Inside the Hidden Costs of Sole Proprietorship

Professionals continue to bet on themselves as they embrace entrepreneurship as a pathway to success. However, navigating this landscape can be daunting, even for seasoned professionals. The terrain is full of complex front-office operations and logistical nightmares, and resources for support are few and far between.

Self-employed professionals often rely on trial and error to find their way, but what you don’t know, you can’t learn. And in the realm of business structures and taxation for 1099 professionals, there are crucial considerations that can’t be ignored.

According to the Census Bureau, in 2019, there were 27 million non-employer establishments (NES). An NES is typically a self-employed individual or a business operated solely by the owner without additional members. And out of 27 million, a whopping 23 million were classified as sole proprietors.

Related: 10 Productivity Tools for the Sole Proprietor

Sole proprietorship: Unveiling the risks

A sole proprietorship is the default classification for self-employed. While it seems convenient and inexpensive for those starting or treating their business as a hobby, there are three serious concerns regarding this structure:

1. Liability exposure: In legal terms, a sole proprietorship is not considered a disregarded entity because they are not registered as a business entity with the state, so there is no legal distinction between the business and the individual. If your business faces legal issues or debts, you are personally responsible, which puts your personal assets at risk.
2. Cost: You might think you’re saving upfront by paying a minimal cost towards a CPA once a year or even by filing taxes yourself (yikes), but the money you end up overpaying negates anything you thought you might be saving. Out of every 10 tax returns we review, we find eight are overpaying on their self-employment tax by the thousands, either because they are missing critical deductions or not taking advantage of proactive tax strategies. Self-employed business owners also tend to over-expense themselves to reduce their tax liability, a strategy that doesn’t yield the same results as putting that money towards retirement or investments that compound over time.
3. Exposure to audit: Sole proprietors report their income on a Schedule C, and reports suggest that Schedule Cs have a higher rate of underreported net income, misreporting of income and expenses and a noticeable proportion of reported losses. Because of this, the IRS has allocated significant resources toward auditing this category of taxpayers to improve compliance.

So while the ease of setup and complete control over decision-making make sole proprietorship seem like an enticing option, this structure has substantial drawbacks. In 2023 unless this business is your hobby, there is no room for sole proprietorships to be part of the entrepreneurial world.

Related: 12 Things That Are Awesome About Being a Solopreneur

Why do people go with a sole prop?

1. It’s the default: Sole proprietorship is the default business structure for self-employed individuals. When someone starts a business without actively choosing a specific structure, they automatically become a sole proprietor.

2. Lack of awareness: Most people are unaware of the structures available to them or the different advantages and disadvantages they offer.
3. Decision paralysis: When they are made aware of the options available to them, they are riddled with a collection of pros, cons, benefits and opinions of peers and online reviews. The amount of information needed to sort through can be overwhelming, not to mention the robust tax code, state regulations, federal laws and more.
4. Mindset: Self-employed don’t always consider themselves business owners, but they certainly are. This mindset encourages prioritization of their profession or trade, causing focus on the delivery of services rather than equal focus between service and business operations. Couple this with a fear of change, and professionals will find themselves making the comfortable, albeit harmful, choice.

If not sole prop, then what?

There are several other structures, and to determine which one is best for your business, here are some important considerations:

1. Income: Is this business primary or supplemental income? If primary, at minimum, you need to incorporate. If supplemental, look at how much revenue the business generates annually and the liability you’re exposed to.
2. Business goals: Are you planning to grow, scale or higher employees? Are you launching a startup that might be subject to mergers, acquisitions, raising capital or require an exit strategy down the road? The size and scope of your business will help narrow down the best fit.
3. State and industry limitations: Depending on your industry, field and state, you will be subject to certain regulations. Check your state website or consult with professionals for guidance.

After considering all the above, you need to evaluate your options for structure. Here are a few common ones for solopreneurs:

Partnership: Like a dynamic duo, partnerships involve two or more individuals joining forces. We always recommend against this as the cons can outweigh the pros. But hey, sometimes there is strength in numbers, right?

Limited liability company (LLC): These are hybrid creatures offering the best of both worlds: liability protection and operational flexibility — a popular choice! Plus, there are a number of different classifications for LLCs depending on your needs.

Corporation: The heavyweight contender, offering substantial liability protection and growth potential. It’s like the skyscraper of the business world.

Beyond these structures, there are also ways to treat your business from a tax perspective, such as electing to file as an S-Corporation (S-Corp).

Conclusion

The world of self-employment brims with possibilities, but it requires a reasonable selection of the best structure and tax treatment to ensure long-term success. Finding the best solution can be overwhelming, but don’t let that discourage you. Talk to others in your field, use an online tool or contact professionals for advice, such as a tax consultant, CPA, accountant or other professionals in your network.

If you take away anything from this article, at minimum, set up an LLC for your business. The setup cost is nominal compared to the invaluable peace of mind you’ll get knowing that your personal assets are protected.