What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with just one owner and no distinction between the business and the owner. The owner receives all profits but is also liable for all debts and losses.
The owner pays personal income tax on profits earned from the business. Many sole proprietors do business under their own names because creating a separate business or trade name isn’t necessary.
Also referred to as a sole trader or a proprietorship, a sole proprietorship is the easiest type of business to establish or dissolve, primarily due to minimal government regulation. This business model is popular among individual self-contractors, consultants, and sole owners of businesses. Most small businesses start as sole proprietorships and either stay that way or transition to a limited liability entity or corporation as the company grows.
Key Takeaways
- A sole proprietorship is an unincorporated business with only one owner who pays personal income tax on profits earned.
- Sole proprietorships are easy to establish and dismantle due to minimal government involvement, making them popular with small business owners and contractors.
- Most small businesses start as sole proprietorships and transition to a limited liability entity or corporation as they grow.
- One major disadvantage of sole proprietorships is the lack of liability protection; all business liabilities extend to the owner.
- Sole proprietors report income and expenses on their personal tax returns and pay income and self-employment taxes on their earnings.
Understanding Sole Proprietorships
If you want to start a one-owner business, a sole proprietorship is the simplest and fastest way. It begins when you start conducting business and doesn’t require federal or state form filing, making it ideal for self-employed individuals starting out.
Unlike corporations, limited liability companies (LLC), or limited liability partnerships (LLP), no separate legal entity is created in a sole proprietorship. Consequently, the business owner is not exempt from liabilities incurred by the entity.
For example, debts incurred by the sole proprietorship are also the debts of the owner. However, profits earned are also profits of the owner, as all earnings flow directly to them.
Advantages and Disadvantages of a Sole Proprietorship
Advantages
The main benefits of a sole proprietorship include the pass-through tax advantage, ease of creation, and low fees for creation and maintenance.
- Tax Benefits: Income generated from a pass-through business is subject only to a single layer of income tax. In some cases, it may be eligible for a 20% tax deduction under laws like the Tax Cuts and Jobs Act of 2017.
- Less Paperwork: You do not need to register with your state, though you may need specific licenses or permits depending on your business.
- Simpler Tax Process: No need to obtain an employer identification number (EIN) if you are the sole proprietor—you can use your Social Security number (SSN) instead.
- Flexible Banking: A business checking account is not required; you can manage finances through your personal account.
Disadvantages
A notable downside is the lack of liability protection. Sole proprietors face unlimited liability, which means their personal assets can be used to satisfy business debts.
This unlimited liability can make it difficult to secure capital funding from conventional sources like banks and large investors, as such entities usually require a business to have a track record and view new businesses as high-risk.
Pros and Cons
Pros:
- Minimal paperwork.
- No need for an EIN.
- Swift and easy setup.
- Low fees and costs.
- Pass-through tax advantage.
- Flexible banking.
Cons:
- Unlimited liability extends to the owner.
- Difficulty in raising capital.
How to Create a Sole Proprietorship
Starting a sole proprietorship is straightforward because it avoids many of the usual legal hurdles other business organization types face.
- Get Necessary Licenses and Permits: Check if your state or county requires specific business or occupancy licenses and permits.
- Register Business Name (DBA): If required by your state, register your business under a Doing Business As (DBA) name. If not, you can operate under your name.
- Apply for an EIN: Obtain an EIN if you plan to have employees or want to file tax returns separately from your SSN. Always consult a tax advisor to avoid errors.
If you plan to hire employees, an EIN is necessary. For selling taxable products, a sales tax license will be required from your state.
Sole Proprietorship vs. LLC vs. Partnership
Below are key distinctions between a sole proprietorship, an LLC, and a partnership:
| Feature | Sole Proprietorship | LLC | Partnership |
|---|---|---|---|
| Establishment | Easy, minimal paperwork | Must file articles of incorporation | May require partner contracts |
| Business Name | Can be owner’s or DBA name | Secured and established | Can be owner’s or DBA name |
| Liability | No protection, full owner liability | Legal protection for owners | No protection, full owner liability |
| Taxation | Filed on personal taxes if no EIN | Filed on personal taxes for one owner or as partnership for more | Declares income and losses on personal returns |
Transition From Sole Proprietor to LLC
Transitioning to an LLC is often the next step when a sole proprietor seeks to expand. This process involves ensuring the business name is available, filing articles of organization, creating an LLC operating agreement, and obtaining an EIN for the new entity.
Sole Proprietorship Tax Forms
Sole proprietors report their income and expenses on their personal tax returns and pay income and self-employment taxes on their profits. Here are the forms usually required:
- 1040: U.S. Individual Income Tax Return
- 1040-SR: U.S. Tax Return for Seniors
- Schedule C: Profit or Loss from Business (Sole Proprietorship)
- Schedule SE: Self-Employment Tax
- 1040-ES: Estimated Tax for Individuals
- W-2: Wage and Tax Statement (for employees)
- W-3: Transmittal of Wage and Tax Statements (for Social Security Administration)
- 940: Annual Federal Unemployment (FUTA) Tax Return
Example of a Sole Proprietorship
Most small businesses start as sole proprietorships. Take the example of Kate Schade, who began Kate’s Real Food as a sole proprietorship, creating and selling energy bars. From local vending in Jackson Hole, Wyoming, her business expanded into a corporation to better manage growth and investment.
Since its 2005 inception, Kate’s Real Food has grown significantly, now available in over 4,000 retailers nationwide and operating a production facility in Bedford, Pennsylvania.
Starting a Sole Proprietorship: Tips and Steps
To kick off a sole proprietorship:
- Launch your business and choose a company name.
- Check local regulations to determine if you need a local business permit or license.
- If hiring employees, obtain an EIN from the IRS, and register for a sales tax license if you will sell taxable products.
Is Being a Sole Proprietorship the Same As Being Self-Employed?
Yes, being a sole proprietor equates to being self-employed since a sole proprietor operates independently without an employer.
How Do You File Taxes As a Sole Proprietor?
File the standard tax Form 1040 along with Schedule C for your business’s profits and losses. Your tax owed totals the income from both forms. Additional forms may be required if you have employees.
Should You Form an LLC or a Sole Proprietorship?
Your decision depends on your business needs. A sole proprietorship is suitable for low-risk, low-profit small businesses with a manageable customer base. It often starts as a hobby that turns into a business.
On the other hand, an LLC is more appropriate if your business has liability risks, large profit potential, a wide customer base, and could benefit from specific tax structures.
How Do You Convert a Sole Proprietorship to an LLC?
Convert this by filing articles of organization with your state, re-filing your DBA to keep the company name, and obtaining an EIN from the IRS.
The Bottom Line
Starting as a sole proprietor is a simple and effective way for individuals to venture into business. Although it offers ease of setup and straightforward operations, it also comes with risks like unlimited liability that may prompt transitioning to a different business structure as the enterprise grows.
Related Terms: LLC, corporation, self-employment, business entity, limited liability partnership.
References
- Internal Revenue Service. “Topic No. 407 Business Income”.
- Internal Revenue Service. “Qualified Business Income Deduction”.
- Internal Revenue Service. “Form SS-4 & Employer Identification Number (EIN) 1”.
- U.S. Small Business Administration Office of Advocacy. “2023 Small Business Profile”, Page 1
- Internal Revenue Service. “Do You Need a New EIN?”
- Kate’s Real Food. “About Us”.
- Jackson Hole News & Guide. “Tram Good: Local Product Goes National”.
- Internal Revenue Service. “Sole Proprietorships”.
