The type of business entity you choose can impact everything from how you pay your taxes to the amount of paperwork you have to fill out to whether you can bring on investors or not. One of the most common business structures is a sole proprietorship, which many individuals running small businesses use, including freelance graphic designers and computer programmers.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned by one person. At its core, there is no real distinction between the owner of a sole proprietorship and the business itself. Because of that, a sole proprietor has unlimited personal liability. That means your personal assets—your house, personal bank accounts—are also at risk if a claim is made against the business (e.g., through a lawsuit) or you have to pay back business debts.
On the flip side, filing taxes is relatively painless because of the simplicity of the business structure. As a sole proprietor, you file your business income on your personal income tax return.
What are the advantages of a sole proprietorship?
A sole proprietorship is the simplest of all the structures for a single-owner business. Your business is automatically considered a sole proprietorship without having to incorporate your business. However, you must apply for any licenses or permits that your state requires for your profession.
As the owner, you are responsible for all business debts, losses, and liabilities, but are also entitled to all the business profits, too. Other advantages include:
- Ease. Because there is no formal action required to form a sole proprietorship, owners can save money and time that would otherwise be spent fulfilling paperwork requirements.
- Complete control. As the sole proprietor, the owner can make all the decisions about the business without partners or shareholders to consult.
- No corporate tax payments. Instead of completing corporate income like a large corporation would, sole proprietorships require the owner to pay only personal income taxes. You simply have to attach a Schedule C to your 1040 form.
- Inexpensive. While sole proprietors must abide by licensing requirements designated by the states where they work, other paperwork and formalities are limited. As a result, it’s less costly to start than a corporation. Costs to forming a sole proprietorship typically come when filing taxes, as you might need to enlist the help of a tax professional.
What are the disadvantages of a sole proprietorship?
Here are some of the drawbacks to the sole proprietor business structure:
- Debts, duties, and obligations all on you. As the sole proprietor, you are solely responsible for paying all the company’s debts and obligations. That’s true even if an employee or contractor causes the issue.
- Unlimited personal liability. Not only can someone make a claim—such as in a lawsuit—against your business assets, they can also make a claim against your personal assets, like your home. Unlike other business structures, a sole proprietorship doesn’t protect your personal assets from creditors.
- Capital contributions. As a sole proprietor, you’re responsible for paying for all the capital needs—office equipment, for example—of the business. You may also find it harder to get a loan from a bank, since lenders typically view sole proprietor businesses as risky investments.
- Lack of investors. Investors usually bypass opportunities to invest in sole proprietorships because they want to receive equity in exchange for their money. Because a sole proprietor can have only one owner, there is no possibility to distribute equity.
- Increased taxes. As a sole proprietor, you have to pay self-employment tax on top of personal income tax. It can also be trickier to figure out how much you will owe in taxes because you are combining business and personal taxes. To avoid paying a larger-than-expected tax bill at the end of the year, the IRS recommends estimating and paying your taxes quarterly.
Starting out as a sole proprietor is a good way to test the waters as an entrepreneur since there is very little investment in both time and money to this type of business entity.