A sole proprietorship is the simplest entity type for new businesses, and it’s also a somewhat popular option for entrepreneurs in a number of different industries.
The sole proprietorship is an informal business type that does not require any sort of registration with your state government ― all you need to do to form one is to start working.
That said, while this business structure lacks official rules and regulations, there are still some general guidelines that you should adhere to when operating a sole proprietorship. As with any other business entity, there are pros and cons of the sole proprietorship. While it’s incredibly easy to form and maintain, the lack of personal asset protection is a huge drawback.
Let’s discuss the various advantages and disadvantages of a sole proprietorship and discover how you can create your own sole proprietorship.
Select a state below to learn how to become a sole proprietor and the pros/cons of doing so. We'll outline how to get everything set up.
What Is a Sole Proprietor?
Much like a general partnership, the sole proprietorship is an informal business type, but the difference is that a sole proprietorship operates with only one owner, while a general partnership requires at least two.
There are very few legal requirements for owning a sole proprietorship, which is why we often say that it’s the easiest type of business to form. All you need to do to get a sole proprietorship up and running is to simply start working, as there is no formal formation process, and no paperwork to file with the state.
A sole proprietorship is an unincorporated business. In fact, from a legal standpoint, the business and its owner are one and the same ― taxes and lawsuits against a sole proprietorship are brought against the owner personally.
A sole proprietor is a relatively popular business type simply because it’s a good starting point. It’s simple to create, the startup costs are almost nonexistent, and a sole proprietorship can be converted into another entity type later on.
How Does a Sole Proprietorship Work?
A sole proprietorship springs into existence whenever its owner starts conducting business. It’s not necessary to file any formation documents with the Secretary of State.
For example, let’s say you sell baked goods. Technically, you formed your sole proprietorship when you sold your first baker’s dozen. That said, the owner must get any licenses required in their field in order to operate a compliant business.
Taxes for a sole proprietorship are fairly straightforward ― you actually won’t have to pay “business taxes” at all. Instead, a sole proprietor pays personal income tax rates, even on their business income.
This is because a sole proprietorship is not a separate business entity from its owner. You still pay taxes on the business profits, but you don’t report them on a separate tax return. Instead, you report that income on Schedule C of your personal income tax return.
As a sole proprietor, you’d also need to pay self-employment taxes. Normally, someone’s employer withholds these taxes from the employee’s paycheck, but if you’re your own employer, then it’s a different story. You’ll need to make payments for Medicare and Social Security taxes yourself, which comes to a 15.3% tax rate on top of your income taxes. You can find more information on these taxes here.
With employees, taxes can get a touch more complicated, since the proprietor needs to handle these tax payments on behalf of the employees. You can find more information on those taxes with the IRS’s employment tax guide. If you’re selling a qualifying good or service, you’ll also need to consult with your state’s Department of Revenue to learn about your sales tax responsibilities.
Does a Sole Proprietorship Provide Legal Protection?
First off, we have to clear the air on what we mean by “legal protection.” Basically, a business with legal protection has personal asset protection as a result of what’s known as the corporate veil, which separates the finances and assets of each owner from the assets of the business itself.
But in a sole proprietorship, there is no corporate veil, and as a result, no legal protection. In fact, in the eyes of the law, the sole proprietorship is indistinguishable from the owner ― there is no separation between the sole proprietorship’s business finances and the owner’s personal finances.
In our opinion, this is the biggest disadvantage of sole proprietorships. It’s difficult to overstate how catastrophic even one liability claim against your business could be if you remain a sole proprietor instead of forming a formal business entity, like a limited liability company or a corporation. After all, if someone sues your sole proprietorship or you default on a debt, you as the owner are 100% liable. That means your creditors can pursue your house, car, personal bank accounts, investments, and more.
Steps to Becoming a Sole Proprietor
1) Select a Business Name
You have two options for a sole proprietorship business name. You can use your own personal name, which is the default option. Therefore, if your name is John Johnson, your business is also called John Johnson. Or, you can register a DBA and create an assumed business name for your sole proprietorship.
Just remember, either way, you will not have the exclusive rights to your business name unless you register your DBA in a state that provides exclusivity for these filings. This means that if another entrepreneur wants to use your name, they’re legally allowed to do so.
