Okay. You’ve already started a business, you’re in the process of doing so or you’re thinking about it. There are three business structures that you can choose from:
• Sole proprietorship – an unincorporated business;
• Partnership – an unincorporated business; and
• Incorporated company – a corporation
Today we’ll look at the sole proprietorship. A sole proprietorship is a business that’s owned by one person. They’re the most common type of business. A sole proprietorship usually represents the realization of becoming your own boss. It doesn’t take much money to start a business as a sole proprietor. And there are few legal restrictions. As the sole owner, you get to make all of the business decisions. You don’t have to be accountable to anyone else. Of course, this means that you get 100% of the credit for the successes and failures of your business.
Sole proprietorships are often limited in size because individuals who start businesses usually have limited resources. The amount that you can invest in your business is limited to the amount that you can provide and/or borrow. You are personally responsible for all of the debts and obligations of the business. This personal responsibility extends to your entire wealth – regardless of the amount you’ve invested in the business.
From an accounting perspective, a sole proprietorship is considered to be an accounting entity that’s separate from your personal affairs. Accordingly, the financial records and transactions for your proprietorship must be kept separate from your personal records and transactions. You want to be able to monitor how your business is doing. If you’ve started more than one business, you want to be able to monitor each business independently.
Although a sole proprietorship is considered to be a separate accounting entity, it isn’t legally separate from you, the owner. If you retire, sell the business or die, the sole proprietorship is terminated and ceases to exist. Since it isn’t a legal entity, a sole proprietorship isn’t subject to taxation on the income it earns. Instead, you are taxed on the net income earned by the business together with any other income you’ve earned from other sources. For example, if your sole proprietorship’s net income for the year was $50,000 and you have $15,000 in income from other, unrelated, sources you must pay income taxes on $65,000. It doesn’t matter whether you’ve withdrawn the $50,000 from the business or left it in to provide additional financing.
If you’re preparing financial statements for your proprietorship – an unincorporated business – there are some special considerations that you need to be aware of.
Personal Equity And Liabilities
The assets and liabilities of your business belong to you, the owner. Accordingly, the assets of your business are subject to the claims of your personal creditors and your personal assets are subject to the claims of your business’ creditors.
When you engage in other business or investment activities that aren’t included in the financial statements, it may be necessary to give sufficient details of the nature of the business to distinguish it from these other activities. This information may be included in the headings of the financial statements or in a note to the financial statements.
• The financial statements of your business must indicate clearly the name under which your business is conducted.
• The fact that your business is unincorporated and that the statements don’t include all of your assets, liabilities, revenues and expenses must be disclosed.
Salary, Interest On Invested Capital Or Residual Profits
An unincorporated business’ earnings may be considered as salary, interest on invested capital, residual profits or as a combination of the three. The income statement of an unincorporated business may include charges for your salary and for interest on invested capital in order to reflect more clearly the economic costs of your business. However, these charges form part of the earnings you receive from your business. The level of any such charges is at your discretion.
• Any salaries, interest or similar items accruing to you must be clearly indicated by showing them separately either in the body of the income statement or in a note to the financial statements.
• If no such charges have been made in the accounts, this fact must be disclosed in the financial statements.
As noted above, an unincorporated business isn’t liable for taxes on its income. While the income or losses of your business do affect your personal tax liability, any calculation of your tax liability relating specifically to the business would necessarily be arbitrary because it would be affected by factors completely unrelated to the operations of the business.
• No provision for income taxes is made in the financial statements of your business because you are taxed directly for it.
• The fact that your business isn’t subject to tax because its income is taxed directly to you must be disclosed.
Statement Of Owner’s Capital Account
Your business’ financial statements must include a statement setting out the details of the changes in your equity during the year – or period – and this statement must separately disclose your capital contributions and withdrawals and income or losses.
Keith C. Macdonald, CA