If you are going into business and want to legitimize your business, you will need to incorporate. Often the answer is a sole proprietorship. The simplest and most common form of business ownership, the sole proprietorship is owned by an individual who is responsible for all of the debts of the business. Unlike other business structures, this is not a separate entity from the owner. You are your business and you are your business.
Sole proprietorships make up the bulk of all businesses in the United States. That said, you won’t find any on Wall Street – only corporations can become publicly traded entities. In fact, individual companies do not issue any shares, since there is only one direct interest in the company. Nonetheless, they are worth understanding from an investment perspective.
Here’s a quick look at individual businesses, how they work, and what their structure means to those at the helm.
The advantages of sole proprietorships
Many of the benefits associated with sole proprietorship revolve around the simplicity of establishing and maintaining one. To establish one, individuals simply need to start functioning. There is no tax entity to be established, which means no formal document or registration required.
The cost of operating a sole proprietorship is also minimal. The individual does not have to worry about paying corporate tax, keeping a return, or paying many of the costs associated with setting up a business. The only real costs are those of maintaining the business and, of course, personal income taxes paid on profits.
Speaking of taxes, a sole proprietorship is a tax situation passed on. Because there is no incorporated business, it cannot pay taxes. Instead, the person who operates the business takes responsibility for all taxes paid on profits. Filing taxes involves submitting a Schedule C for business activity along with your year-end or quarterly personal income tax return.
Finally, great ease of use is associated with this simplified business format. Since the individual is business, there is no need to separate bank accounts or assets. Individuals can conduct business related to their personal finances without encountering scrutiny. Although, as we’ll explore in a moment, that’s not always a good idea.
The disadvantages of a sole proprietorship
Sole proprietorships play an important role in the early days of a new business venture. That said, as businesses grow, individual businesses quickly become obsolete. They are not equipped to handle the increased liability potential and financial complexities that come with a growing business.
The biggest disadvantage of a sole proprietorship is the lack of separation between the business and the individual. In the event of legal action against the company or insolvency, these responsibilities are transferred to the person who runs it! This opens the door to unlimited liability. Incorporating the business adds a layer of protection that separates the business and the individual.
Another disadvantage for growing businesses is the inability to raise capital for an unstructured business. Investors want to buy from a legitimate business: not a person. It is almost impossible to raise capital through a sole proprietorship, and many banks will treat loans as personal loans rather than business loans. Unless you are planning on starting your path to success, incorporation is a better way to secure capital.
The transition from ownership to society
As sole proprietorships grow into more mature businesses, owners need to think about transitioning to a different business structure. The larger the financial operations of the business, the greater the personal liability of the owner. A move to an LLC, S-Corp, or C-Corp further legitimizes the business and adds a buffer of protection between owners and their business. In addition, it allows the company to issue shares to partners and investors.
Going from owner to corporate status involves filing with local and state authorities to obtain an Employer Identification Number (EIN), which is used to file company taxes. Sole proprietorship businesses in transition must also file articles of incorporation and other legal documents to secure the business name and register it with tax authorities and other registrars.
Sole proprietorship vs self-employed worker
In the age of the economy of odd jobs and the ease of entrepreneurship, many self-employed people will find themselves running their own businesses. Is operating a sole proprietorship the same as being self-employed? Yes. Just like a freelance writer or contract worker, people who run a sole proprietorship should file a Schedule C next to their Form 1040 when they do their taxes. Schedule C is a record of business income and loss, intended to contextualize the income reported on Form 1040.
The easiest way to start a business
Sole proprietorship is the easiest and most efficient way to start a business. In fact, it’s so simple that many entrepreneurs inadvertently start one on the way to creating something more structured like an LLC. And while most sole proprietorships become incorporated, for a time they were a simple way for aspiring business owners to get their idea off the ground.
And you can learn how to build wealth in your life by making informed business and investment decisions! Just sign up for the Freedom through wealth e-letter below for daily updates on stock market trends and other investment opportunities!
The biggest downside to a sole proprietorship – and the reason it evolves the most into a corporation – is that it comes with unlimited liability. Business owners are responsible for all operating profits and losses and are open to any liability that could affect their personal finances. Moving into an LLC or other corporation isn’t just a sign of business maturity, it’s a sign of mixed responsibility. Until it grows big enough to warrant incorporation, most businesses start out as a budding sole proprietorship: a motivated founder with a great idea.