Advantages and Disadvantages of Sole Proprietorship
There are several advantages and disadvantages of sole proprietorship and entrepreneurs often turn to sole proprietorship to set up a solo business.6 min read
There are several advantages and disadvantages of sole proprietorship. Entrepreneurs often turn to sole proprietorship to set up a solo business. It's the quickest and easiest way to set up a legal structure to do business. If you're starting a solo business, your legal set up will likely be a sole proprietorship, too. It gives you the legal framework for a business owned and run by one person.
Characteristics of a Sole Proprietorship
Individuals that run sole proprietorships can report business income and expenses on their individual tax returns. Small investors like setting up sole proprietorships too, as they are the sole receiver of all the profits from a sole proprietorship.
But there is risk involved as well. Sole proprietorships offer little protection for the owner in the case of a deal gone wrong. Sole proprietorship can be seen as an extension of the owner, who can be held liable for losses or debts incurred by the sole proprietorship. The owner can also be held responsible for any business violations. The risks are inherent in running a sole proprietorship. But let's look at the advantages first.
Advantages of a Sole Proprietorship
If you want to run your own business, then a sole proprietorship gives you the luxury of control, requires less effort, and offers other rewards in the business structure. For starters, there are no separate business tax returns required. Any income made by sole proprietors from the business is counted as personal income. Owners then pay taxes according to their individual tax rates.
Launching a sole proprietorship is relatively simple. Filing a business name is swift and inexpensive. You should check your state's particular rules on forming and filing a sole proprietorship, but in most cases, there is an online application available. Alternatively, the owner may visit a state office and fill out a DBA (Doing Business As) form to operate under a given business name.
The owner can then receive the business name and set up bank accounts and apply for credit cards for the business. Individuals owning sole proprietorships are not required to file the annual reports or legal documents that are required by some other business structures.
Owners of sole proprietorships have no boss they need to report to. For some people, this may be the most important reason of all to choose this business structure. As the entrepreneur and owner, you're in complete control. If you find it necessary to make decisions, especially in an emergency, you can do so right away; you don't need to wait for other people's approval. You also have the authority to sell the entire business if you choose to do so.
Since all profits go directly to the business owner, sole proprietors can use the money any way they choose. It can be reinvested in the business for expansion. It can be used to start another business or establish a new location for the business. It can also be used for personal reasons.
Filing annual taxes is much easier with a sole proprietorship as well. The IRS treats sole proprietors and their businesses as one and the same. All profits go directly to the business owner. Because of this, sole proprietorships avoid the double taxation that corporations have on business earnings.
Sole proprietors are allowed to take deductions on business expenses, such as office supplies and equipment, travel, car mileage, and even home office space in some cases. That means the taxable income amount of sole proprietors can be lowered substantially.
If you want to launch with more protections, you can always consider a limited liability company instead, as this also offers various legal structures for solo entrepreneurs looking to set up a business.
In summary, here are the clear advantages for sole proprietors:
- Minimal formation costs
- Fewer formal business requirements
- No corporate tax payments
- Complete control over a business
- Power over sale or transfer of assets
- No need to wait on a decision from others
An individual with a sole proprietorship can choose to have employees or not. An owner can have a looser structure with a handful of employees in a sole proprietorship. For instance, the owner can pay a higher wage instead of dealing with the complexities of health insurance. Bonuses and incentives are up to the discretion of the owner as well.
Hiring employees can be beneficial to sole proprietors in many ways. For one thing, tax breaks may be available for job creators. A sole proprietor can employ their spouse without formally declaring them as an employee. It's also possible for a married couple to launch a sole proprietorship together. However, only one individual can assume the liability, not both parties.
While a proprietor can keep all the profits in a sole proprietorship, he also has the option to share the profit with a few employees. A sole proprietor doesn't have to discuss this with any business partners.
A sole proprietor can also choose to stop business operations at any time. The process is easy to do. Only a few documents are necessary, and the timeframe is shortened.
Disadvantages of a Sole Proprietorship
There are also disadvantages for sole proprietors in running their own businesses. In fact, some of the advantages can actually become disadvantages in certain circumstances. For example, an entrepreneur may enjoy the freedom of being able to make decisions without consulting with other partners or shareholders. However, this also means that the responsibility for making tough decisions rests on their shoulders alone and nobody else's.
Along with having all the responsibility for making decisions, a sole proprietor is also responsible for all business obligations. This includes any debts that the business incurs or any lawsuits filed against it. If the company hires employees, the sole proprietor may also be held responsible for any violations that the employees commit.
Therefore, while this type of business entity can be simple to form and run, it does not offer much legal protection to its owner against unforeseen circumstances. The owner and the business are one and the same.
Other disadvantages include:
- Sole proprietors must file any forms needed for the business name and operations.
- Sole proprietors are responsible for all monies and debt for a business, even under a separate marketing name.
- Sole proprietors' money is generally tied into the business. There usually is no legal separation between personal funds and business funds. This can become a problem if the owner faces legal actions about the business. Personal funds can be at risk for a sole proprietor.
- Sole proprietorships typically have less working capital. Without partners, or other investors, you may have difficulty obtaining enough capital to launch the business or keep it afloat. Even if the business idea is sound, you may find yourself short of cash at a crucial time in the company's development and growth.
- Sole proprietors may have difficulty securing loans or investors. It's not easy convincing a bank to extend a loan to a sole proprietorship, especially when it's just starting out. Also, investors typically will not work with sole proprietorships.
- A sole proprietorships may come at the cost of increased pressure and time demands. A sole proprietor faces the disadvantage of working too hard on the business. It's a possibility that his personal life and family life could suffer. Vacation time can be interrupted by word demands.
- Since a business set up as a sole proprietorship is not taxed corporately, the profits and losses are assumed by the sole proprietor.
Can You Change Business Structures?
Many entrepreneurs choose to begin their businesses as sole proprietorships, then switch to a different structure at a later time — such as an S Corporation, LLC, or partnership — when the business grows. Others may be content with maintaining a sole proprietorship for many years, even for the entire life of the business.
If your business grows over time and you find that the sole proprietorship structure is no longer the best fit, it's not a difficult process to change to a different status. All you need to do is file the paperwork for the new business structure.
If a sole proprietorship sounds like a good fit for your business goals, it pays to do some research and learn about all of the pros and cons of this setup — as well as every other type of business entity, for comparison. Even better, get in touch with an attorney who is familiar with business law before filing your business documents. The laws governing businesses vary depending on the state of formation, an attorney can make sure you're aware of every detail or special requirement.
A good attorney can also help you consider the risks and benefits of the business itself and help you decide if a sole proprietorship is best or if you should consider a different structure.
If you need help weighing the advantages and disadvantages of a sole proprietorship, you can post your legal need on UpCounsel's marketplace. Lawyers on the UpCounsel platform have experience setting up sole proprietorships, LLCs, corporations, non-profit organizations, and more. Let them do the work for you!