As an entrepreneur, launching a new business in the era of COVID-19, it is understandable that you want to get it up and running as soon as possible. This desire to launch quickly certainly makes sole proprietorship appealing. After all, as a sole proprietor all you really need to do is just start conducting business. However, sole proprietors face significant risks that those who incorporate their businesses will not face. Here are five common sole proprietor business risks you take on, if you decide to forgo incorporation and operate as a sole proprietor.
1. Increased Tax Rates
As a sole proprietor, you’re at risk for higher taxes. Without a corporation, all of your income is subject to the marginal individual tax rate; whereas if you incorporate your business, you are only taxed on the money you actually pay yourself as an employee. This is important because the flat corporate tax rate may be lower than your individual tax rate.
Also consider that as a sole proprietor, you’ll be responsible for paying self-employment tax. The self-employment tax covers your Medicare and Social Security contributions, which you are wholly responsible for paying as a sole proprietor. As an employee of your own corporation, the corporation pays half of these for you.
Finally, consider that sole proprietorships are far more likely to be audited by the IRS than a corporation. Anyone who has been through an audit will attest that the experience was not pleasant. They usually have no desire to repeat it.
2. Unlimited Personal Liability
Business debts and lawsuits filed against you as a sole proprietor expose your personal assets. In other words, if you operate as a sole proprietor, and you are sued, your car, home, personal bank accounts are all fair game for legal claimants or creditors. Conversely, when you incorporate your business, the business is a legal entity completely separate from you. This limits creditors or claimants’ ability to seize your personal assets.
3. Failure to Raise Capital
Investors want to know that their investment is secure. They frequently require ownership in your business, in exchange for funding. As a sole proprietor, there is no legally established business, making it impossible for you to offer ownership. As such, venture capitalists and angel investors are unlikely to help fund your ideas, without a legally established corporation. (Just imagine going on “Shark Tank” and trying to convince Mark Cuban to fund your business idea by writing you a personal check, with absolutely no ownership, nor reassurance that he will get any of his money back). Even relatively inexperienced investors are extremely unlikely to back a business that is not incorporated.
4. Inability to Secure Customers
As a brand-new business owner, you’re going to need to drum up customers. It is certainly possible to earn some customers through word-of-mouth marketing/advertising, and through family and friend connections. However, when it comes to attracting new customers who don’t know you or don’t have a connection to you, it can be extremely challenging as a sole proprietor.
Having a corporation shows that you’re serious about your business; that the business you’re operating is a unique, legitimate company. By contrast, as a sole proprietor, you’re really just marketing yourself. This lacks the structure and legality of an incorporated business.
5. Challenging Succession Plans
When you operate as a sole proprietor, there is no distinction between you and your business. Therefore, in the event of your passing, or incapacitation, there technically isn’t a business to pass on to an heir, or even a colleague, informal partner, or co-worker. To put it in blunt terms, as a sole proprietor, when you die, your business—at least from a legal standpoint—also dies. When you incorporate, your business is a separate entity from you and may be passed onto another in keeping with your wishes.
When it comes to launching a business today, the adage that haste makes waste resonates loudly. While it may be exciting to launch your business as soon as possible, as a sole proprietor, it’s vital that you legally incorporate your business as soon as possible, to mitigate unnecessary exposure, and to prevent avoidable mistakes.
Incorporating your business protects your personal property, limits your legal exposure, allows for succession planning, and helps give your business legitimacy and credibility.