Five Biggest Disadvantages of a Sole Proprietorship

Thinking about starting your business as a sole proprietor? You’re not alone. There are more sole proprietors in the United States than any other type of business. Recent information puts the number of sole proprietorships in the U.S. around 22.3 million.

While nearly every sole proprietorship typically starts as a small business, it doesn’t necessarily stay that way. Have you ever won an auction on Ebay, spent a night in a Marriott hotel, or gotten a deal at Walmart? Each of those corporations started as a sole proprietorship.

So, if a sole proprietorship is working for all those people, doesn’t it make sense that it would work for you and your business? Yes. No. Possibly. Like any big decision, starting your own business as a sole proprietorship should be done only after looking at it from all sides.

It’s easy to look at the upside of almost anything and feel good about it. But if you can look at the downside and still whistle a happy tune, then you can feel good about it. That’s what we'd like to help you do here.

Five Big Disadvantages of a Sole Proprietorship

1. Personal liability.

Starting and running a business takes a lot of time, effort, and passion. You need to put a lot on the line. With a sole proprietorship, you’re putting even more on the line.

In the eyes of the law, you are the business and the business is you. That means you’re personally responsible for all your business’s debts and all claims against it.

If your business owes money or you’re sued, both your business assets and your personal assets could be made available to settle claims or debts. Not only could you lose the laptop, your inventory, and the company vehicle, you could also potentially lose your home, savings, jewelry, and other personal assets.

There are similar risks in your personal life as well. If you can’t pay your credit card company, student loan holder, or mortgage lender, they can seek to recover their money through liquidating your business assets and forcing you out of business.

And closing your doors may not be the worst of it. Because you and the business are intertwined in a sole proprietorship, you can't file for business bankruptcy without filing personal bankruptcy. Once again, what happens to your business can also happen to you.

While personal liability is often cited as the biggest disadvantage of a sole proprietorship, there are others as well. And we’ll get to those in just a bit.

This Deep Breath Brought to You by Business Insurance

We get it. You may not have even baked your first pizza or designed your first webpage, and we’re already bringing up the possibilities of lawsuits and bankruptcy. So let’s take a break and mention something that might brighten your outlook.

It’s sole proprietorship insurance. (Cue the sunlight streaming through a sky of dark clouds.)

Sole proprietorship insurance can help protect your business from many risks, so even if there is an accident or a negligence claim, you’re not left holding the financial bag by yourself.

We work with hundreds of sole proprietors, so we know what you’re up against. We can help you understand what type of coverage you may need. And we'll find it for you from top insurance carriers. Simple. Just like in our name — Simply Business.

2. Taxes, taxes, taxes.

As a sole proprietor, it’s not just the law that views you and your business as one. The IRS and other tax entities do as well.

The net income from your sole proprietorship (revenue minus expenses) needs to be reported with your personal income. This is important to look at if you're running your sole proprietorship along with holding down a day job, or if your spouse is working as well.

First, the federal tax rate for corporations is a flat 21%, whether you earn several thousand dollars or several million.

It’s not the same with personal tax rates. They range from 10% to 37%, depending on how much money you make in a given year. The more you make, the higher your tax rate.

Here’s why that’s important with a sole proprietorship. Your income, your spouse’s income, and net income from your sole proprietorship all get lumped together. That combined amount could push you into a higher tax bracket.

That means the salaries from your and your spouse’s day jobs could wind up being taxed at a higher rate than they normally would be taxed.

Self-employment tax.

This is similar to the FICA tax that is paid by employers and employees in corporations. In that instance, the employee and employer each pay half.

As a sole proprietor, you have to pay the full amount, which is currently 15.3%. It includes 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

Quarterly estimated tax payments.

Along with the potential for a higher tax bill, a sole proprietorship may have to file and pay taxes more often. If you expect to owe at least $1,000 in taxes, you may need to pay quarterly Estimated Tax payments to the IRS.

As with many considerations related to taxes and finance, much depends on specific aspects of your business, including state and local tax requirements. It’s a good idea to consult an accountant, or a tax or financial professional to get the best insight into your particular tax situation.

3. Funding.

Whether it’s a laptop and a mobile phone, or a commercial lawn mower with hydrostatic drive, you’ll likely need some equipment or tools to run your business. You also may need office space, a store front, or a vehicle to house and haul that equipment.

Meet your “chief financial officer:” you. As a sole proprietor, you’re often the sole source of funding needed to get your business off the ground and keep it running.

A sole proprietor is not allowed to sell stock or bring on investors. To do so, you would typically have to change the sole proprietorship business structure (a bit more on that later in the article).

That often means you’ll have to rely on your own savings, creditworthiness, or help from family or friends.

Savings.

Using your own money allows you to maintain the greatest level of control over your business, which is one of the reasons most people become sole proprietors. Many business owners put up their own money to get things going and then replenish what they used over time with profits from the business.

Believing in yourself and your business can be powerful forces to drive your success, but they’re not always enough to ensure a good outcome. So before withdrawing your life savings, consider how long you want to wait to get your investment back from your business. Also, consider the possibility of not getting it back.

