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Proprietorships - Advantages and Disadvantages

 

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Introduction
A proprietorship is the simplest form of business organizational it is an unincorporated business owned entirely by one individual. Few, if any, laws govern the formation of proprietorships. As a result, they are easy and inexpensive to form and often are the entity of choice for individuals just starting a business.

Unlike a corporation or partnership, a proprietorship is not a separate legal entity. Its assets and liabilities are personal assets and liabilities of its owner, and its income and expense is reported on the owner's personal income tax return. Because it is not a separate entity, few legal requirements must be met to begin operating as a proprietorship. Generally, an owner need only offer a product or service to the public to start business.

 

Advantages of Operating as a Proprietorship
Ease of Formation No formalities are needed to form or operate a proprietorship. For example, there is no need to draft organizational documents defining the rights and responsibilities of owners because (a) the sole proprietor is the only owner of the business and (b) there are no requirements to file such documents with state agencies before beginning operations. In addition, proprietorships generally are not subject to special statutory reporting and recordkeeping requirements once operations begin. The lack of formalities means that proprietorships often are less expensive to organize than other forms of entities; proprietorships need not incur large legal fees in connection with the organization and operation of their proprietorships.

 

Simplicity of Operations Although management may be delegated to employees or agents, a proprietor ultimately has the sole responsibility for decision making. As a result, decisions can be made quickly without consulting others. In addition, because key employees report directly to the proprietor, proprietorships generally have short and direct lines of communication; proprietors can keep abreast of the business's activities, evaluate employee performances, and manage operations with minimal time lost.

 

No Payroll Tax Liability on Wages Paid to Children A unique advantage of a proprietorship is the ability to pay wages to children of the owner without incurring any FICA or FUTA payroll tax liability. Children of the owner that are under age 18 are exempt from FICA and those that are under age 21 are exempt from FUTA. In addition, the child does not owe the employee portion of the FICA tax. This tax break allows the proprietor to reduce taxable business income for both income tax and self-employment tax purposes without incurring the FICA and FUTA taxes that apply to wages paid to other employees. Because the child's wage income is earned income, some of it can usually be sheltered by the child's standard deduction. The wages paid to the child must be reasonable in relation to the actual work performed.

 

Not a Taxpaying Entity A proprietorship does not pay income taxes. Instead, a proprietor reports the business's income and expenses on Schedule C of his or her individual income tax return.  As a result:

  1. Proprietorships have fewer tax returns to file than corporations or partnerships.
  2. Proprietorships are not subject to the double taxation of income that C corporations are.
  3. Tax on proprietorship income is based on individual tax rates, which may be lower than corporate tax rates.

 

Disadvantages of Operating as a Proprietorship
Unlimited Liability Unlike corporations, proprietorships do not offer limited liability to their owners. A proprietor directly owns the proprietorship's assets and is fully subject to unlimited personal liability for all of its liabilities. Therefore, if a proprietorship is sued, all of the proprietor's personal assets can be taken to satisfy the plaintiff's claims. That applies not only to liabilities to creditors, but to product liabilities and liabilities for personal injuries that may occur on the business premises as well. (Proprietorships and partnerships are similar in that respect since general partnerships also do not offer their owners limited liability protection. Unlike partners in a partnership, however, proprietors have no partners to help satisfy claims. In addition, a partnership's assets generally must be exhausted before creditors can seek the personal assets of partners.)

 

Transferability of Interests Generally, proprietors may dispose of their business interests without restriction.  However, since an interest in a proprietorship is evidenced by ownership of specific assets (rather than stock in the entity as is the case with a corporation) the transfer can be complicated. In effect, a proprietorship is sold by selling its assets.

 

Limited Sources of Capital Credit sources may be more limited for sole proprietors than for entities with more than one owner. For example, a lender may be more willing to loan money to a partnership or corporation than a sole proprietor because those entities have several owners that could guarantee the debt. Also, partnerships and corporations can raise capital by selling partial interests in the business (that is, by admitting new partners or by selling shares of stock) sole proprietors cannot.

 

Limited Management Resources As discussed above, sole proprietors have the ultimate responsibility for making decisions. Although that can be an advantage to operating as a proprietorship, it can also be a disadvantage. With no other person to share that responsibility, the business can demand tremendous amounts of the proprietor's time and energy. In addition, because a sole proprietor normally is actively involved in the business, growth beyond a certain point is limited to the proprietor's capacity to perform.

 

No Continuity of Life The existence (and often the success) of a proprietorship depends on the efforts of the sole proprietor. As a result, a proprietorship ceases to exist upon the death or incapacity of the owner. In such instances, the assets of the business usually are sold or otherwise transferred to other individuals.

 

Self-employment Tax A key disadvantage of a proprietorship is that all business net income is subject to self-employment tax. Owners of a proprietorship are considered self-employed persons subject to a special tax to fund social security benefits under the Self-Employment Contributions Act (SECA). Self-employment tax (SE tax) rates consist of two separate components an old-age, survivors, and disability insurance (OASDI) or social security component and a Medicare component. All of the net business income of a proprietorship is subject to the Medicare component, which becomes a very costly factor of the proprietorship format. As income rises in a self-employed trade or business, the format of the business is often changed to a corporation to mitigate SE tax. Only wages withdrawn from a corporation are subject to social security tax (OASDI and Medicare components), as opposed to all of the income of a proprietorship being subject to the Medicare component of the SE tax.

 

Lack of Fringe Benefits In general, a sole proprietorship without a spousal employee is unable to provide tax-free fringe benefits (other than qualified retirement plans) to the owner/proprietor and the family members of the proprietor. This occurs because the proprietor lacks the employee status necessary to receive tax-free fringes. In some cases, however, it may be possible for the proprietor to employ his or her spouse, and thereby accomplish tax-advantaged fringe benefits. Alternatively, the proprietor can separately deduct his or her self-employed health insurance. However, this deduction will not reduce self-employment tax as a tax-free fringe benefit would.

 

All Income Taxed at Individual Level In the proprietorship format, the net trade or business income is combined with the taxpayer's other income to calculate taxable income. If the proprietorship reports a loss, and assuming the loss is not restricted by the Section 469 passive activity limits, this combining can reduce the taxpayer's tax liability. Conversely, the net income of a proprietorship is combined with the taxpayer's other income to arrive at taxable income. If the proprietorship is quite profitable, the trade or business income combined with the taxpayer's other income can bring the taxpayer into the highest individual tax

bracket.

 

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