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| Sole Proprietor C Corporations S Corporations Limited Liability Company |
TYPES OF BUSINESSES
The sole proprietorship is perhaps the most common form of business
ownership. Conducting business as a sole proprietor has distinct
advantages and disadvantages. You should be aware of these
characteristics, as they can have a significant impact on your business.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned by one person
(hence, the term sole). The owner of a sole proprietorship is known as a
sole proprietor. If you conduct your business through a corporation, your
business will not be a sole proprietorship. If you share ownership of your
business with someone else, including your spouse, your business will
not be a sole proprietorship.
The most important feature of a sole proprietorship is that the law makes
no distinction between you, the sole proprietor, and your business. Virtually
all the legal and tax consequences associated with sole proprietorships
flow from this essential element.
As a sole proprietor, you can conduct business under your own name or
under a trade name. For example, let's say I am a janitor. I can conduct
business under my own name, Marsha Still, Janitor. Or, I can conduct
business under a trade name, such as Still Clean. ( In either case
--whether you conduct business under your own name or under a trade
name--if you are the sole owner of an unincorporated business, your
business will be a sole proprietorship, and you will be the sole proprietor.
A sole proprietorship can hire any number of employees. Because the law
makes no distinction between you, the sole proprietor, and the business,
you are not considered an employee. Sole proprietorships may also hire
any number of independent contractors. Whether you have zero or 100
employees (or independent contractors) makes no difference. If you are the
sole owner, your business will still be a sole proprietorship.
Starting business as a sole proprietorship
Your sole proprietorship exists as soon as you start doing business. Let's
return to our plumber example. As a plumber, my sole proprietorship starts
to exist as soon as I do my first plumbing job. Consequently, the legal and
tax implications of doing business as a sole proprietorship will also exist
as soon as I do my first work as a sole proprietor.
The advantages of doing business as a sole proprietor
Conducting business as a sole proprietor brings two tax advantages.
These advantages arise because the law makes no distinction between
you and your business.
The first advantage is avoidance of double tax. What, you may ask, is
double tax? Basically, double tax can occur if you conduct your business
through a corporation rather than through a sole proprietorship.
Corporations pay income tax separately from their owners. Double tax can
occur when you (through your personal tax return) and your business
(through its corporate tax return) must both pay taxes on the same dollar of
income. As a sole proprietor, you will not pay double tax on your business
income because the law make no distinction between you, the sole
proprietor, and your sole proprietorship. All your business income is
treated as your personal income.
The second tax advantage of sole proprietorships is that you can deduct
your business losses to the extent of your total income that you may have
from all sources, including interest, dividends, and gains from the sale of
nonbusiness property. Furthermore, if you are married and file a joint tax
return, your business losses will also offset your spouse's income. Your
ability to deduct losses as a sole proprietor may reduce your family's total
income tax burden and may be particularly useful during a startup or
downturn phase of your business.
The disadvantages of sole proprietorships
In the "real world," every action has a reaction. In the "legal and tax world,"
every advantage has a disadvantage.
The principle disadvantage of sole proprietorships is that you, the sole
proprietor, are personally liable for all the debts of your sole proprietorship.
The reason for this is, once again, the law makes no distinction between
you, the sole proprietor, and your sole proprietorship.
For an example, let's again assume that I am a janitor. While attempting to
fix a pipe, I accidentally flood my customer's basement with sewage. I am
personally liable for the damages caused by the flooding. This means that
my customer can look to all of my personal and business assets to pay for
the damage, including my bank accounts, my vehicles, my equipment, and
perhaps even my house!
You can reduce your personal liability in several ways. If you are married
and own your home with your spouse, you can shelter your house from
personal liability by holding title with your spouse as tenants by the entirety
rather than as joint tenants. You might also try to get a release from your
customers. For example, as a plumber before starting on a job, I would ask
my customers to sign a paper saying that they would not hold me
responsible for any damage I cause, including damage caused by my
negligence. Of course, customers may not want to sign such a release and
you may not even want to ask for it. Another way may be to purchase
insurance to cover potential damages, which you should do whenever
possible. However, insurance may be costly, and not every risk is
insurable. The best way to avoid personal liability may be to incorporate
your business. This will be discussed in more detail next month.
A second disadvantage of conducting business as a sole proprietorship is
that you may pay higher income taxes. I am sure you remember that as a
sole proprietor you report your business income on your personal tax
return. While you do avoid double tax this way, if as a single person your
total adjusted gross income exceeds $115,000, or as a married person
filing jointly your adjusted gross income exceeds $140,000 , you may pay
income tax at the highest rate. By incorporating your business, you may be
able to reduce your tax rate.
As a sole proprietor, you face two additional disadvantages. Starting in
1994, you cannot take any tax deduction for your health or life insurance.
There is no good reason for this; the Internal Revenue Code just does not
allow sole proprietors to take the deductions. A full deduction for your
health insurance and a deduction for a $50,000 life insurance policy is
available to corporations, so long as all employees of the corporation are
offered the insurance. If these deductions will save you enough money, you
may want to incorporate your business.
Conclusion
Every business is different. What may be advantageous to you may be
disadvantageous to someone else. However, because significant tax and
legal repercussions flow from your decision to conduct your business as a
sole proprietor, you should be aware of them. By being aware, you can best
avoid unexpected and unintended consequences.
| DOING BUSINESS AS A SOLE PROPRIETOR |
What Type of Business
Should You Be?
Should You Be?
| THE BRANDON GROUP, INC. |