Sole Proprietorship and Company Case Study

Type of paper: Case study

Topic: Business, Company, Finance

Pages: 6

Words: 1650

Published: 2019/10/04

Executive summary

There are several factors that are generally considered in the starting of a business. These factors include availability of capital, skills available, location of the business among others. In an advanced level, one should also consider the tax implications of starting each particular business.

There are several forms of business formations. Depending on the owner’s preference, one may decide to start a sole proprietors business, a partnership or incorporate a company. This study will majorly discuss the modes of formation of a sole proprietorship and a company, the advantages of running these types of business and the suitability of such businesses at different levels of revenue. We shall however dwell on the in depth analysis of the after tax returns to the owners of the business for each form of business formation.

Sole proprietorship

Formation

This is the simplest form of business formation. This business is owned and run by a single owner although he may enlist the assistance of family members. There are several advantages to the formation of this business as explained below.

Small amount of capital is required at the start up stage. Since only one person runs this form of business, capital may not be a major set back

Decision making is quite fast since only one individual is involved unlike a corporation or partnership where wide consultations may be required to approve any decision.

In a sole proprietorship, the owner gets all the profits unlike in companies or partnerships where the profit is shared amongst the owners.

It’s very easy to form a proprietorship business since very few formalities and legal requirements are necessary in the formation of this business.

There are several shortcomings that rock this form of business.

Any losses that may arise in the course of business are borne by only one person, the owner.

Bad decisions are likely to be made since the owner makes them solely without much consultation

There is overburdening the owner with too much work since he has to do virtually everything on his own.

It is not very easy to raise capital for a sole proprietor since he may not have enough collateral to secure loans from financial institutions limiting his scope of expansion.

Company

This is probably the most complex business formation. There are several requirements for a company to be incorporated. After the members have agreed to form the company, they must agree on the major business objective which is included in the memorandum of association, one of the documents required by the company registrars for the formation of the business.

After the owners have raised the required capital, they must submit the following documents to the registrar before the company is incorporated:

Memorandum of association

This document defines the relationship between the business and outsiders. It contains the following clauses.

Name- this gives the desired name of the company as intended by the owners

Location clause- this clause indicates the physical address of the company, usually the head office of the business.

Capital- this indicates the authorized capital for the company; this capital must be raised before the company is incorporated.

Liability- this clause mentions whether the company is a limited company or not and its limited, whether its limited by guarantee or by shares. Just to mention a few.

Article of association

This is the internal constitution in the business and it governs the internal affairs of the business.  All issues pertaining the management and members rights and obligations, appointment, dismissal and terms of directorship are discussed in this document. Rules relating to dividends are also available in this document.

Declaration by members- this document simply confirms that the members have agreed to form the said business.

Declaration by directors- here the directors confirm their acceptance to act as directors of the company.

After the promoters of the company present the above documents to the register of the company, a certificate of incorporation is issued. For public companies though, a certificate of trade is required for them to commence business.

Despite the above formalities and other legal requirements, companies have very many advantages compared to other forms of business formations. These are explained below:

Limited liability – the liability of a company is limited to the capital contributed and personal property cannot be attached incase of insolvency.

Ability to raise capital- due to the large collateral that may be available to the company besides the owners contributions, companies are able to get financing from financial institutions.

Professional management- due to the nature of the business and the legal entity status, the business is run separately from family and domestic issues in amore professional way.

Other advantages that relate to this form of business include the benefits of incorporation which include: the ability to own property in its own name, ability to sue and be sued among other factors arising from the separate legal entity status.

After an analysis of the theoretical issues governing these forms of businesses, we shall now evaluate the suitableness of each of these business formations from the benefits that accrue to the owners of the business after federal taxes have been deducted, beginning from given revenue levels.

We shall begin our analysis with the sole proprietor.

Sole proprietorship

Revenue 30000

Expenses

Salaries and wages 18000

Electricity 1000

Rent and rates 2000

Licenses 500

Postages 1000

Miscellaneous expenses 200          22700

Net profit before tax 7300

Tax computation for the entity

Assuming a single individual is involved in this business, the following taxes will apply.

0-8375 USD……………………………………10%

8376-34000 USD………………………………15%

34000-82400 usd………………………………..25%

82401-171850…………………………………28%

171854-373650…………………………………33%

373651+…………………………………………35%

Since in a sole proprietorship the owner gets all the profits, the profit becomes the income of the owner and it’s thus taxed on him at the graduated scale rates as follows;

The income lies in the bracket of 0-8375 so it’s taxed at the rate of 10% leaving the owner of the business with 7300-(10%*7300) = 6570.

YEAR II

At a revenue level of 60,000, the analysis will be as follows.

