What is a Sole Proprietorship?

A sole proprietorship is like a child’s lemonade stand…

A kid running a lemonade stand probably didn’t file paperwork with the local town and state governments to officially incorporate a business or get permission to sell beverages to the public. A sole proprietorship is similar. Sole proprietors don’t file paperwork to form a company officially. Instead, they go out and start operating like a business.

A sole proprietorship is a type of business. It’s the simplest and the most common form of business because it usually doesn’t require paperwork to form. In most cases, anyone who wants to start a business can begin operating, immediately becoming a sole proprietorship. Unlike most other forms of business, there is no distinction between the company and the person running the business. The firm does not file a separate tax return. The owner reports all of the business’s income and expenses on his or her personal tax return. The company also doesn’t need to maintain different financial accounts. The owner can use personal bank accounts for the business if they like. However, there are many advantages to separating accounts.

As the name sole proprietorship implies, you can only operate as a sole proprietor if you’re the only person involved in your business. If you work with another co-owner, you have a partnership instead of a sole proprietorship.

The simplicity of a sole proprietorship makes this form of organization accessible, but it also brings disadvantages. The most significant drawback of operating as a sole proprietor is the liability. Because the owner and the business are legally the same entity, the owner is fully liable for the business’s debts. Other forms of business can provide more protection for the owner’s assets.

One example of a sole proprietorship is a freelance writer. The writer operates as a business, contracting out his or her services to multiple clients. The clients each pay the writer, and the writer records that income. The writer can also record related expenses, such as the cost of a laptop they use solely for writing. During tax season, the writer reports writing income as business income on his or her tax return.

Any freelance worker can operate as a sole proprietorship.

Another example of a sole proprietorship is someone who produces and sells homemade goods like candles, soap, or food. They make the products and sell them, but they haven’t submitted any paperwork to form another type of business, like a limited liability company (LLC).

Sole proprietorships have a few features that make them distinct from other types of business.

Sole proprietors have full control over their businesses. They don’t answer to anyone and don’t have any co-owners that hold a stake in the company. That means that they make all the business decisions, but it also means that they can’t sell shares in their business to raise money.

Because sole proprietors are the only owner of the business, they receive all of the company’s profits. They do not need to split the income with other people.

Sole proprietorships do not file separate tax returns because they are not legally separate from their owners. The owner records all of the business’s income and expenses and reports them on his or her personal income tax return.

Because there is no distinction between the owner of a sole proprietorship and the business, the owner accepts full responsibility for the company. If the company borrows money and isn’t able to repay its debt, the business owner must pay the debt from personal funds. If someone sues the business, the owner is liable for any judgment a court hands down.

This makes sole proprietorships risky for business owners, especially those who operate in industries where potential liability can be high.

Anyone can form a sole proprietorship at any time with minimal bureaucracy. Starting to act as a business is all that’s required to form a sole proprietorship. To make sure your business is operating within the law, however, you may need to comply with local registration, business license, or permit laws.

Sole proprietors also need to file for relevant licenses if they want to work in a regulated industry, such as food preparation or childcare. Some industries are subject to significant government regulations — such as investment advising or manufacturing firearms — and those require registration with the federal government. Sole proprietors in other industries may have fewer filing requirements.

There are a few key distinctions between a sole proprietorship and a limited liability company (LLC).

One distinction is the filing requirements. In general, anyone can form a sole proprietorship and start operating immediately. In many cases, there isn’t any need to file paperwork with local governments or obtain permission to begin operating, other than licensing for businesses such as food service. (Though, to keep your business legitimate, you may need to comply with local regulations regarding business registration, licensing, and permits.)

The process for forming an LLC varies from state to state, but it is more formal than starting up a sole proprietorship. You generally need to file a form and pay a fee to your state government. For example, in Massachusetts, you can form an LLC by registering with the state. You must pay a $500 filing fee to form the LLC and provide a variety of information. You also need to file an annual report and pay a $500 annual fee. The exact cost and requirements vary from state to state. You have a choice of how the IRS treats your LLC for tax purposes, but most people report their LLC income on their personal tax return.

The other significant difference is the owner’s personal liability for the business. With a sole proprietorship, the owner is fully liable for all of the business’s debts and other obligations. If you form an LLC, the owner is not responsible for the business’s debts. However, maintaining that limited liability protection requires careful structuring of the business’s finances. You must keep personal funds and the business’s funds separate to retain that protection.

In short, sole proprietorships are easy and cheap to form but expose you to liability. LLCs require more effort and cost but protect you more if the business fails.

The IRS taxes sole proprietorships as part of the owner’s income taxes. Filers who run the business must file Schedule C along with their standard tax return.

Schedule C includes space for the business owner to enter their income from the company as well as relevant business expenses, like advertising, the cost of materials, the portion of their home they use for business offices, and the employer portion of payroll taxes.

If the business turns a profit, the owner adds the income to their personal tax return. If it loses money, they can deduct their losses from their income when calculating income taxes.

Note: Robinhood does not provide tax advice. For specific questions, you should consult a tax professional.

The primary advantage of running a sole proprietorship is that it is the most accessible type of business to establish and start running. If you have an idea for a company that you want to start, you could start it today as a sole proprietorship and in many cases without filing any paperwork to form the business or paying any fees to get started.

Sole proprietorships tend to be easier to manage. In general, there aren’t any annual filing requirements beyond the addition of a Schedule C to your taxes.

The ease of running a sole proprietorship comes at a cost. The disadvantage of a sole proprietorship is the liability. Because you are the business, you have full responsibility for all of the business’s debts and other obligations. If you borrow money to fund the business or someone sues the company, you could lose personal assets.

Additionally, formalized businesses, such as LLCs, can elect to have the IRS treat them differently for tax purposes, which can be beneficial if the owner structures their business income properly. That means that sole proprietors may pay more in taxes than formal businesses.

There is no formal process for starting a sole proprietorship. If you have an idea for a business, start doing it. You typically don’t need to file any paperwork or pay fees to establish a sole proprietorship. As soon as you start operating a company, you become a sole proprietor unless you take steps to create another type of company, like an LLC.

If you are looking to operate in an industry that is subject to local, state, or federal regulations, you must comply with all relevant regulations. To operate your business legally, you may also be subject to local regulations in terms of registration, business licensing, or permits.

You also need to file a Doing Business As (DBA) notice if you want to do business as a sole proprietor using a name other than your own.