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Sole Proprietorships

Introduction

If you started a business by yourself and never incorporated, i.e. failed to submit paperwork to your state agency to establish your business, you likely created a sole proprietorship. Sole proprietorships start up all the time – often without the owners even knowing that they’ve created one. However, most people that know even a little bit about business law generally stay away from creating sole proprietorships.

While sole proprietorships are easy to create, there are many drawbacks associated with sole proprietorships including personal liability for all acts and/or omissions of the business. (Note: You may have insurance that or other avenues that limit your liability.) Therefore, it’s often better to operate as a limited liability company or possibly even a corporation if you are the only owner of the business. However, once you bring on another owner (i.e. another partner), to your business you automatically cease operating as a sole proprietorship.

In this article, we’ll take a general look at how sole proprietorships often begin, talk about some "advantages" and "disadvantages" of being a sole proprietor, and go over some business formalities to be aware of for sole proprietorships.

Next, we’ll take a brief look at how sole proprietorships often start.

Sole Proprietorship Beginning

Let’s take a look at a possible real world example to show how a sole proprietor often begins business:

Let’s assume you decide to start a side business cutting lawns every weekend in addition to your full-time job. You call your business Friendly Grass Cuts. You take no legal actions and do not file any papers with the federal government or your secretary of state. At the moment you hold yourself out as a business and/or take your first offer to cut a lawn, you’ve officially begun your business – as a sole proprietor.

Over time, you do such a good job that your current customers refer your name to other people. You get more calls, become busier, and start making more money. You suddenly have some good problems – you’re too busy to do all the work by yourself. So, you call a few friends to help out cutting lawns with you. At the moment you bring on new workers, the law will either classify these workers as employees or independent contractors. At this point, you’re still a sole proprietorship because you’re the only owner of the business. But you are personally liable to third parties for the acts and/or omissions of you and your workers while cutting the lawns.

For example, assume you or one of your workers forgets to turn off one of your lawnmowers and it runs into a customer’s brand new Mercedes. That customer could sue you for damages to the Mercedes done by the lawnmower (e.g. business asset) and your own car and money in your personal bank account (e.g. personal assets). That is why it is essential to limit your liability so a third party or creditor cannot go after your personal belongings. If you set up your business to limit your personal liability, the Mercedes owner would likely not be able to successfully go after your personal assets like your personal bank accounts.

Next, we’ll go over some advantages and disadvantages in operating as a sole proprietor.

Advantages & Disadvantages of Sole Proprietorships

There are both pros and cons to operating as a sole proprietor. Here’s a brief overview of some of the advantages and disadvantages of operating as a sole proprietor:

Advantages

Easy to form
Fairly easy to maintain, i.e. hardly any business formalities

But you’ll still have to keep sufficient tax records

Fairly simple tax structure - You’ll be taxed at your personal income tax rate
Easy to dissolve, i.e. terminate

Disadvantages

Personal liability

This is a BIG drawback because you could lose more than just all of your business assets – you could even lose your personal assets!

Often difficult to raise revenue for the business because lenders don’t generally like dealing with sole proprietors (because of the liability issues)

So, sole proprietors are often limited to using funds from their personal savings and assets

False sense of security if nothing goes wrong for a long time.

It often only takes 1 lawsuit to ruin a sole proprietor with any protections.

No opportunity for other individuals to take an ownership interest in your business.

This may keep some top-level investors away from working with you.

If you live in a community property state (see some examples listed below) your spouse may automatically own a 1/2 interest in your sole proprietorship even though you have full control over the business. But you’ll have to check with your particular state’s laws, as this rule may not apply to your particular state.

Upon last check, community property states include:

Arizona
California
Idaho
Louisiana
Nevada
New Mexico
Texas
Washington
Wisconsin

NOTE: You can often purchase liability insurance, such as business liability insurance (or professional liability insurance if you’re a professional like a lawyer or accountant) which will limit what you’d have to pay on certain claims. However, because it’s generally fairly easy to set up an entity like an LLC to limit your liability, it’s often to your benefit to avoid operating as a sole proprietor and purchase liability insurance.

Next, we’ll take a brief look at some business formalities you’ll still likely have to deal with as a sole proprietor.

Sole Proprietorship Business Formalities

If you choose to operate as a sole proprietor, you’ll still have to take care of some business formalities, prepare your business’s taxes, and manage other concerns. As for business formalities, you still likely have to:

Secure appropriate business licenses
Obtain permits for any real estate owned by your business
Apply for registration and/or franchise numbers

In regard to taxes, you’ll have to keep track of your taxes for federal income tax purposes (and likely also state and local income tax purposes).

Federal Tax Forms for Sole Proprietorships include:

Form 1040: Individual Income Tax Return
Form 1040-ES: Estimated Tax for Individuals
Schedule C (or C-EZ): Profit and Loss from a Business
Schedule SE: Self-Employment Tax
Form 8829: Expenses for Business Use of Your Residence
Form 4562: Depreciation and Amortization

As you can see, you’ll still have to take care of business formalities and tax issues to properly create and maintain your sole proprietorship.

Finally, let’s wrap up this article with some highlights and additional considerations.

Conclusion

In this article, we took a look at how sole proprietorships often begin, talked about some their advantages and disadvantages, and reviewed some business formalities to take into consideration. Now that you’ve read this article you should have at least a better understanding of what it means to be a sole proprietor.

Many new businesses start off as sole proprietorships because it is the default business structure for a single business owner. In fact, many new sole business owners simply "open shop" one day (like with the Friendly Grass Cuts example) and don’t even know they’re operating as sole proprietors. This can have some devastating consequences for those owners who do not know their legal rights and liabilities if something goes wrong.

With that said, we encourage you to take a look at other business structures including LLCs and/or corporations to limit your personal liability. As a new business owner, the world is at your fingertips – including your creditors and plaintiffs looking to sue. So, take every reasonable precaution to protect yourself and your business.