The Internal Revenue Service (IRS) requires every business to classify itself as a specific type of legal entity. These entities come in five forms—partnership, corporation, limited liability company (LLC), S corporation, and sole proprietorship—and each has its own legal and tax considerations.
Declaring your business as a sole proprietorship is easy, and if you are working as a consultant, freelancer, or other singular business, you may already be operating as one without realizing it.
If you're interested in establishing a sole proprietorship (or if you're already running one), here's a basic overview of this legal business structure.
What is a sole proprietorship?
A sole proprietorship is the simplest and most common business structure in the United States. Sole proprietorships are run by a single individual who is responsible for all business assets, profits, and liabilities.
Because this type of entity is so easy to form, administrative startup costs are minimal. The law does not even require you to set up a formal structure before launching your business. The only legal expenses that may apply are for any licenses and permits you may need, depending on your industry.
[Read more: A Guide to Business Licenses and Permits]
Pros and cons of sole proprietorship
Two of the many benefits of a sole proprietorship include:
- Full control over the business: Since you are the sole owner, you make all the business decisions.
- Simple tax preparation: Known as pass-through taxation, your sole proprietorship does not need to be taxed separately from your Social Security number. You simply need to report your business profits and losses to the IRS on a Schedule C form and Form 1040 and file your taxes as usual. As an added bonus, sole proprietor tax rates are the lowest among all business structures.
Of course, some of these perks can also lead to potential disadvantages, including:
- Full financial responsibility: As the sole owner and decision maker, you alone are liable for any financial losses and debts that may occur within your business.
- Difficulty with finding investors: The SBA also notes that it takes more work for sole proprietors to raise money. Banks view sole proprietors as particularly risky since the business's success and failure depend on a single person. You can also not sell stocks in a sole proprietorship, which may limit your opportunities to bring on investors.
Who should operate as a sole proprietor?
There are certain types of businesses that are well-suited for sole proprietorship status:
- Business consultants and speakers: Professionals in this space may take on a few gigs a year or operate as a full-time business.
- Freelancers: Photographers, copywriters, web developers, and more are typically a business of one contracted on a per-project basis by their clients.
- Home health care specialists: Home care assistants typically work as contractors and provide services to clients in their homes.
- Professional cleaners: Residential and commercial cleaning can easily be done as a side job or a full-time business.
- Landscapers. These businesses often begin with one person who does all the work. As demand increases, the sole proprietor may hire employees or outside contractors for assistance.
Businesses like these are ideal sole proprietorships because they are inexpensive to start and typically don’t need investors or financing to cover overhead expenses like storefronts or specialized equipment. They are also primarily built on the owner's personal reputation and skill set.
If you want to operate as a sole proprietor, there’s no action needed on your part. Assuming you’re the sole owner, you’re automatically classified as a sole proprietor.
Sole proprietorship vs. LLC
Many new business owners weigh forming an LLC against the advantages offered by a sole proprietorship. Limited liability companies (LLCs) are legal entities formed and run by one or more owners (“members"). LLCs are formed at the state level and function as a separate legal entity from its members.
In practice, that means your personal assets are protected from liability if something should go wrong in your business. LLCs protect individual business owners from risking their own assets from lawsuits that can result from selling products, maintaining a physical location, or hiring employees.
LLCs enjoy similar tax flexibility to sole proprietorships. “By default, all profits made by an LLC are only taxed once, a process known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return,” wrote LegalZoom.
Sole proprietorships are much easier to form than LLCs. The process of how to start an LLC requires more paperwork and planning; sole proprietorships don’t require any.
[Read more: Sole Proprietorship vs. LLC: Which Should You Choose?]
How to register as a sole proprietorship
If you want to operate as a sole proprietor, there’s no action needed on your part. Assuming you’re the sole owner, you’re automatically classified as a sole proprietor. The IRS automatically considers you a sole proprietor if you are the only owner and are operating under your legal name (not under a DBA name).
If you wish to get a Doing Business As (DBA) name, you must file some paperwork. The requirements for filing a DBA vary from state to state, city to city, and even depending on the type of business structure you use. “A DBA is often necessary when opening a bank account or credit card for your business. Your state might also require follow-up steps after registration,” wrote HubSpot. “A DBA also ensures no one else in your county is doing business under the same name.”
How are sole proprietors taxed?
Sole proprietors are taxed as “pass-through entities,” a term the IRS uses to explain that the tax responsibility passes through the business to land with the individual. You will pay taxes for your sole proprietorship as part of your personal tax return. Use Form Schedule C with your personal income tax form, Form 1040.
Becoming a sole proprietor leads to several tax implications. First, any net income from your business will increase your personal taxable income. Your business income may qualify you into a higher tax bracket than you were previously.
Secondly, the income taxes you pay can’t be claimed as business expenses. “Some business owners post income tax payments on their profit and loss statement as expenses; however, this is incorrect if you’re a sole proprietor—these payments are actually distributions of equity and should not be posted as expenses,” explained NerdWallet.
Fortunately, you will only pay sole proprietorship taxes on the profit of your business, not on your total income. There are also special tax deductions applicable to sole proprietorships. It’s worth consulting a tax expert to learn how to lower your tax burden as a sole proprietor.
Is a sole proprietorship right for your business?
When your business is just starting out, and plans are to remain as a business of one, sole proprietorship makes sense. If you have big growth plans for your business, you may consider a different legal structure since sole proprietorships can come with financial, business, and legal risks. However, if you plan to keep your business small, you can indefinitely operate as a sole proprietorship.
[Read more: Getting Ready to Launch? How to Choose the Right Business Structure]
This article was originally written by Sean Peek.
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