Question

f you are advising a new client to open a new business, would you advise him to form a corporation or a single proprietorship as a small business? Explain.

Answer 1

Incorporation of corporate benefits include:

• Limited Liability – Corporations provide limited liability protection to their owners (who are called shareholders). Typically, the owners are not personally responsible for the debts and liabilities of the business; thus, creditors cannot pursue owners’ personal assets, such as a house or car, to pay business debts. Conversely, in a sole proprietorship or general partnership, owners and the business are legally considered the same and personal assets can be used to pay business debts.
• Tax Advantages – Corporations often gain tax advantages, such as the deductibility of health insurance premiums paid on behalf of an owner-employee; savings on self-employment taxes, as corporate income is not subject to Social Security, Workers Compensation and Medicare taxes; and the deductibility of other expenses such as life insurance. For information on the types of tax advantages your business may gain by forming as a corporation, consult an accountant or tax advisor.
• Establishing Credibility – Incorporating may help a new business establish credibility with potential customers, employees, vendors and partners.
• Unlimited Life – A corporation’s life is not dependent upon its owners. A corporation possesses the feature of unlimited life, meaning if an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business.
• Transferability of Ownership – Ownership in a corporation is typically easily transferable. (However, there are restrictions on S corporation ownership).
• Raising Capital – Capital can be raised more easily through the sale of stock. Additionally, many banks, when providing a small business loan, want the borrower to be an incorporated business.
• Retirement plans – Retirement funds and qualified retirements plans, such as a 401(k), may be established more easily.

Potential disadvantages of a corporation include:

• Double Taxation – C corporations are subject to double taxation of corporate profits when corporate income is distributed to the owners in the form of dividends. The double tax is created when tax is first paid at the corporate level. If corporate profit is then distributed to owners as dividends, the owners pay tax at the individual level on that income. The double tax can be avoided by electing S corporation tax status with the Internal Revenue Service.
• Formation and Ongoing Expenses – To form a corporation, articles of incorporation must be filed with the state and the applicable state filing fees paid. Many states impose ongoing fees on corporations, such as annual report and/or franchise tax fees. While these fees often are not very expensive for small businesses, formation of a corporation is more expensive than for a sole proprietorship or general partnership, both of which are not required to file formation documents with the state.
• Corporate formalities – Corporations are required to follow both initial and annual record-keeping tasks, such as holding and properly documenting initial and annual meetings of directors and shareholders, adopting and maintaining bylaws and issuing shares of stock to the owners. Sole proprietorships, general partnerships and even LLCs do not incur the formalities imposed on corporations.

Advantages of a Sole Proprietorship

So, with this overview in mind, let’s answer our target question: What are the advantages of a sole proprietorship?

5 Advantages of Sole Proprietorship

1. Less paperwork to get started
2. Easier processes and fewer requirements for business taxes
3. Fewer registration fees
4. More straightforward banking
5. Simplified business ownership

Ultimately, there’s a reason that most small businesses in the United States register as sole proprietorships: it’s easy, quick, and straightforward. The majority of small companies don’t need to bother with the requirements that come with other business entity types. After all, it’d be a significant amount of work to form a board of directors if you run a one-person hot dog stand, and you wouldn’t benefit from forming a C-corporation if you’re a freelance writer—since it wouldn’t make sense to file business and personal taxes separately.

All of this being said then, let’s break down the five major advantages of sole proprietorship:

1. Less Paperwork

The advantages of sole proprietorship are vast and varied—especially if your company’s small. One of the first and most basic advantages, however, is that you won’t have to fill out a ton of paperwork with this business entity type.

To explain, other business structures, such as limited liability corporations (LLCs), require you to register with your state government before you can do business. With sole proprietorships, on the other hand, you generally do not need to register with the state, instead, you become a business entity merely by virtue of doing business.

It’s important to note, however, that you may have to obtain a business license or permit, depending on the requirements of your state or local government. Nevertheless, one of the initial benefits of sole proprietorship is that this structure allows you to scale up your business much more quickly, and with less government paperwork in the balance.

2. Easier Tax Setup

Another one of the biggest advantages of sole proprietorship is the much simpler and straightforward tax requirements, especially compared to other entity types.

First, whereas other business structures need to apply for an employer identification number (EIN) with the IRS, sole proprietors are not required to file for an EIN. With an EIN, these businesses can collect and pay employees separate from the filer’s social security number, but as a sole proprietor, you have the option to use your SSN just like you would for any other financial transaction that requires it.

This being said, however, you also have the option to apply for and use an EIN if you choose (there are also certain benefits associated with doing so).

Additionally, in terms of actually filing taxes, a sole proprietorship has another notable benefit. Sole proprietorships are taxed as a pass-through entity, meaning the business’s income and losses are reported on your personal tax return. Therefore, you don’t have to worry about paying taxes separately for your business, you can complete all your requirements with your own annual 1040 form.

Plus, some sole proprietors may be able to take advantage of the 20% tax deduction as defined in the Tax Cuts and Jobs Act of 2017, which allows you to deduct 20% of your business’s net income from your taxes.

3. Fewer Business Fees

When you’re starting and first running a business, your budget can be tight. Therefore, another one of the crucial advantages of sole proprietorship is the ability to save on registration fees.

As we mentioned above, states require LLCs and other business entities to register with the state before they can conduct business. Most states also require LLCs to pay a yearly fee to maintain their registration and these fees can add up quickly. Luckily, sole proprietorships do not have these same ongoing legal requirements—meaning you’ll be saving on these fees (as well as the time and hassle) compared to other business structures.

