The Ultimate Guide to Sole Proprietorships

There are more than 23 million sole proprietorships in the U.S., making this by far the most common type of business entity.[1]

Sole proprietorships are so common because the setup is very easy. If you’re operating an unincorporated business and are the only owner, you are automatically a sole proprietor. When it comes down to it, however, there are both advantages and disadvantages to running a sole proprietorship—and this entity type will not be well-suited for every small business.

Is a sole proprietorship right for you? We’re here to help.

In this guide, we’ll break down everything you need to know about sole proprietorships—including how they work, how they compare to other entities, and how to decide if a sole proprietorship is best for your business.

What Is a Sole Proprietorship?

A sole proprietorship is an unincorporated business with one person or a married couple as the owner.

According to IRS data (shown in the graph below), more than 70% of small businesses are organized as sole proprietorships, without a doubt making this the most common type of business entity.[2]

Sole Proprietorship

Unlike corporations and limited liability companies (LLC), which are state-registered business entities, a sole proprietorship doesn’t require you to file formation papers with the state.

So if you’re running a business on your own and haven’t registered the business, you already have a sole proprietorship. This being said, you might still have to obtain business licenses and permits to comply with local laws.

Compared to other entity types, the main characteristics of a sole proprietorship can be summarized by the following:

  • Easy to form, with no official registration requirements
  • One owner (or a married couple) who is entitled to all profits, but is also personally responsible for all of the business’s losses, debts, and legal obligations
  • Run by the single owner who is not subject to documentation or compliance regulations (unlike corporations)
  • Taxed as a pass-through entity—meaning the business income and profits are passed on to the owner’s personal tax return and subject to their individual income tax rate

Sole Proprietorship Examples

Given how common they are, sole proprietorship examples are everywhere you look.

Some examples of businesses that might be sole proprietorships include:

  • Freelancers
  • Consultants
  • Bookkeepers
  • Virtual assistants
  • Home-based business owners

Essentially, any time you open a business without any business partners, you have a sole proprietorship. The business starts the moment you begin offering goods or services for sale.

You can elect to incorporate your business or register as an LLC, but in the absence of filing papers with the state, you have a sole proprietorship on your hands.

Advantages of a Sole Proprietorship

So, why is it worth electing to be a sole proprietorship instead of choosing another entity type?

It is the simplest way to start and run a business, and there’s a lot to be said for that. Small business owners are very busy people, with the majority devoting more than 50 hours per week to their business.[3] If that describes you, then a sole proprietorship can be very appealing.

This being said, overall, here are the biggest advantages of sole proprietorships:

1. Initial setup is fast.

As we’ve mentioned, it’s quick and easy to start a sole proprietorship as there’s no need to register or incorporate your business with the state. All you have to do is obtain business permits and licenses (e.g. zoning permits, sales tax permits, liquor permits, etc.) that your state or local government requires.

Additionally, if you’ll be operating your company under a trade name (i.e. a name other than your own) you’ll also have to file a fictitious business name, or doing business as (DBA) form with your state or locality. After that, you’re legally authorized to do business.

2. There are few ongoing legal requirements.

After you’ve set up shop, things remain pretty easy for a sole proprietorship from a paperwork standpoint. That’s why you’ll find freelancers, consultants, and other busy professionals often decide to organize their businesses as sole proprietorships—at least in the beginning.

Sole proprietors don’t have to keep a bunch of documentation to maintain their business’s legal status. In contrast, owners of corporations and LLCs have to keep meeting minutes, bylaws, resolutions, and other documents.

3. Management is easy.

As a sole proprietor, you have complete control over business decisions and priorities. Conflicts among partners are one of the leading causes of business failure, but fortunately, sole proprietors don’t have to worry about this.[4] You can change priorities, shift goals, and adjust your schedule however you please (of course, you have to keep employees in mind if you have staff).

Another advantage of a sole proprietorship is that your personal financial and legal situation and your business financial and legal situation are exactly the same. This can remove some of the headaches associated with keeping track of your personal and business interests—but also poses certain risks.

4. Sole proprietorship taxes are simple.

Filing taxes as a sole proprietor is also relatively straightforward. As we briefly mentioned above, sole proprietorships are considered pass-through entities for tax purposes. This means that the owner reports business income and losses on the personal tax return.

Therefore, in order to file taxes as a sole proprietor, you simply need to attach a Schedule C to your 1040 tax return. Since you’re the sole owner, there’s no need to figure out different ownership percentages and shares. You take home all of the after-tax profits.

Additionally, many sole proprietors operate out of their homes—meaning they can take advantage of home business tax deductions like home office space and car expenses (if you drive your personally owned car for business purposes).

5. Many sole props can take advantage of a 20% income tax deduction.

Moreover, the recent tax reform law—the Tax Cuts and Jobs Act of 2017 (TCJA), aka the Trump tax plan—contains a provision that allows owners of pass-through entities, such as sole proprietorships, to deduct 20% of the business’s net income from their taxes.

