Sole proprietorships account for the largest number of businesses in the United States. According to the most recent data from the Internal Revenue Service, nonfarm sole proprietorship tax returns totaled approximately 25.5 million. For comparison, C Corporation tax returns were around 2 million.
While extremely popular, every small business owner eventually has to answer the question: Should I stay a sole proprietorship or should I incorporate?
Sole proprietorships have several advantages, but they also come with a few significant disadvantages. Let’s run through both so you can make your own pro/con list to help you make the decision on whether or not to incorporate.
Advantages of Being a Sole Proprietorship
Simple to create– The business can operate in the owner’s name or a fictitious trade name. Creating a trade name only requires filing with the local government authority and obtaining the necessary business licenses.
No formal filings – Sole proprietorships do not need to hold corporate meetings, keep minutes or file annual reports. If you just start running a business – a landscaping business for example – you’ve become a sole proprietor without having to notify any government authority.
Owner control – The owner in a sole proprietorship has 100 percent control and makes all the decisions.
No unemployment tax – The owner does not have to pay an unemployment tax on himself. However, payment of unemployment taxes are required if the business hires employees who are paid regular wages.
Can comingle personal and business funds – Since the owner and the business are the same, one checking account can be used for both business and personal transactions. Although a single checking account is allowed, it’s still a good idea to separate business and personal transactions.
Owner keeps all profits – A sole proprietorship only has one owner; and the owner reports all profits from the business on his/her tax returns.
Disadvantages of Being a Sole Proprietorship
Personal liability – The owner is personally liable for all the debts and contractual obligations of the business. This liability is unlimited. An owner could lose all business assets plus personal assets in the event of a loan default or adverse ruling from a lawsuit. The risk of losing a home, car, savings accounts and other personal possessions is the most serious disadvantage of a sole proprietorship.
Difficult to raise capital – Sole proprietorships cannot raise capital by selling shares of stock or interests in the business to attract outside investors. A business that needs to attract more capital to support growth will have to convert to a corporate form.
Harder to get bank loans – Banks prefer to make loans to companies with several years of business credit. Sole proprietorships must rely on the creditworthiness of the owner.
Survivability– Sole proprietorships rarely survive the death of the owner. Since the business is usually run entirely by the owner, there is hardly ever any management level person to take over the business. It simply ceases to operate. However, with advance preparations, a business owner can pass on the business to their heirs.
Filing a tax return for a sole proprietorship is fairly simple. The only requirement is for the owner to include a Schedule C with the personal tax return.
Schedule C is a summary of the business’s income and expenses. Losses shown on a Schedule C can be offset against other income the owner might have from other sources.
Should I Stay a Sole Proprietorship?
As a business grows, the owner will eventually face the decision of whether to incorporate or stay a sole proprietorship.
The main issues that affect this decision are liability risk and the need to raise funds.
When a business starts to borrow money to expand or finance growth, the risk to owner’s personal assets goes up. If you find yourself in the situation where you need to raise capital to expand or for growth support, then that is the time to consider the change. In addition, if you are in the situation where you need to begin adding employees, you should consider incorporation. Employees can come with their own host of liabilities and incorporation can help you manage that risk.
Because they’re simple to form and don’t require filing complicated legal documents, millions of business owners use sole proprietorships to get started. But, once they begin to grow – and risks to personal assets begin to increase – it’s time to ask yourself the question: Should I stay a sole proprietorship? The answer: looking into incoporation is the right next step.