A Guide to the Sole Proprietor Business Structure
In the United States, there are a variety of different business structures available; the choice you make among them will depend on the type of business you’re running and your goals. New small business owners may choose to operate as a sole proprietorship because it’s less expensive and easier to set up than other business structures, like a corporation. With fewer hoops to jump through than a limited liability company (LLC) or a corporation would require, sole proprietorships are an easy and inexpensive way to run your side gig or freelance hustle.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business with one owner. No legal distinction is made between you and the business. That means you are responsible for all aspects of the business, including debts, losses, and liabilities. In other words, the business owner has unlimited personal liability. If someone makes a legal claim against a sole proprietor, they can potentially go after both the assets of the business and the owner’s personal assets.
Unlike other types of business structures—like LLCs, S corps, or C corps—you don’t have to file any paperwork or pay any fees to establish a sole proprietorship. In fact, any new business with one owner is considered a sole proprietorship automatically. For example, if you do freelance work outside of your normal job where you are a full-time employee, that work is done under a sole proprietorship if you haven’t set up any other type of business entity.
How are sole proprietors taxed?
Filing income taxes as a sole proprietor is fairly simple because a sole proprietorship is not a separate legal entity from the owner. The income from the business is treated as your personal income, so a sole proprietor files their business income (profit minus expenses) on their personal income tax return.
You’ll use the Schedule C section of your Form 1040 to report your business income to the Internal Revenue Service (IRS). You will be responsible for paying federal and state income tax on your business profits, as well as self-employment taxes. Keep a log of your profits and losses for tax purposes throughout the year to make tax filing easier.
As a sole proprietor, you have to pay the full amount of Social Security and Medicare taxes (a.k.a. self-employment taxes), according to the IRS, Schedule SE on the 1040 form. (You can deduct half the amount). The IRS recommends that sole proprietors pay their estimated self-employment income taxes quarterly to avoid fees or a massive tax bill in April.
If you have employees or contractors who earn more than $600 in a year, you’ll need to include a W2 or 1099 form for each when filing taxes. For any employees, you’ll have to pay half of their Social Security and Medicare taxes.
What sole proprietors can and cannot do
There are a few important restrictions to a sole proprietorship that you should know to make sure you’re paying your taxes correctly and to avoid any penalties or fees:
As a sole proprietor, you can:
- Get an EIN (employee identification number) from the IRS to avoid sharing your SSN (Social Security number) with clients
- Hire employees (if you have an EIN)
- Merge your personal and business property and funds (although it’s a good idea to keep separate bank accounts for your sole proprietorship so you can more accurately track expenses, which you can claim as deductions on your tax return)
- Register the name of their business, if it differs from your own name
- Own more than one sole proprietorship (though you’ll have to report earnings and expenses on separate Schedule Cs)
- Opt out of liability insurance (although the IRS encourages having liability insurance)
As a sole proprietor, you cannot:
- Escape personal liability for any debts or losses
- Pass on the business to someone else unless specified in a will
- Report business losses for more than two years in a five-year period—the IRS might decide your business is a hobby and not allow you to deduct expenses in the future
- Protect personal finances from liability related to your business
What are the advantages of a sole proprietorship?
When deciding the type of business entity that works best for you, a sole proprietorship has many advantages, not the least of which being that they are quick and cheap to set up:
- Easy to form. Because no formal action is required to form a sole proprietorship, you can save money and time that would otherwise be spent meeting certain legal requirements specific to other types of business entities, like LLCs. Your business is automatically considered a sole proprietorship if you have not pursued other routes for incorporation.
- Complete control. As the sole proprietor, the owner makes all decisions for the business without needing to consult anyone else, as they would in a partnership. Owners can even pass down the business to heirs of their choice.
- No corporate tax payments. Instead of completing corporate employment taxes like a large corporation, sole proprietorships require the owner to pay only personal income taxes on the profits.
- Inexpensive to establish. While sole proprietors must abide by licensing requirements designated by the states where they conduct business (if their business requires a license, like that of an esthetician), other paperwork and formalities are limited significantly compared to corporations. As a result, starting a business is less costly.
- Entitled to all profits. The owner of a sole proprietorship is entitled to all of the business profits.
What are the disadvantages of a sole proprietorship?
When setting yourself up to successfully run a business, particularly a sole proprietorship, fully inform yourself by considering the disadvantages of this type of business:
- Full responsibility for debts and obligations. As the sole proprietor, the owner is personally liable for the debts and obligations of their business, even if those liabilities are a result of something an employee did. Corporate structures, including LLCs, protect owners from personal liability.
- Capital contributions. A sole proprietor contributes whatever capital the business needs because they are solely responsible for the business. A sole proprietor cannot seek outside investment. A small business where more than one person owns equity cannot be a sole proprietorship.
When to consider converting a sole proprietorship to an LLC
Some business owners love the flexibility and ease of a sole proprietorship. However, as your business grows, you might want to share the management, bring on investors, or limit the risk to your own personal finances. In this case, the logical next step may be to become a limited liability company. Becoming an LLC requires the business owner to register with the state and become an incorporated business.
An LLC is a separate legal entity from its owner. This distinction separates the business from your own personal finances and can have many advantages, including:
- Eliminating personal liability. Your personal finances are safe from lawsuits, debts, or other claims against your business.
- Sharing management. Most businesses with more than one owner cannot be a sole proprietorship and are automatically considered a general partnership where all owners are personally liable. Consider an LLC or LLP if you want your business to exist as a separate entity and eliminate all personal liability.
- Adding investors. It is impossible to bring on investors with a sole proprietorship.
Final thoughts
When considering whether to run your business as a sole proprietorship, here are some questions to work through for yourself and your business:
- What’s my risk level in terms of liability? What are scenarios in which my business could face a legal claim?
- What personal assets would be at risk if that happened?
- Does my business make enough money to justify the costs associated with incorporating?
- Do or will I need outside investment to fund my business?
- Will I always be the only owner of my business? Or might I want to bring on partners?
- Could I, or do I want to, handle the administrative burden associated with other business entities like an LLC or corporation?