Advantages and Disadvantages of Sole Proprietorship

Advantages and Disadvantages of Sole Proprietorship

A sole proprietorship is a legal form of business in the United States solely owned by an individual or a so-called self-employed person. As an unincorporated business, the owner pays personal income tax on profits.

The Pros: Advantages of Sole Proprietorship as a Form of Business Entity in the United States

Note that sole proprietorship is the simplest and easiest business form to set up because of limited government requirements and regulations, making it popular among individual contractors and small or budding entrepreneurs in the U.S.

Below are the purpose and benefits or advantages:

1. Easy to organize

The great advantage of operating a new business as a sole proprietorship is an easier set up procedure, unlike in other business forms such as partnerships, including general partnerships and limited liability partnership, and corporations. There is no need for an attorney and consultant to draft and file required documents or for the government to approve them. However, it is worth noting that an increasing number of states require business owners to secure a local business license. This is easier to accomplish compared to partnerships and corporations.

2. Simple financial reporting

The profit or loss from the business belongs to the owner or sole proprietor and must be reported in his or her federal income tax return. This is tantamount to simpler financial reporting or financial statement and tax preparation. Another advantage of this is that in case of losses or significant tax credits, the owner may use tax losses or tax credits to reduce taxes on income from other sources. Overall taxes may be less than corporations if the sole proprietorship generates modest profits—around USD 75,000 to USD 100,000 a year.

3. Unemployment tax exemption

The sole proprietor does not need to pay an unemployment tax from his or her self-employed income because he or she is not considered an employee of the company. Note that state and federal laws in the U.S. impose unemployment taxes on wages or salaries but not on self-employed income. However, a sole proprietor must pay unemployment tax on any employees of his or her business.

4. Qualified joint venture for married couples

The Small Business and Work Opportunity Tax Act of 2007 provides another advantage for a sole proprietorship. This law allows married couples to form a qualified joint venture to become both owners and operators of the sole proprietorship. In other words, this law allows couples to retain the sole proprietorship status of their business and exempt them from filing and paying partnership income tax returns.

5. Easy and tax-free withdrawal of assets

The owner or sole proprietor can easily move funds in and out of the business account or withdraw assets with less legal and documentary limitations. This is another advantage of sole proprietorship over partnership, limited liability company, and corporation. In a partnership or limited liability company, withdrawal of funds is only possible by an agreement among owners. In a corporation, withdrawing funds or assets might be taxable as a dividend or capital. Some state corporate laws do not allow easy withdrawal of assets.

The Cons: Disadvantages of Sole Proprietorship as a Form of Business Entity in the United States

The drawbacks of this form of business are also similar to the drawbacks and limitations of freelancers and self-employed individuals. Fundamentally, the sole business owner can encounter problems regarding financial liabilities, funding requirements, and management issues.

Below are the limitations and disadvantages:

1. Personal liability

The most daunting disadvantage of a sole proprietorship is unlimited personal liability. The owner or sole proprietor is personally liable for any debts or taxes of the business or other claims, including damages resulting from lawsuits. In comparison, a limited liability company or corporation provides owners with limited liability protection. Take note that a sole proprietor is not an entity separate from the business, unlike the owners of a limited liability company or corporation. This means that he or she would have to file for bankruptcy personally under the Bankruptcy Code.

2. Few tax savings from fringe benefits

The sole proprietor is not entitled to several tax benefits pertaining to group-term life insurance benefits, long-term disability insurance coverage, and medical insurance or medical expenses reimbursements. This is another major drawback because these tax benefits mean tax savings.

3. Problem with continuity of existence

The life of the sole proprietorship is only as good as the lifespan of its owner. In other words, the business cannot exist beyond the life of the sole proprietor. This can be disadvantageous for several reasons. In case of death, business continuity will become a problem for existing employees and contractors. A business-to-business deal with a sole proprietorship could cease to exist abruptly if the owner dies unexpectedly.

4. Limited funding options

The sole proprietor might require additional funding through financing, especially if he or she wants to scale up the business. However, another disadvantage of a sole proprietorship is that it is not attractive to banking institutions or other lenders because of its lack of existential continuity. In comparison, a limited liability company and corporation have more likely to secure financing from financial institutions and even investments from angel investors or venture capitalists because they provide the legal structures for continuity and asset or profit arrangements.