Disadvantages of a sole proprietorship business
Some drawbacks of operating as a sole proprietorship include:
- Mixing business and personal liability and taxation. Your personal assets and business finances are one and the same as a sole proprietor. This means that any losses will affect not only the business, but your own accounts as well. You also represent the business when it comes to legal situations and is responsible for all of its debts.
- Business bankruptcy means personal bankruptcy. Since sole proprietorship businesses are indistinct from their owners for financial purposes, business bankruptcy means personal bankruptcy. If you instead owned a separate business such as a C corporation, you could file for business bankruptcy without being personally liable.
- Personal assets are at risk. The above example shows that your personal assets are always at risk when you operate as a sole proprietor. They’re also at risk if your business faces a lawsuit. Since you and your business are equivalent for legal and taxation affairs, you’ll be personally responsible for all outcomes of lawsuits against your business.
- Difficulty raising capital. Since you can’t protect your personal assets as a sole proprietor, you may find that investors are unwilling to risk funding you. Investors may also see your business as less stable and less credible if you’re the only person at the helm. Corporations typically face fewer obstacles obtaining funding given their inherent business-personal divide and perceived credibility.
- Perceived lack of professionalism. The above funding examples hint at the perceived lack of professionalism that sole proprietors may sometimes face. This perception may extend to all things business. For example, a potential client choosing whether to hire a third-party sole proprietorship or corporation may choose the corporation because its large staff may appear more legitimate.
- Self-employment tax rates can be high. Despite the earlier explanation that sole proprietorships have the lowest effective tax rates, this fact may not always hold true. For starters, sole proprietors pay self-employment tax rates of 15.3 percent, and these taxes don’t apply to corporation owners. Additionally, the federal corporate tax rate is 21 percent, which could be lower than your personal income tax rate.
Taxes a sole proprietor owes
The income brought in by a sole proprietorship is simply owned by its owner. This means that you report your revenue and expenses by filing a Schedule C in addition to the regular Form 1040.
You’ll also have to file a Schedule SE with your Form 1040, which is used to calculate how much self-employment tax you owe.
How Does a Sole Proprietorship Get Started?
Ready to launch your business as a sole proprietorship? All you really need is a few essentials:
- Business name. It’s one thing to come up with what you think is a great business name. It’s another to determine whether someone else has already trademarked that name. To find out, you’ll need to search the US Patent and Trademark Office trademark database.
- Business checking account. Even though your business and personal finances are equivalent for tax purposes, you should still separate your business and personal finances. Opening a business checking account is the simplest way to do so. This way, you can have your sole proprietorship income deposited in your business account and keep a certain portion there for tax payments and business expenses. You can then move the rest to your personal account.
- Business plan. A business plan guides all your operations and can potentially help you obtain funding. It’s an important document to create before launching any type of business, not just a sole proprietorship. Use the SmartBiz Loans ® guide to business plans to start creating your plan.
Some legal requirements include:
- Local business license. To operate a business in your municipality, you must obtain proper licensure from your local business authority. To find the right authority, visit your city hall or contact your city government via its website.
- Sales tax permits. If you sell anything on which sales taxes can be levied, you need a sales tax permit to go into business. This permit is required even for sole proprietorships despite sole proprietors having no non-personal tax burdens. Learn whether you need a sales tax license and how to get one via the SmartBiz Loans ® sales tax guide.
- Relevant licenses and permits, depending on your industry and location. Your services or products and location may subject you to additional licensure requirements. Find some potential licenses you might need and tips on how to obtain them via the SmartBiz Loans ® business license guide.
- Federal Employer Identification Number (EIN) . If your sole proprietorship has employees, you’ll need an EIN to operate. You can apply for an EIN for free via the IRS, and that’s important. Unfortunately, it’s not unheard of for scammers to target small businesses owners with fake paid EIN application services. In reality, you’ll never have to pay to apply for an EIN.
Once you have these tasks checked off your to-do list, you’ve started a business!
For more helpful tips, visit the SmartBiz ® Small Business Blog. You’ll find insights on building, growing, and managing your small business. We’ve got you covered every step of the way.
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