Is there a business beyond incorporation? Sure, there is. A sole proprietorship is a bright example of such an enterprise. If you work solo and seek to initiate a venture without any formation formalities and routines, this option is for you. However, before you rush into this alternative, we suggest that you look into it in more detail and consider all sole proprietorship pros and cons. This will help you get a better idea of this entity type and the perspectives it offers.
What Is a Sole Proprietorship?
To make it clear from the start, this type of company is rather a business form than a legal structure. In fact, it has no legal structure since it’s an unincorporated business entity. As the name suggests, the firm is run by a single individual. And the owner is directly associated with the company. It means a sole proprietor is personally liable for business risks, obligations, and duties. For this reason, this role is not an option for bigger ventures and businesses targeting growth and expansion. It might be a reasonable choice for low-profit smaller businesses run from home or started as hobbies as well as for freelancer activities or services delivered to a group of permanent customers.
When it comes to the formation process, simplicity is the name of the game here. Strange though it might seem, sole proprietorships are established automatically involving no official registration at all. There are no common formalities to follow, no piles of papers to fill, and no filing fees to pay. Once you start selling goods or providing some sort of services, you are considered a sole proprietor. Note, though, that this status is not exempt from licensing requirements. You will have to register appropriate licenses and pay for them.
Understanding a Sole Proprietorship
To better understand how this type of entity is set up and functions, let’s consider the following aspects.
Naming a Sole Proprietorship
As you’ve already guessed, establishing this enterprise is as simple as one, two, three. Skipping the legalities, you also skip the business name search. In contrast to more complex entities, sole proprietorships are named after their owners. You’ll only have to perform a name search if you choose to operate under a different name more appropriate for marketing purposes and the industry you work in. In this case, you’ll also have to apply for a DBA (doing business as) in the state where you run your activity.
Though not a legal entity in common sense, as a sole proprietor, you’ll still be entitled to hire employees if necessary or as your business venture grows. You just need to acquire a federal tax number or EIN for that. Yet, it won’t take you much hassle since the IRS issues those numbers for free and you can apply for that online to get the EIN the same day.
A sole proprietorship is not distinguishable from its founder, hence, income taxes of the firm pass on to the owner’s personal tax return. So, any revenues brought by the venture are considered the profit of its owner and are payable under an individual tax rate valid for a sole proprietor as a physical person in a certain state. Thus, along with your standard Form 1040 for personal taxes, these entrepreneurs file Schedule C for business taxes. Besides, sole proprietors are considered self-employed and should pay self-employment taxes as well. On top of that, they are exposed to unemployment taxes for the hired employees.
Along with business profits, a sole proprietor also carries the business losses to be reported under the above Schedule C on their personal tax return. Yet, there is a positive aspect to it. If you have some other sources of income, your sole proprietor losses will cut down the overall taxable amount on your tax return.
As a proprietor, you are your enterprise and you are the company in the eyes of the law. In practice, it means you are the only one liable for all business matters. It includes debts, lawsuits, and any legal issues or other potential problems that might arise. Thus, if you take a loan or credit for company needs and your firm fails to pay it, you’ll have to settle those debts with your personal assets, be it the funds on your bank account, real estate, or any other property. What’s more, should you or your employee be involved in any act of negligence resulting in some serious consequences for other individuals, your individual assets will be again put at stake.
Sole Proprietorship Pros and Cons
As with any other business form, a sole proprietorship has its pluses and minuses that make it attractive for some entrepreneurship scenarios and not the best alternative for others. To see if this structure will fit your business needs, let’s first see how its pros and cons stack up.
- Fairly simple formation process with no registration procedures to follow and compulsory fees to pay;
- Fewer ongoing formalities to match. There are no annual reports to be filed and no internal records to support;
- Sole proprietorships can skip opening separate bank accounts for the business, and the owners can use their own checking accounts for the firm purposes as well;
- Unemployment tax exemption for the company owner;
- Pass-trough taxation, not to mention commonly lower sole proprietor’s tax rates.
- Lack of liability protection against business losses, duties, debts, lawsuits, and other legal problems. Potential legal issues might put your personal financial stability at great risk since your personal assets can be used for resolving those issues, be it a bank loan repayment or court order settlement;
- Lower growth potential as compared to other types of enterprises. Due to the liability risks it brings, sole proprietorships are good for smaller and low-risk businesses. Boosting up your revenues, you’ll automatically increase the liability degree and related financial risks;
- Limited fund-raising opportunities. Sole proprietors are not attractive for investors and can’t engage capital by issuing stock or selling interest. The owner can only take a personal loan and use it for company purposes. Yet, here comes the liability again;
- Sole proprietorships are not entitled to tax benefits. Unlike LLCs and corporations, they should pay FICA taxes in full.
All in all, sole proprietorships are simple entrepreneurship structures that need nearly no effort from your side to be set up. Actually, they exist by default as soon as you start running some commercial activity. Ideal for entrepreneurs on a budget, sole proprietorships are widely popular in the US. As your venture grows and becomes more profitable, you can transform it into an LLC at a legal level to avoid liability aggravation.