14 Things to Consider Before Signing Up As a Sole Proprietor
- The Small Business Association defines a sole proprietorship as “an unincorporated business owned and run by one individual with no distinction between the business and you, the owner.”
- Pros: It's easy and low-cost to start up, there's less paperwork and regulation, the taxes are straightforward and you have control over decisions.
- Cons: You'll incur the legal and financial liability, there's no tax write-off, it can be difficult to obtain funding and the business cannot live indefinitely.
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If you’re starting your own business or thinking of doing so in the future, you’ll need to carefully consider the right business structure for you and your commercial activity. According to the IRS, currently, 73% of all businesses in the United States are sole proprietorships. For women-owned businesses, the percentage is around 85%. These businesses cover a great range of services and professions, from freelance writers and artists working from home to companies selling a physical product at a brick-and-mortar location.
But is sole proprietorship right for you? Find out what it means and the pros and cons of the structure.
What is a sole proprietorship?
The Small Business Association defines a sole proprietorship as “an unincorporated business owned and run by one individual with no distinction between the business and you, the owner.” This means that as a sole proprietor, you’ll be personally liable for all financial debts and legal responsibilities associated with the business. A sole proprietorship can have only one owner, but it can take on employees or contractors.
Around 25 million people in the U.S. are sole proprietors, according to the most recently available IRS statistics, and the number is growing. So, why is it so popular? The main reason is that it’s by far the easiest way to set up your own business, compared with other types of business structure. Another popular option, which is also open to individual business owners, is the Limited Liability Company (LLC).
There is sometimes confusion over the difference between a sole proprietorship and an LLC. Although an LLC can be owned and run by a single individual and they may have the option to file taxes as a sole proprietor, there are significant distinctions between the two. LLCs require a little more financial output to establish because they need to be formally registered in their state as a business, and they have more restrictions and regulations affecting them. Corporations are the most closely-regulated type of business and the least dependent on any one owner. They have legal rights and responsibilities like a person and can own property, possess income, have legal action taken against them and exist indefinitely, separate from any individual owner or shareholder.
In contrast, sole proprietorships are so easy to start that it’s thought that many people could be sole proprietors without realizing it. If you’re self-employed, you could be a sole proprietor for tax purposes without having to take any special or formal actions to establish a sole proprietorship. This makes it the default position for many workers, such as freelancers. With the increasing number of freelance and gig-workers, sole proprietorship is likely to continue to grow.
Pros of sole proprietorship
1. It's easy and low-cost to start up.
No special forms, fees, or licenses are necessarily needed to become a sole proprietor. In fact, in many cases, you don’t really have to do anything to set it up, other than pick a name, start working and call yourself a sole proprietor! You don’t have to formally register with your state, as you would with an LLC. However, be aware that certain types of businesses, such as agriculture and financial services, require federal and state licenses, no matter what type of business structure you choose. The Small Business Association offers guidance on federal licensing requirements, as well as other aspects of forming your business, such as registering your business name and opening a business bank account.
2. There's less paperwork and regulation.
Sole proprietorships require the least work of all business structures when it comes to submitting paperwork and adhering to formal regulations. Unlike a corporation, that must by law hold annual general meetings, submit financial reports, and conform to a much wider set of business regulations, the sole proprietor isn’t required to consult with or report to anyone.
3. The taxes are straightforward.
As a sole proprietor, your business’ income is your personal income and is reported as such on your tax return. There’s no separate business tax to deal with, although sales taxes on products you sell will apply. The IRS lists the various tax forms you may require as a sole proprietor. For LLCs, there are a number of options for how to file taxes, while corporations are subject to a flat rate tax, and owners may wind up paying tax on profits as well as on individual income. You may still want to hire a professional advisor to be on the safe side, but sole proprietorship is certainly the simplest business structure when it comes to tax time.
4. You have control over decisions.
This is probably a large motivating factor in your decision to go into business for yourself. As a sole proprietor, you answer to yourself. Since you both own and run the business, you get to decide what you think is best for the business, in terms of long-term strategy and day-to-day operations. Unlike with corporations and partnerships, which might require discussions, formal meetings and votes from a board of directors, a sole proprietorship allows you to implement your vision unimpeded and efficiently. This can feel great and be extremely effective. However, consider the possibility that this may be a con as well as a pro. For some, making final decisions doesn’t come easily. For others, decisions can be reached too quickly. This doesn’t mean sole proprietorship isn’t for you. It's just a good idea to have people around for consultation or discussion. Otherwise, go for it and have fun calling all the shots!
