If you’re wondering about the best business structure for your new company, side business or freelancing gigs, know that your choice in legal structure can have a significant impact on your business, determining everything from how you pay taxes, to how much paperwork you’ve got to contend with, to what happens if you get sued.
The sole proprietorship is the simplest way to operate a business. If you’re self-employed or conducting any kind of business and haven’t picked a formal business structure, then by default, you’re operating as a sole proprietor. This business structure has advantages and disadvantages, depending on your specific set of circumstances.
The Pros of a Sole Proprietorship
The biggest advantage of the sole proprietorship is that it’s simple to form and manage. All you need to do to run a business as a sole proprietor is to register the business name via a DBA — if you will be using a business name that’s different than your own name — and get any required local business licenses. If you’re running a consulting business under your own name, you don’t need to register the name. However, if you’ll be using a different name (like Joe’s Consulting), then you’ll need to file a DBA (Doing Business As ) with your state to use the name Joe’s Consulting.
The sole proprietorship is the simplest business type to maintain. When you incorporate a business, you’re required to operate at a higher administrative level. This means preparing formal financial statements, keeping separate accounting books from your personal financial information, holding annual meetings, keeping meeting minutes, filing reports with the state, etc. Many small business owners aren’t interested in keeping up with all that paperwork.
When it comes to reporting your taxes, the sole proprietorship makes it easy. Since there’s no separation between the sole proprietorship and the owner, any income earned by the business is considered income earned by the owner. A sole prop owner just needs to keep track of all the business’ income and expenses and report it on a Schedule C with their personal tax return.
As expected with taxes, what can be an advantage for one individual can be a disadvantage for another. If you like the simplicity of one tax return for your personal and business, the sole prop’s “pass-through” taxation is preferred. In addition, it you have a side business that takes a loss for the year, this loss can be used to offset other sources of income on your personal return.
However, in some cases, it can be beneficial to keep your business and personal taxes separate. And it’s also important to know that other formal business structures, like the Limited Liability Company (LLC), let you be taxed like a sole proprietorship.
The Cons of a Sole Proprietorship
While the sole proprietorship is undeniably easier, it also entails some serious drawbacks. The biggest drawback being that the owner of a sole proprietorship is personally liable for any debts of the business. So if your sole proprietorship business runs into financial trouble, creditors can come after your personal property and savings. Likewise, you’ll be personally liable for any lawsuits brought against the business.
It’s very important to consider your personal liability and how much risk you want to take on before selecting a sole proprietorship as your business form. Granted, you probably don’t anticipate being sued or unable to pay your bills, but things do happen.
In addition, owners of sole proprietorships generally have to sign contracts in their own name, because the business doesn’t have a separate identity under the law. Sole proprietorships can’t gain business credit, take out business loans or raise capital in other ways.
Once your business is incorporated (either by forming an LLC or Corporation), it exists as a separate business entity. Essentially, this puts a wall between your personal assets and the business. This step minimizes your personal liability to protect your personal property and also gives you the ability to build business credit, get loans and raise capital. If you’re interested in minimizing your own liability but don’t feel up for the administrative requirements of a corporation, the LLC can be a good option.
Editor’s note: This was originally written by Nellie Akalp for Business News Daily.