Sole Proprietorships: The Good, The Bad and The Ugly

Sole Proprietorship

by
August 29, 2014

A sole proprietorship is the most simple business form out there. A sole proprietorship is owned and operated by the same individual who has the sole authority to make any and all decisions regarding the business.

Sole proprietorships provide business owners some financial advantages. Sole proprietorship owners do not incur the same costs generally associated with forming a business entity. Since businesses, with one owner, are sole proprietorships by default, owning one is free.

In addition, owners of sole proprietorships are allowed to report all incomes and expenses derived from their business on their individual tax returns. Sole proprietorship owners are not legally required to report separate tax reports for their business, rather, they can report all profits and losses as part of their individual report. This advantage saves business owners on costs associated with accounting and filing taxes.

Although continuing business as a sole proprietorship seems attractive at first glance, there are many disadvantages associated with it as well. Before starting business as a sole proprietorship, consider the following:

Personal Liability 

The most obvious and devastating risk associated with a sole proprietorship is being held personally liable for all losses and debts incurred by the business. Because a sole proprietorship does not separate owners from their businesses, sole proprietorship owners are entitled to directly claim all the profit the business generates. However, this singularity generates a huge liability issue.

By being held personally liable for all losses and debts incurred, the owner of a sole proprietorship will be held personally responsible for any legal issues arising out of the business. Any and all debts incurred by the business will be satisfied from a business owner’s personal accounts. These issues can include any acts committed by employees of the business.

Examples of liability issues include creditor claims against the business owner, default judgments against the business owner, breaches of contracts and even tortious acts committed by the owner and/or his or her employees.

Although purchasing proper insurance policies may offer limited protection, there is no substitute for properly forming your business into either a corporation or LLC. Some legal issues arise out of conduct that will never be covered by any insurance policy, exposing business owners to major liability issues.

Tax Detriments

Business owners who own a sole proprietorship are subject to “pass-through” taxation and are required to report all business profits and losses on their personal income tax return. Therefore, the business itself is not taxed separately. All profits derived from the business “pass-through” the business onto owners’ individual tax returns.

For tax purposes, profits are defined as total income minus business expenses, period. There is no exception made for any income not withdrawn from the business account. Therefore, business owners must still pay taxes on any money remaining in the business bank account.

In addition, the sole proprietor must pay taxes Social Security and Medicare, known as self-employment taxes, on all profits derived from the company. However, because a corporation maintains a sense of autonomy from the business, a corporation owner may carve out a designated “salary” and required to only pay taxes on his or her “salary” and bonuses. The corporation is then responsible to pay taxes on the remainder of the business profits.

Similar to all other businesses however, sole proprietorship owners may deduct ordinary business expenses on their tax returns. These expenses include money spent on company advertising, traveling for the benefit of the business, meals and entertainment. In addition, sole proprietorship owners may deduct costs associated with running and operating the business.

Funding Issues 

Individuals who do not have deep pockets or have poor credit histories are less likely to receive funding from investors or banks. Many investors are hesitant to invest any money into a sole proprietorship, while banks are hesitant to lend them money. This is because rather than basing their decision on a corporation or LLC’s professional reputation, the banks and investors must rely solely on an individual’s merit. 

In addition, because sole proprietorships do not issue stocks or other investment tools like corporations and LLCs do, it is difficult for business owners to raise capital for their business.

Owner’s Death 

Unlike other business structures, sole proprietorships do not survive their owners. Meaning, when a business owner passes, becomes ill or incapacitated, the business dies as well.

Upon death all the business assets are liquidated and transferred into the business owner’s estate. All the profits are then equally distributed among the beneficiaries. As a result, the beneficiaries suffer a huge tax burden relating to inheritance and estate taxes.

Individuals interested in starting a new business should consider all the benefits and detriments of conducting business as an LLC, corporation or sole proprietorship. It is highly recommended to consult a professional before deciding how to successfully operate your new business. 

 

 

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