Disadvantages & Hidden Costs of a Sole Proprietorship

It’s the simplest type of business—the sole proprietorship, a default classification for a business operated by someone who has decided not to form an official entity. If you know someone selling crafts on Etsy.com, for example, they are operating a sole proprietorship, if they have not formed an official company.

Sure, there are no state filing fees, and no requirements like licenses or insurance, but the sole proprietorship is deceptive and has hidden costs and complications.

Four Hidden Costs of the Sole Proprietorship:

1. Unlimited personal liability
   This means you are personally liable for all debts of the company. This is the greatest risk of a sole proprietorship. Without having a separate entity for your tax and legal issues, a court is likely to see all of your assets and liabilities, including personal, non-business-related items, as a single group.
   
   If you became the target of a lawsuit, a judge could easily rule that your personal assets and bank accounts be used to pay damages incurred as a result of your business activities. If you have outstanding tax obligations, the IRS or other agencies may pursue you, personally, rather than your business.
    
2. Difficulty in raising investment capital
   Elsewhere on this site, we discuss why investors prefer Delaware corporations over any other business entity. In short, it’s much more difficult to sell ownership in an LLC than in a corporation. And for a sole proprietorship, it’s basically impossible.
    
3. Difficulty in getting a business loan or line of credit
   As a sole proprietor, you’ll have to rely mainly on friends and family who already know and trust you. It is extremely unlikely you’ll find a venture capitalist willing to write a check to invest in a business that has no formal company encompassing it.
   
   Similarly, credit lenders will not be eager to extend a line of credit to an individual for a business operation without a business entity.
    
4. No business write-offs
   Business write-offs lower the amount of taxable income you have at tax time, and this reduces the amount of tax you owe. Here is how it works: deduct the costs of running your business from your income. Make sure you have records to support your claims to the IRS and that the costs are ordinary and necessary. This is the way to benefit doubly, when you invest in your business. Electing not to do this may cost you a lot of money.

Because of these and other disadvantages, Harvard Business Services recommends all sole proprietors think about forming a Delaware company (Corporation or LLC) rather than operating a sole proprietorship. We are happy to answer questions for you and help you to compare business entities and determine which is appropriate for you.