Fact checked for accuracy by Janet Berry-Johnson, CPA.
Did you know that most business owners are sole proprietors? That is because sole proprietorships are easy to start and manage. Read on to find who is a sole proprietor and the attributes of a sole proprietorship.
Who Is a Sole Proprietor?
A sole proprietor is a person who owns a small business. A sole proprietor is also known as a sole trader. Therefore, a sole proprietor does not need to incorporate or register a business entity. This makes a sole proprietorship the simplest form of business structure. In addition, a sole proprietor is not a legal entity and has complete control of the business.
Characteristics of a Sole Proprietorship
Here are the characteristics of a sole proprietorship.
There are no legal formalities
In a sole proprietorship, there are no separate laws to govern the business entity. Therefore, there are a few special regulations and rules to follow. A sole proprietor does not require registration to run; it only requires a license to start and run any desired business.
Risk and profit
In a sole proprietorship, the owner of the business is the only one to bear the risks because the sole proprietor is the only one to invest in the business financially. So in case the business suffers or fails, the owner will be the one to feel the effect.
Consequently, if the business succeeds, the owner will be the one to enjoy all the profits. The profits are not shared with any stakeholders because there are none.
Continuity
In a sole proprietorship, the business is fully independent and only depends on the owner. Thus, the owner and the business are one entity. Therefore, it will only affect the sole proprietor in retirement, bankruptcy, death, or imprisonment. In this situation, the business will cease its operation because the sole proprietor is no longer available to run the business.
Liability
The business owner’s liability is unlimited since there is no separation between the business and the owner. Therefore, if the business fails to meet its liabilities or debts, it will eventually fall for the proprietor to pay the obligations and the liabilities. For example, they may be forced to sell their personal properties such as cars and houses to pay the liabilities and debts.
There is no separate identity
In a sole proprietor business entity, the owner and the business are one thing. Therefore, there is no other legal identity presentation to the sole proprietor. In addition, the proprietor will have complete responsibility for all the transactions and activities of the business.
Advantages of a Sole Proprietorship
A sole proprietorship is easy to start
Sole proprietorships are not expensive and are easy to establish. As long as you own the business and control the operations, you don’t need to incorporate or register your business entity. The fees you only need to pay are the ones for acquiring licenses and permits and the ones for registering your business name.
The licenses will vary from one industry or operation to another. However, a sole proprietorship happens while working as a contractor using your identity.
The operation of a sole proprietorship without any registration or high costs is beneficial when you start your business as a side hustle outside your primary job. They are easy to establish, which means that you don’t have to commit entirely or invest 100 percent financially.
You can protect the name of your business entity
As the owner of the business or sole proprietor, the name of your business is your name. If you want to change the name and run your business with a different name, you have two options to continue with this.
First, you can incorporate a trademark on the United States and Trade Office official website. The process of registering takes at least 90 minutes, and it does not need a lawyer. It would be best to check the trademark website in time to ensure that no other business has already your name or the name you desire.
Secondly, you can file a Doing Business As (DBA) at your state or office of the county clerk. It will enable you to run a business under a different name than yours. However, the process involves completing the required paperwork and paying a filing fee. The time of processing DBAs varies from one state to another, and these DBAs also expire after a couple of years.
Difference Between DBAs and Trademarks
DBAs are there to offer non-exclusivity, and they exist to give protection to the public in that they provide information about the business owner. On the other hand, trademarks are there to provide exclusivity to the business owner, assisting them to differentiate their services and products from other competing companies.
You will have full control of the entire business
Since a sole proprietorship constitutes individual ownership, it means that you will have complete control of your entire business entity. There is no pressure about making decisions according to shareholders because there are none. You can strategize and start your business the way you want it to grow.
Due to this advantage, it means that sole proprietors have free rein to start and build a business. The structure provides flexibility to experiment before binding yourself to the rules involved in running the company or corporation.
You enjoy all your profits
The business owner enjoys the profits alone in a sole proprietorship because no other partners or shareholders are present. So the work put into the business determines the output and the profits at the end.
Tax advantages
When you compare sole proprietorship to other business entities, the sole proprietorship owner only pays taxes once. The sole proprietor pays personal income tax on the entity’s profits, and the government does not tax the business separately.
Government regulations are few
In a sole proprietorship, there are a few government requirements, unlike other entities. The company is not required to spend a lot of resources and time on government requirements such as financial reporting.
Disadvantages of a Sole Proprietorship
The following are some of the disadvantages of a sole proprietorship:
Limitations in capital raising
In a sole proprietorship, the owner of the business is the only one funding the entity. Personal liability represents risks, and banks or financial institutions can hesitate to give out loans or issue credit.
