Do you like having your own business where it is just you and no one else? Do you prefer it because of its convenience and flexibility? If so, then a sole proprietorship may be the best business entity option for you. But there are some disadvantages that flow from a sole proprietorship if it's not set up properly and if you are not adequately prepared. Sole proprietorships are one of the most preferred business structures for small business owners, but approximately half will fail within the first year of operation.
What is a Sole Proprietorship?
A sole proprietorship, or sole trader, is a business owned and operated by one person who receives all of the business's profits while being personally liable for all of the business's debts and liabilities.
A sole proprietorship is the simplest and quickest way to start a business. There's no formation paperwork to file, although you may need to apply for state or industry-specific business licenses or permits or to file a trading name if different from your own.
The tradeoff for this simplicity is that sole proprietors assume all risks associated with the business. Personal assets can be used to cover the business's debts and liabilities.
Sole proprietorships are the most common business structure in the United States. Due to their simplicity, sole proprietorships are ideal for low-risk businesses making comparatively lower profits.
Common Businesses as Sole Proprietorships in Texas
Businesses that often operate as sole proprietorships include:
- Freelancers, e.g., writers, photographers, virtual assistants, career counselors, personal trainers, and web designers
- Businesses that start as a side hustle, e.g., an Etsy shop
Before deciding whether a sole proprietorship is the best structure for your business, it's important to consider the pros and cons.
Advantages of a Sole Proprietorship in Texas
There are many advantages that flow from a sole proprietorship, and that's in part why they are so popular.
- Low setup costs. The paperwork to start trading as a sole proprietor is limited, meaning there are minimal costs involved. In some circumstances, you will only need to apply for relevant licenses or permits and register your business name. The setup costs will reflect the fees associated with licensing and registration.
- Easy to run. When it comes to sole proprietorships, there is much less government regulation compared to other business structures. Unlike a corporation, for example, sole proprietorships don't require a board of directors or annual meetings. You also do not have employees, so you manage only yourself and no one else unless you enter into a contract with a third party.
- Simple taxation. Sole proprietorships are pass-through entities. There is no legal distinction between the owner of the sole proprietorship and the business. The owner simply reports the income from the business on their personal tax return, which is then taxed at the personal rate.
- Full ownership and control. The owner of a sole proprietorship makes all the decisions about the business, without needing to consult other owners or members or answer to shareholders. They have complete control over the business.
Of course, these advantages only benefit your business if they are aligned with your business goals and mission. When your business starts to grow, you may need to rethink the business structure.
Disadvantages of a Sole Proprietorship in Texas
Understanding the disadvantages of a sole proprietorship will help you proactively strategize and plan your business.
- Unlimited personal liability. As the owner and business are treated as one, an owner of a sole proprietorship is personally liable for the debts, liabilities, and obligations of the business including loans and lawsuits. This means their personal assets can be seized to pay any liabilities.
- Full ownership and control. While the owner of a sole proprietorship has full control over the business and can freely make business decisions, the success and failure of the business also rests entirely on them. This can be stressful and create a heavy workload.
- Limited funding options. Attracting outside investment in a sole proprietorship is difficult. Due to the unlimited liability of the owner, there's no protection against creditors. Investors and banks, therefore, often view sole proprietorships at a greater risk of business failure than other structures.
- Taxation. While the profits of a sole proprietorship are passed to the owner and taxed at the personal rate, the owner has to pay both income tax and self-employment tax, which can add up.
When deciding on your business structure, you should weigh these factors in light of your circumstances.
When Should You Incorporate a Sole Proprietorship or Form an LLC in Texas?
Sole proprietorships commonly transition to a limited liability company (LLC) or incorporate as they grow.
While a sole proprietorship is a great starting point for your small business, once it begins conducting higher-risk business activities, incorporating or forming an LLC limits your liability.
In addition to reducing risk, corporations and LLCs are more heavily regulated business structures, making them a more attractive investment choice for investors. You might consider forming an LLC or incorporating when you want to seek capital investment to expand your business.
Changing your business structure like this as your profits increase may also unlock potential tax advantages.
If you're considering incorporating your sole proprietorship or forming an LLC, you should speak to a business lawyer in Texas for advice based on your specific circumstances and your goals for your business.