What’s the definition of a sole proprietorship?
Sole Proprietorship - A business that legally has no separate existence from its owner. Income and losses are taxed on the individual’s personal income tax return.
A sole proprietorship is the simplest and easiest form of business, or business entity, that can be used to operate a business. It’s not a legal entity and doesn’t require you to file anything with the state to get started. Costs of getting one started are very minimal.
There are more than 23 million sole proprietorships (and more than 70% of small businesses) in the U.S., making this by far the most common type of business entity. They are common because the setup is so easy. If you are operating a business as the sole owner without having incorporated or registered with the state, you are automatically a sole proprietorship.
With sole proprietorships being so popular, it is not unusual that they pop up in all types of businesses and industries, such as:
- IT Consultants
- Bookkeepers
- Small Local Groceries
- Art Studios
- Cleaning Services
- Lawn Care Services
- Virtual Assistants
5 Advantages of a Sole Proprietorship:
Easy setup
Starting up a sole proprietorship is very easy. As mentioned above there’s no need to file any entity paperwork with the state or incorporate anything. All you need to do is acquire the necessary business licenses or permits (these will vary by location) and determine whether or not you need to file for a fictitious name (DBA) with your local government or the state. That’s about it, and depending on your business that may take less than a day. Then, you’re legal and in business.
Unlike other business entities, starting a sole proprietorship requires less time and paperwork to get started.
Few to no corporate formalities
Another of the most basic advantages to a sole proprietorship is that there are few to no corporate formalities. Most every other business type has some sort of corporate formalities (bylaws, operating agreement, meetings, annual filings, partnership agreement, boards of directors, formal corporate structure, etc.) that they have to abide by and govern the operations of the company. Not the case with a sole proprietorship, there’s one owner who owns everything and doesn’t need to document decisions, have written authorization to take certain actions or file paperwork with the state in order to remain in existence.
Simple management
As a sole proprietor, you have complete control over business decisions and priorities. Partnership disputes commonly cause businesses to fail, but that’s not an issue for sole proprietors. You’re the boss, and you ultimately control everything; you can change your goals, schedule, operations or whatever else you want in any way you please.
You own 100% of the business, make all the decisions (or at least any you want to, and haven’t delegated to an employee) and don’t have to answer to any shareholders or a board of directors. Your work environment and situation can be tailored to fit whatever your requirements, needs or wants are.
Another benefit of a sole proprietorship is that personal financial and legal liability and the business financial situation and legal liability as the same thing, there’s nothing separating them. This makes managing them easy and straght-forward, and can reduce some of the administrative burden of keeping them separate (but, read below as to why this is also your biggest risk).
Taxes are easy
Filing taxes as a sole proprietor is also relatively straightforward. Sole proprietorships are considered pass-through entities for tax purposes. This means that the owner reports business income and losses on the personal tax return. You simply need to attach a Schedule C to your 1040 tax return. Since you are the sole owner, there is no need to figure out different ownership percentages and shares. You take home all of the after-tax profits.
Many sole proprietors operate out of their homes. If that’s the case with your business, don’t forget to deduct home business expenses and car expenses (if you drive your personally owned car for business purposes).
Privacy
Since a sole proprietorship does not file any formation documents or annual reports with the federal or state governments, your business operations are not subject to public disclosure like an LLC or corporation.
5 Disadvantages of a Sole Proprietorship:
Unlimited Personal Liability
As briefly mentioned above there is no legal or financial separation between a sole proprietor and the business. This is by far the biggest issue facing sole proprietors - it means that any debts, liabilities or commitments made by the business will fall on you, personally, as the owner.
If the business fails or defaults on debt of your personal assets, house and any other assets registered in your name, it could be seized in order to cover the liabilities of the business. On a similar note, if the business is sued for negligence or harm caused in the course of business, damages that are awarded can be collected from your personal assets.
Since sole proprietors don’t need to register as a business in order to get up and running, they also don’t get any of the benefits that come from having a legal business entity (mainly limited liability). You are considered self-employed with a sole proprietorship, which means that you are on the hook with regards to your business transactions.
Burnout
Sole proprietors wear many different hats when running a business. Of course, you can hire employees and independent contractors to help with the business, but the reality is that’s probably difficult when you’re starting out, and even when you do grow, you’re still going to have the stress of running a business to deal with.
Some of the responsibilities that sole proprietors often deal with on their own include sales, marketing, advertising, finances, strategy, and leadership, not to mention everything else (and the stress) that comes with running a business. Doing it all on your own can work, and may even be a necessity when you’re starting out, but it will eventually be hard to expand, and all of the responsibilities rest on your shoulders.
Lifespan of Business
One concern with sole proprietorships is that the business won’t survive the owner. Often, sole proprietors have worked hard to build a business, a brand, loyal clients or customers and other intangible value, all of which is great, and beneficial while the sole proprietor is alive, but none of that is going to survive the death of the owner. If you are looking for options to have your business outlast you, consider a form of registered business entity such as a corporation or an LLC.
Additionally, sole proprietorships can be difficult to sell since the business is completely tied to the owner with no separation. With no separation there are issues of determining a proper valuation of the business becomes difficult; customer loyalty often resides with the original owner of the business and may not readily transfer to a new owner; and family or friends are many times unwilling to carry on the business.
Raising Money
Raising capital is difficult for sole proprietorships. Incorporated companies can raise equity financing from angel investors or venture capitalists by selling shares in the business.
Sole proprietors can have a hard time securing loans, financing or capital compared to other types of business entities. It is more difficult for sole proprietors to build business credit the same way that other companies can, since they often don’t have their own business credit cards and business bank accounts and can’t be separated from their owner.
Additionally, since all of the liability and backing for any financing comes from a sole owner, the entire business is reliant on the owner’s finances, credit and investments. Personal loans are typically one of the most common ways sole proprietors fund their businesses; just be aware that going that route will leave you personally liable for anything the business isn’t able to pay or defaults on.
Potential Client Concerns
Clients, customers and vendors are more likely to take you seriously when you are operating as a registered business entity such as an LLC or corporation. There are endless stories about sole proprietors losing out on work or failing to reach an agreement with a potential vendor because of the sole proprietor status. Depending on your industry, market and potential clients, your choice of business entity may play a much bigger role in the success or your business than you first realized.
Some businesses, government agencies, suppliers, service providers, etc. simply will not deal with unincorporated businesses such as sole proprietors; they either view sole proprietors as not having the same level of legitimacy and professionalism as a registered business entity incorporated business, or that working with a sole proprietor increases the risk of the tax authorities treating the person as an employee rather than an independent contractor, a risk they aren’t willing to take.
Let's Sum It Up
Sole proprietorships have many advantages and are appealing to many entrepreneurs across numerous industries. It’s important to consider what type of business entity you will be when starting out, you can always change as you go, but it helps to get off to a solid start. Weigh the pros and cons with your particular situation and decide what’s best for you, and take into consideration the other business entities that are available to you.
Ultimately, a sole proprietorship offers some advantage around simplicity and ease of operations, but more than likely the potential risks (especially the personal liability) aren’t worth the risk.
Have questions about Sole Proprietorships or legal strategy in general? Contact us for a free consultation.