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Disadvantages of sole proprietorships

By Higginbotham on July 27 , 2021

Sole propriertorship blog

Higginbotham is not a law firm, and this article is not meant to provide legal advice.

The majority of small businesses start as sole proprietors, due to the ease and single focus allowed by the entity form. According to the IRS, there are 23 million sole proprietorships in the U.S., compared to just 1.7 million C corporations and a combined 7.4 million partnerships and S corporations.

Sole proprietorships are generally easier to start, simpler to run and can be less burdened by paperwork and regulations than any other form of business. But there are also disadvantages, including potential liability for the owner. In this article, we’ll take a closer look at the initial advantages of sole proprietorships, and how they tend to become disadvantages depending on the type of business.

 

What is a Sole Proprietorship?

A sole proprietorship is a business that has only one person with ownership interest and decision-making authority. In legal terms, the owner and the business are one and the same. The business does not exist separately from the proprietor.

Owners of a sole proprietorship have personal title to all business assets and are the only people entitled to the profits of the business. Likewise, they are solely and personally responsible for any debts and taxes owed, as well as any liabilities or losses.

In this business structure, the single focus of authority and responsibility is the source of both the initial advantages enjoyed by sole proprietors and the disadvantages the business owner may encounter.

 

Initial Advantage #1: Easy to Launch

While it takes time, money and legal assistance to establish a corporation or limited liability company (LLC), sole proprietorships may cost little to launch.

In a partnership, there many startup decisions, financial and organizational, on which you and your partner or partners must agree and coordinate. In a sole proprietorship, you alone decide how, when and where to proceed.

If you are doing business in your own name, you won’t even need a fictitious name filing to put your proceeds in the bank. Depending on what business you’re in, you may have to get a local or state license, but you may not be required to register the business with the state.

 

Initial Advantage #2: Simplified Taxes

In most cases, the profits of your business can be reported on your personal taxes. A corporation, partnership or LLC must get a unique Employer Identification Number (EIN), but with a sole proprietorship, you may be able to file under your personal Social Security Number and may not be required to get an EIN unless you become an employer by hiring someone.

 

Whether or not you obtain a separate EIN, a sole proprietorship is considered a pass-through entity for tax purposes. This means that owners of a sole proprietor can report general income and losses from the business on their personal tax return, with no need to prepare a separate tax return for the business.

To learn more about how to file federal taxes as a sole proprietor, use this link to IRS instructions.

 

A Special Tax Break for Sole Proprietors

Many sole proprietorships can also take advantage of a special provision of the Tax Cuts and Jobs Act of 2017, under which the business owner is allowed to deduct 20 percent of the net income.

The qualified business income (QBI) deduction allows self-employed business owners to deduct 20 percent of their QBI – if their taxable earnings are under $163,300 for single filers or $326,000 on a joint return. Above these limits, a sole proprietor may still qualify for a partial deduction. Visit with your tax or legal adviser to determine whether this could apply for you.

 

Initial Advantage #3: Simplified Banking

A corporation is a legal entity that must report revenue, expenses and taxes on its own, and that requires a separate bank account. A partnership is a separate legal entity in which each partner owns a share. The partnership has a separate account that is not the property of any partner individually. A limited liability company is an entity that shields the proprietor from being personally liable for financial and legal liability arising from the business. While a separate account may not be strictly required, it is recommended for almost all LLCs.

On the other hand, a sole proprietorship may provide flexibility to either combine business and personal banking, or to keep separate accounts. A business account is good idea to keep income and expenses organized, and it can be helpful in applying for credit. However, it may not be required for a sole proprietorship – visit with your legal advisor to determine what’s best for your situation.

 

Initial Advantage #4: One Person Driving the Business

Among all the legal forms for a business entity, the sole proprietorship gives the founder the most control. There is no board of directors to win over when you need to make a decision, and there are no partners with whom you must share authority.

Likewise, with few requirements for reporting and likely no requirement for sharing your business results or information with anyone else, you can maintain a level of financial and personal privacy that would simply be impossible with any other form of business organization.

 

Disadvantages of Sole Proprietorships

The disadvantages of sole proprietorships arise from the same single focus of authority and responsibility that can give this form of business its operating advantages.

Not all types of business lend themselves to operating as a sole proprietor – especially those with high potential for legal liability. Further, as a business grows and the founder seeks to scale up a breakthrough opportunity into an enduring business, sole proprietors often find that the business entity itself is either limiting their options or exposing them to elevated risks. This is when the advantages are clearly disadvantages.

 

Disadvantage #1: Financial Liability

While a corporation or LLC can shield the business owner from personal liability, there is no such protection with sole proprietors, who may face unlimited liability for debts and other financial obligations.

If the business is unable to repay a loan, the lender could go after personal assets, including bank accounts, investments or property. In many states, this includes the owner’s home.

The same goes for income tax liability. If the sole proprietorship owes the state or federal government back taxes, they can be seized from the owner’s personal assets and property.

 

Note that even if a sole proprietor later converts to another entity form, any debt existed before conversion is still a debt of the individual.

