The Pros and Cons of Sole Proprietorship
One of the major considerations that entrepreneurs and businessmen make when they are planning to start a new business is its legal structure. Should it be a partnership or should they form a corporation instead? Maybe it would be better to just set it up as a sole proprietorship? There are several factors affecting this decision, including the type or nature of business and the availability of capital or resources required to set up the business and start its operations. Others are more circumspect, however, and prefer to look into the various characteristics of the legal structures and weigh their pros and cons, in order to see which structure fits their need the best.
In this article, you will learn 1) what is the sole proprietorship and 2) what are the advantages and disadvantages of starting a business as a sole proprietorship.
THE SOLE PROPRIETORSHIP
Quite easily the most common business structure and the simplest out of all the other structures, a “sole proprietorship” is a business that is owned by only one person. Many people are confused whether the phrase applies to the business owned by one person or the one person who owns that business. It refers to both: the business and the owner since, in this type of structure, there is no legal distinction between the owner and the business.
To understand the concept further, let us break down the basic features of the sole proprietorship.
- A sole proprietorship is owned and run by one person, where the person often runs the business under his own name.
- A sole proprietorship does not have a separate legal entity. This is its major difference from partnerships and corporations.
- The sole proprietor (the owner) owns all the assets of the business.
- The sole proprietor also bears all the risks and the benefits associated with it.
We can gain a better understanding of a sole proprietorship, and be aided in our decision on whether to choose this type of structure or not, by taking into account its various pros and cons.
PROS OF A SOLE PROPRIETORSHIP
The following are the advantages or benefits that you can enjoy in a sole proprietorship type of business.
1. Easy setup or formation
A sole proprietorship is very easy to form, which most likely explains why it is the oldest type of business structure known to man. Creation of a sole proprietorship does not involve the formal creation of a business organization. It can be a one-man operation, where the sole proprietorship has only one employee, who also happens to be the owner.
- Setting it up requires very little paperwork or legal formalities. This is the complete opposite of corporations or partnerships, where you have to prepare sets of documents and submit them to specific regulatory agencies and government bodies. The business can be formed by simply filing with the local office in your city or locality.
- It is not necessary to set up a separate trade name for the business. The sole proprietor can proceed to doing business under his or her own name.
- There are small startup costs involved. A sole proprietorship is also the least expensive to set up. While it is true that it is not entirely free to form it, the legal fees that have to be paid (such as permits and licenses) are usually minimal.
This simplicity is the primary reason why individuals who are attempting to go into business for the first time choose it. Consultants and professionals often take this option when they want to go into business for themselves. They can start small, as a way to “test the waters”, before considering taking the next step and expanding their business operations. Many partnerships and corporations – even the large companies we see today – started out small, as sole proprietorships.
This also makes it possible for practically anyone to set up a business. Even if you have limited assets or resources, you can start your own sole proprietorship, since there is no minimum amount of startup capital that must be met.
2. Management flexibility
The reason why many individuals go into business is because they want to “be their own boss”. They want to be the one in control, holding the reins, and making all the decisions.
- The sole proprietor has complete power over the decision-making. He is the only one running the business, so all the decisions are made by him. It certainly spares him the headaches of getting the approval of a board of directors (in case of corporations) or the consent of other partners (in a partnership business). This also cuts down the time it usually takes between arriving at a decision and implementing it, since it cuts through any delays or deadlocks usually encountered in a bureaucratic environment.
- The owner has the sole discretion when it comes to costs incurred by the business. He is, after all, the one holding the purse strings of the company, so it is up to him how to allocate the costs and utilize the resources of the business. This is not something that can be done in a corporation or a partnership, since costs have to be subjected to a series of scrutiny by all the partners and stakeholders.
- This also means that the sole proprietor also gets to solely enjoy the profits that will be earned by the business from its operations. In a partnership, depending on the agreement among the partners as to their share in earnings, they will have to split the net income (after tax) among themselves. The sole proprietor has no one to split with, so he gets to enjoy all the profits by himself.
- Management flexibility results in faster pace of transactions. Response is quicker on the part of the manager in terms of decision-making because you get to do it alone. You call all the shots, so you can move forward, instead of being held back waiting for what others have to say about a certain matter related to the business.
3. Less government control
A sole proprietorship is subject to only a few regulations. This is already noticeable from the time you set up the business. A simple and quick trip to the local business office is enough to have your business registered. You will not be required by many government and regulatory agencies to submit a lot of documentation for your business, which is the case with corporations and partnerships.
Corporations and partnerships are governed by specific rules and regulations that they must comply with, such as issues relating to their organizational structure and the like. Sole proprietors are not bound by these guidelines and can run their business in the manner they deem fit.
4. Tax advantages
Taxation is one of the touchy subjects when it comes to business. Sole proprietorships have the benefit of being subject to simpler taxation procedures; since it is not a separate entity, it is not taxable. That does not mean, however, that it is completely free from having to pay taxes.
In a partnership or a corporation, the business entity will have to file its own tax return, and the owner-partners or stockholders have to file their own separate tax returns for the income that they received from the operations of the business.
This is not the case in a sole proprietorship. Remember that the owner of the sole proprietorship business is not considered to be distinct from the business itself. It means they are treated as one and the same, so there is a need for only one income tax return: that of the owner or sole proprietor. Any income earned by the business is also income earned by the owner. Taxing them both, separately, would be a case of double taxation.
