When starting a business, one of the most important choices that is frequently overlooked is the business entity selection. The choice between forming your business as a sole proprietorship, partnership, LLC, C Corporation or S Corporation is much more than a choice of letters. Each entity alters how the business must be structured, how taxes are reported and paid by the owners, and the impacts the business' ability to raise capital. Further, it is difficult to change business entities once the business is running, and may incur substantial costs. This post will be the first in a series of explanations of the different corporate entities as well the features that make them attractive or unattractive to new businesses.
Sole proprietorships are a common business structure for single owner small businesses. Forming this type of business entity is very simple. Several states, including New York, only require you to register with the state if you will be doing business under a name other than your own. For instance, if Bob Jones opened up Happy Time Graphic Design in New York, he would have to register his sole proprietorship with the state. On the other hand, if Bob Jones were to do business under his own name, he could operate his graphic design business without having to register with New York. This ease of formation is what attracts single owner small businesses to this structure. Additionally, under the sole proprietorship, income is directly imputed to the owner. That means the business income is reported on the owner's taxes directly.
Sole proprietorships have two main disadvantages. Firstly, the business owner and his/her line of credit is all that is available to the business should it need additional capital. This could become particularly problematic if the business owner's credit score is low. In contrast, other business entities have the multiple methods to raise capital for their businesses. Secondly, and most importantly, sole proprietors face unlimited liability. This means that the owner can be personally sued for any debts obtained in the process of running the business or any accidents at the business. For most, the risks should outweigh any advantage. Hypothetically speaking, a sole proprietorship structure is not worth losing your family's home because someone slipped at your business and broke their arm. Yes, an owner should have insurance which would help mitigate the liability faced by the owner, but the coverage may not be sufficient.
So what types of businesses are best suited for a sole proprietorship? Home businesses are best suited for sole proprietorships. Assuming that the home business does not meet with clients in the home, the liability risk for accidents on the business premises is eliminated. The business would still be liable to creditors, but at home businesses generally operate with little overhead as compared to their storefront counterparts, so the need for a line of credit may also decrease.
These are just some of the advantages and disadvantages of sole proprietorships. It is important to remember that the best choice of entity varies business to business.
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