and offers certain advantages for the school owner, depending on your situation.
There is another benefit you expect from your corporation, and that is tax savings. When you use the C-Corporation structure, you have, along with some positive tax advantages, a negative potential for paying income tax twice on the same income. This is due to the fact that, since a C-Corporation is a separate entity, it is taxed just as any other individual taxpayer. In other words, when the corporation makes a profit, it must pay tax on that profit. If you, as an owner/shareholder, do not stay well organized, your corporation may be forced to pay income tax on profits before it distributes what is left of the profits, and then you pay tax again on your personal share.
The S-Corporation was designed to rectify this circumstance, and it works quite well for some school owners. The S-Corporation is taxed much the same as a partnership. That is, the shareholders pay the income tax on the profits of the corporation. The S-Corporation is not responsible for paying income tax on its earnings. The income tax liability on the profits passes through to the owner/shareholder.
The S-Corporation is not a different entity that you file for when you organize your corporation in the beginning. You always form a C-Corporation and then file the proper form with the IRS (Internal Revenue Service) to do business as an S-Corporation. This is called and S-Corporation election. The S-Corporation isn¹t for everybody, and you should give it careful consideration with your tax advisor before choosing the S-Corporation option.
Advantages of a Corporation
- Limited liability of shareholders. In most cases, a lawsuit against your incorporated school can only attach the assets of the school, not your personal assets. This is the primary advantage to incorporation. Separate taxation of the corporation from its owners. Possible lower taxation rate.
- The corporation may sue and it may be sued in the corporation name.
- Using a corporation provides a more prestigious image associated with doing business. Perpetual existence of the corporation. The corporation can continue after the death of a shareholder or withdrawal of the shareholder by the sale of his/her shares.
Disadvantages of a Corporation
- Higher initial start-up formalities and cost. A corporation requires that articles of incorporation be filed, a head office designated, notice naming director(s) and officer(s) and a record book (called a "minute book") must be maintained which contains, among other information, details of meetings of shareholders and directors.
- Requires annual maintenance by an accountant and lawyer. A corporate tax return must be filed and the "minute book" must be updated. This is critical. Failure to maintain the corporation in this manner can result in a collapsing of the corporation, creating liability for you and your family in the case of a lawsuit or debt.
- Losses incurred during the start-up years cannot be used to offset income of the owner from other sources of income.
Granden, J. An excerpt from How to Open and Operate a Successful Martial Arts School.