Many people starting a business have little knowledge or interest in business entities and thus 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 proprietorship. Congratulations! If you start a business with another person and do not form a business entity such as a LLC or corporation, you are not a sole proprietorship. You are a general partnership. Just thought I would be clear on that.
There are some major advantages to being a sole proprietorship. First and foremost, it is very simple. Obviously, you don’t actually have to do anything other than get the necessary business licenses for your area. You can just focus on making money with a minimum of administrative issues. This also makes it inexpensive to get up and running.
Sole proprietorships are also very simple 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 the revenues, expenses and so on with the Schedule C that goes with the 1040 form. Unfortunately, keep in mind that you will have to pay the self-employment tax, a whopping rate of 15.2 percent. If you are not aware of it ahead of time, it can be a killer when tax time rolls around.
If sole proprietorships are so easy, why does anyone form a LLC or corporation? Well, there is a major downside. As a sole proprietor, you are personally responsible for all of the debts of the business. This includes debts because the business doesn’t make money and you owe a vendor as well as any judgments arising from a lawsuit against the business. Most businesses fail within the first two years, so this represents a very big risk. If you were to form an LLC or corporation, you would be protected from such debts even if the business failed outright or lost a judgment for a gazillion dollars.
Many small business people start out as sole proprietors. Sometimes it is an intentional choice, but sometimes people just don’t know any better. Either way, this is a fine approach, but you run a huge risk of being personally liable. If you own anything of value, such as a house, you should seriously consider forming an LLC or corporate entity so you don’t lose the assets if things go bad.
Richard A. Chapo is with SanDiegoBusinessLawFirm.com - providing California incorporation services .