As a hardworking freelancer, you may find the legal side of operating your business somewhat puzzling at times. There are plenty of freelancers who find themselves pondering sole proprietorship pros and cons. Or wondering exactly what an LLC is, and which format would be best for their specific business.
If you are one of these people, you’re not alone.
At Millo, we’re here to help you discover what might be the ideal business structure for your purposes. In this article, we’ll be covering exactly what it means to establish a sole proprietorship. We’ll also examine what your options are when it comes to registering your business.
Hopefully, we will be able to help you decide on the optimal entity for your freelance operations. Then, you can get your new business off the ground as soon as possible.
What is a Sole Proprietorship?
A sole proprietorship is the most basic of all legal business structures.
Many startup entrepreneurs choose to list their businesses as sole proprietorships. Although not all of them know whether it is the best choice for their needs.
Essentially, a sole proprietor is a business consisting of just one person without corporation or limited liability status. This individual represents the company legally and in full at all times.
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Some of the most commonplace proprietorship structures include new startups, direct sellers, part-time businesses, consultants and contractors.
According to the IRS, a sole proprietor is someone who owns an unincorporated business by themselves. They also note that if you are the only member of a domestic limited liability company, or LLC, you are not a sole proprietor if you choose to treat this LLC as a corporation.
Sole Proprietorship Pros and Cons Explained
The Pros of a Sole Proprietorship
1. Low Startup Expenses
Many startups and young small businesses battle with limited capital during their infancy.
The expenses associated with establishing and operating a corporation are far higher and more complex than those associated with setting up a sole proprietorship.
Most corporations require the assistance of lawyers during their formations. While sole proprietorships can be easily established and listed by their founders.
Another major perk of establishing a sole proprietorship is that you, as the owner, can keep all of your business’s profits to yourself. If you were in a partnership or a corporation that has co-owners and investors, your profits would get divided among these individuals instead.
2. Quicker and Simpler Tax Preparations
If you choose to list your business as a sole proprietorship, filing your taxes will be significantly easier in general than it would be if you were filing taxes for a corporation.
All you need to do in this case is to file an individual income tax return that includes your freelance business’s profits and losses. If you’re based in the US, you would use IRS form 1040 to file your business taxes.
Your individual and business incomes are considered one and the same. Self-employed tax rates and regulations will apply to you.
Business owners who have listed as sole proprietors can make quick, independent decisions about taxes and other financial operational matters. You will have full control over how you manage and run your business.
You will not be beholden to discuss issues with shareholders and partners before you can devise solutions and handle pressing issues. However, be warned. If you make a poor decision, the responsibility to rectify it rests solely on your shoulders.
3. Streamlined Money Handling Processes
Handling money while operating a sole proprietorship is vastly simpler than it is for other business structures. This is one of the lesser known sole proprietorship pros and cons, but it is one of the most beneficial.
Having a sole proprietorship to your name means that you don’t need to set up payroll to pay yourself.
However, it’s recommended that you set up a separate business bank account to keep your company’s funds separate from your personal money. In doing so, you’ll avoid mixing your personal and business activities, which can complicate your finances in the long run.
The Cons of a Sole Proprietorship
1. A High Degree of Personal Liability
If you choose to list your small business as a sole proprietorship, you will be personally and solely liable for all of your company’s actions and debts.
Unlike an LLC or a corporation, your business will not exist as a separate legal entity. Your own personal assets and finances link directly to your business.
Entrepreneurs who operate in high-risk industries, such as manufacturing, tend to gravitate towards corporate structures because of this. But as a freelancer, your personal risk should be minimal when choosing this business structure.
If a sole proprietor’s business encounters an issue or incurs debt and other financial obligations, they risk losing their own personal money. Sole proprietors also put their personal properties at risk, should their businesses fail or face legal proceedings.
Corporations keep personal and business assets very separate. But in a sole proprietorship, your personal and business assets have no legal separations between them. If any costly issues do arise, you will have to handle them on your own.
Speaking of personal liability, it’s also important to know that many sole proprietors find it challenging to strike a healthy work-life balance.
As the sole owner and operator of your company, you may find you spend most of your time running your business and tending to any issues that may arise. And holidays may be hard to come by.
You may need to make a concerted effort to set aside time for yourself, your family and your loved ones to ensure that you don’t develop burnout.
2. General Lack of Financial Control
Sole proprietorships have somewhat looser structures than other business forms. As such, they don’t require the maintenance of company minutes. Nor do they need the publication of financial statements that a corporation requires.
This lack of accounting control may seem like a boon to begin with. But it can spell trouble for your freelancer business if you aren’t careful.
Regardless of the legal structure of your enterprise, it’s essential to take time to set up proper accounting software to track your expenses and income. This will help you to keep your spending in check.
3. Expanding Can Be Challenging
Think about the probable state of your freelance business in 5 years’ time. Do you plan to still be operating it by yourself at that point? Or do you want to hire other freelancers and expand your operations later down the line?
Growing your freelance business will require cash capital to allow you to grab new opportunities and branch into different markets. It’s important to be aware that most outside investors are more likely to invest in your company if you are a corporation.
Corporations have investors who can make additional cash investments whenever the need arises. But sole proprietorships do not have this luxury at their disposal. This means that you may need to finance your business’s growth with personal business loans if you ever want to branch out.
Furthermore, sole proprietorships tend to pose limitations when it comes to business expansion and growth. This structure provides little room for growth. There is only room for one owner and employee—you. If you aim to expand your business in the future, you will need to change your business structure to do so.
Forming a Sole Proprietorship
In the eyes of the IRS, your small business is a sole proprietorship. Unless you have physically registered it under another structure, such as an LLC or S-corporation.
