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.
  • 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.
  • To pay taxes, sole proprietors must fill out Form 1040 and Schedule C.

Understanding a Sole Proprietorship

A sole proprietorship is very different from a corporation (corp.), 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's owner.

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Advantages and Disadvantages of a Sole Proprietorship

The main benefits of a sole proprietorship are the pass-through tax advantage mentioned before, the ease of creation, and the low fees of creation and maintenance.

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 IRS. You can obtain an EIN if you choose to but you can also use your own Social Security number to pay SSN taxes rather than needing an EIN.

In addition, because you are not required to register with your state, you do not need to pay any fees associated with renewing your registration or any other fees associated with the process. This saves you a lot of money, which is important when starting your own business.

With a sole proprietorship, you don't need a business checking account, as other business structures are required to have. You can simply conduct all your finances through your own personal checking account.

There are 32.5 million small businesses in the United States.

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.

When a business is registered, it has some protection from the state. As a sole proprietorship is not registered, you have no support when it comes to liability. An LLC has protection against creditors from seizing your personal assets, such as your home. With a sole proprietorship, you do not have such protection.

Funding can also be difficult with a sole proprietorship. Banks prefer to work with companies that have a track record. Being an individual who is starting out with a small balance sheet can make it a risky endeavor for banks to lend money. Also, obtaining equity from large investors can be difficult as they prefer more refined startups.

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).

Pros
  • Less paperwork

  • No need to obtain an employer identification number (EIN) from the IRS

  • Quick and easy setup compared to 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

Real World Example

Most small businesses start as sole proprietorships but end up evolving 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 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.

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

Since launching in 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).

How Do You Start a Sole Proprietorship?

To start a sole proprietorship you need to for the most part just start your business. It does not require registering with your state. It is recommended to come up with a company name and then apply for a permit or license with your city and state if needed. If you plan to hire employees then you will need an employee identification number (EIN) from the IRS and if you are going to sell taxable products you will need to register with your state.

Is Sole Proprietor the Same as Self-Employed?

Yes, a sole proprietor is the same as self-employed. A sole proprietor does not work for any company or boss, just for themself, hence 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 then Schedule C, which reports the profits and loss of your business. The amount of taxes you owe will be based on the combined income of both Form 1040 and Schedule C.

Should I Form an LLC or Sole Proprietorship?

Depending on your business, it will be beneficial to create either an LLC or a sole proprietorship. A sole proprietorship is best suited to small businesses with low risk and low profits. The business will not have a wide range of customers but rather a small, dedicated group. Sole proprietorships usually start as hobbies and become a form of business. The reasons to start an LLC would be the opposite of the reasons above. The business is associated with some risks, the possibility for very large profits, a large customer base, and in a position 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. You will also have to refile your "doing business as" (DBA) to keep your company name, and lastly, you will need to obtain an employee identification number (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 creating an EIN with the IRS. As such, a sole proprietorship is a quick and easy way for an individual to start a business and run with it. It's important to be aware of some of the risks involved, such as all liabilities being passed through from the business to the individual.