A recent Wall Street Journal article discusses what they call the "double whammy of bankruptcy" - the danger of owning a small business organized as a sole proprietorship and facing bankruptcy. While a sole proprietorship is very simple to start, there is no separate business entity, which means no separation between you and your business if your business finances go bad. Most small businesses (73 percent, according to the Small Business Administration) are sole proprietorships, and it is most likely that you will consider becoming a sole proprietor, or that you will become one by default. Let's look at this business type more closely, including the advantages and disadvantages of the sole proprietorship:
Advantages of a Sole Proprietorship
- Start-up. You can start a sole proprietorship easily, quickly, and cheaply. All you need to do is open a business checking account, get a business license from your city, and file a fictitious name/trade name registration with your county. Then, just start operating, marketing, getting customers, and taking in money.
- Control. As the sole owner of your business, you are in complete control. You do not have to answer to a board of directors, shareholders, or other owners of the business. Having this control is a big reason why many independent contractors and new business owners prefer the sole proprietorship.
- Tax Preparation Taxes for a sole proprietorship are also easy - you fill out a Schedule C reporting your business income and expenses, and the resulting profits are taxed to you on your personal tax return. You are taxed on the business profits at your personal tax rate, which can be lower than the corporate tax rate.
- Tax Rate. According to the Small Business Administration, sole proprietorship tax rates are the lowest of any business form (13.3 percent tax rate as compared to 26.9 percent for S corporations).
- Use of Losses. Losses on your business can be used to offset income from other sources (like your spouse's income, for example), as long as those losses don't cause the IRS to wonder if you are running a business or a hobby.
Disadvantages of a Sole Proprietorship
The primary disadvantage to a sole proprietorship is that your personal finances and those of your business are one and the same. You cannot file bankruptcy for your business without filing personal bankruptcy. You cannot expect to shield your personal assets from liability for the debts of the business, nor can you avoid being sued personally for negligence due to some problem with your business.
Having a sole proprietorship leads many small business people down a dangerous path. They assume that since they have a business entity and a personal entity, and they have set up a separate business checking account, that somehow the business and personal are not going to be combined if they get into financial trouble. Not true. If your sole proprietorship cannot pay its bills, your personal credit card will probably come into use. And filing bankruptcy for your sole proprietorship, whether it is a reorganization (Chapter 11) or liquidation (Chapter 7) means involving your personal assets. As stated by the U.S. Courts website (in the Chapter 11 section): "a bankruptcy case involving a sole proprietorship includes both the business and personal assets of the owners-debtors."
What are the Alternatives?
By the time you start to get concerned about your business and wonder if you will need to file bankruptcy, it is too late to change business structure. Before you get into financial trouble, consider other alternative business structures, particularly the Limited Liability Company (LLC) form. If you have personally guaranteed your business loans, though, you can't be protected from filing personal bankruptcy by forming a corporation or LLC (more on this tomorrow).
Before you make any decisions about business structure or bankruptcy filing, check with a tax attorney or adviser to discuss alternatives.
For More Information:
How Can I Avoid Having My Business Considered as a Hobby?