If you’ve thought about pursuing a side hustle or business, but don’t want to commit and file all the paperwork to make it official, a sole proprietorship is a happy medium.
Last year’s Great Resignation led to an entrepreneurial fever in America. In 2021, 5.4 million new business applications were filed, breaking the previous record by more than 20 percent, according to a fact sheet from the White House. Americans are more curious about self-employment than ever before. You might be one of them.
“Sole proprietorship is the simplest structure for self-employment,” says Chad Rixse, Director of Financial Planning at Forefront Wealth Partners, a company that provides financial advisory services. “It doesn’t require any special filings or special administrative duties.” As an added bonus, a sole proprietorship has no fees, and you can always change the structure of your company later as you grow.
Here’s what to know about sole proprietorships and how they work.
What Is a Sole Proprietorship?
The Internal Revenue Service defines a sole proprietor as “someone who owns an unincorporated business by himself or herself.” The business owner can file for a sole proprietorship, but the business designation is also automatic for anyone who hasn’t formally incorporated yet and is making money with a side hustle or other venture.
“When someone starts a business, by default, they operate as a sole proprietorship unless they take the steps to formally form a Limited Liability Company (LLC), partnership, or corporation,” says Nellie Akalp, CEO and co-founder of CorpNet, a company that provides formation and compliance services.
Sole Proprietorship Advantages and Disadvantages
There are many advantages to starting a business as a sole proprietor.
“A sole proprietorship is easy to establish,” says Laila Ghauri, a trademark and business attorney at Antares Law Firm in Austin, Texas. “A client does not need to take any legal steps to form this type of business. If the client is the only owner, and begins conducting business, he or she automatically becomes a sole proprietor.” Ghauri adds that there is no need to formally file paperwork at the federal, state, or local level, and a business owner does not need to separate taxes for the business. “Any profit the client makes is simply treated as his or her own income.” Small business owners report their business income on their personal income tax return.
Furthermore, small businesses classified as sole proprietorships aren’t required to apply for an Employer Identification Number (EIN) from the IRS unless you plan to hire employees. It’s still recommended that you do get an EIN, because an EIN can be a replacement for using your Social Security number (SSN) on tax forms, like W-9s, provided to clients. You can file for an EIN with the Internal Revenue Service for free.
Despite the ability to quickly launch your business and avoid incorporating or paying formation fees, sole proprietorships do have their drawbacks. The most significant disadvantage lies in the personal liability you’ll assume as a sole proprietor. Any business debts you incur and cannot repay can put your personal assets at risk, unless you have a business liability policy to help offset some damages. The same applies to liabilities caused by your employees — you’re personally responsible.
Raising the working capital needed to grow your business or attracting the right investors can also be challenging. Some lenders view sole proprietorship as a riskier business structure than established, incorporated companies. Investors may be hesitant because it’s not possible to sell stock in the business, notes Ghauri. “If the business fails, all the responsibility falls on the shoulders of the owner to repay the loans. This business rarely survives if the owner dies or is incapacitated,” she says.
Sole Proprietorship vs. LLC
Unlike sole proprietorships, limited liability companies (LLCs) are incorporated businesses. Ownership isn’t limited to a single member; a limited liability company can have several owners, so the financial responsibility falls on the business structure instead of the owners. Most importantly, each member’s personal assets are shielded from any claims against the business.
“An LLC is like a corporation, but twenty times more flexible,” says Sarnaa Archie, Principal Advisor at Capital Tax Advisors, a company that provides independent tax preparation, accounting, and consulting. “There can be multiple owners and investors, and the entity itself can own all the assets and be liable for damages, protecting the individual owners. For tax purposes, an LLC can be either an S-Corp or a C-Corp, depending on whether it qualifies for and elects this status.”
Related: LLC vs. S Corp: How to Ensure You Don’t Overpay on Taxes
“The advantage of an LLC over a sole proprietorship is that limited liability companies can provide a separation between the owner and the business,” says Akalp. “The main benefit of a sole proprietorship over an LLC is that the sole proprietorship is simple and easy to start. There is no paperwork or fees involved.”
Sole Proprietorship Examples
A sole proprietorship could be a good option if you’re engaging in individual entrepreneurship and don’t want to go through the business formation process yet.
“Many professionals like accountants and lawyers are sole proprietors,” says Archie. “Even brick-and-mortar and online e-commerce businesses are sole proprietors.” Archie notes that owners can file for a “Doing Business As” (DBA) name if they want to make their company name official. “ For example, John Doe can open a baking business and do business as ‘The Cake Store.’”
In a sole proprietorship, license fees are inexpensive, and you’re typically eligible for some tax deductions, says Ben Michael, Attorney at Michael & Associates, an insurance advisory firm in Chandler, Arizona. “For a law firm, the easiest business structure to set up is a sole proprietorship. It gives you full control of everything, and it’s the structure that best accommodates lawyers who don’t have an actual office space yet or would rather just work from home.”
Ghauri also finds that many sole proprietors work as landscapers, virtual assistants, housekeepers, graphic designers and caterers. Even if they’re not required to incorporate, her firm advises these clients to be cautious and form a business structure like an LLC to protect themselves from liability.
Frequently Asked Questions About Sole Proprietorship
Do I have to incorporate as a sole proprietorship?
No. If you start a single-member business without formally registering as an LLC, partnership, or corporation, it is automatically categorized as a legal entity in the form of an unincorporated sole proprietorship. Remember that multi-member entities are not eligible to operate as sole proprietors, and must incorporate instead.
How do I report sole proprietorship earnings on my taxes?
All the profits and income earned from a sole proprietorship are claimed on Schedule C (Profit or Loss From Business) of your personal tax return.
What types of businesses or side hustles are best for sole proprietorships?
A sole proprietorship could be ideal if you’re a freelancer, consultant, creative service provider or if you have a side hustle or side gig. “If you have a self-employed side hustle or are just starting out, a sole proprietorship is often the easiest, simplest, and most cost-effective route. However, if you need a lot of liability protection, you may want a business entity structure that’s not a sole proprietorship or LLC,” says Rixse.
Start Your Sole Proprietorship Today
Setting up a sole proprietorship can give you the confidence boost you need to pursue your business idea and start making more money. When you understand how your entrepreneurial idea fits into the overall picture, you’ll be well on your way toward achieving financial independence.