What Is A Sole Proprietorship?
A sole proprietorship is a business structure in which, from a legal point of view, the business and its owner are one and the same. By definition, a sole proprietorship can have only one owner, who has complete control over the business. This form of business ownership is by far the most common structure for businesses in the United States, accounting for about 72% of all businesses. Sole proprietorships are the easiest form of business to start, requiring almost no paperwork to establish. If you have ever rendered a service for someone and gotten paid for doing so, you were operating as a sole proprietor.
Is A Sole Proprietorship Right For Your New Business?
- Easiest business structure to start, organize, operate, and dissolve
- Highest level of freedom and control
- High level of privacy for owner
- Business owner receives 100% of profits
- Beneficial pass-through taxation of profits
- Start-up capital is usually limited
- Difficulty in attaining sufficient credit for expansion
- Owner may lack management and human resources skills
- Unlimited personal liability for damages caused by the business
- Unlimited liability of business assets for damages caused by the owner outside of the business
- Business owner bears 100% of losses
- Difficult in selling the business, as the business and its owner are one and the same
- Automatic dissolution at owner's death
Of all the drawbacks of operating a sole proprietorship, unlimited personal liability is the most severe. If a lawsuit is filed against a sole proprietor for the actions of his or her business, all of the business owner's personal assets can be awarded to the plaintiff in the suit. Conversely, any assets of the business can be taken in a lawsuit filed against the business owner for his or her actions outside of the business. An automobile accident caused by the owner, for example, could result in the loss of all of the owner's personal and business assets, regardless of whether the accident occurs during course of business or personal activity.
Because sole proprietors face so much liability, anyone operating a sole proprietorship should seriously consider carrying a sizable liability insurance policy before doing business. In today's incredibly litigious environment, an umbrella policy worth several million dollars would not be excessive. Running a proprietorship without liability coverage is known figuratively in the business world as running naked, and it is every bit as ill-advised as is its literal counterpart.
Because the sole proprietor is directly responsible for all of the legal and civil woes of the business, anyone undertaking this kind of business venture should make sure to always have access to competent legal counsel. While this is true of any business, it is especially true in sole proprietorships and partnerships, where there is no liability barrier between the owner and the business.
How To Form A Sole Proprietorship
Forming a sole proprietorship is as simple as performing the first business transaction. As soon as someone starts doing business under their own name, he or she considered to be a sole proprietor. There are, however, several steps that can be taken and the outset that will help a sole proprietorship to operate more smoothly.
First and foremost, anyone operating a sole proprietorship should open a separate bank account to be used only for business-related transactions. A sole proprietor should never use a personal account for transactions directly related to the business; this could potentially cause the IRS to disallow the deduction of legitimate business expenses when the sole proprietor files his or her taxes. Always ensure that business transactions occur in a separate account from personal transactions to safeguard against this situation.
When setting up a business bank account, the sole proprietor is well-advised to open the account using an EIN rather than his or her Social Security number. An EIN, or Employer Identification Number, is a number provided without any cost by the IRS as a tax identifier for businesses. A sole proprietor can obtain an EIN in just a few minutes by visiting IRS.gov and filling out a short online form. In addition to being used for opening business accounts, this number is shown on W-2 forms given to employees of the sole proprietorship.
A sole proprietor must normally do business under his or her own name. Most states will allow the business owner to append an accurate description of the service being provided to the end of the owner's name, however. For example, a sole proprietor named Bill Smith who provides janitorial services could operate as âBill Smithâ or as âBill Smith's Janitorial Servicesâ without having to fill out any paperwork. If Bill wanted to call his service âSpick-and-Span Janitorial Servicesâ, however, he would first have to file with his state for a fictitious business name. From a legal standpoint, he would become âBill Smith, DBA Spick-and-Span Janitorialâ. DBA stands for âDoing Business Asâ, and is a very common term used in the world of sole proprietorships.
What To Expect
While the formation of a sole proprietorship is easy, actually operating such a business may be much more complicated. There may be many rules and regulations that apply to a sole proprietorship depending upon the nature of the business. Many kinds of services require licensing, such as construction trades, food service, cosmetology, etc. It is up to the potential sole proprietor to determine what legal requirements must be met during the operation of his or her business, and to comply with those requirements.
Though paperwork and regulatory control will vary from one sole proprietorship to another depending upon the nature of the business, there is very little paperwork inherent to this form of business structure. Taxes on the business profits are calculated as part of the sole proprietor's personal income tax return. Due to the private nature of personal income tax returns, a sole proprietor enjoys a significant amount of secrecy in disclosing the business's profits to outsiders. The most common tax forms filled out by a sole proprietor are:
- Form 1040: Individual Income Tax Return
- Form 1040-ES: Estimated Tax for Individuals
- Schedule C: Profit and Loss from Business
- Schedule SE: Self-Employment Tax
- Form 4562: Depreciation and Amortization
- Form 8829: Expenses for Business Use of Your Home
- Employment Tax Forms