What Is a Sole Proprietorship? [Full Breakdown]
One of the first steps to getting a business off the ground is deciding which type of business you’re going to create. You can establish a partnership, limited liability company, corporation, or a sole proprietorship. But what is a sole proprietorship? Don’t worry, we’ll help you understand each of these business types, including a deep dive into sole proprietorships, the most common business entity.
So you’re ready to launch your business, but where do you start? You have a great idea to make money on your own and a solid business plan. It’s time to tackle some of the legal business jargon like the type of business entity you want to launch.
Sole proprietorships are the most common businesses out there due to the ease of formation and limited hassle that goes into getting them off the ground. In this article, we’ll go over what sole proprietorships are, the advantages and disadvantages, and some other business types you can look into.
What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business entity that’s owned and operated by a single person or married couple. Sole proprietors benefit from all business profits, but they’re also responsible for all debts and legal obligations.
Sole proprietorships are the easiest business entity to form making them the most common type of business in the United States. According to the IRS integrated business data, over 70% of all businesses were sole proprietorships in 2013.
This type of business is inseparable from its owner and operator. Since sole proprietorships aren’t incorporated, the business owner reports all earnings and losses on their personal income tax return at the end of the year.
Although sole proprietorships are convenient and easy to form, they do expose you to some risks. While you get to reap all the benefits of your company’s profits, you’re also responsible for all the debts and losses your company incurs. You’re even vulnerable if a customer tries to take legal action against your company.
We’ll go over how you can set up your sole proprietorship, but first, let’s go over some of the pros and cons of going this route.
Advantages of a Sole Proprietorship
Sole proprietorships have several advantages. They’re easy to set up, require little maintenance, give you full ownership, and are great for tax purposes.
1. Quick to Set Up
Setting up a sole proprietorship is easy. We’ll get into the details below, but in summary, you simply start doing business and, just like that, you’ve formed a sole proprietorship. You’ll need to obtain the necessary licenses, permits, and establish a business name, but that’s pretty much it — no paperwork required.
2. Little Ongoing Maintenance
Once you’re operating a sole proprietorship, there’s little ongoing legal maintenance you need to worry about. This isn’t the case for other types of businesses like LLCs which require legal documentation on a regular basis. As a busy business owner, you can spend all of your time focusing on growing your business and turning a profit.
3. You Have 100% Ownership
You have 100% ownership meaning you get to rake in any profits your company makes. This also means you’re the boss and have complete control. You won’t have to answer to anyone besides yourself. You can set your own schedule, work when you want, and work however long you want.
4. Tax Season Benefits
Filing self-employment taxes is a breeze when tax season rolls around. You’ll only need to file one tax return since your profits or losses are reflected on your personal tax return. You also open the door to some tax benefits that others don’t have access to.
One of these tax benefits is a 20% tax deduction granted by the Tax Cuts and Jobs Act of 2017 (TCJA). This enables sole proprietors to deduct 20% of the business’s net income from their taxes.
Additionally, you can deduct business losses from your personal income if you have another job beyond being self-employed. This is especially beneficial to those who are currently employed elsewhere and are starting a business on the side.
Disadvantages of a Sole Proprietorship
Sole proprietorships do have their drawbacks. They leave you vulnerable to company losses and legal action, they may make it difficult to land clients and financing, and they are difficult to sell if you ever want to step away from the business.
1. You’re Personally Liable
Sure, you get to pocket all of the profits. But what happens if your company loses money? You’ll be personally liable for any losses your company endures. Therefore if you overextend yourself and get into financial trouble, lenders and disgruntled customers can collect from you personally.
This also applies to legal action. You’re unprotected if a business or customer decides they want to sue your company. You’re inseparable from the business when it comes to profits, losses, liabilities, and legal action.
2. Difficulty Landing Clients
It may seem odd, but you may have trouble trying to land clients. This is because other businesses or agencies may view you as being less legitimate. Companies that are incorporated tend to be taken more seriously than sole proprietorships.
You may want to consider another business entity if you’re looking to scale your operations and present yourself as a trusted professional.
3. Difficulty Securing Financing
You may also have difficulty securing financing for the same reason you may find it hard to land clients — sole proprietorships can appear to be less legitimate than incorporated businesses.
