Sole Proprietorship: Definition, Pros, and Cons

What Is a Sole Proprietorship?

A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

A sole proprietorship also called a sole trader or a proprietorship is an unincorporated business that has only one owner who pays personal income tax on the profits generated by the business.

A sole proprietorship is the easiest form of business to set up or establish, due to the lack of government regulation. As a result, these types of businesses are very popular among sole owners of businesses, individual self-contractors, and consultants. Many sole proprietors do business under their own name as there is no need to create a separate business or trade name.

A sole proprietorship is very different from corporations, limited liability companies (LLCs) or limited liability partnerships (LLPs), as no separate legal entity is created. As a result, the business owner of a sole proprietorship is not exempt from the company’s liabilities.

For example, the sole proprietorship debt is also the owner’s debt. However, the sole proprietorship profit is also the owner’s profit, as all profits go directly to the owner of the business.

Examples of sole proprietors include small businesses like a local grocery store, local clothing store, artist, freelance writer, IT consultant, freelance graphic designer, beauty salon, barbershop, general store, and candy store that are run by a single owner.

Key Takeaways:

  • It is that type of business organization which is owned, managed and controlled by a single owner.
  • The word “sole” means “only” and “proprietor” notes to “owner”.
  • A sole proprietor is the beneficiary of all profits.
  • All risks are to be borne by the sole proprietor.
  • The sole proprietor has unconditional and full control over its business.
Sole Proprietorship

Characteristics of Sole Proprietorship

  • Single ownership. A sole proprietorship is 100% owned by an individual. The individual supplies the entire capital from his own fortune or from borrowed funds.
  • One-man control: The owner alone makes all decisions that affect the business. He doesn’t have to consult anyone. Ownership and management are with the same person. Some people can be hired to help the owner, but final control is with them.
  • No legal entity: A sole proprietorship does not have a separate legal personality from the owner. The law makes no distinction between the owner and his company. The company and the owner coexist. If the owner dies or becomes insolvent, the company is dissolved. Business and owner are one and the same.
  • Unlimited liability: The owner is personally responsible for all debts of the company. If the assets are insufficient to settle the debts, the owner’s personal property can be attached.
  • No profit-sharing: The sole proprietorship is entitled to all profits and losses from business operations. He bears the full risk and there is no one to share the gains or losses.
  • Small size: The scope of activities carried out by a sole proprietorship is generally small. A sole proprietorship can arrange limited resources and management skills. The area of application is therefore limited.
  • No legal formalities: No legal formalities are required to start, manage and dissolve sole trader business.

How do Income Taxes and Legal Liability Work in a Sole Proprietorship?

A sole proprietorship is considered to be the same legal and taxable person as to its owner.

The owner is personally liable for the company’s legal and financial debts. So if a sole proprietorship fails to pay its bills or is sued by a customer or seller, the owner’s personal assets (house, car, checking and savings accounts, etc.) can be confiscated to pay off those debts.

Sole proprietorships are “pass-through” businesses for income tax purposes. Business profits and losses are included in the owner’s personal tax return. In addition, all profits of a sole proprietorship are subject to self-employment tax (Medicare and Social Security); That’s because the owner does not receive a paycheck from which these taxes are deducted. In general, sole proprietorships are required to make quarterly estimated tax payments to the IRS, state, and local tax authorities throughout the year.

How Do You Form a Sole Proprietorship?

No formal action is required to start a sole proprietorship. If you are the sole owner, this status is automatically derived from your business activities. In fact, you could already own one without even knowing it. For example, if you’re a freelance graphic designer, you’re a sole proprietor.

But like any business, you need to obtain the necessary licenses and permits. Regulations vary by industry, state, and location. If you choose to operate under a name other than your own, you will most likely need to provide a fictional name (also known as an assumed name, trade name, or DBA name, short for “doing business as”).

Unlike a Limited Liability Company or a C corporation, a sole proprietorship is not a formal business unit. Sole proprietorships do not have to submit a business registration to the state. As soon as the owner starts a business with the intention of making a profit, the sole proprietorship is created.

Sole proprietorships may need to acquire certain types of business or professional licenses and permits to operate legally in their industry or location.

If sole proprietorships do not want to include their first and last name in their company name, they must apply for the use of a trade name by filing a DBA (“Doing Business As”). Some states call it a “fictitious name” filing. Depending on the location of the business, the fictitious name must be deposited with the state or district clerk.

For example, if Lena Caswell wanted to market her new business under the name Immaculate Image Consulting Services, she would have to file a DTA to get permission to use that name with the state or administrative agency.

Some states also require companies to post a notice of their fictional name in one or more approved newspapers or other publications in the district in which it was filed. In some states and counties, DTAs require periodic renewals.

The deposit of a fictitious name does not offer any legal protection of the company name. Its purpose is to protect customers, sellers, and others from unwittingly doing business with shady owners who are trying to hide their real identities.

It establishes the owner’s identity as the person running the company under the false name. In order to obtain exclusive rights to use a fictitious name, an individual owner must register it as a trademark through the USPTO (US Patent and Trademark Office).

When Might the Sole Proprietorship Business Structure Be a Good Fit?

Operating a business as a Sole Proprietorship might be a viable option when an entrepreneur:

  • Does not plan to reinvest money back into the business.
  • Does not want to deal with compliance formalities.
  • Does not have and doesn’t intend to hire employees.
  • Will sell products and services that have minimal legal risks associated with them.

In deciding whether a sole proprietorship or some other form of business is ideal for their circumstances, entrepreneurs should seek advice from lawyers and accountants or tax experts.

