Choice of entity is one of the first and most important decisions faced by someone starting a small business. Two of the entity forms available to the small business person are sole proprietorship -- operating the business as an individual, perhaps with an assumed business name -- and corporation, which is a separate entity from its owner. Sole proprietorships and other business entities differ in their formation, taxation and liabilities, and offer different advantages and disadvantages to small business owners.
Formality and Organization
Starting a sole proprietorship is simple, compared to other business entities. Some states and localities require business licenses, depending on the type of business. If the sole proprietorship is operating under a fictitious business name, the owner will have to register that name with the appropriate state or local agency. The sole proprietor can make her own business decisions and can terminate her business without having to go through a formal dissolution process. Forming a corporation, however, is formed (or dissolved) under state law; you must file Articles of Incorporation with the agency appropriate for your state -- usually the Secretary of State's office. You also must designate the directors, officers and number of shares which the corporation will issue. Corporations are owned by their shareholders and must hold regular meetings, maintain minutes of actions and file annual or biennial reports with state agencies.
Sole proprietorship taxation is simple, as all business income is personal income to the owner. The sole proprietor reports the income and expenses of her business on the Schedule C of her Form 1040 federal income tax return. Sole proprietors should maintain clear records of business expenses to support the proprietor's claim of business deductions. One disadvantage of a corporation is that of double taxation. Corporate profits are first taxed at the corporate level, then again as income to the shareholders on their personal income tax returns. Sole proprietors have to pay self-employment tax on their income, but this is a wholly deductible business expense. Corporations can deduct the full cost of health insurance provided to shareholders, while sole proprietors can hire spouses and provide their spouse with fully deductible, family health insurance.
One of the key advantages of the corporate business form is that the shareholders, or owners of the corporation, are not personally responsible for corporate debts and liabilities. On the other hand, a sole proprietor is personally liable for all the debts and losses of her business. If the business is sued for any reason, the sole proprietor's personal assets -- including her home, child's college savings account or personal retirement account -- are at risk. Insurance may help offset the personal liability of a sole proprietorship, but a corporate business form provides significantly more liability protection.
Raising Funds and Transferring Business
A sole proprietorship may have difficulty raising funds to expand, because investors generally won't fund a sole proprietorship. Unlike a corporation, a sole proprietorship does not have shares to sell to investors. A sole proprietor can sell her business if she can find a buyer, usually by a sale of all the assets to that buyer, but the new owner must often reapply for any required licenses and permits, as they are often non-transferable. However, the sole proprietorship itself is terminated upon the owner's death, and often must be liquidated, in which case the assets of the business become part of the decedent's estate and creditors of the business can make claims against it. If an heir continues business operations, it would then be considered that heir's sole proprietorship. In contrast, ownership of a corporation can be easily transferred by selling shares.