Pros and Cons of Sole Proprietorships

When establishing a new business, owners are faced with many taxing decisions. Perhaps the most important one is deciding on the appropriate business structure. One of the most common options that many small business founders choose is a sole proprietorship, an unincorporated entity in which the business and owner are one and the same. As a result, the sole proprietor receives all the profits but is also responsible for all business losses, liabilities, and debts. 

To help determine if a sole proprietorship is the right business structure for you, it’s important to learn more about what it is, how it works, what it takes to form one, and the pros and cons of doing so. 

What Is a Sole Proprietorship?

A sole proprietorship is an unincorporated business entity run by one individual and in which there is no distinction between the business and owner. According to the Small Business Administration (SBA), a sole proprietorship is the easiest and most common structure that people choose to form a business. If you’re a freelance writer or graphic designer, for example, you’re technically already a sole proprietor.

“Before I decided to incorporate my business as an LLC, I was a sole proprietor for many years,” said personal finance and small business expert Laura Adams, author of “Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers,” in an email to The Balance. “When you start a trade or business without registering it with the state, you’re automatically a sole proprietorship under the law. Fact is, many people who earn income on the side have a sole proprietorship without realizing it.”

Tax Filing for Sole Proprietorships

Sole proprietors are responsible for several types of tax payments throughout the year. Here are some of the key tax filings to note. 

Self-Employment Taxes

Because sole proprietors are self-employed individuals, they must pay self-employment taxes —including Social Security and Medicare tax—based on business income. Self-employment tax is included in Form 1040 for federal taxes and is calculated using Schedule SE. If the business has a loss, no self-employment tax is payable, but the owner doesn't receive Social Security/Medicare benefit credits for that year.

Estimated Taxes

A sole proprietor is technically not an employee, so no income taxes or self-employment taxes are withheld from their pay. However, the IRS requires that these taxes be paid quarterly throughout the year on April 15, June 15, Sept. 15, and Jan. 15 of the next year.

How to Form a Sole Proprietorship

Although no formal action is necessary to form a sole proprietorship, there are certain important steps to follow to truly establish your business, which are outlined below.

Name Your Business

Naming your business is an important initial step. Sole proprietors who choose to operate under a different name than their own may have to file a fictitious name (also known as an assumed name, trade name, or "doing business as", otherwise known as DBA), which must be original and not used by another business. You can visit the U.S. Patent Office's website to check for registered trademarks and the availability of a name. Registering your business name can help establish your brand with customers, be used to create a domain name for your business’s website, and is critical for legal business contracts and agreements. 

Ensure Legal and Tax Compliance

Find out from your state and local government agencies if you need certain licenses or permits, such as a home business permit, to operate. Zoning laws also vary and it’s to your benefit to establish a business address within your local jurisdiction. You also may have to purchase a business license, obtain a business tax receipt, and pay taxes to your state or local government.  

Pros and Cons of Sole Proprietorships 

Pros Explained

There are several benefits that come with forming a sole proprietorship including the minimal to no cost involved, convenience, and simplicity in areas such as tax filing. “You include the business profit or loss on your personal tax returns,” Adams said. “However, later on, if you decide to convert it into another type of business entity, such as a C corporation, S corporation, or LLC, it’s easy to do.”

In addition to the ease with which a sole proprietorship can be started, Adams mentions other notable benefits that it offers:

• The owner has complete control and is not encumbered by partners, shareholders, and board members.
• It is a low-risk way to test a business idea before forming another business structure.
• It is popular with freelancers, consultants, and independent contractors who seek a high level of flexibility.
• The business is not constrained by government reporting regulations and business income and expenses are reported on the owner’s personal taxes. 

Cons Explained

While sole proprietorships offer freedom and flexibility to start, they can also come with subsequent financial risks.  “The main downside of being a sole proprietor is that you’re personally liable for your business’s debts and liabilities,” said Adams. “In other words, there’s no legal separation between you and your business. Once I began working with large firms as a PR spokesperson, influencer, and content creator, I decided to form a single-member LLC to reduce my personal liability for any potential legal upsets.” 

According to Adams, here are some other challenges of sole proprietorships:

• There are no personal financial protections found in other business structures, meaning owners can be sued personally.
• It can be harder to raise money from investors or obtain loans from banks so you may have to self-finance the business through savings and alternative means.
• There is no requirement to maintain separate accounting records or financial statements, which can result in a lack of proper account management and financial reporting.

Adams suggests that sole proprietors and other business owners can minimize their potential legal risk by having the right types of insurance. “There are various products you can purchase to cover gaps or unexpected business problems,” she said. Depending on the business, some insurance policies sole proprietors should consider are:

• A business owner’s policy (BOP)
• Commercial auto insurance 
• Car insurance for food delivery
• Cyber liability insurance
• General liability insurance
• Product liability insurance
• Professional liability insurance

Is a Sole Proprietorship Right for You?

Establishing a sole proprietorship can help set your business in motion with less effort than other business entities. However, there are certain challenges that business owners face. While it may be just right for your business, you should first take the time to research your industry and weigh the possible risks you could be exposed to by going it alone.  

Adams, who is a proponent of solopreneurship, encourages sole proprietors to be flexible with their business plans. “As your business needs and clients change, you can always change your business entity,” she said. “However, if you’re in an industry where lawsuits could arise, such as food service, real estate, and professional services, it’s wise to incorporate your business earlier rather than later—that will give you maximum protection from personal liability.” Forming a limited liability company (LLC) is one relatively straightforward way to do so.

Adams also advises business owners to consult with a business attorney or tax professional to discuss state laws and issues that could affect incorporating. “And if you do change from a sole proprietorship to another business entity, consider doing it at the beginning of a new year,” she said. “That allows you to avoid having to file two sets of taxes, one for each entity.”