As a new entrepreneur, you may enjoy the ease and simplicity of operating as a sole proprietor, but there are several things to consider like the size of the business, the nature of the product or service that you provide, tax considerations, and more that should determine whether to continue running it as a sole proprietor or establish a formal company.
While each person’s situation is unique, it is safe to say that more often than not, it is usually more beneficial to operate your business as a formal legal entity or company than as an individual or sole proprietor. The following discussion will give reasons why.
Running Your Business as a Sole Proprietor
There are probably a host of reasons why you might want to remain a sole proprietor. Whatever these reasons are, perhaps the most important question to ask is whether it is more advantageous to run the business this way? And perhaps just as importantly, whether the advantages outweigh the disadvantages, which also surely exist.
Some of the advantages in question include things like its simplicity to set-up and manage, fewer maintenance requirements, simpler tax schedule and more. On the flip side, serious consideration should be given to some disadvantages of operating as a sole proprietor like the absence of any personal liability protection, difficulty in raising business capital, inability to get business insurance, limited business life span and others.
Arguably, one of the most important disadvantages of note is the absence of any personal liability protection. In a very litigious society like America, this can easily prove fatal to your business. As a sole proprietor, your business is not considered a separate legal entity from yourself. This means that any liabilities or debts that you incur in running the business will also be incurred under your personal name. The same goes for lawsuits or judgements that go against the business. This could be disastrous as any claims against the business could be taken out of your personal assets such as your home, car or other assets. It is, therefore, possible to lose everything you’ve worked for in your personal life and end up in a lot of personal debt when you conduct business as a sole proprietor.
As previously mentioned, the specific situation of each individual or business will be different and the weighing of the disadvantages against the benefits should often be used to determine what route to take. It is, however, safe to assume that for the vast majority of people, this singular disadvantage of unlimited personal liability is enough to discourage most people from running their business as a sole proprietor, once they become aware of this fact.
Running Your Business as a Registered Company
On the flip side of being a sole proprietor is registering a company with the state and running your business under this entity. It is important to note that there are also advantages and disadvantages to operating your business as a registered entity, just as with a sole proprietorship.
As previously stated, it is usually more beneficial to form a company to run your business under, instead of remaining a sole proprietor. Some of the reasons for this include the previously-mentioned main disadvantage of unlimited personal liability that a sole proprietor has. When you take that into consideration with the following advantages of a formally registered business, you begin to understand why so many choose to form a company. Some of the advantages include: limitation of personal liability, the possibility of perpetual existence of the company, wider scope for taxable deductions, higher business credibility, and more. All of these factors are more likely to make operating under a registered company a more attractive or beneficial proposition than a sole proprietorship.
Notwithstanding the advantages of a registered company, it is not without some disadvantages and these should also be considered. Things like the potential for double taxation, likely being more expensive to maintain, more regulation, lack of privacy and others.
After all is said and done, and if the decision is made to establish a legal entity, then the next question that will naturally arise is exactly what type of legal business entity to create.
Different Types of Legal Business Entities
Besides the sole proprietorship, there are generally three types of legal entities under which you can operate a business, namely: Partnership, Limited Liability Company (LLC), or Corporation. Let’s take a look at these options.
Partnership
If you are considering taking on one or more partners, registering your business under a partnership could be the way to go. The benefits of such an entity include the fact that the partners are better able to work together to grow the business together, the partnership itself pays no taxes, there is shared financial burden and more.
There are two different types of partnership, namely a General Partnership and a Limited Liability Partnership. A General Partnership is one where the partners have unlimited personal liability for the liabilities and debts of the business, while owners of a Limited Liability Partnership have limited personal liability in the business.
Limited Liability Company (LLC)
An LLC is a hybrid entity that contains elements of both a sole proprietorship and a corporation. More specifically, it provides for the pass-through taxation feature of a sole proprietorship while also providing the limited personal liability protection of a corporation. It is cheaper and simpler to create an LLC while also providing a lot of flexibility in how you run the day-to-day affairs of the business. An LLC can be as simple as a single person registering a business or maybe more complex with multiple members joining, each with their own stipulated roles, responsibilities, and more, all of which will be regulated by the specific terms contained in an operating agreement.
Corporation
A Corporation is a legal business entity under state law that allows all the shareholders, employees, and directors to remain separate entities from the business while conducting the affairs of the business. This is the personal liability protection that was previously spoken of under the LLC structure.
The business will be taxed on its profits or losses while its employees and shareholders are taxed on their salaries or capital gains. Each officer or employee of the corporation has designated roles and responsibilities and can be held accountable accordingly, although fiduciary responsibility lies mostly with the directors. You need to keep in mind that a corporation has much more rules and regulations than the other business entity types.
In Conclusion
As a sole proprietor, you can be proud of what you are hoping to, or have already built. However, as we have shown there are potential legal risks and other disadvantages that your business faces just by the fact of operating as a sole proprietor. These risks, and perhaps how they can affect you personally, are some of the reasons why you might want to consider forming a legal business entity.
Having said that, it is perhaps best to seek professional advice from an experienced business attorney who will be better able to look at the specific circumstances of your business, including the legal and regulatory environment that you operate in, and who will then be able to advise you on what your best way forward might be, including helping you decide what the right business structure might be for your specific business and situation.