Starting a Sole Proprietor Business
Advantages and Disadvantages of Sole Proprietorship
Most small businesses are sole proprietorships because this type of business is the easiest and least expensive way to start a business. But what is a sole proprietor? Should you start a sole proprietor business?
Are You a Sole Proprietor?
If you haven't selected a specific business form and registered it with your state, you are most likely a sole proprietor. You can stay as a sole proprietor your entire business life, or at some point, you may want to consider a different business form, for several reasons. This article reviews the advantages and disadvantages of the sole proprietor business, to help you decide when to move to another business form.
What is a Sole Proprietorship?
The sole proprietorship is the oldest and simplest form of business ownership. A sole proprietorship (or “sole prop”) is a form of business in which an individual starts a business under his or her own name. It's a one-person business; if there is more than one owner, your business can't be a sole proprietorship. In a sole proprietorship, you are the business; that is, the business is not a separate entity from you.
A sole proprietorship is unique because it's the only business that doesn't have to register with a state. All other business types - partnerships, limited liability companies, and corporations - must file a registration form with each state in which they do business.
How Does a Sole Proprietorship Get Started?
Starting a sole prop business seems simple, and it is. To start a sole proprietorship, all you need to do is:
You don't need to prepare any legal documents because you are not in business with someone else, and you don't have to set up an elaborate business structure: no board of directors, no meetings, no minutes, no complicated accounting for shares in the business.
If you decide to set up your new business as a sole proprietorship, follow the Startup Steps, and you will be ready to go.
Advantages of Sole Proprietor Form
The advantages of forming a sole proprietorship include:
As the sole owner of the business, you have complete control over all the operations, and you get to make all the decisions. You don't have a board of directors, shareholders, or other owners to answer to.
Use of Losses
Because you are including your sole proprietorship income/loss on your personal tax return, you can use any business losses to offset personal income from other sources (a spouse's salary, for example). You do need to be careful not to run up against the IRS restrictions on "hobby" businesses which generate losses for years, but if you can prove your business is legitimate and not a hobby, those losses can lower your taxes.
Disadvantages of the Sole Proprietorship
The primary disadvantage of a sole proprietorship is that your personal finances and those of your business are one and the same. You cannot file bankruptcy for your business without filing personal bankruptcy. You cannot expect to shield your personal assets from liability for the debts of the business, nor can you avoid being sued personally for negligence due to some problem with your business.
For example, if your sole proprietorship cannot pay its bills, your personal credit card will probably come into use. And filing bankruptcy for your sole proprietorship, whether it is a reorganization (Chapter 11) or liquidation (Chapter 7) means involving your personal assets. As stated by the U.S. courts website (in the Chapter 11 section): "a bankruptcy case involving a sole proprietorship includes both the business and personal assets of the owners-debtors."
For many business people, the issues of personal liability and involvement of personal assets outweigh the advantages of sole proprietorship structure. If this is the case with you, consider forming a limited liability company (LLC) or corporation.
Getting Business Insurance Protection
You can't protect your personal assets if your business is in trouble financially, but you can get some protection from liability lawsuits if you get property and liability insurance. You will probably have to get this insurance specifically for your business, but it can help protect you if your business is involved in a liability lawsuit.
If you drive your car for business, you might want to get business auto insurance to cover you while on business trips. Most personal auto policies won't cover business driving.
Taxes and Sole Proprietorships
The sole proprietor pays income taxes on all of the net income of the business (income minus deductions), even if you don't have cash in hand to pay these taxes.
Your business income is included with your personal income on your personal tax return. The tax rate you pay may on the business income is hard to determine, since it's all combined. The corporate tax rate is 20 percent, so your tax rate may be higher or lower than this. That's why, if your business is profitable, you may want to consider becoming a corporation or S corporation.
As a sole proprietor (and as the owner of any business except a corporation), you must also pay self-employment taxes (Social Security and Medicare tax) on your business net income. This is a disadvantage to being a business owner, but it also gives you Social Security credits based on your income.
Check with Tax and Legal Professionals
Even if you have a very small one-person business, you should check with your tax and legal advisors before settling on a business form. There may be other things you need to consider before you start a sole proprietorship business.