Whether you’re a novice or seasoned investor, one of the most difficult choices you’ll have to make is determining how to take and hold title of your commercial real estate investment. When it comes to choosing an entity, there is no “one-size-fits-all” solution. In fact, your choice of entity will be largely swayed by your state laws and the way you plan to operate your company.
Two of the most common types of business structures used for commercial real estate investing are sole proprietorships and general partnerships. But which one is right for you? In this article, we’ll take a deep dive into sole proprietorship vs. general partnership, explore the pros and cons of each entity, and discuss some tips for making the right decision.
What Is a Sole Proprietorship?
If you’re the sole owner of a company, and you have not formally created a limited partnership, limited liability company (LLC) or a corporation, you are operating as a sole proprietor. This business entity is one of the most popular choices because it is the simplest entity in which to run a business. Sole proprietorships account for about 73% of all U.S. businesses.
As a sole proprietors, you will have total control over the company itself and are responsible for assets, losses, liabilities and debt. Within this entity, the investor and business are considered one and the same when it comes to legal and tax-paying obligations. There is no separation between you and your business.
Despite being the sole owner of your business when forming a sole proprietorship, you don’t have to work alone. You can still employ consultants, freelancers and full-time associates to help run your company. However, you are the one who is responsible for making the tough decisions and dealing with the consequences of your choices, whether good or bad.
What Is a General Partnership?
A general partnership is formed when you start a business with one or more other owners. In the simplest of terms, a general partner is a co-owner of a company. The owners (or “partners”) are jointly liable for the company’s liabilities, debts and losses, including for the other partners’ actions. A general partnership could begin with an informal conversation and a handshake or a signed work agreement.
However, without clearly specified written partnership agreements, profits could be disproportionately allocated, prohibiting you, the general partner or sponsor, from your piece of the pie.
Consider These Differences Between a Sole Proprietorship vs General Partnership
When considering which business entity is right for you, there are a few key differentiators between sole proprietorships vs. general partnerships, including:
By law, single-owner businesses are sole proprietorships, whereas companies with two or more owners are required to file as general or limited partnerships. If you’re the only business owner, you must create a sole proprietorship, unless you set up a limited liability company (LLC).
It’s important to understand that a sole proprietorship is not a legal entity unto itself. Under the law, the owner is still responsible for the company’s assets and debts. There is no liability protection unless you have business insurance. However, there are several ways to protect yourself if you do decide to take the self proprietorship path.
“Sole proprietorship is not a recommended ownership structure for commercial real estate,” explained Rob Beardsley of Lone Star Capital. “One form of protection would be to sign non-recourse debt so there is at least no personal liability associated with the debt, but if a tenant sues the property, that would go against the personal assets. The way to protect this is by setting up a single-purpose LLC to own the CRE, and the sole proprietorship can have 100% ownership of the LLC.”
The biggest choice when deciding between being a sole proprietorship or a general partner is whether you want to operate a business by yourself or with one or more partners, who could be general or limited partners in the case of a limited partnership. Limited partners typically invest capital, but hold limited liability in case your business fails. In the case of both general and limited partnerships, the general partner is responsible for the debts.
When you create a sole proprietorship, you have total control over all business decisions. Comparatively, under a general partnership, you need to come to an agreement with the other co-owners on all business matters. One of the most crucial aspects of a general partnership is the relationship you have with your partners. To be ethical and fair, all co-owners must practice due diligence when carrying out business matters.
In a sole proprietorship, you and you alone are responsible for your company’s liabilities. In a general partnership, each partner is responsible for the liabilities of every other co-owner.
A general partnership is a lot like a marriage in this regard. For example, if one partner decides to take out a business loan, all of the other co-owners are now responsible for that loan, even if they didn’t know or didn’t approve it.
If you want your business to be seen as more credible by third parties, you should opt for a general partnership. With a sole proprietorship, there isn’t an added layer of responsibility or protection if you were to walk away from the company. With a general partnership, more people are involved, providing more layers of protection. Third parties feel more confident conducting business when there are more people responsible for the company. If you want to boost business credibility, it’s a wise choice to form a partnership.
If you choose to form a sole proprietorship, the lack of separation between you and your business will affect your taxes. You treat your profits as personal earnings and pay taxes accordingly. The same applies to general partnerships. Both of these entities are “pass-through entities,” meaning that your company does not pay corporate taxes. Rather, your income will “pass-through” the entity. As the owner, you’ll pay taxes on your personal tax returns.
Under a sole proprietorship, you will report your business’s losses and profits on your personal tax returns, using a Schedule C. General partnerships require you to file two returns, including a Schedule E and a Form 1065.
Pros and Cons of Sole Proprietorships and General Partnerships
To know what business entity is right for you, it’s important to explore the pros and cons of sole proprietorships and general partnerships.
Pros of Being a Sole Proprietor
- Total flexibility and control of business operations
- You obtain all business profits
- The simplest type of business entity
- One tax form to file
Cons of Sole Proprietorship
- You are personality responsible for all business liability and debt (unlimited liability)
- Banks hesitant to give sole proprietorships loans
- Seen as less credible by third parties
- Creditors can target your personal assets and/or properties to satisfy a claim if you don’t have sufficient business assets
- Tougher to raise capital over an extended period of time
- Responsible for paying self-employment tax on all business earnings
Pros of Forming a General Partnership
Some general partnership advantages include:
- Partners jointly responsible for the company’s debt and losses
- Partners can pool valuable resources and share obligations
- Viewed as more credible by third parties
Cons of Partnerships
Disadvantages of general partnerships include:
- Profits may be unequally distributed among partners
- Partners are all responsible for the liabilities of another
- Two tax forms to file
Do You Need to Form a General Partnership in Commercial Real Estate Investing?
General partnerships are better business entities for commercial real estate investing than sole proprietorships because they offer more protection.
Most successful commercial real estate investors have gotten where they are today by partnering with others. Many professionals choose to form general partnerships to beef up their list of planning and zoning department contacts, reduce personal risk, and secure bigger and more profitable deals.
But what is the best way to form a real estate partnership? First, you need to identify who you’d want to partner with. Thoroughly assess their strengths, weaknesses, industry expertise, credibility, and reputability. Create clear-cut responsibilities, roles, and expectations for each partner. Most importantly, generate a written partnership agreement with the assistance of a real estate attorney so all profits are allocated appropriately.
When it comes to forming a business entity, both sole proprietorships and general partnerships come with their own unique benefits and drawbacks. While you have total control over your business operations under a sole proprietorship, you also are solely responsible for your company’s losses and liabilities.