Most small businesses are sole proprietorships because they're the easiest and least expensive way to start a business. In fact, the IRS reports that over 25.5 million businesses paid taxes as sole proprietors by filing Schedule C of Form 1040 in 2016 (the last year calculated).
What is a Sole Proprietorship?
The sole proprietorship is the oldest and simplest form of business ownership. A sole proprietorship (or “sole prop”) is a form of business in which an individual starts a business under his or her own name. It's a one-person business; your business can't be a sole proprietorship if it has more than one owner. In a sole proprietorship, you are the business in a sole proprietorship. The business isn't a separate entity from you.
The IRS calls a sole proprietor someone who owns an "unincorporated business by himself or herself." That means the business isn't a corporation (or S corporation) or a single-owner limited liability company (LLC).
Many sole proprietors work from home. This article on Starting a Home Based Business answers commonly asked questions about the additional requirements for starting your sole proprietorship from home.
How Does a Sole Proprietorship Get Started?
A sole proprietorship is unique because it's the only business that doesn't have to register with a state. All other business types - partnerships, limited liability companies, and corporations - must file a registration form with each state in which they do business.
Starting a sole prop business is fairly simple. To start a sole proprietorship, all you need to do is:
- Create a business name and decide on a location for your business
- File for a business license with your city or county, and get permission from your locality if you want to operate your business from home.
- Set up a business checking account so you don't mix up business and personal spending.
In addition, your sole proprietorship may have to register with federal or state entities (these registrations are the same for all types of businesses):
- If you plan to sell taxable products or services, you must register with your state's taxing authority.
- If you plan to hire employees, you'll need an Employer Tax ID Number (EIN) from the IRS. Your bank may also require this tax number.
Advantages of a Sole Proprietorship
Forming a sole proprietorship offers several advantages.
You don't have to prepare any legal agreements because you're not in business with someone else, and you don't have to set up an elaborate business structure: no board of directors, no meetings, no minutes, no complicated accounting for shares in the business. You just start running your business.
You have complete control over all the operations and you get to make all the decisions as the sole owner of the business. You don't need a board of directors or shareholders, and you won't have other owners to answer to.
Tax Preparation and Filing
Use of Losses
You can use any business losses to offset personal income from other sources (a spouse's salary, for example), because you're including your sole proprietorship income/loss on your personal tax return.
You must actively participate in the business and not be just an investor to take the maximum loss. You also have to be careful not to run up against the IRS restrictions on "hobby" businesses which generate losses for years. Losses can lower your taxes if you can prove your business is legitimate and not a hobby.
See this article about Claiming Business Losses on your Tax Return to learn more about limits to business losses.
Disadvantages of a Sole Proprietorship
The primary disadvantage of a sole proprietorship is that your personal finances and those of your business are one and the same. You're personally liable for any debts or obligations of the business when you're the owner. Lawsuits or creditors may be able to access your personal accounts, assets, or property if your business can't pay its bills.
You can't file bankruptcy for your business without filing personal bankruptcy. Filing bankruptcy for your sole proprietorship means involving your personal assets. A bankruptcy case involving a sole proprietorship includes both the business and personal assets of the owners and debtors.
The issues of personal liability and involvement of personal assets outweigh the advantages of sole proprietorship structure for many businesspersons. Consider forming a limited liability company (LLC) or corporation instead if this is the case for you.
Getting Business Insurance Protection
You can't protect your personal assets if your business is in trouble financially, but you can have some protection from liability lawsuits if you get property and liability insurance. You'll probably have to get this insurance specifically for your business, but it can help protect you if your business is involved in a liability lawsuit.
You might want to get business auto insurance to cover you while on you're on business trips if you drive your car for business purposes. Most personal auto policies won't cover business driving.
Taxes and Sole Proprietorships
A sole proprietor pays federal and state income taxes on all the net income of the business (income minus deductions), even if you don't have cash on hand to pay these taxes.
Your business income is included with your personal income on your personal tax return. The tax rate you pay may on your business income can be hard to determine because it's all combined. The corporate tax rate is a flat 21% for all corporate income levels, so your tax rate might be higher or lower, depending on your personal tax rate.
And don't forget the self-employment tax. Sole proprietors must pay self-employment tax (Social Security and Medicare) on the profits of their business. This withheld from your business income, so you'll probably have to make quarterly estimated tax payments for this and your business income tax.
The IRS publishes a Tax Guide for Small Business, which you might find helpful in dealing with federal taxes.
Check with Tax and Legal Professionals
Check with your tax and legal advisors before settling on a business form, even if you have a very small, one-person business. There may be other things you should consider before you start a sole proprietorship business.