What is a Sole Proprietorship?

Written by Steven Tennies on May 6, 2013 at 7:39 pm

sole-proWhether you already own a small business or are considering starting one, you may be curious about what your business entity options are and the pros and cons of each. In this article I’ll explore the sole proprietorship—what it is, how to form one, and its advantages and disadvantages.

Sole proprietorship defined

A sole proprietorship is an unincorporated business entity owned by one person. The business is identified with and intertwined with you. In other words, there is no legal distinction between you and your business. Thus, when your business makes a profit, it is personal income for you. When your business incurs a debt, it is your personal debt. When your business is sued, you are sued.

The one-owner requirement of a sole proprietorship gets a little more complicated for married couples. Prior to 2007, the Internal Revenue Service allowed married couples who lived in a community property state (there are nine—AZ, CA, ID, LA, NV, NM, TX, WA, WI) to treat their jointly owned business as a sole proprietorship rather than a partnership. Now, all married couples have this option provided: (1) the only owners of the business are the husband and wife, (2) both spouses materially participate in the business, and (3) both spouses elect to be treated as a sole proprietorship and file a joint return.

How to form a sole proprietorship

A sole proprietorship is the easiest business entity you can form. Since you and your business are one and the same there aren’t any formalities you must follow to form it. You simply announce to the world that you are in business and presto! You are a sole proprietor. As long as you continue to call yourself a business, you are a business.

Nevertheless, there are a few formalities you must follow to operate it. For example:

  • If your business name is not the same as your personal name, then you must register a d/b/a or fictitious name statement in the county or state where your business operates
  • If you sell products or services subject to sales tax, then you’ll need a sales tax permit
  • If you have employees, then you must obtain a Federal Employer Identification Number (FEIN) by filing IRS Form 2553
  • If you work from your home, then you may be subject to certain zoning restrictions
  • If you work from an office or deal with the public, then you may need to obtain a business license or permit

Advantages of a sole proprietorship

Easy and inexpensive to form—A sole proprietorship is the least regulated business entity. There are no forms to fill out or fees to pay to legally establish your business. Just say that you’re open for business and you are!

Simple tax treatment—Because there aren’t any business income tax returns to file, there is no concern with complex bookkeeping or double taxation. All your business income and expenses are reported on your personal income tax return (IRS Schedule C and IRS 1040).

Few compliance formalities—When it comes to maintaining your business as a sole proprietorship there is very little for you to worry about: there are no corporate records to maintain, no meetings to hold, no minutes to keep, no resolutions to draft, and no annual reports to file.

Disadvantages of a sole proprietorship

Unlimited personal liability—You are personally liable for all of the debts, liabilities, obligations, and taxes of your business. Your personal assets can be taken from you to satisfy a judgment. Furthermore, if you have employees, you are personally responsible for any legal claim against your employee when they act within the course and scope of their employment.

Fewer tax reduction opportunities—Because of the simple tax treatment you have fewer tax reduction strategies available to you. The result: you may pay higher taxes than you need to. As a sole proprietor you cannot take advantage of special business income tax rates or deductions.

Difficulty obtaining capital— Whether it’s finding human capital or financial capital, finding much-needed resources for a sole proprietorship is very difficult.