Going It Alone: Pros and Cons of Sole Proprietorships

Whether you are an entrepreneur with a new business idea or have been around the block a few times, at some point in the business development process you must decide what form of business entity to establish.

You might already be familiar with the various business entities and the pros and cons of each. If not, this article and future TCOB feature stories will highlight the most common forms of business entities and their various advantages and disadvantages. They include

• Sole Proprietorships
• Partnerships
• Corporations
• S Corporations
• Limited Liability Company (LLC)

While this article focuses on sole proprietorships, each entity type has its own set of legal and tax considerations and the type of entity you select will generally determine the type of income tax forms you are required to file. Consequently, it’s a good idea to consult your attorney, accountant, financial advisor, tax advisor or banker before you settle on a specific entity type. Such advisors can help you determine which entity is best suited for your business, your goals and the various state and federal tax implications.

What’s a Sole Proprietorship?

The IRS says a sole proprietor is “someone who owns an unincorporated business by himself or herself.” As a sole proprietorship you and your business are one and the same. Sole proprietorships are the most common and simple form of business organization.

Sole proprietorships are formed by individuals who own all or most of the business property and assets. There are no special tax filing requirements with sole proprietorships and no formal paperwork, unless you have assumed a fictitious business or trade name (other than your own). In such cases you may need to record a “DBA” (doing business as) with the Utah Department of Commerce.

As a sole proprietor, your business income is your personal income. Both income and expenses are reported in your individual tax return on Schedule C of the federal Form 1040. What's more, you’ll most likely be obligated to pay self employment taxes (Schedule SE). With regard to employees, a sole proprietor may hire employees for the business, but they are employees of the sole proprietor. As such, the sole proprietor is personally responsible for all taxes and filings associated with employees.

Advantages

In a sole proprietorship you are 100 percent responsible for all of the control, liabilities and management of a business. You have the right to make all of the management decisions of the business. Furthermore, all business profits are yours. Additional advantages include low organization costs, the greatest amount of freedom from regulation and possible tax advantages (taxation at your individual rate and possible deduction of losses on your individual return).

A sole proprietorship is also highly transferable. "Transferability" means the ability of the owner to sell or convey his or her business ownership interest to someone else.

Disadvantages

A sole proprietorship is a risky form of business for its owner. In return for complete managerial control and sole ownership of profits, you assume total liability. You are personally liable for all the obligations of the business, which includes all of the debts of the business and debts on contracts signed in the name of the business. If the assets of your business are insufficient to pay the claims of your creditors, the creditors may require you (the sole proprietor) to pay the claims using your individual non-business assets, which could include money from personal bank accounts and the proceeds from the sale of your house or other personal assets. Ultimately, you have the potential to lose everything if your business becomes insolvent.

In sole proprietorships it may also be difficult to raise capital. You may have to use your own money, borrow from family and friends or borrow against personal assets. What’s more, your liability is unlimited if your business is sued. Because the sole proprietorship is merely an extension of its owner, it has no life apart from its owner. It is not a legal entity. It cannot sue or be sued. Instead, creditors must sue the owner. Conversely, the sole proprietor, in his or her own name, must sue those who harm the business.

Sole Proprietorship are Most Common

In light of all the risks, the sole proprietorship is the most common form of business in the United States. That’s because sole proprietorships are easy and inexpensive to form. A person need merely begin operation of the business—no formalities are necessary. In fact, because few people select a business entity when they begin their businesses, by default they automatically become sole proprietorships.