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We advise hundreds of businesses every year. It is extremely rare that we ever think it is in a person’s best interest to operate their business as a sole proprietor. The Number One reason why you should never be a sole proprietor is that there’s no legal or financial separation between you and your business.
While many entrepreneurs conduct business as sole proprietors due to the fact that it’s simple to set up and that the business owner has total control over the business, the disadvantages of sole proprietorship as a business organization far outweigh any advantages. This article will outline some of the major negatives of this type of business structure.
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1. Unlimited Personal Liability. Perhaps the primary pitfall of opting to be a sole proprietor is liability for claims against the business. It’s essential to understand that there’s no legal distinction between the business and its owner. The owner of a sole proprietorship IS the business, so there’s no separation between business assets and personal assets. As a result, if there’s a legal action brought against the business, the sole proprietor is responsible, and if business funds aren’t enough to settle a lawsuit, the owner’s personal assets, like bank accounts, motor vehicles, and real estate, may be at risk.
2. Tax Issues. A sole proprietorship is subject to pass-through taxation; as such, the business owner reports income or loss on their personal income tax return. This means that any net income from your business increases your personal taxable income. That could move you into a higher tax bracket; any business losses would lessen the amount of personal income on which you’d pay taxes. Sole proprietors must pay the full 15.3% self-employment tax (covering both the employer and employee portions of Social Security and Medicare) on all business profits, regardless of whether they draw a salary or reinvest funds into the business. While sole proprietors can deduct business expenses, they may have fewer opportunities to deduct certain benefits (like health insurance premiums or retirement contributions) compared to LLCs or corporations. Sole proprietors cannot divide income between salary and distributions, reducing options for minimizing self-employment tax. Sole proprietors tend to be audited at higher rates than other business structures, in part because of the potential for commingling personal and business finances.
3. Difficulty in Raising Capital. A C Corporation has the ability to raise capital by selling part of the business to shareholders. But a sole proprietorship doesn’t have any shareholders and can’t sell shares without changing its business structure. So, without any financial assistance from family and friends, a sole proprietorship is on his or her own to find their own capital to fund the business. This may entail applying for a business loan, but lenders see sole proprietors as risky because they may not have any of the following: (i) a regular and established income stream; (ii) significant savings; or (iii) insurance to protect against lawsuits. When a sole proprietor gets a personal loan, personal assets will have to be used as collateral; thus, personal assets may be risk if the business owner defaults.
4. Inability to Add Partners. A Sole Proprietorship is an unincorporated business with just one owner, so you can’t have any partners. If you bring in a partner, your business will no longer be a sole proprietorship and will instead operate as a general partnership where both individuals share business profits and losses. This type of business structure has a lot of the same disadvantages as a sole proprietorship. Moreover, it’s possible that a partner could enter into a business agreement against the wishes or without the knowledge of other partner(s). As a result, the contract would be legally binding for everyone. We never advise clients to enter into general partnerships due to the extreme risks involved.
5. Hard to Sell the Business. The assets of a sole proprietorship can be sold, but not the business itself. That stems from the fact that the business and the owner aren’t considered separate from one another, which really complicates a sale.
6. There’s No Paycheck. A sole proprietor doesn’t get a paycheck, and the funds you take out of the business to cover your personal expenses is called a “draw.”
7. The Death of the Owner Dies Means the End of the Business. With a sole proprietorship, the business doesn’t survive after the death of the sole proprietor.
Takeaway
We can help you choose the right type of business entity for your business. Reach out to us with your legal needs, and we’ll let you know the value we bring and the cost we charge. You’ll find that we stand by our motto: “Build. Not Billed.”®
If you liked this article, check these out as well:
How to Choose the Right Entity for Your NY Business
LLC or S-Corp - Which One is Better for Your New York Business
Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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