Forming a Legal Entity
A sole proprietor is the one-man band of the small business community. Although a sole proprietorship is a simple form of business ownership, there are some advantages and disadvantages you need to know about.
There are more than 10 million self-employed people in the U.S., the vast majority of whom function as sole proprietors.
Despite the fact that partnerships and incorporation offer certain advantages, most people find the tried and true sole proprietorship to be an effective form of business ownership.
The basic idea behind a sole proprietor business structure is that the owner is legally and financially inseparable from the business. In other business structures (e.g. certain partnerships and corporations) the business exists as a separate legal entity. But for a sole proprietor, the business and the person are legally one and the same.
The Upside of Sole Proprietorships
A sole proprietorship offers some important benefits for the business owner. Unlike owners of partnerships and corporations, a sole proprietor isn't forced to share his role as a decision-maker. In other words, when you're a small proprietor there is no one looking over your shoulder or telling you what to do.
Sole proprietors also benefit from minimal fees and startup requirements. One of the reasons sole proprietorships are so popular is because it allows the individual to launch a business without having to navigate a sea of red tape. Since sole proprietorships are considered "flow through" entities, profit and loss are reported directly on the owner's personal tax return, so IRS reporting requirements are limited, as well.
The Downside of Sole Proprietorships
However, sole proprietorships also have a few drawbacks. By far, a sole proprietor's biggest concern is liability. Remember: In a sole proprietorship the individual and the business are legally and financially identical. So the liabilities of the business automatically become the liabilities of the owner. Some partnerships and corporations shelter owners from liability. But as a sole proprietor, you're on the hook for everything.
Likewise, sole proprietors can sometimes experience higher tax rates than the owners of other kinds of businesses. Because profits flow through to the owner's personal tax return, it's not uncommon for sole proprietors to face some significant tax consequences. With a little maneuvering, you may be able to minimize those consequences but your should consult your accountant for guidance.
Finally, it's important to note that sole proprietors find it difficult to raise capital beyond their personal and family resources. Sole proprietorships are non-perpetual entities. If the owner dies, is disabled, retires, etc., the business may no longer exist and all but the most daring investors are unwilling to tolerate that kind of risk.
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