One of the first steps in researching how to start a business is deciding how you’ll structure it. There are a variety of structures available for small businesses in the United States. Which business structure you choose will depend on the type of business you’re running and your goals for the future.
New small business owners may choose to operate as a sole proprietorship because it’s less expensive and easier to set up than other business structures, such a limited liability company (LLC) or corporation. With fewer hoops to jump through than other business forms, sole proprietorships are an easy and inexpensive way to run your side gig or freelance hustle.
What is a sole proprietor?
A sole proprietor is a person who runs an unincorporated business with a single owner. No legal distinction is made between you and the business. That means you are personally responsible for all aspects of the venture, including business debts, losses, and liabilities. If someone makes a legal claim against a sole proprietorship, they can potentially go after both business assets and the owner’s personal assets.
In other words, a sole proprietor has unlimited personal liability.
Unlike other types of business structures—like LLCs, S corps, or C corps—you don’t have to file any paperwork or pay any fees to establish a sole proprietorship. In fact, any new business with one owner is considered a sole proprietorship automatically. For example, if you do freelance work outside of your normal job where you are a full-time employee, that work is done under a sole proprietorship if you haven’t set up any other type of business entity.
How are sole proprietors taxed?
Filing income taxes as a sole proprietor is fairly simple because a sole proprietorship is not a separate legal entity from the business owner. Income from the business is treated as your personal income, which means that a sole proprietor must file any business income (profit minus expenses) on his or her personal income tax return.
You’ll use the Schedule C section of your Form 1040 to report your business income to the Internal Revenue Service (IRS). You will need to pay self-employment taxes, as well as federal and state income tax on your business profits. To make tax filing easier, keep a record of profits and losses for tax purposes throughout the year.
As a sole proprietor, you have to pay the full amount of Social Security and Medicare taxes (a.k.a. self-employment taxes), according to the IRS Schedule SE on the 1040 form (you can deduct half the amount). The IRS recommends that sole proprietors pay their estimated self-employment income taxes quarterly to avoid fees or a massive tax bill in April.
If you have employees or contractors earning more than $600 in a year, you’ll need to include a W2 or 1099 form for each when filing taxes. You’ll have to pay half of any employees’ Social Security and Medicare taxes.
What sole proprietors can and cannot do
There are a few important restrictions to a sole proprietorship that you should know to make sure you’re paying your taxes correctly and to avoid any penalties or fees:
As a sole proprietor, you can:
- Get an employer identification number (EIN) from the IRS to avoid sharing your SSN (Social Security number) with clients
- Hire employees (if you have an EIN)
- Merge your personal and business property and funds (although it’s a good idea to keep separate bank accounts for your sole proprietorship so you can more accurately track expenses, which you can claim as deductions on your tax return)
- Register your business name, if it differs from your own name
- Own more than one sole proprietorship (though you’ll have to report earnings and expenses on separate Schedule Cs)
- Opt out of liability insurance (although the IRS strongly recommends having liability insurance)
As a sole proprietor, you cannot:
- Avoid personal liability for any debts or losses, whether as a result of business activities or litigation.
- Transfer the business to someone else (unless specified in a will)
- Report business losses for more than two years in a five-year period. Otherwise, the IRS may decide your business is a hobby, and bar you from deducting expenses in the future
What are the advantages of being a sole proprietor?
When deciding the type of business entity that works best for you, a sole proprietorship has many advantages, not the least of which being that they are quick and cheap to set up:
- Easy to form. Because no formal action is required to form a sole proprietorship, you can save money and time that would otherwise be spent meeting certain legal requirements specific to other types of business entities, like LLCs. Your business is automatically considered a sole proprietorship if you have not pursued other routes for incorporation.
- Complete control. As the sole proprietor, the owner makes all decisions for the business without needing to consult anyone else, as they would in a partnership. Owners can even pass down the business to heirs of their choice.
- No corporate tax payments. Instead of completing corporate employment taxes like a large corporation, sole proprietorships require the owner to pay only personal income taxes on the profits.
- Inexpensive to establish. While sole proprietors must abide by any relevant licensing requirements in the states where they conduct business, they face less paperwork and fewer formalities compared to a limited liability company, C corp, or S corp. As a result, it is typically less costly to start a sole proprietorship business.
- Entitled to all the profits. The owner of a sole proprietorship is entitled to all business profits.
What are the disadvantages of being a sole proprietor?
When setting yourself up to successfully run a business, particularly a sole proprietorship, fully inform yourself by considering the disadvantages of this type of business:
- Full responsibility for debts and obligations. As the sole proprietor, the owner is personally liable for the debts and obligations of their business, even if those liabilities are a result of something an employee did. Corporate business structures, including LLCs, protect owners from unlimited liability.
- Capital contributions. When raising capital, a sole proprietor cannot seek outside investment or sell stock. Instead, the owner contributes whatever capital the business needs. A small business in which more than one person owns equity cannot be a sole proprietorship, but may seek other kinds of funding.
When to consider converting a sole proprietorship to an LLC
Many small business owners love the flexibility and ease of a sole proprietorship. However, as your business grows, you might want to share the management, bring on investors, or limit the risk to your own personal finances. In this case, the logical next step may be to become a limited liability company (LLC).
An LLC is a distinct legal entity that separates the business from your personal finances. This can have many advantages, including:
- Eliminating personal liability. Your personal finances are safe from lawsuits, debts, or other claims against your business.
- Sharing management. Most businesses with more than one owner cannot be a sole proprietorship, and are automatically considered a general partnership in which all owners are personally liable. Consider an LLC or LLP if you want your business to exist as a separate entity and eliminate all personal liability.
- Adding investors. It is impossible to bring on investors with a sole proprietorship.
Final thoughts on sole proprietorship
When considering whether to run your business as a sole proprietorship, here are some questions to work through for yourself and your business:
- What’s my risk level in terms of liability? What are scenarios in which my business could face a legal claim?
- What personal assets would be at risk if that happened?
- Does my business make enough money to justify the costs associated with incorporating?
- Do or will I need outside investment to fund my business?
- Will I always be the only owner of my business, or might I want to bring on partners?
- Could I (or do I want to) handle the administrative burden associated with other business entities like an LLC or corporation?
Sole proprietor FAQ
Is it better to be a sole proprietor or LLC?
A sole proprietorship is a simpler and less expensive business structure, while an LLC offers more legal protections and may provide tax benefits. Ultimately, your decision should be based on the size and complexity of your business, the level of personal liability you are comfortable with, and the amount of paperwork you are willing to handle.
How does a sole proprietor pay taxes?
A sole proprietor pays taxes on business income through a self-employment tax. This tax combines Social Security and Medicare taxes and is reported and paid quarterly on Form 1040-ES. A sole proprietor also reports income taxes on their personal tax return (Form 1040), using Schedule C.
How do you protect yourself as a sole proprietorship?
While sole proprietors can’t avoid personal responsibility for business losses or debts, they can protect themselves to some extent by purchasing professional liability insurance and maintaining a separate bank account for business expenses.
What taxes do I pay as a sole proprietorship?
A sole proprietorship business owner must pay self-employment taxes on any profits. The current self-employment tax rate is 15.3%.