What is a sole proprietorship?
A sole proprietorship is a type of business owned by one individual where the legal responsibility lies with that individual instead of being separated from the business. This means that all profits, losses, debts, taxes and other legal obligations are assumed entirely by the owner, also known as unlimited liability.
Unlimited liability means that the business is a pass-through entity, also referred to as a flow-through entity, implying that all financial happenings are “passed through” to the business owner and claimed on their personal tax returns. Therefore, there is no legal distinction between the business and the owner. If a lawsuit is filed against a sole proprietor, they must use their own personal assets to pay off any debts, whether it’s generated from business revenues or not.
Sole proprietorships are the most popular business structure because they’re extremely simple and affordable to establish due to minimal government oversight. In fact, the majority of US businesses are sole proprietors which makes them a great first step to becoming an entrepreneur. Many larger businesses start out this way and eventually restructure themselves as they evolve. Typically, the next business structure to establish after a sole proprietorship is an LLC or partnership.
To upgrade your business, the owner must ensure that their business name isn’t already in use, which can be done by checking the United States Patent and Trademark Office. Then, they can file articles of organization with the state where the business is based. Finally, an employer identification number (EIN) needs to be obtained from the Internal Revenue Service (IRS).
You may also be interested in:
Examples of sole proprietorships
This form of business is especially popular among small businesses and contractors. Common examples are a bookkeeping business, freelance writing, a landscape or catering company, house cleaning, tutoring and more. You get the point: If you don’t have a ton of assets or employees, it makes sense to set up your business in the simplest way possible. Another simple, yet essential, step you can take in setting up your business, is creating a business website to enable more users to find you online.
How to register as a sole proprietor
Sole proprietors must have a single owner. There is no need to register with the state to assume business status unless you are planning to hire employees. In this case, an employee identification number (EIS) is required.
Certain business licenses and permits may also be required depending on your type of business and location. For example, many states require food truck owners, street performers and other types of merchants to get a permit for each location that they want to conduct business in.
Filing taxes as a sole proprietorship
Sole proprietors are required to fill out the standard 1040 tax form for individual taxes as well as a Schedule C form, the form businesses use to report profits and losses. However, because the business is not taxed separately, the government determines how much tax is owed based on the combined income of both Form 1040 and Schedule C.
Business owners can deduct expenses like any other type of business, including operating and equipment expenses, product and marketing costs, and travel expenses. They are also required to pay self-employment taxes, which includes contributions to Social Security and Medicare.
It’s important to keep in mind that tax laws can vary based on state and locality. For complete, updated information about the tax implications of a sole proprietorship, refer to the IRS website.
Determining if a sole proprietorship is right for you
When establishing a business, there are several structures to choose from. If you’re considering becoming a sole proprietor, it’s important to take the following points into consideration:
Taxes: Your business structure affects how much tax you pay. As a sole proprietor, you claim profits on your personal tax return. However, most business types, such as corporations, are subject to double taxation, which sole proprietors are protected from.
Liability: Sole proprietors take personal responsibility for all of their financial decisions because their business is not considered a separate legal entity. However, business owners of LLCs and partnerships are protected from personal liability.
Cost: Registering as a sole proprietorship is the cheapest type of business to establish. This is highly beneficial for small business owners with limited funds.
Investors: If you plan to work with investors, a sole proprietorship may not be the best choice because business laws don’t allow external parties to fund this type of venture. However, you can always start off as a sole proprietorship and expand into another business structure at a later point.
Advantages and disadvantages of a sole proprietorship
Can be set up instantaneously for minimal cost
No fees to renew registration with your local municipality
Very little paperwork required to get started
Simple accounting and taxes (file under the owner’s personal tax form)
Doesn’t require official registration with your state
Owners do not need an official employee identification number (EIN) from the IRS
Owners have unlimited personal liability for their business’ debts and losses
It can be difficult to receive loans without prior business activities
Impossible to raise capital because sole proprietors cannot sell to investors
No state protection, as sole proprietorships are not registered and have unlimited liability
FAQ (Frequently asked questions)
What are 3 examples of sole proprietorships?
A freelance artist or designer, a small clothes or grocery shop owner, an independent contractor such as a plumber or house painter.
Is sole proprietorship the same as self-employment?
Yes. With a sole proprietorship you are your own boss.
Why do sole proprietorships fail?
There are many reasons why these types of business might fail. Bad financial management, a lack of leads and business, difficulties meeting client expectations, a lack of time and/or resources and growing too fast or too slowly can all have an impact on the success of a sole proprietorship.