Loans and credit.

A business credit card can be a useful tool in your funding tool kit. Getting a business credit card can be as easy or difficult as getting a personal card. A lot depends on your personal credit rating.

Your personal credit rating plays a significant role in obtaining a business loan from a bank or other financial institution. This all goes back to the concept of the business and the business owner being considered the same entity in a sole proprietorship.

4. Business after life.

Like taxes, death is something none of us can avoid. If you’re a sole proprietor, your passing can affect your loved ones financially as well as emotionally.

Sole proprietors often believe passionately in what they’re doing and how they want to do it. They often devote their entire lives to the business. When they pass on, the driving force behind their business usually passes as well.

As in life, there is no separation between a sole proprietor’s business assets and personal assets when the owner dies. The IRS and state tax authorities typically view a sole proprietorship the same as an individual’s personal finances. That can mean that any debts of the business will potentially need to be settled by the sole proprietor’s heirs.

This can depend on a number of variables including whether or not the sole proprietor had a will, so it is important to obtain legal advice if you have questions about your particular business and any implications.

If the assets from the business aren’t enough to pay off the creditors, the creditors may be able to go after personal assets. This can potentially affect how much of your estate will go to your beneficiaries.

As much as you need a plan to run your business in life, you may also need one if you want your life’s work to continue after your passing.

5. Doing it all on your own.

One of the traits sole proprietors share is the passion to do and build something that’s all their own. Doing it all on your own can be immensely satisfying. It also can be very demanding. It’s a good idea to look at the personal commitment that could be involved in running your own show.

Freedom.

Many people want to have their own business as a way of having more freedom in terms of what they do, when they do it, and how much they can earn. Many sole proprietors understand this and are willing to make sacrifices early on for more freedom down the road.

However, it’s not unusual for a sole proprietor to go quickly from a dedicated business owner to an owner consumed by their business.

Health care.

If you’re thinking about leaving your day job to pursue your dream, one of the biggest considerations you may face is getting healthcare coverage for you and your family. The coverage you got through an employer may be more expensive if you’re buying it on your own.

Giving up your career.

If you plan to quit your day job to pursue your dream, it may be a good idea to think about the impact it could have if your business struggles or fails. Going back to your previous career could be difficult, especially the longer you’re away from it.

Relationship strain.

Even if you’re doing all the work, the stress and demands of a sole proprietor can affect life with your family and friends. This can be especially true if your business starts to consume more and more of your time, energy, and patience.

Burnout.

While a sole proprietorship gives you complete control to chart your success, there are times when being the CEO, the sales director, the chief of manufacturing, and the head of IT can feel like a lot for one person.

Remember, as a sole proprietor, you’re likely the one who’s doing everything. You’re also the only one keeping your dream alive. So while you want your business to grow and thrive, you don’t want to burn yourself out in the process.

Sole Proprietorship Not for You? Consider These Other Business Entities

We’ve taken a cold, hard look at the shortfalls of a sole proprietorship, but we believe having a clear-eyed view of what you’re getting into is a good way to start out in business.

The good news is that there are other ways to form your business. Like a sole proprietorship, they come with their own sets of pluses and minuses. We recommend taking a good, hard look at these, as well, so you can determine what suits you and your business the best.

1. Partnerships.

A partnership comes with many of the advantages and disadvantages of a sole proprietorship, but they’re generally shared with two or more owners.

Profits from a partnership pass through to each partner’s personal income. That means each partner has to treat their tax situation much the same as a sole proprietor. The same is true with liability.

Partners are “jointly and severally liable” for the firm’s debts. Creditors can take action against any partner individually, or more than one at the same time. If one partner ends up paying more than their share of the business’s debts, they can take action against the other partners to recover the difference.

There are two common types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).

Limited partnerships.

Limited partnerships typically have only one general partner with unlimited liability, and all other partners have limited liability. With that limited liability comes limited control, which is generally outlined in a partnership agreement.

Profits for all partners pass through to their personal tax returns, just as with a sole proprietorship, but only the general partner must pay self-employment taxes.

Limited liability partnerships.

These partnerships are very much like limited partnerships, except that each partner has limited liability from debts against the partnership. They’re most often used for professional groups, such as attorneys.

2. Limited liability company (LLC).

As the name indicates, an LLC offers you limited liability. In general, only your business assets can be touched in debt collection or legal claims. In most states, and under most circumstances, your personal assets are protected.

Business profit or net income for sole proprietors and LLC members is considered “pass-through income” by the IRS. It’s taxed on your individual tax return at your individual tax rate.

However, operating as an LLC offers additional tax options. Depending on elections made by your LLC and the number of members it has, your LLC can be treated as either a C Corporation or an S Corporation (more on those below). This could help reduce your self-employment tax liability.

We have a series of articles with helpful information about starting your business as an LLC that you can read here.

