A sole proprietorship is the simplest form of business structure. You run the business as the sole owner and operator and you’re not required to formally incorporate with a state filing. As soon as you start doing business, you’re regarded as a sole proprietorship in the eyes of the IRS. Because there are no partners or shareholders involved, you have full control over all operational, financial, and strategic decisions of the business.
In a sole proprietorship, you and your business are viewed as a single entity. This makes taxes simple since you personally get to keep 100% of the profits and file all your business taxes through your personal tax return. However, this also means that you’re personally liable for business losses, debts, and liabilities.
There are many advantages to operating your business as a sole proprietorship, but there are also several major disadvantages and risks to be aware of. In this article, we’ll go through the main characteristics, and the biggest advantages and disadvantages to running your business as a sole proprietor.
Main characteristics of a sole proprietorship
Before we dive into the pros and cons, let’s look at the main characteristics of a sole proprietorship.
- Ownership: The business is owned and operated by a single individual. There are no partners or shareholders involved.
- Legal status: A sole proprietorship is not considered a separate legal entity. Legally, the owner and the business are seen as one and the same. This means the owner is personally liable for all debts, obligations, and legal liabilities of the business.
- Decision making: The sole proprietor has full decision-making authority and control over the business. They can make all operational, financial, and strategic decisions independently.
- Profit retention: As the sole proprietor, you are entitled to all the profits generated by the business. There is no need to share profits with partners or shareholders.
- Taxes: In a sole proprietorship, business income and expenses are reported on the owner’s personal tax return. The owner pays taxes on the business’s profits at their individual tax rate, even if the business’ profits remain in the business.
- Liability: One significant drawback of a sole proprietorship is unlimited liability. The owner’s personal assets are not protected, and they are personally responsible for the business’s debts and legal obligations. This means that if the business faces financial or legal trouble, the owner’s personal assets can be at risk.
- Limited growth and funding: Sole proprietorships may face challenges when it comes to raising capital or expanding the business. Without the ability to sell shares or bring in partners, the options for accessing significant funding can be limited.
Pros and cons overview
|Easy and inexpensive set up since you don’t need to formally incorporate your business.||You and your business are viewed as a single entity, meaning you’re personally liable for all business debts, obligations, and legal issues.|
|EIN and business banking account optional. You can run your business through your personal bank account and your Social Security number.||Sole proprietorships cannot bring on investors or partners, and getting financing from banks may be more difficult.|
|Simpler to file taxes since everything is done through your personal tax return. No annual tax filing requirements other than your personal tax return.||Running all aspects of the business on your own can be burdensome.|
|More privacy since you’re not required to disclose your business’ financial information publicly.||There is no formal succession plan, making it difficult to transfer ownership or maintain continuity.|
|You have full control over all financial, operational, and strategic decisions of the business without having to consult with partners or shareholders.||Because everything is tied directly to the owner, a sole proprietorship is more difficult to sell than other business structures.|
|As the sole owner, you’re entitled to all profits generated from the business.||Some businesses and customers may perceive sole proprietorships as less credible or stable compared to other business structures|
|Business losses can be deducted from your personal tax return.|
Pros of operating as a sole proprietorship
The advantages of running a sole proprietorship is simplicity and ease of set up. There’s no formal registration process to get started, taxes are straightforward, and you have full control over all financial and operational decisions.
Easy and inexpensive setup
Establishing a sole proprietorship is low-cost and typically requires fewer legal formalities and paperwork compared to other business structures. When you’re establishing a corporation, you have to file articles of incorporation. When you’re establish an LLC, you have to file articles of organization. You’ll have to pay filing fees and some states will require you pay an annual fee as well. With a sole proprietorship, there are no fees or filing required since you’re not creating a separate legal entity. You and the business are one entity, and you’re automatically viewed as a sole proprietorship if you have any business activity. However, you may still have to obtain business licenses or permits depending on your industry or local government.
EIN and business bank account optional
With other business structures, you’re required to have an EIN to operate your business. With a sole proprietorship, it’s optional. While there are many advantages of having an EIN, you have the option to operate your business using just your Social Security number.