Establishing your proprietorship usually does not require that you register your business.
If you want to use a specific business name or an alias to operate your company, your state’s laws may require a trade name registration. Or they may demand that you file your company name to avoid bureaucratic confusion.
Picking the best business structure for your freelance enterprise will depend on a wide range of factors. Your type of freelance business, tax situation and your industry liability are just some of the many considerations.
Whatever your choice may be, it will have implications both legally and on a personal basis.
It’s recommended that you do your research. Work with a mentor if possible to determine the type of business structure that’s best for you. Especially if you plan to grow your operation in the future.
Paying Income Tax as a Sole Proprietor
A sole proprietorship will pay income taxes in the US by completing a Schedule C form and including this business income on the owner’s personal tax returns. The Schedule C will list all the income streams of your business and all the expenses you wish to deduct.
As a freelancer, you can even include home business expenses if you work from home. You can include the cost of your home office rental, power requirements, and office suppliers. You may also deduct vehicle expenses if you travel to the homes of your clients or your suppliers for business purposes.
Your total net income from Schedule C gets entered on Line 12 of your Form 1040, along with any income from other sources. You can then calculate your self-employment tax based on your freelance business’s net income and add this after your income tax is calculated. The self-employment tax and income tax must be totaled to calculate your total tax liability.
Sole proprietorships need to pay taxes in much the same way as other businesses do. All of these taxes must get reported and paid at specific intervals and amounts in order to remain compliant with regional tax requirements.
Over and above income tax, your business must also collect and pay sales taxes on all taxable services and goods sold. Plus, you must pay property tax on any land and buildings you personally own, and collect. And you must report and pay employment taxes if your sole proprietorship has any employees.
The Importance of Insurance for Your Sole Proprietorship
As a sole proprietor, all of your business’s liability will fall on you. It will be up to you alone to settle lawsuits and financial claims against your enterprise. This is why it is essential to have the right insurance policies in place to mitigate your risks.
You can lower your risks as a sole proprietor by taking out sole proprietorship insurance. Depending on the nature of your business, you may need to buy more than one different type of liability coverage.
There is a wide range of different insurance policies that can protect your freelance business. Many of which are designed specifically for sole proprietorships. They include general liability insurance, product liability insurance, professional liability insurance, commercial property insurance, workers compensation insurance, and home office insurance.
Contact your business’s insurance carrier to discuss your personal needs and find the right coverage types that will best protect your company from liability.
Is a Sole Proprietorship Right for You?
You’re now aware of the main sole proprietorship pros and cons. But you may still be unsure of whether or not this structure is right for you.
We recommend asking yourself the following questions to assess whether or not this structure is the right fit for your freelance company.
- Am I capable of handling 100% of my business’s responsibilities, even while I am away for business reasons or traveling for personal reasons?
- Do I want to operate my freelance business on my own without assistance from other employees, shareholders, and owners?
- Am I willing to handle these responsibilities and my business’s liabilities and risks in full?
- Am I equipped to make important decisions that could affect the future of my freelance business?
- Can I handle the stress and daily demands of being a sole proprietor?
- Am I happy for my personal and professional financial situations to be legally considered one and the same?
- Am I comfortable being solely personally liable for my entire business and all of its assets?
If you’ve positively answered all of these questions, a sole proprietorship may be perfect for you.
If Not a Sole Proprietorship, Then What?
There are a number of other business structures that may suit your freelance business if a sole proprietorship is not right for your needs.
Limited Liability Company
The LLC business structure combines many of the benefits of other business entity types. It provides its owners and members with limited liability for the business risks and debts associated with its ownership. This could be ideal for when your freelance business grows larger and you sign more freelancers on board.
LLCs also avoid the ‘double taxation’ that most corporations face by functioning as a flow through entity for the purpose of income taxes. Read more about how to go from a sole proprietor to an LLC here.
The S-corporation is often considered to be a hybrid business structure that offers many of the best features of other types of entities.
This is a legal entity that gives its owners the benefits of significantly limited liability. All while still allowing company profits and losses to flow directly to the business owners for the purpose of income taxes to avoid double taxation.
The costs and legal requirements associated with starting an S-corp are relatively modest. The regulatory requirements are also usually simple enough to fulfill too. S-corporation structures do place limits on the number of owners that can operate a business, and may not be owned by a C-corporation.
C-corporations can be expensive and time-consuming to establish and to maintain. However, this structure gives you the greatest amount of business risk and liability protection as the owner of a C-corp.
Businesses of this structure are governed by stringent government regulations and disclosure and reporting requirements.
C-corporations have unlimited lives, and their ownership rights will pass on to selected heirs if an owner were to pass away. This corporate entity boasts plenty of income tax flexibility, and offers the widest range of tax deductible benefits.
However, it can also be double-taxed on some corporate profits. It’s taxed both at the corporate and individual levels, as taxable dividends are paid over to shareholders in the business.
Make The Move For Your Business
Now that you know about sole proprietorship pros and cons and how you can benefit from adopting this business structure, you should know that a whopping 73% of businesses in the US are sole proprietorships.
Sole proprietorships are easy and inexpensive to form. They give you a high degree of control over your operations and your finances, and simplify your tax preparations. Plus, they pose less paperwork at the end of the day.
After weighing out the sole proprietorship pros and cons, and you’re ready to take the next step to establish a sole proprietorship, you will already know that the process is relatively simple.
You can get started by establishing a name for your business, opening a business account, obtaining a business license, and applying for state-specific permissions and permits.
You’ll be ready to take your freelance business to the next level in no time.
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