The sole proprietorship is both the simplest and most common type of business operating in the United States today. Most businesses that are owned and operated by one person take this form; in fact, small business owners who have sole ownership of their enterprises are automatically categorized under this business type if they do not take steps to legally establish themselves as another type of business. The essential feature of a sole proprietorship is that the law makes no distinction between the person, the sole proprietor, and the business. Virtually all of the legal and tax consequences associated with sole proprietorships flow from this basic fact.
ADVANTAGES OF SOLE PROPRIETORSHIP
Many aspects of sole proprietorship are attractive to entrepreneurs. Primary reasons why small business owners choose to operate in this fashion include:
- Sole proprietors enjoy a great deal of independence and autonomy. The sole proprietor makes all the decisions. As a sole proprietor, you alone can decide what to sell and how to sell it, when to expand and when to pull back, when to look for financing, when to buy new equipment, when and how long to work, and when to take the day off. In some instances, sole proprietorships can benefit enormously as a result of this streamlined management structure. An entrepreneur who keeps abreast of business trends, community events, and other factors that can impact on a company's fortunes may, in some cases, be able to adjust to changing business realities far more quickly than a partnership or corporation, where multiple owners and/or managers need to reach agreement on appropriate responses to changes in their business environment.
- Figuring taxes is fairly straightforward. Unlike other business types, sole proprietorships do not have to file separate income tax returns. In addition, FICA (Federal Insurance Contributions Act) taxes for such businesses are less than they are for partnerships or other legal operating forms.
- Accounting is a relatively simple affair, although small business experts encourage the owners of even the most modest business ventures to establish separate bank accounts and record keeping practices for their enterprise.
- Business operations, too, are generally simpler in a sole proprietorship. Other forms of business often have to contend with more cumbersome or time-consuming regulatory requirements in conducting or reporting on their operations.
- Start-up costs are often modest. This is due in part to the fact that entrepreneurs who intend to establish sole proprietorships do not need to secure the services of an attorney to prepare documents required by state or federal agencies, since none are needed.
- Business losses can be used to offset other income on personal tax returns. Conversely, business profits do not have to be shared with any other owners.
- Sole proprietors are not forbidden from securing and building a work force. Indeed, many businesses that qualify as sole proprietorships (delicatessens, landscaping firms, canoe liveries, flower shops, etc.) have employees.
DISADVANTAGES OF SOLE PROPRIETORSHIP
While business owners who choose sole proprietorship understandably enjoy their autonomy and their freedom from the paperwork that can be considerable in other, more complicated, business types, they still need to consider the following drawbacks in the areas of liability and business financing.
"In a sole proprietorship," warned Jocelyn West Brittin in Selecting the Legal Structure for Your Business, "the business and the owner are one and the same. There is no separate legal entity and thus no separate legal 'person.' This means that as a sole proprietor you will have unlimited personal responsibility for your business's liabilities. For example, if your business cannot pay for its supplies, the suppliers can sue you individually. The business creditors can go against both the business's assets, including your bank account, car or house'¶. The reverse is also true; i.e., your personal creditors can make claims against your business's assets." She does note that some states offer sole proprietors protection of their personal assets from business risks through legal designations that involve the owner's spouse and/or children, but such arrangements are complex, and should not be entered into without first consulting with an attorney. Business owners can also elect to purchase liability insurance for protection from lawsuits and other threats. In addition to general liability insurance, producers or sellers of goods may also want to consider securing product liability insurance. The cost of such insurance varies considerably depending on the type of business under consideration.
Raising capital for a sole proprietorship can be quite difficult as well (though many businesses that operate as sole proprietorships are of modest size and thus are not impacted by this reality). Many lenders are reluctant to provide financing to owners of sole proprietorships—in large part because of fears about their ability to recover the funds should the owner die or become disabled—and even those who make such loans require borrowers to provide personal guaranties on the loan. Sole proprietors who consent to such arrangements are in effect pledging their personal assets as collateral on the loan. Small business advisors counsel clients who are considering these stipulations to proceed cautiously. If a potential lender is taking extra measures to protect itself from default, it may be an indication that the prospective borrower's business plan is viewed—legitimately, perhaps—as flawed or risky. In addition, even well-conceived businesses sometimes fail as a result of circumstances beyond the owner's control. An entrepreneur might, for example, establish a store that is enormously successful for its first few years of operation, only to see it suffer a dramatic downturn in performance with the arrival in town of a much larger competitor that provides its customers with a wider variety of services and goods. Banks and other lending institutions are aware that such scenarios occur, and they plan accordingly.
Continuity and Transferability
Unlike other businesses that can be passed down from generation to generation or continue to exist long after the passage of its original board of directors, sole proprietorships have a limited life. As Brittin wrote, "a sole proprietorship can exist as long as its owner is alive and desires to continue the business. When the owner dies, the sole proprietorship no longer exists. The assets and liabilities of the business become part of the owner's estate."
A sole proprietor is free to sell all or a portion of his or her business to a buyer, but any transaction that transfers ownership or turns the business into one with two or more owners puts an end to the sole proprietorship that had been in existence.
STARTING A SOLE PROPRIETORSHIP
Sole proprietorships often operate under the name of the owner of the business, but this is not a requirement. If the owner decides to select a fictitious name, however, he or she may be required to file a certificate explaining the arrangement in the region in which he or she is operating the business in question (this requirement also gives the sole proprietor legal protection, for it serves to protect them from other persons who might otherwise use the name for their own business enterprises). In addition, many states forbid business establishments from using words like "incorporated," "Co.," or "Inc." unless they actually qualify as corporations. Some cities and counties also require sole proprietorships to secure a business license before launching their business. Owners who subsequently change their business location or add new locations to their operation are often required to obtain new business licenses for those sites as well.
Many sole proprietorships also will need to obtain federal and state payroll ID numbers. These numbers are required for any businesses that will have employees or will do business with establishments that have employees. Finally, owners of sole proprietorships will, like all other business owners, have to obtain the appropriate operating licenses and certificates, if any, for the area in which they will be conducting business. Business licenses and zoning permits are among the types of licenses that are sometimes required. Once these few minor licensing issues have been addressed, the sole proprietor is free to conduct business.
Once a sole proprietorship has been established and proven viable, many business owners eventually choose to incorporate. Incorporation is both more expensive and more time-consuming than sole proprietorship, but it also affords the business owner considerably more legal protection from lawsuits and other liabilities than does sole proprietorship, and it also makes it easier to secure financing for business expansion.
Anderson, Brian L. "Benefit Issues Regarding Partnerships, S Corporations, and Sole Proprietorships." Jouranl of Pension Benefits. Spring 2004.
Fraser, Jill Andresky. "Perfect Form." Inc. December 1997.
Hawkins, Carole. "Beyond the Sole Proprietorship." Home Office Computing. March 2001.
How to Set Up Your Own Small Business. American Institute of Small Business, 1990.
Schneeman, Angela. The Law of Corporations, and Other Business Organizations. Thomson Delmar Learning, 2002.
Sitarz, Daniel. Sole Proprietorship: Small Business Start-Up Kit. Nova, 2000.
U.S. Small Business Administration. Brittin, Jocelyn West. Selecting the Legal Structure for Your Business. n.d.