Pros and cons of organizing as a sole proprietorship

When I ask entrepreneurs what type of business they plan to start, I can always count on hearing exuberant descriptions of innovative product and service ideas. Yet, when banks, credit card companies, and suppliers ask the same question on applications, they expect a different sort of response. They seek to know a company’s legal business structure before making credit decisions.

Why does a company's business structure matter so much? And what is it startup entrepreneurs may not know about the business structure that influences so many other important decisions?

The quick answer to these questions is that a company's legal structure determines income tax rates, the "ownership" of company debts, and the ease in which owners can invite partners and investors into a business.

The simple terms of a sole proprietorship

The leading business structure options available to startup entrepreneurs in most states are a sole proprietorship, a limited liability company (LLC), or one of several types of partnerships and corporations.

The most popular form of business organization—preferred by more than 18 million small-business owners—is the sole proprietorship. The great advantage of a sole proprietorship structure is that it is simple and inexpensive to organize. This means startup entrepreneurs get to spend more time pursuing customers than doing paper work.

Another benefit: the ease of tax reporting. Entrepreneurs simply need to add up all relevant business income and expenses and report them on Schedule C of a personal income tax return. It's that easy.

In contrast, organizers of C corporations must prepare a personal income tax return as well as a more complex corporate tax return. In addition, in order for entrepreneurs to keep their corporation in "good standing," they must prepare formal financial statements and keep accounting books and records that are separate from personal income tax information. All of this adds to the administrative costs of running a business.

Sole proprietorships also make it easy for entrepreneurs to start and stop business activities at will. This benefit can be cost-effective for sole proprietors who work part time, or unemployed workers who hope to rejoin the workforce in the near future.

You can avoid double taxation

A key tax-saving benefit of a sole proprietorship is the opportunity to bypass traditional higher-rate corporate taxes and just report business-related income on a personal income tax return. Equally, entrepreneurs may apply most business losses on a personal return, thereby reducing personal tax obligations too.

In contrast, organizers of C corporations are first taxed at standard corporate income tax rates and then again to the extent that the business pays dividends to founding entrepreneurs and other shareholders. This is called "double taxation."

Entrepreneurs can also receive the same beneficial single-tax (often called "pass-through" or "bypass") treatment as sole proprietors through a limited liability company, a general partnership, and if elected, an S corporation business organization.

Despite all the tax and time-saving advantages of a sole proprietorship organization, it still may not be the best business structure for every startup entrepreneur. Here are four types of businesses where a sole proprietorship might not be the best legal structure.

1. You run a high-risk business operation.   Do you produce or sell toys, food, or medical products, or work within an industry that is known to be litigious? Do you offer professional advice as part of your service to customers? If so, you might consider organizing your company as something other than a sole proprietorship. If your startup doesn't have the financial resources to pay the costs of the wrongful acts of employees, bank debts, or liability claims, then you may be personally responsible for these obligations. Business structures that can shield owners' assets from business debts and liabilities include corporations and limited liability companies.
2. You are appealing to investors.   Startup entrepreneurs who expect to raise money from foreign investors, corporations, venture capital funds, or "angel" investment clubs should consider a C corporation. Professional investors mostly prefer to invest in C corporations for flexibility in issuing shares of different classes of stock to an unlimited number of shareholders, and the ability to easily carve out portions of a business for sale or joint-venture activities. Ambitious startup entrepreneurs who are working toward the day they can take their companies public on a U.S. stock exchange, or sell to a large corporation, should organize as a C corporation too.
3. You offer employee incentive plans.   Creative yet cash-poor entrepreneurs have long offered initial employees and even professional-service providers the opportunity to earn equity in a business, in exchange for their business-building assistance. The administration of most types of equity grants, particularly stock option plans, is best suited to C corporations.
4. You want to keep your business assets separate.   Entrepreneurs who want to keep business assets separate from spouses who share bank accounts should consider a liability-limiting structure that doesn't mix business income and losses on personal tax returns. While it may seem a little sneaky or deceitful to separate your business interests from spouse's assets, I believe it can be an act of love. Think about this. It's better to take steps to keep potential business losses within a business, than for two people to potentially lose everything they have ever owned as individuals or as a married couple.

Fortunately, young companies have many options when it comes to business structure. Think carefully about your short- and long-term goals, and if needed, consult a small-business tax or legal expert if you're still unclear on the proper organization for your business.

About the author   Susan Schreter is a Seattle-area investment banker and venture-funding expert serving startup entrepreneurs and fast-growth company executives. She also teaches business financing and entrepreneurship at business schools, angel forums, and microfinance organizations in the United States and internationally. Write to Susan at susan@takecommand.org.