Sole-Proprietorship is an unincorporated entity that is owned by one individual who is responsible for running it. For example, if you are a sole proprietor or sole trader, you would be running your own business as an individual and self-employed.
Without a formal business structure, a sole proprietorship is the simplest type to establish without a formal business structure. It is often seen among individuals who want to handle the responsibility and expenses of starting up their own company on a limited budget, including the cost of having the legal structure that corporations require. Because of the simplicity and cost, being self-employed via sole proprietorship is one of the most common forms of employment.
Characteristics Of A Sole Proprietorship
- Sole ownership: A single individual owns this type of business. This means that everything put into the business comes directly out of their pocket, and investors or equity holders pay for no expenses at the beginning. The owner himself bears all responsibility for success, including starting up and organizing everything from top to bottom.
- Unlimited liability: The liability of a sole proprietorship is unlimited. On the occasion where any loss befalls a self proprietor, not only do they stand to lose their business’s assets, but they are personally at risk. They will have to sell off their other personal property to recover from the debt.
- Limited work area: sole proprietorship businesses come with many limitations due to the limits of their owner’s capital and can only progress as much as their resources allow.
- Sole right on capital: The arrangement of capital for the sole proprietorship has to be done by the sole individual proprietor themself. Thus, they have full rights to the capital.
- Sole management: A self proprietor is the owner of a company who has unlimited liability. This means that the owner is entirely responsible for the management and control of the business. When expanding and hiring employees, the sole proprietor can incorporate their company. The advantage of incorporating is that it removes all responsibility from themselves and distributes it among its shareholders.
- No legal formalities: To begin your business, some legal formalities like registration with the local authorities, among others, are required. However, individual sole proprietors do not have to register their business or other formalities. They can begin operating immediately.
- Free to select business: A self proprietor has the freedom to select any business they wish and may make any changes if they want to do so.
- Willful commencement and closure: The sole trader is the only person running the business and is free to start or stop trading at any time. Sole traders have no rules to follow to begin or cease trading formally.
How Does A Sole Proprietorship Work?
A sole proprietorship is an entity owned and run by a single person. It does not require any paperwork to start up, and it kicks in when you begin doing business. The name sole proprietorship comes from the fact that the business and the owner are the same. This is why all business losses are considered personal losses because there isn’t a huge separation between the owner and the business.
For instance, if you accept freelance contracts, then this would mean that self proprietor is the designation that applies to you – even if you are earning while working alone, on your schedule, and without any supervision or office space.
If it is a side hustle, you will probably not see the need to apply for business licenses when working as an individual sole proprietor. You may decide to stick with small contracts and file taxes on your own. In essence, a self-proprietor is more of a general description of your business rather than an official title. So legally speaking, it carries no significant implications.
Types Of Sole Proprietorship
While there aren’t any differences between them with regard to legal and tax requirements, there are three types of sole proprietorship. When starting a sole proprietorship, these are your options and their characteristics:
- Self-Employed & Freelancers: These individuals come from diverse backgrounds, and many work independently. Freelancers often help with small business operations and can be found as bloggers, graphic artists, or writers. As they are most likely to be working from home without major investments or capital, many regular 9-5ers supplement their income by working as a freelancer on the side or even pursuing it full-time to sustain themselves.
Between freelancers versus self-employed people, it could be generally said that, for the latter group, their sole proprietorships are their main source of income, and they depend on it as a full-time job. A common example would be small retail businesses that employ family members.
- Independent Contractors & Subcontractors: In this category, you would find several different occupations. As the name suggests, it includes construction-related workers with jobs like plumbing, carpentry, and electricians. They would all be considered self-employed occupations as they are individually hired on their own.
On the other hand, when a general contractor (GC), who oversees operations on a large commercial project, hires an independent contractor, the latter can be considered as subcontractors who are receiving payments from the former and are reported to the IRS.
- Franchises: While the ownership structure and tax reporting may be similar, a franchise has a prescribed way of doing business which is laid out by an organization or franchisor who holds the licensing rights to its name, logo, products, and services. This reflects in the operations and marketing strategies of the franchise as well.
Therefore, while franchisees may have some autonomy in their management style, they can’t control how the brand is presented and promoted because the brand itself sets that. Similarly, they can’t alter essential aspects of their business like quality, appearance, and consistency.
How Do You Start A Sole Proprietorship?
To start a sole proprietorship, you simply head out into the world and begin working for yourself. However, that does not mean there isn’t paperwork involved completely! You will need to get a business license to sell or distribute any taxable products related to your business. If you want to hire employees, you will require an employee identification number (EIN) approved by the IRS.
It is always recommended to have a company name, register your sole proprietorship, and apply for a license or permit in your city or state, as required.
Personal Liability For Business Debts
A sole individual proprietor is the most basic business structure. If you own a sole proprietorship, you are held liable for your business’ obligations personally; if your business defaults on a payment or loses a lawsuit, the creditor has the legal right to come after your assets.
