A sole proprietorship is a business that one individual owns that is not organized as a corporation, LLC or other entity. They are usually the easiest businesses to start up, and the simplest business structure type. However, organizing a business as a sole proprietorship leaves the owner personally liable. All of the legal and financial liabilities of the business flow through to the owner. So, though one is simple to start, it is not the best choice to take advantage of liability protection and tax advantages.
Sole Proprietorship vs. Corporation or LLC
A properly structured and operated corporation or LLC has built-in liability protection. When someone sues a sole proprietorship, on the other hand, the owner’s personal assets are at risk of seizure. Moreover, all business income is taxed as the owner’s personal income. Plus, there are fewer tax benefits or shelters than those afforded by an incorporated businesses. Further, even though one can use a “DBA,” there is no true legal separation between the owner and the business. This is because no separate legal entity as the owner and the business are one and the same. In contrast, when you form a corporation or LLC the company is a separate legal “person” from the owners.
Why People Form Sole Proprietorships
People generally utilize sole proprietorships situations where an individual is looking for the easiest way to get a business off the ground. Basically, as soon as one starts doing business, a sole proprietorship exists. In the event that the owner wishes to share ownership (a partnership, for example), then a different business model needs to be considered. A sole proprietor can engage in any type of legal business whenever, and wherever, they choose, subject to licensing and zoning requirements. Some of the reasons people maintain their businesses as sole proprietorships are as follows:
- One person owns the business
- The business owner wants a minimum of paperwork and legal restrictions
- The owner is not concerned about current or future lawsuits
- The owner is not concerned about tax deductions that are available to corporations.
Advantages and Disadvantages of a Sole Proprietorship
As a sole proprietor, any income from the business can be utilized by the owner in any manner he deems fit. However, the business owner also shoulders the business losses. As the sole owner, one person makes the business decisions for the company. This means that there is no need for any true formalities, yearly meetings of owners/shareholders to decide on policy, strategy, etc. The owner makes all of those decisions. There are also modest tax advantages to a sole proprietorship. For example, one can deduct business losses from all of the reported net income. This may help to reduce the total tax burden in some instances.
Additionally, a sole proprietorship allows for a minimum of paperwork and formalities. There are few legal formalities necessary to start or operate the business. There is no requirement for formal meetings, keeping minutes, or extensive record keeping, etc. Naturally, state and local agencies may require licenses that they require of any type of business entity.
Advantages of a Sole Proprietorship
- Income is reported on the owner’s tax returns
- Owner makes business decisions
- Minimal paperwork
- Ease of “start up”
On the other side of the coin, we find the unlimited personal liability for obligations and debts of the company. This, experience tells, is one of the biggest disadvantages of a sole proprietorship. This means that, unlike a corporation, a business lawsuit brought against the business could easily put your personal assets at risk. A business lawsuit can take your bank accounts, real estate, and even certain types of retirement accounts in some instances. A sole proprietorship also has a limited duration. The business is dissolved when the owner dies, abandons the business, becomes bankrupt. It is the same story if the owner sells the business to another person, or group of persons. Often with sole proprietorships, there are no written arrangements for the transfer of ownership in place.
Because of the general precarious stability and duration of a sole proprietorship, the recruiting and retention of high quality employees can be difficult. Further, raising capital is another area where a sole proprietorship has enormous difficulty. Investors are generally reluctant to invest in a sole proprietorship due to the exposure to liability and the diminished sense of legitimacy. Most sole proprietors have to rely on their personal assets or loans to finance their business. Further, a sole proprietorship cannot readily take on partners without having to undergo extensive regulatory processes and filings. The only exception that is allowed by the IRS is that of a spouse –when a spouse of a sole proprietor works for the company, though not in the capacity of a partner or independent contractor, the sole proprietorship can avoid needing to submit a partnership income tax return.
Disadvantages of a Sole Proprietorship
- Unlimited personal liability for debts and obligations of the business
- Tax advantages are not as great as with incorporated companies
- Personal assets can be at risk in a business lawsuit
- The business terminates upon the death of the owner
- Raising “outside” capital and earning the trust of investors can be extremely difficult
If your intent is to grow your company in any way, reap enduring tax benefits, protect your assets from legal and financial liability, and attract potential investors to a professionally organized and run business, then incorporating your business is right for you!