Sole proprietorship is a specific legal term used to describe an unincorporated business owned by a single person. There are many benefits of sole proprietorship. It is the simplest and most straightforward of all the business entities, it is also the most common type, and it offers significant advantages.
If you’re considering starting your own new business and you’re trying to decide between sole proprietorship and other business structures, here’s what you need to know.
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What is a Sole Proprietorship?
Of all the different business structures available — sole proprietorship, partnership, limited liability company, and corporation —a self-employed sole proprietorship is the one that is easiest to establish and operate. It provides the individual owner with total control of how they operate their business, with nobody to report to or to whom they need to justify any of their decisions. All the profits of the business go directly to the owner. Read our guide on how to pay yourself as a sole proprietor.
There are no stakeholders other than the single individual who owns the business, though a sole proprietorship can hire employees. Examples of sole proprietorships can be retail shops, home-based businesses, consultancies, professional service providers, and freelancers to name a few possibilities. In all cases, the owner is inextricably linked and associated with the business itself. The two are as one.
A Sole Proprietorship Is A Pass-Through Business Structure
Sole proprietorships provide no separation between the owner and the business, either from a tax perspective or a personal liability perspective. Sole proprietorship businesses operate as pass-through entities. This means that all revenue and profits belong to the owner and get reported on their personal tax return.
Not only is the owner directly responsible for paying and filing taxes on the business’ income, they are also responsible for paying all employee wages and have no personal protection from their business's debts or legal liabilities.
A Simple Set Up is One of the Top Reasons for Choosing to Operate as a Sole Proprietor
There are few things more exciting than opening your own business, but the prospect of doing so can also be daunting. For some, entrepreneurship was never an if or a what, but rather a when. They have a skill or an idea and simply need the running room and the opportunity. Others have long wanted to be their own boss — or may have an absolute aversion to working for somebody else — but don’t even know how to start or what service or product to sell.
A Business Structure With No Legal Paperwork Required
Whichever of these scenarios best describes you, once you’ve overcome your initial obstacles and are ready to start, your next step is to choose a business structure. Choosing sole proprietorship as your business structure offers tremendous simplicity and ease. From a paperwork perspective, sole proprietorship requires absolutely no formal action. There are no contracts, agreements, or registrations outside of the appropriate licenses associated with your operation or industry. That means no additional costs and more money in your pocket.
Other Businesses Require Contractual Agreements
By comparison, a written agreement is highly recommended (though not required) when forming a partnership to formalize the management and contributions of money, profits, and responsibilities. Forming a limited liability corporation from a sole proprietorship or by itself requires that articles of the organization be filed with the state in which you operate, and an operating agreement is highly recommended. Incorporation requires principals to formally register articles of incorporation with the Secretary of State where your business operates.
Avoiding all of these complications is particularly advantageous if you are starting your business as a test run or are operating it in addition to having responsibilities elsewhere. You can start a sole proprietorship without spending too much time on bureaucratic tasks not associated with the business itself.
You Can Operate Your Sole Proprietorship Under Your Personal Name
Some entrepreneurs spend hours dreaming up the perfect business name, but if you’re not hanging out a shingle or a sign above a storefront, having a novel name may be of little interest. As a sole proprietorship, you can simply use your personal name as your business's legal name, and that saves you from having to register a business name at the trademark office or file a Doing Business As with your local administration. It also saves you from the fees associated with each of these processes.
Sole Proprietorships Don’t Pay Business Taxes
Because sole proprietorships are the same legal entity as their owners, the Internal Revenue Service treats them as pass-through entities. They pay using the owner's Social Security Number and do not need to use an employer identification number unless they have employees. The business pays no separate taxes and all income is reflected on the owner’s personal tax return and reported on their individual IRS 1040. There is no need to use any separate, unfamiliar forms, and the tax rate that sole proprietors pay is lower than that of any of the other available business entity types.
When a sole proprietorship is prepared to file taxes, they use a Schedule C to reflect all of their business’s income, expenses, and losses. They then transfer the pertinent total into their personal tax calculation and pay any taxes due accordingly. Notably, these owners are required to pay self-employment taxes and to submit quarterly estimated income taxes.
Sole Proprietors Can Have Employees
Just because the name of the business entity includes the word “sole,” you’re not required to operate it all by yourself. A sole proprietor can hire as many employees as they like to help them run their business. Of course, when they do so, they are personally responsible for paying wages, providing benefits, and withholding appropriate taxes on behalf of their employees.
Every Sole Proprietor is Their Own Boss
Probably the single most important part of choosing to be a sole proprietorship is the ability to have complete control over every aspect of the business. Whether you’re a small business owner or your sole proprietorship grows to include multiple locations and hundreds of employees, as long as you continue to operate as a sole proprietor you are able to be the sole owner or decision-maker.