This is evident in the sole proprietorship examples shown below:
Example 1: John owns a small manufacturing company as a self-proprietor. When the business was promising, he ordered $100,000 worth of goods and supplies to create his products. However, there is an unseen drop in the demand for his products, which in turn means that sales will not live up to his expectations. When John’s business that sold the goods demands payment, he can’t fulfill it. In such a case, as a sole individual proprietor, John is held personally liable for his business obligations. The business can sue him, and go after his business assets and personal property. This would also include his properties, vehicles, and personal bank account too.
Example 2: Kate owns a cake shop as a self-proprietor. Matt, one of Kate’s employees, was delivering cakes with a truck registered under the proprietor. This is when he gets into an accident and injures an elderly pedestrian. The injured pedestrian sues Matt for driving recklessly and causing the accident.
The lawsuit names Kate as a co-defendant in the case. After the trial, the jury returns a verdict against Kate as the owner of the business. She is personally liable to the injured individual. This means he can go after all of Kate’s business and personal assets.
On the other hand, owners of Limited Liability Companies (LLCs) and Corporations usually have more limited liability for business obligations than individual sole proprietors or partners as prescribed by the law. Unlike the latter, they may be able to keep their house and other personal property even if their business goes under.
How Do Taxes Work For Sole Proprietorship Businesses?
A self-proprietor is an independent business owner. This means minimal legal separation between their business and themselves.
Any losses or profits made by a sole proprietorship are passed through to the proprietor’s income taxes and are included on the owner’s tax return. The Internal Revenue Service refers to these small businesses as pass-through entities for tax purposes, meaning that the business’s income or losses are added to those of its owner for reported income.
As a sole individual proprietor, one will have to do all the work usually handled by an employer. This means that you’ll be responsible for withholding and paying all your income taxes, which most employees never think about. You will have to pay a Self-Employment Tax, which includes contributions to Medicare and Social Security contributions while paying estimated taxes annually.
How Do I File Taxes As A Sole Proprietor?
Filing taxes as a self-proprietor means that you would be required to fill out the standard tax Form 1040 as well as Schedule C. The latter reports the profits and losses of your business-related income.
The combined final amounts from Form 1040 and Schedule C will determine how much tax you will have to pay in total for the year.
Is Sole Proprietor The Same As Self-Employed?
Yes, a sole individual proprietor is the same as a self-employed person because only they own and operate the business. By being self-employed, they have more freedom when making important business decisions as there isn’t any interference from outside sources such as other stakeholders or partners.
Advantages And Disadvantages Of A Sole Proprietorship
When you are a self-proprietor, there are several advantages as well as disadvantages of a sole proprietorship. Here, we have listed them down:
Advantages Of Sole Proprietorship
- Total Ownership: When you’re the owner of a sole proprietorship, you are solely responsible for all your business’ debts and income. You can make business decisions without any input from shareholders or partners.
- Easy And Cost-Effective Setup: It costs nothing to operate a sole proprietary business. This business formation carries minimal corporate formalities because you do everything yourself and in your name.
Compared to any other business structure, all you need to do to keep sailing on as a sole trader is to file your taxes accurately. Moreover, self-proprietors are free to mix business and personal assets.
- No Strict Regulations: Any business structure other than sole proprietorship will have to follow several regulations. This is especially true in how the business is structured – who gets the power to make decisions and what should be disclosed to which members.
Sole proprietorships are truly free from such requirements.
- Easy Tax Filing: As a sole individual proprietor, you are only required to fill out Form 1040 Schedule C. There aren’t any other complicated tax forms to learn because there are no other business structures to consider!
Additionally, sole proprietors may not pay employment tax for themselves. However, they will have to pay the same for their employees, if they have any.
- Least Recordkeeping: When compared to business structures, sole proprietorships have the least requirement for recordkeeping. Bookkeeping of daily activities is essential as it lets you plan your business’ future and file your taxes accurately and on time.
For example, corporations must keep three different sets of books – one each for internal use, the board, and the IRS.
Disadvantages Of Sole Proprietorship
- Unlimited Liability: If you own a sole proprietorship, your assets and savings accounts are on the line if someone files a lawsuit against your business.
However, if you form an LLC or a corporation, the business’ assets can be frozen while the case works through court, but most of your finances would be safe.
A self-proprietor will be held liable for any debts or losses of the business without limits.
- Uncertain Lifespan: The company is dissolved if a sole proprietorship owner decides to go out of business.
In other cases, there is a possibility that the company could stay open even if it isn’t owned by the previous owners. However, there are ways to pass on ownership of your business to other business structures by including someone as a partner at some point in the future.
Moreover, sole proprietorships typically do not survive the incapacity or death of their owners. Hence, they do not retain any value.
- Difficulty To Raise Loans: Banks are less likely to lend money to sole proprietorships when compared to other types of business structures. Unfortunately, they are viewed as not “professional” or steady. Moreover, since self-proprietors cannot sell shares in their business, like with a corporation, it is even more difficult for investors to trust and rely on them.