Financiers look for ways they can receive a return on their investment. One of those ways is through equity financing which entitles them to ownership shares of a company. You would be unable to divide shares of your company since you’re the sole owner.
4. Your Business May Be Hard to Sell
You may find it difficult to sell your business if you ever decide to step away. Sole proprietorships are difficult to sell for a few reasons.
First, the lines are blurred between the company assets and personal assets. It’s hard to tell what the business owns and what you personally own since you’ve always filed a single tax return. This also makes it hard to assign a valuation to your business.
Running a sole proprietorship also makes you the face of the business. This is a huge advantage when you’re running the business because you can build up strong customer loyalty. People love doing business with you and are personally connected to your business. However, if you’re trying to sell your business, this brand loyalty may not come along, making potential buyers wary.
How to Form a Sole Proprietorship
So if sole proprietorships are common because they’re easy to set up, what are the steps to actually set them up? Not many. If you’re not incorporated and are already doing business with customers, you’re operating a sole proprietorship.
Incorporated businesses are required to file legal papers within the state they do business in. Sole proprietors don’t need to file any papers within their state to operate their business.
In some states, you will be required to fill out a DBA — or Doing Business As — which is filed through your state. This lets you operate with a business name that isn’t your own name. If your state permits, you can simply use your own name, which won’t require additional action on your part.
Sole proprietorships aren’t legal entities. However, that doesn’t mean you can just start doing business like it’s the Wild West. You’ll still need to follow local laws and secure any necessary business licenses and permits.
Let’s take a look at examples of different types of companies that might operate as a sole proprietorship.
Examples of Sole Proprietorships
There are many different types of companies that are sole proprietorships. For the most part, sole proprietorships are a single person using their expertise or skill in a certain area to make money, such as a bookkeeper or freelance graphic designer.
Many of these types of these businesses are home-based. They’re also businesses that have low liability. It’s not very common that you’ll see a doctor who is operating a practice that’s a sole proprietorship — it would be too risky given the accompanying liabilities.
Here are some different types of businesses that are sole proprietorships.
- Virtual assistants
- Repair services
- Financial planner
- Tax preparers
- Direct sellers
- Fitness instructor
If your company has a large amount of liability attached to it, then we recommend pursuing another type of business — like a limited liability company — to protect you from any losses or legal action that can occur.
Other Types of Business Entities
Before deciding to pursue a sole proprietorship, you should know a little bit about the other types of business structures. There are a few different routes you can take including a partnership, limited liability company, or corporation.
Partnerships are similar to sole proprietorships but are meant for two or more people forming a business together. They operate in the same manner as a sole proprietorship, meaning the owners are one and the same as the business.
Both owners can collect profits and aren’t exempt from personal liability for losses and legal action. Profits and losses are also reflected on each individual’s personal tax returns.
Like sole proprietorships, there aren’t any legal documents you need to submit. You can draft up a partnership agreement to account for responsibilities or succession plans in case things go south.
Limited Liability Company
Limited liability companies (LLCs) give you the flexibility of sole proprietorships and partnerships, with the protection that corporations offer. They give you the tax benefits of having a sole proprietorship or partnership and also separate your personal assets from business assets. This means you’re protected if your company goes bankrupt or is sued. LLCs require some more legal documentation and paperwork.
Corporations are completely separate from their owners and have limited liability. Corporations can operate as an individual entity meaning they can enter contracts, sue others, be sued, loan, and borrow money. They also pay their own taxes on business income, have property ownership, and can sell ownership of the company through stocks.
Here are the different types of corporations you can look into.
- S corporations
- C corporations
- B corporations
- Closed corporations
- Nonprofit corporations
Some of the most well-known businesses out there are corporations. Due to their complex structure, this distinction is generally reserved for larger business entities ready for the big leagues.
Launch Your Sole Proprietorship
As a newly minted small business owner, it can seem intimidating getting your business off the ground. There are many decisions that must be made before you start taking on clients.
Luckily, the decision to start a sole proprietorship can be an easy one, especially if you’re operating on your own and aren’t entering a risky area where you have a lot of liabilities.
You should also realize that you can always change you business type if need be. Once you start bringing in more clients and revenue, you can graduate to a limited liability company or corporation.
If you need help launching your business, make sure you check out this entrepreneurship guide before starting.