Sole proprietorships are the most common type of small business in the United States because they are the simplest structure for business owners looking to start and operate a business. If you own a sole proprietorship, the business belongs 100% to you, but you are also 100% liable for anything that happens to your business. While forming a sole proprietorship may seem relatively easy, there is still a great deal of responsibility for sole proprietors to keep their business financially and legally sound. Here is what you need to know about sole proprietorships.
Sole Proprietorship Defined
A sole proprietorship is defined as an unincorporated business structure with a single owner, in which there is no legal separation between the owner and the business. The defining characteristics of a sole proprietorship are:
Ownership by a single, self-employed individual
No corporate entity exists (no incorporation)
The owner is an extension of the business
The owner is responsible for any business assets and liabilities
If you conduct business activities on your own and have not taken any formal action to form a partnership or incorporate your business, you automatically own a sole proprietorship. No formal legal action is required to create a sole proprietorship, unlike all other business structures, such as limited liability companies, S Corps and C Corps. As the owner, you and all your assets are completely attached to your business.
Advantages of a Sole Proprietorship
The sole proprietorship business structure has a lot of advantages, which is why the majority of businesses are sole proprietorships or at least start as sole proprietorships. The main advantages are the ease of setup, operations, and financial requirements.
1. Simple Process to Start a Business
Typically all a business owner has to do to form a sole proprietorship is register with a local office to obtain necessary licenses. Sole proprietorships may not need legal counsel in order to create a business, which also helps to reduce costs. Sole proprietors can file a business name (DBA), but do not have to do so. Business owners operating a sole proprietorship can basically just visit their local business office and then start working, which is far simpler than other business structures.
Many businesses are created because someone has a great idea and wants to get started right away. The ease of starting a sole proprietorship in the United States is a big advantage to the business owner.
2. Complete Ownership
Sharing business ownership can be difficult even if you get along perfectly with your co-owner(s). As a sole proprietor, you are the only one making decisions and you aren’t responsible for anyone else’s mistakes. You can also choose which times and days your business operates and are held accountable for your work only by yourself and your clients. Similarly, all the profits are yours and you are free to change or grow your business to fit your exact vision.
3. Simplistic Income Taxes
Because you are completely connected to your business, you do not need to file business taxes separate from your personal income taxes. For sole proprietorship taxes, the business income is your personal income, so a personal tax return (1040) and a tax form called a Schedule C allow you to report income and losses to the IRS using just your social security number. In addition, all your business expenses are tax-deductible, including the cost of goods, travel expenses, and much more. Tax rates are also lower for sole proprietorships than partnerships and corporations.
Disadvantages of a Sole Proprietorship
On the other hand, owning a sole proprietorship does have some serious risks to your own assets and can make it significantly harder for you to fund and grow your business into a bigger business. The main disadvantages of sole proprietorships involve legal liability and personal assets.
1. Personal Liability
Personal liability is the biggest disadvantage for many sole proprietorships, especially in certain industries. Because the owner and the business are a single legal entity, all personal assets, including real estate, retirement savings, and investments are legally tied to the business. Unfortunately, this means that if you are a sole proprietor and you default on a loan, the bank could potentially take any and all of your assets for what you owe. Similarly, if you are sued by a client and the client wins, your personal assets are also on the line.
The risk of liability may be more significant in certain industries than others. For example, if a client sues a wedding photographer and wins the plea, the photographer would likely only be responsible for returning any funds paid by the customer. On the other hand, if you own a landscaping business and your backhoe goes through the side of your client’s house, you may be responsible for any damages. Business insurance can help protect against some of these situations and should be considered an essential investment for sole proprietors.
2. Self-Employment Isolation
While it can be a wonderful advantage to be able to make all business decisions, sole proprietors often lack the breadth of perspective that partnerships and corporations have. The lack of alternative ideas and support from other owners can be isolating for these business owners.
Sole proprietors also don’t have anyone to carry on or cover for them in case of an absence. For example, if a mechanic who owns his own shop falls ill and must be in the hospital for a couple of months, this can result in complete closure of the business during that time, which is not ideal for business continuity and growth.
3. Financial Constraints
While there are significant advantages to the tax structure of a sole proprietorship, having all business income and profits directly tied to the owner can make it difficult to get funds or sell the business. Sole proprietors cannot raise money from investors and it can be difficult to value a company where there are no assets belonging solely to the company.
How to Start a Sole Proprietorship
With a sole proprietorship, starting the company may actually be the easiest part of owning the business. With very few legal requirements (depending on the industry) and very few expenses, it can be as simple as choosing an idea and executing it. Here’s a brief guide to starting your own sole proprietorship.
1. Decide on a Business Idea
Before you can start a business, you definitely need to know what service or product you want to provide and if you want to operate under your own name or a “doing business as” name. Make sure you have a business idea and plan in hand before launching into the administrative tasks of starting a business.
2. Research Local Laws and License Requirements
While sole proprietorships are notably absent of many requirements, you will likely still need some type of local license to operate, and potentially state or federal licenses if you are operating in a regulated industry. One common example is obtaining a liquor license if you are opening a restaurant or bar that will serve alcohol.
3. Start Selling Your Service or Product
The final step is to start doing business! Sole proprietorships are quick and easy, so as soon as you have any needed licenses, your service or product can hit the market. Once you have started selling your services, you will have additional considerations, like how you are going to do your accounting and paying quarterly taxes. It may be wise to consult another business owner in your area for advice.
Sole proprietorships allow everyone to open their own business, with complete ownership and responsibility for their own successes and failures. However, it is important to remember that starting and operating a business can be as hard and stressful as it is rewarding. Even if a sole proprietorship is the right business structure for you, surrounding yourself with supportive business owners and using free business resources from the SBA or local business centers can help you succeed in operating and growing your business.