What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with one owner. There is no legal separation between the company and the owner, who receives all profits but is liable for all debts and losses. A sole proprietorship is the easiest type to establish and a popular choice for small businesses, individual contractors, and consultants. Most small businesses start as sole proprietorships and either stay that way or expand and transition to a limited liability entity or corporation.
Key Takeaways
- A sole proprietorship is an unincorporated business with only one owner who pays personal income tax on profits earned.
- Sole proprietorships are easy to establish and popular with small business owners and contractors.
- Most small businesses start as sole proprietorships and may transition to a limited liability entity or corporation as the company grows.
Establishing a Sole Proprietorship
The easiest way to start a one-owner business is through a sole proprietorship. The debts of the sole proprietorship are also the debts of the owner. However, all profits flow directly to the business owner. There are certain steps individuals should take to get started including:
- Some states require that individuals apply for business or occupancy licenses and permits.
- States may also require businesses to file a "Doing Business As name" or operate under an assumed name, usually the sole proprietor.
- Apply for and obtain an Employer Identification Number (EIN) for employees or to file tax returns. Some sole proprietors can use their own Social Security Number (SSN). Owners may want to check with a tax advisor to determine which works best.
- To sell taxable products, businesses must register for a sales tax license with their state.
33.3 Million
The number of small businesses in the United States in 2023. Together, these businesses employed 61.6 million people across the country.
Sole Proprietorship vs. LLC vs. Partnership
A sole proprietorship is very different from a corporation, a limited liability company (LLC), or a limited liability partnership (LLP), in that no separate legal entity is created. As a result, the business owner of a sole proprietorship is not exempt from liabilities incurred by the entity.
When a sole proprietor seeks to incorporate a business, the owner usually restructures it into an LLC. For this to work, the owner must first determine that the company name is available. If the desired name is free, articles of organization must be filed with the state office where the business will be based. The business owner must create an LLC operating agreement defining the business structure. Finally, the new company must obtain an EIN from the IRS.
| Sole Proprietorship | LLC | Partnership | |
| Establishment | Easy to establish, no paperwork unless required by the state | Must file articles of incorporation with the state | May require contracts for each partner |
| Business Name | Can operate under owner's or fictitious name or formally register under Doing Business As | Established and secured | Can operate under owner's or fictitious name or formally register under Doing Business As |
| Liability | No legal protection, owner is fully liable | Protection for owners | No legal protection, owner fully liable |
| Taxation | Filed under owner's personal taxes if there is no EIN | Filed under owner's personal taxes for one owner Treated as partnership for two or more owners | Filed under partnership Partners declare income and losses from partnership on personal returns |
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Advantages and Disadvantages
A sole proprietorship requires a limited amount of paperwork to get started. The tax process is simpler because an employer identification number (EIN) from the Internal Revenue Service (IRS) is not required and owners can use their Social Security number (SSN) to pay taxes.Income generated from a pass-through business is only subject to a single layer of income tax and, in some cases, may be eligible for a 20% tax deduction until 2026.
An important downside of a sole proprietorship is that it provides no liability protection to the owner. By contrast, an LLC separates business and personal assets and the owner is protected against creditors seizing their assets, such as their home. This unlimited liability goes beyond the business entity to the owners themselves. Sole proprietorships must rely on standard funding like bank loans or lines of credit. Banks may view a new business with a small balance sheet as a high-risk borrower.
Pros
No need to obtain an EIN from the IRS
Quick and easy setup compared with other business structures
Pass-through tax advantage
Cons
Personal assets are not separated from business assets
Difficulty in raising capital
Owners assume all debt and tax liability
Note
The Tax Cuts and Jobs Act (TCJA) of 2017 added a tax break for pass-through entities that essentially allows them to deduct up to 20% of qualified business income. That deduction can result in huge savings and runs until Jan. 1, 2026—unless extended by Congress.
Taxation
The owner of a sole proprietorship pays personal income tax on profits earned from the business. Sole proprietors report their income and expenses on their tax returns and pay income and self-employment taxes on profits.Tax forms include:
| Tax Forms for Sole Proprietorship | |
|---|---|
| If you are liable for: | Use form: |
| Income tax | 1040, U.S. Individual Income Tax Returnor 1040-SR, U.S. Tax Return for Seniors and Schedule C (Form 1040 or 1040-SR), Profit or Loss from Business (Sole Proprietorship) |
| Self-employment tax | Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax |
| Estimated tax | 1040-ES, Estimated Tax for Individuals |
| Social Security and Medicare taxes and income tax withholding | 941, Employer’s Quarterly Federal Tax Return; 943, Employer’s Annual Federal Tax Return for Agricultural Employees; 944, Employer’s Annual Federal Tax Return |
| Providing information on Social Security and Medicare taxes and income tax withholding | W-2, Wage and Tax Statement (to employee) and W-3, Transmittal of Wage and Tax Statements (to the Social Security Administration) |
| Federal unemployment (FUTA) tax | 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return |
What Is an Example of a Sole Proprietorship?
Independent photographers, small landscaping companies, freelance writers, or personal trainers are examples of sole proprietorship businesses.
Is a Sole Proprietorship the Same As Being Self-Employed?
A sole proprietor owns and operates an unincorporated business independent of partners and is solely responsible for the liabilities and tax implications of the business. The sole proprietor is also considered self-employed, however, "self-employed" is a broader term that can be applied to those who work as independent contractors, writers, tradespeople,lawyers, salespeople, and insurance agents. Self-employed individuals generally file an annual income tax return and payestimated taxesquarterly.
Should Individuals Choose Limited Liability Company or a Sole Proprietorship?
A sole proprietorship is best suited to small businesses with low risk and low profits. Generally, these businesses don’t have a wide range of customers but rather a small, dedicated group. Sole proprietorships often start as hobbies that grow into a business. The reasons to start a limited liability company (LLC) are that the business entails some liability risks, has the potential for large profits and a large customer base, and is positioned to benefit from certain tax structures.
The Bottom Line
A sole proprietorship is a straightforward way for an individual to start a business. It does not require registering with a state authority for most situations and does not require obtaining an EIN from the IRS. The benefits of simplicity are accompanied by some drawbacks, including all liabilities passed through from the business to the individual and obtaining funding.