2) Get an EIN
A federal tax ID number (commonly known as an employer identification number or EIN) is a necessity for any American business, as it enables you to hire employees, pay taxes, open business bank accounts, and more. Even if you don’t plan on immediately doing any of these things, you should still get one because you can obtain an EIN for free from the Internal Revenue Service online, and the process is quick and easy.
3) Open a Business Bank Account
Once you’ve secured your EIN, it’s time to get a bank account for your new business. This is another very easy step, as you simply need to bring your EIN to your bank of choice and ask them to open an account for your business. You will almost certainly require either an EIN or a DBA to get your business bank account.
Even for sole proprietors, we think it’s a good idea to get a separate bank account from the one you use for your day-to-day expenses. And, again, there’s no reason not to, seeing as it doesn’t cost you anything. Plus, if you have a DBA name, you can get that name printed on your checks, which looks much more official than checks with your own name on them.
4) Obtain Licenses and Permits
Just because your sole proprietorship is an informal business entity doesn’t mean it won’t need to register with the state in one way or another. Some states have general business licenses that are necessary to conduct business in the state, and many industries also require licensure on either the federal, state, or local level. Make sure you check with every relevant government agency to acquire the licenses and permits you need to operate a compliant business.
5) Acquire Business Insurance
If your business has employees, you will be legally required to acquire workers’ compensation insurance in most states. And, even if your business is located in Texas (the one state that doesn’t require workers’ comp), you should still absolutely obtain this coverage.
Beyond workers’ comp, there are many industry-specific insurance policies that might be advisable depending on the nature of your business, and a general liability policy is almost always a good idea, especially for businesses with retail locations that customers visit in person.
Pros and Cons of a Sole Proprietorship
A sole proprietorship is a popular choice for many new businesses, and it has several advantages that make it entrepreneur-friendly.
For one thing, a sole proprietorship lets the owner keep full control of the business. It’s also easy and cheap to form, and there is minimal government oversight (especially compared to a corporation or LLC).
Other than acquiring your business licenses, there really aren’t any ongoing compliance tasks to keep track of as a sole proprietor. While corporations and LLCs have to file annual reports in most states and franchise tax forms in some states, sole proprietors don’t have any maintenance issues to address on a regular basis.
There is also no requirement for a sole proprietor to designate a registered agent. Every LLC and corporation needs to have a registered agent, who receives their important document deliveries from the state and forwards them to the business. As a sole proprietor, you are certainly allowed to get a registered agent if you would like to, but no one is forcing you to do so.
As you can see, there are some advantages to being a sole proprietor, but there are certainly some disadvantages as well.
The biggest drawback is that there is no personal asset protection with a sole proprietorship ― if the business runs into debt or a lawsuit, your personal funds and assets can be taken as payment. This is in sharp contrast to LLCs and corporations, which do limit ownership’s personal liability.
Another downside is the fact that sole proprietors don’t have exclusive rights to an assumed business name. Most sole proprietorships operate under their owners’ personal names. Therefore, if your name is Sarah Smith, your company’s name is also Sarah Smith. While sole proprietorships can obtain doing business as (DBA) names, there is no exclusivity involved with a DBA in many states, so other companies are free to use your business name if they want to.
This is another area where LLCs and corporations have a huge advantage over sole proprietorships, because formal business entities do have exclusive rights to their business names.
It’s also harder to change ownership of a sole proprietorship because a sole proprietor and their business are legally considered to be one and the same. You also can’t add a co-owner without changing your entity type, because the sole proprietor is exclusively a one-person operation ― you are allowed to hire employees, but you are not allowed to bring in other owners.
In addition, banks are less likely to give large loans to an unincorporated business. Technically speaking, any loan you get from a bank would likely be considered a personal loan ― again, because the owner and the business are not distinct entities. Many banks won’t even allow sole proprietors to open business bank accounts unless they have a DBA, EIN, or both.
The Sole Proprietorship vs. Other Business Entities
If you stay as a sole proprietor, you cannot protect your personal liability ― we consider this to be the fatal flaw of the sole proprietorship as a business structure. There are a few other options to protect yourself, however.
For one thing, you could consider forming a multi-member limited liability company (LLC). This entity type is more expensive to form and has more formality than a partnership, but it provides personal liability protection.
For the vast majority of our readers, we strongly suggest forming an LLC rather than sticking with the informalities of the sole proprietorship. Not only does the LLC provide personal asset protection, but it also lends an air of credibility to your business that a sole proprietorship can’t match.
