Choosing an Entity

The simplest form of business—The Sole Proprietorship

The most basic of all business legal structures is the sole proprietorship. For new start-ups the choice of becoming a sole proprietorship is the simplest of all business forms but is it the best?  A sole proprietorship is a business of one without corporation or limited liability status. The individual represents the company legally and fully. Common proprietorships include part-time businesses, direct sellers, new start-ups, contractors, and consultants.

Advantages of Sole Proprietorship
This form of business has several advantages, such as: 

1. Quicker Tax Preparation: As a sole proprietor, filing your taxes is generally easier than a corporation. Simply file an individual income tax return (IRS Form 1040) including your business losses and profits. Your individual and business income are considered the same and self-employed tax implications will apply.

2. Lower Start-up Costs: Limited capital is a reality for many startups and small businesses. The costs of setting up and operating a corporation involves higher set-up fees and special forms. It's also not uncommon for a lawyer to be involved in forming a corporation. 

3. Ease of Money Handling: Handling money for the business is easier than other legal business structures. No payroll set-up is required to pay yourself. To make it even easier, set up a separate bank account to keep your business funds separate and avoid co-mingling personal and business activities.

Disadvantages of Sole Proprietorship
There are also several disadvantages of this form of business, including:  

1. Personally Liable: Your small business in the form of a sole proprietorship is personally liable for all debts and actions of the company. Unlike a corporation or LLC, your business doesn't exist as a separate legal entity.  All your personal wealth and assets are linked to the business.  If you operate in a higher risk business such as manufacturing or consumables, the cost to benefit ratio is favorable toward a corporate structure. 

2. Lack of Financial Controls: The looser structure of a proprietorship won't require financial statements and maintaining company minutes as a corporation. The lack of accounting controls can result in the demise of your small business. No matter the legal structure of your business, take time to set up the proper financial statements for your company.

3. Lonely at The Top: Being a business of one can be lonely. All the decisions, actions, and results rest on you. Are you able to work alone and be productive? If not bring in a partner can be necessary for your small business survival.  

4. Difficult to Raise Capital: Imagine your business in 5 years. Will it still be a business of one? Growing your small business will require cash to take advantage of new markets and more opportunities. Outside investors will take your company more serious if you are a corporation.

Forming a Sole Proprietorship
From the IRS's perspective, your small business is a sole proprietorship unless you have registered it as a corporation or other business structure such as an LLC. Setting up your proprietorship often does not require registration of the business. If you are planning to use another name or business name to operate your company, state laws will require a trade name registration or filing of your company name.  Choosing the best business structure for your business will depend on a host of individual factors including your type of business, tax situation, industry liability, among others. Your choice of business structure will have legal and personal implications. Work with your business professional team of a lawyer and an accountant to determine the type of business structure best for you.

Should you incorporate your small business?

Every small business person considers whether or not to incorporate his business at some point. The form of a business isn't immutable; you can change the legal structure of your business as it grows. A common scenario is for small businesses to start out as sole proprietorships or partnerships and become incorporated at some later date when the business has grown. If you're one of the people considering incorporating your business, here are the main advantages of incorporating: 

1. Limited Liability. The main advantage to incorporating is the limited liability of the incorporated company. Unlike the sole proprietorship, where the business owner assumes all the liability of the company, when a business becomes incorporated, an individual shareholder's liability is limited to the amount he or she has invested in the company.  If you're a sole proprietor, your personal assets, such as your house and car can be seized to pay the debts of your business; as a shareholder in a corporation, you can't be held responsible for the debts of the corporation unless you've given a personal guarantee. On the other hand, a corporation has the same rights as an individual; a corporation can own property, carry on business, incur liabilities and sue or be sued. 

2. Corporations Carry On  Another advantage of incorporating is continuance. Unlike a sole proprietorship, a corporation has an unlimited life span; the corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.

3. Raising Money Is Easier Corporations also have more ability to raise money, which may make it easier for your business to grow and develop. While corporations can borrow and incur debt like any sole proprietorship, they can also sell shares and raise equity capital, a big advantage because equity capital generally does not have to be repaid and incurs no interest. (Of course, by issuing shares, you are reducing your percentage of ownership in the company.) 

4. Income Control.  If you incorporate your small business, you can determine when you personally receive income, a real tax advantage. Instead of getting your income when it's received, being incorporated allows you to take your income at a time when you'll pay less in tax. 

5. Potential Tax Deferral. Becoming incorporated gives you tax deferral potential. Because you can defer paying some tax until a later time, you may be able to realize tax savings if you are then in a lower tax bracket, or if the tax rates have fallen.  

6. Income Splitting. Another tax advantage of incorporating is income splitting. Corporations pay dividends to their shareholders from the company's earnings. A shareholder does not have to be actively involved in the corporation's business activities to receive dividends. Your spouse and/or your children could be shareholders in your corporation, giving you the opportunity to redistribute income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.  

7. The Small Business Tax Deduction If you incorporate your small business, your corporation may qualify for the small business deduction. This annual tax credit is calculated at the rate of 16% on the first $200,000 of taxable income, which may be a much lower tax rate than that applied to your personal income.

8. Increased Business? Having Ltd., Inc., LLC., or Corp. as part of your company's name may increase your business, as people perceive corporations as being more stable than unincorporated businesses. If you're a contractor, you may also find that some companies will only do business with incorporated companies, because of liability issues.