A sole proprietorship refers to a business owned and operated by one person who hasn't made a legal entity selection and filed with the state such as a corporation or limited liability company. Although a sole proprietorship is the easiest and least expensive type of business entity to set up and run, it does have a number of drawbacks not present with other entity choices.
Unlimited Personal Liability
One of the greatest drawbacks in operating as a sole proprietorship is unlimited personal liability. Legally, there's no distinction between the sole proprietor and his business, which means anything for which the business is liable could come from the owner's own pocket. For example, if you're a sole proprietor who makes wines and a customer gets sick, when the customer sues the business, you're also a defendant. If the court rules against the business, you risk losing your personal assets, such as your bank accounts, car or house, to satisfy the judgment.
Since a sole proprietorship doesn't have a separate legal existence from its owner, as a sole proprietor, you can't really sell ownership in the business like a corporation, which can sell shares to stockholders. A person who wants to invest in your sole proprietorship can provide a loan to the business, gaining a profit from the interest he receives on his investment. However, if your business is expanding and you want to bring on additional investors, you'll likely have to form a partnership, incorporate, or form a limited liability company to have others share ownership in your business.
Less Professional Creditability
Lenders typically require a sole proprietor to personally guarantee loans or even use personal property as collateral for business loans. As a sole proprietor, to obtain a business loan, you might have to rely on your personal credit or assets. For example, you might have to use your home as collateral, which means that if the business goes bankrupt, you could lose your home. In addition, operating as a sole proprietorship often carries less credibility with customers and other businesses than if you selected a more formal entity, such as a corporation or limited liability company, for your business.
No Separate Existence
A sole proprietorship is essentially just the ownership of the business's assets. When you operate a sole proprietorship, all the assets are in your name and you're personally liable for paying any debts of the business. Once you retire or die, your sole proprietorship ceases to exist. While you can leave all your business assets to an heir, if that heir uses those assets to operate a business in the same manner, he is creating his own sole proprietorship.
Difficulty Keeping Accounts Separate
In addition, since the sole proprietorship does not have a separate legal existence, you may have a hard time keeping your personal and business expenses separate for record-keeping purposes. For example, if you're shopping at an office supply store to get printer ink for your personal printer and office supplies for your business, you have to separate the expenses so that only the office supplies are counted as a business expense.