A sole proprietorship is one of the easiest ways to start and operate a business, however, there are distinct disadvantages that you need to be aware of before you start your new company. Here are the top reasons to reconsider forming your business entity as a sole proprietor.
Its popularity lies in its simplicity because, in order to become a sole proprietor, all you have to do is register your name and acquire a legal license. Moreover, a sole proprietorship is not considered to be a legal entity and therefore is not distinct from the person who owns it.
If you have a registered sole proprietorship, you may operate it using your own name or any other moniker that you like. This is because the business name is merely a trade name. Legally, you are still the owner and the business is not separate from your name.
Disadvantages of Sole Proprietorship
- Disadvantages of Sole Proprietorship
This lack of legal distinction can be bothersome for a business owner since you will remain liable for any and all business expenses. If you happen to run into financial trouble, you will have to utilize your own personal assets to bail yourself out. Any lawsuits that arise will be filed directly against you. As a sole proprietor, you will have to pay with your own cash. This distinct disadvantage will be discussed in further detail below.
Alternatively, one of the beneficial factors of owning this type of business is that the taxation process is straightforward. Any revenue earned by the business is earned by the sole proprietor. All you have to do is report this income and fill out a Schedule C, along with Form 1040 for standard taxation.
Once you file this, the “bottom line amount” from the Schedule C form is put back into your personal tax return. This is great because any losses in business will not diminish other sources of income. What’s more, the most recent tax reform law states that qualifying sole proprietors will be offered new deductions. As a sole proprietor, you can deduct 20% of your Qualified Business Income (QBI). Learn more about how to pay yourself as a sole proprietor
In addition, sole proprietors must pay Self Employment taxes. This is what income tax is to employees of any business.
Ask any individual who works for themselves and they will all likely agree that filing taxes when you are self-employed versus being an employee is quite a bit different.
Employed individuals do this through payroll cuts but sole proprietors need to add these payments when they file their income taxes. Most likely you will also need to get an EIN – Employer ID Tax Number. Learn more in our Entrepreneur’s Guide to EIN.
It’s true that a sole proprietorship is a simple way of owning a business. Furthermore, sole proprietors have been known to avail the lowest tax rate out there – 15.1%. However, there are also some distinct disadvantages of a sole proprietorship that make them a less attractive option than other kinds of business structures. These are the must-knows for new entrepreneurs
1. Unlimited Personal Liability
One of the most serious disadvantages of a sole proprietorship is unlimited liability. This is because as the owner of a sole proprietorship, your personal assets are on the line. This is why the majority of small businesses choose to form an LLC (which is easy and affordable) to minimize their risk of losing their personal assets due to business debts.
If a lawsuit is filed against the sole proprietorship, your assets could be confiscated and/or seized to settle any debts or possible bankruptcy. You could lose everything you own, including your house, cars, properties, bank accounts and more.
2. Difficulty in Raising Capital
Big corporations can raise capital by selling shares or attracting investors. A sole proprietorship can have no shareholders and cannot take another owner on board in the business. It’s practically impossible to sell ownership in a sole proprietorship which is why you will have trouble finding worthy investors. If you are planning on using investors to fund your startup you are advised to set up a C corporation so you can issue share equities in exchange for money.
3. Lenders Don’t Lend
Moreover, lenders are more hesitant to give out loans to sole proprietors than LLC or INC. You are free to borrow money but you will have to use your own assets as collateral with the financial institution. Again, this means that your assets will be seized if you fail to pay back your loan. This is not true for all lenders.
>More progressive lenders like Kabbage, focus more on your business metrics than your legal formation.
4. The Business Dies with You
As the owner of a sole proprietorship, YOU are irrevocably tied to it. Your business is not a separate business entity and therefore, in the tragic event of your demise, your business will die with you. Unlike a corporation, you won’t have the luxury of ‘perpetual existence.’
5. Lax Bookkeeping
Since your business has a less formal structure than a corporation, you probably will not bother to maintain regular financial statements and Minutes of Meetings (MOM). If you practice shabby accounting, you’re more liable to lapse in payments or other financial checks and this becomes a real possibility in sole proprietorship and a danger to your business survival.
6. Few Days Off
As the sole owner of a business, you will probably not get the luxury of days off. You will have to be present 24 hours a day, 7 days a week and so on – even if you are not in the office or shop – your company will be in your thoughts. The work will stop if you stop.
7. Increased Stress and Pressure
As a sole proprietor, you will have to be accountable for any and all decisions made in your business. This could mean more stress and less time available for your family and/or personal life.
8. Poor Management
You will be responsible for the day to day running of your sole proprietorship. If you don’t have sufficient management experience, you might find yourself making poor or detrimental decisions.
9. Less Hiring Prospects
Hiring is difficult for sole proprietors because as a small business, you cannot offer attractive salary packages or perks. Employees also tend to pick larger and more well-known companies on the whole so you might have to shoulder the burden alone.
10. Small Scale Economies
As a sole proprietor, you won’t be able to afford large scale economies for purchasing materials or services. Corporations can reap these benefits since their overhead costs are divided and lower than those of small businesses.
11. No Counseling Available
Large corporations have shareholders and board members who gather and consult before making big decisions. On the other hand, sole proprietors don’t have access to these kinds of resources. As a sole entrepreneur, you might run into difficult business challenges and won’t have ready help available to fight them.
The Way Forward
Admittedly, sole proprietors have their fair share of problems. However, you should understand that you will not need to stick to the same form of business entity as you start out with. Over time, you can change and incorporate your business to become a proper corporation. Most small businesses follow this model and succeed later on.
A great example is Richard Warren Sears who started a sole proprietorship selling jewelry and watches by mail. Eventually, he entered into a partnership with Alvah Curtis Roebuck and with time, Sears, Roebuck, and Company became one of the United States’ biggest retailers.
You, too, can succeed if you know exactly where you want to go. After you’ve weighed all the pros and cons of sole proprietorship, make the decision of what business entity is best for you.
>Not sure which business entity is right for you? Take this quiz by the business experts at Legalzoom
Check out my guide on how to start your business right with tons of useful tips I learned by successfully starting, building, and selling multiple companies.