Sole proprietorship gives you, as the owner, full control over your business operations. This includes how you file your taxes, how private you choose to be with your business information, and how you make major business decisions. In short, you are the alpha and the omega of your business.
While each type of business organization comes with advantages and disadvantages, a sole proprietorship is the simplest option, requiring the least paperwork and upfront investment. Yet it also impacts your personal liability, restricts how you can raise money and how you deal with debt.
In the next few sections and paragraphs, we’ll review the advantages and disadvantages of a sole proprietorship, how it can benefit your business, and how to determine if its the right business structure for you.
What Are the Benefits of a Sole Proprietorship?
A sole proprietorship is the simplest form of business organization. It has no separate, legal existence from the owner—you could use your own name as the name of the business if you so chose. Since all income and losses are taxed as part of your personal income tax return, you are required to pay an additional self-employment tax on your own income.
Sole Proprietorship Advantages
Perhaps the greatest advantage of a sole proprietorship is how much authority you maintain over your business. While there are laws each business must abide by at a local, state and federal level, the amount of flexibility sole proprietors have is unparalleled in other business structures.
For example, sole proprietors can have their business bank accounts in their own name, and they’re able to blend personal and business assets and funds in ways partnerships, LLCs or corporations are not legally allowed to do.
2. Easy Setup & Low Cost
Since there is no profit-sharing, the amount of paperwork and documentation needed to set up a sole proprietorship is minimal. Compared to other business structures, the whole process is relatively simple.
The registration process includes securing permits and licenses from your state and/or local government to legally operate your business. Depending on the laws and regulations for each municipality, the cost for these licenses can range anywhere from $50 to $400. Since sole proprietorships don’t generally have other registration requirements, the cost of establishing this type of business is more affordable for most entrepreneurs.
3. No Corporate Business Taxes or Double Taxation
One of the most attractive features of a sole proprietorship is that your business avoids paying taxes on profit (unlike a C Corporation, for example).
Because sole proprietorships are directly connected with their owners, business income is earned by and directly passed to the owner. As a result, sole proprietorship taxes are paid as part of your personal income taxes.
Even though you are taxed through your personal tax return, sole proprietors must also file IRS forms Schedule C and Schedule SE. While both are categorized as 1040 Forms—the long form for U.S. Individual Income Tax Returns—Schedule C is a record of your business’s profits and losses from the most recent fiscal year, while Schedule SE is used to determine how much you owe in self-employment taxes.
4. No Annual Reports or Filings
Sole proprietors are able to keep certain financial information about their businesses private. Other business structures, like S-Corps and C-Corps, are registered with the state and are required to file annual reports with state agencies that are often made available to the public as part of the business’s official record. In most states, sole proprietorships are not bound by these annual filing requirements.
5. Not Restricted by Formality
There are several other common business procedures that sole proprietors may forego, which further protects your privacy and control of the business. For example, sole proprietors are not obligated to perform certain oversight tasks required of other business structures, such as:
Certain business organizations, like LLCs and corporations, are required to hold annual meetings and board meetings. These assemblies formally review business decisions, which are then approved by managers and directors of the company, respectively
LLCs and corporations are required to record formal minutes for annual and board meetings
- Formal Reviews and Shareholder Votes
In corporations and LLCs, decisions on new members or managers are put through a formal review process and/or shareholder voting round before being approved
6. Simple Record Keeping
Because there is no legal separation between an owner and a sole proprietorship, you can deposit your business revenue and pay business bills directly through your personal bank account.
However, while combining all of your finances may be convenient, it’s not recommended. Keeping individual records for your business and personal finances may mean more initial effort, but it will help differentiate your business’s operating cash flow from your own personal assets and maintain a clearer understanding of the health of the business.
While record and bookkeeping for sole proprietors is relatively simple, it does get more complex if you start to hire. Your sole proprietorship will be able to hire full-time employees (Form W-2) and independent contractors (Form 1099), but only after you secure an employer identification number (EIN). And then you would be responsible for all the record keeping and tax filings that go along with being an employer.
The Disadvantages of a Sole Proprietorship
There are downsides to being legally “one” with your business, too. Here are some of the risks and consequences to consider.
1. Unlimited Liability
As the sole proprietor, you are personally responsible for every asset, liability, profit and loss your business experiences, meaning your private assets are directly at stake.
