What is a sole proprietorship and how does it work?

Sole proprietorships are the most common way to start a business — and generally also the simplest and most affordable. Whether you are a massage therapist, landscaper, personal coach or owner of another type of one-person business, your business is considered a sole proprietorship by default until you opt to legally form a separate business entity such as a limited liability company (LLC) or corporation. 

Many small business owners, freelancers and other self-employed individuals start out running their businesses as sole proprietorships. Once they have proof of concept for their businesses, they transition to legally forming a business entity that may provide greater legal protection. Here’s a look at the pros and cons of sole proprietorships and how they can be set up.

Advantages and disadvantages of a sole proprietorship

A sole proprietorship offers several key benefits: 

Ease and low cost of setup

Becoming a sole proprietor is the easiest way to launch a business. Compared with other business structures, there is little to no paperwork needed to form a sole proprietorship. Typically, a sole proprietor is someone who owns an unincorporated business by himself or herself. The process is relatively easy, and startup fees are typically low. 

Few bureaucratic constraints

Sole proprietors typically have fewer government rules, paperwork and regulations to wade through than an incorporated business. In comparison, operating an LLC or corporation requires more administrative work and financial disclosures. However, if a small business owner has employees, many of the same filings and disclosures are required as if they operated an incorporated entity. 

Full accountability and control

Sole proprietors possess full control and decision-making accountability for all the operational and business activities. While they may choose to have employees and delegate some of their duties, they are ultimately legally and financially accountable for the activities and decisions of the business. 

Tax management and filing ease

Tax filings for sole proprietorships are typically easier to complete. Because there is no legal separation between the owner and the business, the owner receives 100% of the profits, losses, deductions and credits. They’ll report the business’s income and deductible expenses and pay taxes on the business’s taxable income as a part of their annual individual tax return filing. 

Sole proprietorships do have some disadvantages. Once these begin to outweigh the advantages, many owners will opt to legally form a business entity. 

Unlimited legal liability

There is no legal separation between the individual owner and the business in a sole proprietorship. As a result, the owner assumes all debts and obligations incurred by the business. 

This means that if the business for some reason cannot satisfy its obligations or if the business is sued, the owner’s personal assets may be legally at risk. 

Capital limits

Sole proprietors are generally limited in terms of the financial resources they can seek from a lending relationship. Some banks may consider sole proprietorships to be a high lending risk. 

Unlike an LLC or corporate entity, sole proprietors have no shares or interest in their business to sell to raise capital.

How to start a sole proprietorship

1. Select and register a business name

In a sole proprietorship, the business’s legal name is generally the owner’s personal name, but the owner can also establish a “doing business as” (DBA) or trade name that may be easier to use for marketing purposes or to protect the owner’s privacy. After identifying some options, a small business owner should check the names’ availability for use through the website of the secretary of state where the business is domiciled. Once registered, the owner can then begin conducting business under that DBA or trade name. Some banks may require a DBA to open a business account. 

2. Secure business licenses and other permits if necessary

Licenses depend on the nature of the business and the state and local area where the sole proprietorship operates. Knowing what licenses are needed is important for the business owner to avoid fines and shutdown of their business. Information on the appropriate agency or office should be listed on the website of each state’s government.

3. Acquire an employer identification number

In most cases, the owner’s Social Security number suffices as a tax ID number for a sole proprietorship. However, a sole proprietor will need an employer identification number (EIN) if they elect to hire employees or are required to file certain other federal tax filings. In that case, a sole proprietor would also use the EIN to file taxes. An EIN is free and may be obtained through the IRS site.

Opening a business banking account

Regardless of how the business is structured, it is important for the business owner to separate their business and personal finances through a separate bank account. This not only allows the owner to detail specific business expenditures for tax deductions, but it also gives them the ability to establish and build a credit history for the business.

Conclusion

There are many benefits to starting a business as a sole proprietorship. But a sole proprietorship comes with a degree of risk, namely that the owner’s business and personal finances will be considered one and the same with no legal separation between the owner and the business. The risks can increase as the business grows. So, while a sole proprietorship may be an easy starting point for launching a new business in a cost-effective way, it should be looked at as a way station — one that the owner may depart at some point if they need the legal protection of a more complex business entity such as an LLC or corporation.