This article is for informational purposes only and is not legal or tax advice. Consider consulting with legal or tax professionals to help you determine what's best for your situation.
A sole proprietorship is an unincorporated business owned and run by one person, making it one of the simplest business structures available. When someone initially sets up a small business, develops a freelance role, or starts a side hustle, they generally choose a sole proprietorship.
Individuals exploring what is a sole proprietor and whether this is the best option should be aware that a business owner who operates without forming a separate legal entity becomes personally responsible for the business’s assets, liabilities, and profits. That means, while they are entitled to all of the generated profits, they are also legally liable for all financial obligations, including any debts incurred, and are personally responsible for repaying them.
Understanding what is considered a sole proprietor is crucial here: the business and the owner are legally one entity. This affects how taxes are filed and which IRS forms must be filled out. Sole proprietors typically report business income and expenses on their personal tax return using a Schedule C form.
One of the main advantages of this business structure is its low startup costs. Sole proprietors often face fewer barriers to entry and lower initial expenses compared to other business types. Whether a drop shipping service, a local bakery, or an online retail shop, startups that are sole proprietorships tend to be more affordable because there’s less red tape and fewer formal requirements.
A key way to understand what is a sole proprietorship is to compare it to other available structures, such as a limited liability company (LLC). An LLC is a separate legal entity that can provide more legal protection to the owners, known as members. While LLCs may offer tax advantages and protect personal assets from business liabilities, they generally involve higher startup costs and additional paperwork.
On the other hand, the simplicity of a sole proprietorship makes it appealing to entrepreneurs looking to keep their startup expenses low and maintain full control over their business. However, this simplicity comes with greater personal risk.
If you’re running a business by yourself and haven’t taken steps to create a formal business entity, you’re likely operating as a sole proprietor. Setting up as a sole proprietor is generally straightforward, but may vary from state to state. Business owners must be aware of the following:
You can operate under your own name, which will be the legal name of your business, but you can also choose a ‘doing business as’ (DBA) name to trade under. This will need to be registered according to the rules in your state. In certain states, if you conduct business under your legal own name, you don’t need to register anywhere.
As a sole proprietor, you are your business, which means any debts or obligations must be repaid by you alone.
Sole proprietors typically report their business income and expenses on their personal tax return, or a W-2 Wage and Tax Statement. There could be extra paperwork to complete with the IRS, depending on your specific circumstances. It’s important to check your local state's website for guidance.
While setting up a sole proprietorship is simpler than forming a corporation, it’s crucial to understand the differences. A corporation is a legal entity separate from its owners, which means it provides limited liability protection. A sole proprietorship ties personal and business assets together.
Many types of businesses, such as freelance graphic design, consulting, landscaping, and small retail shops, are often operated as sole proprietorships. These types of businesses usually involve a single owner and have simpler financial structures.
As simple as setting up a sole proprietorship can be, it’s important to seek advice from qualified professionals and tax advisors to understand legal and financial responsibilities, as well as any liabilities. There could be other paperwork to file or register for, depending on whether you hire employees or require permits or licenses to operate in your industry.
There are some sole proprietorship pros and cons to consider, including responsibilities to fulfil, paperwork to file, and possible legal liabilities. Understanding these will help you determine whether a sole proprietorship or an alternative business structure is most relevant for you.
Want to start a dropshipping business? Thinking of offering writing, personal training or photography services, or opening an online store? Many small-scale retail operations and service-oriented businesses are commonly run as sole proprietorships. Each of these businesses benefits from the simplicity and flexibility that comes with sole proprietorship, but they also expose the owner to personal liability for any business debts or legal issues.
If you’re wondering what is an advantage of being a sole proprietor, there are actually several worth considering, including more autonomy, higher profit and simplified paperwork.
Perhaps the most significant advantage is that you’re the boss. You have sole control of the business’s operations and structure because there are no partners or shareholders. This business structure can be valuable if you’re just getting started or if you have been trading as a solo entrepreneur for years.
Sole proprietors keep all their profits. Once overheads, taxes, and any other costs are paid, the money you make is all yours.