This is due in part to the fact that an LLC has a unique business name that is registered with the state, whereas a sole proprietorship is simply referred to using the personal name of its owner — for instance, if your name is Susan Smith, your sole proprietorship would simply be known as “Susan Smith,” not by a formal business name.
Incorporating your business as a corporation is another option. Corporations can issue stock, making them much more appealing to investors than an LLC or sole proprietorship. In addition, it can be easier to expand a corporation to other states than it is for a sole proprietorship or LLC. This is because the corporation’s structure is the same across all 50 states, while an LLC can vary from state to state. Therefore, you can easily expand a corporation into different states without worrying much about varying legal requirements.
Do you still want to stay as a sole proprietorship instead? If so, you should look into obtaining a general liability insurance policy for your business. A general liability policy helps you cover expenses caused by mistakes made in the course of operating your business.
Of course, it won’t necessarily cover the entire expense, but it will help reduce the personal impact of a lawsuit or debt for your sole proprietorship.
Things to Consider Before Starting a Sole Proprietorship
How serious are you about your business?
If you’re taking your business venture seriously, as all entrepreneurs should, we don’t think starting a sole proprietorship is a good idea. This entity’s lack of personal asset protection is a non-starter, even if it seems like your business shouldn’t have much liability. All it takes is one successful lawsuit against your business to wipe out your personal savings and put your other assets on the line. It simply isn’t worth the risk, especially considering how few concrete advantages the sole proprietorship has over formal business entities.
Is having an exclusive business name a priority for you?
If it is, you should not operate your business as a sole proprietorship. Informal business entities don’t have assumed business names unless they register a DBA, and in many states, a DBA still doesn’t provide name exclusivity. If you want an exclusive business name, forming an LLC or corporation is a better idea.
What is your budget?
If you’re operating on an extremely tight budget, and your business has very little liability, it’s possible that a sole proprietorship could work for you. After all, if you can’t afford formation fees for a corporation or LLC, the sole proprietorship may be your only option.
Frequently Asked Questions
How long does it take to form a sole proprietorship?
Because there is no formation process for sole proprietorships, this business entity is formed automatically as soon as you start conducting business.
Do I need to designate a registered agent for my sole proprietorship?
No. Because the sole proprietorship is an unincorporated business with an informal structure, there is no need for a registered agent. If the state needs to get in touch with your business, it will simply contact you directly.
Does a sole proprietor need to register with the state?
There are no legal requirements regarding sole proprietorship ownership. You will not need to tell the state who owns your business unless you file a DBA name, incorporate your company, or perform other similar business functions.
What does it mean for a sole proprietor to have full liability?
In an LLC or corporation, each owner has what’s commonly referred to as limited liability. This means that each member’s financial obligations are limited to their contributions to the business, and their house, car, personal bank accounts, investments, etc. are not at risk. In a sole proprietorship, the owner has full liability. If the business is sued or defaults on a debt, the owner can be held legally liable for 100% of the amount owed.
Can I hire a business formation service to create my sole proprietorship?
For LLC formations, incorporating a corporation, and more, we love hiring a reputable online business formation service to take care of the legwork for us. However, that isn’t an option with sole proprietorships, as there is no formation process for this entity. If you’d rather form an LLC or corporation — we strongly recommend forming one of these entities rather than operating a sole proprietorship — check out our list of the best options available. ZenBusiness and Northwest Registered Agent are our favorite.
A sole proprietor is a somewhat popular business type because it allows entrepreneurs complete control over the business, and the state requirements are minimal.
However, there are quite a few downsides to the sole proprietorship, especially when it comes to the area of personal asset protection. Just to recap, if your sole proprietorship is sued or defaults on a debt, you will be held personally liable, which is not the case for LLCs and corporations. Additionally, the lack of an exclusive business name is a significant negative for the sole proprietorship.
At the end of the day, while there are some minor positives to forming a sole proprietorship, we typically recommend forming a limited liability company (LLC) instead. It doesn’t cost too much more, and the LLC has an overwhelming set of advantages compared to the sole proprietorship.
If you would like some more information about the similarities and differences between an LLC and a sole proprietorship, we invite you to take a look at our “LLC vs Sole Proprietor” comparison guide.