Sole Proprietorship: What It Is, Pros & Cons, Examples, Differences From an LLC

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. Many sole proprietors do business under their own names because creating a separate business or trade name isn’t necessary.

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. Most small businesses start as sole proprietorships and either stay that way or expand and transition to a limited liability entity or corporation.

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.
Most small businesses start as sole proprietorships and end up transitioning to a limited liability entity or corporation as the company grows.
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.
Sole proprietors report their income and expenses on their personal tax returns and pay income and self-employment taxes on their profits.

Understanding a Sole Proprietorship

If you want to start a one-owner business, the simplest and fastest way is through a sole proprietorship. Sole proprietorship begins when you begin conducting business. It doesn’t require filing federal or state forms and has few regulatory burdens, making it an ideal way for self-employed people to start out.

A sole proprietorship is very different from a corporation, 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 owner.

Advantages and Disadvantages of a Sole Proprietorship

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

Let’s start by looking at the tax benefits. Income generated from a pass-through business is only subject to a single layer of income tax and, in some cases, may be eligible for a 20% tax deduction. The Tax Cuts and Jobs Act (TCJA) of 2017, other than slashing the corporate tax rate, added a tax break for pass-through entities that essentially allows them to deduct up to 20% of qualified business income (QBI). That deduction can result in huge savings and runs until Jan. 1, 2026—unless extended by Congress.

With a sole proprietorship, you also 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 Internal Revenue Service (IRS). You can obtain an EIN if you choose to, but you can also use your own Social Security number (SSN) to pay taxes rather than needing an EIN.

If you plan to hire employees, you will need an EIN from the IRS. If you are going to sell taxable products, you will need to register for a sales tax license with your state.

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

32.5 million

The number of small businesses in the United States in 2021

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 legal protections. For example, a sole proprietorship provides no liability protection to the owner. By contrast, an LLC has protection against creditors seizing the owner’s personal assets, such as their home.

Funding also can be difficult for a sole proprietorship. Banks prefer to work with companies that have a track record and generally view those who are starting out with a small balance sheet as high-risk borrowers. Obtaining equity from large investors can also be difficult.

Thus, entrepreneurs who are sole proprietors begin as an entity with unlimited liability. As the business grows, it often transitions to a limited liability entity that offers some degree of protection to the owners, such as an LLC, an LLP, or a corporation (e.g., S corporation, C corporation, or benefit corporation).

Pros

Less paperwork
No need to obtain an EIN from the IRS
Quick and easy setup compared with 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

Example of a Sole Proprietorship

Most small businesses start as sole proprietorships and evolve 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 began as a local vendor in Jackson Hole, WY. The sole proprietorship currently has a production facility in Bedford, Pa., and can be found in more than 4,000 retailers.

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. In response, Schade restructured the business from a sole proprietorship to a corporation to take on investments and expand, a natural step for a growing business.

Transition from Sole Proprietor to LLC

Usually, when a sole proprietor seeks to incorporate a business, the owner restructures it into an LLC. 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, the new company must obtain an EIN—similar to an SSN, but for businesses—from the IRS.

Sole Proprietorship Tax Forms

Sole proprietors report their income and expenses on their personal tax returns and pay income and self-employment taxes on their profits. The tax forms you may need to file could include the following:

Tax Forms for Sole Proprietorship
If you are liable for:	Use form:
Income tax	1040, U.S. Individual Income Tax Return or 1040-SR, U.S. Tax Return for Seniors and Schedule C (Form 1040 or 1040-SR), Profit or Loss from Business (Sole Proprietorship)
Self-employment tax	Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax
Estimated tax	1040-ES, Estimated Tax for Individuals
Social Security and Medicare taxes and income tax withholding	941, Employer’s Quarterly Federal Tax Return; 943, Employer’s Annual Federal Tax Return for Agricultural Employees; 944, Employer’s Annual Federal Tax Return
Providing information on Social Security and Medicare taxes and income tax withholding	W-2, Wage and Tax Statement (to employee) and W-3, Transmittal of Wage and Tax Statements (to the Social Security Administration)
Federal unemployment (FUTA) tax	940, Employer’s Annual Federal Unemployment (FUTA) Tax Return

Source: Internal Revenue Service

Frequently Asked Questions

How do you start a sole proprietorship?

To start a sole proprietorship, you generally just have to launch your business. It is useful to choose a company name. Depending on your business and local regulations, you may need to apply for a permit or license with your city, county, or state. If you plan to hire employees, you will need an employee identification number (EIN) from the Internal Revenue Service (IRS). If you are going to sell taxable products, you will need to register with your state for a sales tax license.

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, so 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 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. If you have employees, there will be other forms to fill out.

Should I form a limited liability company (LLC) or a sole proprietorship?

That depends on your business. A sole proprietorship is best suited to small businesses with low risk and low profits. Generally, these businesses don’t have a wide range of customers but rather a small, dedicated group. Sole proprietorships often start as hobbies that grow into a business.

The reasons to start a limited liability company (LLC) are the opposite of the reasons above: The business entails some liability risks, has the potential for large profits and a large customer base, and is positioned 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. Also, you will have to refile your “doing business as” (DBA) to keep your company name. Lastly, you will need to obtain an 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 obtaining an EIN from the IRS.

The benefits of simplicity are accompanied by some drawbacks, including all liabilities being passed through from the business to the individual and funding being harder to come by. Those risks shouldn’t pose much of an issue initially. However, as the business grows, it may make sense to transition into a different legal structure.