7 Disadvantages Of A Sole Proprietorship
What is a sole proprietorship?
A sole proprietorship is a business owned and operated by one person.
The owner is responsible for all aspects of the business, from day-to-day operations to long-term strategic planning. While this type of business entity offers many advantages, such as complete control and flexibility, it also comes with a number of risks, including unlimited liability.
As a result, sole proprietorships are not right for everyone; before starting a sole proprietorship, it is critical to weigh the pros and cons carefully.
Here we will go over the disadvantages and advantages of a sole proprietorship.
Disadvantages of a sole proprietorship
Unlimited personal liability
As the sole owner of the business, you are personally liable for all debts and obligations incurred by the business. This means that your personal assets, such as your home or savings, could be at risk if the business is unable to pay its debts or faces legal action.
Higher tax burden
Unlike the Limited Liability Company and corporation, the sole proprietorship has only one way to be taxed. All profits of a sole proprietorship are subject to self-employment taxes and are also taxed as personal income on the owner’s tax return.
The LLC and corporation have other tax options, and what makes these other entities unique is that once a reasonable salary is paid to the owner, the remaining profits can be distributed to the owners, which are not subject to self-employment taxes.
Difficulty raising capital
It can be difficult to raise capital for a sole proprietorship as you are limited to your personal financial resources. You may find it difficult to secure loans from banks or investors.
Raising money for a sole proprietorship is strictly based on the owner’s personal credit history. If their credit history isn’t great, they either can’t get the funding they need, or the interest rates are high.
Unlike the LLC or corporation, you can’t sell off a portion of a sole proprietorship to an investor.
If the owner passes or a new buyer wants to take over the business, a sole proprietorship has to be dissolved and a new one has to be created for the business to continue. This is because you can’t transfer ownership in a sole proprietorship like you can in an LLC, corporation, or partnership.
This can be a challenge because if the business has contracts, special relationships, or better pricing with vendors, these may not be transferred to a new owner.
Selling the business
Selling a sole proprietorship can be a challenge because, in most sole proprietorships, the value of the business is due to the number of hours the owner works in the business, along with the owner’s personal reputation and relationships.
Most buyers aren’t looking to buy a job or will look for other opportunities since the business is built around the owner’s personality. As a result, the business may be hard to sell.
This isn’t exclusive to only sole proprietorships, but it is a good reminder to build your business with an eventual exit.
Reliance on the owner
A sole proprietorship is often reliant on only the skills and abilities of the owner. If the owner is unable to work, for example, due to illness or injury, then the business may suffer.
Less Hiring Prospects
A sole proprietorship may have more difficulty hiring the best prospects for the job since they may not appear to be as professional as an LLC or corporation.
Despite the disadvantages of a sole proprietorship, it’s worth considering that there are over 23 million sole proprietorships in the United States, according to The Tax Foundation. This is compared to the 7 million other types of entities.
This number is a little misleading because Limited Liability Companies are lumped in this number as they can be taxed as a sole proprietorship. Regardless, there are a lot of small business owners who are organized as sole proprietorships and this type of business entity has some benefits worth considering.
Let’s dive into some of the advantages to see if the sole proprietorship is for you.
Advantages of a sole proprietorship
Simple to form and less paperwork
A sole proprietorship is the easiest and most affordable business entity to set up.
Unlike the corporation or LLC, there is no registering the business with the state or fees to pay, however, the business may need to register the name with the county. Each state has different requirements, but in general, should the sole proprietorship want to operate under a business name that is different from the owner’s full first and last name. The name registration may be referred to as a Doing Business As, DBA, Fictitious Business Name, or Assumed Name.
Related: How to register for a DBA
Just like any other entity, a sole proprietorship may also need to obtain a business license. Learn more about what business licenses are needed in each state.
As you would expect since the sole proprietorship is the easiest business entity to form, it is also the least expensive to form and maintain.
The sole proprietorship entity isn’t filed anywhere. So there are no fees to ever pay, with the rare exception of the business name registration.
Freedom and flexibility
The owner of a sole proprietorship has complete control over the business. The owner makes all of the decisions, from what products or services to sell to how to run the day-to-day operations.
This can be both an advantage and disadvantage as we’ll see later, but for now, let’s focus on the advantages.
Another advantage of a sole proprietorship is that the owner has complete control over any decisions. A single owner can have complete control in an LLC or corporation, however, if the owner chooses, these entities can also have shareholders, investors, or members that may have a say in business operations.
A sole proprietorship has the simplest income tax reporting of any business entity. The owner reports all business income and expenses on their personal tax return, which is filed with the IRS each year. The IRS Form 1040, Schedule C is used to report this information. Any business profit is subject to personal income tax, and any business loss can be used to offset other personal income.
It is worth noting that by default, a single-member LLC is taxed as a sole proprietorship. The LLC offers the flexibility of changing its tax election as the business grows.
Related: How to form a sole proprietorship
What is the biggest disadvantage of sole proprietorships?
The biggest disadvantage of a sole proprietorship is that the business owner is personally liable for all business debts and obligations of the business. This means that if the business cannot pay its debts, the creditors can go after the personal assets of the business owner, including their home, car, and savings account. In addition, if there is a lawsuit against the business, the business owner is personally responsible for any judgment against the business.
This is in contrast to a corporation or LLC, which is a separate legal entity from the owners who are not personally liable for the debts and obligations of the business (unless they sign a personal guarantee for a business loan). This liability protection is one of the biggest advantages of forming a corporation or LLC.
Related: How does an LLC protect you?
What is the biggest advantage of sole proprietorships?
The biggest advantage of sole proprietorships is that they are easy and inexpensive to set up and maintain. Funds can be tight when starting a business or the owner wants to try their idea to see if it is feasible.
What is the difference between a sole proprietorship and being self-employed?
The terms are often used interchangeably, but anybody generating income from self-employment is a sole proprietor. This also includes independent contractors and freelancers. The term sole proprietorship is used for the type of business structure.
Does a sole proprietor need an EIN?
The EIN or Employer Identification Number is a unique identifying number that is assigned by the Internal Revenue Service (IRS) for a business.
A sole proprietor is not required to have an EIN unless they have employees. A sole proprietorship without employees will simply use the owner’s social security number (SSN).
Some sole proprietors will get an EIN even if they are not required to as some of their clients will require the business to supply an identifying number which will be used to issue a 1099 at the end of the year. They could choose to use their SSN, but don’t want to share it for privacy reasons. Another reason some sole proprietors will get an EIN is a bank or lender may require one in order to open a business bank account or take out a loan.
Related: How to apply for an EIN