Sole proprietorships are the most basic business structures available and the default for many solo entrepreneurs. If you have just started a business and not established a legal structure for it yet, then it is considered a sole proprietorship.
The reasons why they are so widespread include nominal legal costs and minimal, formal requirements. The simplicity and low costs explain why sole proprietorships comprise many small businesses. However, most entrepreneurs eventually give up this format and restructure their businesses into either corporations or LLCs. If you are already operating a sole proprietorship or preparing to open a new business altogether, then you may want to consider formal incorporation. Here are five reasons to restructure sole proprietorships:
1. Personal Liability Protection – Sole proprietors are personally liable if their businesses go under and accumulate significant debt. That liability means that your savings, property, and any other assets can be seized by creditors to settle the company’s debts. The reason this is allowed is that sole proprietorships do not legally separate the business from the business owner; they are considered one and the same entity.
When you create a corporation or LLC, a legal barrier is erected between business and owner. This barrier provides protection mainly for the owner’s personal assets from creditors and is known as ‘the corporate veil.’ Corporations or LLCs exist as unique entities and are responsible for taking care of their bills and obligations. It is this barrier that prevents business owners from worrying about unexpected events or other problems creating financial problems they are held liable for personally.
2. Securing Loans or Investors – Another primary reason to incorporate your business is it helps secure capital you will eventually need to grow your venture. Whether you are looking for a business loan or individual investors, your company will need a formal corporate structure to close funding deals. This restructuring is necessary because banks and investors can see that there is a legal separation between yourself and the business itself and are more comfortable because of it. Investors feel secure knowing that ownership shares can be issued, and banks are then allowed to issue business loans instead of personal ones.
3. Looking for Bigger Business Partnerships – During your venture’s growth phase, you may look for opportunities to partner up with larger companies in either joint ventures or act as a third-party vendor. Often, more significant partners will require your business to operate as either an LLC or corporation. This insistence on structure exists for a few reasons. First, large companies view LLCs or corporations as more trustworthy and stable than sole proprietors, for better or worse. Second, if a company hires a sole proprietor, they may have to provide proof for the IRS to verify the worker is an independent contractor and not being mislabeled for payroll tax purposes. If a business works with a corp or LLC instead, then there is no need to provide such proof.
4. Tax Flexibility – Sole proprietors are required to report all business income on their personal tax returns. Part of that filing includes self-employment taxes, which entrepreneurs are responsible for paying. It’s always best to consult with a tax advisor or CPA to figure out the best structure to use tax-wise.
5. Self-Perception – A more natural reason to make the shift is the change in perception it helps create for some entrepreneurs – instead of being self-employed you are now a business owner. Being self-employed often implies still living as a worker; being a business owner forces one to think strategically and consider how to grow a venture from the ground up. Filing incorporation paperwork can help instill confidence that may not have existed before within one’s self.
Despite requiring more paperwork filing, LLCs or corporations can be prepared within a matter of hours, providing your business with a strong legal foundation. If you are a sole proprietor considering to make the switch, it is recommended to speak with an advisor to figure out which structure works best and how to begin the formation process. Anderson has many advisors who understand how to restructure sole proprietorships for those interested in it.