Understanding sole proprietorship: A simplified guide

This simple guide explains the definition, purpose, and pros and cons of the ‘sole proprietorship’ business model to help you decide whether this may suit your business.

What is a sole proprietorship?

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.

As the business owner, you are entitled to all the profits, but are also legally liable for the business’s financial responsibilities. This affects how you file your taxes, and which IRS forms you need to fill out.

A simple way to understand a sole proprietorship business structure is to compare it to other available businesses.

For example, a limited liability company (LLC) is a separate legal entity owned by one or more people and involves filing specific paperwork within your state. The main difference between a sole proprietorship and an LLC is increased liability and responsibility for the owner, along with legal protection and possible tax advantages.

Understanding a sole proprietorship

Setting up as a sole proprietor is straightforward, however it can vary from state to state. You should be aware of:

• Business registration and naming

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.¹

• Sole proprietorship liability

As a sole proprietor, you’re personally responsible for any of the business’s debts or obligations. You are your business, which means any debts must be repaid by you alone.

• Sole proprietorship taxes

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.

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 sole proprietorship liability. 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.

Advantages and Disadvantages of a Sole Proprietorship

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.

Advantages

• Full control

One of the main advantages of a sole proprietorship 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.

• High profit retention

Sole proprietors keep all their profits. Once overheads, taxes, and any other costs are paid, the money you make is all yours.

• Simplified bookkeeping

The advantages above mean accounting for sole proprietors is generally straightforward. 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 number of staff members.

Disadvantages

• Unlimited liability

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.

• Limited resources

It’s harder for sole proprietors to access credit and benefits 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.

• Separate business and personal finances

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.

Is a sole proprietorship for you?

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, and tax benefits. A sole proprietorship could be the right business structure right now, but you can change this structure 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.