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 has its own legal and tax considerations.
Declaring your business as a sole proprietorship is easy, 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 this legal business structure.
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 not even require you to set up a formal structure before launching your business. The only legal expenses that may apply are for any licenses and permits you may need, depending on your industry.
[Read more: 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 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. 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 usual. 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 takes more work for sole proprietors to raise money. Banks view sole proprietors as particularly risky because the business's success or failure depends on a single person. You also cannot sell stock in a sole proprietorship, which may limit your opportunities to attract investors.
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 healthcare specialists: Home care assistants typically work as contractors and provide services to clients in their homes.
- Professional cleaners: 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.
Sole proprietorship vs. LLC
Many new business owners weigh forming an LLC against the advantages offered by a sole proprietorship. Limited liability companies (LLCs) are legal entities formed and run by one or more owners (“members"). LLCs are formed at the state level and function as a separate legal entity from their members.
In practice, that means your personal assets are protected from liability if something should go wrong in your business. LLCs protect individual business owners from risking their own assets from lawsuits that can result from selling products, maintaining a physical location, or hiring employees.
LLCs enjoy similar tax flexibility to sole proprietorships. “By default, all profits made by an LLC are only taxed once, a process known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return,” wrote LegalZoom.
Sole proprietorships are much easier to form than LLCs. The process of how to start an LLC requires more paperwork and planning; sole proprietorships don’t require any.
[Read more: Sole Proprietorship vs. LLC: Which Should You Choose?]
Sole proprietors are taxed as 'pass-through entities,' a term the IRS uses to explain that the tax responsibility passes through the business to land with the individual.
How to register as a sole proprietorship
If you want to operate as a sole proprietor, there’s no action needed on your part. Assuming you’re the sole owner, you’re automatically classified as a sole proprietor. The IRS automatically considers you a sole proprietor if you are the only owner and are operating under your legal name (not under a DBA name).
If you wish to get a Doing Business As (DBA) name, you must file some paperwork. The requirements for filing a DBA vary from state to state, city to city, and even depending on the type of business structure you use. “A DBA is often necessary when opening a bank account or credit card for your business. Your state might also require follow-up steps after registration,” wrote HubSpot. “A DBA also ensures no one else in your county is doing business under the same name.”
How are sole proprietors taxed?
Sole proprietors are taxed as “pass-through entities,” a term the IRS uses to explain that the tax responsibility passes through the business to land with the individual. You will pay taxes for your sole proprietorship as part of your personal tax return. Use Form Schedule C with your personal income tax form, Form 1040.
Becoming a sole proprietor leads to several tax implications. Any net income from your business will increase your personal taxable income. Your business income may qualify you for a higher tax bracket than you were in previously. “You can deduct 50% of the self-employment tax you calculated on Schedule SE because the IRS considers the employer portion of the self-employment tax a deductible expense. (This deduction isn’t claimed on Schedule C but as an Adjustment to Income on Schedule 1.)” wrote Bench, an accounting software.
Fortunately, you will only pay sole proprietorship taxes on the profit of your business, not on your total income. There are also special tax deductions applicable to sole proprietorships. It’s worth consulting a tax expert to learn how to lower your tax burden as a sole proprietor.
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, a sole proprietorship makes sense. If you have ambitious growth plans for your business, you may consider a different legal structure, as sole proprietorships can entail financial, business, and legal risks. However, if you plan to keep your business small, you can indefinitely operate as a sole proprietorship.
[Read more: Getting Ready to Launch? How to Choose the Right Business Structure]
Sole proprietor setup checklist
Because it’s so easy to get started as a sole proprietor, the checklist of things you need to get started is simple. Here are a few boxes to tick to make sure your business is compliant and set up to succeed.
- Tax ID: Apply for an EIN. It's free via IRS.gov and takes about five minutes online. You'll need one if you plan to hire anyone or open a business bank account.
- Permits & licenses: If you're operating under any name other than your own, file a DBA (doing business as) with your county or state. Most cities also require a general business license—check your local government's website. If you're in a regulated industry like food, health, or construction, look into any additional permits that apply.
- Banking: Open a dedicated business checking account to keep your personal and business finances separate. This makes bookkeeping and tax prep much cleaner. A business credit or debit card is also worth setting up early—it simplifies expense tracking and starts building business credit.
- Bookkeeping: Pick accounting software before money starts moving. Set aside 25–30% of net income for taxes as you go, and put quarterly estimated tax payments on your calendar: they're due April 15, June 15, September 15, and January 15.
The EIN is technically optional if you're a solo operator with no employees, but banks often require it to open a business account, so it's worth getting upfront anyway. And, put the quarterly estimated taxes deadlines in your calendar to make sure you stay on track throughout the year.
Risk management for sole proprietors
As a sole proprietor, your personal assets are on the line if something goes wrong. General liability insurance is a good way to protect yourself. It covers third-party bodily injury, property damage, and basic legal costs.
If you're selling advice or services, add professional liability insurance (also called errors and omissions), which covers claims that your work caused a client financial harm.
And, if you work from home, don't assume your homeowner's policy covers business equipment or client visits—it usually doesn't, and a separate home-based business rider or small business policy is inexpensive.
Contracts are another way to mitigate risk. At a minimum, every client engagement should have a written agreement that defines the scope of work, payment terms, and what happens if either party walks away early. Include a limitation of liability clause to cap your exposure to the value of the contract, and an indemnification clause so clients can't hold you responsible for problems caused by their own actions. If you use subcontractors, have them sign agreements too, since you’re accountable for their work if a client has an issue.
Speak to a lawyer to make sure your templates are in good shape before you sign any contracts. It's a modest upfront cost that can prevent a much larger problem later.
Sean Peek contributed to this article.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.
