8 Important Sole Proprietorship Pros & Cons
Understanding the advantages and disadvantages of this business structure can be the key to small business success.
There are a lot of considerations to make when establishing a small business, but you may be surprised to learn how easy it can be to set up your business structure if it’s a sole proprietorship.
Depending on your goals and industry, your small business might be a good candidate for sole proprietorship. But what exactly is a sole proprietorship, and what are the business advantages and disadvantages of operating one?
We’ve selected eight sole proprietorship pros and cons to help guide you in determining which business structure is the right fit for you.
What Is a Sole Proprietorship?
A sole proprietorship refers to a type of business ownership in which there is a single owner who oversees an unincorporated business. Essentially, the owner and business are one and the same, as there’s no financial distinction between the two. Therefore, the owner is personally responsible for all taxes, debts, and lawsuits associated with the business. As with each business model type, whether Limited Liability Company (LLC), Partnership, Corporation or S-Corporation, the pros and cons that must be weighed.
Pros Explained
There are many advantages associated with operating as a sole proprietorship, especially if you’re looking for a simple business ownership solution. For some businesses just starting out or those poised to remain small, this turn-key business structure can be the perfect fit.
1. Easy to Establish
When compared to other business structures, a sole proprietorship is much easier to set up. It is an informal business structure, and does not come with the many protocols and processes that something like incorporation requires. With a sole proprietorship, you don’t need to fill out any paperwork or pay any fees before you can begin working. In fact, in many cases, you become a sole proprietor simply by operating your business. This makes sole proprietorship a great option for those just starting out because you don’t have to invest much time or money in securing this structure type.
That said, some sole proprietors will need to obtain a business license, depending on their industry and/or respective state and local government requirements. Even if this is the case, acquiring a license as a sole proprietor is a relatively easy and affordable process that you can DIY, many times online. For example, the filing fee to apply for a sole proprietorship business license in California is only $26 and can be done online. To check on your state’s requirements, check out our state-by-state list of business license resources.
2. Simple Tax Filings
The ease of filing taxes is another advantage of a sole proprietorship. You see, sole proprietors are taxed as a pass-through entity, meaning you can report your business income and losses on your personal tax return.
Because you don’t need to file separate taxes for your business, you’re taxed at the individual income tax rates, thus avoiding corporate taxes. This is a biggie, as the current corporate tax rate is 21%.
Additionally, 2018 tax reform changes allow sole proprietors to take advantage of a 20% deduction on self-employed income on their net business income. Sole proprietors are also usually exempt from paying state franchise or excise taxes, so they only need to pay state income tax, self-employment tax, and potentially sales tax (if they’re selling goods).
3. Little to No Oversight
As a sole proprietor, you have a lot of freedom compared to other business structures. For one, sole proprietors aren’t required to file annual reports, unlike LLCs, S-corporations, and C-corporations, which must keep the state up to date on certain aspects like changes in management or members. Some business structures also have to submit annual audits and corporate tax returns. What’s more, there’s a fee associated with each of these filings.
Sole proprietors also get to have total control over their business, while other business structures must comply with certain reporting requirements for each state. For instance, when making business decisions, LLCs and corporations are required to follow an approval process, which may include hosting annual meetings, voting on formal actions, and holding formal reviews.
4. Hassle-Free Recordkeeping
As a sole proprietor, you can begin operating your business without jumping through any hoops, such as separating your finances, something that is required of other business structures. In fact, sole proprietors are the only entities that don’t need to set up a business checking account before business can begin.
Sole proprietors are not required to separate their business and personal finances, which explains why they can file their business taxes on their personal tax returns. As a sole proprietor, you can accept all your business payments right through your own personal checking account.
However, just because you’re not required to segregate your business and personal accounts, it doesn’t mean you shouldn’t. Separating your accounts can actually make it easier to keep track of your profits and losses.
Cons Explained
While there are certainly some advantages of operating as a sole proprietor, there are also some drawbacks you’ll want to consider before going this route. Business size matters and it’s important to think about how your goals and overall business model may play into how large your company aims to grow.
1. Unlimited Liability
The freedom to operate your business without any oversight or interference does come at a cost.
Perhaps the biggest drawback of a sole proprietorship is that you don’t have limited liability protection, so you are personally liable and can be sued personally. Simply put, there’s no difference between you and your business, so you’re on the hook for any debts, injuries, and civil damages associated with your business, products, or services.
Alternatively, other business entities, like LLCs and corporations, enjoy liability protections, which means their personal assets are not on the line should the business fail.
2. More Difficult to Secure Funding
Raising funds for your business can be more challenging for a sole proprietor for a number of reasons.
