Of the four business entity types, the sole proprietorship is by far the most flexible and easiest to manage. There are very few drawbacks. In the world of business, the key is to maximize profit with the least amount of risk. Each of these two elements is addressed as it relates to 1) decision making, 2) paperwork, 3) taxation and 4) civil matters.
The sole proprietorship is a legal entity status whereby the individual acts as the entity. When people need answers, it is you that they look to for the response. As another type of entity status, an employee can provide that response. If they make the wrong response, the entity is responsible for the outcome whether good or bad. As a sole proprietor when the business performs well, you get 100% of the reward. There is no sharing like in a partnership or double taxation in a corporation status. There isn’t any requirement to report it via different documents like in a limited liability status. Simply put, what you see is what you get!
This section is straight forward, you make the decision. You don’t need to consult with a partner, you don’t need permission from a board of directors (corporation) nor do you need to comply with some legal obligations as structured within limited liability companies or S-Corporations. It’s just you. When you go to the bank to open an account, they use you as the entity. With a partnership or corporation status, the bank requires a resolution of some sort. This means you have to document the request, print it, and process it with the bank.
At loan time, the bank lends you the money and not some entity. When a vendor wants to extend credit, they extend it to you, not an entity. Often creditors want a separate set of forms filled out to extend credit to some entity that is not an individual.
When generating operating policies and procedures, you make the decision. Some policies and procedures require board action in a corporation status or some form of endorsement in a partnership relationship.
You can see that when it comes to the decision making process, it’s much faster and easier with an entity status of sole proprietorship.
The other three entity types (Partnership, Limited Liability Company, Corporation) require additional paperwork to operate as a business. These three require an application and processing by the state corporation commission or state board to act as a legal entity in that state. Unlike you, born with a birth certificate that never expires, the other three entities must renew their birth certificate each year (some states do not require documentation for a partnership). Plus pay a fee to renew. If they want to cease existence, you have to request that too and pay a fee.
For tax purposes, a sole proprietorship fills out a Schedule C which is two pages long. The other three entities require a separate tax return which is no less than 7 pages long (the simplest approach) and then that information still requires you to process no less than one page on your personal tax return.
As illustrated in the decision making section above, any form of application to a creditor requires more paperwork and documentation and maintenance of that documentation to obtain credit. Furthermore, banking becomes a little more complicated because deposits and checking require full separation from your personal banking. As a sole proprietor, you may from time to time use your own bank account (I don’t recommend this, but it is legal).
No matter what the entity status is, you must obtain a Federal Employer Identification Number (FEIN) or Employer Identification Number (EIN) (these two acronyms are used interchangeable). You file form SS-4 (Application for an Employer Identification Number) http://businessecon.org/resources/ with the Internal Revenue Service to receive this identification number. Although the application says it is for an employer, you still must get one even if you are not going to hire employees. The number is used for banking and tax filing purposes. This is similar to your social security number and it will be requested hundreds of times throughout your business activity.
Sole proprietorships are taxed at the individual level, so whatever is your personal tax rate, and then your tax is calculated using this rate. For the other entities, it depends. For the partnership and limited liability entities, the tax is taxed at the individual owner’s tax rate. In effect, it is equal to your status as a sole proprietor. However, at the corporate level, there is separate tax for the business and if dividends are paid, those dividends are taxed at your personal rate depending on the nature of how those dividends are issued (regular or qualified). Sometimes, corporations can be taxed as pass through entities which means the owner pays the tax at his tax rate. So bottom line, the best overall tax rate that can be used by any of the entities is your personal rate. Therefore, there is no real loss in taxation over the other entities if existing as a sole proprietor.
This is probably the number one reason attorneys advocate the use of one of the other three entities. They want to protect you from civil claims in a court of law. This makes sense; their job is to protect you. However, I often find this is not necessary. I AM NOT AN ATTORNEY AND THERE IS NOTHING MORE VALUABLE THAN GOOD LEGAL ADVICE.
First off, you have to have some form of wealth to protect. Think about this for a minute, if you have no wealth, then what is the other party going to get from you? Once you go into business and spend the money on the capital investment, odds are that there will be very little wealth left over anyway. To go even one more step further, let us assume that you have accumulated some wealth and usually that wealth is in the form of assets in the company. If you are sued and lose, the other party is going to get that wealth anyway. So the real key here is to not get sued. But it will happen, most likely at the smaller claims level for some inattention to your responsibilities as an owner or something your staff does.
But most small businesses don’t really need to be one of the other forms of entity status because often there is no or little risk to you. Allow me to elaborate. The most common type of business lawsuit is employer/employee related. That is to say, your employee sues you for some form of an accident. By law, you are required to carry workman’s compensation insurance to provide for accidents on the job. But if it goes beyond that level, then it is possible for you to be sued. So if you don’t have employees and most sole proprietorships don’t, then this type of risk doesn’t exist.
The next most common risk is a customer suing you. Many forms of businesses (not business entity status) don’t interact with customers. Examples include trading securities on the market: is there any way the customer can get physically hurt at your place of business? Or you have what I refer to as a low customer risk scenario environment. Many small business start out in the weekend trade shows or fair environment. You put out your wares for sale on a table and the customers come by perusing the goods. In effect, it’s a hobby more than anything else. Or you make some form of an item that you personally deliver to your customer or even render service at your customer’s place of business or domicile (you cut the grass). So where is the real risk of a lawsuit to you? Furthermore, even if they did sue, how much could they really sue for in a court of law? Most judges are going to be reasonable in nature as it relates to the economic value of the loss sustained by the plaintiff. If you mowed over the RUBIK ROSE at your customer’s house and that rose is worth let’s say $80 because it is so rare; how much is the judge truly going to award the plaintiff?
Furthermore, much of the lawsuit risk is mitigated with insurance. You can purchase a higher payout policy for marginal dollars. I would rather pay out an extra $200 per year to get an additional two to three million dollars of coverage than to pay out $600 to $1,000 per year in additional fees to the accountant and your state to maintain the entity status. Seriously, if you have nothing to lose; then there is no real basis to justify spending and dealing with another level of protection.
Finally, in some professional situations, the entity status does not fully protect you from lawsuit. If you carry a license as a surveyor, and you miscalculated the bearing for some project that cost several hundreds of thousands of dollars, not only is your business going to get sued, but you will lose your license and your means of income anyway. The same goes for any of the professional actions out there, once you are sued (a serious type of lawsuit), odds are that you will lose that license too. So the higher level of entity status didn’t really protect what was the most important aspect of what this is all about, making money.
There are many other examples to use that have low risk, they include:
1. Owning rental properties – again insurance can eliminate risk here
2. Home based business – are you going to sue yourself?
3. Wholesaling products – very little to no physical interaction with customers
4. Transportation operations – by law you must have vehicle insurance, insurance eliminates risk here too
5. Buying/selling real estate – if no or limited restoration work, no need to have a separate entity status, risk is minimal
Even with what I illustrated above, you should still get some legal advice. Although you may not have wealth right now or the business operation is low risk, it does not mean that you should just operate as a sole proprietorship. Again, seek out legal advice. There are other aspects of this you should consider including family situations, physical risk issues, social implications etc. The key is to have a full understanding of your situation.
The Sole Proprietorship is useful in many situations, it’s the easiest to implement, has the lowest paperwork, has the overall least taxation, and often civil issues are not applicable. But one needs to fully understand your own operation and make informed decisions. The sole proprietorship works well in certain circumstances. Make sure you meet the criteria to use this type of entity status. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.
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