Article Summary
- A sole proprietorship is a business owned and run by one person, with no legal distinction between the owner and the business.
- The owner has complete control over all business decisions and receives all profits but is also personally liable for all debts and obligations.
- Sole proprietorships offer tax benefits and flexibility but may have limited funding options and growth potential.
- Entrepreneurs must consider their goals, risk tolerance, and financial situation when deciding whether a sole proprietorship is the right structure for them.
- It is important to consult with legal, financial, and tax professionals to make informed decisions about business structure.
Have you been thinking about starting a business, but you're unsure whether a sole proprietorship is right for you? Becoming an entrepreneur is a big step, one that deserves careful consideration. In this article, we'll dig into everything you need to know about sole proprietorship, including the meaning of sole proprietorship, its advantages and disadvantages, and how it compares to other forms of business structures.
What Is a Sole Proprietorship?
A sole proprietorship is a common business structure for entrepreneurs because it is easy to set up and has minimal regulatory requirements. However, there are some important considerations, so let's determine what qualifies a business as a sole proprietorship.
Definition and Characteristics
A key characteristic of the sole proprietorship is that it's an unincorporated business owned and run by one person. There is no legal distinction between the owner and the business. The owner has complete control over all the decisions being made and receives all profits generated by the business.
Legal Nature and Ownership
An entrepreneur who chooses sole proprietorship as their business structure has unlimited liability.[1] This means that they are personally responsible for any business debts and obligations. If a situation arises where a customer is unhappy and wishes to take legal action, they will be doing so against the owner, which means the business owner's personal assets could be affected.
With a sole proprietorship, the business and the owner are considered the same legal entity. Depending on the nature of the business, this could result in potential risks to the owner.
Advantages of a Sole Proprietorship
A sole proprietorship has several advantages, including ease of setup and operation, potential tax benefits, and flexibility.
Simplicity and Direct Control
Every state has its own requirements for starting a business, such as registering a business name and obtaining certain licenses, so it's always best to check the requirements for your state. However, generally speaking, to start a business as a sole proprietorship, all you have to do is start spreading the word about your new venture.
As a sole proprietor, you have complete control over your business since it's just you operating it. This means you won't have to spend time discussing things with your business partner or waiting for a board of directors to make a decision.
Tax Benefits and Flexibility
When it comes to taxes, a sole proprietorship is what's known as a pass-through entity.[2] This means all the business profits are taxed on the owner's personal tax return by completing Form 1040, Schedule C, Profit or Loss from Business. You can also claim eligible business expenses as deductions on this form. If your business is in a loss position and you have income from other sources, such as employment, the loss from your business may be deducted (subject to restrictions) from your employment income, saving you taxes.
A sole proprietorship is arguably one of the most flexible business structures because it is controlled by only one person. This makes it easier to pivot and adjust to changing economic circumstances.
Disadvantages of a Sole Proprietorship
When considering the structure of your business, it's equally important to consider disadvantages. The sole proprietorship comes with challenges, such as increased personal liability and limited capital and growth potential.
Personal Liability Risks
Since a sole proprietorship isn't recognized as a separate entity from the business owner, you are more exposed to personal liability when you are a sole proprietor. This means your personal assets, not just those of the business, may be considered in any legal battles. If the business defaults on loans or declares bankruptcy, this may also be reflected in your personal credit history.
Limited Capital and Growth Potential
Capital is what is required to start a business. When you start a sole proprietorship, you are limited in the ways you can obtain funding since you aren't incorporated and can't secure funds by selling shares of the company. The survival of a sole proprietorship often depends entirely on the owner's continued ability to run the business. In this case, the business may not be able to carry on if something were to happen to the owner. This may be viewed negatively by investors.
Key Considerations for Starting Business as a Sole Proprietor
In addition to the advantages and disadvantages of starting a business as a sole proprietor, it's important to consider things like tax and legal implications as well as the suitability of the business structure for the type of business.
Tax and Legal Implications
When you work as an employee, the company you work for is responsible for sending payments for Social Security and Medicare to the government on your behalf. Part of these payments are deducted from your paycheck, and the other part is paid by your employer.