For one, that unlimited liability aspect makes you a risk as your business is tied up in your personal affairs. Because lenders, vendors, and customers can come after your personal assets, banks may be wary of lending you money or issuing credit. Not to mention, if you don’t have a separate business account, you can’t build credit associated with your business and prove your worth to the banks.
Second, since your business isn’t required to follow formal reviews or approval processes, this means it won’t have equity shares. Equity shares are what give the shareholder (aka the investor) the right to vote in company decisions. Without these shares, investors don’t have any say in the way you run your business, so they won’t have any incentive to invest.
If you’re a sole proprietor looking to raise capital, you may have to rely on your personal savings, crowdfunding, or bank loans associated with your personal assets.
3. Limited Scalability & Life of Business
Your business model may be dependent upon the ability to hire and retain employees who will be integral to the growth and success of your organization. In a sole proprietorship, you are not able to hire any full-time or W2 employees. You can still hire freelancers and contractors, but there are certain limitations on how many hours a single employee can work in that capacity depending on the state in which you live. Without full-time employees it can be harder to retain talent, which can be especially damaging to a smaller company whose success is dependent on a limited number of contributors.
Additionally, if something should happen to a sole proprietor, like a planned exit or death, there is no structure in place to make sure the business can continue on under someone else. Although someone else can continue to run the day to day business, they would essentially be doing so as a new business, at least on paper. If you structure your business as an LLC, C-corp, or other formal model, your business may continue on as long as business filings are kept current and all the required licenses are maintained.
4. Harder to Hand Over Your Business
With a sole proprietorship your business is wrapped up in your personal finances and is essentially an extension of yourself, so selling it can prove challenging.
To sell your business as a sole proprietor, you’d have to sell your business assets—not the entire business. Also, once you pass your business over, your name will no longer be attached to it unless you registered a Doing Business As (DBA) or trade name. If you do plan to sell your business down the road, you may want to look into a different business structure that’s more seller-friendly by design.
Examples of Sole Proprietorships
Sole proprietorship businesses are a great option for sole owners with businesses that don’t require complex legal or financial aspects, such as writing business plans or raising capital. Sole proprietors are independent contractors, business owners, or franchisees who often operate at-home or small local businesses. Some examples of sole proprietors include:
- Freelance writers, web developers, and graphic designers
- IT consultants
- Plumbers
- Fitness instructors
- Artists
- Photographers
- Tax accountants
- Tutors
- Clothing store owners
- Daycare providers
- Caterers
How to Set up a Sole Proprietorship
When it comes to establishing yourself as a sole proprietor, you don’t need to take any formal action. You’ll automatically receive this status when engaging in your business activities if you're the owner. That said, here are some preliminary steps you’ll want to consider taking:
- Decide if a sole proprietorship is right for you and your business. Look at the various aspects of your business, such as how you’d like to file your taxes and whether you’re willing to put your personal assets at risk. Think through the pros and cons outlined above.
- Determine if your business requires any licenses or permits. Depending on your business location and your specific business activities, you may need to apply for certain licenses or permits. Check out this list for more information regarding licensing.
- Consider your business name. Your business name is automatically your personal name unless you decide you’d like to set up a trade name, also known as a DBA. If you go this route, you’ll need to register your DBA. DBA requirements vary by location, so check with your state, county, and municipality for specific guidelines.
- Register for an Employee Identification Number (EIN). While you’re not required to have an EIN as a sole proprietor, you will need one if you plan to pay freelancers or open a retirement plan for yourself. You can apply for free online with the IRS.
- Claim your business income on your individual tax form. When filing your taxes, report your gains and losses on your personal tax return using the IRS Form 1040 Schedule C.
Sole Proprietorship FAQs
A sole proprietorship refers to a business entity where a sole owner runs an unincorporated business.
A sole proprietorship is a popular choice because it’s the easiest and most affordable business structure to establish. It’s also the most common type of business ownership, with more than 23 million businesses operating as sole proprietorships in the United States.
Compared to other business structures, a sole proprietor doesn’t pay more in taxes. In fact, sole proprietors are exempt from paying the corporate tax rate, so they are only responsible for self-employment taxes.
Determining which one is better really comes down to what’s best for your individual business. Remember, a sole proprietorship doesn’t protect your personal assets, while an LLC does. If you’re running a small, low-risk business, a sole proprietorship may be best, but if you’re overseeing a business with more liability, an LLC might be the better choice.
In some cases, if you’re engaging in business for yourself, you might already be considered a sole proprietor. For example, freelancers and independent contractors are automatically sole proprietors. You don’t need to take any formal action to establish yourself as a sole proprietor as long as you’re the official owner of the business.
It’s important to note that there is no distinction between your business and yourself, so you are personally liable for any losses, debts, or lawsuits that your business accrues. If you’re unable to cover the costs, your personal assets are on the line. If you’re concerned about liability, a sole proprietorship may not be the best option for you.
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