5. You'll have freedom and flexibility.
The dream of setting your own schedule and fitting your career around your life, instead of the other way around, is what leads many toward the sole proprietorship route in the first place. Inevitably, it won’t be that simple. The number of hours you work and level of freedom you have as you establish your business in the first few years will depend on the nature of the business itself and whether it’s intended as a full-time or part-time endeavor. However, a sole proprietorship does give that advantage of having some control over when, where and how you work, compared to the level of flexibility offered by the average job. And since a large proportion of sole proprietorships are run as work-from-home freelance services, many do achieve the desired flexibility with this business structure.
6. The structure is easy come, easy go.
If the time has come to change direction, a sole proprietorship is the simplest type of business to bring to an end. Although there will be processes to follow and formalities to take care of, because you're the only one who owns and runs the business, it shouldn't involve any divorce-like legal wrangling that could potentially occur if you need to dissolve a partnership or larger company. On a more optimistic note, should your business grow, it would be possible to switch from sole proprietorship to LLC or even become a corporation.
7. You keep all the profits.
Forget about consulting with the board — you control the revenue and are free to reinvest profits into your business or take it as income as you see fit. While LLCs require a careful separation of personal and business finances, with a sole proprietorship, there's no legal distinction between you and your business. That said, it’s generally recommended that you do keep accurate records and separate your personal and business expenses.
Cons of sole proprietorship
1. You'll incur the legal and financial liability.
Legally, you and your business are one. As a sole proprietor, you’re personally responsible for the business finances. That means if the business is in debt, you’re in debt. Not only that, but if any legal issues arise and the business is sued, you’re personally being sued. So, if your business is failing, your personal assets will be at risk and you may personally have to declare bankruptcy. You also won’t have the legal protection of working for a corporation that would be liable in any legal disputes or litigation.
2. Your business could be perceived as unprofessional.
Unfortunately, perhaps because of the ease of establishing a sole proprietorship, your business may be seen as less legit and professional in comparison to an LLC or incorporated business. This can make it tougher for some sole proprietorships to gain credibility, as both clients and quality potential employees might be harder to attract. If you do choose to go down the sole proprietorship route, consider how you might counteract this attitude by maintaining levels of professionalism and presenting a confident image.
3. There's no tax write-off.
It's a common misconception that you’ll be able to write off any business losses as a tax deduction. This doesn't apply to sole proprietorships in the way it might to other business types. All business income is classified as personal income for the sole proprietor, whereas, if you run an LLC, you can choose to be taxed as either a sole proprietor, partnership or even a corporation, depending on what suits you best.
4. The entire responsibility is on you.
This is the flip side of having all the control over how your business is run. Of course, you may and hopefully will have supportive people around you, whether employees, professional advisors or friends and family. Although that will help, the bottom line is that, as a sole proprietor, you carry the burden. At the end of the day, the success or failure of your business is down to no one but you. Of course, depending on your personality type, this could be another pro! But be honest and realistic with yourself when considering whether to take on this challenge. While it might bring out the best in some people, it’s not a weakness if you feel it won’t bring out the best in you. Going into it aware and prepared could make all the difference.
5. It can be difficult to obtain funding.
Sole proprietors frequently find it a challenge to secure outside investment and loans. This is partly due to the perceived lack of professionalism, mentioned earlier, and also because they tend to be seen as higher risk since they're dependent on one individual. It’s worth checking out the grants and other support offered to small businesses in general, particularly sole proprietorships.
6. The business cannot live indefinitely.
Because, as a sole proprietor, you as an individual are the business, it can’t continue indefinitely. Whereas a corporation is its own legal entity, a sole proprietorship is legally and financially inseparable from the sole proprietor. A corporation will easily continue after the founder has left but not so for sole proprietorships. Although you can pass the business onto someone, technically, that would make it a new sole proprietorship.
7. You carry all the losses.
If your sole proprietorship runs at a loss, there’s no way to write that off. You’ll have to find the funds to cover the damage or just live with it coming out of your own pocket. Debts will affect your personal credit score, and there’s no denying the added stress of knowing your business performance will directly affect your own finances in a way that you’d be protected from with an LLC or corporation.
The last word
While sole proprietorship may seem like an attainable and fulfilling way to achieve your career and lifestyle dreams, it clearly isn’t without its downsides. Low-risk and low-investment enterprises that are just starting out would seem to be the most suited to the sole proprietorship route, yet many people find success with this structure in a range of fields. Ultimately, only you can assess the balance of the sole proprietorship pros and cons, with respect not only to the nature of your proposed business activities but also to your personality, preferences, options and tolerance for risk.
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