 

Disadvantage #2: Legal Liability

An even larger risk is legal liability for a judgement against the business. If a sole proprietorship is sued for injuring a customer or financially damaging another company, a large judgement against the individual could be personally devastating.  

Although a sole proprietor may work with employees or may hire advisors or consultants, the proprietor alone is answerable for the acts or omissions of the company. The legal doctrine respondeat superior (literally, “let the master answer” in Latin) means that the owner is personally liable for the decisions or recommendations of an employee or consultant.

Because the proprietor and the company are the same under the law, the business owner is again exposed to unlimited liability. There is no way to even partially shield the owner’s personal assets from collection of a judgement. The prevailing party in a lawsuit can claim the value of the owner’s savings, investments, personal property – sometimes even their home.

 

As with the debts of a sole proprietor, if the business later converts to another entity form, any liability that already existed, including potentially lawsuits filed in the future for actions taken in the past, will still attach to the individual. This is why it is important to consult with a qualified business attorney before deciding to open as a sole proprietor.

 

Disadvantage #3: Selling the Business

There are many reasons why founders would want to convert their interest in a business to cash. A founder might wish to retire and hand the reins to an heir. Poor health might force an early retirement. An owner might want to retain valuable employees by giving them a path to buy equity in the business. Unfortunately, when the owner and business are one and the same, there are few options for sole proprietors to make an orderly exist from this business structure.

When an owner leaves the business (or dies), a proprietorship literally ceases to exist. Although it may have cash, revenue, accounts receivable, investments and buildings or machinery, these are now part of the owner’s estate and may actually belong to the owner’s surviving spouse or children.

This is not the case with a corporation. Because it is a legal entity apart from the owners, corporate equity may be sold to new owners. In a partnership, the founding agreement may specify how a deceased or withdrawing partner’s equity is to be purchased and redistributed.

However, with a sole proprietorship, there is no equity to sell. It is possible to sell the company’s assets and goodwill, but there are no shares of ownership interest the company.

If a sole proprietor held valuable patents or product trade names that were synonymous with the company, these can be sold to, but the company legally ceases to exist.

 

Key Concept Review

Three disadvantages of sole proprietorships are:

  1. Financial Liability – a lender could go after the owner for a bad debt.
  2. Legal Liability – a claimant could seize the owner’s property to settle a judgement.
  3. Selling the Business – aside from assets, there is no company equity to transfer.

Resolving the Disadvantages of Sole Proprietorships

In certain industries, when a new business is just getting off the ground, the simplicity, reduced paperwork, solo decision-making and other advantages of a sole proprietorship may be substantial. However, in certain fields, or as the business grows, other goals and strategies will take precedence, including:

  • Protect what the owner has accomplished (Reduce personal liability).
  • Provide for the perpetual continuity of the business (Stock offering).
  • Let the founder retire or restructure to fulfill their journey (Buyout strategy).

When these goals become equally important as the simplicity and centralized control of a sole proprietorship, it is time to look at a corporation or LLC, which may offer the only pathways to achieving these goals.

 

Protect the Owner

A corporation or LLC can protect business owners from the unlimited financial and legal liability to which they are exposed in sole proprietorships. This protection is not perfect, as there are still circumstances in which the corporate veil can be pierced. However, it can be harder to attach liability to an owner who is the primary shareholder of a corporation, rather than a sole proprietor.

 

Scale Up the Business

When a small business needs help raising capital, conventional lenders may be more interested in business loans for a corporation or LLC that has accounts, business credit cards and a credit history separate from the owner. Investors may be able to provide loans or direct infusions of capital in return for corporate equity that can be sold to profit from their investment.

 

Provide for the Continuity of the Business

If the purpose of a business is to focus the ability of the owner, and it fulfills that purpose with engaging work and the opportunity to build wealth, there may be no need to convert a maturing small business from a sole proprietorship to another form.  However, many businesses grow beyond the life of the founder to become the home of many employees and active in many markets. These businesses may need the form of a corporation to provide continuity of leadership, as well as legal existence in perpetuity.

 

Let the Founder Retire or Restructure

In a sole proprietorship, the business and owner are like a horse and rider. Beauty in motion, but when the owner wants to dismount, the ride is over. There are many company founders who want a modified role when they have achieved career success. Some want a new role as a chairman, advisor or researcher. Others want to develop a family heir for leadership. Still others want to sell the business and pursue a new dream. None of these goals are well suited for transitions within the sole proprietorship form, but all are feasible with a corporation. 

 

The Bottom Line

Sole proprietorship is a business entity with both advantages and disadvantages. The advantages have made it the chosen form of operation for three out of four U.S. businesses, but the disadvantages should be carefully reviewed with tax and legal counsel. Many owners find that the advantages of a sole proprietorship suit their business perfectly for an entire career, while others ultimately address the potential disadvantages of sole proprietorship with opening an LLC or corporation, or converting at a later date.

 

Before making any decision on forming a sole proprietorship or any other entity, consult your legal or tax advisor to determine what’s best for your situation.

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