What Is a Sole Proprietorship?

A sole proprietorship also referred to as a sole trader or a proprietorship, is an unincorporated business that has just one owner who pays personal income tax on profits earned from the business.

A sole proprietorship is the easiest type of business to establish or take apart, due to a lack of government regulation. As such, these types of businesses are very popular among sole owners of businesses, individual self-contractors, and consultants. Many sole proprietors do business under their own names because creating a separate business or trade name isn't necessary.

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.
  • Many sole proprietorships end up getting restructured into an LLC, in sync with the company's expansion.

Understanding Sole Proprietorship

A sole proprietorship is very different from corporations (corp.), limited liability companies (LLCs), or limited liability partnerships ( LLPs), 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's owner.

The main benefits of the sole proprietorship are the pass-through tax advantage mentioned before, the ease of creation, and the low fees of creation and maintenance. The disadvantages of a sole proprietorship are the unlimited liability that goes beyond the business to the owner, and the difficulty in getting capital funding, specifically through established channels, such as issuing equity and obtaining bank loans or lines of credit.

Thus, entrepreneurs begin as an entity with unlimited liability. As the business grows, they often transition to a limited liability entity, such as an LLC or LLP, or a corporation—e.g., S Corp, C Corp, or Benefit Corp.

Image
Image by Sabrina Jiang © Investopedia 2020

A sole proprietorship has no separation between the business entity and its owner, setting it apart from corporations and limited partnerships.

Example of Sole Proprietorship

Most small businesses start as sole proprietorships but end up evolving into different legal structures as time passes and the company grows. For example, in 2005, Kate Schade started her company, Kate's Real Food, as a sole proprietor. The company creates and sells energy bars, and it began as a local vendor in Schade's hometown of Victor, Idaho. The sole proprietorship sold its energy bars at local farmer's markets and then expanded to sell online and to a few accounts in Jackson, Idaho.

Since 2005, Kate's Real Food has grown to supply accounts across the country. She restructured the business from a sole proprietorship to a corporation to take on investments and expand, which is a natural step for a growing business.

Special Considerations

Usually, when a sole proprietor seeks to incorporate a business, the owner restructures it into an LLC. In order 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, an employer identification number (EIN), similar to a Social Security number for businesses, needs to be obtained from the Internal Revenue Service (IRS).