Starting your own business is an exciting venture that can quickly turn into a daunting undertaking for even the savviest entrepreneur. Before you hang your shingle, you must first decide how you will structure your company for tax and legal purposes. Should you incorporate? Will you have partners? Do you plan to hire employees? You should discuss your plans with an attorney as well as a tax professional because the wrong decision now could have disastrous consequences later.
One very popular option is a sole proprietorship; that is a business run by one single individual, often under their own name. It is the easiest, cheapest, and quickest way to start doing business; so much so that it requires no planning at all. Anyone who is making money by selling a product or service is a sole proprietor. Hair Stylists, freelance writers, and craft fair vendors are often sole proprietors.
A wise businessperson knows the easiest path is not always the best path. As with everything in life, there are advantages and disadvantages of a sole proprietorship. It is important to understand this business structure so you can make the right choice for your company. View an overview of the pros and cons of sole proprietorship below:
| Advantages of Sole Proprietorship | Disadvantages of Sole Proprietorship |
|---|---|
| Simple & Inexpensive: Starting a sole proprietorship requires no planning, contracts, or start-up costs. Dissolving the business is also hassle-free. | Personal liability: The owner has unlimited personal liability, meaning they are fully responsible for the business's debts and lawsuits, which can result in the seizure of personal assets. |
| Minimal operating procedures: Sole proprietors have little to worry about in terms of managing the business. Obtaining an Employer Identification Number (EIN) is recommended but easy to obtain. | No corporate tax benefits: Sole proprietors file business taxes under their personal names, missing out on tax breaks enjoyed by corporations such as salary deductions, insurance premium deductions, and waivers from social security taxes. |
| Easy tax preparation: Sole proprietors have no special tax burdens, and income or loss from the business is reported on the owner's personal tax returns, simplifying tax preparation. | Limited access to bank funding: Sole proprietors may face difficulty in securing bank loans or investments due to being perceived as risky or lacking professional status, potentially hindering business expansion. |
As mentioned, starting a sole proprietorship requires no planning. No contracts, no registration, no start-up
Aside from keeping basic financial records, sole proprietors have very little to worry about in terms of managing the business. That being said, it is recommended that every business owner applies for an Employer Identification Number (EIN) with the IRS. An EIN can be used in place of a Social Security Number on invoices and other documents where you may not want to divulge personal info. It is also required by most banks to open a separate business account. Obtaining an EIN is free and only takes a few minutes.
There are no special tax burdens for sole proprietorships; no need to worry about quarterly filings or annual information returns. Any income or loss from the business is reported on the owner’s personal tax returns and can be filed at the beginning of the year like normal. Do be sure to keep a ledger of sales and expenses, along with any receipts to use during your yearly tax preparation.
The biggest drawback of the sole proprietorship business model is unlimited personal liability. It is imperative to understand that the business is not a separate legal entity, but rather an extension of the individual owner. If the business incurs debts or is a party to a lawsuit, the owner is fully responsible. This means that all personal assets, including bank accounts, houses, and other property could be seized if the business were to run into trouble. This is devastating for people unfortunate enough to find themselves in such circumstances.
Sole proprietors file their business taxes under their own names on their personal annual returns. While this method is simple, it does not allow for the tax breaks that corporations enjoy. There is no salary deduction, no insurance premium deduction, and no waiver from social security taxes. A tax professional can help determine if you could reduce your tax burden by incorporating.
It is the entrepreneur’s dream to grow their fledgling business into a thriving company. Often, a bank loan or investor is an essential part of expansion plans. Many lenders will not offer financing to sole proprietors because they are considered too risky or lack professional status. A sole proprietor can change the business structure to an LLC or corporation at any time, but it may be too late to secure funding if the window of opportunity has closed.
Every business is unique, what works for one may not work for another. Best practice is to consult a reputable tax accountant and a business attorney to determine what structure is best for your company. It is also wise to revisit these options every couple of years or whenever there is a significant change. Partnering with a trusted tax advisor is a prudent approach to achieving long-term success.