This 20% deduction can result in a big tax cut for many sole proprietors, though there are limits (which we’ll describe below).

Disadvantages of Sole Proprietorships

Although there are notable advantages of sole proprietorships, there are disadvantages associated with this entity type as well.

Overall, with just one person at the helm, a sole proprietorship is easy to set up and manage—however, this also makes the business and your personal assets more vulnerable.

With this in mind, here are the main disadvantages of sole proprietorships:

1. You face unlimited personal liability for business debts and lawsuits.

One of the biggest drawbacks of a sole proprietorship is there’s no clear distinction between the sole proprietor and their business. Imagine two overlapping circles, one representing you (the owner) and the other representing the business—as illustrated below.

Although there are steps you can take to separate yourself from the business, financially and legally, there will always be some degree of overlap.

sole proprietorshipWhen it comes down to it, sole proprietors are fully, personally liable for the business’s debts and obligations. That means creditors and legal claimants can go after your personal assets  (e.g. your car, your personal bank accounts, your home in some cases) to get their money.

This can be very risky, particularly in industries where injuries are more common.

For example, say you have a landscaping company and mow customers’ lawns. If someone trips on your lawnmower and injures themselves, they could very well sue your business for their medical costs.

Since you’re a sole proprietor, the court could allow a successful claimant to go after your personal assets to get their money. Had you started an LLC or corporation, only your business assets would be on the line.

Kelli Daniel, founder of Dart Frogg Communications, decided to incorporate her business to shield herself from personal liability:

“I am a freelancer, but established an LLC as soon as I started accepting work. I did so to protect myself should (in the admittedly very rare case) someone wishes to press charges. If I was a sole proprietor, someone could press charges and take my personal assets. The LLC protects me from business-related legal matters that could otherwise compromise my financial security. Although I don’t ever expect to be sued for anything, I am someone who believes in insurance and in taking precautions.”

2. Sole proprietorship taxes are higher.

As we mentioned above, recent tax reforms let pass-through entities like sole proprietorships take a 20% tax deduction. This is a great way to lower your tax bill, but sole proprietors still usually end up paying more taxes than corporations and LLCs.

One reason is not all sole proprietors can utilize the 20% tax deduction. Tony Deutsch, CPA and head of Concannon Miller’s tax department, says there are three main limitations:

  • Amount of income: If you’re a sole proprietor and make over $315,000 (married joint filers) or $157,500 (single filers) in annual business income, you can’t take the full deduction. This business tax deduction phases down as your income increases.
  • Business’s employees/assets: After reaching those income thresholds, you can only take a phased-down version of the deduction if you have employees or depreciable business property. If you don’t have employees or depreciable business property, you’re out of luck.
  • Industry: Sole proprietors who provide certain types of services, including actors, artists, athletes, lawyers, and accountants, also can’t take the full deduction after reaching a certain income threshold.

On top of these limitations to the 20% tax deduction, sole proprietors often end up paying more self-employment taxes (Medicare and Social Security tax).

All sole proprietorships must pay income taxes and self-employment taxes on the total income of the business. If your business is making a lot of money, that can be a big bill to pay.

All business owners have to pay self-employment taxes, says Deutsch, but owners of corporations can reduce their tax burden by taking some money out of the business as dividends. Those dividends aren’t subject to self-employment taxes.

This being said, the tax code is very complicated, so we ‘d recommend consulting a tax professional to learn more about how different business structures will affect your tax bill.  

3. Burnout is more likely.

Sole proprietors wear many different hats when running a business. Of course, you can hire employees or independent contractors to help, but the reality is that many sole proprietorships don’t have extra hands to help out. 

Sole proprietors have to take care of marketing, advertising, finances, strategy, and leadership—and everything else that comes with running a business. Doing too much on your own can lead to serious burnout and cause the business to fail.

4. Succession plans might be unclear.

Another problem with sole proprietorships is that the business might not survive the owner.

Sole props often build up a ton of intangible value and customer loyalty from the owner. That is great for a time, but can hurt the business’s prospects if the owner passes away, experiences a disability, or retire.

So, if you want your business to outlast you, you might consider incorporating or starting an LLC.

5. Landing clients is harder.

As trivial as it may seem, customers and vendors may be more likely to take you seriously when you structure your business as a corporation or LLC. You might find the choice of business entity is important when trying to land a big client or buy raw materials from a major supplier.

Here’s what happened to Michael Simonson, founder of viral marketing agency ClickBoost:

“I actually lost a potential client two months ago because they were not comfortable working with an agency that wasn’t incorporated. I would have been the agency of record for this client, and it would have been a nice-sized gig. But they eventually rescinded the job offer, explaining that they had a policy against hiring unincorporated companies.”

