Sole Proprietorship: Definition, Pros & Cons (w/ Examples)

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Starting a small business doesn't have to be difficult or expensive. Whether you're a web designer, copywriter or marketing consultant, you can set up a sole proprietorship. This business structure is easy to set up and operate and requires no formal action other than obtaining the necessary licenses and permits. However, it does have its limitations and may or may not be the best choice for you.

What Is a Sole Proprietorship?

Sole proprietorships are the most common business structures in the U.S. Their number reached 23 million in 2014, according to the Tax Foundation. This form of business organization is a preferred choice for consultants, freelancers, self-employment and individual business owners in general. In fact, you may already be operating as a sole proprietorship without even realizing it.

With this business type, there is no distinction between the business and its sole owner from a legal standpoint. Limited liability companies, on the other hand, are business entities separate from their owners. As a sole proprietor, you have personal liability for all business debts and losses and can keep all profits.

If you sell products or services and pay tax on your income, you are a sole proprietor. This status comes automatically from your business activities, as no registration is required. In this case, though, you may need to apply for certain business licenses and permits depending on your industry. Any money you earn from your business is yours to keep and will be treated as personal income.

Setting Up a Sole Proprietorship

This business structure requires no registration with the state. From a legal perspective, it's an unincorporated business with one owner who pays self-employed income tax. However, you can still hire staff and operate under a different name than your own if desired.

An independent contractor may choose to operate as a sole proprietor so he can get paid by companies that need his services, but he may also operate as a small business. For example, if you're a web designer, you can market yourself as a local business, hire employees and rent an office, but you may also be an independent contractor and offer freelance services. It's this flexibility that makes sole proprietorships so appealing to entrepreneurs.

If you're just getting started, you may open a business bank account under your own name or your business name, and use your Social Security number to become a sole proprietor. Optionally, you may register for a "Doing Business As" name. This isn't a legal requirement, but it can make it easier to obtain business licenses and permits. Plus, you can trademark your name for branding purposes.

Speaking of licenses and permits, research the regulations in your state to make sure you're legally compliant. For example, if your business owns and uses a truck to transport goods, you may need a license from the U.S. Department of Transportation. A chiropractic business, on the other hand, may need signage permits and zoning permits among other documents. Also, you may need to obtain an employer identification number from the IRS if you hire employees, take in partners or file any excise or pension plan tax returns.

Advantages of Sole Proprietorships

Sole proprietorships have several advantages over LLCs and corporations. First of all, this business structure is easy to set up and has minimal reporting requirements. As a sole proprietor, you have full control over your business and don't need to seek the approval of shareholders, directors, officers and other parties. Second, it's not necessary to pay any fees for setting up your business.

Another advantage is that you may report your earnings and losses on your personal income tax form. This type of business entity doesn't require separate tax filings like corporations. You may not even need to hire an accountant. Most freelancers and small-business owners who operate as sole proprietorships do their taxes on their own.

Furthermore, everything you earn goes straight to your pocket. If you opt for this business structure, you don't have to justify your expenses. However, it's recommended to separate your business bank account from your personal one so you know which expenses are business related and can be deducted on your tax returns. Having a business bank account also makes it easier to file your tax return, keep accurate records and do your accounting.

A sole proprietorship also requires less paperwork than other business entities. Corporations, for instance, deal with extensive documentation such as annual reports, corporate bylaws, meeting minutes, shareholder agreements and more. Tax filings are simpler too for sole proprietorships since they're not taxed as separate entities. All you need to do is to file Form 1040 (Schedule C) to report your earnings and losses.

Are There Any Drawbacks?

As you would expect, this business structure isn't perfect. Since there is no distinction between personal and business liability, you may end up losing your home and other personal assets if something goes wrong. Creditors, for example, may go after your car if you cannot pay off business debt. The same can happen if one of your clients sues you for some reason.

One of the biggest disadvantages of operating as a sole proprietorship is raising capital. This kind of business cannot secure funding by selling stock. Additionally, it may have a difficult time attracting investors or getting a loan. Many times, sole proprietors have to use their savings or borrow money from family and friends to grow the business.

A sole proprietorship gives you complete control over the company. While this sounds great in theory, it can turn into a disaster. As your business grows, you may find yourself stuck between possibilities and struggling with decisions. All responsibilities will fall on your shoulders, so you may end up having little or no time for yourself.

Another drawback is that this kind of business dies with its owner. Additionally, you cannot sell a sole proprietorship or pass it on to your family. Corporations, on the other hand, have perpetual existence. Similarly, an LLC won't cease to exist if its owner dies, retires or leaves the organization.

Make an Informed Decision

All in all, a sole proprietorship isn't for everyone. Consider your short- and long-term goals, the nature of your business and your industry before making a decision. Generally, this option works best for low-risk businesses, such as marketing consulting, tutoring or photography services.

Think about your long-term business objectives. If you're planning to expand your services at some point, you may either start an LLC or operate as a sole proprietor and register an LLC later. Sole proprietorships may also be a good choice for self-financed businesses. However, if you want to grow your business and reach out to investors later, consider setting up an LLC.

Many successful entrepreneurs started as sole proprietors, and you can do it too. Annie's Homegrown, for example, operated as a sole proprietorship during its first years in business. Today, it's one of the most popular suppliers of organic foods. Ebay, the largest online marketplace, was started as an experiment by Pierre Omidyar – he launched Auction Web as a sole proprietorship back in 1995 and incorporated his business soon after.

Whether you're a copywriter, an accountant or a fitness instructor, there is nothing wrong with starting small. Setting up a sole proprietorship will allow you to experiment and get to know your target market. If everything goes as planned, you can always upgrade to an LLC and expand your business.