It is also tough for a sole proprietor to get financial support from investors. In addition, the owner’s personal credit history has a significant impact on the ability to get loans.
Personal liability
The business owner is personally responsible for paying contractors, taxes, employees’ salaries, and honoring debts in a sole proprietorship. Since a sole proprietorship has no separate legal entity, the owner faces many personal liabilities for all the obligations of the business entity.
Therefore, if the entity does not pay its debts, the owner will have to use their private assets to clear the standing arrears.
A sole proprietorship lacks financial control
Since financial reports are not required, and one person runs the business entity, sole proprietors sometimes backslide in financial business transactions. It will lead to a lack of financial control and risk using them for personal expenses or even mix them with personal income.
In addition, these profits and losses may go uncounted for and during tax time, and they can face many challenges.
Selling is a challenge
Sole proprietorships are practically tricky to sell when compared with corporations. As a result, owners may not consider selling their entities as an option, but it is essential to consider this possibility. If your company has massive profits, then selling the business will bring capital gains.
Capital gains are the taxes on the profits from selling an asset for more than you invested into the asset. And selling a sole proprietorship means that you are also selling debts.
Newly obtained businesses may carry previous obligations that exceed profits, especially when they first begin operation. However, this may be a regular thing, and it can be challenging to predict profits in the future for buyers.
Unlimited liability
Unlimited liability affects not only the business entity but also the individual assets of the business owner. People who collect debts can access your personal properties, personal savings, and many more to ensure that you clear the debt.
Therefore, during the registration of your company, you should look into insurance as a precaution.
How Taxes Work in a Sole Proprietorship
In a sole proprietorship, the taxes pass through a personal tax return of the business owner, and it will reduce the paperwork requirements during the annual tax filing. Sole proprietors have responsibility for paying the following taxes:
Federal and State Income Tax
There are two forms that sole proprietors need to file to pay federal income tax. First, there is Form 1040, which is an individual tax return. The other form is the Schedule C that reports on business profits and losses. Form 1040 is a report on personal income, while Schedule C is the form where you record business income.
Self-employment Tax
For a sole proprietor to operate, they have to pay self-employment taxes based on their income from the business reported on Schedule C. However, if the company incurs a loss, there is no payment of self-employment tax, and the owner will not receive social security for that year.
Estimated Taxes
Sole proprietors are required to make estimated payments for both federal income taxes and self-employment taxes. The payment of these taxes is due in January, April, June, and September. The first tax payment is in April, and the last happens in January of the following year. Therefore, filing deadlines are the 15th day of that month except if the day is a holiday or weekend. In addition, it is essential to ensure you are paying enough on these taxes quarterly.
Sales Tax
After selling products or services from your business, you may need to pay tax on sales. The way you collect the sales tax and the rate you pay depends on state law in every state in which you have a physical presence or economic nexus.
Alternatives to a Sole Proprietorship
Sole proprietorship might be the most common and simplest form of business. But it is not the only form of business. You can opt for the options below. Read our entire guide on the best business structure for a full comparison.
LLCs
An LLC is the most common business structure in the United States and a great way to separate your personal assets from your business. They are also pretty simple to set up. Read our guide on what is an LLC and our comparison on LLCs vs. sole proprietorships to learn more.
Partnerships
A partnership is a business that has two or more owners. Two or more individuals oversee the operation of the partnership. The partners have the overall management, contribution to the business, and they share the profits equally.
There should be a written contract among the partners. If the partnership owns some property, the filing of the agreement is done in the county offices.
Corporations
A corporation is a legal company that is separate from the managers and owners of the company. Small shares entitle ownerships in corporations on the profit and equity of the company. The two main types of shares on equity are preferred and common stock.
When Should a Sole Proprietor Become an LLC?
There is no best or worst time to incorporate your business into an officially entity. If you use a professional accountant to help you prepare your taxes, there might be some tax preparation cost benefits of officially switching over to an LLC at the beginning or a new year.
Ultimately, the right time to switch from a sole proprietorship to an LLC should be based on how big your business is and your comfort level with keeping your personal assets tied to your business. As we mentioned above, that’s one of the biggest drawbacks of running your business as a sole proprietor – personal liability.
The Last Word
Sole proprietorships are a great way to get your side hustle or business off the ground. As your business grows and scales though, you should definitely consider forming an LLC to protect yourself, your family, and create a structure that can help your business grow even more. Read our guide on how to start a sole proprietorship if you’re interested in this business setup.
Filed under: Advice Columns
