Sole proprietorships: simple, but not very flexible

By Joseph Anthony

I was at a seminar listening to a lawyer talk about factors to consider when choosing your business's legal form — sole proprietorship, S corporation, C corporation, Limited Liability Company (LLC), etc. A member of the audience, probably figuring that what the lawyer does for himself would be a good guide, asked how the attorney operated his own business.

"I've been a partnership, a C corporation, an S corporation and a Limited Liability Company," the lawyer said. "Right now, I'm a sole proprietor — but that may change in the next few months." So much for viewing him as a role model.

I think that small-business people can never just choose the form for their business and say, "That's that." It's not just that our businesses change over time. The tax laws and other regulations that influence the way we operate also are in constant flux.

The vast majority of small businesses start as sole proprietorships. Many self-employed folks run their businesses for years or even decades as sole proprietorships.

The chief appeal of sole proprietorships is that they are simple, simple, simple. Boy, are they simple. Just a few examples of their simplicity:

Simplicity in taxation. Sole proprietorships have the simplest form of tax filing. You don't have to file a separate return. As a self-employed individual, all of your income and expenses are reported on your personal income-tax return. You file a Schedule C for business profit and loss, along with forms for automotive costs, equipment depreciation and other expenses, when you send in your Form 1040.
Simplicity in formation. You don't have to pay any fees to the IRS or the federal government for starting your business. At the state level, you may have to pay a fee and file a form reporting the name of your business. But use your own name as the name of your business and you typically don't even have to do that. (People in licensed occupations — architects and attorneys, for example — do have to pay separate licensing fees.)
Simplicity in employment. As a sole proprietor, you don't have to worry about paying employment or unemployment taxes for yourself. You make your tax payments quarterly. I usually have sole proprietors make quarterly payments based on their previous year's total tax bill, with appropriate adjustments if their income looks to be significantly higher or lower this year.
Simplicity in home-office deductions. If you have a dedicated space that you use regularly and exclusively as your place of business, you may qualify for a home-office deduction. It's not so easy once you incorporate. The tax code effectively restricts owners of S corps, for example, from getting the full benefit of the home-office deduction.
Simplicity in retirement plans. As a sole proprietor, you can put money into a Simplified Employee Pension (SEP), a SIMPLE plan, a Keogh or an Individual Retirement Account. Figuring out how much you can put into each plan and how they interact aren't so simple, but that's a function of how Congress has created and revised and re-revised the rules for retirement plans.

Simple though it is, the sole proprietorship is not for everyone. (If it was, there wouldn't be those other types of businesses, now would there?)

For example, an entrepreneur with a profitable business who wants to set up a fully deductible health benefits plan will want to know more about a C corporation. A sole proprietor looking for some liability protection with a minimum of additional paperwork will probably consider an LLC. Anyone who wants to bring in partners or outside investors is going to have to look at a partnership or corporate structure. The self-employment tax (15.3% on the first $76,200 of net income, compared to the 7.65% you pay as an employee) drives sole proprietors nuts, even with the partial offset of being able to take an income deduction for half of the tax paid.

Because of the unlimited personal liability of sole proprietorships, legal professionals often suggest that another form of business be adopted once a sole proprietor takes on employees. Indeed, most of my clients who have employees have conferred with a lawyer and incorporated.

But I know at least one businesswoman who remains a sole proprietor, feeling it is the most convenient setup for her, even though she now has several employees. Her answer to concerns about liability: "That's what insurance is for."

Her business: She owns an accounting firm. Guess it proves there are exceptions to just about every rule.