What is a Sole Proprietorship
A sole proprietorship, also known as a sole trader or a proprietorship, is an unincorporated business with a single owner who pays personal income tax on profits earned from the business. With little government regulation, a sole proprietorship is the simplest business to set up or take apart, making sole proprietorships popular among individual self-contractors, consultants or small business owners. Many sole proprietors do business under their own names because creating a separate business or trade name isn't necessary.
BREAKING DOWN Sole Proprietorship
A sole proprietorship has no separation between the business entity and its owner. It is therefore different from corporations and limited partnerships, in that no separate legal entity is created. Consequently, the business owner of a sole proprietorship is not safe from liabilities incurred by the entity. For example, the debts of the sole proprietorship are also the debts of the owner. However, all profits flow directly to the owner of a sole proprietorship.
The benefit of the sole proprietorship is the pass-through tax advantage, mentioned above. The disadvantage of a sole proprietorship is obtaining capital funding, specifically through established channels, such as issuing equity and obtaining bank loans or lines of credit. As a business grows, it often transitions to a limited liability company (LLC) or an S-corporation.
An Example of a Sole Proprietorship
Most small businesses start as sole proprietorships and change to different legal structures as they grow. 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 town 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.
Restructuring a Sole Proprietorship to an LLC
Usually, when a sole proprietor seeks to incorporate a business, he restructures it into an LLC. First, the name of the company needs to be available. If the desired name is free, articles of organization must be filed with the state office where the business will be headquartered. After paperwork is filed, the business owner must create an LLC operating agreement, which outlines the business structure. Finally, an employment identification number (EIN), similar to a Social Security number for businesses, needs to be obtained from the Internal Revenue Service (IRS).