Upon
reading the title to this article you may have asked yourself, “What is a sole proprietorship?” Well, a sole proprietorship is the simplest
business form under which one can operate a business. It is not a legal
entity, unlike a limited liability company (“LLC”) or corporation. It is simply a person who owns the business
and is personally responsible for its debts.
Many people
may be operating a sole proprietorship without knowing it. For example, the stay-at-home mother who does
freelance photography and earns income from those activities is a sole
proprietor. So is the brick mason,
landscaping professional, or farmer who simply “went to work” and never formed
a legally recognized entity by registering it with the state.
Now you
may be wondering, “I’ve been doing business as a sole proprietor, should I change
that?” As with so many other legal
questions, the simple, yet unsatisfying, answer is, “That depends.” One must consider the advantages and
disadvantages of a sole proprietorship and weigh those against the advantages
of other business forms. This analysis
is specific to each individual and his or her business.
So what
are some of the advantages of a sole proprietorship? The most obvious advantage is that they are
easy to form. Really, no “formation” is
actually necessary. All that is required
is for a person to offer a service or product for sale. That’s it.
There are also no registration fees because there is no registration.[1] Also, sole proprietors are not required to
file a separate tax return[2]
for the business. This can save on
accounting fees. There are additional
tax advantages. One of the main tax
advantages of operating a sole proprietorship is that the owner can deduct the
cost of health insurance for herself, her spouse and any dependents. The owner can take this deduction even if she
doesn’t itemize deductions on her tax return.
Another advantage is that there are
no operational formalities that a sole proprietor must follow. By contrast, other business forms require
their owners to keep their personal assets separate from business assets. Since a sole proprietorship is not separate
from the individual owner, there is no distinction between personal and
business assets.
While the lack of operational
formalities can be an advantage, there is a cost to that benefit. Since there is no distinction between
business and personal assets, all of the sole proprietor’s assets are at risk
should he be sued for actions he took in his business. For example, if our brick mason negligently
installs a brick wall for a homeowner and the homeowner gets a judgment against
the brick mason through a lawsuit, any of the brick mason’s assets (e.g. his
home, car, boat, bank accounts, etc.) may be used to satisfy the judgment. Or, let’s say that the brick mason purchases
brick from a supplier on credit. If the
brick mason fails to pay the supplier, the latter may go after the former’s
personal assets to collect the costs of the brick.
In addition to personal liability,
there are tax disadvantages for a sole proprietorship.[3] Sole proprietors are responsible for
self-employment taxes, in addition to regular income tax. Self-employment taxes
are the equivalent of the employer's share of the Social Security and Medicare
taxes that all workers have to pay. When an individual works for an employer,
he only pays the employee's portion of these taxes. The sole proprietor, on the other hand, has to
pay both the employer's and the employee's portions.
Another concern with a sole proprietorship is the attention it gets from
the IRS. Business and personal expenses must still be kept separate and
this can be somewhat difficult distinction in a sole proprietorship. Whereas a
computer purchased for the sole use by the business is a business deduction, a
personal computer is not deductible on an individual’s taxes. The IRS is more likely to scrutinize business
deductions for a sole proprietorship.
One popular alternative to a sole proprietorship
is an LLC. While a sole proprietor is
personally liable for all of the debts and obligations of his business, owners
of LLCs have limited liability for business activities. Like the advantages discussed above, limited
liability comes with a cost. LLCs and
their owners must be much more diligent in keeping business and personal assets
separate. If an LLC commingles its funds
with those of its owner, or if the LLC pays the personal expenses of an owner,
the limited liability protection may be destroyed and the LLC treated as a sole
proprietorship.
LLCs must be registered with the
state in order to be recognized. As with
nearly every state registration, there is also a fee involved. The LLC registration process in Utah is not
overly burdensome; however, there are some potential pitfalls that an
experienced attorney can help you avoid.
An attorney can also assist LLCs by preparing an operating
agreement. This is a vital document
which provides the LLC with a “road map” for conducting its business
activities.
In addition to sole proprietorships
and LLCs, there are other business structures for an individual to consider,
including partnerships, limited liability partnerships, and corporations. Individuals and businesses should seek out
competent legal counsel to determine which structure is best. Let the attorneys at the law firm of Gurr
& Brande, PLLC use their skills and experience to help you organize and
operate the right business entity for you. Call today (435-634-8868) or visit our website!
[1] Most
cities will require that a sole proprietor obtain a business license.
[2] Although,
additional tax forms are required on your personal tax return.
[3] One
alternative to a sole proprietorship is an LLC.
LLCs are not recognized by the IRS.
They are called “disregarded entities.”
An LLC with one owner, or member, is taxed as a sole proprietorship
unless the LLC elects to be taxed as a corporation. This election is a topic which will be
addressed in a future article.
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