- Define sole proprietorship
- Discuss the advantages and disadvantages of sole proprietorships
A sole proprietorship is the simplest and most common legal structure someone can choose. It’s an unincorporated business owned and run by one individual in which there is no distinction between the business and the owner. If you own a sole proprietorship, you are entitled to all profits and are responsible for all your business’s debts, losses, and liabilities.
Forming a Sole Proprietorship
You don’t have to take any formal action to form a sole proprietorship. As long as you are the only owner, this status automatically arises from your business activities. In fact, you may already own one without knowing it. If you are a freelance writer, for example, you are a sole proprietor.
As is the case when you own any kind of business, you may need to obtain the necessary licenses and permits. For example, certain businesses, like ones that sell alcohol or firearms, require a federal license or permit. Some states have requirements for other specific businesses. Additionally, some professions such as Certified Public Accountants (CPAs) may have licensing or certification requirements that must be met before you can promote yourself as engaging in that business or trade. Regulations vary by industry, state, and locality.
If you choose to operate under a name different from your own, you will most likely have to file a fictitious name (also known as an assumed name, trade name, or DBA name—short for “doing business as”). This document is usually filed in the records of the county or city in which you do business. This requirement exists because if customers want to contact (or sue) the person running the business, the law requires the owner to inform the public of the person behind the “business.” You must choose an original name; it cannot already be claimed by another business. In order to check the availability of a business name, business owners may search the database maintained by the State Secretary of State.
Sole Proprietor Taxes
Because you and your business are one and the same, the business itself is not taxed separately—the sole proprietorship income is your income. It’s your responsibility to withhold and pay all income taxes, including self-employment and estimated taxes.
Advantages of a Sole Proprietorship
- Easy and inexpensive to form. A sole proprietorship is the simplest and least expensive legal structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary license or permits.
- Complete control. Because you are the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.
- Easy tax preparation. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the legal structures. However, sole proprietors are encouraged to consult a tax adviser regarding taxes that they may have to pay once an employer is no longer withholding and remitting tax payments on their behalf.
Disadvantages of a Sole Proprietorship
- Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions. Individuals running a business as a sole proprietorship should carefully review their insurance policies on vehicles and equipment and verify that they have adequate liability coverage. Some businesses may require specialized forms of insurance such as Worker’s Compensation, Liability, or Errors & Omissions. Checking coverage with a reputable insurance agent will help the owner identify potential risks and the insurance available to mitigate these risks.
- Hard to raise money. Sole proprietors often face challenges when trying to raise money. Because you can’t sell stock in the business, investors won’t often invest. Banks are also reluctant to lend to a sole proprietorship because of the perceived risk and uncertainty around repayment of funds if the business fails.
- Heavy burden. The flip side of complete control is the burden and pressure it can bring. You alone are ultimately responsible for the successes and failures of your business.
Example: TW’s Construction
Given how easy it is to establish a sole proprietorship, Tom decides that this is the form of ownership he’ll choose. He doesn’t need to borrow any money to start his business, and since he will be doing all the work himself, at this point he isn’t worried that this type of ownership will add additional burdens or stress. He also likes the idea that he is in control of which jobs he takes and who his customers are.
He stops by his accountant’s office and asks her about the taxes, because that part is still a little unclear to him. She explains that when Tom was working for Bob the Builder, federal and state income taxes were withheld from his paychecks. Bob the Builder sent those funds to the IRS and state department of revenue on Tom’s behalf. Those were the taxes he got credit for when he filed his tax return at the end of the year. Bob the Builder also paid half his social security and medicare taxes for him. The company also paid into the state unemployment insurance fund in case an employee ever filed for unemployment benefits. The accountant tells Tom that now, as a sole proprietor, he’ll need to plan for taxes throughout the year, not just in April—no one else will be withholding or paying taxes for him. This is depressing news, but Tom is happy to learn that he may be able to deduct many of the expenses he incurs in the course of operating his business. These include things like his work van, tools he purchases, office supplies, and possibly the small office he has set up in his home. She recommends that Tom come see her at the end of each fiscal quarter (March, June, September, and December) to make sure that he is on track with his taxes for the year. He thinks this is great advice and schedules the appointments on the spot.
After leaving the accountant’s office, he goes to the courthouse and files his DBA certificate (for the name of his business) and begins operating as a sole proprietorship: TW’s Construction. Lastly, he stops by his insurance agent and makes sure that he has the proper insurance on his vehicles and equipment, verifying that he has sufficient liability insurance to cover any potential claims against him.
He heads home to start calling homeowners and setting up appointments to bid on jobs. He has joined the ranks of the self-employed!
Check Your Understanding
Answer the question(s) below to see how well you understand the topics covered above. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.
Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.