Business lingo has a funny way of sounding more complicated than it is. For example, if you run a business on your own, you’d probably just say you’re a business owner. While this is true, you’re also likely a sole proprietor. That is, your business has no legal separation from the owner. (That’s you.)
Sole proprietorship is the most common form of business in the United States. This makes it fairly likely you are actually a sole proprietor of your business. This business model is pretty common for good reason: It’s simple.
An example of sole proprietorship
To better understand the ins and outs of sole proprietorship, let’s pretend for a moment you sell hand-made, free-range, organic leather shoes. (Hey, it could be a real thing.) You have a pretty niche market, so you take the first logical step and sell your shoes locally as a hobby.
Soon, word of your fancy shoes has traveled through town. You’re feeling confident about the leap to full-time self-employment, so you leave your job and focus on your shoes. You have a business name, pay self-employment taxes, and have turned your shoes into your entire source of personal income.
Your shoe trade has turned into the type of business known as a sole proprietorship, making you the sole proprietor. While you have a business name, you’re conducting business as yourself and are responsible for the entirety of the business. This makes you different from a limited liability corporation, or LLC, as you have full legal responsibility for the company.
You might be wondering if a sole proprietor is the same thing as an independent contractor. Well, yes and no. Both are individuals representing themselves, but a sole proprietor pays their taxes via Schedule C, while an independent contractor files their taxes using a 1099-MISC.
You can be a sole proprietor and work as an independent contractor, or you can be a sole proprietor and treat yourself as an employee by using a Schedule C.
Why would you want to be a sole proprietor?
Sole proprietorship is simple for the most part. But, like all things, it has its pros and cons. All that simplicity has to come with a price, right? Let’s take a look at the ups and downs of being a sole proprietor to better understand this.
Pros of sole proprietorship
Sole proprietorships are simple. When it comes to starting a business, nothing is as simple as being a sole proprietor. You don’t have to register for an Employer Identification Number, your income tax return can be simple, and you retain complete control of the business.
Sole proprietorships are also quick to start. Unlike an LLC, a sole proprietor can be up and running fairly quickly. After obtaining any relevant business licenses, you can start your business and start earning. As the sole owner, you don’t have to answer to a board or investors, so you can get moving as quickly as you want.
There are no separate tax forms. That’s right. A sole proprietor doesn’t have all the additional tax forms that come with larger corporations. You tackle your taxes as if you were self-employed and don’t have to worry about any kind of corporation taxes, etc.
You can pivot quickly. When a large corporation wants to change direction or introduce a new product, there are generally board meetings, votes, protocols, and investors to think about. Seeing as you answer only to you, you’re in control of all business activity. If you want to pivot and tackle the competition in a different way, you alone can make that choice.
Cons of sole proprietorship
All debt and obligations are on you. With all that freedom comes a lot of financial responsibility. If the company goes into debt or faces any kind of legal battle, the pressure is all on you. An LLC owner has limited liability because the business structure helps separate the owner’s assets the business’s assets. As a sole proprietor, you have to figure out how to tackle financial and legal woes without that veil of protection.
Owning a business is no small feat. With a larger company, you can lean on other executives or co-owners for support. As a sole proprietor, you carry the weight of the company and all the stress that comes with that.
Fundraising can be difficult. An LLC can have investors and backers that take care of financial problems. Sole proprietors are far less likely to secure investors, meaning any costly expansion or upgrade is going to come out of your pocket or the bank’s.
The business can die with you. Not to be morbid, but if you fall ill or pass away unexpectedly, the business can go too. With a larger company, people can take over in your absence. While you can set up some kind of inheritance for your sole proprietorship, it can be far messier since you alone manage things. This sets the successor up for a rough time.
4 Signs you’ve outgrown a sole proprietorship
We’ve established that so many businesses are sole proprietorships for good reason. Sole proprietorships are easy to form, inexpensive to maintain, and don’t require you to file separate business tax returns with the IRS.
While a sole proprietorship is convenient and easy to form, this approach may not serve your needs as your business grows and becomes more profitable. Here are four signs that you may need to consider a different business structure. (Hey, don’t be sad. This just means your business is doing well.)
1. You need limited personal liability
As a sole proprietor, there’s no legal separation between you and your business. If you’re the only employee in your sole proprietorship and you’re bankrolling the business, this may not be a problem.
However, if you take out a business loan, being a sole proprietor means that the bank could come after your personal assets to satisfy your business debt. It also means that you can be held personally liable if an employee, landlord, vendor, or customer decides to sue and you don’t have adequate liability insurance.
In contrast, an LLC, S corporation and C corporation enjoy limited personal liability for business debt and lawsuits. However, small business owners can still be liable if they personally guarantee a loan, if they personally injure someone, or if a court deems that they’ve acted negligently. (There’s no “get out of jail free” card, folks.)
2. You need funding
The definition of a sole proprietorship is that there’s only one owner. That means sole proprietors are unable to sell any interest or shares in the business, which limits the opportunity for equity funding.
Sole proprietors that pledge personal assets may be able to obtain a loan for business needs, but according to the U.S. Small Business Administration, banks aren’t as likely to lend to a sole proprietor because of a perceived lack of credibility.
In short, if you need more funding to grow your business, it might be time to upgrade your business classification.
3. You’re extremely profitable
For the most part, sole proprietors can deduct all the same business expenses as other business entities, with one caveat: The net income from a sole proprietorship is subject to payroll tax and income tax. Since sole proprietors are both employer and employee, they have to pay the full 15.7% of Social Security and Medicare payroll taxes.
S corporations, on the other hand, have the potential to reduce taxes for a very profitable business. S corporation owners must pay themselves a fair salary, which is subject to both payroll tax and income tax.
That being said, S corporation shareholders can also pay themselves in the form of distributions, which aren’t subject to payroll taxes. Depending on your company’s net business income, that could mean thousands of dollars a year in tax savings.
4. You want to retire
If you’re planning your exit from a profitable business, being a sole proprietor can be a liability. Because sole proprietors can’t have multiple owners, you can’t transfer or gift part of your business ownership as part of the succession process.
Again, if you pass away, your sole proprietorship dies with you, and all the assets become part of your estate. If you have a fairly large estate, this can leave your heirs with a large tax liability.
If you’re a sole proprietor with a large estate, it might be a good idea to look into life insurance for reasons like the reasons mentioned above. Life insurance can cover your funeral costs and be used to pay for back taxes or liability that come with your company (assuming you have enough coverage).
Sole success: knowing your limits as sole proprietor
A sole proprietorship is a great, easy, and affordable way to get your start as a business owner. For tax purposes, it can be a breeze, lacking the complicated filings of a limited liability company. A business bank account, company credit card, and your own name are pretty much all you need to start on the right foot.
Still, it’s important to be mindful of the limitations that come with being a sole proprietor. It’s never fun to say goodbye, but if you feel your business needs more funding, carries too much risk, makes too much money, or you simply want to retire, it might be time to say farewell to your sole proprietor status and take your business to the next level.
No matter what you do, remember this: you’re the walking definition of motivation and drive and a business owner that is carving their own destiny. At the end of the day, that’s something to be proud of, no matter what your business status says.