You also don’t need to open a separate business checking account and can choose to conduct all your business through your personal banking account.
Because sole proprietorships are pass-through business entities, the profits and losses of the business are reported on your personal tax return. You don’t have to worry about paying taxes separately for your business and can typically do everything through your annual 1040 return. In fact, all profits generated from your business are considered your personal income whether or not you take money out of the business.
Sole proprietorships pay tax at two different levels.
- Ordinary income tax: Sole proprietors don’t take a salary. All business profits and losses are reported through your personal tax return and taxed at your ordinary income tax rate. You must list your business’ profits and/or losses on a Schedule C, Profit or Loss from a Business. This form is submitted along with your Form 1040, which is your individual tax return. Your tax rate is determined by your tax bracket, which is determined by combining the incomes from your Form 1040 and Schedule C.
- Self-employment tax: Self-employment taxes consist of both employer and employee portions of Social Security and Medicare taxes. In 2023, 12.4% of your self-employment taxes goes towards Social Security taxes, on up to the first $132,900 of your income, and 2.9% of your self-employment taxes goes towards Medicare tax. These amounts are reported on Schedule SE each year when you file your federal tax returns.
No annual reporting or filing requirements
With LLCs, S-corporations, and C-corporations, you’re required to file annual reports. With a sole proprietorship, there are no other annual reporting or tax filing requirements besides the owner filing their personal tax returns.
Because there are no strict filing requirements, sole proprietorships offer a level of privacy. Since you’re not required to disclose financial information publicly, your business operations and finances can remain more confidential.
Direct control and high flexibility
As the sole owner, you have complete control and decision-making authority over your business. You can quickly implement changes, adapt to market conditions, and make decisions without consulting others. You can also choose your own working hours, business strategies, and focus areas without the need for extensive consultations or approvals.
Retention of profits
In a sole proprietorship, you are entitled to all the profits generated by the business. There is no need to share profits with partners or shareholders.
Business losses can be deducted from personal income
In the same way that the business’ profits flow through to your personal income, losses can also be deducted from your personal taxable income that you earn from other sources like a full-time day job.
Cons of operating as a sole proprietorship
Because a sole proprietorship is such a simple business structure, there can be limitations when it comes to getting access to credit or investments. But perhaps the biggest con of this business structure is that you’re personally at risk for all business liabilities.
The biggest drawback of a sole proprietorship is that there is no legal separation between the business and the owner. You, as the sole proprietor, are personally liable for all debts, obligations, and legal issues of the business. This means your personal assets can be at risk if the business faces financial or legal trouble.
For example, if your business does something to harm someone, that person who is suing the business can come after you for your personal assets. With a structure like an LLC, they can only go after the LLC’s assets.
Limited access to capital
Sole proprietors often face challenges when it comes to raising capital for business expansion or investment. Without the ability to sell shares or bring in partners, the options for accessing significant funding can be limited.
In the same way, sole proprietorships can find it harder to obtain a loan since most banks prefer to work with established companies with a long history of credit. The business’ ability to get loans and financing will depend on the owner’s finances and credit history.
You bear the burden of running the business single-handedly. This can be overwhelming, as you are responsible for all aspects, including operations, finances, marketing, and legal compliance. It may be challenging to handle all these responsibilities alone.
Lack of continuity
Sole proprietorships are tied directly to the owner. If the owner decides to retire, becomes incapacitated, or passes away, the business may cease to exist. There is no formal succession plan, making it difficult to transfer ownership or maintain continuity.
Difficult to sell your business
Because everything is tied directly to the owner, a sole proprietorship is more difficult to sell than other business structures. Instead of selling your business as a whole, you have to sell the assets of the business, which may turn off buyers.
Limited professional credibility
Some businesses and customers may perceive sole proprietorships as less credible or stable compared to other business structures, such as corporations or LLCs. This perception can affect potential partnerships, clients, or investors who prefer working with more established entities.