When deliberating the question, “what is an advantage to being a sole proprietor and is it the right choice for me,” don’t forget that accounting for sole proprietors is a generally straightforward process. Sole proprietors may only need to record cash flow coming in and out of their solo business, but this can become more complex depending on income and the number of staff members.
So what is a disadvantage of being a sole proprietor? There are several to consider when weighing your decision.
One of the main risks of a sole proprietorship is liability for debts. If you can’t repay creditors, your own assets and home could be at risk. You also represent your business legally, which means you’re personally responsible if the business is sued.
When business owners discuss what is a drawback of being a sole proprietor, one common pain point is how much harder it is for them to access credit and benefits. This is because banks and financial organizations prefer to work with established entities that are legally separate from their owners. Government grants and benefits are more likely to be allocated to LLCs, so your sole proprietorship could miss out.
As a sole proprietor, it’s your job to keep your personal and business finances separate. This prevents accounting confusion and helps you to keep a close eye on your business’s cash flow.
There’s often confusion around the difference between legal business designations, such as LLCs or sole proprietorships, and tax designations, like S-corporations. These terms all represent different ways to structure and operate your business.
A sole proprietorship is the simplest structure, where you report taxes on a Schedule C. An LLC is a legal designation to protect your personal assets but doesn’t change how you’re taxed unless you elect otherwise. Finally, an S-corp is a tax designation that can apply to various business structures, including LLCs, but it’s not a business type itself. Understanding the distinctions between these designations is key to managing both your legal liabilities and tax obligations effectively.
A sole proprietor typically reports their business income and expenses using a Schedule C form, which is filed along with the federal 1040 individual tax return. This means that all of your business’s profits (or losses) are reported on your personal tax return, and the income is subject to self-employment taxes.1
As a sole proprietor, you might choose to operate under a different name, known as a “doing business as” or DBA name. For example, if your name is Jane Smith but you run a graphic design business under the name “Creative Solutions,” you would file a DBA to use that name. The DBA is just the name under which you conduct business—it doesn’t change the legal structure of your business.2
An LLC, or Limited Liability Company, is a legal business designation that you can file for with your state to create a formal business entity. One of the key benefits of forming an LLC is that it provides personal liability protection. This means that your personal assets—such as your house, car, or savings—are generally protected if your business faces a lawsuit or accumulates debt.
It’s important to understand that an LLC is a legal designation, not a tax one. When you form an LLC, you’re creating a separate legal entity for your business, but the way you file taxes may not change unless you make an election to do so. A single-member LLC (which is just an LLC with one owner) can still file taxes the same way as a sole proprietorship, using a Schedule C with the 1040.3 So, forming an LLC doesn’t automatically change your tax obligations, though it does provide legal protection.
An S-corp, or S-corporation, is not a type of business structure but rather a tax designation that you can elect for your business. You can choose to have your LLC (or even a corporation) taxed as an S-corp by filing a specific form with the IRS—Form 2553. This election can potentially reduce your self-employment taxes because, as an S-corp, part of your income can be treated as a distribution rather than wages, which aren’t subject to self-employment taxes.4
It’s crucial to understand that electing S-corp status doesn’t mean you’re incorporated, nor does it change the type of business you’re running. For example, you could still be a single-member LLC legally, but you’ve just chosen to be taxed as an S-corp for federal tax purposes. This is a decision you’d typically want to make with the help of a financial or tax advisor to ensure it makes sense for your situation.
Many entrepreneurs begin their journey as sole proprietors because it’s the simplest way to start a business. Over time, as their businesses grow, they often form LLCs to protect their personal assets. Once they reach a certain level of profitability, they may consult with a tax advisor and decide to make the S-corp election to potentially reduce self-employment taxes.
Still trying to answer the question, “Should I be a sole proprietor?” It’s important to carefully assess your needs and goals before choosing a business structure.
For some entrepreneurs and freelancers, a sole proprietorship offers a simple and effective way to manage business finances and limit responsibilities. For others, a more complex business structure can offer greater peace of mind, organization, tax benefits, and also make getting funding easier. A sole proprietorship could be the right business structure right now, but you can change it as your needs evolve. For more business resources, learn how to track business expenses to gain a better understanding of how much money you’re spending to keep your operations running.
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