For many, starting a company is a part of the American Dream. In fact, entrepreneurs are often celebrated for their initiative, determination, and gutsy decision-making.
Making tough decisions is a key part of any business. One such decision is what business type to form. For many, the answer is to remain as a sole proprietor ― the U.S. Small Business Administration says it’s the most common way to start a business.
Before you jump on the sole proprietor bandwagon, however, you need to understand all of the advantages and disadvantages. Let’s discuss all the important details of America’s simplest business structure.
What Is a Sole Proprietor?
Much like a general partnership, the sole proprietorship is an informal business type, but the difference is that a sole proprietorship operates with only one owner.
There are very few legal requirements for owning a sole proprietorship, which is why we often say that it’s the easiest type of business to form. All you need to do to get a sole proprietorship up and running is to simply start working, as there is no formal formation process, and no paperwork to file with the state.
A sole proprietorship is an unincorporated business. In fact, from a legal standpoint, the business and its owner are one and the same ― taxes and lawsuits against a sole proprietorship are brought against the owner personally.
A sole proprietor is one of the most popular business types simply because it’s a good starting point. It’s simple to create, the startup costs are almost nonexistent, and a sole proprietorship can be converted into another entity type later on.
How Does a Sole Proprietorship Work?
A sole proprietorship springs into existence whenever its owner starts conducting business. It’s not necessary to file any formation documents with the Secretary of State.
For example, let’s say you sell baked goods. Technically, you formed your sole proprietorship when you sold your first baker’s dozen. That said, the owner must get any licenses required in their field in order to operate a compliant business.
Taxes for a sole proprietorship are fairly straightforward ― you actually won’t have to pay “business taxes” at all. Instead, a sole proprietor pays personal income tax rates, even on their business income.
This is because a sole proprietorship is not a separate business entity from its owner. You still pay taxes on the business profits, but you don’t report them on a separate tax return. Instead, you report that income on Schedule C of your personal income tax return.
As a sole proprietor, you’d also need to pay self-employment taxes. Normally, someone’s employer withholds these taxes from the employee’s paycheck, but if you’re your own employer, then it’s a different story. You’ll need to make payments for Medicare and Social Security taxes yourself, which comes to a 15.3% tax rate on top of your income taxes. You can find more information on these taxes here.
With employees, the taxes can get a touch more complicated, since the proprietor needs to handle these tax payments on behalf of the employees. You can find more information on those taxes with the IRS’s employment tax guide. If you’re selling a qualifying good or service, you’ll also need to consult with your state’s Department of Revenue to learn about your sales tax.
What Are the Advantages and Disadvantages of a Sole Proprietorship?
A sole proprietorship is a popular choice for many new businesses, and it has several advantages that make it entrepreneur-friendly.
For one thing, a sole proprietorship lets the owner keep full control of the business. It’s also easy and cheap to form, and there is minimal government oversight (especially compared to a corporation or LLC).
Other than acquiring your business licenses, there really aren’t any ongoing compliance tasks to keep track of as a sole proprietor. While corporations and LLCs have to file annual reports and franchise tax forms, sole proprietors don’t have any maintenance issues to address on a regular basis.
There is also no requirement for a sole proprietor to designate a registered agent. Every LLC and corporation needs to have a registered agent, who receives their important document deliveries from the state and forwards them to the business. As a sole proprietor, you are certainly allowed to get a registered agent if you would like to, but no one is forcing you to do so.
As you can see, there are some advantages to being a sole proprietor, but there are certainly some disadvantages as well.
The biggest drawback is that there is no personal asset protection with a sole proprietorship ― if the business runs into debt or a lawsuit, your personal funds and assets can be taken as payment. This is in sharp contrast to LLCs and corporations, which do limit ownership’s personal liability.
Another downside is the fact that sole proprietors don’t have exclusive rights to an assumed business name. While sole proprietorships can obtain doing business as (DBA) names, there is no exclusivity involved with a DBA, so other companies are free to use your business name if they want to.
This is another area where LLCs and corporations have a huge advantage over sole proprietorships, because formal business entities do have exclusive rights to their business names.
It’s also harder to change ownership of a sole proprietorship, because a sole proprietor and their business are legally considered to be one and the same. You also can’t add a co-owner without changing your entity type, because the sole proprietor is exclusively a one-person operation ― you are allowed to hire employees, but you are not allowed to bring in other owners.
In addition, banks are less likely to give large loans to an unincorporated business. Technically speaking, any loan you get from a bank would likely be considered a personal loan ― again, because the owner and the business are not distinct entities.
A sole proprietor is a very popular business type, because it allows entrepreneurs complete control over the business, and the state requirements are minimal. Even better, it leaves room for growth later on.
However, there are quite a few downsides to the sole proprietorship, especially when it comes to the area of personal asset protection. Just to recap, if your sole proprietorship is sued, or if you default on a debt, you will be held personally liable, which is not the case for LLCs and corporations. Additionally, the lack of an exclusive business name is a significant negative for the sole proprietorship.
At the end of the day, while there are some minor positives to forming a sole proprietorship, we typically recommend forming a limited liability company (LLC) instead. It doesn’t cost too much more, and the LLC has an overwhelming set of advantages compared to the sole proprietorship.
If you would like some more information about the similarities and differences between an LLC and a sole proprietorship, we invite you to take a look at our “LLC vs Sole Proprietor” comparison guide.
Alternately, you can get started by hiring a service like Incfile or ZenBusiness to create an LLC for you.