Revenue 60000

Salaries and wages 36000

Electricity 3000

Rent and rates 3000

Licenses 2000

Postages 1000

Miscellaneous 400         45400

Net profit before tax 14600

The money that remains after tax will be computed as:

8375*10% = 837.5

(14600-8375) 0.15  = 879.75

Profit after tax = 14600-(837.5+879.75) = 12882.75

Year III

At a revenue level of 180,000, the tax computation will be analyzed as follows,

Revenue 180000

Expenses

Salaries and wages 108000

Electricity 8000

Rent and rates 10000

Licenses 2200

Postages 4000

Miscellaneous  4000       151800

Net profit before tax  28200

The net profit after tax is computed as follows;

8375*10%  =  873.5

(28200-8375)*15%  =  2973.75

Profit after tax  = 28200-(873.5+2973.75) = 24352.75

Year IV

At a revenue level of 375000, the after tax profit can be computed as follows;

Revenue 375000

Expenses

Salaries and wages 225000

Electricity 20000

Rent  20000

Postages  3000

Licenses  5875

Miscellaneous  10000         283875

Net profit before tax      91125

The after tax net profit to the owner is computed as follows

8375*10% = 837.5

34000*15% = 5100

48750*25%  = 12187.5

Profit after tax  =  91125-(837.5+5100+12187.5) = 73000

Year V

Starting with revenue of 650,000 the analysis will be as follows

Revenue 650000

Expenses

Salaries and wages   390000

Rent and rates  30000

Electricity   35000

License  20000

Postages  6833

Miscellaneous expenses  10000  491833

Net profit before tax       158167

After tax profit retained is calculated as follows;

8375*10% =  873.5

34000*15% =  5100

82400*25%  = 20600

33392*28%   = 9349.76

Net profit after tax  = 158167-(873.5+5100+20600+9349.79) = 122243.74

The owner of the business is left with the after tax net profit as the net income since he gets all the profits. In the case of company the analysis is different in the following way;

The owners of the business are a paid fee that is tax deductible when computing tax liability.

The corporate tax rate is a flat rate of 35%

The expenses in a company are slightly different from those of the sole proprietorship as shown by the illustrations below.

Year I

Beginning with a revenue level of 30,000, the analysis will be:

Revenue 30000

Expenses

Salaries and wages  10000

Directors fees  2000

Loan interests  1000

Rent and rates  2000

Electricity  5000

Commissions 2200

Miscellaneous expenses  500      22700 

Net profit before tax   7300

Tax will be computed as 35%*7300 = 2555

The value available to the owners of the business will be 7300-2555=4745

Year II

With a revenue level of 60,000, the tax analysis will be as follows

Revenue 60000

Expenses

Salaries and wages 30000

Director’s fees  3000

Electricity  6000

Rent and rates  4200

Commissions  1200

Miscellaneous expenses  1000    45400   14600

After tax net profit is computed as 14600-(35%*14600) = 9490

Year III

Computation

Revenue  180000

Expenses

Salaries and wages 108000

Directors fees  5800

Rent and rates 16000

Electricity  13000

Commissions  7000

Miscellaneous expenses 2000    151800

Net profit before tax  28200

Profit after tax=28200-(0.35*28200) =   18330

Year IV

Computation

Revenue   375000

Expenses

Salaries and wages   210000

Directors’ fees  15375

Rent and rates   15000

Electricity 10000

Commissions  8500

Miscellaneous expenses  5000    283875

Profit before tax 91125

Net profit after tax 91125-(35%*91125) =     59231.25

Year V

Revenue 650000

Expenses

Salaries and wages  400000

Directors fees 15000

Commissions 15833

Rent and rates 25000

Miscellaneous expenses  8000

Electricity      18000        491833     

Profit before tax    158167

Tax computation is as follows 158167-(35%*158167) =  102808

From the analysis above, it’s evident that corporations bear a larger amount of tax compared to the sole proprietorship business. At the various revenue levels, the corporation pays a large amount of tax compared to the sole proprietor. This issue can also be viewed from the fact that the owners of the business are already paid in the corporations in the form of directors fees.

Whilst the sole proprietor is charged final tax at the graduated scale rates indicated above, the owners of the company are charged double tax, at the corporation level and at personal level. The amount they earn as directors fees is still subject to the prevailing income tax rates.

In my opinion, its preferable to run a sole proprietorship business since at all levels of income, the after tax profit is more than the one for an incorporated company at the same pre tax profit.

References

Brumbaugh, David L. Esenwein, Gregg A., Gravelle, Jane G., “Overview of the Federal Tax System,” Congressional Research Service Report for Congress, updated June 2, 2006

Hart, Phil, Constitutional Income: Do You Have Any?, 3rd edition, (Alpine Press, 2005)

Johnson, Calvin H. “Fixing the Constitutional Absurdity of the Apportionment of Direct Tax,” Constitutional Commentary, Volume 21 No. 2 (June 2004), p. 295

Becraft, Larry. Uncertainty of the Federal Income Tax Laws, (Sept. 1, 1999),

Thorndike, Joe, “An Army of Officials: The Civil War Bureau of Internal Revenue,” Tax History Project, Dec. 21, 2001.

Skinner, Otto. The Biggest “Tax Loophole” of All, (San Pedro: Otto U. Skinner, 1997)

Stratton, Lawrence M. Jr. and Moore, Stephen and Roberts, Paul Craig, “The Roots of the Income Tax,” National Review, April 17, 1995