The Benefits and Drawbacks of Being a Sole Proprietor

The Benefits and Drawbacks of Being a Sole Proprietor

Find out why this type of organizational structure might work for you and why it might not.

The proprietors of a new firm must make a number of decisions regarding taxes when the business is first established. Choosing the most suitable organizational structure for the company is perhaps the most significant one. One of the most common choices made by new owners of small businesses is to establish a sole proprietorship. 

A sole proprietorship is an unincorporated business structure in which the owner also functions as the business. As a consequence of this, the proprietor of a sole proprietorship is entitled to 100% of the earnings but is also personally liable for 100% of the business’s losses, liabilities, and obligations.

It is crucial to gain a better understanding of what a sole proprietorship is, how it functions, the requirements for forming one, as well as the benefits and drawbacks of forming one, before deciding whether or not it is the best business structure for you.

Key Takeaways

A sole proprietorship is a business that is not incorporated and is run by one person. There is no difference between the owner and the business itself.

Even though sole proprietors are exempt from the requirement that their businesses be registered with the state, depending on state and local regulations, they may be required to get various business licenses, permits, and tax receipts.

The owner of a sole proprietorship is entitled to all of the company’s income, and filing taxes is a much less complicated process because there is no requirement for any kind of official action or expense to get the business off the ground.

There are a few negatives associated with sole proprietorships, including the fact that the owner is personally liable for any debts and losses; the business can have trouble obtaining capital, and there might not be adequate account management.

What Does It Mean to Be a “Sole Proprietor”?

A sole proprietorship is a type of business entity that is not incorporated and is controlled by a single individual. In this type of company arrangement, there is no separation between the owner and the enterprise. 

According to the Small Business Administration (SBA), the easiest and most common structure that people choose when starting a business is a sole proprietorship since it offers the most flexibility. For example, if you are a freelance writer or graphic designer, you are theoretically already operating your business as a sole proprietor. 

Adams is the author of the book “Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers.” According to the law, if you begin a profession or enterprise without first registering it with the state, you are legally considered a sole proprietorship. It’s a well-known fact that many people who have a second job run their businesses as sole proprietorships without ever realizing it.

According to the regulations of the state and the municipality, sole proprietors are required, just like other types of business owners, to acquire specific licenses or permissions. Your company, on the other hand, does not need to be registered with the state in which it is doing business.

Tax Returns for Individual Businesses and Sole Proprietors

Throughout the course of the year, sole proprietors are held accountable for a number of different tax payments. The following is a list of the most important tax filings to take note of.

Taxes on Independent Contractor Work

Due to the fact that sole owners are considered to be self-employed individuals, they are required to pay self-employment taxes, which include the Social Security and Medicare taxes, based on the income generated by their businesses. Form 1040, which is used to file federal taxes, has a section for the self-employment tax, and Schedule SE is used to compute the tax. If the company has a negative profit, the owner is not required to pay taxes on their self-employment income, but they will not collect Social Security or Medicare benefit credits for that year. 

Estimated Taxes and Fees

Due to the fact that a sole entrepreneur is not considered an employee under the law, no income taxes or taxes on self-employment are deducted from their remuneration. On the other hand, the Internal Revenue Service mandates that these taxes be paid in four installments throughout the year on the 15th of April, June, September, and January of the following year. 

Since there is no separation between the owner and the business, sole proprietorships are taxed through the owner’s personal taxes on Form 1040, and the business’s earnings are estimated and recorded on Schedule.

Instructions for Establishing Oneself as a Sole Proprietor.

The formation of a sole proprietorship does not require any official actions to be taken. However, there are a few essential procedures to follow in order to truly create your business, and these steps are explained below.

What Will You Call Your Company?

Choosing a name for your company is one of the most crucial first steps. If a sole proprietor decides to conduct business under a name other than their own, they may be required to register a fictitious name. A fictitious name is also known as an assumed name, trade name, or “doing business as,” otherwise known as “DBA.” 

A fictitious name must be unique and not already be utilized by another company. You can check for registered trademarks and see if a name is available by visiting the website of the United States Patent and Trademark Office. The process of registering your company’s name provides a number of benefits, including the ability to generate a domain name for your company’s website; increased customer recognition of your brand; and compliance with legal requirements for business contracts and agreements.

Ensure Compliance with the Law and Taxes

Find out from the relevant state and local government agencies in your area whether or not you are required to have specific licenses or permits in order to operate, such as a home business permit. It is to your advantage to establish a company address within your local jurisdiction because zoning restrictions can differ from place to place. 

Additionally, it is possible that your state or the local government will require you to buy a business license, acquire a company tax receipt, and pay taxes to them.

