What Is a Sole Proprietorship?
A sole proprietorship is just one of several legal structures you can choose for your small business. They legitimize your business and allow you to handle taxes, raise money, and determine several other key factors. In many cases, you won’t be able to register your business in your state without selecting a business structure.
Each business structure has its advantages and drawbacks. You should sit down with an accountant to examine your options and find the ideal direction for your business. It also wouldn’t hurt to get insights from a trusted mentor who has successfully started and structured businesses in the past.
“Of all the decisions you make when starting a business, probably the most important one relating to taxes is the type of legal structure you select for your company,” explains a report from Entrepreneur. “Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face, and your ability to raise money.”
Sole proprietorships are the most popular business structure in America, with tens of millions of entrepreneurs using this structure to make their dreams a reality. Why are they so in demand? It’s largely the same reason that frozen foods are more popular than ever right now: they’re easy to use, which makes them more enjoyable.
Sole proprietorships are designed for maximum user-friendliness. The paperwork involved with creating one is minimal, the cost is low, there are fewer hoops to jump through, and you aren’t even required to register with your state.
One of the aspects of a sole proprietorship that makes them so downright amiable is referenced in the name: sole proprietorship. When you structure your business this way, you’re the only owner (sorry, but if you have partners, you’ve got to move along and look at other options).
By working alone, you won’t be required to navigate the sometimes-volatile waters of partner agreements. Every aspect of the formation and operation of your business under the sole proprietorship structure will be more efficient because there’s just 1 person calling the shots.
On top of that, you’ll receive all the profits brought in by your business. This might seem like an obvious perk, but if you’re still unsure, ask someone who’s in a partnership with 7 other people what it’s like to split profits 8 ways.
When tax season rolls around, a sole proprietorship’s filing process will also be easier than for more sophisticated business structures. As far as the government is concerned from a tax perspective, you and your business are a single entity. Your business’s profits will have passed directly through to your personal taxes, making it easier to keep organized and take care of any payments needed. And the tax rates for sole proprietorships can be some of the lowest around.
What Are the Drawbacks of a Sole Proprietorship?
We’ve looked at many of the perks that make sole proprietorships so tantalizing. But there’s always a trade-off, so you should be aware of the possible issues that come with structuring your small business as a sole proprietorship.
For starters, you bear a lot of responsibility as a sole proprietor. The fact that you don’t have any partners in the mix also means that there won’t be anyone to share the burden if problems arise. If your business suffers debts and losses, you’ll be individually responsible. Your name is legally tied to your business, and there’s no liability protection available to you, which means your assets could be at risk if you’re unable to meet your financial obligations.
The lack of a barrier between you and your business offers lots of benefits in the good times, but it can make things quite rough in the bad times. If things get particularly bad and your business was to file for bankruptcy, your personal finances would take a corresponding hit. The same threat exists if someone files a lawsuit against your business.
Additionally, your tight connection to the business can impact your ability to sell or transfer the business if you ever want to pursue those routes.
“Sole proprietorships can be difficult to sell because the business is completely tied to the owner,” says The Balance Small Business. “Since there is no distinction between the assets of the owner and the business’s assets, the proper valuation of the business can be hard to achieve. Operation-wise, unless the sole proprietor has friends or family members who can carry on running the business, illness or injury can affect business continuity. Customer loyalty resides with the original owner of the business and may not readily transfer to a new owner.”
As you can see, sole proprietorships are far from perfect. But many small business owners feel that the benefits of this structure far outweigh the negatives.
What Are My Other Options for Business Structures?
After all this talk about sole proprietorships, it’s important to remember that there are several other options that might work for your business. Each has its quirks and weaknesses, similar to what you’ve seen with sole proprietorships.
Let’s take a closer look at 4 other legal structures to consider for your small business:
Remember how sole proprietorships offer as much liability protection as an umbrella offers flood protection? Corporations address this limitation by establishing a clear separation between small business owners and their businesses. The business is set up as its own legal entity, so if there were debt or losses, your personal assets would be shielded. This means your home, vehicles, boat, and real estate won’t be in jeopardy.
There are inevitable trade-offs that come with the ample liability protection provided by a corporation. For starters, they’re substantially more challenging to create. If you have an aversion to paperwork, beware—it takes piles of forms and documents to get a corporation up and running.
The reason for all the additional paperwork: a corporation is built from the ground up. Remember, it’s considered a separate entity from yourself. With a sole proprietorship, you bypass many of these requirements because you’re merely connecting the business to your own already-established records.
On top of the paperwork, you should also be aware that corporations are more expensive to create than sole proprietorships. But if you were to determine that a corporation makes more financial sense for your business, these costs would certainly be worthwhile.
With a corporation, profits don’t pass through to your personal taxes as they would when you have a sole proprietorship. This means you’ll pay both state and federal corporate income tax. If earnings have been distributed as dividends to shareholders, you’ll also owe money on your personal taxes.
While the idea of working as a sole proprietor is enticing to many entrepreneurs, there are times when a partnership offers more resources and growth potential. You can combine forces with other talented individuals to create something greater than the sum of its parts.
