Five Reasons to Begin Business as a Sole Proprietorship

Small business owners and entrepreneurs regularly agonize over the incorporation question--and about related topics such as when a limited liability company makes sense and whendoes an S corporation really save an owner taxes.

This obsessing over more sophisticated (and expensive!) entity options is too bad, however. New small business owners can count at least five great reasons to start a small business as a sole proprietorship.

Reason 1: Simple Setup

As compared to incorporating or forming a limited liability company, sole proprietorships are a breeze. All you really need to do is start. That's it.

Note: State and local governments usually want you to get a business license so they can begin taxing your new business. But getting a business license in many cases is pretty easy. Check the phone book or call your local state or municipal government offices.

Reason 2: Easier Accounting

If you run your business as a sole proprietorship, you keep your accounting truly easy. If you're the only worker, you won't even have to do payroll. Not having to do payroll saves tons of time, lots of money, and means you avoid doing between five and ten payroll tax returns a year: quarterly federal and state returns, the annual federal unemployment tax return, W-2s, and so forth.

What's more, you won't have to prepare balance sheets as part of your business tax return. Your sole proprietorship's income and deductions will typically be reported inside your individual tax return on a single page of paper.

In comparison, corporations and partnerships often do have to prepare balance sheets for their tax returns and a boatload of other supporting schedules. Commonly a corporate tax return runs between ten and twenty pages in length. Yikes.

Reason 3: Minor Children as Tax Shelters

If you employ your minor children in your business, a sole proprietorship offers up one of the sweetest small business shelters there is. Wages you pay your teenage kids count as business tax deductions--which saves you income taxes and self-employment taxes. But the amounts your minor children earn probably aren't taxable to them for either income tax or Social Security and Medicare taxes purposes if they make less than the standard deduction amount.

Note: The standard deduction amount equals $5450 in 2008. In the years after 2008, the standard deduction increases because of inflation.

The ability to employ minor children, take the tax deduction on your tax return, and then let the kids avoid income and payroll taxes could save your family almost $3,000 in taxes per year per kid working in the family business. Wow.

A final caution: The kids need to be doing real work and be paid a reasonable wage.

Reason 4: Easy Deductibility of Health Insurance

Sole proprietors can more easily take a deduction for family health insurance. The rules are a wee bit tricky. The family can't be benefiting from subsidized health insurance from, say, a previous employer (like the military) or the spouse's current employer. And you get the medical insurance deduction only to the extent your business makes money.

Nonetheless, sole proprietors will often be able to deduct their health insurance. (Employees normally don't get to deduct health insurance premiums.) And sole proprietors can much more easily take the self-employee deduction than corporation shareholder-employees and partners in partnerships.

Note: Technically, the self-employed health insurance deduction is available to S corporation shareholder-employees and partners in partnerships, but the rules for taking the deduction are more complicated and tend to change from year to year. Ugh.

Reason 5: Future Flexibility

One final reason exists for considering the under-appreciated sole proprietorship option. With a sole proprietorship, you can easily switch to some other form at a later date--and almost always with zero negative tax consequences.

With a sole proprietorship, for example, you can decide in year two or three that you want to incorporate your business or reform as a limited liability company. No problem. What's more, at that point, you can think about whether making an S corporation election makes good sense.

A sole proprietorship keeps things simple now but also keeps open your future options.

In comparison--and this is especially true with corporations and somewhat true with limited liability companies--reforming other business entities takes time and can cost lots of money (including taxes).