Is a Sole Proprietorship the Right Legal Structure for Your Small Business?
After months — or maybe years — of dreaming and planning, you’re ready to launch your small business and make your way to the Fortune 500; or at least, the Inc. 5000. However, before you start implementing your integrated marketing campaign and chiseling elegant window lettering at your corporate headquarters (which for the time being may be your basement, kitchen or spare bedroom), there is a critically important question to answer: what legal structure is right for your business?
The first thing to note is that if you’re looking for a ready-made answer to this pivotal question, then you won’t find one here — or anywhere else for that matter. This is simply because various legal structures have pros and cons, and only you can decide what makes sense. Below, we take a deeper look at one of the most common and simplest legal structures: sole proprietorship.
What is Sole Proprietorship?
In a sole proprietorship, you personally assume responsibility for your business’s liabilities and debts. Contrary to what some self-employed individuals believe, a sole proprietorship is the default business structure. In other words, even without formally registering a business, everyone who has ever freelanced or worked as a consultant has, in effect, owned and operated a sole proprietorship (with this being said, the government expects all freelancers and consultants to register their business and comply with all applicable tax, permit and registration laws).
Sole Proprietorship: Advantages
A sole proprietorship is the simplest, easiest and cheapest business structure to create. You can co-mingle personal assets with business assets (just make sure that you keep clear records), and your earned income may be offset by losses from other sources — and vice versa. For example, if despite your best effort to turn a profit you lose $5,000 in your first fiscal year of operation, and if you have taxable income from another source, then you should be able to reduce your taxable income by that amount. Just be sure that you can clearly demonstrate that you did indeed attempt to make a profit. Otherwise, the IRS may block your deduction and slap you with some pretty nasty fines and penalties. This is to prevent some business owners (obviously not you, of course!) from creating a sole proprietorship simply to lose money, so they can pay less overall tax.
What’s more, if you do want to re-enter the world of full-time employment later on, a sole proprietorship is relatively easy to dissolve, and you do not need to defer decision-making authority to any other party. You’re the boss, and the buck stops with you.
Sole Proprietorship: Disadvantages
Unlike a limited liability company (LLC) or corporation, sole proprietors cannot raise capital by selling an equity stake in the company. This can be a major obstacle, since at least for the first little while, the lifeblood of small businesses is cash flow, since there are usually many up-front expenses (e.g. equipment, computers, software, leasehold improvements, etc.).
Furthermore, sole proprietors assume unlimited liability, and are personally responsible for all debts and obligations of the business. Someone can come along and sue you for all your money! In addition, some costs like health insurance premiums cannot directly be deducted from business income. It may also be a challenge to onboard specialized staff who, in exchange for offering their expertise for a small business at a below-market rate, want equity in the company.
The Best Advice?
The best advice is to speak with a professional (such a qualified accountant or business coach), who will help you understand what the landscape looks like. For example, you may start out with a sole proprietorship, but once certain strategic milestones are met (e.g. revenue, sales, lifespan) you graduate to a more sophisticated structure like an LLC, general partnership, or corporation. With the low cost of starting your own LLC (now as low as ~$150), it may be a good idea to go that route if it’s hard for you to sleep at night thinking you could be sued for all your worth. Good luck with your decision!
Thank you for breaking this down so well., Derek! I’ve heard a lot of people having problems or legal issues with regards to the sole proprietorship of their business. At some point, some people fail to understand what constitutes a sole proprietorship as well as the documentation that is involved. It’s always better safe than sorry and asking professional legal advice is preferable. I had a great time reading your post and I hope you will continue to post more. Cheers!
Thanks for stopping by!