A sole proprietorship is the simplest form of business to start. Ordinarily, all you need to do is start operating as a business under your own name (or a fictitious name - a DBA, "doing business as") and Social Security number, obtain any required licenses or permits, and you're in business.
But there are some distinct disadvantages to operating as a sole proprietorship, which you should consider when determining if this business form is right for you.
By definition, a sole proprietorship has only one owner. If you have a business partner, you may be a partnership or choose a different business form, but you cannot operate as a sole proprietorship.
Using a DBA
In most jurisdictions you may do business under your own name. However, if you wish to use a variation of your name or a completely different business name, you may register a DBA ("doing business as..."), such that you may lawfully conduct business under that fictitious name. Most commonly DBAs are filed at the County level, but in some jurisdictions and circumstances they may be filed at the state level.
When you register a DBA, the clerk who processes your application will check to make sure that nobody else in their registry is using the same name you have requested. They will also maintain a record of your real identity for anybody who wishes to find out who is operating under the selected business name.
Restrictions on Business Names
States impose certain limits on the names businesses may choose. For example, corporation names are subject to restrictions to help ensure that the name won't mislead people into believing that the corporation is run by licensed professionals. For that reason you can expect the state to reject a corporation name that includes the words "law office".
Non-incorporated entities are restricted from choosing names that suggest that they are incorporated. You can't get a DBA for your sole proprietorship that calls it the "Example Corporation", or that includes similar terms suggesting that your business is a corporation, limited liability company (LLC) or other incorporated entity.
Finally, when choosing a business name you should check state and federal trademarks registries to verify that you won't find yourself of infringing somebody else's trademark for the same or a similar name. You should also check trademarks and business names in other states into which you hope to expand.
Investigate Other Meanings of Your Business Name
You should check slang dictionaries, run the name in your favorite search engine, or even check foreign languages before selecting a business name.
There have been a number of stories about businesses and products that are inadvertently named after a derogatory term or where the product name has an embarrassing meaning when translated into another language, at times amusing to outsiders but potentially damaging and expensive to correct for the business.
The biggest potential downside of operating as a sole proprietorship is the lack of protection you receive from personal liability. Business owners who operate incorporated entities, such as corporations or LLCs, benefit from considerable protection of their personal assets in the event of litigation or if their creditors are seeking to collect business debts.
When a business is incorporated, creditors can ordinarily only reach the assets of the business entity, not the personal assets of owners or investors. In contrast, a sole proprietorship is not legally distinct from its owner.
If you operate as a sole proprietorship, your personal assets are potentially subject to creditor claims.
If you are engaged in a business that has a significant chance of being the subject of litigation, you should make sure that you carry adequate insurance. In most cases you should choose a business form that shields you from personal liability in the event of a lawsuit. By way of example, if your business activity consists of giving piano lessons you have a low risk of liability; but if you are giving swimming lessons or horseback riding lessons, a small mistake by you or a student could result in a significant liability to your business..
Even if you are incorporated you can potentially be held liable for injuries resulting from your own acts, but you gain protection from individual liability for certain actions of co-owners and employees.
It is important to consider tax consequences when selecting the form of your business. Although many small businesses may not experience significant tax savings based upon their decision to incorporate, or in some cases may even see their cost and tax burden increase, many businesses will gain tax benefits from a well-chosen corporate form.
When you operate as a sole proprietorship:
- Any income to the business is treated as income to the business owner,
- All income is reported on your individual tax return, and
- Your income is taxed in the year it is received
With a sole proprietorship, even the money you leave in your business bank account is taxed in the year it is earned. That remains true even if you are saving it to pay for business expenses in the coming year.
Some corporate forms such as the S Corporation allow for pass-through taxation, with the business income treated in the same manner as other income earned by the proprietor. However, when it offers an advantage, a proprietor may choose a business form that allows the business to generate its own separate income, and to file its own income tax return, potentially allowing the business to defer income to a different tax year.
Some sole proprietors will benefit from incorporating and becoming an employee of the newly formed corporation, primarily by limiting their self-employment taxes and by creating tax-deductible benefits packages.
The income you earn from your sole proprietorship remains subject to income and self-employment tax (your Medicare and Social Security contributions), and you are responsible to pay those taxes at the end of the year. In most cases you are required to make quarterly payments of your estimated tax liability, to both the state and to the federal government.
Whether or not you incorporate, you may deduct your legitimate business expenses when you calculate your taxes, and you may report losses from your sole proprietorship on your income tax return.
If the type of business you are operating has the potential for incurring significant liability and you want to shield your personal assets from lawsuits and creditors, you should consider a business form that protects your assets. The corporation provides a broad shield against personal liability for business debts and, for many businesses, an LLC offers similar protections with fewer formalities.
If you do not want to have all of your business income treated as your personal income, or would rather have the business pay taxes on its own income than have that income included on your personal tax return, you may benefit from incorporating.
- If your goal is to lower your overall business and personal tax liability, you should keep in mind that incorporation may increase the total tax obligations of a business even with no change in income.
- Even if you will benefit from tax savings, you will want to consider the costs and burdens of maintaining a corporation as compared to continuing as a sole proprietorship.
You should calculate any effect on your tax liabilities along with the added costs of operating as a incorporated entity before incorporating your sole proprietorship.