What Is A Sole Proprietorship?
Sole proprietors are the lone wolves of the business world. They’re not as bound by regulatory red tape and tax requirements as their corporate counterparts, and they thrive in their independence. However, you may find that it’s more beneficial to travel as a pack, operating as a corporation or LLC.
How can you know for sure? Read on to learn more about what defines a sole proprietorship, including the:
- Legal and financial liability
- Tax requirements
- Ability to raise capital
Defining a Sole Proprietorship
The IRS defines a sole proprietor as “someone who owns an unincorporated business by himself or herself.”
Sole proprietorships are not to be confused with the terms “self-employed” or “independent contractor.” While both sole proprietors and independent contractors are self-employed, independent contractors are not their own business—they are individuals who work for someone else, offering services not as an employee, but as an independent expert.
But what factors delineate a sole proprietorship from, say, a single-member LLC, which is also an official business structure owned by one person?
Sole Proprietorship—Defining Factors
If you’re a sole business owner with zero to few employees, you may want to consider structuring your business as a sole proprietorship or as a single member LLC.
A single-member LLC is a business, like a sole proprietorship, with a sole owner.
Unlike a sole proprietorship, a single-member LLC is its own legal entity, separate entirely from the person who owns it. What separates these two seemingly similar structures are:
- A sole proprietorship costs less to form – The monetary gap between forming a sole proprietorship and forming a single-member LLC can be anywhere between $100-$800, which can make a difference for new business owners. While an LLC must pay filing and ongoing fees (the price varies depending on the state in which you’re filing), a sole proprietorship is free to form, you’ll only need to pay for registering your business name.
Curious about how much it would cost to form an LLC in your state? Check out this state filing fee spreadsheet.
- A sole proprietorship requires less paperwork – Another appealing aspect of forming a sole proprietorship business organization is that it involves little red tape. Because sole proprietorships are not considered separate legal entities, they do not have to comply with corporate formalities. Even a single-member LLC must file annual reports and maintain a separate bank account.
Examples of Sole Proprietorships
Business owners pursue sole proprietorship status because it allows them both maximum control over business decisions, and makes business tax filing easier.
Sole proprietorships are so popular, in fact, that 73% of U.S. businesses are registered as sole proprietorships. If you’re still wondering, “What is a sole proprietorship,” chances are you encounter this kind of business on a daily basis. Common sole proprietorships include:
- Independent restaurants
- Boutique retail and homegoods stores
- Financial planners
- Computer repair services
- House cleaning services
- Home healthcare services
- Web developers
- Graphic designers
- Professional photographers
With so much freedom comes a lack of structure that might hurt your business organization in the long run, including limited liability protection and increased fund-raising challenges.
Sole Proprietorships’ Legal and Financial Liability
Unlike other business structures—including LLCs and corporations—sole proprietorships do not offer limited liability protection. When you structure your business as a sole proprietorship, your personal assets are at stake because you and the business are, in the eyes of the law, one and the same.
According to the Legal Information Institute, the definition of liability is: “A legally enforceable claim on the assets of a business or property of an individual. In business, liability results from a breach of duty or obligation by act or failure to act. Liability also refers to the debt or obligation of a business in contrast to its assets.”
Let’s unpack this definition further by looking at limited versus unlimited personal liability.
Unlimited vs. Limited Personal Liability
If you choose to become a sole proprietor you are taking on the responsibility of unlimited personal liability.
Unlimited liability means that should your business default on a loan, you as the sole proprietor are at risk of losing personal assets to cover the loan’s value, including your car, home, jewelry, money market accounts, and more.
Under unlimited liability, a sole proprietor business entity must also take into account situations which are out of their control.
To demonstrate just how quickly your personal and professional life could be turned upside down with unlimited liability, consider the following:
You own a popular local deli. You pay all of your bills on time every month and are a responsible businessperson. One day, an older customer comes by the store and slips, breaking a hip where you just recently mopped the floor. This customer sues the business. Being that you didn’t have a warning sign for slippery floors, the court finds your business guilty.
As a sole proprietor, if you don't have enough business assets to cover the customer’s injuries, you may have to sell off your own property. Imagine having to sell your house and move your family across town all because of one forgotten sign.
While this is a rare occurrence, this is how unlimited liability operates. For this reason, sole proprietorships are recommended for “low-risk” businesses.
