Updated: March 23, 2023
Are you considering becoming a sole proprietor for your business? It is often said that starting a business as a sole proprietorship is the simplest option. However, This structure offers some benefits, however, it also has significant drawbacks which may not be suitable for your business. When deciding to assume responsibility for business activities, operations, and finances, it is important to evaluate the potential risks.
Sole proprietorship businesses are not able to raise capital for their business, do not have limited liability protection, and are subject to tax audit risk. A sole proprietorship may cause you to lose all your personal assets or incur significant debt. To address these concerns, contact us today at Monahan Law Firm and speak to a Glendale business law attorney about restructuring your business to mitigate potential financial risks.
What is a Sole Proprietorship?
A sole proprietorship business is a type of unincorporated business that has just one owner who is responsible for all aspects of the business. This single entity assumes complete responsibility and controls over its business operations with no legal distinction between their personal assets and the company’s finances.
As such, profits earned from the business are taxed personally on their individual income tax return. All business expenses and business profits are considered personal expenses and profits.
Many entrepreneurs choose to have a sole proprietorship because it doesn't require much paperwork or any formal filing with a government agency. Becoming a sole proprietor for your business can be inexpensive at first and it may allow you to focus more on growing rather than setting up your venture in the beginning days.
Although a sole proprietorship may appear to be a convenient and advantageous method of operating a business, there are multiple and very serious disadvantages associated with it, including personal liability risk, difficulty accessing capital, and the risk of a tax audit.
Managing the business income and business losses in your own name could lead to significant financial problems in your personal life. If you are running a business as a sole proprietor, it is advisable to consult with a legal representative to assess personal financial risks.
Understanding Sole Proprietorships
A sole proprietorship is a way for self-employed people to easily launch their own business quickly and without many of the regulatory burdens that come with other business structures such as corporations, limited liability companies (LLCs), or limited liability partnerships (LLPs).
When you begin conducting business, your sole proprietorship begins. Because no separate legal entity is created, there are few forms to file and no complications from various agencies.
The primary benefit of a sole proprietorship is the pass-through tax advantage that it offers. The only layer of income tax imposed on income generated from a sole proprietorship is that of the individual owner, which allows for a much lower rate than other types of business entities. Therefore, in addition to avoiding double taxation, many sole proprietorships can receive significant tax breaks on their incomes.
Another benefit that sole proprietorships offer is simplicity in terms of their formation and maintenance costs. There are few requirements to meet when setting up and filing taxes as a solo business owner, greatly reducing any red tape compared to larger corporate structures. Such fees include obtaining any required license or permits from your state government depending on the type of business you are running. In comparison to other forms of businesses such as corporations or LLCs, the hassle and cost involved in making sure all paperwork needed is filed correctly is significantly reduced with a sole proprietorship which makes it an attractive option for those looking for a relatively low-cost start-up solution.
Learn More: Why Forming an LLC is a Good Idea
Although a sole proprietorship is initially simpler to handle while setting up the business, it may lead to various types of serious risks for you in the long run. If you are a sole proprietor of the business, you are not exempt from liabilities incurred by the entity and all profits flow directly to you. This means that if the sole proprietorship incurs debts then you will be held responsible for them; however, it also means that all profits made by the business are also your profits.
Additionally, owners of sole proprietorships are personally responsible for any losses sustained by their businesses; unlike with other kinds of businesses where losses can be passed on to shareholders or partners. As such, you must consider your risk tolerance when deciding if this business type is suitable for you.
A sole proprietorship could be a good choice for someone starting a small business with minimal risk and low profits. For entrepreneurs that start out as side hustles or hobbies, sole proprietors are a way to get your feet wet without making an extensive commitment.
However, if your business is picking up and has high potential profits and more exposure to liability risks, a sole proprietorship is not good enough. As your business grows, it's often a good idea to transition from a sole proprietorship to a limited liability entity, such as an LLC, that will offer you, as the business owner, personal financial protection.
The Cons of a Sole Proprietorship
A sole proprietorship is a type of business structure in which one person owns and operates the entire business as an individual. This type of business structure is popular because it's easy to establish, there are minimal filing and formalities requirements, and you have full control over the business. However, it’s important to note that there are also significant drawbacks associated with a sole proprietorship.