“Partners share the workload of a business, although partners may handle different responsibilities,” says small business expert Matthew C. Keegan. “One partner may be skilled with accounting, another might be an expert marketer, and yet another could be an innovator. Such a collaboration of talents may allow the sum parts to thrive where, individually, each partner might not be able to succeed on his own.”
This “strength in numbers” approach also proves to be advantageous when facing debts and losses, as 1 person won’t necessarily be left on the hook from a liability standpoint.
On the complexity scale, establishing partnerships falls somewhere between sole proprietorships and corporations. You can plan on a moderate level of required paperwork and the costs are usually reasonable.
There are a couple of different options when structuring your business as a partnership. First up are general partnerships, which are as basic as the name implies. All the partners share equal roles in these businesses, meaning they have a stake in business decisions and will also share the burden of financial liability.
Limited partnerships take a more customized approach, where only certain partners have the full responsibilities as described above. Other partners have a more limited role, where they act more as an investor than a leader. These limited partners enjoy a similar level of liability protection to a corporation.
As with a sole proprietorship, there are pass-through tax rules for partnerships. There’s no corporate income tax, and your small business’s profits and losses transfer to the personal taxes of all relevant partners.
3. S Corporation
What if you want the liability protection of a corporation and the pass-through tax laws of a sole proprietorship? The hybridized S corporation fills this role, giving you many of the benefits provided by the structures listed above.
With an S corporation, you create a separate legal entity that protects you from personal responsibility in the case of losses. And this structure offers more flexibility than a corporation when it comes to shareholders, as you can invite up to 100 into the fold.
Just like with sole proprietorships and partnerships, S corporations allow for the profits and losses of your business to pass through to your personal taxes. This makes tax season much more enjoyable, as there are fewer forms and processes to manage. Additionally, you won’t have to deal with the issue of paying your taxes twice, as you sometimes do with a corporation.
As you might have guessed, there are some drawbacks to S corporations. They’re expensive to set up, and you’ll need to be cognizant of the provisions put in place for shareholders, like regular meetings for shareholders and directors, detailed minutes recorded from these meetings, and the ability for your shareholders to vote on major business decisions.
4. Limited Liability Company (LLC)
If sole proprietorships are the most popular business structure in America, LLCs are probably the runners-up. One of the major reasons for their desirability is right in the name: limited liability. This structure provides personal financial protection, similar to corporations and S corporations.
As with sole proprietorships, your LLC’s business profits and losses pass through to your personal taxes. This can often save you time and money when doing your taxes. Just know that you must pay self-employment tax with an LLC, potentially adding to your overall tax bill.
Given their hybrid structure, LLCs are often compared to S corporations. These 2 options definitely have a lot in common, with the most distinct differences being that LLCs have no cap on shareholders and all individuals who are part of the business have a seat at the table when decisions are made.
How Do I Take the Sole Proprietorship Plunge?
Now that you’ve had a chance to learn about how sole proprietorships stack up against the competition, you’re prepared for a productive conversation with your accountant and mentor. Every business is different, so there’s no silver bullet when it comes to structure. Pay attention to the nuances of your operations and find an option that maximizes your strengths.
Assuming everything checks out and you want to proceed with a sole proprietorship, it’s time to review your checklist and make sure everything is in order. Here are the bare necessities for creating a sole proprietorship:
- Your business has been named
- Your business has a website
- Your business has customers
- Your business has a checking account
- Your business has a license to operate within your locality
- Your business has state sales tax permits
- Your business has all other necessary permits and licenses
Work with your accountant and business mentor to initiate the business structuring process. Your mentor will be a particularly powerful resource at this point, as they’ll have likely gone through a similar process with their businesses in the past. This type of hands-on guidance is essential to setting everything up correctly.
If you don’t currently have a trusted mentor, reach out to the SCORE office in your area. They should be able to recommend a potential mentor and provide resources.
Another option: review your LinkedIn connections and identify people who have the experience and temperament to serve as a mentor. Choose a few top contenders and then contact them to see if they’d be willing to serve as your business mentor.
Once your business is established as a sole proprietorship, you’ll be in prime position to secure funding and grow your operations. Whether you own a bakery or a construction company, there are numerous expenses to be covered. Possible examples include licenses, permits, marketing, vehicles, equipment, insurance, rent, payroll, and supplies.
Take the time to survey your financing options, then identify an option that best lines up with your business goals. Here are 9 great options you should consider:
- Short term loans
- Business lines of credit
- Equipment financing
- Startup loans
- SBA loans
- Business term loans
- Merchant cash advances
- Accounts receivable financing
- Business credit cards
You also might want to research the microloans provided by organizations such as Kiva, Accion, and Opportunity Fund. These loans are usually on the smaller size from a dollar perspective, but they can be easier to qualify for—so if you need a quick jolt of cash, they often fit the bill.
One final source of financing to look into is grants. The process of qualifying for a grant is usually difficult, but if you can get one, it’s positively heartwarming to know that you’ll never need to repay the money.
Start your grant search on these websites:
- Amber Grant
- Idea Cafe Grant
- Halstead Grant
- National Association for the Self-Employed (NASE) Micro-Business Grants
Whether you utilize loans, microloans, grants, or some other source to fund your business, the important thing is that you have the fuel necessary to reach your goals. And with the right business structure complementing your finances, you’ll enjoy the money-maximizing benefits needed to make your business thrive.