Small Business Advice

5 advantages of a sole proprietorship

Deciding on a business structure? Here are 5 Advantages of using a Sole Proprietorship for your small business.

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73.1% of all businesses in the U.S. are sole proprietorships1. It’s by far the most popular business structure, accounting for 20.3 million firms. For context, the next most popular type of business is S-Corp with 13.1% or around 3.65 million firms1.

Part of the reason why entrepreneurs opt for sole proprietorships is because they are the cheapest and easiest types of businesses to start. They are also simple to run and dismantle.

Plus, if circumstances change in future, it’s easier to modify the business structure of a sole proprietorship into any other type of business. This means you can easily switch it into a limited liability company (LLC), partnership, corporation or S corporation. Going the other way is generally harder.

These are some of the factors that draw business owners like independent contractors, freelancers and startup-up founders to proprietorships. But is it the right fit for you?

There may be numerous advantages of sole proprietorship, but this type of business does come with some considerations. For example, it comes with unlimited personal liability, which essentially puts your personal assets at risk.

Therefore, before making the leap, make sure to weigh sole proprietorship advantages against disadvantages. This article breaks down both sides of the coin to give you the pros and cons of a sole proprietorship.

Key takeaways

  • A sole proprietorship is a business entity that’s owned and operated by one person.
  • The main advantages of sole proprietorship are full ownership of the business, low set up costs, simple tax procedures and deductible expenses.
  • On the other hand, the biggest disadvantages of a sole proprietorship include unlimited liability, bigger tax burden and difficulty accessing funding.
  • Many people often use sole proprietorships as stepping stones to incorporation.

What is a sole proprietorship?

A sole proprietorship is a type of business structure where one person owns and runs the whole enterprise. Sole proprietorships are, by nature, unincorporated. That means there’s no legal distinction between the business owner and the business entity. As such, the sole proprietor is personally liable for the business’s debts and losses. The upside is that the owner is also entitled to all the assets and profits of the business.

One of the many advantages of a sole proprietorship is that it doesn’t require federal registration to start and operate. You don’t even need to pick a business name. As the owner, you can run your sole proprietorship under your own name.

In fact, when you create a sole proprietorship, the legal name of the business defaults to your name2. If you want to conduct business under a different name, you may need to choose a separate name for your company.

Alternatively, you can opt to conduct business activities using a DBA name. DBA stands for “doing business as”. It essentially means that rather than using a trade name or your own name, you’re opting to use a fictitious name (also known as assumed name) to represent your business.

That assumed name will allow you to conduct business while keeping your own name private. Your “doing business as” name must be unique and registered with your state or county.

Since it’s easy to create, a sole proprietorship offers a practical path into self-employment for many freelancers, start-up founders, creatives, and even business owners with storefronts. The good thing is that there’s no limit to how many employees you can hire. So, even if you start as a small business entity, you can bring in more people and grow the company. If your business keeps growing, you can always convert it to a limited liability company, S corp, partnership or corporation.

5 advantages of starting a sole proprietorship

There are many advantages of a sole proprietorship. For example, as the sole business owner, you get to retain all the profits from the business. Plus, it’s an easy and affordable type of business to set up. And because of its simplicity, filing income tax for your company is a fairly straightforward process. Below is a look at these sole proprietorship advantages in detail.

Full business ownership

As a sole proprietor, you fully own your company and all of its assets. As such, this type of business gives you complete control. While you have the option to consult others, ultimately all business decisions are for you to make. You don’t need to hold meetings or have a voting process before making decisions.

The downside of being the sole decision-make is that it can be burdensome. The upside is that sole proprietors are allowed to hire employees and also work with professional consultants. Therefore, you’re free to delegate tasks as much as you want.

Of course, having full ownership also means that all business income goes to you. You do not have to share the profits of a sole proprietorship business with anyone as is the case with partnerships. Similarly, there are no dividends or draws as is the case with a corporation and limited liability company (LLC).

Finally, being the sole owner of a business means that you can set your own work schedule. It may be based on your availability or your customers’ demand. Either way, you have more flexibility when it comes to working hours.

Easy to set up

Unlike LLCs and corporations, you don’t need to register a sole proprietorship with the federal or state government. This typically means less paperwork and an easier route to self-employment. You don’t need to file articles of incorporation, annual reports or exhibits before you open your doors to customers.

However, if you plan to operate the business in a name other than your own name, then you may need to obtain a business name. This can either be a registered business name or a DBA (doing business as) name.

A DBA name creates a bit of distance between a business entity and its owner. It’s a great path to take if you don’t want people to constantly associate you with your sole proprietorship business. Further to the point, the operations of a sole proprietorship are not subject to public disclosures (unless demanded by a court). This makes such a business structure ideal for entrepreneurs who prefer to shun public scrutiny.

That said, you may need to obtain relevant business permits and licenses before your new business starts operations. The exact documentation will depend on your state laws and the nature of your business. In California, for example, you must obtain the California Food Handler Card before opening and operating a restaurant.

Low formation costs

One of the biggest sole proprietorship advantages is that there are no registration costs3. It’s completely free to create. Even if you want to register a DBA, you’ll typically pay anywhere between $10 and $100.

