What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business that has just one owner with no separation between the business and the owner. The owner receives all profits but is also liable for all debts and losses.
The owner of a sole proprietorship pays personal income tax on profits earned from the business. Many sole proprietors do business under their own names because creating a separate business or trade name isn’t necessary.
Also referred to as a sole trader or a proprietorship, a sole proprietorship is the easiest type of business to establish or take apart, due to a lack of government regulation. As such, they are very popular among sole owners of businesses, individual self-contractors, and consultants. Most small businesses start as sole proprietorships and either stay that way or expand and transition to a limited liability entity or corporation.
Key Takeaways
- A sole proprietorship is an unincorporated business with only one owner who pays personal income tax on profits earned.
- Sole proprietorships are easy to establish and dismantle due to a lack of government involvement, making them popular with small business owners and contractors.
- Most small businesses start as sole proprietorships and end up transitioning to a limited liability entity or corporation as the company grows.
- One of the main disadvantages of sole proprietorships is that they do not have any government protection, as they are not registered. This means that all liabilities extend from the business to the owner.
- Sole proprietors report their income and expenses on their personal tax returns and pay income and self-employment taxes on their profits.
Understanding Sole Proprietorships
If you want to start a one-owner business, the simplest and fastest way is through a sole proprietorship. A sole proprietorship begins when you begin conducting business. It doesn’t require filing federal or state forms and has few regulatory burdens, making it an ideal way for self-employed people to start out.
A sole proprietorship is very different from a corporation, a limited liability company (LLC), or a limited liability partnership (LLP), in that no separate legal entity is created. As a result, the business owner of a sole proprietorship is not exempt from liabilities incurred by the entity.
For example, the debts of the sole proprietorship are also the debts of the owner. However, the profits of the sole proprietorship are also the profits of the owner, as all profits flow directly to the business owner.
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Advantages and Disadvantages of a Sole Proprietorship
Advantages
The main benefits of a sole proprietorship are the pass-through tax advantage, the ease of creation, and the low fees for creation and maintenance.
- The tax benefits. Income generated from a pass-through business is only subject to a single layer of income tax and, in some cases, may be eligible for a 20% tax deduction. Along with slashing the corporate tax rate, the Tax Cuts and Jobs Act (TCJA) of 2017 added a tax break for pass-through entities that essentially allows them to deduct up to 20% of qualified business income. That deduction can result in huge savings and runs until Jan. 1, 2026—unless extended by Congress.
- With a sole proprietorship, you do not need to fill out a tremendous amount of paperwork, such as registering with your state. You may need to obtain a license or permit, depending on your state and type of business. But less paperwork allows you to get your business off the ground faster.
- The tax process is simpler because you do not need to obtain an employer identification number (EIN) from the Internal Revenue Service (IRS). You can obtain an EIN if you choose to, but you can also use your own Social Security number (SSN) to pay taxes rather than needing an EIN.
- With a sole proprietorship, you also don’t need a business checking account, as other business structures are required to have. You can simply conduct all your finances through your personal account.
33.3 million
The number of small businesses in the United States in 2023. Together, these businesses employed 61.6 million people across the country.
Disadvantages
There are some disadvantages of sole proprietorships, which can be impactful to the business owner. When a business is registered, it has some legal protections. A sole proprietorship provides no liability protection to the owner. By contrast, an LLC separates business and personal assets. The owner has protection against creditors seizing their personal assets, such as their home.
This unlimited liability goes beyond the business entity to the owners themselves. It can be difficult to get capital funding, specifically through established channels. Standard funding avenues include the ability to issue company equity and obtain bank loans or lines of credit. Banks prefer to work with companies that have a track record and generally view those who are starting out with a small balance sheet as high-risk borrowers. Obtaining funding from large investors can also be difficult.
Pros
Less paperwork
No need to obtain an EIN from the IRS
Quick and easy setup compared with other business structures
Low fees and costs
Pass-through tax advantage
Easier banking
Cons
Unlimited liability goes from business to owner
Difficulty in raising capital
How to Create a Sole Proprietorship
It isn't very difficult to start a sole proprietorship. That's because there aren't the usual legal hurdles that you have to overcome with other types of business organizations. In most cases, starting the entity is as easy as establishing yourself as the owner and starting up. Depending on where you live, there are certain steps you can take to formally launch your sole proprietorship.
- Get your business license and any permits you may need. Some states require that you apply for licenses (business or occupancy) as well as permits. Check with your state or county clerk to see if you need any special paperwork to begin your business.
- You may need to register your business under its Doing Business As name if your state requires it. If this isn't the case, you can operate under an assumed name, which can usually just be your own. Keep in mind that there are legal ramifications if you choose to run your sole proprietorship under your name.
- Apply for and obtain an EIN. This is an important and necessary step if you're going to have any employees or file tax returns. If this doesn't apply to you, you're able to use your own SSN. Either way, it's always a good idea to check with a tax advisor so you don't make any mistakes.
If you plan to hire employees, you will need an EIN from the IRS. If you are going to sell taxable products, you will need to register for a sales tax license with your state.