This means that the sole proprietorship also gets the advantage of being subjected to lower tax rates, since there are separate (and higher) rates when it comes to business taxation and corporate taxation, as compared to income taxation, which is what sole proprietors are liable for.
To sum it up, there is only one tax return that will be filed, and it is not a requirement to attach a balance sheet of the business as a supporting document to the tax return.
5. Least amount of recordkeeping
Books of accounts of partnerships and corporations are considerably more complicated than that of a sole proprietorship. You have to maintain separate books for the partners, the business, and for taxation purposes. There are certainly more ledgers and records to maintain. In a sole proprietorship, recordkeeping is straightforward. In fact, the owner is not even required to avail the services of a bookkeeper or an accountant since he can do it himself. Corporations and partnerships are expected to present formal financial statements, so they have a financial team to take care of the recording and recordkeeping process. Minutes of meetings have to be taken diligently. This is not the case in smaller, sole proprietorship type of businesses.
6. Easy dissolution
It is as easy to cease all operations of a sole proprietorship as it was to set it up. Once the owner decides to stop running the business, he can easily do so. There is no need to undergo a lengthy process since the business does not have very formal registrations binding it. All it takes is to pay off all the business debts and obligations and close all accounts. Of course, you have to notify the tax authorities about the dissolution of the business for tax purposes.
CONS OF A SOLE PROPRIETORSHIP
Now it is time to look at the other side of the coin and take into consideration the disadvantages of choosing the sole proprietorship business structure.
1. Unlimited personal liability of the sole proprietor
This is the downside of being the only one who owns the business and enjoying its profits: you are also left to shoulder all its liabilities as well as its losses, if any. Corporations, which are considered to be separate legal entities from the incorporators and shareholders, offer liability protection (to varying extent) from the debts and actions of the business.They will only be liable up to the extent of their investment in stocks or shareholdings in the business, and their personal assets remain theirs. The same is true for partnerships, particularly LLCs, or limited liability companies.
The sole proprietor does not have any protection from liability, since the debts and obligations of the business are also his debts and obligations. In the event that the business has incurred major losses and is unable to pay its debts, the creditors can go after the proprietor’s personal assets, from his car, house and other real and personal properties. Even his savings will become fair game to creditors and everyone else that the business owes. In other words, sole proprietors are at risk of losing practically everything if their business does not succeed.
The same is true when someone files a case in court against the business. In effect, this is tantamount to the owner or sole proprietor being sued. In case the business loses the case, the owner will be personally liable.
2. Uncertain business life
Corporations are deemed to have an unlimited life, with the concept of going concern holding that it is expected to continue existing for the foreseeable future, even if the original incorporators, the stockholders, and managers resign or even die. This is the same with a partnership, where the withdrawal of one partner does not automatically mean that the business ceases to exist. The remaining partners can simply come up with a revised partnership agreement, without the operations of the business being affected.
Continuity of the business is an issue when it comes to sole proprietorships. It has been said that the owner and the business are a single entity; that means, therefore, that the retirement or death of the owner, and any impairment that will render him incapable of making decisions or managing the business, will automatically mean the cessation of the business and its operations. Yes, it is easy to dissolve, but this also indicates fragility in the existence and continuity of the business.
3. Difficulty in raising capital or obtaining financing
This is deemed by many as one of the biggest disadvantages of a sole proprietorship. You are setting the business up with the intention of being the only one in control. Naturally, raising the capital you need is entirely up to you. This is why most sole proprietorships use their own money when starting their business. The working capital of the business will be limited to the funds of the sole proprietor, and other funds that it can obtain through loans.
There is the added disadvantage of banks, lending and financing institutions that are more wary about extending loans or granting financial aids to sole proprietorships. These sources of financing often look into the stability of a business as a going concern (and we have already established that the life of a sole proprietorship is uncertain and fragile) and its assets which is often fewer than, say, a corporation or a partnership with more partners pooling their resources together. Banks and lenders view these as an indication of the capability of the business to meet its dues and repay its obligations. On these counts, sole proprietorships are not attractive prospects for investors and lenders.
When corporations require funding for expansion or some other major project, it can issue equity in the form of shares of stocks. They are also in a better position to have lines of credit and have an easier time obtaining bank loans.
4. Limited view in business management
There is a hitch in having full control of the management of the business. You call all the shots, what you say goes, and you pretty much make the decisions on everything. There are higher chances of your objectivity being impaired because you are the only one making the decisions. In a partnership, you have partners to throw ideas around with. In a corporation, you have a team to brainstorm with.
In a way, being the only one making the decisions is a heavy burden to bear. The success and the failure of the business all boils down to you, so unless you have strong grit and you feel confident that you can handle possible failure, you might want to rethink setting up a sole proprietorship.
5. Less business-like in appearance
Compared to a corporation or a partnership, which are legal entities, a sole proprietorship is often viewed as one that is not as professional or like a business. This is most likely because it did not undergo the rigid procedures that corporations and partnerships did when it started out. It looks informal to the public.
It is hard to say outright whether a sole proprietorship is the best business structure for you to start with. There are certain considerations to be made, and in-depth analysis is required. Some of these factors include the type of business you will want, the product or service you will offer, the market that you are trying to enter, and even the resources available to you for your capital.