Sole proprietorship: What is it and how to form

If you’re thinking about opening your own business, being a sole proprietorship is likely your easiest option. As soon as you start your business activities, you become a sole proprietor. You have full control over your business and get all the profits, but you’re responsible for all the debts and liabilities. 

Forming a sole proprietorship is relatively easy and inexpensive. However, you can complete a few steps to make your business more official. Let’s look at what a sole proprietorship is, your tax options, and how to start your business:

• How a sole proprietorship works
• Types of sole proprietorships
• Sole proprietorship vs. LLC vs. C-corp
• How to form a sole proprietorship
• Pros and cons of sole proprietorships
• Examples of sole proprietorship
• Sole proprietorship taxes
• Starting your business with confidence

How a sole proprietorship works

A sole proprietorship is the simplest form of business structure, with one individual owning and operating the business. There are virtually no legal formalities, making it easy and cost-effective to establish. However, this also means that the owner has no legal or financial protections and is personally liable for business debts.

As a sole proprietor, the business owner reports their business income and expenses on their individual tax return. This means you’ll pay business profits at your personal tax rate—and are responsible for paying self-employment taxes.

Types of sole proprietorships

There are several types of sole proprietorships. Each type operates within the sole proprietorship business structure, having full control of decision-making. However, some key nuances between sole proprietors are self-employed individuals vs. business owners: 

• Independent contractors offer their services to clients or companies on a contract basis, such as freelancers, gig workers, and consultants. They work on a contractual basis and control how they perform their work, often serving multiple clients simultaneously. 
• Business owners can operate and manage their businesses as individuals. These are solopreneurs that have a bit more structure than sole proprietorships, such as an e-commerce store.

Independent contractors typically have the most freedom and control over their work. Complexity tends to increase for solopreneurs, as they have more responsibilities.

Sole proprietorship vs. LLC vs. C-corp

While a sole proprietorship is the simplest form of business, you may need a different business structure, like a limited liability company (LLC) and a corporation, if you need: 

• Liability protections: LLCs offer liability protection, but they require more formalities and administrative tasks. C-corps provide strong liability protection and access to outside funding, but they also have more complex regulations. 
• Tax flexibility: Sole proprietorships have pass-through taxation, meaning business profits go on the owner's tax return. LLCs default to pass-through taxation but have the flexibility to choose other tax statuses, while corporations file their own tax returns.

Ultimately, the best business structure depends on your needs and goals, such as liability protection, tax advantages, and ownership flexibility. 

How to form a sole proprietorship

A sole proprietorship is popular for solo entrepreneurs and small business owners. Let’s look at how to form a sole proprietorship, including the legal requirements, tax implications, and the necessary documents:

Whether you're a freelancer, consultant, or independent contractor, understanding how to register your sole proprietorship is crucial for establishing and running your business effectively.

1. Register your business

If you want to use a name for your business that is not your personal name, you need to register a “doing business as” (DBA) name, also known as a "fictitious business name." This lets you legally operate your business under a different name without having to form a different business structure. You can register your business and get a DBA with your secretary of state. 

2. Apply for licenses and permits

Regulations vary from state to state, but you may need to obtain licenses and permits on the federal, state, and local levels. The specific licenses and permits for your business type and locations will vary. 

For example, state requirements may include sales tax permits, professional licenses, or health permits, depending on the nature of the business. Local permits could include zoning permits or health department licenses.

3. Get an EIN and business bank account

Now, you’ll want to set up a business bank account for business expenses. Doing so will make it easier to track your expenses and income, simplifying sole proprietorship taxes at the end of the year. However, you’ll need an Employer Identification Number (EIN).

An EIN is a unique identification number for your business that the IRS issues, akin to an individual’s Social Security number. You can apply for an EIN for free via the IRS.

Pros and cons of sole proprietorships

Sole proprietorships are the simplest business structure an individual can operate. They offer key advantages but also come with drawbacks. 

Advantages of sole proprietorship

Sole proprietorships provide freedom and flexibility for the owner, particularly for new entrepreneurs and individuals with side hustles. It’s the easiest and least expensive way to start a business.

The three key advantages of sole proprietorships:

1. Low costs: Sole proprietorships are inexpensive to start and maintain, requiring minimal legal and administrative formalities.
2. Full control: The owner has full control over decision-making, operations, and the direction of the business, allowing for quick and efficient decision-making.
3. Tax simplicity: The tax rate for business income for sole proprietors is the same as their personal tax rate. However, you are eligible for certain self-employed tax deductions and credits not available to other business structures.

You also have the freedom to set your own hours and pursue your passion. This flexibility enables entrepreneurs to navigate business challenges and opportunities more independently, without constraints often associated with larger business structures. 

Sole proprietorship disadvantages

With the ease of operating as a sole proprietor comes some key disadvantages, such as: 

• Unlimited liability: The sole proprietor is personally liable for all business debts and legal obligations. If your business faces a lawsuit, our personal assets could be at risk.
• Limited growth: Sole proprietorships may face limitations in accessing funding or expanding the business due to their structure and size. 

Note that even if you’re a sole proprietor, you can still get liability protection if you form a single-member LLC.

Operating as a single-member LLC can also alleviate some of the limitations of securing loans or funding due to the lack of a formal business structure.

Examples of sole proprietorship

Sole proprietorships are common among independent artists, creatives, freelancers, and many other self-employed jobs.

Businesses you can operate as sole proprietorships include: 

• Freelancers: Writers, graphic designers, photographers, or consultants. 
• Service providers: Plumbers, electricians, carpenters, and other tradespeople.
• Professional services: Doctors, lawyers, accountants, or therapists. 
• Online businesses: Bloggers, affiliate marketers, or e-commerce stores. 

And as you grow, businesses that start as sole proprietorships can evolve into different legal structures. For example, a graphic designer may transition from a sole proprietorship to an LLC as it takes on employees and expands its client base.

Sole proprietorship taxes

As a sole proprietor, you need to report your business income and expenses on Schedule C, which is a part of your Form 1040. Your business income flows through to your tax return, and you pay taxes at your personal income tax rate. Additionally, you must also file Schedule SE to calculate and pay self-employment taxes. 

When it comes time to file sole proprietorship taxes and make your small business tax payments, here’s what you need to know: 

• Self-employment taxes: Sole proprietors pay self-employment taxes at a 15.3% rate on net business income.
• Tax status: Business and personal taxes are not separate. Business profits and losses flow to your personal tax return.
• Key tax forms: Form 1040 is where you’ll report your sole proprietorship taxes. You’ll attach Schedule C to it, which will include a breakdown of your income and expenses. You’ll also need to file Schedule SE for reporting and paying self-employment taxes. 

You’ll want to follow IRS guidelines and deadlines to avoid penalties and ensure compliance with tax obligations.

Starting your business with confidence

If you have no employees, you and your business are legally the same. This means business decisions are quick and easy. However, it also means filing your small business taxes can be cumbersome.

Not to mention—you’re already managing all aspects of your business yourself. Using accounting software built for sole proprietors, like QuickBooks Self-Employed, frees up more time to manage cash flow and grow your business.