Choosing a Business Entity: Sole Proprietorship

By | November 14, 2007

A sole proprietorship is both the simplest and the most prevalent form of business organization. An important reason for this is that it is the least regulated of all types of business structures. Technically, the sole proprietorship is the traditional unincorporated one-person business. For legal and tax purposes, the business is the owner. It has no existence outside the owner. The liabilities of the business are personal to the owner and the business ends when the owner dies. On the other hand, all of the profits are also personal to the owner and the sole owner has full control of the business.

Disadvantages

Perhaps the most important factor to consider before choosing this type of business structure is that all of the personal and business assets of the sole owner are at risk in the sole proprietorship. If the demands of the creditors of the business exceed those assets which were formally placed in the name of the business, the creditors may reach the personal assets of the owner of the sole proprietorship. Legal judgments for damages arising from the operation of the business may also be enforced against the owner’s personal assets. This unlimited liability is probably the greatest drawback to this type of business form. Of course, insurance coverage of various types can lessen the dangers inherent in having one’s personal assets at risk in a business. However, as liability insurance premiums continue to skyrocket, it is unlikely that a fledgling small business can afford to insure against all manner of contingencies and at the maximum coverage levels necessary to guard against all risk to personal assets.

A second major disadvantage to the sole proprietorship as a form of business structure is the potential difficulty in obtaining business loans. Often in starting a small business, there is insufficient collateral to obtain a loan and the sole owner must mortgage his or her own house or other personal assets to obtain the loan. This, of course, puts the sole proprietor’s personal assets in a direct position of risk should the business fail. Banks and other lending institutions are often reluctant to loan money for initial small business start-ups due to the high risk of failure for small businesses. Without a proven track record, it is quite difficult for a small business owner to adequately present a loan proposal based on a sufficiently stable cash flow to satisfy most banks.

A further disadvantage to a sole proprietorship is the lack of continuity that is inherent in the business form. If the owner dies, the business ceases to exist. Of course, the assets and liabilities of the business will pass to the heirs of the owner, but the expertise and knowledge of how the business was successfully carried on will often die with the owner. Small sole proprietorships are seldom carried on profitably after the death of the owner.

Advantages

The most appealing advantage of the sole proprietorship as a business structure is the total control the owner has over the business. Subject only to economic considerations and certain legal restrictions, there is total freedom to operate the business however one chooses. Many people feel that this factor alone is enough to overcome the inherent disadvantages in this form of business.

Related to this is the simplicity of organization of the sole proprietorship. Other than maintenance of sufficient records for tax purposes, there are no legal requirements on how the business is operated. Of course, the prudent businessperson will keep adequate records and sufficiently organize the business for its most efficient operation. But there are no outside forces dictating how such internal decisions are made in the sole proprietorship. The sole owner makes all decisions in this type of business.

As was mentioned earlier, the sole proprietorship is the least regulated of all businesses. Normally, the only license necessary is a local business license, usually obtained by simply paying a fee to a local registration authority. In addition, it may be necessary to file an affidavit with local authorities and publish a notice in a local newspaper if the business is operated under an assumed or fictitious name. This is necessary to allow creditors to have access to the actual identity of the true owner of the business, since it is the owner who will be personally liable for the debts and obligations of the business.

Finally, it may be necessary to register with local, state, and federal tax bodies for I.D. numbers and for the purpose of collection of sales and other taxes. Other than these few simple registrations, from a legal standpoint little else is required to start up a business as a sole proprietorship.

A final and important advantage to the sole proprietorship is the various tax benefits available to an individual. The losses or profits of the sole proprietorship are considered personal to the owner. The losses are directly deductible against any other income the owner may have and the profits are taxed only once at the marginal rate of the owner. In many instances, this may have distinct advantages over the method by which partnerships are taxed or the double taxation of corporations, particularly in the early stages of the business.

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