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A Sole Proprietorship is a business entity which provides a legal structure for an individual who is conducting some type of business activity. This designation indicates that a business is owned by a single person, and there is no legal distinction between the business and the owner. The income of a Sole Proprietorship is reported through an IRS Schedule C and taxes are assessed individually.
Advantages of a Sole Proprietorship
- Minimal Paperwork
- Minimal Legal Restrictions
- Ease of Dissolution
- Simplified Tax Filing
A Sole Proprietorship is ideal for a small business with virtually no employees and no future plans to hire, no property, little income, and only moderate growth expectations. Many individual consultants (for example, a person who receives a 1099 from an assignment as an “independent consultant”) and smaller businesses (for example, a typical “mom and pop” shop) choose to operate as a Sole Proprietorship. The paperwork required to establish a Sole Proprietorship is minimal, and there are very few legal restrictions governing the business operations. It is also relatively simple to dissolve a Sole Proprietorship since no formal operating agreement is necessary. Arguably, one of the most significant benefits of a Sole Proprietorship is simplified tax filing, since no corporate forms or double taxation is required.
Disadvantages of a Sole Proprietorship
- Unlimited Personal Liability for Business Debts/Liabilities
- Owner’s Personal Assets Vulnerable
- Restricted Ability to Raise Capital
- Highest Taxation Rates
- Business is Terminated Upon Death of Owner
The most significant disadvantage of a Sole Proprietorship is the lack of legal distinction between the owner and the business as a separate entity. Because there is no legal separation between the owner of the Sole Proprietorship and the business itself, owners have virtually no protection from liability. Even though credit may be established in the name of the business, the owner is entirely responsible for every debt and obligation incurred by the business and is personally obligated to creditors and vendors associated with the business. For example, a business-related lawsuit or IRS tax audit puts the personal assets of the owners at risk for seizure. In addition, owners are often required to include personal assets as collateral for any business credit that is established, and those personal assets can be seized to cover any obligations that are unmet by the business. For example, if a business secures a loan from a bank and fails to meet the repayment terms of that loan, the bank can seize whatever personal property was put up as collateral for the loan, including the home of the business owner! In addition, there is no guarantee of perpetuity of the business since the Sole Proprietorship is Terminated upon the death of the owner. Another significant disadvantage of a Sole Proprietorship is the limited ability an owner has to raise capital. Business loans are issued based on the personal credit, collateral, and the business owner’s personal ability to repay the loan. A business owner of a Sole Proprietorship is also restricted in his or her ability to raise capital from investors since there is no provision for the inclusion of an investor in the structure of a Sole Proprietorship. Beyond that, the taxation of a Sole Proprietorship is assessed at the highest levels, and business expenses are limited. Finally, since a Sole Proprietorship is not incorporated, there is no guarantee of perpetuity, and the business can be dissolved through sale, abandonment, death or bankruptcy of the owner.
Recommendations for a Sole Proprietorship
A Sole Proprietorship is not recommended for any business entity that hires employees or owns real property such as computer equipment, furniture, or automotive vehicles. It is especially dangerous to run a business as a Sole Proprietorship if it is associated in any way with high liability industries, such as the medical or legal professions, as well as any type of business dealing with hazardous materials.
Formation of a Sole Proprietorship
Typically, an owner of a Sole Proprietorship will register a trade name or “Doing Business As” (DBA) with the clerk of the city where the business is located. This DBA allows the owner to conduct business with designated business name other than his or her personal name. This also allows the owner to open business checking and savings accounts with financial institutions and establish credit in the name of the business.