Sole Proprietorship vs. LLC vs. Partnership
As noted above, there are certain distinctions between a sole proprietorship, a limited liability company, and a partnership. The chart below highlights some of the key differences between the three.
| Sole Proprietorship | LLC | Partnership | |
| Establishment | Easy to establish, no paperwork unless required by the state | Must file articles of incorporation with the state | May require contracts for each partner |
| Business Name | Can operate under owner's or fictitious name or formally register under Doing Business As | Established and secured | Can operate under owner's or fictitious name or formally register under Doing Business As |
| Liability | No legal protection, owner is fully liable | Protection for owners | No legal protection, owner fully liable |
| Taxation | Filed under owner's personal taxes if there is no EIN | Filed under owner's personal taxes for one owner Treated as partnership for two or more owners | Filed under partnership Partners declare income and losses from partnership on personal returns |
Transition From Sole Proprietor to LLC
When a sole proprietor seeks to incorporate a business, the owner usually restructures it into an LLC. For this to work, the owner must first determine that the name of the company is available. If the desired name is free, articles of organization must be filed with the state office where the business will be based.
After the paperwork is filed, the business owner must create an LLC operating agreement, which specifies the business structure. Finally, the new company must obtain an EIN—similar to an SSN, but for businesses—from the IRS.
Note
A sole proprietorship has no separation between the business entity and its owner, setting it apart from corporations and limited partnerships.
Sole Proprietorship Tax Forms
Sole proprietors report their income and expenses on their personal tax returns and pay income and self-employment taxes on their profits.The tax forms you may need to file could include the following:
| Tax Forms for Sole Proprietorship | |
|---|---|
| If you are liable for: | Use form: |
| Income tax | 1040, U.S. Individual Income Tax Returnor 1040-SR, U.S. Tax Return for Seniors and Schedule C (Form 1040 or 1040-SR), Profit or Loss from Business (Sole Proprietorship) |
| Self-employment tax | Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax |
| Estimated tax | 1040-ES, Estimated Tax for Individuals |
| Social Security and Medicare taxes and income tax withholding | 941, Employer’s Quarterly Federal Tax Return; 943, Employer’s Annual Federal Tax Return for Agricultural Employees; 944, Employer’s Annual Federal Tax Return |
| Providing information on Social Security and Medicare taxes and income tax withholding | W-2, Wage and Tax Statement (to employee) and W-3, Transmittal of Wage and Tax Statements (to the Social Security Administration) |
| Federal unemployment (FUTA) tax | 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return |
Example of a Sole Proprietorship
Most small businesses start as sole proprietorships and evolve into different legal structures as time passes and the company grows.
For example, Kate Schade started her company, Kate’s Real Food, as a sole proprietor. The company creates and sells energy bars and began as a local vendor in Jackson Hole, Wyoming. The sole proprietorship currently has a production facility in Bedford, Pennsylvania, and can be found in more than 4,000 retailers.
Since launching in 2005, Kate’s Real Food has grown to supply accounts across the country. In response, Schade restructured the business from a sole proprietorship to a corporation to take on investments and expand, a natural step for a growing business.
How Do You Start a Sole Proprietorship?
To start a sole proprietorship, you generally have to launch your business. It is useful to choose a company name. Depending on your business and local regulations, you may need to apply for a permit or license with your city, county, or state. If you plan to hire employees, you will need an employee identification number from the IRS. If you are going to sell taxable products, you will need to register with your state for a sales tax license.
Is Being a Sole Proprietorship the Same As Being Self-Employed?
Yes, being a sole proprietor is the same as being self-employed. A sole proprietor does not work for any company or boss, so they are self-employed.
How Do You File Taxes As a Sole Proprietor?
Filing taxes as a sole proprietor requires you to fill out the standard tax Form 1040 for individual taxes and Schedule C, which reports the profits and losses of your business. The amount of taxes you owe will be based on the combined income of both Form 1040 and Schedule C. If you have employees, there will be other forms to fill out.
Should I Form a Limited Liability Company or a Sole Proprietorship?
That depends on your business. A sole proprietorship is best suited to small businesses with low risk and low profits. Generally, these businesses don’t have a wide range of customers but rather a small, dedicated group. Sole proprietorships often start as hobbies that grow into a business.
The reasons to start a limited liability company (LLC) are the opposite of the reasons above. The business entails some liability risks, has the potential for large profits and a large customer base, and is positioned to benefit from certain tax structures.
How Do You Convert a Sole Proprietorship to an LLC?
Converting a sole proprietorship to an LLC requires you to file articles of organization with your state secretary. Also, you will have to refile your DBA (or Doing Business As) to keep your company name. Lastly, you will need to obtain an EIN from the IRS.
The Bottom Line
A sole proprietorship is a straightforward way for an individual to start a business. It does not require registering with a state authority for most situations and does not require obtaining an EIN from the IRS.
The benefits of simplicity are accompanied by some drawbacks, including all liabilities being passed through from the business to the individual and funding being harder to come by. Those risks shouldn’t pose much of an issue initially. However, as the business grows, it may make sense to transition into a different legal structure.
