Sole proprietorships are the most common type of business entity in the country. According to the latest statistics, there were 23 million of these businesses in the U.S.
With so many business entities to choose from, it can be challenging to determine what type of business makes sense for you.
Here are the pros and cons of America’s most common business type.
Pro: Easy to Setup
Sole proprietorships are the easiest businesses to establish because a sole trader has no formal business structure. You just launch your business and get started drumming up customers. Compare an LLC vs. C-Corp vs. S-Corp, and you will see how much easier it is to get your firm off the ground.
Unfortunately, this comes at a cost. You give up many of the protections that a separate business entity grants its owners.
Note that depending on where you live and the type of firm you’re starting, you may still need to acquire business licenses and permits to operate.
Con: No Liability Protection
Sole traders have no personal liability protection. So if someone files a lawsuit against you, both the assets of the business and your personal assets are at risk.
An injured employee or customer could take everything you own if a lawsuit goes against you. This is why people decide to incorporate because a formal business entity broadly protects the personal assets of its owners.
There are steps you can take even as a sole trader. One sole proprietors’ insurance policy you may need is general/public liability protection. Rather than paying everything out of pocket, a comprehensive insurance policy means your insurer will cover the costs.
Insurance is not the perfect alternative to a lack of liability protection, but it does help.
Pro: No Ongoing Costs
Every formal business entity must pay a small fee annually to the state it is registered in. LLCs may pay less than a hundred dollars to maintain themselves, but running a corporation costs thousands of dollars in admin and renewal fees every year.
Sole proprietorships are unregistered and do not need to concern themselves with annual fees. Therefore, there are no costs associated with maintaining your business status.
Con: Higher Tax Rates
Successful sole traders will soon find themselves paying higher tax rates than those who are incorporated.
You are directly responsible for all profits and losses, which must be reported on your annual tax return.
LLC and corporation owners can elect to keep the money within the business and only pay the standard corporation tax. However, if you are successful, you could lose thousands in unnecessary tax liabilities yearly.
Incorporating opens a whole world of various tax mitigation strategies.
Pro: No Paperwork
Paperwork is a burden on any business. Yet, sole traders get to enjoy the luxury of practically no required paperwork. On the other hand, incorporated companies have several obligations they need to fulfill every year, such as:
- Annual Filing – Most states will require you to file a report annually and pay a fee to keep your company active.
- Change of Manager – Many states require you to file a formal notice if there is a change of director or manager.
- List of Members – Most corporations will need to notify the state whenever its list of members changes.
- Audit – Some companies must submit to an annual audit to fulfill their business responsibilities.
- Company Tax Returns – Any LLC or corporation must prepare an individual tax return as a separate business entity. They will also need to pay separate taxes, including corporate taxes, on any declared profits.
Granted, most of the above paperwork won’t apply to most businesses, and documents like your annual report can be filled out in minutes. Either way, not worrying about this is one of the big reasons, so many people choose to remain as sole traders.
Con: Problems Raising Capital
Raising capital will be vital during the initial few years of your company. After that, you will need an initial and subsequent business loan to fund any expansions.
Traditional lenders and investors want an incorporated business because it provides them with guarantees. Investors nearly always demand a portion of ownership in exchange for their money.
The problem is a sole proprietorship is not its own legal entity. Therefore, it cannot be divided among others, and investors have no protection.
Sole traders will find it nearly impossible to raise capital from reputable investors without incorporating first.
Pro: Flexible Business Structure
An LLC or C-Corporation must abide by restrictions on its business structure. You have plenty of flexibility, but there are models that you have to follow.
Sole proprietorships can be set up in any way you see fit. Since it is not a business entity on its own, you can do whatever you like.
Total control allows you to turn on a dime and react to changing situations without being concerned about corporate bylaws or other potential encumbrances.
Con: No Succession Planning
Your sole proprietorship is attached directly to you. In other words, if you’re incapacitated or die, your business cannot be passed on to the following generation. Sole traders die with their owners, and there is no way of altering that fact.
Granted, sole proprietorships can quickly offload their assets to someone else, but it becomes a more complex process. Outstanding bills in the event of your demise could also involve selling off the business because there is no separation in place.
If you want a business that will stand the test of time, you must incorporate at the earliest possible opportunity.
Planning for the worst-case scenario is just good business.
Does it make sense to start a sole proprietorship?
There are plenty of reasons why sole proprietorships are a good idea. During the early days of your business, sole proprietorships allow you to road test your idea and see if it works. However, all entrepreneurs should aim to incorporate as soon as they can to protect themselves and their families.
Are you thinking about formally incorporating your business?