Specifically, you could be held personally responsible for:
- Civil damages
- Property-related injury
- Product-related liability
- Business-related debts and expenses
In a sole proprietorship, any party you’ve interacted with—vendor, lender, customer, etc.—can take legal action against your business. Unlike LLCs and corporations, your assets can be seized to satisfy any obligations of the business.
Other business structures provide a legal barrier between the business and its owners. For example, LLCs or C-corps protect your assets from being seized by lenders, customers or vendors to settle business debts. Unless the business owners sign a personal guarantee that would permeate the corporate veil, this buffer protects their assets. Sole proprietors don’t get that level of insulation.
A good commercial general liability (CGL) insurance policy that covers any accidents or damages can help protect you from some of these risks, but not all of them.
2. Business Continuation
What happens to your business if something happens to you? If you were to pass away unexpectedly or decided to move on from the business, there would be no paperwork or succession plan with a sole proprietorship.
In other business organizations, the company would live on as long as its current leaders keep maintain any necessary filings and licensing. In a sole proprietorship, it ends with the owner. While an employee or family member may keep your business going, they would essentially be starting a brand new entity.
3. Raising Capital Is Difficult
If you ever plan to raise money from outside investors, operating as a sole proprietorship would become impractical. Without any independent business assets, investors won’t have anything to actually buy into.
Most investors also want to have a say in the direction of the businesses they’re financing. Because every decision funnels through the sole proprietor, there is no voting interest available for these shareholders.
While S-Corporations and LLCs make your business more open to outside investments, a C-Corporation could be the best way to attract the investors you want. While S-Corps are capped at 100 owners, LLCs and C-Corps have no limitations on ownership, meaning they can exceed 100 shareholders. LLCs and C-Corps are able to offer preferred stock, which pays higher dividends and puts stockholders at the top of the list in a liquidity event.
4. Can’t Take on Business Debt
Consider this scenario: Your business is growing steadily and things are going great. They’re going so great that you just received the largest purchase order in your business’s history. Only there’s a problem: You can’t afford the materials to fulfill this order. In a sole proprietorship, you would not be able to secure a loan for the business, as a separate entity.
Because a sole proprietorship is not legally separate from you, the owner, securing a loan for your business would mean signing a personal guarantee and placing your own assets at risk. While sole proprietorships are not the only business organizations subjected to personal guarantees, LLCs and corporations have the ability to absorb and take on liability in ways a sole proprietor cannot.
5. Perceived Lack of Professionalism
Because sole proprietors may pay bills through a personal checking account and are not organized as rigidly as a corporation, sole proprietorships are not always taken as seriously by everyone they interact with. Though it may not be fair, vendors, customers and potential partners sometimes interpret a sole proprietorship as unprofessional.
Two simple ways to address this perception is by filing a DBA (a “Doing Business As” name representing a person) and establishing a business checking account. These changes will present a more polished moniker to the public, allowing customers to pay by credit card or check directly in the name of your DBA.
How Does a Sole Proprietorship Compare to Other Business Structures?
Before structuring your business as a sole proprietorship, understand how it compares to other business structures. While sole proprietorships feature a simple set up and registration, each structure impacts taxes differently.
|C Corp||S Corp||LLC||General Partnership||Sole Proprietor|
Limited liability on business debts and obligations for owners
Company name protected by cross-state registration
Business can live in perpetuity
Permits unlimited number of owners
Non-U.S. citizens or residents may own the business
May be owned by a parent company
Shares of stock can be issued
Business profit and loss can be reported on owner’s tax returns
Owners can split profit and loss with the business for a lower overall tax rate
Permitted to distribute special allocations, under certain guidelines
Required to hold annual meetings or record meeting minutes
|C Corp||S Corp||LLC||General Partnership||Sole Proprietor|
Will the Advantages of a Sole Proprietorship Work for You?
Hopefully, this post has helped give you a clearer idea of what sole proprietorship really means.
Businesses without significant acknowledged risk in their industry can function as a sole proprietorship without much issue. For example, independent consultants, wedding planners, housekeepers, landscapers, freelance designers, computer consultants and online drop-ship retailers are excellent candidates to operate as a sole proprietorship.
The advantages of a sole proprietorship are great for small businesses, side projects and for when you’re just starting your business. But it has real limitations that you need to consider. And keep in mind, just because your business begins as a sole proprietorship, doesn’t mean it has to remain one. As you grow, you will probably want to transition to a business structure that allows you to expand, evolve and adapt. Above all else, make sure the organizational structure you choose provides every advantage for the needs of your business today and in the near future.