Sole Proprietorship and Law

Benefits and Drawbacks of Sole Proprietorship

Benefits of Operating as a Sole Proprietor

Sole proprietors have fewer formalities to follow, and they do not need to register the business with the state (depending on the type of business involved).

The sole proprietorship has no forms to submit to governmental entities other than a tax form, which consists of paperwork required by tax laws as the result of specific economic activities, such as paying wages to employees. If a sole proprietorship has any employees, the sole proprietor must obtain an Employer Identification Number from the Internal Revenue Service and report employee compensation paid to and employment taxes withheld from employees. The Employer Identification Number (EIN) is a unique number issued by the Internal Revenue Service and is used to identify a business that has employees.

Once the sole proprietorship business begins, the sole proprietor has the right to make all business decisions. No partners, boards of directors, or management committees exist in a sole proprietorship, so the sole proprietor can make the necessary decisions without input or delay from others.

Benefits of a Sole Proprietorship

Being a sole proprietor means all losses belong to one person, but so do all profits, as well as tax benefits and the perk of being the only decision maker. A sole proprietorship is also easy to organize.
All profits (and losses) generated by the sole proprietorship business belong to the sole proprietor. A profit is the result of income earned by a business that exceeds the expenses incurred by the business. A loss is the result when expenses incurred exceed the income earned. At tax time the sole proprietor prepares a federal tax form titled Schedule C—Profit or Loss From Business (Sole Proprietorship), showing all the income and expenses of the business. The sole proprietor includes the resulting profit or loss from the business in their federal personal income tax return and pays whatever income taxes are due. In states that collect income taxes, the sole proprietor will file similar forms in that state and pay the necessary taxes.

A sole proprietor is often eligible for several tax benefits. A sole proprietor can establish a simplified employee pension (SEP), which is a tax-deferred retirement plan for that individual. SEP plans allow the sole proprietor to designate up to 25% of the earnings from business or $55,000 (in 2018), whichever is less, into an individual retirement account (IRA). The amount put into the SEP is not taxed to the sole proprietor until the funds in the SEP are disbursed after the sole proprietor retires.

Also, if the sole proprietorship has at least one employee in addition to the sole proprietor, then the sole proprietorship can buy health insurance for the sole proprietor and employees. The sole proprietor pays the cost of that insurance as a business expense that is deductible in determining the profit or loss of the sole proprietorship business.

Drawbacks of Operating as a Sole Proprietor

There is no liability shield in place to prevent creditors of the business from taking all of the sole proprietor's personal assets if the business fails.
The drawbacks of operating as a sole proprietorship are unlimited liability, limited capital sources, and lack of continuity.
The primary drawback of doing business as a sole proprietorship is the existence of unlimited liability, which is the responsibility of a business owner for the debts or obligations of the business that is not limited to the assets of that business. This liability, or responsibility for wrongful business acts, arises from the fact that there is no difference between the sole proprietorship business and the sole proprietor themselves. If the sole proprietorship incurs a legal liability, then the assets of the sole proprietorship business, which can be anything of value—such as property, inventory, and equipment—will be called on to be used to pay that liability. However, if the assets of the proprietorship business are not enough to pay that liability, then the personal assets of the sole proprietor, which might include a personal car, savings, or securities, can be called on to satisfy the liability.

Unlimited Liability and Sole Proprietorships

Unlimited liability in sole proprietorships means that if the assets of the sole proprietorship are insufficient to pay legal liabilities of the sole proprietorship, then assets of the sole proprietor will be used to pay the liability.
As a new business begins to succeed, it often needs capital, which is the money used by a business to pay operating expenses, invest to expand the business, or take advantage of new opportunities. Sources of capital for a sole proprietorship are limited to additional funds (including borrowed funds) from the sole proprietor. Investors who want to contribute the needed capital cannot be brought into a sole proprietorship without converting it into some other form of business. An investor is someone who contributes funds to the business in return for an ownership interest in the business. Because a sole proprietorship can have only one owner, if an investor contributes funds to a sole proprietorship business and gains an ownership interest in that business, the business necessarily has to be converted to a form of business that accommodates more than one owner, such as a partnership, a corporation, or a limited liability company.

An additional drawback of using the sole proprietorship form of doing business involves the continuity of business concept. Continuity of business is the ability of a business to endure in a consistent form. In a sole proprietorship, one person owns the business. That person can sell the business that the sole proprietorship operates, but what can be sold is essentially what the business owns, not the business itself.

For instance, a lawn mower repair shop operated as a sole proprietorship can be sold. However, what is sold are the assets, such as tools, customer lists, and any prepaid advertising and leasing that is unused. The sole proprietorship business itself will cease to exist when that sale is final, and the purchaser of the business will form a new sole proprietorship or operate the business in some other business form.

This lack of continuity of the sole proprietorship business can also be an issue when a sole proprietor dies. That sole proprietor's heirs can inherit the business, but if that business continues to operate, it will either be as a new sole proprietorship operated by a new sole proprietor or as some other form of business.