A sole proprietorship is probably the simplest and most prevalent form of business organization. It is the least regulated of all other forms of business and provides numerous tax benefits for the owner. A sole proprietorship is available to companies owned by one person and gives the owner the ability to hire other employees, including his or her own minor children, without being liable for payroll withholding.
A sole proprietorship however is not without risk. At first glance, it appears attractive to the average entrepreneur—you get to reap all of the profits and to have full control of the business. On the flip side, sole proprietors may find it difficult to obtain loans for the business start-up. Many times the owner must use his or her own personal assets, mortgaging a home, for example, to obtain a loan.
What's even riskier is that a sole proprietor has unlimited liability. In other words, all of your personal and business assets are at risk. If the business debt begins to exceed the assets, creditors may obtain the personal assets of the owner to cover the outstanding debt. Another drawback is that a sole proprietorship cannot exist without the owner. Upon death, the business dies.
The protection of incorporating
A sole proprietor can avoid the pitfalls of unlimited liability by simply electing to incorporate. Although standard corporations can be more complex than necessary, there is the option of the S corporation. A sole proprietor may also choose to form a limited liability company (LLC).
Both S corporations and LLCs have incredible advantages. These business forms give limited liability to their owners, meaning your personal assets are not in jeopardy as they are with a sole proprietorship.
They also have the benefit of being taxed as a partnership. All income, deductions, credits, etc. "passes through" to the individual shareholders or members and are reported on their individual tax returns. This allows the two entities to avoid the double tax on income that is inflicted upon regular corporations.
It is also an attractive method to raise much-needed capital. While a corporation requires you to take on shareholders, the S corp and LLC allow you to simply sell shares to raise capital.
In many ways, S corporations are particularly ideal for small businesses. To even qualify for S corp status, the business must have fewer than 75 shareholders who are all either U.S citizens or resident aliens and only one class of stock.
LLCs allow a bit more leeway when it comes to business formation. For example, unlike S corporations, LLCs allow any entity including individuals, partnerships, trusts, estates, corporations, or other LLCs, to be owners. They offer greater flexibility than S corporations, such as not having any limits on the number of members. In addition, with the IRS "check-the-box" regulations, a business that is currently a sole proprietorship can change to an LLC with no tax consequences.
It is important to note that since LLCs are a relatively new type of business entity, their track record with the courts and the IRS is not as well established as an S corp. There is a narrow body of court cases that limit the LLC's member liability protection to withstand certain court challenges. Additionally, all 50 states are not uniform in their tax treatment of LLCs. Until a nationally uniform set of rules is agreed upon, confusion may arise when LLCs engage directly or indirectly in multi-state operations
If your company is thinking about bringing on another owner, or if the unlimited liability is too intimidating, an S corp or LLC could be very beneficial choice for your business. However, be sure to investigate all of your business formation options with your legal and tax professionals before venturing into business as a different entity.
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FAQs
A sole proprietorship is riskier because the entire business is the responsibility of just one person. The sole proprietorship is a business organization where the proprietor and the business are one and the same. The assets and liabilities of the proprietor are all at risk if anything goes wrong in the business.
What is the biggest issue with owning a sole proprietorship? ›
Among one of the biggest disadvantages of a sole proprietorship is unlimited liability. This liability not only spans the business but the business owner's personal assets. Debt collectors can access your savings, property, cars, and more to see a debt repaid.
Why do most sole proprietorships fail? ›
The most common reasons that small businesses fail include a lack of capital or funding, retaining an inadequate management team, a faulty infrastructure or business model, and unsuccessful marketing initiatives.
What do you think are some of the tax risks of a sole proprietorship? ›
Today we are discussing five common sole proprietor business risks you can take on if you decide to operate your business as a sole proprietor.
- Increased Tax Rates. ...
- Unlimited Personal Liability. ...
- Failure to Raise Capital. ...
- Inability to Secure Customers. ...
- Challenging Succession Plans. ...
- The Bottom Line.
The main risks include the following:
- Unlimited liability. One of the most significant problems of the Partnership Act is that it imposes unlimited liability on all partners for the debts and obligations of the partnership. ...
- Profit-sharing issues. ...
- Unclear exit provisions. ...
- Unclear decision making. ...
- Deadlocks and disputes.
A general partnership entails greater risk that a sole proprietorship because: A sole proprietor has unlimited personal liability. However, in a general partnership, each partner has unlimited personal liability, and each partner can create such liability for all of the partners.
What are 3 disadvantages of a sole proprietorship? ›
Some disadvantages to starting and running a sole proprietorship include less financial and legal protection, the inability to add a partner, higher self-employment taxes, obstacles to getting approved for startup or sustenance funding, fewer benefits than W-2 employees and no guidance from board members.
What is the issue with sole proprietorship? ›
Disadvantages of a sole proprietorship
There is no separation between the assets of the owner and the assets of the business. Personal liability allows creditors of the business to go after your personal assets if the business assets are not sufficient to cover the business debts.
Why is sole proprietorship a good idea? ›
A sole proprietorship allows small business owners to begin a business without taking formal legal action through the state. There's no need to form a board of directors. A business banking account isn't required. "It can be good for ease of operation," Hlavacka said about a sole proprietorship.
What is the biggest risk of a sole proprietorship? ›
The most serious risk of a sole proprietor is unlimited personal liability for the business' debts. This means that if the business is unable to pay its debts, your house, assets, and bank accounts are in jeopardy. If you are married, your spouse's interest may also be at risk.
We've compiled a list of eight different types of businesses that make good sole proprietorship examples.
- Freelance Writer. A freelance writer provides written content for clients, either for print or digital publication. ...
- Photographer. ...
- Personal Trainer. ...
- Plumber. ...
- Freelance Graphic Designer. ...
- Housekeeper. ...
- Bakery Owner. ...
- Tutor.
As a sole proprietor, the debts of your business are your personal debts and don't transfer with the sale of your business assets.
How to avoid risk in sole proprietorship? ›
One way to protect your personal interests against these risks is to form a limited liability company (LLC). An LLC is a business entity that exists separately from its owner(s). As such, it is responsible for its own rights, responsibilities, and liabilities. As the owner of an LLC, you have limited liability.
Can you get sued as a sole proprietor? ›
Being a sole proprietorship removes one major area of potential liability: lawsuits from co-owners. But other parties pose potential lawsuit risks, both contract and tort claims.
What is the biggest problem a sole proprietor may face? ›
Unlimited personal liability
This is the greatest risk of a sole proprietorship. Without having a separate entity for your tax and legal issues, a court is likely to see all of your assets and liabilities, including personal, non-business-related items, as a single group.
Is it better to be a sole proprietorship or partnership? ›
Overall, the advantages of sole proprietorship over partnership lie in its simplicity, control, profit retention, reduced administrative burden, and limited liability.
Which is more risky an LLC or a sole proprietorship Why? ›
This preference doesn't extend to sole proprietors, who are considered riskier investments than LLCs or corporations. As a result, you could struggle to access business funding as a sole owner. To get funding for your venture, you may need to take out personal loans, which have their own pitfalls.
What is the biggest disadvantage of a sole proprietorship and a partnership? ›
Partnerships also have their share of disadvantages. The unlimited liability that applies to sole proprietorships is even worse for partnerships. As a partner, you are responsible not only for your own business debts, but for those of your partners as well.
What is the major disadvantage of a sole proprietorship or a partnership quizlet? ›
What is a disadvantage of sole proprietorship and partnerships? They have unlimited liability.
