- A sole proprietorship is a business that is owned and operated by a single person, with no legal separation between the owner and their business.
- Though a sole proprietorship is simpler than other business structures, it comes with some major drawbacks.
- Earnings from a sole proprietorship are taxed along with the business owner's personal taxes.
- This article is for entrepreneurs who are considering setting up their business as a sole proprietorship.
At the start of your small business journey, you need to determine your business's legal structure before registering it, since your business structure will affect everything from how you pay taxes to the amount of liability you take on. Some structures are more complex than others, but if you're looking to strike out as the only person responsible for your business, then a sole proprietorship may be the best-suited structure for you.
What makes up a sole proprietorship?
A sole proprietorship is a business that is owned and operated by a single person, with no legal separation between the owner and their business. A business automatically becomes a sole proprietorship if it is registered without a designated business structure.
When setting up a sole proprietorship, there are some associated costs involved, depending on the type of business you're starting. At the state and federal levels, there are licensing fees. Over time, other costs include business taxes, operating costs, and capital improvements or equipment purchases, among other things. [Read related article: What Business Startup Costs Should You Consider?]
Key takeaway: A sole proprietorship is the default legal structure. It gives the business owner complete control over the company.
How are sole proprietorships taxed?
Since a sole proprietorship is not considered a separate legal entity by the IRS, taxes for this type of business structure are relatively easier than others. When filing a 1040 or 1040-SR, the business owner of a sole proprietorship must include a Schedule C form to report the business's income or losses.
According to the IRS, a business's profits are calculated by adding all profit and income, then subtracting the costs of goods and services, in addition to other business expenses incurred during the tax year. That figure is added to Line 12 of the business owner's 1040. If the business brought in positive revenue, that income is added to the owner's personal income and taxed accordingly. If a business operates in the red, however, those losses are also reflected in the owner's taxes, resulting in a potentially reduced total adjusted gross income. [Read related article: How to Reduce Your Business's Tax Liability]
Taxation of a sole proprietorship works differently in each state. As such, you're going to have to consult your state's tax laws before filing for the first time. You may also want to consult a CPA, if your budget allows. As a general rule, states often charge a sales tax and an excise tax. In addition, any property or real estate occupied by the business could have related tax obligations levied against it.
Sole proprietorships have access to some of the same credits and deductions that other businesses enjoy. Other tax deductions include health insurance deductions for the business owner, their spouse and their dependents. The IRS also says "ordinary and necessary" operating expenses can be deducted on a tax return.
Furthermore, once the Tax Cuts and Jobs Act of 2017 became law, sole proprietors were able to utilize new pass-through tax deductions of up to 20% of net business income earned each year until 2025. These deductions are considered additional personal deductions as long as you meet the federal government's guidelines.
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Personal tax impacts
Once you collect any income from the business, you're going to pay taxes on it. As the only person in the company, you're going to have to withhold and file self-employment taxes and ensure you have enough money at the end of each quarter to pay an estimation of what you owe to the IRS.
By estimating and setting aside how much money you need to cover your taxes, you will avoid any problems with the IRS. You do that by using the IRS' 1040-ES form. An estimated tax will be required if the two following statements are true:
- You expect you'll owe at least $1,000 in taxes after subtracting your withholding and refundable credits.
- You expect your withholding and refundable credits to be less than the smaller of 90% of the taxes shown in your next tax return or 100% of the taxes shown on your tax return from the previous year, if it covers all 12 prior months.
Self-employment tax is calculated using the Schedule SE form. Not unlike a payroll tax at larger companies, the self-employment tax covers both Social Security and Medicare taxes, with the total self-employment tax rate currently sitting at 15.3%, with 12.4% going to Social Security and 2.9% going to Medicare.
Key takeaway: Sole proprietorships are taxed in conjunction with the owner's personal taxes, though there are special deductions, credits and calculations for small business owners.
What are the advantages and disadvantages of starting a sole proprietorship?
By their very nature, business structures designate how much personal liability the owner or partners face, what paperwork will need to be filed when establishing the business, and how taxes are calculated and paid on a quarterly basis. Like other business structures, sole proprietorships have distinct advantages and disadvantages. [Read related article: How to Choose the Best Legal Structure for Your Business]
Sole proprietorship pros
Sole proprietorships are the most popular organizational structure in the country. According to the IRS, tax returns for approximately 25.5 million sole proprietorships were filed in 2016, making up nearly 75% of all small businesses in America. That figure marks a continuing upward trend year to year, further highlighting the popularity of this business structure.
