I want to start a business!
The electric wave of excitement goes down your spine. But then it lands somewhere in your stomach, and another question pops up: how do I get operationally set up? Sounds familiar?
All small business owners, freelancers, startups, and self-employed folk have faced the same decision. Some decided to get incorporated from the get-go as a limited liability company (LLC).
Others prefer to operate as a sole proprietorship. Here’s what it is and what it isn’t.
- A sole proprietorship what it is and what it does?
- What advantages does a sole proprietorship have?
- What disadvantages does a sole proprietorship have?
- Examples of: typical sole proprietorship businesses
- How does a sole proprietorship compare to other business structures?
- Taxation of sole proprietor business
- How to form a sole proprietorship?
- Key takeaways
- FAQ Commonly asked questions
What is a sole proprietorship, and what does it do?
A sole proprietorship is an informal, unincorporated business structure with a single business owner. Essentially, you work for yourself and represent your business. The sole proprietor and the sole proprietorship are not separate legal entities. And so, the business owner is responsible for all aspects of the company.
Separately, a sole proprietorship is also a tax classification used by the IRS to determine the applicable tax regime for the business.
For example, most self-employed individuals report their freelance income as sole proprietors on personal tax returns. And so do members of the limited liability companies (LLCs).
According to the latest government stats, 86% of businesses without employees operate as sole proprietorships. This stat, however, also includes single-member LLCs who also report business taxes under this category.
Advantages of a sole proprietorship
There are many good reasons why a sole proprietorship is the most popular form of business ownership in the US.
1. Easy to form
To become a sole proprietor, you don’t need to register with a state, file any paperwork, or pay any fees. You remain in this status as long as you do the work and properly report your business income and expenses.
Also, another advantage of a solo business owner entity is there will be less internal bureaucracy. You don’t need to create an operating agreement or create company bylaws.
2. Full control
As the sole owner of this business structure, you have complete control of the company. Sole proprietors also receive all profits from the business and can deduct business expenses on their personal tax returns.
You have a full view of your finances and can decide on the optimal direction for your business.
3. Simpler tax filing and accounting
Sole proprietors report the income and expenses for their business activity on Schedule C of the personal tax returns. The IRS provides instructions and forms that self-employed sole proprietors may need to file.
These include forms for personal income tax and accompanying schedule C, self-employment tax forms, and other tax forms for specific situations or industries.
Also, unlike incorporated business entities, sole proprietors typically don’t need to pay extra state taxes such as annual franchise taxes, employment taxes, corporate income taxes, and so on. It simplifies accounting for the small business owner.
4. Deductible business losses
As a sole proprietor, you can deduct business losses and expenses from your personal income tax form to reduce your taxable income. This helps offset the reportable income to account for the costs of starting a business.
Disadvantages of a sole proprietorship
While a sole proprietorship is easy to form, operating as an unincorporated entity opens you to certain risks.
1. Personal liability
Business owners and sole proprietors are not legally separated. Sole proprietors are personally responsible for the liabilities of the business. If the company can’t repay debts, creditors can turn to a sole proprietor’s personal assets.
Likewise, if you ever get sued by a disgruntled customer, all the litigation will be addressed personally towards you.
2. Limited fundraising options
Incorporated business structures can raise money by selling an interest in the entity or shares in the company. Also, an LLC or Inc can have multiple owners (and add extras at any time after formation). For sole proprietors, that’s not an option. To raise funds, most solo business owners will need to apply for a business loan.
However, banks view sole proprietorships as higher-risk borrowers as the owners may not have sufficient assets to repay a loan if the business fails.
3. Hard to sell the company
Since a sole proprietorship is not a separate legal entity, it’s not feasible to sell the company. The sole proprietor could change the business structure or sell some business assets. But the sole proprietorship could not be sold as a separate entity and still maintain the same business structure.
4. Less credibility
Sole proprietorships tend to be viewed as part-time side-hustlers rather than serious small business owners.
Some sole proprietors operate under the individual owner’s legal name. It may come across as less professional. Filing for a DBA (trade name) helps deal with the naming issue only to some extent.
You still can’t trademark or service mark your business name. Or prevent another incorporated business entity from registering operations under it.
