Guide to Understanding a Sole Proprietorship
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When establishing a new business, you’re most likely to start a sole proprietorship. If you’ve already begun making sales, then you’ve probably been a sole proprietor all along.
Anyone who sells products or services is automatically considered a sole proprietor. A sole proprietorship is the simplest and most common structure or entity for new businesses — in fact, unlike other business entities, such as a limited liability company (LLC) or corporation, it costs nothing to form one.
Your business entity determines your personal liability, how much you pay in taxes and required paperwork that you have to file. The structure you choose would also depend on the ownership of the business.
Each has its own pros and cons, including sole proprietorships. While they are easy to set up and come with lower tax rates than other entities, the biggest disadvantage is that owners may be personally liable for the debts and obligations of the business.We’ll explain the ins and outs of sole proprietorships and alternative entities for business owners to consider.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business with one individual owner. Running a sole proprietorship means that you, as the owner, are responsible for all the business’s debts, losses and liabilities. You’re also entitled to all profits.
As an alternative to setting up a sole proprietorship, you could operate as an LLC or a corporation as an individual business owner, which would limit your personal liability. However, you may have to pay additional taxes.
Although it’s easy to start a sole proprietorship, there’s much to understand about the business structure. Continue reading to find out what you need to know about running a business as a sole proprietor.
Advantages of being a sole proprietor
Although it’s a good idea to form what’s known as a fictitious name or DBA, you don’t need to take any formal action to become a sole proprietor. This title would automatically come from your business activity. In addition to being easy to form, there are some other advantages of sole proprietorship:
- You have complete control. As the sole owner of the business, you would be able to make all decisions. You wouldn’t have to compromise with a business partner or answer to stakeholders.
- Simple tax preparation. Sole proprietorships are not taxed separately. Business income is treated as your personal income. Sole proprietorships have the lowest tax rates of all business entities. Sole proprietorships — along with other “pass-through” entities — benefited from the Tax Cuts and Jobs Act. Read more about small business tax planning for 2019 here.
- Inexpensive to form. Because you don’t have to file any paperwork to form a sole proprietorship, legal expenses are limited to the licenses or permits you need to run your business.
A sole proprietorship may be the best business entity for low-risk businesses, such as consulting, tutoring or other service-based businesses, as well as entrepreneurs who want to test an idea before sinking the cash into forming an LLC or corporation.
Disadvantages of being a sole proprietor
Despite the simplicity and ease of running a sole proprietorship, there are downsides of this business structure.
- Personal liability. Sole proprietorships do not provide any liability protections versus a legal entity that’s separate from its owners, including corporations. Sole proprietors are personally responsible to cover all business debts, obligations and any liabilities that result from employee actions.
- Difficulty raising money. Raising capital can be challenging for sole proprietors, as you’re unable to sell stock. Traditional lenders usually see sole proprietorships as riskier than other types of businesses and are hesitant to issue loans.
- High-pressure environment. Being ultimately responsible for the success or failure of your business can feel like a heavy burden. You may feel unwanted pressure from having complete control of your operation.
Compare sole proprietorships with other types of businesses owned by an individual.
|Sole Proprietorship||1 person||Unlimited personal liability||Personal tax only|
|Limited Liability Company (LLC)||1 or more people||Owners are not personally liable||Self-employment tax; personal tax or corporate tax|
|C Corporation||1 or more people||Owners are not personally liable||Corporate tax rate, now capped at 21%|
|S Corporation||1 or more people, but no more than 100||Owners are not personally liable||Personal tax|
|B Corporation||1 or more people||Owners are not personally liable||Corporate tax rate, now capped at 21%|
|Nonprofit Corporation||1 or more people||Owners are not personally liable||Tax-exempt but corporate profits can’t be distributed|
How to start a sole proprietorship
If you don’t register as any other entity, you are automatically a sole proprietorship when you begin selling goods and services. But there are a few steps all new business owners should take, even if you’re running the operation on your own.
Register your business name.
If you’re doing business under a name other than your own, you’ll need to file a DBA, or “doing business as” name. This would allow you to operate under a name separate from your own without having to create a new business entity.
A DBA doesn’t provide any legal protections, so you may want to register your entity name at the state level. Some states may require you to register your DBA, even as a sole proprietor. This would prevent anyone else in the state from using the same business name as you.
