About 80 percent of small businesses in the United States have just one employee: the owner.1 While there are certainly advantages to running your own shop, such as total control and flexibility, there’s plenty of risk as well.
Mike Davidov, owner and managing principal of Davidoff & Associates CPAs in Alexandria, Virginia, has more than 20 years of accounting experience. He specializes in helping small business owners grow their bottom line, stay compliant with tax requirements and develop efficiency strategies. As a small business owner himself, Mike offers the following advice and tips to sole proprietors.
Q: What are some of the main business advantages to sole proprietorship?
Mike: First, it's easy to form and maintain. All owners need to do is come up with the name and then register with their local authority, such as a city or a county. There are no hoops to jump through. The same goes for exit strategy. Sole proprietors can simply cease operations, or sell or gift the business.
Sole proprietors can also react much faster than larger companies to demand fluctuations, new trends, new technologies and legislation. Many of my clients can easily reorient themselves if one product line doesn’t sell well or falls out of demand.
Q: What is the biggest piece of financial advice you’d give to someone just starting out?
Mike: One important action is to maintain two separate bank accounts: One strictly for business and one for personal expenses. Not doing so will make it difficult to prepare tax returns. Separating expenses can be very painful, especially if you do not remember if expenses were personal, business or partially one or the other.
It’s also important to keep separate accounts to be able to generate correct financial reports, which show an owner how their business is performing. Owners may be able to reallocate their funding, cut costs or invest in a different product line. Having commingled funds may lead to inaccurate financial reports, and result in decisions being made based on bad data.
Q: What other risk factors should sole proprietors be aware of?
Mike: Being unincorporated exposes the business owner to litigation and lawsuits. If a customer or another third party sues a sole proprietor, then there is really no protection. Personal assets will be available to satisfy any claims, whereas in a corporate structure, personal assets are generally protected.
In addition, while filing tax returns as a sole proprietor is relatively easy, the actual tax burden is less-than-ideal. An owner will end up paying more tax than certain corporation owners or shareholders because some deductions or business credits are simply not available. There’s a requirement to pay self-employment tax in addition to income tax. It may mean a difference of up to tens of thousands of dollars in taxes owed, depending on revenue size.
Q: What should owners keep in mind about the reality of being their own boss?
Mike: With no one to report to, and no partners to consult with, business owners have complete freedom to make decisions. Sole proprietors can generally control their schedules and set aside time during work days for non-business matters, errands and vacations without having to ask permission.
While making solo decisions is great, sometimes being overconfident or too risk averse can damage growth prospects or, even worse, jeopardize the ability to sustain a business. Sole proprietors may not have a built-in system of checks and balances from outside opinions to help steer them in the right direction.
That being said, many standalone business owners become jacks-of-all-trades by engaging in accounting, marketing or technology, even if they aren’t a trained expert in any of those fields. This experience can be useful for years to come.