Setting up a new business involves a lot of decisions, including determining the kind of structure you want to form from a legal standpoint. Choosing a business type may seem confusing, but understanding the different entities can help you align the needs of your business and make the decision-making process easier.
One business structure you’ve probably heard of is a sole proprietorship. It is one of the most common business formation types, but there are also benefits drawbacks for business owners who go this route.
In this article, we’ll introduce you to the most common form of business ownership for self-employed individuals, independent contractors, and freelancers. Learn how a sole proprietorship operates, and why it may (or may not) be the best choice for your business.
What is a sole proprietorship?
A sole proprietorship is a business not formally structured as a corporation, partnership, or as a limited liability company (LLC). In a sole proprietorship, the owner is the business as far as legal liability and taxes are concerned. As an owner of a sole proprietorship, you’ll report business income on your personal tax return. You’ll also be personally liable for the debts and losses of the business.
As a sole proprietor, you operate under your legal name. If you want to advertise your products or services as “Dylan’s Custom Furniture” or “Murphy’s Plumbing Services,” for example, you can navigate this by applying for a “doing business as” (DBA) name. A DBA name or a trade name will allow you to operate under a business name that’s more representative of your products and services.
Although the law says the business is not a separate legal entity — which means its debts are also your personal liability — you should still ensure there’s a separation between your personal finances and the transactions of the business. This practice will help you account for business expenses and ensure you are claiming accurate deductions on your tax form.
Being a sole proprietor is a good starting point for small business owners, contractors, and freelancers because it’s easy and affordable to establish. The registration process is relatively simple and does not require extensive paperwork. Being a sole proprietor also allows owners to get their brand and idea out in the world before expanding and registering for a more formal type of business.
When Does a Sole Proprietorship Makes Sense for Your Business?
The formation type you choose for your business will have legal and tax implications. That’s why it’s recommended that you choose a business structure that provides you with the right balance of liability protection and benefits.
Some advantages of a sole proprietorship include:
- It’s easy and inexpensive to form. As an unincorporated business, you may not need to formally register to establish a sole proprietorship. You may need a business license and a permit, but the requirements are minimal, such as your Social Security number (SSN). At the most, you may be required to get an employer identification number (EIN); you won’t have to comply with submitting documents, such as annual reports or your Articles of Organization.
- You will report profits and losses on your personal income tax return. This allows you, as a new business owner, to offset some of your losses from your other income. For instance, let’s say you are doing freelance photography while working as a receptionist, and you incur a loss after accounting for all business expenses. You may be able to deduct the losses from your employment income and take advantage of paying lower taxes.
- You avoid double taxation. Double taxation happens when companies pay corporate tax rates on their profits. Then, shareholders who receive the profits as dividends also pay taxes on their personal income.
- You have complete control of your business. Since you’re the sole owner of the business entity, you make all the management decisions and you don’t have to report to a board or shareholders.
Some disadvantages of a sole proprietorship include:
- A sole proprietorship does not offer liability protection. Since the business is not a separate legal entity, your personal assets could be used to pay off its losses and liabilities. For instance, if your business fails or if you get sued for damages, your house, car, and other personal assets could be seized to settle business debts.
- Sole proprietorships have limited funding options. Investors and banking institutions may not recognize the legitimacy of a sole proprietorship. Hence, it could be difficult to convince them to give a sole proprietor a loan.
- A sole proprietorship may not qualify you to apply for a business bank account. In most states, you may not need to register a sole proprietorship, which could be a problem if you want to apply for a bank account. Banks usually require formal documentation proving your business is legit before allowing you to open a business account.
Common Businesses That Use Sole Proprietorships
As an independent business owner or contractor in the early stages of business formation, you may question if a sole proprietorship fits your type of business. What you may not realize is that many home-based businesses operate as sole proprietorships, with others expanding to form LLCs and corporations eventually. Below are some examples of small businesses where forming a sole proprietorship makes the most sense.
Freelance photographers may operate from a studio or from their home and offer on-location photo shoots for events, such as weddings and other special occasions. Many freelance photographers start their businesses with only a camera, a laptop or computer, and a car to get to venues. Being a sole proprietor allows this type of small business owner to apply for a DBA name and claim business expenses.
Plumbers are skilled tradespeople who install, repair, and maintain pipes, fixtures, and other plumbing equipment used for water distribution and wastewater disposal. Some plumbers are employed by construction companies and city or county departments to maintain residential, commercial, and industrial buildings. Many are self-employed who work with construction companies as independent contractors or serve the public.
A sole proprietorship is a good start for a plumbing business because it allows the owner to build a brand without having to spend time and resources registering for a formal business structure.
Graphic designers create marketing materials, such as flyers, brochures, and logos for businesses. Most graphic designers, when not employed by a marketing or advertising agency, offer their services as freelancers and operate from their homes. This is why a sole proprietorship works well with their business needs for licenses and tax advantages.
Crafts Making and Other Artistic Ventures
With platforms like Etsy and Shopify, many enterprising individuals are leveraging their talents and converting their craft-making hobbies into small businesses. Many of these businesses are registered as sole proprietorships, which allows them to claim business expenses while building a customer base and making money on the side.
Form a Sole Proprietorship Today
At the start of your entrepreneurial journey, you will have to choose a formation type for your business. To find the right one that aligns with your needs, consider if you have the time and resources to create a formal business structure or incorporate. List your daily business activities and examine if they are high risk for debt or liability. Lastly, consider the tax advantages of the different business types and how they apply to you.
At ZenBusiness, we understand that pursuing your dream of having your own business involves many decisions that can feel overwhelming. We can make the business startup process easier. Let our dedicated team help you with all the details so you can focus on sharing your passion and talent with the world.