Many people who start a business have little knowledge or interest in business entities and therefore become sole proprietors. There are pros and cons to this approach.
A sole proprietorship is a default business form. If you start your own business and do not form an official entity, you are a sole proprietor. Congratulations! If you start a business with someone else and do not form a business entity such as an LLC or a corporation, you are not a sole proprietor. You are a general society. I just thought I would make it clear.
There are some important advantages to being a sole proprietorship. First of all, it is very simple. Obviously, you don’t really have to do anything other than obtain the necessary business licenses for your area. You can focus on making money with a minimum of administrative hassle. This also makes it inexpensive to start up.
Sole proprietorships are also very straightforward from a tax point of view. Since there is no official business entity, the finances of the business are handled on your personal tax returns. You report income, expenses, etc. with Schedule C that accompanies Form 1040. Unfortunately, keep in mind that you will have to pay self-employment tax, a whopping 15.2 percent rate. If you don’t know ahead of time, it can be fatal when tax time comes.
If sole proprietorships are so easy, why would someone form an LLC or a corporation? Well, there is a big downside. As the sole proprietor, you are personally liable for all debts of the business. This is because the company does not make money and you owe a supplier, as well as any lawsuit that arises from a lawsuit against the company. Most businesses fail within the first two years, so this represents a very big risk. If you were to form an LLC or a corporation, you would be protected from such debts even if the business failed entirely or lost a million dollar judgment.
Many small business people start out as sole proprietorships. Sometimes it is an intentional choice, but sometimes people just don’t know any better. Either way, this is a good approach, but you run a great risk of being personally responsible. If you own something of value, like a house, you should seriously consider forming an LLC or corporate entity so that you don’t lose assets if things go wrong.