Since you own the business in its entirety, you bear full responsibility for all the liabilities associated with it. You’re on your own when it comes to financially risking your assets if something goes wrong and you may be negatively impacted by debts incurred by your business.
Additionally, your personal liability for decisions made in connection with your business will also never be limited so you risk losing all of your personal possessions if things don’t go as planned.
Difficulties Raising Capital
Raising capital and business funding is an important part of any business as it provides the necessary funds for growth and expansion. Unfortunately, a sole proprietorship isn't well-suited for this purpose, as it does not offer the same access to funding sources as other business structures.
The primary way of raising capital with a sole proprietorship is by taking out a loan or finding investors willing to put money into the business. In businesses structured on an LLC formation, they will be able to find more financial support from investors or lending institutions.
Without the ability to raise capital, business growth can be difficult due to limited resources. This means that the owner must rely on their own personal finances or seek out alternative sources of funding. It’s important to assess whether or not a sole proprietorship can really benefit you prior to starting up a business using this structure.
Personal Liability Risk
Personal liability risk is one of the biggest concerns for solo entrepreneurs. As a sole proprietor, your personal property is not protected from creditors in the same way as it would be under limited companies or other corporate structures.
In the event that you default on a business loan, lenders can come after your personal possessions such as cars, real estate, and other investments. Similarly, if deadlines with customers are not met or service agreements are breached, you could find yourself dealing with lawsuits that may lead to damage claims against you personally.
Related Content: How to Choose the Right Entity for Your Business
The fact that there is no firewall between business assets and personal assets means that setting up a separate checking account won’t necessarily protect individual finances in cases of default. States may offer some protections from creditors seizing primary residences thanks to homestead exemptions and certain retirement accounts may be protected in bankruptcy proceedings – but these are exceptions rather than guarantees.
For business owners who are hesitant about taking on extended personal risk, pursuing a different business structure could be beneficial for mitigating exposure to such liabilities.
Tax Audit Risk
As a sole proprietor, you are likely to draw more attention from the IRS during tax season due to the potential for fraud and abuse. The reason behind this increased risk of an audit is that, as a sole proprietor business owner, you do not pay any taxes on your profits; they are instead passed directly through to your personal tax return.
Therefore, there is an even greater need for the IRS to conduct a rigorous examination of these business accounts due to the potential implications on individual income taxes. Business Tax Lawyers may be able to help you through this problem if you find yourself in trouble, but changing from a sole proprietorship to an LLC may be the best way for you to avoid tax audit risks.
How to Transition from Sole Proprietor to an LLC
If your business has high potential profits and more exposure to liability risks, a limited liability company (LLC) is definitely the best choice for you. An LLC is a common business structure and can aid your business growth. They benefit from certain advantageous tax structures and provide more flexibility in terms of ownership, allowing for multiple owners in addition to single-member businesses.
If your business is growing quickly and you're looking at more complex financial structures, a type of business entity such as an LLC can provide the benefits you need while minimizing the financial burden of separate legal entities. The process of transitioning from a sole proprietorship to an LLC can be time-consuming but is ultimately beneficial for the business. Business attorneys can help you in this process, so you won't be alone.
When starting this process, it is important for the owner to first determine if the desired name for the business is available. For this task, you can use a business name search to confirm if the name hasn't already been taken by another business entity. Once the business name has been confirmed, articles of organization must be filed with the corresponding state office where the business will be based.
It is also necessary to create an LLC operating agreement that sets forth all the details of how the business will run and how liabilities are handled; this should always be completed with legal counsel in order to ensure utmost accuracy and compliance. Once these steps have been taken, a new EIN must be obtained from the IRS. Similar in function to a Social Security number, this will help identify your business officially in all accounts and financing processes.
Ultimately, completing these steps with due diligence helps facilitate future expansion or growth without sacrificing any potential gains that could come with founding an LLC.
Call Monahan Law Today!
Are you considering restructuring your business from a sole proprietorship? Would you like help changing it to an LLC? At Monahan Law in Glendale, Arizona, our experienced business formation lawyers can offer customized legal advice to help you make the best decision for your company. Call us today at (623) 300 2727 to talk to one of our attorneys.