Sole Proprietorship

Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What is Sole Proprietorship?

Sole proprietorship (or sole trader or proprietorship) means an unincorporated business operated by an individual with no separate legal existence. As a result, owners receive all profits from the business but are personally liable for all losses. It is widely popular for starting small businesses as it is easy to set up and manage.

Sole Proprietorship

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Unlike a corporation, a proprietorship is a pass-through entity, i.e., business income is taxed as the owner’s personal incomePersonal IncomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc.read more. Proprietors can start the business in their own name or have a trading name and get it registered locally. Due to negligible paperwork involved in its establishment, it is the most preferred type of business structureBusiness StructureBusiness structure is the legal framework adopted by a company to execute business activities in compliance with the corporate rules and regulations. An organization can be a sole proprietorship, partnership, limited liability company or corporation.read more. All freelancers fall under proprietorship.

Key Takeaways

  • A sole proprietorship is a type of business where there is no legal distinction between the owner and the business entity.
  • It is the easiest form of business to start as minimal legal formalities are involved.
  • A sole proprietor enjoys all profits from the business and bears unlimited personal liability for all business losses.
  • A sole proprietorship is a pass-through entity for taxation.
  • All profits and losses of the business are reported on Schedule C of the owner’s personal income tax return (Form 1040).

Sole Proprietorship Explained

A sole proprietorship is a business entity that isn’t legally separate from its owner.  Any individual can start such a business as it is not governed by any statute. It can be thought of as an extension of the owner. Therefore, its continuity is solely dependent on the owner.

Proprietors exercise total control over their businesses and have the freedom and flexibility to operate according to their preferences. This gives them the right to keep all the profits of the business. However, at the same time, they have to incur all losses of the business unconditionally.

Business creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more can hold the owner personally liable in case of unsettled debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more.  In addition, any public harm caused by the product or any major accident at the business site is the personal responsibility of the proprietor.  Thus, any damage to or by the business can bring a bad name to the proprietor or result in legal issues.

A proprietorship firm can file a legal suit against their suppliers or customers if they default. Likewise, customers and suppliers can also initiate legal proceedings against the sole trader.

Furthermore, the owner is also responsible for all the tax obligations of the business as it is a pass-through entity for taxation.  Therefore, the proprietor has to report profits and losses of the business in Schedule C of Form 1040 while filing federal income tax for any given year.

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How to set up a sole proprietorship?

To start working as a sole proprietorship, individuals can set up the business in their name without any legal paperwork and commence trading. However, if the business is not using the proprietor’s name, the owner must register it with the local authority by filing a “Doing Business As” (DBA) form. DBA ensures that the business has a distinct name assigned and that the nature of the business is known to the authority.

Note that filing a DBA is not mandatory. It depends on the nature of the business and the proprietor’s preference. After filing DBA, the proprietors can employ staff and rent commercial premises for operating their business. On hiring employees, the proprietorship must apply for an employer identification number (EIN) from the Internal Revenue Service (IRS).  

Before commencing business, sole traders can also open a business checking accountChecking AccountA checking account is a bank account that allows multiple deposits and withdrawals. Additionally, it provides superior liquidity.read more with a bank to accept payments from customers, give payments to suppliers, and credit salaries to their staff. However, it is not compulsory. Now, the business is ready to take off. Owners can contract with suppliers and manufacturers and begin selling goods to customers.

Sole proprietorship Characteristics

The following are the key characteristics of a sole proprietorship:

Examples

Here are some sole proprietorship examples to understand the concept of a sole trader better.

Example #1

Let us assume a person called ABC wants to start a gym. He has little education and a small amount of capital. He is planning to start the business immediately and run it himself. Since a sole proprietorship comes without too many legal complexities, ABC opts for this business structure.

ABC gets its sole trading firm registered by filing DBA at the local authority. After this, he gets a business checking account opened to transact with suppliers and customers. Next, he rents a business premise, hires employees, obtains DBA, and starts the business easily in a short time with minimal capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more.

Example #2

Suppose there is a lawyer Mr. D who is an independent law practitioner in a court. He is earning and filing taxes as an individual. However, he intends to start a law firm where he will hire junior lawyers and accountants to offer legal services to the public.

In this case, the lawyer files the DBA with the local administration and starts his law firm as a proprietary firm. Now, he can hire the staff for his firm and enjoy all the profits of the firm.

Since the proprietory firm is a pass-through entity for taxation, he is liable to personal income taxes on the firm’s income. Therefore, he must report all profits and losses of the firm in Schedule C of Form 1040. Note that though all the gains of the firm will be his own, the firm’s loss will affect his reputation in the market.

 Advantages

Most of the businesses in the US are proprietorship firms. This is because there are numerous advantages of a sole proprietorship:

  • Minimal legal paperwork required
  • Easy to establish and wind up
  • Maximum freedom and privacy in operation
  • Simplified banking through business checking accounts
  • Considered a pass-through business for taxation
  • No separate taxation of the entity; owners report business profits and losses on their personal income tax returns
  • No corporate tax charged
  • Complete control over the business
  • Quick decision making possible
  • Sole beneficiary of all business profits
  • Minimum government regulation
  • Easy switching to other business structures

Disadvantages

A sole proprietorship also has several disadvantages, as discussed below:

Frequently Asked Questions (FAQs)

Who is a sole proprietor?

A sole proprietor is an individual who owns a business, conducts its affairs, and assumes responsibility for all its obligations. The sole proprietor and the business entity are one and the same. Therefore, all the profits of the entity are taxed as the proprietor’s personal income.

Is registration required for a sole proprietorship?

No, a sole proprietorship does not mandate registration if the business is started in the owner’s name. However, if the business is not using the owner’s name, then the name must be registered as Doing Business As (DBA). A DBA is often required for opening a business checking account.

Can sole proprietorship have employees?

Yes, a proprietorship firm can recruit any number of employees as per its requirement. For this, it has to obtain an employer identification number (EIN) from the Internal Revenue Service (IRS).

This has been a Guide to what is Sole Proprietorship. We discuss sole proprietorship, its characteristics, advantages & disadvantages, along with examples. You can learn more about accounting from the articles below –

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