As a self-employed entrepreneur, you are now the employee and the employer. This means it is up to you to pay both the employee and employer portion of self-employment taxes, which fund your future Social Security and Medicare benefits.[3]
Suitability for Entrepreneurs
It's important to consider your goals as an entrepreneur when deciding if a sole proprietorship is right for you. This type of business structure is often a great fit for someone looking for a simple operation with maximum control. However, if you have big dreams of growing your operation into something larger, it may be more tax advantageous to select another form of business structure.
Your business industry could also contribute to your decision. For example, businesses with low overhead, such as freelance writing or consulting, may be well suited to the sole proprietorship structure, while a manufacturing business that requires significant startup funds might be better structured as a corporation.
Some business owners may not be comfortable with the unlimited liability that comes with a sole proprietorship. For this reason, they may prefer to start their business as a separate legal entity right from the start.
Sole Proprietorship vs. LLC vs. Partnership
There are other key forms of business structures to consider before making a decision on how you want to set up your business. These include limited liability corporations (LLCs) and partnerships. Let's take a look at what sets these types of business structures apart from the sole proprietorship.
Business Structures
Both an LLC and a partnership provide limited liability that the sole proprietorship doesn't. An LLC is a separate legal entity. This means it stands on its own, apart from the shareholders (also known as the business owners). While this can offer protection for shareholders, it's still a good idea to consult with your lawyer to understand exactly how this works. Another advantage offered by the LLC is that some people view a business as more credible if they see the letters LLC at the end of a business name.
Partnerships can be limited liability or general liability. In a limited liability partnership (LLP), the partners' liabilities are specified in the partnership agreement. With a general partnership, partners have unlimited liability, just like in a sole proprietorship.
The liability in a partnership is generally limited to the amount of funds each partner contributes to the business when first setting it up. For example, if Partner A pays $40,000 toward startup costs for the business, their liability in the partnership would be limited to that $40,000 contribution. This means that if the business incurs any debts or legal liabilities, Partner A would only be responsible for their initial investment.
It's important to note that limited liability in a partnership only applies to the partner's personal assets. Any business assets or funds are separate from personal assets and can be used to settle any business debts or obligations. This limited liability feature is one of the advantages of forming a partnership. It offers partners a level of protection by ensuring they are not held personally responsible for the business's financial obligations beyond their initial investment.
Both LLCs and partnerships require legal documentation for their creation, whereas a sole proprietorship does not.
Pros and Cons of Each Structure
For quick reference, here's a summary of the pros and cons of each type of business structure discussed in this article:
Sole Proprietorship
Pros:
- Simple to set up and operate
- Complete control by business owner
- Easy to adapt to changing circumstances
Cons:
- Unlimited liability
- Raising funding may be more challenging
- Growth potential may be restricted
- If business owner dies, business may cease to operate
Limited Liability Corporation (LLC)
Pros:
- Limited liability
- Increased opportunities to raise funds through share sales
- Potential tax-saving opportunities
- May be seen as more credible by potential customers
Cons:
- Requires legal documentation to set up
- More costly to file corporate tax returns
- Depending on taxable income and tax structure, you may pay more tax than sole proprietorship
Partnership
Pros:
- Limited liability (if this type of partnership is chosen)
- Potential to pool resources from partners
- May have better access to funding than sole proprietorship
Cons:
- Requires legal documentation
- Potential for disagreements among partners
- Unlimited liability for general partners
Making the Decision: Is a Sole Proprietorship Right for You?
Choosing the right business structure for your entrepreneurial endeavor isn't a decision to be made lightly.
Self-Assessment and Examples
In order to decide which business structure is right for you, keep your business goals, risk tolerance, and financial situation in mind, as well as the type of business you want to start.
Consulting Professionals for Guidance
When it comes to important business decisions, it's always best to consult the experts. If you're not sure which business structure is best for you, consider consulting a lawyer, accountant, or other financial professional.
Once you've decided on your business's legal structure, check out our business products and services designed with your success in mind.