How Do Sole Proprietorships Compare to Other Entities?

Although we’ve discussed how a sole proprietorship compares to other entity types in passing, it may be helpful for us to break down these distinctions in more detail so you can determine if another entity may be better-suited for your business.

Sole Proprietorship vs. Independent Contractor

First, you might be wondering what the difference is between a sole proprietorship vs. an independent contractor. This distinction may be confusing initially because an independent contractor (unlike a LLC or corporation) is not an entity type—but instead, is a designation used for someone who works for someone else and receives a 1099-MISC form at the end of the year.

In this way, someone can be both a sole proprietor and an independent contractor. As an example, say you have a freelance writing business and are contracted to complete work for Company X. Your freelance writing business is a sole proprietorship, as you’re the only owner—and you’re an independent contractor working for Company X (as opposed to being an employee of Company X).

To this point, however, not every sole proprietorship is an independent contractor—a small retail store that sells shoes, for instance, wouldn’t be an independent contractor.

Sole Proprietorship vs. LLC

Unlike an independent contractor, an LLC is another popular entity structure among small business owners.

There are several differences between LLCs vs. sole proprietorships:

  • Formation: In order to form an LLC, you have to file formation papers, called articles of organization, with the state. A sole proprietorship, on the other hand, is the default form of ownership for a single-owner company.
  • Taxes: LLC owners can choose whether to be taxed as a disregarded entity or as a corporation. A sole proprietor must report business income and losses on a Schedule C attached to their personal tax return.
  • Liability: Members of an LLC are shielded from personal liability for business debts and obligations. Sole proprietors face personal liability for any lawsuits or debts of the business.

Other than these core differences, it’s costlier and more time consuming to maintain an LLC compared to a sole proprietorship. For instance, most states require LLCs to file an annual report and pay an annual tax.

This being said, however, many business owners opt for an LLC to receive limited liability protection.

Sole Proprietorship vs. Corporation

There are also several differences between sole proprietorships and corporations:

  • Formation: To form a corporation, you must file articles of incorporation with the state. As we’ve discussed, sole proprietorships don’t require a business filing for initial setup.
  • Taxes: C-corporations and S-corporations have different tax rules. C-corps are subject to a flat 21% corporate income tax. In an S-corp, similar to a sole proprietorship, business income and losses pass through to shareholders’ personal tax returns.
  • Liability: Shareholders in a corporation are shielded from personal liability for business debts and obligations. Sole proprietors, as mentioned above, can be sued personally by business creditors.

Ultimately, a corporation is the most complex type of business entity, with three layers of ownership and management: shareholders, officers, and directors. Whether you’re a C-corporation or S-corporation, there are several corporate formalities that you need to follow, such as holding shareholder meetings, to keep your corporation in good standing.

For this reason, many small businesses opt for an LLC, partnership, or sole proprietorship.

How to Start a Sole Proprietorship

Ultimately, if you’re the only owner of your business and you’ve started providing goods or services, you have a sole proprietorship. This being said, however, there are a few additional steps you’ll want to take to make your business official:

  • Register your business name: As we mentioned above, if you want to operate under a name other than your personal name, you’ll need to file a DBA with your local business authority.
  • Get licenses and permits: Again, to operate your business legally, you’ll need to acquire any business licenses or permits that your state, locality, or industry requires. Learn more about the business licenses you might need here.
  • Apply for an EIN: An employer identification number (EIN), sometimes called a business tax ID, is not required for sole proprietorships, however, applying and receiving one from the IRS can help you separate your personal and business finances.
  • Open a business bank account: Similar to an EIN, sole proprietors don’t necessarily need a dedicated business bank account, but having one can help separate your finances and prevent bookkeeping, tax, and legal issues in the future.
  • Get business insurance: As we’ve mentioned, one of the disadvantages of a sole proprietorship is a lack of legal protection. Therefore, it’s even more important to get business insurance to mitigate your risks.

The Bottom Line

Ultimately, when you’re choosing a business structure, sole proprietorship offers the value of simplicity, but there are many potential downsides. Among them, higher taxes, more legal exposure, and more difficulty landing new business.

Therefore, you’ll want to think carefully about which entity type is best for you—you might even consider changing your sole proprietorship to an LLC or corporation as your business grows.

At the end of the day, if you’re unsure of which business structure is right for you, you’ll want to consult an accountant or business attorney for advice. These professionals can help you weigh the options and make the most informed decision.

Article Sources:

  1. TaxFoundation.org. “The U.S. Has More Individually Owned Businesses Than Corporations
  2. IRS.gov. “SOI Tax Stats – Integrated Business Data
  3. Score.com. “How Hard Small Business Owners Work
  4. Forbes.com. “Why Partnership is Harder Than
Senior Contributing Writer at Fundera

Priyanka Prakash, JD

Priyanka Prakash is a senior contributing writer at Fundera.

Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.

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