Takeaways
- A sole proprietorship is an unincorporated business run by a single individual.
- Sole proprietors pay personal income tax on profits earned from the business.
- Sole proprietorships are easy to set up and have reduced compliance costs.
- Sole proprietors can face challenges in raising seed or venture-backed capital.
- Sole proprietorships that flourish often pivot to being LLC or C Corporations.
The entrepreneurial spirit thrives in the United States, and millions of businesses launch each year. A recent report showed that there are over 28 million sole proprietorships operating in the United States. [1] While many dream of starting their own business, few take the necessary steps. Starting your own sole proprietorship could be the kickstart you need.
One of the first tasks a business founder must undertake is navigating the complexities of creating a business structure. A sole proprietorship is a business model widely adopted by small businesses, freelancers, contractors, consultants, and gig workers because it is easy to establish and maintain.
What Is a Sole Proprietorship?
A sole proprietorship is the simplest form of business ownership, consisting of a single individual who controls and operates the entire business.[2] In a sole proprietorship, there is no legal distinction between the business entity and the owner. This lack of distinction means the business's profits belong to the owner. Still, it also means they hold complete personal liability for any debts or losses incurred by the company.
Here's an example. Imagine you are a talented culinary chef who decides to sell your delicious creations from home. You decide to test the market for your goods before opening your brick-and-mortar shop. Instead of absorbing the time and expense of establishing a Limited Liability Company or a C Corporation, you just started selling goods as the sole proprietor.
In this scenario, you keep all the profits from your sales, but you are also personally responsible for any expenses associated with the baking operation, such as ingredients, packaging, and marketing materials.
Weighing the pros and cons of a sole proprietorship should be done in the context of your overarching business goals, risk tolerance, and financing needs.
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Advantages of a Sole Proprietorship
When starting a business, you can choose from various business structures, ranging from a non-profit organization to a C Corporation.[2] The simplicity of a sole proprietorship makes it a popular choice for aspiring business owners. Here are some key advantages to consider:
- Ease of Formation: Setting up a sole proprietorship is incredibly straightforward. Unlike more complex business structures like corporations or limited liability companies (LLCs), minimal paperwork is involved. Often, simply starting business operations is sufficient. However, some states require registering a business name, also known as a "Doing Business As" (DBA) name, if your business name differs from your legal name.
- Complete Control: The sole proprietor reigns supreme regarding ease of decision-making. You have full control over all aspects of your business, from product development and pricing strategies to marketing campaigns and operational processes. This autonomy allows quick adaptation, flexibility, and new strategies in a dynamic marketplace.
- Reduced Compliance Costs: Compared to more intricate business structures, sole proprietorships involve significantly less administrative burden. Tax filing is usually less complex, and there are fewer regulatory requirements to comply with. This translates to lower operating costs and more time dedicated to core business activities.
- Potential Tax Benefits: Sole proprietors report business income and expenses on their tax return. This can be advantageous, as they may qualify for certain tax deductions and credits unavailable to other business structures. For example, owners of a C Corporation cannot write off business losses on their tax returns.
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Disadvantages of a Sole Proprietorship
While there are undeniable advantages, sole proprietorships also come with limitations. Capital-intensive businesses that need cash to grow may have better options than a sole proprietorship in the long run. Here are several cons to consider:
- Unlimited Personal Liability: This is undoubtedly the most significant drawback. Since the business and the owner are not legally separate entities, the owner's personal assets (like a car or house) can be seized to cover any business debts incurred. This exposes the owner to significant financial risk if someone sues the business or the business cannot pay its debts.
- Limited Access to Capital: Raising funds for growth or expansion can be challenging for sole proprietors. Unlike corporations that can have an initial public offering and issue shares or sell bonds in the debt markets, sole proprietors have more limited financing options. Sole proprietors may have to rely on personal savings, business loans, or convince other lenders based on their creditworthiness. (Read more about your credit score and how to get your free credit report.)
- Difficulty Attracting Employees: Sole proprietorships often have few employees and don’t attract or retain highly skilled employees. The absence of employee benefits such as health insurance or retirement plans, like a 401(k), 457(b), or 403(b) plan, makes it difficult to retain top talent. This human capital issue can limit the growth of your business.
- Lack of Continuity: A sole proprietorship is inherently tied to the owner. If the owner becomes incapacitated or doesn't want to run the business personally, the entity ceases to exist. This is juxtaposed to a C Corp that can continue its ownership to stockholders and have the business run by professional management. When one CEO leaves, the other steps in to run the business. The lack of continuity in a sole proprietorship poses challenges for securing long-term partnerships or business loans.
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5 Steps to Start a Sole Proprietorship
Starting a sole proprietorship is relatively simple. A sole proprietorship could be the perfect solution for you and your business. Here is an essential roadmap to get your sole proprietorship up and running in five short steps:
1. Choose a Business Name
If you plan to operate under a name different from yours, research and choose a unique and available business name. You may need to register it as a DBA with your local government office.
2. Obtain Business Licenses and Permits
Research any licenses or permits required to operate your business in your specific location and industry. These may vary depending on your business activity and local regulations.
3. Open a Business Bank Account
Opening a separate business bank account helps distinguish business finances from personal finances, promoting clarity and simplifying tax filing.
4. Understand Your Tax Obligations
Sole proprietors use Schedule C to report business income and expenses on their tax return. Familiarizing yourself with relevant tax laws and consulting a tax professional if needed is crucial.
5. Run Your Business
The last step is to manage your business effectively. A convenient feature of the sole proprietorship is that it can easily be converted into an LLC or C Corp. This helps founders who want to prove a minimum viable business idea and pivot into a venture-backed start-up.
Smart Summary
Starting a business can be an incredibly powerful income generator and accelerate your net worth. A sole proprietorship can be a natural starting point for many aspiring entrepreneurs. Its simplicity, ease of setup, and complete control over decision-making are desirable features. However, it is equally important to acknowledge the structure’s limitations and be comfortable with the exposure to personal liability. Consult your financial plan to see where you can tap into pools of capital to invest in your company.
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(1) Big Ideas for Small Business. Sole proprietorship statistics: A mixed bag. Last Accessed January 14, 2025.
(2) Internal Revenue Services. Sole proprietorship. Last Accessed January 14, 2025.
