Investment Glossary – Sole Proprietorship
A question that comes up rather often as people think about starting a business is the age-old “What is the simplest and cheapest way for me to structure a business?” It makes sense, and it’s a good question to ask. Typically, when you’re starting a business, you don’t usually have access to mountains of venture capital money or wealthy relatives who can help foot the bill for years until you reach profitability. So cost and ease of operation are paramount for many small businesses. And the answer that many entrepreneurs find to the above question is typically the sole proprietorship, though there are also some downsides to this business structure.
So what is a sole proprietorship?
It’s a business structure that gives one person the full ownership of the business, with no other entity acting as an intermediary for operations. The company may conduct business under another name. For example, Jimmy Wilson could decide to call his auto body shop Wilson’s Auto Body. The name in which he conducts business doesn’t change the fact that if he has set himself up as a sole proprietor, he owns 100 percent of the business and can also be held personally responsible for any liabilities of the company, as there is no insulating entity created in this setup.
Because there is no other entity involved in the operation of a sole proprietorship, the initial formation of the company is rather straightforward. All payments will be made to and from the owner, meaning sole proprietorships can, and often do, operate using the owner’s personal bank accounts and investment accounts. While this can make it easy to conduct business, it also can lead to issues with accounting and record-keeping if personal funds are comingled with business funds. This is not necessarily illegal in a sole proprietorship, making this area fundamentally different from Limited Liability Companies (LLCs), and other corporate structures such as S-corps and C-corps.
The simplicity of the sole proprietorship also continues over to the tax side of things, as any income earned by the business is simply taxed at personal income tax rates for the owner. A number of expenses can be deducted, though the individual will have to file a 1040 Schedule C to account for the income earned and expenses paid by the business. The net difference between income and expenses from that Schedule C is then transferred over to the owner’s personal return, making the process of filing taxes for a sole proprietorship fairly straightforward.
All of these things make a sole proprietorship sound like a great choice for someone starting a business – it’s easy to do, cheap to do, and the ongoing maintenance is relatively straightforward.
But there are some major downsides to this structure.
But it isn’t just borrowing liabilities that could pose a risk to your assets in a sole proprietorship. Suppose you forget to shovel the front steps of your cupcake shop after a blizzard, and a potential customer falls trying to reach the door and breaks their leg. If they decide to sue, your personal assets are once again at risk. So there is tremendous liability associated with being a sole proprietorship. This type of liability can be somewhat mitigated through the use of different types of insurance policies, but it still exists in the sole proprietorship, while it is not present in other corporate structures.
The issues with sole proprietorships don’t end with potential liability. Let’s say your cupcake shop is actually a tremendous success. People love your shrimp cupcakes, which sounded gross at first, but later became a sensation. Now you want to expand. In a sole proprietorship, you can’t take on other investors by selling an equity stake in your company. Your company is you. Yes, you can take on additional debt, but if you’re that successful, other investors might only do a deal with you in exchange for a stake in the business. And you can’t do that in a sole proprietorship.
The benefits of the sole proprietorship are its simple setup, low cost, and ease of ongoing operations. But the primary downsides are that you take on a lot of liability using this structure, and it is also challenging to grow a business and take on additional investors using this structure. Sole proprietorships can be appropriate for small companies that are starting out, but most businesses tend to outgrow this setup as they expand and have to deal with more complex situations.