Typical sole proprietorship business examples
Anna Smith decides to start a photography business, while David White wants to become a consultant. After freelancing for several months and generating a profit from these business activities, they both choose to go full-time. Now, they’re sole proprietors.
New business owners with less capital may consider starting as a sole proprietorship.
The U.S. Census has stats on the types of industries with high numbers of self-employed individuals:
Who should form a sole proprietorship?
A small business owner just getting started and wants a simple and easy-to-form business structure should consider creating a sole proprietorship.
Some common examples of sole proprietorships include:
- Small e-commerce store owners (e.g., Etsy)
- Independent contractors
How does a sole proprietorship compare to other business structures?
A sole proprietorship is an informal business structure. Respectively, it doesn’t come with the same legal protection as incorporated entities.
However, sole proprietors don’t need to file any formation documents with the state to get their business started.
Here are some other distinctions between this type of business structure and the other popular options.
Sole proprietorship vs. LLC
A sole proprietorship is an unincorporated business entity with one owner, not a separate legal entity.
A limited liability company (LLC) is a registered business structure formed under applicable state laws. It’s a separate legal entity with one or more business owners.
When operating as an LLC, the company becomes liable for debts or legal claims, not the individual business owner(s). That is not the case with a sole proprietorship.
Sole proprietorship vs. partnership
Sole proprietorships and partnerships are similar in a way that both are unincorporated operational structures. However, a partnership always assumes at least two business owners, when sole proprietorship is always a business of one.
Sole proprietorship vs. corporation
Corporations are registered business structures and are separate taxable entities. As such, income tax is reported much differently compared to sole proprietorships.
Public corporations are also owned by multiple shareholders, which is not an option for sole proprietorships. Likewise, the company formation process and day-to-day operations are very different for a sole proprietor vs. corporation shareholder.
The following chart from SBA.gov compares different business structures:
Doing business as (DBA) vs. sole proprietorship
A sole proprietor may run their small business under a personal name. Alternatively, sole proprietors can apply for a trade name (fictitious name, assumed name) with the state authorities.
By filing a doing business as (DBA) form, you establish a link between your sole proprietorship and the operational name you use with customers. Essentially, a DBA helps you operate under a name different from your own.
Using a DBA trade name doesn’t create a separate legal entity for sole proprietorships.
Sole proprietor taxation
Sole proprietorships are not considered separate entities from the business owner (or sole proprietor) for income tax purposes. As such, the income and expenses of the small business are reported on the business owner’s personal income tax form.
You’ll need to download and fill in a Schedule C (Form 1040) to report your business’s financial activity. Then you’d receive a tax bill based on the income generated from all sources.
How to form a sole proprietorship?
There’s no “formation process” for a sole proprietorship per se since this is an informal business structure. As long as someone else hires you to do some one-off job and pays you cash, you essentially become a sole proprietor.
Essentially, once you turn a profit from any side activity — be it photography, web design, or selling baked goods — you’re expected to report it as business income on Schedule C form with the IRS.
The IRS will consider something a hobby instead of a business if the activities don’t turn a profit. A sole proprietorship is not formed unless the owner later turns a profit.
Get all the proper licenses and permits
Even though there’s no formal incorporation process for sole proprietors, you may still need a business license to provide certain services. The requirements depend on your line of business, federal regulations, and state rules.
The SBA (Small Business Administration) provides a helpful resource listing possible required licenses and permits.
The commonly regulated industries include Agriculture, Finance, Education, Beauty Services, Fishing, Transportation, and Logistics.
Optional: open a business bank account
A sole proprietor can have a separate bank account in their name. But many choose to route business payments into their personal bank account.
Legally, that is acceptable. But in practice, having a separate business bank account makes end-of-the-year accounting and tax reporting oh-so-easier!
- A sole proprietorship is the default business type of business for one-person businesses.
- You don’t need to form a sole proprietorship — you become one if you turn a profit from some commercial activity.
- Business income and expenses are reported on the owner’s personal tax return.
- The sole proprietor is personally liable for all business debts and obligations of the business.
Sole proprietorship FAQs
Here are the most frequently asked questions about a sole proprietorship.