Alternatively, business owners who choose to structure their enterprise as a limited liability company or corporation will reap the benefits of limited liability.
With limited liability, if your business is in debt, the only assets at risk are the investments you’ve made with the company. Any property or assets belonging to the company may be seized, but your private property is safe.
Even though the risks associated with unlimited liability are high, owners across the country continue to structure their business as a sole proprietorship. This is in large part due to the ease with which a sole proprietor can file taxes.
Tax Requirements for Sole Proprietorships
When it’s time to file your taxes, a sole proprietorship business entity makes the process easy—especially when compared to filing as another business structure. As a sole proprietor you report and pay your business taxes as part of your personal tax return.
Here’s what you need to consider when filing as as sole proprietor:
- Schedule C tax form – Sole proprietors file a Schedule C tax form along with their personal income tax Form 1040.
- Small business tax deductions – Sole proprietorships can file for deductions like auto expenses, software subscriptions, office supplies, home offices, and so much more. Check out our guide to small business tax deductions for a full list.
- Self-employment taxes – Sole proprietors are also responsible for self-employment taxes, which cover the social security and Medicare taxes that an employer takes out of an employee’s salary. Because you are both employer and employee, you’ll need to pay self-employment taxes. This means you’ll need to file a Schedule SE form, Schedule C, and Form 1040 annually and you’ll need to pay self-employment taxes on a quarterly basis.
How Sole Proprietorships Can Raise Capital
If you want to grow your business rapidly or you foresee high operational costs, you may need investors. For sole proprietorships, raising this sort of capital could pose a challenge.
Why Don’t Investors Like Sole Proprietorships?
Sole proprietorships are simply not designed to attract deep-pocket shareholders and investors.
Because they are unincorporated businesses, the only person who can own equity in a sole proprietorship is the sole proprietor. For capital investors looking for this kind of loan repayment, it doesn’t exist within this business structure.
Also, as we’ve detailed with our hypothetical unlimited liability situation above, there is no asset protection under sole proprietorships.
Alternative Ways to Raise Funds
While investors are a great option for raising capital, they are certainly not the only option. Here are alternative financing methods sole proprietors may pursue:
- Small Business Administration microloans – These small loans—the max amount you can apply for is $50,000—are offered by SBA approved microlenders. You’ll have to put up some form of collateral, and offer a personal guarantee (making you liable for the debt).
- Crowdfunding – According to Forbes, by 2025 the crowdfunding market will be worth $300 billion. There are debt (Kiva), equity (Wefunder), reward-based (Kickstarter), and donor-based (GoFundMe) crowdfunding options. Which type of crowdfunding you choose depends entirely on your concept, but keep in mind you’ll owe something in every scenario except for the donor-based option.
- Line of credit via a corporate card – While not used to “raise funds” per se, a corporate card can offer a line of credit to better facilitate monthly spending. As a bonus, most business cards come with built-in cost-saving opportunities like cash back or expense management software to offer real-time visibility into spending habits.
Why Choose a Sole Proprietorship?
Sole proprietorships offer owners tremendous freedom and control. However, that can come with some downsides. A sole proprietorship may be a good fit for you if the following fall under your “nonnegotiables” list:
- Easy and low-cost to launch
- Minimal paperwork
- Simple tax filing plus the benefit of business deductions
Still unsure of what type of business ownership is right for you? That’s okay. The beauty of this easy-to-create business structure is that it’s also easy to incorporate.
Incorporation of a business simply means your company’s legal structure becomes that of a corporation (C corp or S corp, typically). Once you file the proper documents, your enterprise becomes its own legal business separate from you as an individual. This means that legally and financially your personal assets and your business assets are separate. Many business owners prefer to go this route to protect their personal assets from any business mishaps.
Businesses that started as sole proprietorships before becoming industry giants include eBay, Walmart, and Marriott.
Support Your Sole Proprietorship With Ramp
Being your own boss is appealing, but with this power comes the responsibility of unlimited liability and the burden of having to raise your own capital or borrow funds. No matter which business structure you choose, a smart charge card equipped with real-time accounting visibility is an asset for any company.
With Ramp, you benefit from a built-in expense management platform and vendor management control center. This allows you to be in control of every penny going in and out of your business, helping you prepare for tax day, and more.
Ready to start saving your business money? Check out Ramp.