If you have a company that you run on your own, you are typically considered a sole proprietor. Sole proprietorships are one of the most common business structures in the United States because they require minimal startup costs and don’t have to register with the Secretary of State.
While this sounds like the perfect business system, there are drawbacks, namely, when it comes to liability risks. However, despite these perils, millions of companies have been established with this form of entity formation. Interested in doing the same? This guide will cover the basic concepts of sole proprietorships, including the pros and cons of operating as one.
What Is a Sole Proprietorship?
Much like the name entails, a sole proprietorship is a business with one owner who personally assumes all its successes and risks. Startup costs for this entity structure are minimal, and most jurisdictions won’t require any formal registration to be made to legitimize it.
These business entities are the simplest to create and have minimal administrative costs to set up and maintain. There are no state law prerequisites or paperwork you will have to register either. You may be shocked to find out you’re already technically a sole proprietor if you’re the single owner of a company operating under your personal name and not a DBA.
The Good and Bad of Sole Proprietorships
As mentioned earlier in this article, the simplicity of creating and running a sole proprietorship is a considerable benefit to its owners. When looking at the pros of this business model, two characteristics stick out the most:
Full Managerial Control
Sole proprietorships have only one owner in charge. This means you control all the decision-making about your business and can determine what direction your company should go with important marketing decisions, product or service line offerings, and more.
Simplified Tax Process
Sole proprietorships are treated as pass-through entities by the IRS. This is beneficial to owners because a special tax ID won’t be necessary when making your filings each year. Instead, you can use your own individual return to report your profits and losses. Even better? This one has the lowest tax rate out of all the business structure options!
Scale Up When the Time Is Right
Another great benefit of being a sole proprietor is that as your company grows, you can decide later to create a different entity structure for your business. This is ideal for companies starting up on a slim budget and want to go bigger later once established financially.
For every upside, there is a down. There are some potential risks to running a sole proprietorship instead of an LLC or corporation. Below is an overview of the cons to this business structure option:
Personal Liability Protections Aren’t Built-In
As the owner of a sole proprietorship, you call all the shots for how your business operates. You are also fully liable for any losses, debts, and damages you might cause yourself, your customers, and your employees.
General Liability insurance is the most common insurance policy for businesses to defend against third-party damage and injury claims. This includes defamation and libel suits. This coverage pays these losses on your behalf, but your insurer will also cover the legal expense of your legal defense.
Unfortunately, this may not always be adequate protection on its own. In fact, general liability policies won’t cover any of the following events:
- Property damage to your building after a natural disaster
- Tool and equipment replacement if a thief breaks into your building
- Income replacement if your business suffers an interruption in operations
- Repairs for your commercial fleet after an accident
- Professional mistakes made by yourself or an employee that causes a client damages
- Fall out after suffering a cyber-attack event that compromises your technological infrastructure and client data privacy
Each of the above-mentioned scenarios requires a comprehensive sole proprietors insurance policy to mitigate the losses usually paid out of your own pocket. This protection would ensure your business survives significant losses due to mother nature or a costly settlement for a customer’s personal injury claim.
Securing Capital is More Challenging
The unlimited liability that self proprietorships take on also can impact one’s ability to secure additional funding for their company’s growth. You will likely find it hard to get out of the red on your books when first starting up because of supplier costs, labor expenses, overhead, etc. This means that you’ll probably have your business and personal assets tied up, making banks nervous.
Your success or failure is entirely up to you, so getting a loan to finance equipment or a new branch office requires convincing financial institutions you can repay your debts.
The big question you need to answer is whether a sole proprietorship is suitable for your business or not. You may want to look at the short-term first to arrive at your answer. If you don’t plan to add another owner to the mix during the first few years of operation, this business model may be ideal.
Also, consider what perils you’ll need to protect against. Additionally consider if forming an LLC would be better to keep your personal assets separate from those of your business. The great thing about sole proprietorships is that they are flexible. Plus, you can scale up to a corporation or other entity formation later with little difficulty.