Before deciding on what type of business entity works best for you, understanding the definition is crucial. There are multiple business entities you can establish when starting or changing your business structure, and it’s worthwhile to understand the pros, cons, and limitations of a sole proprietorship.
It’s a good idea to check out out article on what business entity means if that term is unfamiliar to you. That gives a broad overview of the major types of entity as defined by the IRS.
What is a Sole Proprietorship?
A sole proprietorship is a business entity owned and operated by a single person. Essentially, you can think of this business entity as the individual as a business. Sole proprietorships may not have partners, offer shares, or take advantage of some tax breaks offered to other types of business entity.
It can operate similar to other businesses, hire employees, and deal with the requirements that come along with doing so. Most notably, having to run payroll, and offer employees things like a retirement savings plan that your state might require.
Who Usually Operates as a Sole Proprietorship?
Many skilled contractors, creative designers, writers, and other similar professions operate as sole proprietorships. No rule exists that they must choose this entity, it just happens that they often do. Doctors, lawyers, bakers, architects, mechanics, can all operate as sole proprietorships.
Is a Sole Proprietor and Self-Employed the Same Thing?
No, while the two terms share many similarities, they are not synonyms. A self-employed person could absolutely do their work as a sole proprietorship, but they could also operate as an LLC, an S-corp, or even a corporation. Saying “I’m self-employed” only says that you don’t have a superior where you work.
Sole Proprietorship Advantages
Many business owners choose to go with a sole proprietorship because of how cheap and easy they are to establish and operate. This type is easily the simplest in terms of paperwork and accounting. You can write off vehicle usage, home office space, and many other expenses.
This type of entity has little oversight, and almost nil in terms of operational regulations the way there are for a corporation or other business structures. In fact, this type of entity is so simple that if you did some work on the side and responsibly paid your taxes, the IRS would automatically consider you a sole proprietor.
This business entity allows business owners to itemize their deductions or take the standard deduction ($12,900 in 2022 and $13,850 in 2023) There is no “right” decision whether to itemize or take the standard deduction, it really depends on how many expenses a business owner has, as in some cases, the standard deduction will be a much better option.
Sole proprietors can also write off many medical expenses and insurance costs for them and their dependents. GoodRx wrote a really good article on the topic of self-employed medical write-offs that you should check out if you want to know more about this specific category of write-off.
Because sole proprietors often use their home for work, the IRS allows write-offs for office space and separate structures as tax deductions. To do this, you would use Form 8829. Getting into the specifics of this form would be lengthy and unlikely to help you understand it better. Reading the instructions about the form from the IRS is more detailed, and simply handing this information off to your accounting specialist is best. Any qualified accountant will know the do’s and don’t’s of writing off home office space.
Figuring Out if Your Home Structure is Tax Deductible.
The IRS provides the figure below to help people understand whether they can write off. One followup to the chart I quote from the IRS itself, “You can deduct expenses for a separate free-standing structure, such as a studio, workshop, garage, or barn, if you use it exclusively and regularly for your business.”
Sole Proprietorship Disadvantages
The primary reason that many business owners choose not to establish or remain a sole proprietorship is the personal liability. As far as the state and courts are concerned, you are your business. Meaning that the business owner is personally vulnerable to lawsuits and punitive damages.
For example, let’s say you run a catering company. While catering an event, your customer trips over an extension cord you plugged in and injures themselves. Consequently, they need serious medical treatment, and sue your business to pay for the cost of their medical bills. Later, a court rules in your customer’s favor, and says that you are responsible. You have insurance, but insurance doesn’t cover negligence, so you are now on the hook to pay those bills!
With sole proprietorships, the distinction between John Doe Catering and John Doe the person is almost nil. Meaning, this customer can now come after your personal assets to collect on what you owe. This means the plantiff can take your car, equipment, and even your home if you owe an outstanding debt.
A good example of what I mean exists in a conversation between two lawyers. One the writer of an article, one writing a letter in response to the article. They refer to hypothetical doctor’s practice as the business in question when discussing the disadvantages of sole proprietorships.
A Personal Experience with Liability
I, the author, had a brush with liability that could have been catastrophic. At the time, I had a partnership in a construction business, essentially a two-part sole proprietorship. I brought construction debris from a job and some leftover firewood from the night prior to the recycling center in Tinton Falls, NJ. After a 40 minute drive, I arrived, dumped the load. As I collected my paperwork from the attendant, he noticed smoke. Despite being “out” for more than 12 hours, the fire from the night stayed alive. When I dumped it with wood, drywall, and plastic, it kicked back up.
Thankfully, the attendant noticed it and called for a front end loader to dump a load of water on it. He was not pleased in the slightest. Thereafter, he asked what was wrong with me to do this. I pointed out that I had obviously not known it was still burning. I picked it up to put it in there and it felt cold (it was winter), that I drove with that in the van for 40 minutes, that I never would have put a burning fire into a car I was about to drive. He noted my logic was solid, and forgave my error.
The point of this story is that if a real fire had started, I would have been liable. My partner would have been liable. I cannot imagine the costs of starting a fire at a recycling plant, but I feel thankful I didn’t have to buy them a new warehouse or piece of heavy machinery. A sole proprietorship doesn’t protect from this sort of situation, at all, even with insurance. Our insurance would have called it negligence and refused to pay.
While liability is the primary disadvantage, other disadvantages exist too. Banks hesitant more when lending to sole proprietors as everything depends on a single person’s financial wellbeing. It’s also harder to sell the business, as it has been built around a single person. Remove the person? You just removed the business too.
Lastly, on the very human level, a sole proprietor might make a bad business decision if no other opinions exist. This last
How are Sole Proprietorships Taxed?
A few differences exist between working as an employee and working as a sole proprietor. Sole proprietors must pay both halves of the payroll tax in the form of the self employment tax. They also need to file forms Schedule C and SE in addition. This is called “pass-through taxation”
Pass-through taxation simply means that the IRS doesn’t tax the business, they tax the individual. The business is merely an entity that allows that individual to earn a living, but it isn’t a taxable structure itself.
As we discussed in our article about payroll taxes and the parent article for this one, normally the business and its employees split the FICA taxes, otherwise known as payroll taxes. In the case of a sole proprietor, they must pay both halves.
Stay Tuned, Business Entity Fanatics!
Granted, this is not the most exciting topic at first glance. We understand that we think about this kind of stuff at Sharp Payroll Service more than the average person or even the average business owner! That said, we’re going to continue discussing different entities in the coming posts because it’s important. Having the control you want and the legal protection you need over your business matters. Further, saving money on taxes makes everyone smile, so don’t forget that part!