What Are the Disadvantages of a Sole Proprietorship?
Sole proprietorships are a popular form of business for many entrepreneurs. Sole proprietorships are businesses where a single person owns and runs a company with no separate legal existence. This is because there are advantages of a sole proprietorship, such as easy decision-making. They give their owners complete control over the entire business. Sole proprietorships are quick and easy to set up, often need little start-up cash, and accounting is simple.
There is also no need for a separate business organization. The owner of a sole proprietorship can simply use their own name or file a trade name, often called “doing business as" (DBA), to start their business. Many companies start as sole proprietorships. Some stick with that business structure until they close.
However, sole proprietorships have many disadvantages as well. Every new business owner planning on operating as a sole proprietorship should be aware of the potential legal costs and issues. Let's dive into the downsides of running a sole proprietorship business.
Personal Assets Are Business Assets
One of the big disadvantages of a sole proprietorship is that there is no legal distinction between the owner and the business. The sole proprietorship is a business in its simplest form and has few formal business requirements. There is no separation between business assets and personal assets. This means that if anyone sues the business for any reason, the business owner's cash, car, or home is on the line.
This means there is unlimited liability for the entrepreneur. If the business owes money or gets sued, the owner's personal assets, like their bank account or home, are at risk. This lack of liability protection can be scary for small business owners.
This is different from both the LLC (limited liability company) and corporate business structures. In these structures, there are strict separations between business assets and personal assets. When someone sues an LLC or corporation, the most that person can get is its business assets. This protects the business owners.
Most sole proprietors buy business insurance in case they are sued. While insurance can help by providing money to settle lawsuits, it will not always offer complete protection. Many policies only cover certain kinds of cases, such as personal injury suits, if someone slips and falls on your property.
Any other claim, like a collection action from one of your vendors, is not covered by insurance. Additionally, the money the policy provides may not be enough to cover your damages. This can leave your opponents free to go after your personal assets.
Sole Proprietorship Taxes
Another downside is the tax situation. When filing taxes, the Internal Revenue Service (IRS) looks at sole proprietorship business income as the owner's personal income. This means using a Schedule C form for personal tax returns. Sole proprietors also face self-employment taxes. These taxes cover things like Social Security and Medicare.
While there are tax advantages to this form of business, navigating the IRS rules alone can be tricky. Many entrepreneurs find they need professional help to keep up with income tax and other rules.
The Business Dies With Its Owner
In a sole proprietorship, there's no legal entity separate from the owner. So when the owner of a sole proprietorship passes away, the business dies as well. Unlike a C corporation or other business organization types, a sole proprietorship doesn't live on without its founder. This can be a tough pill to swallow, especially for freelancers and others who've put their heart and soul into their work.
Courts do not see any difference between a sole proprietorship and its owner. When the owner passes away, the business ends unless the owner makes a prudent estate plan that allows the company to continue. In a corporation, the business is said to have a perpetual existence. This means that it will continue until its owners, directors, and shareholders decide to end it.
Sole Proprietorships Have Fewer Ways To Raise Money
Raising capital can be challenging for sole proprietors. In contrast, corporations have many ways to raise money to invest in the business. One of the easiest ways for a corporation to raise money is to sell more shares. Selling shares gives people a piece of the company in exchange for the money they invest. However, a sole proprietorship has no shareholders. It cannot sell shares without changing its business structure.
Sole proprietorships may borrow money just like other business structures. However, because there is no separation between business and personal assets, many sole proprietors need to use their personal assets as collateral for the business loan. As a result, banks may be hesitant to give loans. A sole proprietor can even use their home as collateral. If the business fails and the owner does not have enough money to pay the loan, the lender can take away the owner's personal assets to get that money back.
Additionally, there's no separate business entity. It's hard for a sole proprietorship to bring in partners or investors. The bottom line is that the owner might need to rely on their own savings or get creative to fund their business plan. See FindLaw's small business section to help you decide which legal structure is best for you. Also, check out this helpful checklist for setting up a sole proprietorship.
Get Legal Help Setting up Your Sole Proprietorship
Although sole proprietorships are by far the easiest type of business entity to set up, they also subject the owners to personal liability for business debts. If you have any questions about the legal implications of a sole proprietorship, contact a local small business attorney today.
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