What is a Sole Proprietorship?
Janet Schaaf is a freelance writer, editor and proofreader who considers reader advocacy to be her calling. After taking a few roads less traveled, Janet completed a bachelor’s degree in English Literature from the University of Missouri-Kansas City, with English Department Honors. She has been correcting grammar and checking facts since she could string a sentence together. For the past three years, Janet has focused on making personal finance topics understandable and relatable. Loan terms and credit card agreements can look overwhelming, but understanding what you’re agreeing to is paramount in grasping the impact debt can have on your life.
A sole proprietorship is a type of business structure where a single individual, known as the sole proprietor, owns and operates the company. If you’re thinking about taking the plunge and starting your own business, this article covers what it means to establish a sole proprietorship, as well as the pros and cons of structuring your business this way.
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How does a sole proprietorship work?
A sole proprietorship is the simplest form of business structure and is relatively easy to set up. It does not involve registering a legal entity with the state and does not require any special paperwork or filing fees, although you may still need business licenses and permits.With a sole proprietorship, you are personally responsible for all aspects of the business, including debts and liabilities.
This differs from a limited liability company (LLC), another common business entity. LLCs provide limited liability protection, which means that if the business is sued or incurs debt, your personal assets, such as your home, car and personal savings, are protected. Sole proprietorships do not provide this kind of protection, as your personal assets are at risk if the business has unpaid debts or faces a lawsuit.
Sole proprietorship taxes
Sole proprietors are responsible for paying taxes on their business income. In general, sole proprietors must pay both federal and state income taxes as well as self-employment taxes.
- Federal income tax. As a sole proprietor, you must pay federal income taxes on your business income. Instead of filing a separate tax return for the business, you file a Schedule C with your individual tax return. This form reports the business’s revenues and expenses.
- State income tax. Depending on where you live, you may also need to pay state income taxes on your business income.
- Self-employment tax. All sole proprietors with $400 or more of net self-employment income must pay self-employment tax. This is a self-employed person’s version of Social Security and Medicare taxes combined. These taxes are paid at a rate of 15.3% of your net business income.
The U.S. has a “pay-as-you-go” tax system, meaning you must pay taxes throughout the year as you earn income. As a sole proprietor, you don’t have income or payroll taxes withheld from your wages. Instead, you’re required to make estimated quarterly payments.
These payments are generally due:
- Q1: April 15
- Q2: June 15
- Q3: September 15
- Q4: January 15 (of the following year)
If any of these dates falls on a Saturday, Sunday or legal holiday, quarterly taxes are due the next business day.
Making quarterly estimated tax payments allows you to pay taxes on any income you make throughout the year, rather than waiting until the end of the year and potentially incurring penalties for not having paid taxes in a timely manner.
Pros and cons of a sole proprietorship
Choosing the right business structure is an important decision for any entrepreneur, so here are some pros and cons of setting up a sole proprietorship so that you can make an informed decision about what type of business structure best suits your needs.
| Pros | Cons |
|---|---|
Ease of set-up: Unlike other business structures, a sole proprietorship requires no formal paperwork to be legally established. If you start your own business without a partner and don’t select a formal business structure, it’s automatically classified as a sole proprietorship. Control: Sole proprietors have complete authority over all decisions relating to the business, such as hiring and firing employees and setting prices for products or services. No corporate income taxes: The business doesn’t have to file a separate tax return or pay taxes at the business level. Instead, the owner pays taxes on profits on their individual tax return. Easy recordkeeping: Sole proprietorships don’t have the recordkeeping requirements that corporations must abide by, such as maintaining corporate minutes or filing annual reports. | Unlimited personal liability: If the business incurs debt or faces a lawsuit, the owner’s personal assets may be at risk. Limited financing options: Sole proprietorships often have difficulty obtaining financing from traditional banks due to their limited asset base and lack of formal business structure. Hard to sell the business: Because a sole proprietorship isn’t a separate legal entity from its owner, if the owner passes away, becomes incapacitated, or leaves the business for another reason, it ceases to exist. Only the business assets can be sold, rather than the business itself. |
Frequently asked questions
One of the main distinctions between a sole proprietorship and an LLC is liability protection. Unlike sole proprietorships, LLCs offer limited liability protection, meaning the owner’s personal assets are generally not at risk in the event of a lawsuit or debt.
You can start a business as a sole proprietorship and later convert the business to a different kind of entity. The easiest way to convert a sole proprietorship is to form a Limited Liability Company (LLC). This involves filing the necessary paperwork with your local government and obtaining an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). Depending on your state, you may need to register with the Secretary of State and draft an operating agreement.
You may also choose to convert your sole proprietorship into a C Corporation or an S Corporation. This involves filing paperwork with the state and getting an EIN from the IRS. Additionally, you will need to draft a shareholder agreement and appoint a board of directors.
If you’re interested in converting your sole proprietorship to another business structure, it’s a good idea to work with your attorney or tax advisor who is familiar with the laws in your state.
A sole proprietorship is any single individual who operates an unincorporated business alone. For example, if you start a dog-walking business and don’t formally register your business as an LLC or corporation with your state, you’re automatically categorized as a sole proprietorship.
The tax rate that sole proprietors pay depends on their individual tax bracket, which depends on their total taxable income and filing status. There are seven tax brackets, ranging from 10% to 37%. Additionally, sole proprietors are required to pay self-employment taxes at a rate of 15.3%.
In addition to income and self-employment taxes, sole proprietors may be subject to other types of taxes, such as state and local sales taxes, state and local income taxes, payroll taxes (if they hire employees), property taxes and excise taxes. It is important to consult a tax professional when determining the exact amount of taxes due, as additional factors can affect your tax liability.