Introduction to Sole Proprietorship
Today we’re gonna talk about the advantages of sole proprietors. Now, I tend to look at sole proprietors, and know that about anywhere between 60% and 70% of the small businesses are organized that way, and I scratch my head, because they leave a lot of money on the table.
But there’s a reason that there’s 60 to 70% of people that are doing them that way that are opening their businesses. And that’s because they are flipping easy to start just by saying, “I’m in business.” So I could literally go outside today, get a tool belt, and say I’m in the plumbing business, go out and start soliciting people, and I’d get my business license, depending on where I live.
(00:45) And in some places you don’t even need that, and I could just start running a business, and say, “Go ahead and pay it to me. I am my business.” Because that’s what a sole proprietor is.
Filing Taxes as a Sole Proprietor
A sole proprietor files all of their taxes on your personal tax return on a Schedule C. So it’s really easy. In fact, I don’t even have to get a separate tax identification number, if it’s just me. I don’t even have to change my name, it could just be me. I could just decide that I am a business tomorrow, I don’t even need a separate bank account, technically. Now, all of that stuff sounds really, really good, and it’s really easy, but it comes at a cost.
Risks of Sole Proprietorship
Number one, there’s really a blurred line between you and your business. And as a result, the IRS loves to attack sole proprietors. In fact, if I have company A set up as a sole proprietor, and company B running as a S corp, company A will be audited 1000% plus more. Actually, in 2018, the last years that I have the current data for, it was 1200% greater for a typical business making about $100,000 a year, which is really, really ugly.
If it’s a smaller business, let’s say that it’s just the Joe Schmoe making $40,000 a year. It’s still a multiple of more than 400% higher, which is kind of scary. Now, here’s the number that freaks me out the worst: the sole proprietor loses that audit more than 94% of the time, which means like 9 times out of 10, you’re gonna owe more tax.
Legal Concerns
And the reason is ’cause there’s such a blurred line between the business and the individual. So I tend to go do something else. So I’ll almost always create some sort of structure, even if you want to be taxed as a sole proprietor, I’m gonna create a bright line around somebody, I’m an attorney, that’s what I do.
(02:53) I don’t wanna leave it to chance. I’m gonna create an LLC, or something along those lines, and I could still treat it as a sole proprietor, I could make it disregarded for tax purposes where you just file the same Schedule C. So if you are just keen on this idea of being taxed as a sole proprietor, ’cause you have been told it’s easier, you could still do it that way.
(03:15) But as an attorney, I could never, ever tell you it’s a good idea to operate a business in your name, and the reason being is really simple. Because you and your business are one and the same.
Personal Liability
So just as a sole proprietor is easy, it’s also easy for somebody to sue you for everything that you have personally, and follow you around the rest of your life, suing you every year, then garnishing your wages for the next 50 years. It doesn’t stop. They literally can just keep attacking you until you die. Or you go bankrupt if the type of debt that is incurred is dischargeable. So it’s one of those things that can follow you around.
(04:15) So you never, ever, ever operate legally as just a sole proprietor. You always put some sort of entity around it to make sure that you don’t find yourself in a situation where you are ruing the day you decided to do business with somebody X, or that you contracted with somebody Y, or that you put yourself out there, and maybe you did business with somebody else, and they ran off with all the money, and left you with all the bills, and the next thing you know, it’s following you around personally.
Liability Shield and Business Continuity
We would never do that, we’re always gonna create a line. So let’s just look at sole proprietor, very, very easy. If you want it to be easy tax-wise, and again, there’s justifications in doing it a little more complex, ’cause you make more money, which I’ll go over in a second.
But let’s say you just say, “Boy, it’s so easy, everything’s easy. I just don’t wanna have to worry about it, I just wanna put it all on my personal return.” Okay, but we’re still gonna draw a box around it, and isolate the liability, okay? We’re still gonna do that. Plus, we wanna have something that doesn’t die along with you. If you’re disabled, or if you pass away, we wanna make sure that the business does not die that same day.
Financial Limitations and Self-Employment Tax
Sole proprietors, because they’re easy, they’re also low-lying fruit. And they pay the most in tax. They pay something called a self-employment tax, and they have reduced deductions, because if you’re the sole proprietor, you technically can’t be an employee of your company.
Something that we saw recently with the pandemic is that sole proprietors are treated as second-class citizens when it comes to relief, when it comes to banking, when it comes to loans. They weren’t even allowed to participate in the first round of the Paycheck Protection Program, because nobody knew what to do with them.
Difficulty in Accessing Business Loans
And that is because if somebody’s having difficulty recognizing the difference between you and your business, what are the chances of them loaning that business money when their fear is gonna be that you’re just gonna take it personally? It’s a very valid fear, especially if the money’s going into the same account, so they are less likely to do a traditional business loan to that business.
(06:26) What they’re probably gonna do is give you a loan personally, and just let the business put the business name on it, or maybe something called a DBA, and it’s really just a disguised personal loan.
Tax Savings of Incorporation
You want to make sure that you’re creating some separation, and you also wanna take advantage of some tax advantages. One of the things about a sole proprietor is that every dollar you earn is subject to something called a self-employment tax. That is, in part, old age, death, and survivors, social security, and Medicare. And it adds up to 15.3%. Now, the old age, disability, and survivors phases out when you get up over about 137,000. It adjusts annually, so you’d check that out, but it’s around 137,000, where it starts to phase out and just go to the Medicare portion, which is 2.9%. Well, that 15.3 is a big chunk of money.
Benefits of an S Corporation
You could avoid about 2/3 of that, simply by being an S corp. And it makes life a lot easier, saves you a lot of money, and then you become an employee of the S corp, which opens you up to something called an accountable plan, which allows you to save even more money.
If you are a sole proprietor making about $100,000, and you’re an S corp making about $100,000, the difference in taxation between those two is gonna be pretty close to 10%. The S corporation is going to get to keep about an extra $10,000 a year that you’re going to give up because you were lazy and you were a sole proprietor.
The Drawbacks of Staying a Sole Proprietor
Sole proprietorship may seem easy, but it leaves you exposed liability-wise, and you end up paying more in tax.
Once you do that, you get lots and lots of benefits. Sole proprietors are easy, but if you choose to go that route, it will cost you extra money. Now if you’re making $10,000 a year, you may say, “Eh, maybe it’s not worth it.” But if you’re making $100,000 or $200,000 a year, you’re crazy to operate as a sole proprietor.
Final Thoughts
The big question people ask is, “Why do so many people still operate as sole proprietors?” And the answer is simple: it’s the default. If you do nothing, you’re a sole proprietor. If you don’t make an election, it just happens that way.
A lot of accountants default to it, too, because they say it’s easier. It’s easier for them to prepare your taxes as well. But just because it’s easier doesn’t make it better. What’s easiest is rarely what’s best. Be smart. Do what’s right for you and your business. And get the legal protection and the tax benefits that you deserve.
