What is a Sole Proprietor?

If you plan on doing business, you are probably considering different options for the structure of your future company to choose the best one for your business. Nowadays, the most in-demand structure for American entrepreneurs is sole proprietor, a corporation or LLC, and each has its unique features.

A sole proprietorship is an easy and low-cost business entity, both in the start-up phase and during its maintenance. You do not have to formally create your business, wasting time and money on filing documents or paying registration fees.  If you choose this business structure, you will start working as a single-employee operation and be able to sell goods and  services immediately.

Sounds attractive, doesn’t it? Do not rush into a final decision until you have considered all the pros and cons. There are certain risks and restrictions of being a sole proprietor you should be aware of.

Let’s take a closer look at a sole proprietorship to determine whether it’s the right way for you to run your business.

What Is a Sole Proprietor?

A sole proprietorship is a type of informal, unincorporated business with a single owner. Unlike limited liability companies (LLC) or corporations, a sole proprietorship operates under the owner’s name and is not a separate legal entity. 

This is one of the most common American business structures, because all you need to establish a sole proprietorship is just to get started. You may already be one and don’t even think of it, for example, if you are:

• A tutor;
• A freelancer;
• An artist, etc.

Thus, we can conclude that a sole proprietorship is mainly for small businesses that meet the following criteria:

• Small customer base;
• Low chance of financial loss;
• Small profits;
• Sometimes it starts as hobbies.

At the same time, the lack of government regulation regarding the formation of a sole proprietorship does not mean that this type of business is completely free from any requirements. The owner of a sole proprietorship must have the necessary licenses and permits, the type and number of which depend on the industry and location.

All business profits and losses are reported on the personal return of the owner, who is also responsible for business’s debts, losses and liabilities, being legally inseparable from the business. 

Sole Proprietor Taxes

The owner is an integral part of a sole proprietorship from the legal standpoint. Therefore, the IRS treats it as subject to pass-through taxation, which means that profits, losses and expenses “pass through” directly to the owner.   

A sole proprietorship files the individual’s personal income tax return by filing an IRS Form 1040 Schedule C. This is quite convenient because business expenses can offset income coming from other sources.

Additionally, the owner is considered to be a self-employed individual, obliged to pay both income tax and self-employment tax. It consists of 2 parts: Social Security and Medicare tax, which is 15.3% of your income. To calculate the amount, use Schedule SE and Form 1040.

If you have employees, you must withhold and pay all income taxes and unemployment insurance.

When your income taxes are more than $1,000, you will also need to pay estimated taxes.

If you have any questions, visit the IRS website. There you will find a lot of useful information about the taxes that a sole proprietorship may be subject to.

What Are the Advantages of a Sole Proprietorship?

The popularity of a sole proprietorship is due to a number of advantages that this business structure offers compared to other types of business such as corporations or LLCs.

• No Fees: a sole proprietorship has no startup fees, making it the cheapest way to start a business. You will also save on ongoing expenses, because there are no annual reports for a sole proprietorship. Of course, you may have to pay for a license or permit, but that does not apply to all businesses;

• No-Hassle Formation and Maintenance: unlike the process of forming most business types, a sole proprietorship has no maintenance requirements or formal conditions. You don’t have to worry about filling out government forms or hiring a registered agent to get started;

• Commingle Income: the tax reporting requirements for sole proprietorship are quite simple. You do not have to separate personal assets from corporate assets for taxation purposes or when the business is sued, as in the case of LLCs and corporations;
  
• Complete control: as a sole proprietor of the business, you have comprehensive control over its operation and determine the direction of its development. If you want to make changes, you do not need to consult with the other owners.

What Are the Disadvantages of a Sole Proprietorship?

Despite all the advantages, a sole proprietorship is not the best business structure because of such significant disadvantages as:

• No Personal Asset Protection: unlike an LLC or corporation, the assets of a sole proprietorship are inseparable from the personal property of its owner. This means that in the event of a lawsuit, creditors will be able to pursue your business assets along with your personal property. As a result, the debts and obligations of the business put the owner’s financial well-being at risk;
  
• Hard to raise money: a sole proprietorship finds it difficult to raise capital for its development. On the one hand, you cannot sell shares of your business, which limits investor opportunity compared to a corporation. On the other hand, investors rarely want to lend to a sole proprietorship, preferring to entrust their funds to an actual business rather than to an individual. Moreover, if the business fails, banks may also refuse to give a loan. All these factors form the limited growth potential of a sole proprietorship;

• Can’t Transfer Ownership: when you start this sole proprietorship, it makes you legally inseparable from your business. You can only sell each asset individually, but you can’t transfer ownership to someone else.

What Are the Alternatives to a Sole Proprietorship?

If you plan to open one-person businesses, a single-member limited liability company is one of the best alternatives to a sole proprietorship. 

The main argument for an SMLLC is the ability to protect the owner’s personal property. This ensures that your real estate, car, and money will be protected in the event of a lawsuit against the company. At the same time, the limited liability protection makes an LLC more attractive to investors than a sole proprietorship.

Furthermore, a limited liability company has low startup costs and a flexible tax structure that allows you to choose the most appropriate tax treatment. At the owner’s request, the business can be treated as a “pass-through” tax unit or be taxed as a corporation. The latter option is less popular, but gives the right to additional benefits and loans.

To summarize, the benefits of forming an LLC include:

• Mitigating financial risks and ensuring the safety of the owner’s personal assets;
• Increasing the credibility and reputation of the business;
• You can protect your privacy, because a limited liability company operates under its own name, and a sole proprietorship operates under the name of its owner;
• Expanding growth prospects.

Another alternative to a sole proprietorship could be a corporation. Like an LLC, it provides participants with protection of their personal assets, but it is a more complex, formalized and expensive structure to maintain. 

Wrapping Up

Like every type of business, a sole proprietor has its advantages and disadvantages, which are important to consider. However, the needs and goals of each business are unique, so under some circumstances it really will be the best option. As the simplest business structure, a sole proprietorship is convenient if:

• You start doing business for the first time;
• You have a small number of clients;
• Your activities do not generate high income and do not involve the risk of serious financial liability.

Of course, the lack of formal requirements for opening and maintenance is attractive to many entrepreneurs. Nevertheless, in our opinion, creating a single-member LLC instead is more advantageous because it offers more protection and opportunities. Unlike a sole proprietorship, the initial stage of an LLC business requires some investment, but this is offset by the peace of mind and reliability.

Frequently Asked Question