Sole Proprietorship: Definition, Benefits, Taxes & Registration Guide
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These are the main takeaways from the article and the most important facts to consider when starting a sole proprietorship:
- The sole proprietor and their company are the same legal entity
- The biggest benefits of sole proprietorships are low set-up costs, tax and maintenance simplicity, full ownership, and all the profit going to the owner
- Personal liability and difficulties with acquiring the capital are the biggest threats with this type of business
- It is strongly advised to separate personal and business funds
- All business income counts as a personal income and is taxed as such — with tax returns possible for business expenses
A sole proprietorship is the most popular type of business structure in the USA.
It’s the easiest and the cheapest type of business entity to create, maintain, and dismantle. This is why the majority of the small business owners, start-up owners, consultants, self-employed freelancers, and individual contractors opt for it when starting out in the business world on their own.
However, with plenty of advantages come some downsides and considerable legal effects of being a sole proprietor. It’s best to consider all of these before deciding if a sole proprietorship is a right fit for your work.
By the end of this article, you will learn all there is about sole proprietorships:
- Definition of a sole proprietorship
- How does it work
- The advantages and disadvantages of a sole proprietorship
- How to form a sole proprietorship in the United States (and some other countries as well)
- Taxes for sole proprietors in the United States
In the end, we’ll revise the article and note the most important aspects of doing business this way.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned and run by one person only.
There is no legal distinction between the sole proprietorship and the business owner. The owner is entitled to all the business income that comes from this type of business structure.
At the same time, the sole proprietor (also called sole trader) is personally responsible for all of the debts and liabilities that come from operating a sole proprietorship.
How does sole proprietorship work?
A sole proprietorship is not a legal entity on its own — it is conjoined to the owner. This means that there is no legal separation between a sole proprietor and this form of business — therefore, all the business losses are the owner’s personal losses. Likewise, the owner is personally liable for all the business debts the sole proprietorship obtains.
From the taxation point of view, this means that a sole proprietor can use their Social Security Number as an EIN (employer identification number).
There is no need to pick a business name — the owner can run the business under their own name. The owner can also choose a fictitious name (also called trade name, DBA name, or assumed name), but it has to be unique and registered with the local state or county agency.
In case you want to see an example of how sole proprietorship is set up, see our article on registering the sole proprietorship in Oregon, USA.
The advantages of a sole proprietorship
These are the things that make sole proprietorships the most popular choice:
- The cheapest business structure to form — the costs are limited to registration and acquiring licenses and permits tied to your line of work. These vary from state to state and are different for each profession.
- Very easy to set up — in order to form a sole proprietorship, you don’t need to take any formal action, apart from registering the name and getting licenses and permits.
- Deductible business expenses — costs of business activities can be deducted from the income tax; these may include car payments, travel expenses, or even certain home expenses if you operate from your home (here's a list of tax deductions allowed by the IRS).
- Full business ownership — as a single owner, you make all the decisions on your own, without meetings and voting processes with board members and such. You are free to set your own work schedule and working hours, in accordance with your customers’ demands.
- Simple tax preparation — the owner pays a personal income tax on profits earned from the business. As a sole proprietorship isn’t a separate legal entity, it is not taxed separately from the owner. Read more about self-employment taxes.
The disadvantages of a sole proprietorship
The following characteristics of this kind of business structure are unfavorable to business owners:
- Unlimited personal liability — the biggest concern of sole proprietors is that there is no liability protection of any kind. In case anything goes wrong they are personally liable for their business's debts. This means that all of their personal assets (and themselves) are jeopardized: car, house, bank account, retirement account, credit score, and more. This goes for lawsuits as well — they’ll be filed against the owner of a sole proprietorship, and they are personally at fault.
- Difficult to raise money — banks consider this type of business structure as risky, and are reluctant to lend them money because repayments are uncertain in case the business fails. They often request to transition to a Limited Liability Company before they decide to lend the money to the owner. Also, it’s impossible to sell an interest in the business to acquire capital or to sell the stock, limiting the investment opportunity. While it is difficult to raise money, it is not impossible. Small business owners can get assistance from the SBA when raising funds for their business or trying to get small business loans.
- No unemployment benefits — owners cannot file for unemployment benefits in case the business fails.
- Self-employment taxes are covered by the sole proprietor - Contributions such as Social security and Medicare are not partially covered by the employer.
- Hard to sell — as sole proprietorships are inseparable from the owner’s assets, it’s difficult to estimate the real value and sell it. However, if the owner wants to sell their sole proprietorship, they can switch it into a single-member LLC. While this is a long and grueling process, it will enable individuals to market and sell their small businesses more easily.
- More difficult to hire employees and assistance - a sole proprietorship cannot hire regular employees but must rely on the help of independent contractors. This requires a different set of paperwork than when hiring regular employees.
- Reputation issues — other businesses and sometimes even government agencies consider them less professional than incorporated businesses.
How to form a sole proprietorship in the USA
In case you decide this is the right structure for your business, use this step-by-step guide to form a sole proprietorship in the United States:
- Reach out to the nearest Small Business Development Center in your area to learn what your particular state/ city requires so you can set up and run a new business legally
- Pick and register the name (you can check name availability at USPTO)
- Recommended — create a business bank account and a credit card separated from your personal funds (in this case, you’ll need to pick a DBA (“doing business as”) name
- Obtain a business license and all the required permits and licenses
- If your business sells taxable products or services, register with the local taxing authority
- If you want to hire an employee, file for EIN (you’ll need it to set up a retirement plan too)
- Create a domain name and reserve/ buy it (you can start building the website later)
- Purchase business insurance — property damage, business loss, workplace injury, illness, and getting sued are the biggest threats to sole proprietors. Picking a good insurance plan can help greatly with minimizing the consequences of these mishaps
Forming a sole proprietorship in other countries
Sole proprietorships are not exclusive to the United States. These types of businesses bloom everywhere, as they benefit entrepreneurship and single-owned businesses greatly.
Taxes for a sole proprietorship in the USA
Because all of the business income counts as your personal income, business taxes are simple to fill out. These are the only necessary tax forms for the owners:
- Schedule C Form — to report income or loss from the business
- Standard Form 1040 — to file an annual income tax return
- Schedule SE with Form 1040 — to calculate how much self-employment tax you owe (estimated tax)
This counts as a personal income tax on the earned profit.
All profit has to be reported in the year it was earned, as a regular income.
When it comes to tax advantages for sole proprietors, you can request an income tax return (personal tax return) for all the business expenses. The "bottom-line amount" in the Schedule C form is passed on to your personal tax return.
Interested in tax deductions for independent contractors and self-employed workers? Learn everything about it here!
Again — as owner and sole proprietorship are one the same in the eyes of the law, it can be hard to separate personal from work expenses. This is one of the reasons it is advised to create a separate bank account for the business.
Important note: a single member of a domestic Limited Liability Company is also considered as a sole proprietor for tax purposes.
Deel benefits for sole proprietors all over the world
When your business starts to expand (just like ours did), you’ll need a stellar team to help you succeed. Technology has advanced enough for you to pick who you’ll work with, no matter their state and time zone.
Deel makes sure that each contract is compliant with local labor and tax laws. Our payroll platform for remote teams automates and makes each step lightning fast, for safe worldwide payments — the way you choose.