3. Corporation.

A corporation (sometimes called a C corporation or C corp) may come to mind when you think of a business — especially a big business. There are several types of corporations that you could consider, even if your business isn’t large.

Unlike a sole proprietorship or partnership, a corporation is a legal entity that's separate from its owners. Any profits, taxes, or legal obligations apply only to the corporation and not to its owners (shareholders).

While this provides owners significant protection from personal liability, corporations can be more expensive to establish than other forms of businesses. They also are legally required to publish annual reports, hold stockholder meetings, and conform to specific and often rigid management structures.

However, a corporation has more flexibility when it comes to funding. It can sell stock, in addition to securing loans and other investments.

Unlike sole proprietorships, partnerships, and LLCs, corporations sometimes are taxed twice on their profits. The corporation pays taxes on its taxable income, and the shareholders pay taxes on their dividends.

S corporation

If the idea of double taxation doesn’t appeal to you, you may want to consider an S corporation, or S corp. Similar to sole proprietorships, partnerships, and LLCs, profits and some losses can be passed through to an owner’s personal income, avoiding corporate taxes.

While this is true for federal taxation, some states have different laws regarding S corps.

An S corp has to follow the same operating rules as a C corp, but it’s limited to no more than 100 shareholders and they all must be U.S. citizens. S corps also have to file with the IRS to get S corp status.

Closed corporation

Also referred to as a “private corporation,” these businesses are owned by a few individuals, oftentimes family members, and they enjoy the same liability protection as C corps.

Being “closed” or “private,” they do not sell stock to the public like other corporations. This also allows them to operate without many of the reporting requirements and the shareholder direction of C corporations.

Nonprofit corporation

These businesses are often formed to do charitable, scientific, religious, or literary work. They must file with the IRS and, if they meet the requirements, can be exempt from certain federal and state taxes on their profits.

They have to follow rules similar to a C corporation, and there are restrictions regarding what they can do with their profits.

Cooperatives

While a nonprofit primarily operates to benefit people and organizations outside the company, a cooperative is owned and operated for the benefit of people who use its services. Credit unions are a good example of a cooperative organization.

The cooperative is made up of members who purchase shares. And like stockholders, they elect a board of directors and share in the profits.

Protect Yourself with Sole Proprietorship Insurance

OK, that was a lot to go through and make sense of. No doubt there are plenty of considerations to weigh and balance if you’re looking at becoming a sole proprietorship.

For many new business owners, a sole proprietorship can be the fastest, easiest, and most inexpensive way to get the ball rolling. The biggest concern for most owners? Personal liability.

Here’s something that can tip the scales in your favor. Sole proprietorship insurance. We specialize in helping small business owners protect what they’re building and let them put their thoughts and efforts into building it.

General liability coverage and professional liability insurance are two ways to keep you from pacing the floor at night and letting you wake up refreshed and hitting the ground running in the morning.

General liability insurance.

General liability (GL) insurance covers damages resulting from third-party accidents, physical injury, and property damage.

To give you an idea of what the financial risk can look like for your business, the average claim those surveyed reported for a customer injury or damage was around $30,000. Without insurance, a one-time accident could potentially bankrupt a small business and even affect your personal assets.

Need some perspective on when business insurance could protect you? Imagine you’re cleaning a customer’s carpet when your (once trusted) machine’s fluid reservoir explodes. All of that liquid leaks through the carpet and onto the wood floor below, causing significant damage.

It would be an unfortunate accident, but one that your customer could possibly sue you for.

If you have GL insurance for your cleaning business, it could cover damages and legal fees if your customer sues you up to your policy limits. Without insurance, you’d need to clean out a big piggy bank to recover your costs.

Professional liability insurance.

Unfortunately, breaking a window or having someone trip and fall aren’t the only hazards you need to be concerned about.

You can simply make an honest mistake. It comes with being human. And it doesn’t always have to be a huge mistake. Sometimes, it could be something you overlooked or that just slipped through the cracks.

At Simply Business, we can help keep you protected with professional liability insurance.

It’s something to strongly consider, especially if you’re providing a service such as software design, for example.

Imagine you’re up late writing code for a healthcare client. You’re tired and make a mistake. Unfortunately, your error leaves a back door into the software wide open. A few months after delivering the code, your client accuses you of negligence and sues for damages.

If you have professional liability insurance, your policy can help cover the damages and the legal and litigation fees (up to your policy’s limit).

With coverage, you’re less likely to dip into your personal assets and more likely to get back on your feet financially. The truth is, a lawsuit can happen to anyone. You want to be prepared if it happens to you.

OK, Just One More Thing

There you go. There’s a good, hard look at what you might have to deal with if you run your business as a sole proprietorship.

It can be risky. It can be consuming. It can be hard. But as the character Jimmy Dugan says in the movie, A League of Their Own, “It’s supposed to be hard. If it wasn't hard, everyone would do it. The hard is what makes it great.”

It also can be rewarding. It can be profitable. It can be something you’ll be proud of the rest of your life. And if that’s what matters to you the most, congratulations. You have the soul of a sole proprietor.