Sole proprietor definition
A sole proprietorship is a single-owner business that hasn’t been formed into a separate legal entity. The person is the business and the business is the person.
Anyone who charges customers for goods or services with the intention of making a profit is automatically considered to be a sole proprietor, unless they have set up as an LLC or corporation. For that reason, many contractors, freelancers and side-businesses fall into the sole proprietorship category.
A sole proprietor may later choose to reorganize their business as a Limited Liability Company (LLC) or incorporate into an S corporation or C corporation.
Learn about other common small business structures:
Pros of sole proprietorship
You’re regarded as a sole proprietor as soon as you start operating. There’s no extra paperwork to worry about.
Lower upfront admin costs
While it generally costs money to create a legal entity like a company or corporation, there are no such costs involved with being a sole proprietor.
Tax is a bit simpler
Sole proprietors report their income to the Internal Revenue Service (IRS) by filling out a Schedule C and including it with their personal tax return (Form 1040). Some states require a state-specific version of this form as well. The Schedule C must show income and expenses, which means you need to keep good records and you need to understand what expenses can be claimed as tax deductions. For that reason, many sole proprietors use a tax professional but the filing process remains a lot simpler than it is for most other types of business.
Things you should know about being a sole proprietor
Your personal assets are at risk
There’s no legal separation between the business and its owner. So if the business is sued – and loses – the owner will be personally required to pay those debts or damages. Insurance can be an important tool for helping to control this risk.
You’ll pay self-employment tax
If you had a regular job before starting as a sole proprietor, you’ll be used to seeing social security (FICA) and Medicare taxes deducted from your pay. Your employer also paid the same amounts. As a sole proprietor, you’re both employer and employee so you pay both halves, which is referred to as self-employment tax. You get to deduct the employer half from your income on your tax return, which means you come out the same as any other type of business in the end.
You may have to change as you grow
A sole proprietorship is owned by one person. If you want to sell a stake in the business – which can be a popular way to generate capital – you’ll need to change your structure. It’s the same if you want to bring in family members or a business partner with special skills.
How to start a sole proprietorship
You can do nothing and you’ll automatically be considered a sole proprietor. But there are some other aspects to owning a small business that are worth nailing down before you get started.
- Check about permits and licenses: Check if you need a permit to run a business in your home city or state. While you’re at it, see if you need a license to operate in your chosen industry.
- Apply for an employer identification number (EIN): You’ll likely need an EIN to get a business bank account so pick one up, even if you’re not hiring. They’re free and can be obtained online on the IRS website.
- Choose a name: A sole proprietorship legally assumes the name of its owner. If you want to use something different, you’ll need to register a “doing business as” name. The process changes from state to state so do a local search to find out what’s required. It’s generally simple and cheap. If you want to go a step further and copyright your name, you’ll need to visit the United States Patent and Trademark Office (USPTO).
- Open a business bank account: Opening a business bank account helps to separate personal and business finances. That’s a huge help when doing your bookkeeping because you can use your bank statements to track income and expenses.
It’s also worth considering insurance for your business. There are policies to help protect against all sorts of risks, from accidents and injuries to unforeseen closures.
Frequently asked questions about sole proprietorships
People who ask “what is a sole proprietor” also ask these questions.
What’s the difference between a sole proprietorship and an LLC?
With a sole proprietorship, the business and its owner are one and the same. An LLC is legally separated from its owner/s. That can be significant if the business comes under legal or financial stress.
Can a sole proprietorship become an LLC?
A sole proprietor can reorganize their business as an LLC. As a different legal entity, the business will need to change their contracts and bank accounts. Depending on the state and industry they’re in, they may need new licenses, a new employer identification number (EIN) and new payroll, too.
Can I pay myself a salary as a sole proprietor?
No, while a proprietor can take money out of their business at any time, they can’t have a salary like an employee, and won’t receive a W-2 at the end of the year. Instead, you take what’s called an owner’s draw. This can be on a regular schedule, or whenever you want funds.
What taxes do sole proprietors pay?
As a sole proprietor, you’ll pay income and self-employment tax on the net income of your business. You report your income on Schedule C as part of your personal tax return, Form 1040. Because you’re self-employed, you should expect to pay quarterly estimated tax payments to the IRS, so you’ll need to set aside funds to cover these amounts.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.