As a sole proprietorship, a small business enjoys the following advantages:
- Complete control. Unlike other business structures in which a partner, board of directors, or someone else shares ownership and decision-making power, a sole proprietorship gives the business owner full control over the business. Being able to make decisions without needing to obtain a consensus from business partners allows for quick course corrections that could mean the difference between a profit and a loss.
- Easy to start or dissolve. As long as the business is owned by a single individual, is established for the purpose of earning a profit, and will continue to operate with some form of continuity, then a business is a sole proprietorship. As previously mentioned, an unincorporated business automatically becomes a sole proprietorship once it's registered and it fits those criteria. Sometimes, it's just as easy – if not easier – to end a sole proprietorship depending on your business's situation. If your business has inventory, you may need to liquidate it. Likewise, you may need to cancel ongoing customer memberships and complete any contracts you have on the books before closing up. Any professional licenses will also have to be canceled. If your business has its own employer identification number filed with the IRS, that must be closed before formally ending the business. As with most issues regarding the IRS, it’s important that you retain any documentation associated with your business in case an audit is initiated in the future. However, for many sole proprietorships that do not have such responsibilities, all that needs to happen for such a business to fold is to cease operations. Without a constant stream of revenue, the business dissolves with zero paperwork necessary. [Read related article: How to Start a Business: A Step-by-Step Guide]
- Lower associated costs. This benefit depends on a wide range of factors, such as the type of business you're running and its location, but sole proprietorships don't come with the added fees and requirements that other business structures do. All that's usually necessary are license fees and business taxes.
- Simpler taxes. As the owner of a sole proprietorship, your business taxes will be filed with a Schedule C form along with your personal tax return, since sole proprietorships are technically not a separate legal entity. As a result, your taxes will be filed through a simple form and potentially subject to some credits and deductions along the way.
- Good testing grounds. If you have an idea for a low-risk business, a sole proprietorship is a great way to test the waters. Most entrepreneurs, more than 25 million in the U.S., use the structure to get a business going. If the early venture is off to a good start and revenues are coming in, or there's a push to grow the company beyond its status as a sole proprietorship, you can upgrade your business to a more formal structure at a later date.
Sole proprietorship cons
While there are clear advantages to running a sole proprietorship, there are some serious risks associated with doing so.
- Completely liable. When opting to have your business become a sole proprietorship, you're taking on 100% of the responsibility. While nearly every other business structure comes with some protections baked in for the business owners or members of a partnership, there are zero such shields for the single owner of a sole proprietorship. As far as the IRS is concerned, you and your business are considered the same legal entity. Therefore, if issues arise relating to your tax returns, your personal assets can be affected. The same goes for bank loans, credit cards and any other business debt. You will also be personally held liable for any lawsuits filed against your business.
- Personal credit score affects the business. Since you and your business are considered the same entity, your credit score will directly impact how easily your business can secure additional funds. As such, a good credit score will mean access to larger loans and more favorable terms, while a bad personal credit score could result in not even getting a loan or line of credit at all. [Read related article: 8 Factors That Keep You From Getting a Small Business Loan]
- Unable to raise funds outside of profits. As the owner of a sole proprietorship, you're going to need to subsist on the profits or obtain additional funds for your business. Unlike incorporated business structures, a sole proprietorship can't get a quick infusion of funds by selling stock.
Key takeaway: While a sole proprietorship comes with lower associated costs and higher control, the business is not a separate legal entity, which means that the small business owner retains 100% of the liability.
Examples of sole proprietorships
There are many kinds of businesses that would be well suited as a sole proprietorship. If it can be owned and operated by a single person, then it's likely a good fit to be a sole proprietorship. For example, any home business can fit as a sole proprietorship. Tutors, senior home healthcare providers, financial planners, computer repair specialists and housekeeping services can easily fit in the sole proprietorship mold.
In some industries, gig work can also be conducted as a sole proprietorship, though this depends on the industry in question. Freelance photographers and writers can become their own sole proprietorship, but Uber and Lyft drivers are considered independent contractors and are currently in a battle to be considered employees of those companies.
While it may seem like a sole proprietorship is designed to remain a small business, there are examples of them growing into corporate powerhouses. Pierre Omidyar's business started when his girlfriend needed somewhere to sell old tchotchkes and became the online auction powerhouse eBay. Similarly, Kinkos founder Paul Orfelea launched the company as a sole proprietorship – a status he maintained until he sold it to FedEx for $2.2 billion.
Key takeaway: There are plenty of different business types that work as sole proprietorships. Though primarily thought of as very small businesses, they can flourish into major companies.