Is a sole proprietorship right for you? Learn about the advantages and disadvantages and what to consider when establishing this type of business ownership.
Business Basics: How Sole Proprietorships Work
There are more than 32 million businesses in the United States and over 75 percent of them don’t have any employees, according to the U.S. Census Bureau. These businesses are run by self-employed individuals, mostly through sole proprietorships.
A sole proprietorship is the most common form of business ownership in the country. With minimal legal and financial requirements, it’s the easiest way to structure a small business. Owners can enjoy being their own boss; however, they’re also personally liable for any debt or losses.
This article provides an overview of sole proprietorships, their advantages and disadvantages and what to consider when establishing one.
What Is a Sole Proprietorship?
A sole proprietorship is a form of business ownership. Unlike a partnership or corporation, it’s owned and operated by one person.
As a result, the owner isn’t considered distinct from the business. A sole proprietor assumes all the financing, management and risks. Any profits and losses are reported on the owner’s personal tax return, and the owner is personally responsible for any debts.
What Kind of Businesses Are Sole Proprietorships?
Sole proprietorships are present in almost every sector of the American economy. They’re particularly prominent in industries that include real estate leasing, arts and entertainment, consulting, janitorial services, beauty salons and building construction.
Can More Than One Person Run a Sole Proprietorship?
Sole proprietorships are owned and operated by only one person.
In some cases, a married couple may operate a sole proprietorship together as a qualified joint venture, if they meet certain requirements. Or, one spouse may be a sole proprietor and hire their spouse as an employee.
A business that’s jointly owned and operated by a married couple must choose another form of ownership, such as a partnership.
Benefits of a Sole Proprietorship
There are several advantages of a sole proprietorship for individuals who want to be self-employed.
1. Easy to Create
Because sole proprietors work for themselves, there are no legal agreements, articles of incorporation or bylaws required. In fact, if you earn self-employment income and don’t register as any other type of business, you’re considered a sole proprietor by default.
2. Flexible Decision-Making
Sole proprietors are their own bosses. They make decisions without requiring the approval of a board of directors, partners or shareholders, so it’s easy to respond to situations as they arise and quickly implement change.
3. Simple Tax Structure
Sole proprietorships are pass-through entities, which means the owner doesn’t submit a separate tax return for the business. Net income or loss is reported on the sole proprietor’s personal tax return.
All profits flow to the sole proprietor and are taxed based on the owner’s individual federal tax bracket.
Disadvantages of a Sole Proprietorship
While the simplicity of a sole proprietorship is appealing, it’s important for entrepreneurs to consider the challenges and risks of this type of ownership.
1. Personal Liability
As there’s no distinction between the business entity and the owner, the sole proprietor is responsible for all debts, liabilities and legal action.
By comparison, businesses that incorporate are considered separate legal entities. Debts and obligations are assumed by the corporation.
2. Difficult to Raise Capital
It can be challenging for sole proprietors to access adequate funding to expand their operations. They must restructure to take on or shareholders. Applications for bank loans are typically based on the proprietor’s personal assets and credit rating.
3. Limitations of a Single Owner
Sole proprietorships aren’t considered a separate entity from the owner and are limited in their lifespan. Without a partnership or corporate structure in place, a business is finite and can end upon disability or death of the sole proprietor.
How to Form a Sole Proprietorship
Sole proprietorships are easy to set up but still require some documentation and record-keeping. Here are a few things to consider if you decide a sole proprietorship is right for you.
1. Licenses and Permits
Ensure you have the required licenses and permits to run your business at the municipal, state and federal levels. For example, there may be specific regulations pertaining to your industry. Investment advisors must register with the federal Securities and Exchange Commission, and healthcare professionals, such as physical therapists, require a state license.
2. Business Name
Many sole proprietors do business using their own names; however, you can create and register a separate business name to promote your goods and services.
3. Business Bank Account
There’s no requirement to maintain a separate bank account for a sole proprietorship.
4. Paying Taxes as a Sole Proprietor
Sole proprietors report business income on their personal tax return, using Schedule C and Form 1040.
Schedule C is used to provide details of income from the sale of goods and services. It’s also used to claim tax deductions for small businesses, such as advertising, supplies and office expenses. Once the net profit or loss for the year is calculated on Schedule C, it’s reported on Form 1040, the sole proprietor’s personal tax return.
Sole proprietors must also file the appropriate tax forms and pay, as applicable:
- Income taxes
- Self-employment taxes
- Social Security and Medicare withholding
- Federal unemployment tax
- Excise taxes
Does a Sole Proprietorship Make Sense for Your Business?
Whether a sole proprietorship, partnership or corporation is the best choice, your business depends on the complexity of your work, goals and business plans.
If you expect to be the only person running the business on a long-term basis, a sole proprietorship may make the most sense. If you’re interested in expanding over time, inviting investors and hiring employees, a different structure may be more appropriate. You may need to consult a business lawyer if you expect significant legal or financial risk.
It’s also possible to start your business as a sole proprietorship and restructure later if your needs change.