One of the most common business structures in the United States is a sole proprietorship. Quick and inexpensive to establish, sole proprietorships are a popular choice for small businesses owned by one person.
If you’re starting a business, knowing that soleproprietorship is one of several available legal structures, including C corporation, S corporation, and limited liability company (LLC), is helpful.
Since the type of business entity you choose will impact everything from how you pay taxes to how much paperwork you fill out to whether you can bring on investors, understanding how each structure can impact your business is crucial.
While the advantages of sole proprietorship are numerous, there are downsides. Learn the advantages and disadvantages of a sole proprietorship to decide if it’s the right structure for your business.
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What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned by a single person. For legal purposes, the person who owns the business essentially is the business—there’s no separate entity. Sole proprietors are directly responsible for all profits, losses, liabilities, and legal requirements.
Because of that, a sole proprietor has unlimited personal liability. That means your assets—your house and personal bank accounts—are at risk if you get into business debt or a claim is made against your company (e.g., through a lawsuit).
Conversely, filing taxes is relatively painless and sole proprietorship provides you with full control of your business.
Advantages of a sole proprietorship
- Easy to establish
- Full control for the owner
- No corporate income taxes
- Less costly than other business models
- Tax advantages
- Simple dissolution process
1. Easy to establish
A sole proprietorship is the simplest single-owner business structure—whether you sell products or services online, in person, direct-to-consumer, or wholesale. You don’t need to incorporate, register your business, or get an employer identification number (EIN) to be a sole proprietor because sole proprietorship is the default structure. For that reason, it’s a great option if you’re starting a business with no money. (That said, you still need to apply for business licenses or permits required by your state or profession.)
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, allowing for agility and responsiveness.
The owner is also entitled to all profits from the business and can choose to hire employees or not. Although hiring does add complexity to financial reporting and tax filing, there’s no legal limit on the number of staff a sole proprietor can employ.
3. No corporate income taxes
Instead of completing corporate income tax as large corporations do, sole proprietorships require owners only to pay their personal income taxes. Simply attach a Schedule C to your 1040 form, and you’re done.
4. Less costly than other business models
While sole proprietors must abide by state and federal licensing requirements, there’s less paperwork than other business structures, meaning fewer fees.
5. Tax advantages
The IRS considers sole proprietorships as pass-through entities, meaning profits and losses “pass-through” to the owner’s tax return. The double taxation that happens to some corporations—where companies pay tax on profits, and that profit is taxed again when it’s paid out in individual dividends—isn’t an issue with sole proprietorships.
Sole proprietors can deduct legitimate business expenses like home office equipment and advertising directly on Schedule C.
6. Simple dissolution process
The process is straightforward if you decide to end your sole proprietor business. And if you wish to restructure as a different business type, such as an LLC or S corporation, you can.
Disadvantages of a sole proprietorship
- Owner liability
- Unlimited personal liability
- Responsibility for capital contributions
- Challenges securing capital investments
- Higher tax rates
1. Owner liability
Since sole proprietorship does not distinguish between the owner and the business, the owner is responsible for all debts and financial obligations.
This responsibility extends to the actions of employees or contractors—if they create legal or financial burdens for your business, you’ll be responsible for resolving them. A sole proprietorship can expose you to unexpected liabilities if things go wrong.
2. Unlimited personal liability
Unfortunately, your liability as a sole proprietor extends to your personal assets, such as your home, car, or savings.
Other business structures, like corporations, shield these assets from risks such as lawsuits, but a sole proprietorship has zero liability protection. Consider this possibility, particularly if your business operates in a field with high legal risks.
3. Responsibility for capital contributions
As a sole proprietor, you’ll likely be the only source of capital for funding business costs like office equipment and inventory. Traditional lenders perceive sole proprietorships as risky investments, so securing loans can be challenging. Before spending on your business, ensure you have financial resources to support it.
4. Challenges securing capital investments
Investors generally seek equity in exchange for their backing, but since a sole proprietorship can only have one owner, offering equity isn’t an option. This limitation can hamper your ability to scale your business, particularly in industries requiring substantial capital investments.
It’s also difficult to sell a sole proprietorship. You can’t sell the business as a whole, although you can sell its assets. Also, buyers can only use your business name if you establish a DBA or “doing business as,” and transfer rights to them.
5. Higher tax rates
Taxes for sole proprietors differ from those of other business entities, like C corporations. As a sole proprietor, you must pay self-employment tax on top of personal income tax. Determining the amount you owe when combining business and individual taxes can also take time and effort. 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.
In addition to personal income tax, sole proprietors must also pay self-employment taxes, which cover Social Security and Medicare, typically by filing Schedule SE with the federal tax return.
Is a sole proprietorship right for your business?
A sole proprietorship is best for small businesses owned and operated by one person, like freelancers, consultants, or other independent contractors. The structure is best suited to low-risk companies with low profits. Often sole proprietorships start as hobbies or side hustles before becoming full-blown businesses.
Despite the challenges, a sole proprietorship offers easy entry into entrepreneurship. With minimal startup costs, little paperwork, and full business control, 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.
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Advantages of sole proprietorship FAQ
How is a sole proprietorship taxed?
The owner of a sole proprietorship is personally responsible for all income and expenses of the business, and the profits or losses pass directly through to their personal tax return. Rather than filing a separate business tax return, owners report business income and expenses on a Schedule C form attached to their individual tax return (Form 1040). Owners are taxed at their individual income tax rate and also pay self-employment taxes covering Social Security and Medicare.
Can I hire employees as a sole proprietor?
Yes, you can hire employees as a sole proprietor. However, when you do, you must get an employer identification number (EIN) from the IRS and withhold taxes from employee wages, including Social Security, Medicare, and federal income tax. You must also comply with state and federal labor laws, including wage standards and worker’s compensation.
Can I convert my sole proprietorship to another business structure?
Yes, you can convert your sole proprietorship to another business structure. Many businesses begin as sole proprietorships, but as they grow, they may transition to a different business structure, such as an LLC or corporation. Converting to another structure can offer additional liability protection or tax benefits. The process for converting varies by state—consider consulting with a tax adviser or attorney before making the change.
Do I need to separate my personal and business finances?
Technically speaking, you don’t need to separate your personal and business finances. However, it’s highly recommended that you do, even as a sole proprietor. Having a dedicated business bank account and credit card makes it easier to track expenses, manage cash flow, and show a clear distinction between personal and business transactions. This separation is also beneficial if you decide to incorporate or pursue outside funding in the future.
