A sole proprietorship is the most popular type of business structure in the USA.
It’s the easiest and the cheapest type of business entity to create, maintain, and dismantle. This is why the majority of the small business owners, start-up owners, consultants, self-employed freelancers, and individual contractors opt for it when starting out in the business world on their own.
However, with plenty of advantages come some downsides and considerable legal effects of being a sole proprietor. It’s for the best to consider all of these before deciding if a sole proprietorship is the right fit for your work.
By the end of this article, you will learn all there is about sole proprietorships:
- Definition of a sole proprietorship
- How does it work
- The advantages and disadvantages of a sole proprietorship
- How to form a sole proprietorship in the United States (and some other countries as well)
- Taxes for sole proprietors in the United States
In the end, we’ll revise the article and note the most important aspects of doing business this way.
Sole proprietorship definition
A sole proprietorship is an unincorporated business owned and run by one person only.
There is no legal distinction between the sole proprietorship and the business owner. The owner is entitled to all the business income that comes from this type of business structure.
At the same time, the sole proprietor (also called sole trader) is personally responsible for all of the debts and liabilities that come from operating a sole proprietorship.
How does sole proprietorship work?
A sole proprietorship is not a legal entity on its own — it is conjoined to the owner. This means that there is no legal separation between a sole proprietor and this form of business — therefore, all the business losses are the owner’s personal losses.
There is no need to pick a business name — it can run under the owner’s name. The owner can also choose a fictitious name (also called trade name, DBA name, or assumed name), but it has to be unique.
In case you want to see an example of how sole proprietorship is set up, see our article on registering the sole proprietorship in Oregon, USA.
The advantages of a sole proprietorship
These are the things that make sole proprietorships the most popular choice:
- The cheapest business structure to form — the costs are limited to registration and acquiring licenses and permits tied to your line of work. These vary from state to state and are different for each profession.
- Very easy to set up — in order to form a sole proprietorship, you don’t need to take any formal action, apart from registering the name and getting licenses and permits.
- Deductible business expenses — costs of business activities can be deducted from the income tax; these may include car payments, travel expenses, or even certain home expenses if you operate from your home (here's a list of tax deductions allowed by the IRS).
- Full business ownership — as a single owner, you make all the decisions on your own, without meetings and voting processes with board members and such. You are free to set your own work schedule and working hours, in accordance with your customers’ demands.
- Simple tax preparation — the owner pays a personal income tax on profits earned from the business. As a sole proprietorship isn’t a separate legal entity, it is not taxed separately from the owner. Read more about self-employment taxes.
The disadvantages of a sole proprietorship
The following characteristics of this kind of business structure are unfavorable to business owners:
- Unlimited personal liability — this is the biggest concern of sole proprietors. In case anything goes wrong they are personally liable, which means that all of their personal assets (and themselves) are jeopardized: car, house, bank account, retirement account, credit score, and more. This goes for lawsuits as well — they’ll be filed against the owner of a sole proprietorship, and they are personally at fault.
- Difficult to raise money — banks consider this type of business structure as risky, and are reluctant to lend them money because repayments are uncertain in case the business fails. They often request to transition to Limited Liability Company before they decide to lend the money to the owner. Also, it’s impossible to sell an interest in the business to acquire capital or to sell the stock, limiting the investment opportunity.
- No unemployment benefits — owners cannot file for unemployment benefits in case the business fails.
- Hard to sell — as sole proprietorships are inseparable from the owner’s assets, it’s difficult to estimate the real value and sell it.
- Reputation issues — other businesses and sometimes even government agencies consider them less professional than incorporated businesses.