This being said, as long as you don’t end up needing liability protection for your business (more on that later), you can help keep more money in your bank account as a sole proprietor.

4. Straightforward Banking

One of the next significant advantages of sole proprietorship is simplified banking. Sole proprietorships are the only kind of business entity that doesn’t require a business checking account in order to operate a company. (You can theoretically run an LLC without a business checking account, but this invalidates many of the personal-finance protections that come with owning an LLC in the first place.)

As a sole proprietorship, you can make and accept business payments straight from your own personal bank accounts. You don’t have to go through the process of finding a business checking account—although if you want to separate your personal and business finances in this way, you have the option to do that as well.

Ultimately, in terms of banking, all you need is your own checking account to get started—being sure to maintain organized and clear records to distinguish your business and personal spending.

5. Simplified Business Ownership

Sole proprietorships make it easy to start a business, for sure. But they also make it easier to own your business.

With a sole proprietorship, you don’t have to concern yourself with some of the other components included in an LLC or corporation, such as company officers or registered agents. As the sole business owner, you have total control over decisions, finances, and anything else involved with how your company functions.

This being said, you don’t have to worry about boards, officers, or any of the other positions typically required by other business structures—meaning you can focus on your daily operations and long-term goals without having to involve other stakeholders or deal with managing external personnel to keep your company on the right side of state and local registration.

Along these lines, since, as we mentioned earlier, you don’t have to formally register your business, you also receive a level of privacy and autonomy that you won’t find with other business structures. You’re not held to the same disclosure or reporting requirements that governments place on LLCs or corporations—and therefore, one of the benefits of sole proprietorship is that you’re free to control and operate your business as you see fit.

Disadvantages of Sole Proprietorship

All things considered, the advantages of sole proprietorship are pretty compelling. This being said, however, there are other business entity types for a reason—a sole proprietorship won’t be right for everyone or every business.

They’re easy to set up, sure, but that convenience comes at the expense of certain protections that you’d otherwise get through an LLC or incorporated business entity. So, depending on the specifics of your business, you may find that a sole proprietorship doesn’t give you the full range of protections that you need—and that the disadvantages outweigh the benefits.

Here are some of the top disadvantages of sole proprietorship to consider:

3 Disadvantages of Sole Proprietorship

1. No liability protection
2. It’s harder to get financing and business credit
3. It’s harder to sell your business

1. No Liability Protection

Since sole proprietors don’t need to register as a business with their state of operation, they also don’t get any of the benefits that come from having a legal business entity. You’re considered self-employed with a sole proprietorship, which means that you’re on your own with regards to your business transactions.

Although this can certainly be considered one of the benefits of sole proprietorship, it can also be a notable disadvantage. Without the legal protections associated with incorporating your business, you’re personally liable for any of your company’s legal, financial, or tax problems.

As an example, LLCs offer protections that keep creditors from being able to seize your personal assets (in most cases) and prevent people from suing you personally for business-related issues. For sole proprietors, however, these protections aren’t in play, which may open you up to additional risk if there are problems with your business.

2. Harder to Get Financing and Business Credit

Another disadvantage of sole proprietorship is that it can be harder to secure loans or financing than it is for other business entities. Essentially, this is because most banks want to work with established companies—and not just because they’re typically larger in terms of revenue—but also because they tend to have a more substantial history with credit.

It’s more difficult for sole proprietors to build business credit the same way that other companies can, since they often don’t have their own business credit cards and business bank accounts. Plus, since all of the liability and backing from a sole proprietorship comes from a single owner, the business as a whole is reliant on that individual’s initial investments, finances, and credit history.

This being said, although as a sole proprietor, you may not be able to secure business financing from conventional lenders, you can still seek out personal loans to help fund your business. However, this option also comes with its own pitfalls, since you won’t have the same level of protection as you would if your business couldn’t pay back its debts.

For example, if your LLC defaulted on its loans, it’d take a lot longer for creditors to seize your personal assets. But as a sole proprietor taking out a personal loan, you’re signing a personal guarantee and putting up your own personal assets as collateral—and there’s no protection to keep the bank from taking your property if your business is in trouble and you can’t pay back the loan.

3. It’s Harder to Sell Your Business

Since a sole proprietorship is attached to an individual by nature, it’s all but impossible to sell or hand down your business to someone else. Therefore, your business ends in the event of your death, or if you decide that you no longer want to run the company.

It’s not impossible to sell a sole proprietorship, however. This being said though, you do need to go about selling your business in a different way. Instead of selling your business as a whole, with everything it entails, you’d have to sell your business assets, rather than the company itself.

In this case, the buyer won’t be able to keep your business name, unless you’ve established a DBA (“doing business as”) and either sell or transfer the usage rights to the other party. If you wanted to pass your business down to an inheritor, you’d have to go through this same process.

Therefore, although one of the advantages of sole proprietorship is singular ownership and control, this can also be a disadvantage, as it makes it much more complicated to sell your business if you eventually decide you want to do so.

The Bottom Line

So, as you can see, when it comes to the advantages and disadvantages of sole proprietorship, many of the best benefits can also be the top drawbacks, it all depends on what will work for your business. To recap then, if you’re trying to decide if sole proprietorship is right for you, here’s what you have to consider:

• Do you want to set up your business quickly and easily, with less paperwork and registration fees?
• Do you want to have everything related to your business attached to you, as an individual, and under your control?
• Do you not want to worry about other partners, investors, or even government regulations having a hand in your business?

If your answer to these questions is an overwhelming, “yes,” than the advantages of sole proprietorship likely outweigh the disadvantages.