Sole Proprietorship Business Definition, Taxes, and Benefits
A sole proprietorship is one of the simplest and most popular ways to structure a business, especially for freelancers or those turning to the gig economy full time. According to the U.S. Small Business Administration (SBA), over 70 percent of U.S. businesses are owned by sole proprietors or traders.
While a sole proprietorship is the most common way to structure a new business, it may not be the best choice for you. Let’s look at what that means, how it compares to other common business structures, and some of the biggest benefits and drawbacks of forming your business this way.
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What Is a Sole Proprietorship?
Simply put, a sole proprietorship is a business run and owned by a single person. There is no legal distinction between the business and the owner (other than when the owner uses a DBA name for the business), making the owner personally responsible for all profits, losses, and debts. Even if you create a fictitious or trade name for your business, all legal actions — such as signing a contract — must be done under your own name.
As a sole proprietor, you are the only person who can make decisions about your business. You don’t have to discuss changes with any partners, get approval from board members, and even face less government regulation. Further, unlike other entities, you can mix personal funds and business funds.
It requires minimal effort to open and maintain a sole proprietorship. However, if your company becomes more complex and grows larger, you may need to transition to another business structure and take care of any associated paperwork or legalities needed to do so.
Sole Proprietorship Examples
Because they are so popular, there is virtually no limit to what kind of business can be formed this way. Certain industries and niches, though, are better-suited to the structure of a sole proprietorship due to the level of complexity and organization required to run them. Some businesses that are commonly run this way include:
- Freelance writers
- Caterers, bakers, and chefs
- Financial planners
- Virtual assistants
To open your business as a sole proprietorship, you simply need to secure the appropriate licensing and permits. The SBA has a tool you can use to find the documentation you need for your business in your area.
Sole Proprietorship Taxes
Taxes work a little differently for sole proprietorships than for individuals or other business entities. However, it is still fairly simple to file taxes as a sole proprietor. Because there is no legal separation between you and your business, the income earned by the business is also earned by its owner. To report your income on your taxes, you will need to complete a standard 1040 form.
You also need to include a Schedule C form, where you record your business profits, losses, and expenses. The net income from the Schedule C form is then recorded on your 1040. This can work in your favor if you experience business losses but gain profits from other endeavors.
In addition, you need to file a Schedule SE form to determine the amount of self-employment tax you owe. As a sole proprietor, you are self-employed; the profit you make while self-employed is what you are taxed on. This information also needs to be included on your 1040.
Sole Proprietorship vs LLC
A limited liability company (LLC) is a type of corporation that shares many similarities with a sole proprietorship. While it still offers plenty of freedom for the owner and is easy to create, some key differences between the two include:
- Separate Entity: Sole proprietorships and their owners are one and the same. However, an LLC is legally distinct from its owner. All personal and business funds must be kept separate from each other. Additionally, because it is separate, an LLC can have more than one owner.
- Added Protection: Sole proprietors assume all liability for their business, but because LLCs are their own entity, their owners are better protected against lawsuits, debts, and losses. Essentially, your personal assets are not at risk if something happens to the business if it is an LLC.
- Existence: A sole proprietorship can only exist as long as its owner controls the business. If the owner dies, retires, or sells their business, the sole proprietorship will no longer exist. An LLC, on the other hand, can continue to exist even if the owner leaves the company.
Depending on what your business does, an LLC might not be necessary for your needs. For example, a freelance writer is much less likely to cause a customer harm than a caterer or chef. Thus, a writer might choose to become a sole proprietor, while someone who cooks might want the extra protection offered by an LLC.
Sole Proprietorship vs Partnership
Though there are several types of partnerships, the main difference between a sole proprietorship and any kind of partnership is the number of business owners. A sole proprietorship only has one, while a partnership has two or more owners. Primarily, partners share profits, liability, debts, and losses, but having multiple owners affects how business is conducted in a number of ways:
- Decision Making: As a sole proprietor, you make decisions for your company on your own. In a partnership, all partners must make decisions together. This can lead to tension and take more time to make decisions than a single owner might.
- Private Information: When you are the only owner, you don’t have to share private or sensitive information about the business with anyone else. But in a partnership, every partner must be made aware of any and all business secrets.
- Existence: As stated above, a sole proprietorship ends when the owner leaves the business. A partnership, though, can dissolve when one owner leaves the company, or can continue on, depending on what you’ve agreed to.
It can be difficult to work closely with others when opening a business. Partnerships face challenges with communication and conflict that are irrelevant to a sole proprietor. However, some find it comforting to have someone to share the burdens of leadership with. It comes down to what’s best for you and your business.
Advantages and Disadvantages of Sole Proprietorship
Of course, there are both advantages and disadvantages of owning a sole proprietorship. Consider some of the most appealing, as well as most unattractive, aspects before forming this kind of business entity.
Advantages of Sole Proprietorship
There are many benefits to creating a sole proprietorship, such as:
- Ease of Creation: Creating a business with this structure is easy, requires little paperwork, and is relatively inexpensive. It also does not require much administrative maintenance.
- Control of Business: You are in complete control of your business. You do not have to get approval from a partner or board members before making any decisions or changes.
- Simple Taxation: Because your business is not a separate entity, filing taxes is a fairly simple process.
Disadvantages of Sole Proprietorship
Some of the biggest drawbacks include:
- Liability: Perhaps the biggest downside to a sole proprietorship is that you are liable for every aspect of your business. If anything goes wrong, your personal assets may be at risk.
- Difficult to raise capital: Investors cannot buy stock in your company, as you are the only person who can control it, making it difficult to find funding.
- Loss of value: Your business does not retain its value after you withdraw from it, simply because a sole proprietorship cannot really exist without you.
Though it is a popular way to structure your business, a sole proprietorship does come with a unique set of challenges. Be sure to consider both its benefits and drawbacks. You just may come to the conclusion that this business entity is the best one for your needs.
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