For the purposes of taxation, sole proprietors who do not have any workers and who do not submit any tax returns related to excise or pension plans are exempt from the requirement that they obtain an employer identification number (EIN). They can also use their Social Security number (SSN) as their individual taxpayer identification number.

The Benefits and Drawbacks of Being a Sole Proprietor

Pros

  • There is no obligatory activity or expense required to get started.
  • The complexity of the tax filing process has been reduced.
  • The owner has full power over the business and is entitled to all of the money it makes.
  • A low-risk method of putting a company’s idea to the test
  • popular among self-employed individuals such as freelancers, consultants, and contractors

Cons

  • The owner is personally responsible for the company’s debts, losses, and other obligations.
  • It may be more difficult to solicit financial support from investors.
  • The absence of adequate accounting and administration of financial resources 

Pros explained

There are several advantages that come along with establishing a sole proprietorship, such as the fact that there is little to no expense involved, the fact that it is convenient, and the ease with which it is possible to handle tasks such as filing taxes. 

Adams explained that the profit or loss from the firm must be reported on the individual tax forms. However, if you decide in the future that you want to convert it into another sort of business structure, such as a C corporation, an S corporation, or an LLC, it is simple to do so.

Adams highlights a number of other significant advantages that come along with operating a sole proprietorship, in addition to the ease with which one can launch a sole proprietorship:

The owner has full control over the business and is not limited by partners, shareholders, or board members in any way. This method is a low-risk way to try out an idea for a business before putting together another corporate structure.

Freelancers, consultants, and independent contractors who are looking for a high degree of flexibility choose this option rather frequently. The company isn’t required to follow any government reporting rules, and it’s up to the owner to report all of the company’s income and expenses on his or her own tax return.

Defining the Drawbacks

It’s true that starting a sole proprietorship gives you more independence and flexibility, but it also comes with the possibility of having to follow financial concerns. According to Adams, the fact that you are personally liable for the debts and liabilities of your business is the primary disadvantage of operating as a sole owner. 

To put it another way, there is no legal distinction between you and the business that you run. When I first started working with big companies as a PR spokesperson, influencer, and content producer, I decided to form a single-member limited liability company (LLC) so that I could limit my personal liability if any legal issues came up.

The Internal Revenue Service (IRS) views a limited liability corporation (LLC) with a single member as a “disregarded entity,” which means that there is no legal distinction between the company and its owner. But because single-member limited liability companies (LLCs) protect business owners from being personally responsible for business debts and losses, people with a lot of personal assets may be more interested in this form.

The following are some additional difficulties that sole proprietorships present, according to Adams: 

Compared to other business structures, people who own sole proprietorships don’t have any personal financial protections. This means that they could be sued personally.

Because it might be harder to get money from investors or loans from banks, you might have to self-finance the business with savings and other ways to get money.

There is no necessity to keep separate accounting records or financial statements, which might result in a lack of adequate account management and financial reporting. There is no requirement to keep separate accounting records or financial statements.

Adams says that obtaining the appropriate types of insurance can help sole proprietors and other business owners reduce the potential legal risk that they face in their businesses. She stated that there are many different things that may be purchased to fill in gaps or solve unforeseen challenges in business. Some insurance policies that sole entrepreneurs should consider purchasing include the following, depending on the type of business they run:

  • A policy held by a business owner (BOP)
  • Commercial auto insurance
  • Insurance for vehicles used for delivering meals
  • Insurance against liability in cyberspace
  • Insurance against general liability.
  • Insurance for product liability claims
  • Insurance for professionals against legal responsibility

Can a Sole Proprietorship Be The Ideal Business Structure for You?

One of the easiest ways to get your firm off the ground is to organize it as a sole proprietorship rather than one of the other business organizations. Nevertheless, there are a few obstacles that proprietors of businesses must overcome. 

Even though it might be the best choice for your business, you should first take the time to research your market and figure out what risks you might face.

Adams, who is an advocate of sole proprietorship and operating a firm on one’s own, urges other sole owners to maintain a flexible approach to their business goals. “You are always free to change your business entity,” she advised me, “when your company’s requirements and clientele evolve.” 

If, on the other hand, you work in an industry where lawsuits are more likely to be filed, such as the food service industry, the real estate market, or professional services, it is in your best interest to incorporate your company as soon as possible rather than waiting until a later date. 

This will provide you with the greatest amount of protection from personal liability. One easy way to reach this goal is to set up a limited liability company, which is also called an LLC.

Additionally, Adams recommends that business owners speak with a company attorney or a tax professional in order to review state regulations and concerns that may have an impact on the decision to incorporate.

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