The Internal Revenue Service (IRS) requires every business to classify itself as a specific type of legal entity. These entities come in five forms – partnership, corporation, limited liability company (LLC), S corporation and sole proprietorship – and each comes with its own legal and tax considerations.
Declaring your business as a sole proprietorship is easy to set up, and if you are working as a consultant, freelancer or other singular business, you may already be operating as one without realizing it.
If you're interested in establishing a sole proprietorship (or if you're already running one), here's a basic overview of what this legal business structure entails.
What is a sole proprietorship?
A sole proprietorship is the simplest and most common business structure in the United States. Sole proprietorships are run by a single individual who is responsible for all business assets, profits and liabilities.
Because this type of entity is so easy to form, administrative startup costs are minimal. The law does even not require you to set up a formal structure before launching your business. If you are the only owner and are operating under your legal name (not under a DBA name), you are automatically considered a sole proprietor by the IRS. The only legal expenses that may apply are for any licenses and permits you may need, depending on your industry.
[Read: A Guide to Business Licenses and Permits]
Pros and cons of sole proprietorship
Two of the many benefits of a sole proprietorship include:
- Full control over the business. Since you are the sole owner, you make all of the business decisions.
- Simple tax preparation. Known as pass-through taxation, your sole proprietorship does not need to be taxed separately from your Social Security number, which means that you simply need to report your business profits and losses to the IRS on a Schedule C form and Form 1040 and file your taxes as normal. As an added bonus, sole proprietor tax rates are the lowest among all business structures.
Of course, some of these perks can also lead to potential disadvantages, including:
- Full financial responsibility. As the sole owner and decision maker, you alone are liable for any financial losses and debts that may occur within your business.
- Difficulty with finding investors. The SBA also notes that it's difficult for sole proprietors to raise money. Banks view sole proprietors as particularly risky since the business's success and failure depends on a single person. You're also unable to sell stocks in a sole proprietorship, which may limit your opportunities to bring on investors.
When your business is just starting out and plans are to remain as a business of one, sole proprietorship makes sense.
Who should operate as a sole proprietor?
There are certain types of businesses that are well-suited for sole proprietorship status:
- Business consultants and speakers. Professionals in this space may take on a few gigs a year, or operate as a full-time business.
- Freelancers. Photographers, copywriters, web developers and more are typically a business of one contracted on a per-project basis by their clients.
- Home health care specialists. Home care assistants typically work as contractors and provide services to clients in their homes.
- Professional cleaning. Residential and commercial cleaning can easily be done as a side job or a full-time business.
- Landscapers. These businesses often begin with one person who does all the work. As demand increases, the sole proprietor may hire employees or outside contractors for assistance.
Businesses like these are ideal sole proprietorships because they are inexpensive to start and typically don’t need investors or financing to cover overhead expenses like storefronts or specialized equipment. They are also primarily built on the owner's personal reputation and skill set.
Is a sole proprietorship right for your business?
When your business is just starting out and plans are to remain as a business of one, sole proprietorship makes sense. If you have big growth plans for your business, you may wish to consider a different legal structure, since sole proprietorships can come with financial, business and legal risks. However, if you plan to keep your business small, you can operate as a sole proprietorship indefinitely.
[Read: Getting Ready to Launch? How to Choose the Right Business Structure]
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