How to Know If a Small Business Should be Designated as a Sole Proprietorship

When starting your business, you have a lot to consider before deciding what type of business you are opening. You need to choose which entity best fits your company. Make sure you know what you are doing before choosing between a sole proprietorship or other options for your small business.

What is a Sole Proprietorship?

A business that is owned entirely by one person is a sole proprietorship. (It’s important to note that if it is a married couple that runs the business together, they are still counted as one.) If you do not register your business as a specific entity, it will default to a sole proprietorship. There are certain ways you can set up entities: through partnerships, LLCs, and corporations. These ways have specific shields to protect the owner. With sole proprietorships, the company is not separate from the owner, and the owner is then vulnerable to liability. There are fewer hoops to jump through with a single-owner proprietorship. There are fewer fees associated with this option, as well.

Examples of Sole Proprietorships

Think of any company that can be operated and owned by one person. This is a company that can be a good fit as a sole proprietorship. This can include small businesses run out of the home like hair stylists, tutors, financial planners, piano teachers, landscapers, etc. Artists such as photographers and writers can also be considered a sole proprietorship. When your business involves inventory or requires advanced tax planning, then it is time to upgrade your business.

Even though one-owner proprietorships are designed for very small companies run by one person, these small businesses can grow into large, thriving companies. J. Willard Marriott is a famous example. He started a rootbeer stand as a sole proprietorship that grew to become a chain of A&W restaurants. No matter how small a business is to begin with, there is growth available for any company to become large.

How is a Sole Proprietorship Taxed?

It is vital to do the research on taxes and get a good picture of what your tax expense will look like. It is important to always account for taxes as part of your business budget. Taxes for this type of business are typically simpler than other business options. When someone files taxes for a sole proprietorship, they also need a Schedule C to report the company’s gains and losses.

Taxes for single-owner proprietorships are different in all states. Be sure to access the information for your specific state, and it would be sensible to contact a CPA or professional who can lead you to the correct information.

Sole proprietorships include the same deductions that other types of companies enjoy, including health insurance deductions and tax deductions for necessary operating expenses. With the new tax law changes that took effect in 2018, individual businesses can claim tax credits up to 20% of net income earned each year through 2025. This can be a significant deduction from your taxable income if you meet the federal guidelines. Be sure to consult with a credentialed accountant to see if your business qualifies.

When someone sets up their business as a separate legal entity, they have to maintain different accounts. And therefore, pay separate taxes, depending on the entity. This has its benefits as well.

What Are the Pros and Cons of a Sole Proprietorship?

For every type of business, there are pros and cons. The best you can do is gain the knowledge of all pros and cons of a sole proprietorship before starting your small business.

Sole Proprietorship Pros

What benefits will you receive when starting your small business as a sole proprietorship? Let’s take a look:

Complete Ownership

If you don’t have a partner and are the one and only person who owns the company, then this is a great option for your company. You don’t have to wait for the board or a partner’s approval with sole ownership before making a significant change in your company. Because of this, you can course-correct more quickly and save money by moving fast. You can pivot and change your company in any way you would like, with no one to question your judgment.

Easy to Start, Easy to End

As mentioned before, a business is automatically a sole proprietorship if not specified otherwise. You can start your business without declaring anything. And the same goes for ending your company. If you don’t have inventory to sell or customer memberships to cancel, you can simply stop conducting business, and your business is over without paperwork. Easy come, easy go.

Fewer Fees

There are not as many fees for sole proprietorships. Other companies have to pay a variety of fees, while sole proprietorships only have to pay license fees. This can definitely seem enticing when putting together your business budget. Accountant fees will be lower and legal costs will be lower because the business has a simple setup.

Taxes are Straightforward

When you file your taxes for a sole proprietorship, your primary form to include is a Schedule C along with your personal tax form. Because of this, your taxes will be less complicated while still reaping the benefits of business tax deductions.

Great for a Low-Risk Business

Many small businesses start as a sole proprietorship. As the companies grow and profitability increases, the risk of liabilities also increases. This is an opportunity to upgrade your business to a different entity. A sole proprietorship is an excellent option if you would like to test the waters and try out a new idea.

Minimal Reporting Requirements

One of the benefits of a sole proprietorship is you have minimum reporting requirements. You don’t have partnership agreements to worry about. You don’t have mandatory board of director meetings with corporate minutes to keep on file. This is true for the federal and state levels.

Sole Proprietorship Cons

Although many of those talking points above sound exciting, there are some negatives to a sole proprietorship. Make sure to get educated, so you know the risks:

100% Liability

Because your business is not legally separated from your personal affairs, then there are no protections in place. If something goes wrong in your business, then you as the owner are held personally responsible. This can be a considerable risk, depending on the company. With other types of legal entities, there are shields built-in to protect the personal assets of the owner. This is not the case for sole proprietorships. Legally, you and your business are not separate entities. The IRS does not see you as distinct entities, as well as banks and creditors. If there is a lawsuit against your small business, you will be held personally responsible. If your business is found liable, your personal assets can be repossessed to satisfy business debts, including your cars, house, and other assets.

Mixes Personal Credit with Business Credit

If you are seeking a loan for your business, then your credit score will be taken into account. This can make it hard to secure a loan if you do not have a good credit score. On the flip side, if your credit is very good, it will benefit you when seeking a business loan. Your credit history, including all of your assets, will be the deciding factor on whether you secure a business loan.

Cannot Sell Stock for Extra Funds

If you need extra cash for your small business, you will need to rely on the profits or search for investors or loans. With a sole proprietorship, you do not have the option to sell stock in your business in order to get extra funds. If your business needs to expand and you have a need for additional capital, you will not be able to do this with a sole proprietor unless it’s a loan. If you secure an investor, your company will automatically be upgraded to a different entity, like a partnership.

If the Owner Dies, the Business Dies

Keep in mind that when your small business is a sole proprietorship, the business will not live on if the sole owner passes away. Many people set up their small business as a separate legal entity so that the company can be passed onto children or benefactors. When the owner dies, someone else can inherit those shares and continue with the business.

Get Your Questions Answered

Effective tax planning can save you a lot of money, but it has to be done correctly to avoid unnecessary interest and penalties or even a shutdown of your business. You should always talk with a professional to help you get your business started on the right foot.

Do you need help starting your small business? Our team at Easier Accounting has the expertise to answer all of your questions regarding sole proprietorships. We know how hard it can be to tread through those first steps of starting your own business. Let us help! Call us at (888) 620-0770.

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