The sole proprietor, or sole trader, is the most common type of business entity in the U.S. It’s also the default business entity if you decide not to incorporate your business.
Today, there are more than 23 million sole proprietorships operating in the U.S., and this number continues to grow every year. Be aware of the risks of becoming a sole proprietor and develop a strategy to protect your business and your personal assets.
Let’s dive into the most common risks sole proprietors must deal with.
No Liability Protection
Entrepreneurs who opt not to incorporate their businesses must know that operating as a sole trader means you have no liability protection.
Sole proprietors are always personally liable for the debts of their businesses, meaning if someone sues, it comes out of your pocket. Your personal assets could also risk settling legal cases and covering legal fees.
There are actions you can take. A comprehensive insurance policy can offer you liability protection, but it will cost you. Various sole proprietors’ insurance options exist, so ensure you do your research to avoid the consequences of operating with no built-in liability protection.
It is well-known that established investors and lenders are naturally more hesitant about lending to a sole trader. In the eyes of many, sole proprietors are not true businesses because they are not viewed as separate legal entities.
You may not be aware that entrepreneurs often incorporate their businesses after terms as sole traders purely to increase their chances of being taken seriously by third parties.
Increased Tax Rates
Tax saving strategies are a natural part of doing business. But unfortunately, sole traders cannot take advantage of most common tax-mitigation tactics because they are not incorporated as a business.
Sole proprietors must pay taxes on all profits they make on their personal tax returns. However, corporations will only ever pay the standard corporate tax rate, which will always be lower than your personal income tax bracket if you’re a success.
Incorporated businesses can distribute as much or as little to the owners as they see fit. This is where intelligent tax-saving strategies can save thousands of dollars.
Sole traders must pay taxes from their personal tax returns and must also cover self-employment taxes. Sole proprietors are 100% responsible for paying these taxes.
Corporations have far more options available to them. Even LLCs can take advantage of these strategies because, as a pass-through entity, they can elect to be taxed as a C-Corporation or S-Corporation.
An unincorporated setup is not an intelligent decision if you are a successful business. Instead, consider it a stopgap during the early days of starting your business.
Difficulties Raising Capital
Investors want peace of mind that their money is secure. The majority of investors will even demand a portion of the business’s ownership in exchange for their support. It may involve them being a passive entity on the board or choosing to play an active role in day-to-day operations.
The situation creates problems for raising capital from investors because you have no legally established business entity as a sole trader. Therefore, you cannot offer ownership of your business.
Few angel investors or venture capitalists will entertain the idea of investing in any brand that has yet to be incorporated.
An incorporated business leaves investors with some recourse if the company collapses, payments are not made, or a dispute occurs.
Developing a Succession Plan
Younger entrepreneurs rarely give little mind to business succession plans. Anything can happen, and you may find yourself wanting to pass on your business to someone else. However, all companies need an established succession plan should the worst happen.
Sole traders will find it challenging to develop a succession plan because the business is not a separate entity and is entirely tied to you. Should you become incapacitated or die, the sole proprietorship dies with you from a legal standpoint.
Incorporated businesses are separate entities and can be passed onto someone else in your will. Remember, an incorporated business is also considered an asset, and the portion you own/control is directly attributed to you.
Why Incorporating Your Business is the Way Forward
Sole proprietorships are easy to establish because they typically don’t need to be registered. A sole trader is the default designation for when anyone starts a business.
However, you shouldn’t wait to incorporate it. Here are some of the reasons why incorporating your business, even as an LLC, is the best way to protect yourself and your livelihood:
- Easy Incorporation – Incorporating in most states takes no more than a few hours to file all the necessary documents. It also costs just a few hundred dollars, with some states costing even less. For example, it costs just $50 to file your new LLC in Colorado, with a $10 renewal fee per year.
- Protect Yourself – Every incorporated business type comes with a level of liability protection. Defend your personal assets should someone file a lawsuit against you.
- Simple Management – Contrary to popular belief, incorporation does not have to mean accepting complex managerial responsibilities. For example, LLCs require no board, no corporate meetings, and no minutes to record.
- Look Like a Business – Incorporating your brand gives you an elevated sense of credibility. Investors, banks, and even your customers will consider you more respectable when incorporating.
- Save Money – Major tax savings through credits and deductions are available by incorporating. Give yourself more flexibility to save more of your money by incorporating.
As you can see, there’s little reason not to incorporate. There are few major expenses involved, and you can still incorporate an LLC and avoid the challenges of trying to meet the obligations of owning a traditional C-Corporation.
Sole proprietorships are designed for tiny microbusinesses or entrepreneurs finding their feet and road testing a new idea. Ideally, you should aim to incorporate within the first few months of launching your venture.
Incorporation is more straightforward than you might think. Talk to a business attorney in your area to learn more about what it takes to make your business concept a reality.
What type of business entity best suits your business?