A trademark can protect you at the national level. Trademarking your business name would stop someone else in the same industry from using the same name. You should also check the U.S. Patent and Trademark Office’s national database to make sure you don’t choose a business name that’s already been trademarked.
Obtain necessary permits.
States tend to regulate business activity and require permits and licenses for certain industries, including construction, restaurants and retail. You should also check your county and city regulations to find out which permits you need in order to remain compliant.
Some industries have additional regulatory requirements from federal agencies. For example, if you manufacture or sell alcohol, you would need to report to the U.S. Alcohol and Tobacco Tax and Trade Bureau as well as your local Alcohol Beverage Control Board.
Set up a business bank account.
Once you start accepting or spending money as a business owner, you should open a business bank account to keep your professional finances separate from your personal funds. You could open a business checking or savings account — or both — and add a credit card account as well.
A business bank account would communicate professionalism to your customers, as they would be able to make payments to your business instead of directly to you. You would also be able to build credit history for your business, which would allow you to make larger purchases.
To open a business bank account, you may need to obtain an Employment Identification Number from the IRS. An EIN is a nine-digit tax ID for business owners. Sole proprietors are not required to have an EIN unless they pay employees, but you may need one to open your business bank account.
Purchase business insurance.
As a sole proprietor, you wouldn’t have the same personal liability protections as an LLC or corporation. Business insurance can protect both your personal and business assets.
You may want to purchase general liability insurance to protect against financial loss from bodily injury, property damage and lawsuits, among other things. Product liability insurance would protect you against financial loss as a result of a defective product.
You could also purchase professional liability insurance if you’re a service-based business, commercial property insurance or home-based business insurance if you operate out of your home. Many commercial landlords may also require you to have property insurance.
If you have employees, the federal government mandates that you have workers’ compensation, unemployment and disability insurance.
Financing for sole proprietors
Capital can be a major obstacle for sole proprietors, especially those who are just starting out. You don’t have the option to sell stock to investors like you would as a corporation. You may not be able to turn to banks either because of a perceived risk that you may not be able to repay debt if the business fails.
But that doesn’t mean you’re out of luck. Here are some potential financing options for sole proprietors.
Personal loans for business
Personal loans are typically granted based on your personal credit score, while approval for business loans would be based on your business history. A personal loan may be easier for a sole proprietor to attain, especially if they have good credit. Personal loans for business usually don’t require collateral, which means you wouldn’t have to offer up business assets to secure funding. However, personal loan amounts tend to be smaller than business loan amounts, but it may be enough if your funding needs are not large.
Unsecured business loans
Lenders often require business owners put up collateral to secure a loan, such as real estate or a vehicle. Unsecured business loans do not require collateral and are easier to get if your business is in good financial standing. But unsecured business loans often have higher interest rates and stricter terms, and you may face a penalty for early repayment. Also, your personal assets would be at risk if you default on the loan. However, an unsecured business loan may be a possible financing option for sole proprietors who have good credit, a track record of managing debt responsibly and don’t have collateral to back a traditional small business loan.
Accounts receivable financing
Accounts receivable financing, also called invoice factoring, is the exchange of accounts receivable for capital. A factoring company purchases your business’s accounts receivable, which are your outstanding invoices, in exchange for cash. The company would collect a portion of each invoice as payment, including a factoring fee, to repay the debt. Invoice factoring can be a desirable financing option for businesses that don’t qualify for traditional loans, or businesses facing an immediate cash crunch. However, the factoring company could charge high fees and you would still be subject to a credit check.
The bottom line
Establishing a sole proprietorship is the simplest way to start a business. If you’re already selling goods or services, then you’re automatically considered a sole proprietor.
As the owner of sole proprietorship, you are responsible for all business decisions without external input from business partners or investors. As a sole proprietor, you’re also solely responsible for business debts. If the business fails, you are responsible to pay off any loans.
Because of the business structure, you may have trouble securing traditional loans as a sole proprietor. Banks may see your business as risky. However, there are several options you could turn to for financing, including unsecured business loans or personal loans.
If the challenges of running a sole proprietorship are too much to handle, or you have bigger plans for your business, you can change your structure at a later time. You could start as a sole proprietor then become a partnership or corporation, depending on how you want to grow your business.