Guide for sole proprietorships

Many people who start a business have little knowledge of 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 corporation, you are not a sole proprietor. You are a general partnership. I just thought I’d be clear on that.

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 economical to start up.

Sole proprietorships are also very easy from a tax standpoint. Since there is no official business entity, the company’s finances are handled on their personal tax returns. Report income, expenses, etc. with the Schedule C that accompanies the 1040 form. Unfortunately, keep in mind that you will have to pay self-employment tax, a whopping rate of 15.2 percent. If you don’t know it ahead of time, it can be deadly come tax time.

If sole proprietorships are so easy, why would anyone form an LLC or a corporation? Well, there is a big downside. As a sole proprietor, you are personally responsible for all business debts. This includes debts because the company does not make money and you owe a supplier, as well as any judgments that arise from a lawsuit against the company. Most businesses fail in the first two years, so this is a very big risk. If you formed an LLC or a corporation, you would be protected from such debts even if the business failed completely or you lost a multi-billion dollar lawsuit.

Many small business people start out as sole proprietors. Sometimes it’s an intentional choice, but sometimes people just don’t know any better. Either way, this is a good approach, but you run a huge risk of being personally liable. If you own something of value, such as a house, you should seriously consider forming an LLC or corporate entity so that you don’t lose assets if things go wrong.