Some disadvantages to starting and running a sole proprietorship include less financial and legal protection, the inability to add a partner, higher self-employment taxes, obstacles to getting approved for startup or sustenance funding, fewer benefits than W-2 employees and no guidance from board members. In the following section, we explore these disadvantages and their possible solutions.
1. Less Financial Protection
When you run a sole proprietorship, you do not have the protections that a limited liability company (LLC) offers. This means that your sole proprietorship and you are legally considered one entity or “person.” So, if business debts or other financial obligations become overwhelming, you are responsible for paying them from your personal finances, even if they are not your fault. For example, if an employee causes overwhelming business debts, you are still responsible for them.
To avoid this type of financial liability, you can form an LLC that separates your personal finances and other obligations from your business’s. Under this structure, in the event of an overwhelming financial obligation, your business is held responsible, not you personally. This means your home and other personal assets cannot be touched by creditors to collect on LLC business debts.
2. Less Legal Protection
Not only is the owner liable for a sole proprietorship’s financial debts, but he or she is also held responsible for other liabilities. For example, if a client wants to sue your business, they would sue the sole proprietor (owner), not the business. Employees, landlords, suppliers, vendors and customers can sue a sole proprietor. When this happens, the final judgment must be satisfied by the owner of the business, often threatening the business’s continuity and the owner’s personal financial stability.
There are a few potential solutions to this conundrum. As we’ve discussed before, you could turn your sole proprietorship into an LLC. You could also hire consultants to help put standards in place to prevent a lawsuit. However, even with extensive risk management in place, your business could still be at risk. Another way to help protect yourself from lawsuits is to purchase general liability business insurance.
3. No Partners Allowed
Since the definition of a sole proprietorship is an unincorporated business that has one owner, if you add a partner, your sole proprietorship ceases to be a sole proprietorship.
However, there is an easy and automatic fix to this. If you add a partner and remain unincorporated, instead of being a sole proprietorship, your business automatically becomes a general partnership and you share the business’s profits and losses. Incorporation paperwork is generally not required but many localities do require you to file for a business license or permit.
While you can move forward with a verbal agreement, for both parties’ protection, it is a good idea to write and sign a partnership agreement. It is best to work with a lawyer to delineate how the business will be run, how profits and losses will be shared, the responsibilities and expectations each partner must adhere to, how the partnership can end (and the events that signal its end) and required steps at the business’s termination or if a partner wishes to leave.
4. High Self-Employment Taxes
When you work for an employer as a W-2 worker, your employer is responsible for paying a portion of your Social Security taxes. When you are a sole proprietor, you are considered both an employee and employer. Thus, you must pay the full burden yourself. Sole proprietor taxes include Social Security taxes, as well as Medicare taxes. In 2022, Social Security taxes are combined to equal 12.4% of combined earnings below $147,000. Medicare adds a 2.9% tax.
Despite this reality, there is good news. You can offset some of these costs via the above-the-line tax deduction. This deduction allows you to claim one-half of your self-employment taxes as a tax deduction, meaning you don’t have to pay taxes on those gross earnings.
5. Fewer Lender Approvals
Lenders often see sole proprietorships as riskier than larger businesses or even LLCs. Sole proprietors often don’t have business insurance to protect them against lawsuits, extensive nest eggs to protect them in a business downturn and steady income on a month-to-month basis. Unlike other business types, they also don’t have an experienced board of directors to offer key insights for prospering and growing the business.
Still, you have options. A personal loan is approved based on your own income and creditworthiness. While this type of loan is often a lower amount than a business loan, it is a good option for sole proprietors who have a steady income and work on the side to develop their sole proprietorship. A steady job can show financial stability and lends to higher credit ratings. Accounts receivable financing and unsecured loans can also be costlier loan options.
6. Taking a Day Off Means Lost Income
While working a traditional job, you might receive a salary or hourly pay. A benefits package offered in such a W-2 position might include an annual amount of paid time off, sick days and family leave. In contrast, when you are self-employed, if you don’t turn in the photos you retouched or make that handmade item to sell, you cannot invoice for your services or goods and money will not come in. So, taking a sick day is costly.
One way to offset this disadvantage is to save some profits to cover days you cannot work. Aim to quickly set aside enough income to cover all of your personal and business continuity expenses for two months. Once you’ve done that, on a slower but steady scale, increase those savings to cover up to six months. That way, if a significant health concern hits you or a family member, you can stay afloat as you prioritize what matters.
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7. Expensive Benefits
Many W-2 employees receive benefits packages that cover the employees’ health insurance. Often, these health benefits are paid for by the employer. Due to group health and other benefits plans, even optional benefits that employees pay for out of pocket are often obtained at a lower price than if the employee received those benefits as an individual. These group cost savings are often not available to sole proprietors.
Despite this limitation, you can still save. When you apply for health insurance through the Healthcare.gov Marketplace, for example, you may qualify for a premium tax cut to lower your out-of-pocket costs. To find out if you qualify, using your estimated income for the current year, fill out the Income Levels and Savings Survey. If your state does not use this website, contact its call center to learn how to tap into these savings. Find this contact information for your state here.
8. No Board of Directors
By law, corporations are required to have a board of directors, usually with at least three board members. These board members are ideally selected because they have ample experience in the industry or a related business function and can guide in decision-making and crisis prevention and response. They also ensure the company adheres to ethical business practices. As such, the board protects the company and helps it to prosper.
In contrast, a sole proprietorship does not have a board of directors. With only one owner, the expertise held by that owner is often all the business has to protect against crisis, ensure ethical business practices and to set the business up to prosper. Still, there are other avenues to receive this type of support. You could, for example, seek an experienced industry mentor.
To find a mentor, search your contacts on LinkedIn, then reach out to ask for a mentorship relationship. Or, consider SCORE, a large nonprofit that matches entrepreneurs to volunteer mentors. Simply visit the SCORE website and type in your Zip code to begin the process of finding your mentor.
9. Startup Capital Is Usually Invested by the Owner
If your business were a corporation, you would have the option to raise startup capital by offering an ownership interest in your business. As a sole proprietor, that option is not available to you. For this reason, startup capital for a sole proprietorship often comes from the owner.
However, there are some ideas for raising startup capital if you do not have savings you can invest yourself. You could, for example, request a loan from family or friends. As an incentive, you can offer favorable payback terms or other informal perks for having invested. Some businesses are also turning to crowdfunding to raise capital for their startup ventures. You can offer perks, such as a T-shirt with your new company logo, as a thank you for donations.
