Sole proprietorships are the most common form of small business across the United States. Why is that? Primarily because sole proprietorships are the most simple and basic of all small businesses. They are straightforward, easy to start, and they require very little formality. Consequently, you generally do not need legal assistance when crafting your business. For instance, if you wanted to create a business that sold comic books, you would not need to register your business with the Secretary of State. You could start selling comic books tomorrow and begin to generate income. No fuss or bother. However, for many entrepreneurs, sole proprietorships such as this may not be the best fit for their small business. Let’s look at some of the advantages and disadvantages of creating a sole proprietorship:
How are Sole Proprietorship Businesses Taxed?
- Taxed at Your Personal Income Tax Rate. One the biggest advantages of sole proprietorships is that they are taxed at your personal income tax rate. So whatever income you make on your small business the highest amount the federal government can tax you is whatever tax bracket you fall into.
- Not subject to Tennessee Franchise and Excise Tax. Sole proprietorships do not have to pay franchise and excise tax. To learn more about this tax, click here. Avoiding the franchise and excise tax is certainly a major benefit to having a sole proprietorship.
- Sole Proprietorships are Subject to the Self Employment Tax. The self-employment tax is the Social Security and Medicare tax for self employed individuals. Currently, the Social Security tax is 12.4% and the Medicare tax is 2.9%. Fortunately, the IRS provides a deduction on your income tax for half of self-employment tax you are required to pay.
No Liability Protection for Sole Proprietorships
Perhaps the biggest disadvantage of sole proprietorships is the lack of liability protection. If you operate a business in which there is significant risk of accident or injury, a sole proprietorship is most likely not the best business entity choice. For example, we recently had a client that who operated an excavating business. He has several backhoes and trucks that he drove to and from his job sites. What if he or one of his employees hit someone and seriously injured them? Well, the person that was injured could sue, win in court, and have a personal judgment against the owner. Because the judgment would be against the owner personally, all of his assets would be subject to collection by the injured person.
Also consider that even if your business is not inherently dangerous such as bar tending, auctioneering, or creating products, there still can be significant liability associated with your business. The bartender who gives a customer too much to drink can be liable if the customer leaves the bar and kills someone on the road. The auctioneer who handles expensive antiques could be liable if one of the antiques is damages or destroyed. And the small business owner who builds toys for children could have liability exposure if the toy is swallowed by a young child.
No Room for Partners
As the name implies, a sole proprietorship is a one man show. It is just you at the helm. If you add a partner to your business then your business becomes a partnership, whether formalized in writing or not. So if are thinking of adding a partner to your business, it would be a good idea to speak with a business lawyer about formalizing a partnership between you and your new partner. Failing to reduce your agreements to writing and relying on handsake deals can be extremely problematic and lead to lawsuits.
Lack of an Image
For some business owners, the prestige of having the initials “LLC” or “Inc.” behind their business name makes them feel as if their business is more legitimate, that by those acronyms they will attract more customers. While this may or may not be true, rest assured that your sole proprietorship does have some advantages that other businesses do not: it avoids significant taxation, it’s less formal, more flexible, and it is easier to handle.
What Happens When the Sole Proprietor Dies?
In a sole proprietorship, when the business owner dies, the business is essentially concluded and all assets and debts pass through his estate. The sole proprietor’s will can pass the business onto a certain beneficiary, but that creates a new sole proprietorship (or partnership if more than two beneficiaries). Without a will, the sole proprietor’s business will be wrapped up during the probate process and the assets of the business will be divided among his heirs.