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Risks and Benefits of a Sole Proprietorship

Updated: November 3, 2021

At the height of the pandemic last year, there was an unprecedented explosion of new businesses that began in response to record high unemployment and fears of leaving the house. According to the Census Bureau, more than 4.4 million new businesses were created nationwide in 2020, marking a 51% increase from the 2010-2019 average.1

If you are among the new business owners who got their start recently, you may have wondered which business structure would best fit your needs. The most common type is sole proprietorship, which we will focus on in this article. 

Table of Contents

What is a Sole Proprietorship?

A sole proprietorship is an unincorporated business owned by one individual. Often operating under their own name, the owner pays personal income tax on profits earned from the business and reports any losses incurred by the business.2

If you are self-employed and work as a contractor, consultant, or freelancer, you are likely operating as a sole proprietor. With minimal government regulation and necessary paperwork to get it off the ground, this is the most common type of business, accounting for 73% of all existing businesses.3

Advantages of Sole Proprietorship

Compared to business types like LLC or corporations, sole proprietorship comes with some advantages that relate to ease, convenience, and simplicity.

Easy Set Up

A sole proprietorship is essentially established by default when an individual begins operating their business. You don’t need to register the business with your state, unlike entities such as LLCs, so there is a lack of government regulation that allows leeway for how you choose to run your business. Plus, you don’t have to worry about the hefty costs of registration and licensing, so you won’t need much capital to get it off the ground. However, depending on your state or local government, you may need to obtain a business license or permit. 

Full Control, Full Profits

As a sole proprietor, you are the sole owner of your business. That means you maintain full control and ownership of the business and are entitled to all the profits. This would be ideal for smaller operations that do not require a whole lot of legwork. 

Simple Tax Preparation

Under a sole proprietorship, you and your business are seen as one entity. That means that all profits and losses incurred by your business are reported on your personal tax return (Schedule C, also known as Form 1040), unlike a corporation, which requires a separate tax filing. In addition, as a sole proprietor, you are exempt from what’s known as a “double taxation.” This means that the full amount of your income as sole proprietor is not taxed; instead, you only pay taxes on your business profits.4

Disadvantages of Sole Proprietorship

For every advantage listed above, there is a flipside that can serve as a disadvantage to you and your business, depending on your situation. 

Exposure to Liability

Without a legal separation between you and your business, there is no government protection when it comes to liabilities. This means that debts, lawsuits, bankruptcy, and other obligations would extend from your business to you, the owner. Since you would be held personally responsible for these events, lawsuit claimants or creditors may have access to your personal assets if you are unable to cover your business debt.5 

Difficulty Getting Capital 

New businesses typically rely on a stream of seed money to build out its operations. One common source of capital is a business loan or financing from bank lenders, but with a sole proprietorship, it may be difficult to get approved. That’s because banks typically look at the business’ credit history and its level of establishment. With a sole proprietorship, it may be difficult to build a sense of credibility with the lender. 

Sole proprietors also cannot sell equity in their companies to raise capital as commonly done in other business structures. By law, a sole proprietorship can only have one owner. 

Lack of Structure

Business types such as LLCs and corporations often use what’s known as an operating agreement, which outlines the company’s ownership, management, and individual’s roles and is binding unless amended by the board of directors. This ensures that there are established procedures, rules, and standards that have the company’s best interests in mind. As a sole proprietor, however, you alone are responsible for all the successes and failures of your business. It will be up to you to establish a productive operating structure and stick to it.  

When to File as an LLC

With all the advantages and disadvantages of sole proprietorship, it will be smart to weigh all your options at the start of your business. If your business is low risk and restricted to a small set of clients, a sole proprietorship may be the right choice. However, if you are looking to expand your business and have a higher risk with higher potential profits, you may benefit from the legal protections of an LLC. 

Sources

  1. https://www.salesforce.com/blog/small-business-pandemic-entrepreneurs/
  2. https://www.ftb.ca.gov/file/business/types/sole-proprietorship.html
  3. https://taxfoundation.org/overview-pass-through-businesses-united-states/
  4. https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships
  5. https://law.richmond.edu/academics/clinics-skills/in-house/ip-clinic/pdf/business-sole-proprietorship.pdf
  6. https://smallbusiness.chron.com/attracting-capital-sole-proprietorship-59327.html

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