- Limited Expertise: Though many business owners have the skills necessary to run their company almost single-handedly, it never hurts to bring on extra help from a corporate board, experts, or co-owners.
When you do, you can take advantage of more experience and expertise when making decisions about your new business venture. However, with a sole proprietorship, this is not possible.
LLC Or Sole Proprietorship: Which One Should I Choose?
It entirely depends on your business’s requirement–to create an LLC or a sole proprietorship.
A sole proprietorship works well for small businesses with low investments and profits. As a sole individual proprietor, in the early years, you must be capable of managing both the liability and control problems that accompany such endeavors. For these reasons, sole proprietorships are ideally suited for individuals.
However, as time progresses, a sole proprietorship may become more fitting for businesses wanting fewer liabilities but more significant control over their affairs. If you were considering starting an LLC (Limited Liability Company), you might want to consider this as some of your reasons may be the opposite of those outlined above.
For instance, if your business is associated with higher risks but also more significant profits, a more extensive customer base, and many opportunities to benefit from certain tax structures.
How Do I Convert My Sole Proprietorship To An LLC?
If you want to change your sole proprietorship to LLC, it would require you to file articles of organization with your state secretary. Additionally, you will be required to re-file your DBA or “Doing Business As” to retain your company name. For the conversion, you will also be required to obtain an EIN or Employee Identification Number from the IRS.
Real-Time Example Of Changing Sole Proprietorship To LLC
Remember John, who couldn’t pay his creditor back? After his close call as a self-proprietor, he wants to change his sole proprietorship to LLC.
As mentioned earlier, an LLC would help grow a business while reducing risks and protecting the owners’ assets. But, how does he go about with the conversion? Read on!
Step 1: Check The Business Name
A unique business name is essential when converting your sole proprietorship to an LLC. John has to check if another LLC uses his existing business name in his state. If that’s the case, he would not be able to operate under the same name, regardless of operating under it as a sole individual proprietor.
John has to contact his state’s secretary of state office to check for the name’s availability. Typically, there would be an online database for registered business names. John can also seek professional legal help in this matter.
Once John has ensured its uniqueness, he must ensure that it does not infringe on any trademark. He must include “Limited Liability Company” or its business name abbreviation. Typically, he would not have to register his LLC name because the name is automatically registered while filing the paperwork to form the LLC (However, rules may differ per region, so double-check with the state).
Step 2: File Articles of Organization
Articles of Organization is a document that outlines the various details. Information such as LLC’s Name, Address, and Name of Owners is included. John must fill out the form and send it to his state’s filing office.
John would be required to pay a submission fee to file the articles of organization, which differs from state to state.
The articles of the organization would require a registered agent to receive the legal papers. If John is the sole owner of the LLC, then he would be the registered agent. If he has a partner(s), he will need to appoint one of the partners as the registered agent.
Step 3: Write An LLC Operating Agreement
An LLC operating agreement is a set of rules that communicate the LLC’s rules and purpose, which are put in place to ensure that the business functions smoothly.
An operating agreement includes information on who will have voting rights and control over the company and how profits and losses will be allocated.
The operating agreement also outlines member responsibilities, ensures that each member knows their rights, and ensures things run smoothly within the company. John is not obligated to submit an operating agreement to a government entity.
However, creating one if multiple members incorporate the LLC is always a good idea to avoid conflict later.
Step 4: Announce The LLC
To form an LLC in certain states, you must formally announce your intention by publishing a public notice in a newspaper. The notice should appear in the classified section of your local paper.
John’s notice may need to be published more than once, and he may have to submit proof of publication as part of the LLC filing process (check with your state’s business department for exact requirements about publishing a notice for your new business venture).
Step 5: Apply For A New Bank Account
When you incorporate an LLC, you establish an entirely new business entity. In many ways, it has the same legal rights as a person, including the right to own property and open bank accounts.
John would have to open a bank account under the name of the LLC to keep his business funds separate from his finances. Not only does it help him protect his assets, but it also helps him keep accurate records and report taxes on time.
Step 6: Obtain Business Licenses And Permits
To legally operate an LLC as a business, you will need to register new types of business licenses and permits. Typically, the most important licenses are the business license, seller’s permit, and zoning permit. John will have to check with his state government or a government agency to determine which licenses or permits that apply to him and his company’s requirements.
He would also be required to apply for a new Employer Identification Number (EIN) with the IRS, even if he has an existing one from his sole proprietorship days. And that’s it! John is all set to run his Limited Liability Company.
Wrapping It Up
Starting a business as a self-proprietor is one of the most significant decisions you can make. Nothing can match it. It’s great to have total freedom in making your own choices and following your dreams as an entrepreneur. But certain challenges might arise along the way, and you must always stay on top of them, so your business doesn’t fail.
Multiplier helps businesses across the globe to expand their horizons internationally without having to set up a local entity. Head to our website to know more!