In the United States, there are several types of structures available to a single-owner business researching how to start a business, including sole proprietorship, C corporation, S corporation, and limited liability company (LLC).
The type of business entity you choose can impact everything from how you pay your taxes to the amount of paperwork you have to fill out to whether you can bring on investors or not.
One of the most common business structures is a sole proprietorship, which many individuals running small businesses use, including freelance graphic designers and computer programmers.
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What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned by one person. At its core, it’s not a separate legal entity. The owner of a sole proprietorship and the business itself are one and the same, meaning that all profits, losses, liabilities, and legal responsibilities are directly the owner’s responsibility.
Because of that, a sole proprietor has unlimited personal liability. That means your personal assets—your house, personal bank accounts—are also at risk if a claim is made against the business (e.g., through a lawsuit) or you have to pay back business debts.
On the flip side, filing taxes is relatively painless because of the simplicity of the business structure. As a sole proprietor, you file your business income on your personal tax return.
Advantages of a sole proprietorship
- Easy to establish
- Full control for the owner
- No corporate income taxes
- Less costly than other business models
- Offers tax advantages
- Simple dissolution process
1. Easy to establish
A sole proprietorship is the simplest of all the structures for a single-owner business. Your business is automatically considered a sole proprietorship without having to incorporate it However, you must apply for any business licenses or permits that your state requires for your profession.
As the owner, you are responsible for all business debts, losses, and liabilities, but are also entitled to all the business profits, too. The IRS states you don’t even need an employer identification number (EIN) to operate under a sole proprietorship.
Because there is no formal action required to form a sole proprietorship, owners can save money and time that would otherwise be spent fulfilling paperwork requirements.
2. Full control for the owner
In a sole proprietorship, the owner has full authority and responsibility for the business. Since there are no partners, board members, or shareholders, the owner has the final say in all business decisions. This can allow for more agility and responsiveness, as there is no need to consult with or gain approval from others.
The owner is entitled to all profits from the business but is also responsible for all losses and debts. The funds don’t have to be shared or allocated among multiple parties, providing more financial freedom but also increasing personal risk.
3. No corporate income taxes
Instead of completing corporate income like a large corporation would, sole proprietorships require the owner to pay only personal income taxes. You simply have to attach a Schedule C to your 1040 form.
In addition to personal income tax, the owner must pay self-employment taxes, which cover Social Security and Medicare. This is typically done by filing Schedule SE with the federal tax return.
4. Less costly than other business models
While sole proprietors must abide by licensing requirements designated by the states where they work, other paperwork and formalities are limited. As a result, it’s less costly to start than a corporation. Costs to forming a sole proprietorship typically come when filing taxes, as you might need to enlist the help of a tax professional.
5. Offers tax advantages
Sole proprietorships are considered pass-through entities, meaning the profits and losses “pass through” to the owner’s individual tax return. There’s no double taxation as with some corporations, where income is taxed at the corporate level and again at the individual level on dividends.
You can also deduct legitimate business expenses directly on Schedule C. This might include costs related to a home office, equipment, advertising, and more.
6. Simple dissolution process
If you decide to end the business, the process is typically straightforward. There are no complex legal procedures to navigate, unlike with larger, more formal business structures.
Disadvantages of a sole proprietorship
- Owner liable for all debts and obligations
- Unlimited personal liability
- Sole responsibility for capital contributions
- Difficulty securing capital investments
- Higher tax rates compared to other models
1. Owner liable for all debts and obligations
In a sole proprietorship, there is no legal distinction between the owner and the business. This means that if the company incurs debts or other financial obligations, you, as the business owner, are responsible for them.
It extends to the actions of employees or contractors, so if they cause a problem that leads to a financial or legal burden, you will be personally responsible for resolving it. It’s a major consideration that can expose you to unexpected liabilities.
2. Unlimited personal liability
The lack of separation between your personal and business assets means that if someone sues your business, they can go after your personal assets, such as your home, car, or savings.
Other business structures, like corporations, shield personal assets, but a sole proprietorship has zero liability protection. This can create significant risks, particularly if your business operates in a field with high legal risks.
3. Sole responsibility for capital contributions
As a sole proprietor, you’ll be the only source of capital for business needs, from office equipment to inventory. Traditional lenders often view sole proprietorships as riskier investments, so getting a loan might be more challenging. You’ll need to ensure that you have the personal financial resources to support the business.
4. Challenges in securing capital investments
Unlike other business structures, you cannot sell equity in a sole proprietorship. Investors generally seek equity in exchange for their investment, but since a sole proprietorship can only have one owner, this option is off the table. This can limit your ability to grow and scale your business, particularly if you’re in an industry that requires substantial capital investment.
The same goes with selling your business, if you ever decide to. You can’t sell your business as a whole. In fact, you have to sell off the assets. This also means the buyer cannot keep your business name unless you establish as DBA, or “doing business as,” and transfer the rights to the buyer.
5. Higher tax rates compared to other models
As a sole proprietor, you have to pay self-employment tax on top of personal income tax. It can also be trickier to figure out how much you will owe in taxes, because you are combining business and personal taxes. To avoid paying a larger-than-expected tax bill at the end of the year, the IRS recommends estimating and paying your business taxes quarterly.
Is a sole proprietorship right for your business?
A sole proprietorship is best for small businesses that are owned and operated by one person. Think freelancers, consultants, or other independent contractors. It’s best if you have a low-risk business with low profits. More often than not, they are hobbies or side hustles that turn into a new business later on.
Despite the above challenges, a sole proprietorship does offer an easy entry into the business world as an entrepreneur. With minimal startup costs, less paperwork, and full control over the business, it can be an excellent way to validate a business idea or operate a small, personal business. However, understanding and mitigating the risks associated with this type of business structure is vital to avoid unexpected challenges down the road.