The booming gig economy has created a host of sole proprietors, and understandably. This is the most simple business structure for any one person doing business, whether it's freelance work, professional consulting, or running a services business.
The benefits of sole proprietorships are that its startup costs are virtually non-existent and the owner is in unshared control of the business. As an added benefit, that there is no so-called “double taxation” of corporations, at the corporate and personal income tax levels. Under sole proprietorships, individuals simply pay personal income tax rates.
There comes a point, however, when it makes sense to consider other business structures, whether for tax purposes, liability or legacy. After all, many sole proprietorships began with an idea that grows into a viable business or a series of gigs that becomes regular income—a cookie recipe that everyone loved and became a bakery, a number of freelance articles that became a vertical content creation company.
At the end of the day, a sole proprietorship may still be the best way to do business, but it's important to understand the pros and cons of other options. Here are six reasons to rethink your sole proprietorship.
1. Protecting Your Assets
Perhaps the top reason for ditching the sole proprietorship for a limited liability company (LLC) or corporation is legal liability. As a sole proprietorship, the owner’s assets are not legally protected from liability. Whether because your assets have grown or your business has expanded from a part-time gig to a full-blown enterprise, it may be time to change business structures to protect your personal assets.
2. Raising Outside Capital
When a business grows and seeks new opportunities beyond its ability to self-fund them, it may be necessary to seek investment capital, either through debt or equity investors. Banks and investors often treat sole proprietorships as a liability, as there are no required business plans, no operating agreement, and no company assets to value against their investment. Although many funding sources prefer corporations, LLCs have become more acceptable to banks and investors.
3. Buying a Home
As the ranks of self-employed individuals have grown, lenders have become more accustomed to underwriting mortgages and personal loans based on their income. In theory, these individuals receive the same access to home loans as standard employees, but in practice the hurdle may be higher than someone who is an employee, even if the employer is one's own firm.
While the prospect of buying a home should not be the sole driver for nixing a sole-proprietorship, it is one reason to look at whether another arrangement might make more sense.
4. Hiring Employees
Sole proprietors can and frequently do contract with others to help them with everything from accounting to marketing. At some point, however, the business may require bringing more people on board. Hiring a second person to provide support or expand capacity is a key trigger for looking at business structures beyond a sole proprietorship.
5. Adding a Business Partner
Much like adding a new hire to the team, bringing on a motivated business partner to help grow the operations will test the limits of a sole proprietorship. The new partner’s association with the business has legal and tax implications that a sole proprietorship can’t address. Further, the business partner may want or be offered an ownership stake in the business, pushing the sole proprietorship to, at a minimum, a partnership structure.
6. Selling or Gifting a Business
Passing a sole proprietorship on to a successor is exceedingly difficult. According to LegalZoom, an online legal resource, a sole proprietorship's assets are categorized as probate property. That means any sale of those assets would go through the probate process. Meanwhile, the sole proprietorship itself is non-transferable, so a successor would receive its assets, which are subject to probate court.
While every setup is different, many sole proprietors should eventually think about succession planning. A company may be based on the power of one, but there can be a great deal of value in the customer relationships, assets and institutional knowledge built over time.
The sole proprietorship structure may continue to work for those who keep their businesses small, simple and manageable and do not want to pass it on to a buyer or family member. Still, these and other instances should raise the question of whether it's time to reorganize.