The only other costs to keep in mind are fees associated with licenses and permits. These typically vary between states and depending on the nature of business. You may want to visit your state’s website to know the small business licenses and permits that are required for your type of business and the cost of each.

Despite the low formation costs of a sole proprietorship, there are no limits to the size of staff you can have. This can be a good thing because a bigger team may translate to a bigger reach. However, keep in mind that you’re also personally responsible for your employees’ salaries and benefits.

So, while you may not have expenses for registering the business, you will certainly need to account for payroll expenses when setting up your sole proprietorship business. 

Preparing and filing taxes is simple

As a sole proprietor, the IRS requires you to report business profit or loss on your personal tax return. Since it’s an unincorporated business, a sole proprietorship is a pass-through entity. That means it is not subject to corporate income tax. Instead, business profits (or losses) are passed to you the owner, and then you have to report them on your personal income tax return.

Preparing and filing personal income tax returns is a lot easier than doing the same for a limited liability company or corporation. If your business doesn’t have employees and isn’t subject to excise tax, you can complete the entire process using only one IRS form – Form 1040 (Schedule C, and Schedule SE).

If you have employees from whom you withhold Social Security and Medicare, then you may need to also file Form 941 (quarterly tax returns) and/or Form 944 (annual returns)4.

An additional tax advantage of a sole proprietorship is that you can use your Social Security Number (SSN) to file income tax returns. Incorporated business structures typically require an employer identification number (EIN) for filing business taxes. That said, sole proprietorships are allowed to have EINs. You can – and probably should – get an EIN for your small business because it comes with many benefits.

Expenses are deductible

The costs of a sole proprietorship can be deducted from income tax to reduce your overall tax burden. Such costs include travel expenses, car payments and home expenses for those who use their homes for business purposes.

Entrepreneurs can take advantage of these deductions to lower the amount of tax owed. The effect is that you may have more money left for growing your business. It goes without saying that first you’ll need to know the types of small business expenses that are deductible.

Disadvantages of a sole proprietorship

Despite its many advantages, a sole proprietorship is not short of a few drawbacks. For one, it’s generally harder to sell this form of business entity. Oftentimes business and personal assets are inseparable, which may cause a problem during appraisal. For this reason, knowing the real value of a sole proprietorship is not the easiest thing.

Even if you’re not contemplating selling the business, you may still run into a few issues to consider during your day-to-day operations. Here are the main disadvantages of a sole proprietorship.

Difficulty raising capital and accessing financing

One of the biggest disadvantages of a sole proprietorship is that you’re solely responsible for raising all the needed capital. This may require you to dig into your pockets, dip into your savings, and/or probably borrow from friends, family and lenders.

Companies with many founders typically pool funds from those founders, which makes it easier to raise capital. Sole entrepreneurs do not enjoy the same. In fact, many lenders have extremely strict requirements for extending tradelines to small business owners – especially if it’s a startup with zero years in business, no credit history, no annual revenues, and no cash flow.

Even if you’ve been in business for several years, you’ll still need good numbers in your books and a good personal credit score to qualify for small business loans. That’s particularly the case with traditional loans from banks and credit unions. Lenders deem sole traders too risky because small businesses are volatile and their finances are tied to owners’ finances.

SBA loans are not that different either. They typically require a credit score of at least 6905 and a down payment of at least 10%6. If you don’t meet these requirements – for example, if you have bad credit – lenders will simply deny you access to financing. And you can’t sell equity in exchange for capital. You would need to restructure the business from a sole proprietorship to a completely different structure.

The bottom line is that sole proprietors struggle to access financing. If you find yourself in such a situation, you can try applying for credit from alternative lenders. They generally have more relaxed lending requirements and terms.

Unlimited personal liability

Entrepreneurs with sole proprietorships do not have liability protection. As the business owner, your personal assets are intertwined with business assets. And so are your liabilities and debts, and those of your business.

Basically, if your business fails to meet its debt obligations, creditors are legally allowed to seize your personal assets to recover business debts. Thus, your home, personal car, bank account, and even retirement accounts are always in jeopardy.

More taxes

Sole proprietors are responsible for paying their own taxes to the IRS. They don’t have employers who may withhold and submit income tax returns. And of course, self-employment also means there’s no employer to share the tax burden with. You have to pay your full taxes on your own.

In addition to local, state and federal income taxes, sole proprietors are also required to pay self-employment tax. This tax currently stands at 15.3% of net earnings. 12.4% covers Social Security while the remaining 2.9% is for Medicare.

Keep in mind that self-employment tax is not the same as income tax; it is a completely separate tax obligation. That essentially means self-employment subjects you to more taxes. To make matters worse, you can’t get unemployment benefits even if your business fails.

In Summary

Sole proprietorships are the most common types of business in the U.S. because they are easy and affordable to start. However, they do not offer liability protection in the same way that limited liability companies and incorporated businesses do.

Perhaps that’s why some people often use sole proprietorships as stepping stones to incorporation. Before it grew to the retail giant that it is today, eBay was a sole proprietorship owned by Pierre Morad Omidyar.

Sears, JCPenney, Kinkos, and Annie's Homegrown are just a few other big names that started out as sole proprietorships. Therefore, despite the handful of drawbacks, a sole proprietorship can grow as much as any other business structure.

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