The sole proprietorship is the simplest business structure to create and maintain. It’s the default business structure for solo business owners. If you’ve started a business and haven’t filed for a formal legal structure yet, then your business is a sole proprietorship.
There are minimal legal costs associated with forming a sole proprietorship: you just need to make sure you’re complying with any local zoning and business permit laws. Additionally, a sole proprietorship has few formal business requirements. Sounds good, right? This simplicity and affordability are why many small businesses in the U.S. operate as sole proprietorships.
However, there are several drawbacks to the sole proprietorship, and many entrepreneurs eventually restructure their sole proprietorship to a corporation or LLC (Limited Liability Company).
If you’re currently running a business or plan on launching one soon, take note of these five reasons why it might be smart to restructure your sole proprietorship:
Reasons To Restructure Your Sole Proprietorship
1. You’re Concerned about Personal Liability
The sole proprietor of a business can be held personally liable for the debts and obligations of the business. Your own personal savings, property, and other assets are at risk to settle any debts of the business. If something should happen and your business is sued or can’t pay a debt, you will probably be required to pay up from your personal savings or property. This is because with a sole proprietorship, there’s no separation between the business and business owner; they’re one in the same.
When you form a corporation or LLC, you are separating the business from the business owner. In many cases, this offers a shield between your personal assets and the business. In industry terms, we refer to this as the “corporate veil.” A corporation (or LLC) exists as its own entity: it’s responsible for paying its bills, meeting its obligations, etc. Whether you’re in a high-risk business (like catering or selling a product to consumers) or a low-risk business (like writing), unexpected things can happen and having a corporate shield can bring peace of mind that your personal assets are protected.
2. You Want an Investor or Loan
If you plan on expanding in the future, either by finding an investor or getting a business loan, then you’ll need to have a formal business structure that’s different than a sole proprietorship. As a sole proprietor, you can only get a personal loan; that’s because there’s no separation between you and the business. Likewise, investors typically won’t invest in a sole proprietorship, as there’s no way to divide ownership or issue shares for the company. In order to receive a business loan or investment, you need to separate the business from your personal finances by setting up a legal business entity such as a corporation (C Corporation or S Corporation) or LLC.
3. You Start Working with Larger Businesses
In the course of growing your business, you may seek out work with a larger company and be surprised that their contract stipulates that you’re operating as a corporation or LLC. This is for a few reasons. First, there’s an assumption (whether it’s correct or not) that an Inc. or LLC is a more stable and trustworthy business partner than a sole proprietor.
In addition, there has been a lot of discussion over the past few years about the IRS cracking down on companies that improperly classify workers as contractors instead of shelling out payroll taxes and other benefits for an employee. If a company hires a sole proprietor for contract work, they may need to show proof to the IRS or state that the worker is indeed independent and should be considered a contractor. Yet, if a business hires an LLC or corporation for the same work, there’s no question about the classification.
4. You’re Looking for More Flexibility with Your Taxes
Since there’s no separation between the individual business owner and business, sole proprietors report all their business income on their personal tax return. Some first-time entrepreneurs and solo workers are surprised to discover how much they need to pay in self-employment taxes. By forming an LLC or corporation and electing S Corporation status, it’s possible to lower what you pay in self-employment taxes. In addition, corporations can get other tax advantages, such as claiming medical insurance for families as a deductible, and being able to leave profits in the corporation. It’s always wise to speak with a CPA or tax advisor to find out which business structure can provide you with the optimal financial situation.
5. You’re Ready to Think of Yourself as a Business Owner
For some, the simple act of filing business formation paperwork creates a powerful shift in perception: you start thinking of yourself as a business owner, rather than just as self-employed. When you consider yourself self-employed, you’re basically an employee (with really bad benefits!) But, once you start thinking of yourself as a business owner, you’ll stand a little taller and start thinking strategically about the best ways to grow the business outside of putting in more hours. Of course, you don’t need to be a corporation or LLC to start thinking like a business owner, but for some, this level of formality helps.
While an LLC or corporation is more involved to set up than the sole proprietorship, the paperwork can be done in just a few hours, giving your business a solid legal foundation for years to come. And, if you’re particularly concerned about keeping your formalities to a minimum, consider the LLC: it offers the same personal liability protection as the corporation, but with fewer administrative requirements!
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