After conducting a Delaware entity search and checking business name availability, you registered your business as a sole proprietorship in The Diamond State, joining the ranks of Yelp, Facebook, and Coca Cola—and the thousands of other small businesses and Fortune 500 companies. Thanks to low startup and registration costs and pulling 80-hour workweeks, you did the unexpected and finished Year One in the black. While this is cause for celebration, you can’t help but wonder if now is the time to transition to another business entity. Should you? Or shouldn’t you? Read on to find out if you should always be a sole proprietor or incorporate as another business structure.
Why So Many Sole Proprietors?
More often than not, unless you are a tech startup, small business owners register as sole proprietors. Here’s why. First and foremost, the initial registration costs are nearly non-existent and registration normally takes an hour, at most.
Also, unlike corporations that must keep detailed records of shareholder and partner meetings, sole proprietors aren’t required to maintain nearly as much of a paper trail (however, know that you do need to keep track of business expenses, business receipts, contracts, etc.).
Why so many business owners register as sole proprietorships come down to the low cost and convenience of registration and less paper trail requirements. That being said, if you are a one-man (or one-woman) shop who have just started your business, you may not want to incorporate. But should you always stay as a sole proprietorship? Or consider making the jump to another business structure in Year Two, Three, or Four?
Lawsuits Are Especially Hard on Sole Proprietorships
Corporations and LLCs make up for their higher startup costs and less-convenient registration processes by giving owners liability coverage. This is something sole proprietors do not receive and pay for when they are sued. Since the law sees sole proprietors as both business owner and personal citizen, you are treated as one and the same.
Meaning, your personal assets are not protected, pierce the veil or not. Creditors looking to satisfy the judgment can come after business and personal assets. This includes funds in business and personal checking accounts, property, and even your income. Depending on the judgement, the sole proprietor could be stuck paying off the judgement debt for years to come—suffering professionally and personally. Unless in pierce the veil circumstances, LLCs and corporation owners aren’t subjected to personal asset seizure at all.
Should You Stay as a Sole Proprietorship?
If you are in an industry that gets sued often or have employees or a physical shopfront that customers frequent, the answer is a firm no. You stand a better chance of being sued, whether from an employee, landlord, or customer—especially since more than one-third (36%) to over a half (53%) of small business are engaged in alawsuit during any time of the year. Even if you are your only employee and work from home, doing business with other vendors still puts you at risk of a lawsuit.
The point is, sole proprietors are not exempt from getting sued and, like any other business, may become involved in litigation suits ranging from sexual harassment, wrongful termination, illegal and discrimination to breach of contract, contract disputes, and personal injuries.
Self-Employment Tax Cuts into Your Income
If it’s Year One, sole proprietors can pay Uncle Sam a one lump sum before the April due date. Afterwards, much like LLCs and other business entities, sole proprietors must pay quarterly tax installments. Time length alone may not be reason to break out a sweat (yet), but come time to calculate self-employment tax and you’ll wonder what happened to your ever-shrinking income.
Blame it on the self-employment tax rate, which sole proprietors must pay both as an employer and employee. It’s not uncommon—and is recommended—for sole proprietors to set aside 30% of their profits for self-employment tax. While new sole proprietors who are barely making the black won’t see so much of a deficit, those who’ve experienced business growth will notice a sizeable chunk out of their income. For example, if you made $50,000 this year, 30% (or $15,000) would go to Uncle Sam, which leaves you with $35,000 more or less.
Should You Stay as a Sole Proprietor?
If you recently experienced business growth and are looking to hire employees and expand your business, you may want to consider incorporating to another business entity. Other business structures, like S Corporations, offer owners to split profits as distributions and income where distributions bypass taxes.
Working in a Heavily Regulated Industry Makes You Question Sole Proprietor Status
Depending on the state and industry, it might not even be legal to register as a sole proprietorship. Medical and legal industries are too litigious for sole proprietorship to be considered an option and, as we’ve mentioned, may not even be illegal to incorporate as. Food preparation and manufacturing are two other industries where heavy regulation is too much of an issue for sole proprietorship to be put on the table. Industries with more leeway like writing, photography, graphic design, tutoring, etc. are easier to register as—and, in some cases stay as—a sole proprietor.
Should You Stay as a Sole Proprietor?
If you are a sole proprietor in any one of these litigious-friendly industries discussed above, you may want to incorporate to another business entity. You have so much to lose if you do get sued and the chances of this happening to you are increased since you work in such a riskier industry. In fact, it’s probably better if you don’t initially register as a sole proprietor so you have liability coverage from the start.
Is There Any Reason to Stay a Sole Proprietor?
When should you stay a sole proprietor? Should you always incorporate? The answer isn’t an easy yes or no; it depends on your business and what your goals are for the next 3,5,10…years. If you don’t expect your business to grow or treat your business more as a part-time gig than full-time employment, staying a sole proprietor may be your best bet—especially if you want to have some extra cash without much maintenance.
Also, if you work in an industry that isn’t sue-crazy, you may not need the liability coverage as much (or as quickly) as businesses that are prone to litigation. While you may want to get business insurance for some protection, putting your personal assets on the front line is not as risky and, in fact, may be worth it for the many more benefits you get from the sole proprietorship status.
Make Sure You Can Differentiate Your Business from a Hobby
To prevent the IRS from labeling your business a hobby, you need to show proof of income. Why this is important is if the IRS sees that you don’t generate a regular income from your business, it may consider it a hobby which means you don’t get any business-related deductions.
What can be confusing is that sometimes, according to The Balance, hobbies are set up as businesses so “the owner” can claim business deductions he or she otherwise couldn’t if it was a hobby. Also, some hobbies do in fact (unexpectedly) become businesses. Situations like this are why you need to show detailed proof that your business is in fact a business. Corporations don’t have to go through these hoops since the IRS already sees it not as a hobby.
Final Thoughts: To Stay or Not to Stay as a Sole Proprietor?
There are a number of factors that determine if business owners should remain a sole proprietorship or consider incorporating as another business entity. If you are experiencing business growth or are in a litigious industry, it may be in your best interest to switch over to another business structure to avoid the high self-employment tax and personal asset seizure if sued.
For those who enjoy the sole proprietorship benefits, like convenient and low cost registration, incorporating as an LLC with a sole proprietorship status may be the easiest transition; business owners would still have a lot of the benefits except also enjoy the liability coverage an LLC provides.
Since every business is different, we recommend to discuss your options with an experienced financial professional to see which one is the best for you. Have you stayed a sole proprietor? Did you incorporate to another business structure? When did you incorporate? And why the change? Have you benefited from your choice? Do you want to go back to a sole proprietorship? If so, why would you? Be sure to let us know by sharing your thoughts by commenting in the comments section below.
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