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ComplianceDecember 02, 2022

What is a sole proprietorship and how to start one

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A sole proprietorship is the simplest and most common business structure available in the United States.

If you’re thinking about starting a new business as a sole proprietorship, here is what you should know. In this article, we discuss what it means to operate your business as a sole proprietorship, including the advantages and disadvantages when it comes to formation, taxes, maintenance, and liability.

Sole proprietorship: Definition

A sole proprietorship is a non-registered, unincorporated business run solely by one individual proprietor with no distinction between the business and the owner. The owner of a sole proprietorship is entitled to all profits but is also responsible for the business’s debts, losses, and liabilities.

What is the difference between an owner and a sole proprietor?

An owner can either be a person or a legal entity that is the legal proprietor of a business. For example, a corporation (a legal entity) can be the owner of one or more companies.

A sole proprietor specifically refers to the individual owner (proprietor) of a business being run as a sole proprietorship.

How to start a sole proprietorship

A sole proprietorship is easy to establish. You don’t need to take any legal steps to form this type of business. If you are the only owner and begin conducting business, you automatically become a sole proprietorship. There is no need to formally file paperwork or submit anything at the federal, state, or local level to be recognized as such.

Business licenses and permits

It is important to note, that depending upon where you run your business and what kind of business it is, you may need to file for business and/or occupancy licenses and permits. In some jurisdictions, a business cannot begin to operate unless the proper business license has been obtained by the owner.

To find out more about the requirements in your locality, contact your county clerk. The county clerk should be able to answer any questions you have and to give or send you whatever forms you may need.

Operating under an assumed name

If your sole proprietorship business will be operating under a name other than the owner's name, most localities will require you to register a DBA (“doing business as”) name. By filing a DBA, you inform the local government and the public that the business is operating under an assumed name and indicates who owns the business.

Choosing between your own name and a fictitious name can be a difficult decision. If you're reasonably well-known and well-respected in your community or in your business field, using your own name can be a great marketing tool.

However, there's a risk with using your own name. If your business fails or gets into financial or legal trouble, it'll have your name on it. If you try to start another business, people may associate your name with earlier troubles.

Getting an EIN

You will need to obtain an EIN (also known as a Federal Employer Identification Number or FEIN) if you plan to have employees, file excise tax returns (e.g. alcohol, tobacco, firearms), or file pension plan tax returns.

Otherwise, the IRS generally allows you to use your social security number as your taxpayer identification number if you are operating your business as a sole proprietorship

You can obtain an EIN online or by filing IRS Form SS-4, Application for Employer Identification Number.

Advantages of a sole proprietorship

Minimal paperwork and low set-up costs are two major benefits of having a sole proprietorship. In addition, there is the ease of maintaining it. In fact, according to the SBA, it’s the simplest and least expensive business type you can establish.

Let’s take a look at a few additional key advantages.

Taxes: You don’t need to separate taxes for your business. Any profit you make is simply treated as your own income.

But there are two important tax details to consider as a sole proprietorship:

  • You will still be taxed for all the profits of your business, whether you withdraw the money or not.
  • You need to fill out a Schedule C report, which details your profits and losses, along with a Schedule SE, which refers to your self-employment taxes.

These are both submitted with your personal 1040 income tax return at tax time.

Maintenance: A sole proprietorship is easier to start and maintain than a registered business. With minimal legal costs and no ongoing state requirements, you can simply run your business. This is the case even if you’re using a fictitious name, also called a DBA (doing business as).

Control: The sole proprietor has complete control and decision-making power over the business. Without any partners, you are the sole owner of the business, and can therefore run it as you choose.

Disadvantages of a sole proprietorship

There are a few significant disadvantages to consider as a sole proprietor. Before choosing the best business structure for your business, consider these potential drawbacks.

Liability: One of the major disadvantages of a sole proprietorship is that you will be personally liable for all obligations of the business. There is no separation between the assets of the owner and the assets of the business.

Personal liability allows creditors of the business to go after your personal assets if the business assets are not sufficient to cover the business debts. Likewise, your personal creditors can go after your business assets to satisfy your personal debts.

Since you will be personally liable for obligations of the business, you should consider whether the business will be exposed to any potential lawsuits. For example, the business can be exposed to liability for customers injured on the premises or from products sold by the business. If the possibility of lawsuits exist, you can limit your exposure by purchasing business insurance (general liability, malpractice, or product liability, if necessary). Alternatively, you might want to consider a different business form that would provide greater liability protection, such as a corporation or a limited liability company.

Funding: Raising money is a challenge for sole proprietors because it’s not possible to sell stock in the business, which may make investors hesitate to invest. Lending from banks can also be challenging because, if the business fails, all the responsibility falls on the shoulders of the owner to repay the loans.

Long-term survival: Another advantage is that a sole proprietorship rarely survives if the owner dies or is incapacitated. While a corporation is legally a separate entity from its owners and can be taken over by someone else, a sole proprietorship must be run by its owner.

Lack of support: While having complete control is a benefit, the sole proprietor alone is responsible for the successes and failures of the business. This can be a significant disadvantage of owning a sole proprietorship as it adds an extra layer of pressure and stress.

How to decide between a sole proprietorship vs. an LLC or corporation

First and foremost, focus on the needs of your business when deciding between an LLC, a corporation, and a sole proprietorship. If you’re new to being an entrepreneur — for example, you’re a freelancer just starting to find clients — a sole proprietorship is an easy and cost-effective option. On the other hand, a fast-growing business that needs funding would be better suited to forming either as a corporation or a limited liability company (LLC).

Consider your business needs and objectives when reviewing your options, from financial to operational, to make the best choice for you and your business.

For more information, see Single-member LLC vs. sole proprietorship: Advantages & disadvantages.

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