Given the many legal and tax considerations that can affect liability and financial results, it is important to understand the pros and cons before making a decision. Every entrepreneur’s situation is different!

Sole Proprietorship Business Compliance Responsibilities

The management of a business as a sole proprietorship is associated with minimal ongoing compliance tasks compared to other corporate structures. Several responsibilities a sole proprietor may need to keep in mind include:

  • Reporting and paying income and self-employment taxes
  • Withholding and paying payroll taxes (if the sole proprietor hires employees)
  • Renewing required licenses and permits (including sales tax permits, if applicable)
  • Renewing fictitious names

Advantages of Sole proprietorship

1. Less paperwork

The benefits of a sole proprietorship are big and varied, especially if your business is small. However, one of the first and most basic benefits is that you don’t have to fill out a lot of paperwork with this type of business entity. However, one of the first advantages of a sole proprietorship is that with this structure you can scale your business much faster and with fewer government papers on the balance sheet.

2. Easier tax setup

One of the biggest advantages of a sole proprietorship is the much simpler and less complicated tax rules. A sole proprietorship is taxed as a pass-through business, which means that the business’s income and losses are reported on your personal tax return. Hence, you don’t have to worry about paying taxes separately for your business. You can fill out all of your requirements with your own 1040 annual form.

Additionally, some sole proprietorships may be able to avail of the 20% tax deduction as defined in the Tax Cuts and Jobs Act of 2017, which allows you to deduct 20% of your business’s net income from your taxes.

3. Fewer business fees

When you’re starting a business and running it for the first time, your budget can be tight. Therefore, another key benefit of the sole proprietorship is the ability to save on registration fees. As mentioned earlier, states require LLCs and other business entities to register with the state before they can do business.

Fortunately, a sole proprietorship doesn’t have the same ongoing legal requirements – which means you save those fees (as well as time and hassle) compared to other corporate structures. However, as long as you don’t need liability coverage for your business (more on that later), being a sole proprietor can help keep more money in your bank account.

4. Straightforward banking

One of the next major advantages of a sole proprietorship is simplified banking. A sole proprietorship is the only form of business that does not require a business account to run a business. As a sole proprietorship, you can make and receive business payments directly from your personal bank account.

5. Owner Has Complete Control

The owner controls everything that goes on in the business and does not need to seek approval from a board of directors, shareholders, or anyone else. The owner does all the hiring, firing, and making all decisions. However, an owner should consider whether being the sole decision-maker would be a burden. If so, a partnership might be a better choice for the business structure.

A sole proprietorship has only one owner but may have employees. A sole proprietorship who decides to close the business can sell all of the assets and turn off the lights. There is no need to seek permission from other people.

Disadvantages of a sole proprietorship

1. No liability protection

Since sole proprietorships do not have to register as a business with their operating status, they also do not receive any advantages that result from a legal person. You are self-employed with sole proprietorship, i.e. you are self-employed in your business transactions.

This can certainly be seen as one of the advantages of being a sole trader, but it can also be a noticeable disadvantage. Without the legal protection that comes with starting your business, you are personally liable for any legal, financial, or tax problems your business may have.

2. Unlimited liability

One of the biggest disadvantages of a sole proprietorship is unlimited liability. This liability extends not only to the business but also to the personal assets of the business owner. Debt collectors can access your savings, homes, cars, and more to see a debt repaid. When registering a business, it is important to find out about insurance as a precaution. 

3. Raising capital can be challenging

While the cost of setting up a sole proprietorship is low, difficulties in raising capital can limit growth and possibly even put you in the red for a short period of time. Since you are personally liable for business debts, you are also responsible for paying the bill for suppliers, overheads, labor, etc.

This is one of the main disadvantages of sole proprietorships, as the private assets of the entrepreneurs are limited or tied up in the business.

4. Financing and business credit is harder to procure

As a business, you may have a harder time securing finance and business credit than a business. A registered company is eligible for government funding and can raise funds with relative ease. As a rule, a sole proprietorship cannot do this. One reason for this is that a registered business has a legal distinction that a sole proprietorship does not.

5. It’s harder to sell your business

Since a sole proprietorship is attached to an individual by nature, it’s all but impossible to sell or hand down your business to someone else. Therefore, in the event of death or if you decide to no longer run the business, your business will end.

Selling a sole proprietorship isn’t impossible, but you have to sell your business in other ways. Instead of selling your business as a whole and everything that goes with it, you would have to sell your business assets and not the company itself.

FAQs.

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.

What is the Sole Proprietorship Definition?

A sole proprietorship is a simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and the owner.

What is a sole proprietorship example?

It is a type of business organization that is owned, managed, and controlled by a single owner. The sole proprietor has unconditional and full control over its business. Example: Beauty parlor, barbershop, general store, and sweet shop run by a single owner.

What are the Advantages of a Sole Proprietorship?

The following are some of the major advantages of a proprietorship firm.
1. Easy to Establish.
2. Easier to Operate.
3. Sole Beneficiary of Profits
4. Compliance & Taxation.
5. Privacy.
6. Unlimited Liability.
7. Difficulty in Obtaining Funds
8. Higher Tax Incidence.

What are the Disadvantages of Sole Proprietorship?

Disadvantages of Sole Proprietorship:
1. Limitation of Management Skills.
2. Limitation of Capital.
3. Unlimited Liability.
4. Lack of Continuity.
5. Weak Bargaining Position.
6. Limited Scope for Expansion.
7. Risk of Wrong Decisions.
8. No Large-Scale Economies.