Why is a sole proprietorship a popular form of business ownership? A sole proprietorship is an unincorporated business owned (and usually controlled) by a single individual. Because no legal paperwork is necessary to establish a business as a sole proprietorship, many small business owners are sole proprietors without even knowing it. Although a sole proprietorship has only one owner, it can have any number of employees. For example, you can be the owner of a plumbing business with several other plumbers working for you and still operate as a sole proprietorship. Other characteristics of a sole proprietorship are listed in Figure 6.1.

Figure 6.1

Characteristics of a Sole Proprietorship

How do I start a sole proprietorship? The minute you begin doing business by yourself—that is, collecting income as a result of performing a service or selling a good—you are operating as a sole proprietor. There are no special forms to fill out, and there are no special filing requirements with state and federal governments. At a minimum, you might need to obtain a local license or permit, or you might have to ensure that you’re operating in an area zoned for the type of business you are running. If you’re hiring employees, you will need to register your company name and obtain an employer identification number (EIN) from the Internal Revenue Service (IRS).

Are there advantages to being a sole proprietor? There are several advantages of forming your business as a sole proprietorship—one of which we have already discussed: ease of formation. With only one person making all the decisions and no need to consult other owners or interested parties, sole proprietors also have great control and considerable flexibility to act quickly. Another advantage is that there are no specific corporate records to keep or reports to file, including tax reporting. Because there is no legal distinction between the owner and the business, no separate tax return is required. As a result, the income and expenses of a sole proprietorship flow through the owner’s personal tax return. This can be an advantage, especially in the start-up phase of the business when it is likely that the operating costs of the business are greater than the incoming revenues. In this case, the excess expenses (or net loss) can help offset the taxes you owe on any other sources of income you might have.

For example, imagine you run a landscaping business during the summer in addition to your regular job. If the lawn mower breaks down and needs to be replaced, that expense could be more than all the earnings you collected, generating a loss for your lawn-mowing business. You can subtract that loss from the income earned from your regular job, reducing your income tax obligation. Table 6.1 and Figure 6.2 show how a business loss can reduce your tax payment. In this example, a business loss of $3,000 reduces by $450 the federal taxes you would have to pay.

Table 6.1

Personal Income and Taxes Due with and without a Business Loss from a Sole Proprietorship

Figure 6.2

The Effect of a Business Loss on Personal Income

Why wouldn’t I want to run my business as a sole proprietorship? One of the biggest disadvantages of a sole proprietorship is that it leaves you exposed to personal liability. A liability is the obligation to pay a debt, such as an account payable or a loan. Liabilities can also include a breach of contract or losses associated from damages. Unlimited liability means that if business assets aren’t enough to pay business debts, then personal assets, such as the sole proprietor’s house, personal investments, or retirement funds, can be used to pay the balance. In other words, the proprietor can lose an unlimited amount of personal assets. As a sole proprietorship, the business is not a separate legal entity, and all business debts and liabilities are the owner’s personal obligations. As a sole proprietor, you are personally responsible for the business’s contracts, taxes, and the misconduct of employees who create legal liabilities while acting within their employment. Therefore, if the type of business you’re running has the potential for someone to sue you because of damages caused by your business, you may not want to operate as a sole proprietorship.

Imagine that you own a catering business. While you are preparing food in someone’s house, the oven catches fire because you forgot to take the egg rolls off the paper tray. You are personally responsible, or liable, for paying for any damages if the assets of your business (or your insurance) are not sufficient to cover the damages. If the damages are severe enough—perhaps your client’s entire house burns down—you could lose all your assets, including your own home and savings. If you decide that a sole proprietorship is the right business form for you for other reasons, buying insurance—such as errors or omissions insurance, disability insurance, and insurance to protect your assets—will help protect you against unforeseen situations.

Are there other things to consider when operating as a sole proprietorship? Unlimited liability is perhaps the most critical reason for not operating as a sole proprietorship. However, there are other reasons why you might not want to operate your business as a sole proprietorship.

• Financing/investment. A drawback of a sole proprietorship is that it can make it more difficult for you to borrow money to help your business grow. Banks will be lending to you personally, not to your business, so they will be more reluctant to lend large amounts, and the loan will be limited to the amount of your personal assets. Structuring the business as a separate entity may mean more financing options are available to you. In addition, if you decide to bring in investors who want some type of ownership in the company, the form of the business would need to be changed.

• Taxes. As a sole proprietorship, your business income and expenses are included on your personal tax return. The costs you pay for your health care, retirement, and other benefits are not tax deductible for the sole proprietorship itself, although you may be able to deduct some of these expenses on your personal tax return. If your business were to be so successful that taxes became an issue, the legal structure of the business would need to change.

• Selling. If you ever wanted to sell the business, it is much more difficult to sell a sole proprietorship.

• Financial sacrifices. Financial control is great, but it can come with a price. Generally, after the business pays its employees, suppliers, and other creditors, the owner is often the last person to get paid. If the budget is tight, the payments for the owner’s health care and retirement sometimes get postponed, which can be problematic. It is often helpful to run a sole proprietorship as a part-time business and still work for someone else until the business is earning enough money to pay you a salary as well as provide you with benefits.

• Spreading yourself thin. Most importantly, running a sole proprietorship means that all the management duties fall on one person—you! Many a sole proprietor neglect to consider that there are other responsibilities to running a business besides performing the services or making the goods sold to customers. There is a lot of paperwork and time involved to ensure that invoices are created, payments are collected, and salaries and benefits are paid (if there are other employees), as well as generating new business, following up on prior jobs, and performing the marketing tasks. These additional tasks are time-consuming, and ones that proprietors do not anticipate and can undo many new businesses quickly.