What is sole proprietorship? Definition, FAQs, and resources

Table of contents

• How to set up a sole proprietorship
• Advantages of sole proprietorship
• Disadvantages of sole proprietorship
• Tax requirements for sole proprietors
• Sole proprietorship vs LLC and other business structures
• Manage your sole proprietorship finances with confidence
• Frequently asked questions about sole proprietorships

Key takeaways

• Recognize that sole proprietorships offer the simplest business setup with no formal registration required, but expose you to unlimited personal liability for all business debts and legal issues.
• Implement proper financial separation by opening a dedicated business bank account and obtaining an EIN, even if not legally required, to maintain clear records and establish business credibility.
• Prepare for self-employment tax obligations by setting aside funds for the 15.3% Social Security and Medicare taxes on net earnings, and make quarterly estimated payments if you expect to owe $1,000 or more.
• Consider transitioning to an LLC or corporation structure when your business grows, as sole proprietorships limit your ability to raise capital from investors and may reduce credibility with customers and vendors.

How to set up a sole proprietorship

Setting up a sole proprietorship is the simplest way to start a business. Unlike other business structures, you don't need to file paperwork with the state or pay registration fees.

To set up a sole proprietorship, follow these steps:

1. Choose your business name: You can use your legal name or register a "doing business as" (DBA) name
2. Get required licenses: Check local, state, and federal requirements for your industry
3. Open a business bank account: Separate your personal and business finances
4. Get an Employer Identification Number (EIN): Required if you have employees or want to open a business bank account

Time to set up: Most sole proprietorships can be operational within days or weeks, depending on licensing requirements.

Advantages of sole proprietorship

Sole proprietorships offer several key benefits that make them attractive to new business owners and freelancers.

Set up and operational advantages:

• Easy to start: No paperwork or registration fees required
• Complete control: Make all business decisions without consulting partners or boards
• Simple taxes: Report business income on your personal tax return using Schedule C
• Low cost: you have minimal startup expenses and ongoing fees
• Privacy: you don’t need to file public documents about your business

Financial benefits:

• Keep all profits: you keep all earnings and don’t need to share with partners or shareholders
• Tax deductions: you can claim business expenses to reduce your taxable income
• Flexible operations: you can change your business direction quickly without formal processes

Disadvantages of sole proprietorship

Sole proprietorships come with significant risks that you should consider before choosing this business structure.

Liability and financial risks:

• Personal liability: Your personal assets are at risk for business debts and lawsuits
• Limited funding: Harder to raise capital from investors, as you cannot issue securities. Other business structures can use SEC provisions like the “seed capital” exemption to raise up to $1,000,000 by selling securities.
• Self-employment taxes: Pay both employer and employee portions of Social Security and Medicare taxes

Operational challenges:

• Business continuity: your business ends if you become unable to work or pass away
• Limited expertise: you are responsible for all aspects of the business yourself
• Credibility concerns: some customers and vendors may prefer to work with incorporated businesses

Tax requirements for sole proprietors

Sole proprietors report business income and expenses on their personal tax returns, making tax filing simpler than other business structures.

Key tax obligations:

• Schedule C: Report business income and expenses on Form 1040 Schedule C
• Self-employment tax: Pay 15.3% on net earnings for Social Security and Medicare
• Quarterly payments: Make estimated tax payments if you expect to owe $1,000 or more
• Business deductions: Deduct legitimate business expenses to reduce taxable income

Record keeping requirements:

• you should track all business income and expenses
• you should keep receipts and documentation for at least three years
• you should separate business and personal expenses for accurate reporting

Sole proprietorship vs LLC and other business structures

Choosing the right business structure depends on your liability concerns, tax situation, and growth plans.

Sole Proprietorship

• Set up complexity: Very simple
• Personal liability: Full liability
• Tax filing: Personal return
• Ongoing costs: Minimal
• Credibility: Lower

LLC

• Set up complexity: Moderate
• Personal liability: Limited liability
• Tax filing: Flexible options
• Ongoing costs: State fees
• Credibility: Higher

Corporation

• Set up complexity: Complex
• Personal liability: Limited liability
• Tax filing: Separate return
• Ongoing costs: Higher fees
• Credibility: Highest

When to consider other structures:

• LLC: If you need liability protection but want tax flexibility
• Corporation: If you plan to raise investment capital or have multiple owners, as corporations can leverage SEC rules that allow for sales of securities up to $5 million in a 12-month period.
• Partnership: If you have business partners and want to share profits and responsibilities

Manage your sole proprietorship finances with confidence

When you run your own business, you manage everything, including your finances. Staying organized from the start helps you track your financial health and manage cash flow. It also makes tax time less stressful. With clear insights into your income and expenses, you can make smarter decisions and focus on growing your business.

Xero makes bookkeeping simple with tools designed for small businesses. You can track expenses, send invoices, and see your real-time financial position. Try Xero for free.

Frequently asked questions about sole proprietorships

Do sole proprietors need an EIN?

You only need an Employer Identification Number (EIN) if you plan to hire employees or must file certain excise tax returns. Many banks also require an EIN to open a business bank account, so it can be helpful to get one even if it’s not required.

What are the pros and cons of a sole proprietorship?

The main advantages are that it’s easy and inexpensive to set up, you have full control, and taxes are simple. The main thing to watch out for is that you are personally responsible for business debts or legal issues.

Can a sole proprietorship have employees?

Yes, a sole proprietorship can hire employees. If you do, you’ll need to get an EIN from the IRS and handle payroll taxes.