Sole Proprietorship: What It Is and How to Form One
When you’re launching your business, one of the first decisions you’ll make is what type of business entity you want to use. There are multiple different options, each with its own unique benefits and disadvantages.
Sole proprietorship is the most simple business structure, allowing a single owner to offer goods or services without formally incorporating.
- A sole proprietorship is an unincorporated business with a single owner, resulting in no legal separation between the company and its owner.
- Sole proprietors are easy to maintain, but offer no financial or liability protection.
- Individuals who intend to maintain a small business with limited risk — and who prioritize convenience and simplicity — may benefit from a sole proprietorship.
How does a sole proprietorship work?
Having a sole proprietorship means you have complete control over your business. It doesn’t require incorporation, and you’re automatically considered to be a sole proprietor if you engage in business activities and don’t register as another type of business entity. This may be a good option for solopreneurs.
As a result, sole proprietorships don’t create a separate business entity the way LLC or corporation incorporations would. In this situation, your business assets, debts and liabilities won’t be separated from your personal assets and liabilities — as such, you’ll personally be held liable for your business’s financial obligations.
You can get an employer identification number (EIN) as a sole proprietor, which allows you to complete tax forms like W-9s for clients without sharing your personal Social Security number. You can also register for a “doing business as” (DBA) name, which allows you to operate under another trade name.
Advantages of sole proprietorship
Sole proprietorships offer multiple distinct advantages compared to other business entities, especially for sole owners who are looking for simple business structures.
Easy to form
If you start doing business as an individual owner, you’re automatically considered a sole proprietor. You don’t need to file articles of incorporation like you would for an LLC, and it’s significantly easier than filing for more complex business structures like S corporations or C corporations. Still, you may want to register for an EIN, which is free and easy to do online.
However, depending on your line of business, you may still need to acquire business licenses or permits.
Simple tax filing
Since there’s no legal separation between you and your business, tax filing may be easier compared to other business structures. You won’t need to file a separate tax return for your business, and any profit you make will be treated as your own income.
Still, it’s important to remember that you’ll still need to make estimated tax payments on your earned income.
Minimal requirements
Sole proprietorships aren’t just easier to start — they can also be easier to maintain. They don’t require annual paperwork or ongoing reporting the same way other business structures do. They also don’t require the formation of bylaws, like some other business structures. This is true even if you’re using a DBA.
Disadvantages of a sole proprietorship
Though sole proprietorships are easy to form and maintain, there are also a few key disadvantages to consider.
No legal or financial protection
There’s no legal or financial separation between you and your business, which means that all debts and liabilities fall to you. This can put your personal assets at risk.
For example, if you take out a loan to fund your business and default on it, the lender could target your personal savings and assets. This is also true for legal liability — if someone sues you, they can go after personal assets.
All other business structures provide some layer of legal or financial separation, which can provide protection.
Difficult to raise capital
If you need a loan as a sole proprietor, you can’t sell stock like you could with other business structures. This often makes it more difficult for investors.
Acquiring funding from banks or lenders may also be more challenging, as all the responsibility falls on the owner. Your personal credit score, financial history and current debt utilization will play large roles in whether you’re able to receive funding.
Other business structures may offer tax benefits
Some corporation business structures allow you to organize your taxes in unique ways that may lower your overall tax burden.
S corps, for example, allow you to classify some of your income as your salary, and some as distribution. The latter can help you minimize the total amount of self-employment tax that you owe.
Choosing the right business entity for your business’s current and projected revenue is important. Talking to an experienced accountant or CPA can help you decide which business structure will benefit you most come tax season.
Filing taxes as a sole proprietor
Filing taxes as a sole proprietor is relatively simple, as you’ll declare all your business’s income and debts as your own. You’ll pay a self-employment tax on this income, which is 15.3% and contributes to Social Security and Medicare taxes. It’s important to consider other federal and state income taxes that you’ll need to pay, too.
When it comes time to pay your taxes, you’ll need to submit the following federal tax forms:
- Form 1040: Used to file your annual income tax return.
- Schedule C: Reports profit and loss from your business.
- Form 1040-ES: Used to file quarterly estimated tax payments.
After your first year in business, you’ll need to pay quarterly estimated tax payments if you expect to owe $1,000 or more in a year. You can do this online, by phone or by mail.
Many sole proprietors can benefit from using tax software, which can help guide you through the process and simplify taxes. They can determine which forms you need to complete your state and federal taxes and help you with the calculations.
If you still have questions, you can talk to a qualified tax professional like a CPA or an accountant. They can help you with year end tax planning strategies.
How to establish a sole proprietorship
If you start doing business as an individual and earning revenue, you’re automatically considered a sole proprietor. As long as you’re carefully recording and declaring your income on your federal and state taxes, you don’t have to do anything else.
You can take the following steps if you choose:
- Create an EIN so you don’t need to share your Social Security number.
- Create a DBA or trade name if you’re not operating under your legal name.
- Apply for any business permits or licenses that may be required in your area.
- Obtain any required or recommended insurance.
Sole proprietorship vs. LLC
Many people who are considering sole proprietorships also consider creating a limited liability company (LLC). While LLCs will require formal incorporation, they’re relatively easy to set up and maintain, offering valuable legal separation and liability protection compared to sole proprietorships.
| Sole Proprietorship | LLC | |
|---|---|---|
| Definition | A simple business structure with no legal separation between the sole owner and the business. | A separate legal entity is created from the business owner, offering limited liability protection and diverse taxation options. |
| Best for | Solopreneurs who have low liability risk and who are looking for a simple business structure. | Business owners that want to establish a separate legal entity for legal and financial protection and who may want to scale their business. |
| Liability | No liability protection | Some liability protection |
| Taxes | All taxes paid on a personal return |
|
| Formation | Automatically formed if you start doing business as a solopreneur | Requires articles of organization to be formed through your state |
| Ongoing requirements |
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