The Pros and Cons of Being a Sole Proprietor

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By Nellie Akalp2013-12-18 10:11:50 UTC

Are you freelancing, running a consulting or side business, or launching a startup? If you're self-employed, you’ll need to tackle your business structure at one time or another, and that decision can influence how you pay taxes, what happens if you get sued and how much paperwork you have to deal with.

See also: 7 Questions to Ask Before Starting a Business in 2014

By default, your self-employed business operates as a sole proprietorship until you select a different structure. As the simplest way to operate a business, the sole proprietorship has its unique benefits and drawbacks.

The Pros

Simplicity

The main plus of staying a sole proprietor is that it’s the simplest structure to create and manage. All you need to do is register your business name by getting a DBA (which is very easy) and then getting any local business licenses that you might need (such as a reseller's permit). After that, you’ve launched your business and you’re 100% legit.

Lighter Paperwork

A sole proprietorship also simplifies your ongoing management and tax reporting. If you were to incorporate a business, you would to need to operate it at a higher administrative level — and that means paperwork.

With an official business structure, you'd need to prepare formal financial statements, make sure that all your finances stay separate between personal and business, hold an annual meeting, file reports with the state, pay an annual fee and more. For a lot of freelancers and people running side projects, this paperwork is a major headache. You don’t have to deal with any of it with a sole proprietorship.

Easier Taxes

As for taxes, the government doesn’t make any separation between a sole proprietor and the individual. That means that any income you earn with your sole prop business is considered your own personal income. For tax reporting, you just need to keep track of all your business income and expenses, and then file this on a Schedule C with your personal tax return (you can read more about this here).

If you like to keep things simple, it’s obviously a big advantage to just have to file one tax return for your business and personal. In addition, if your business takes a loss for the year, you can use this loss to offset your other income on your personal return. A common scenario is if you’re still fully employed, but decide to launch a side business or get a startup off the ground. You may be able to reduce the overall taxes you pay for the year.

Keep in mind that taxes aren’t always straightforward. For some people, it may be better to keep their business and personal taxes separate. You should also be aware that other formal business structures (like the LLC) let you be taxed like a sole prop and file your business taxes with your personal return.

The Cons

Personal Liabilities

While operating as a sole proprietorship is easier, it involves some serious drawbacks as well. The main problem is that there’s no separation between the individual and the business with the sole proprietorship. That means that if something should happen in the business, you’d be personally liable. For example, if your sole prop business is ever sued or runs into financial trouble, you’ll be personally on the hook and creditors and lawsuits can come after your personal assets.

Granted, you probably don’t anticipate being sued or unable to pay your bills, but things do happen —maybe you’re working in a “risky” business, such as catering, or you’re making a product that you sell to consumers. Even an unreasonable client can sue a PR consultant for a breach of contract. Anything can happen in any industry.

It's important to consider how much risk you want to take on when it comes to personal liability. Once you form an LLC or a corporation for your business, it exists as its own entity. In most cases, this offers a shield between your personal assets and the business.

No Room for Expansion

There are additional limitations to a sole proprietorship beyond liability matters. If you have any plans to expand in the future (for example, by finding investors, a partner or getting a business loan), you’ll need a formal business structure — that is, an LLC or corporation. That’s because a sole prop is just you; there’s no room for anyone else.

Risk of Fewer Partnerships

Larger companies often prefer to work with corporations and LLCs, rather than sole proprietors. As a sole proprietor, you may be the most dependable, long-term partner a business could ever hope to find, but some people just assume that a corporation or LLC is more legitimate and trustworthy than a sole proprietor.

See also: Is Your Business Spending Too Much Time on Facebook?

What's Right for You?

There’s no single, right answer that applies to all circumstances and individuals. You can run a legitimate business even before you form an LLC or incorporate. In general, however, the risk of any kind of personal liability is usually enough to convince a small business owner to form an LLC or corporation. In this case, the LLC comes with much smaller administrative requirements and paperwork than the corporation.

With the new year approaching, it’s a great time to consider your business structure for a new or existing business. You can even speak with a tax advisor to learn more about your own personal situation and how you can lower your self-employment taxes through your business structure.

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Image: iStockphoto, asiseeit

Nellie Akalp

Nellie Akalp is the CEO of CorpNet.com, an online legal document filing service, where she helps entrepreneurs incorporate or form an LLC...More

Topics: Business, contributor, Small Business, Startups