You can take time off whenever you’d like, make your own hours, devise your own operational and marketing strategies without fear of criticism or correction. Of course, that means that when you make mistakes you have nobody to blame but yourself, but if you are the type of person who chafes at taking direction, suggestions, or criticism, then you likely view the risks as worth the reward.
Put simply, there are strengths AND weaknesses to a sole proprietorship. It would be a mistake to choose a sole proprietorship as your preferred business structure based strictly on the advantages that it offers. Smart entrepreneurs make sure they’re as aware of the cons as the pros of every decision that they make. As attractive as a sole proprietorship may be, there are several reasons to bypass its ease and opt for another entity type.
The Lack of Legal Separation Means Your Personal Assets Are on the Hook
It’s tempting for a budding entrepreneur to make important business decisions based on assumptions of success, but not every small business succeeds, and not every entrepreneur’s story has a happy ending.
If a business fails to thrive, it may be left with big, unpaid bills for equipment or inventory. The owner may have signed a lease they can no longer afford, owe sales tax, or be committed to a business contract they are unable to fulfill. Without the liability protection offered by other business structures, a sole proprietorship business owner is personally on the hook for every commitment — to an unlimited degree.
No Liability Protection
Even more frightening is the fact that a sole owner is legally responsible for other liabilities that are assigned to their business. To get a sense of exactly what that means, imagine the owner of a restaurant or small retail shop where a customer or employee slips, falls and suffers serious personal injuries, or a business whose employee commits some type of negligent or irresponsible act that causes harm.
If the injured individual files suit seeking compensation for the damages they’ve suffered, the sole proprietor is personally responsible and faces the risk of losing their personal assets.
By comparison, business owners or sole proprietors who opt for a limited liability corporation or a corporate structure can see their business named as the subject of lawsuits or debts without risking their life savings. The business is a separate legal entity. The sole proprietor is also personally responsible for non-compliance with laws and regulations. Citations and criminal charges all get attached to their name rather than to their business.
It Can Be Difficult for Sole Proprietors to Raise Capital for their Business
Every business has its own capital requirements. A freelancer or consultant operating their business as a side gig may need nothing more than their laptop and phone to get started, while an aspiring coffee shop owner will need espresso machines, refrigeration, and a place to put them.
The more equipment and investment is needed, the more of a challenge it may be to remain within the framework of a sole proprietorship, as sole proprietorships have no stock or equity to sell.
In most cases, sole proprietorships rely on whatever cash savings they have available to them or loans from family members or friends. They may be able to take out a loan, but it would be in their own name and the terms would be dependent upon their credit rating and the risk perceived by the lender.
The owner might need to put up their personal assets as collateral, creating a real risk to their personal credit if the business fails and they find themselves unable to repay their debt.
When the Business Owner Dies, the Sole Proprietorship Dies
No matter how successful a sole proprietorship business may be, should the owner die or for some other reasons become unable to continue, the business ceases to be. Where partnerships, limited liability corporations, and corporations each have structures that allow a business to continue existing, a sole proprietorship’s identity is directly tied to its owner.
Every Sole Proprietor is Their Own Boss
If that heading seems familiar, it’s because you saw it earlier in this article, under the larger category of “advantages” of a sole proprietorship. For all of the freedom and satisfaction that comes with being independent of supervision, there are also significant stressors and burdens that come with being the boss.
In addition to having to pay self-employment tax, every decision and its outcomes rest entirely on the owner’s shoulders, and so too do all of the responsibilities. Unlike other business entities set up as partnerships, sole proprietorships that operate on their own may find it a challenge to take time off. Even having trusted employees often does little to alleviate that dynamic.
Just as Income Passes To The Business Owner, So Too Do Losses
Running a business is not always a high-pressure situation, but it certainly can be. While success is obviously the goal, it is not promised Just as is true of the business's liabilities and income, a sole proprietorship’s failure passes directly to the owner as well.
The Final Advantage - Sole Proprietors are Able to Easily Shift to Other Business Structures
If you are embarking on your own entrepreneurial journey, the benefits of a sole proprietorship are undeniable. The structure allows the fastest, easiest, and least expensive entry point to business ownership, with very few downsides.
One last consideration to keep top of mind is that sole proprietors have significant flexibility. As you become more established and profitable you may wish to expand the scope of your business. Likewise, concerns about personal liability or the need to attract capital investment may become a greater concern.
As the only decision-maker of a sole proprietorship, you will be free at any point to move your business from its unincorporated model to whatever type of legal entity is most appropriate and advantageous.
Sole Proprietorship Offers a Perfect Jumping Off Point
Starting your business venture as a sole proprietor and building a successful entrepreneurial track record gives you all the advantages of independence and simplicity along with the benefit of accumulating financial records and sales data that can help you attract partners, investors, and stakeholders in the future.
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