A sole proprietorship is the simplest form of business entity. It requires no formal organization papers or formalities for conducting the business. Essentially, the individual functions as a business and is liable for all of the debts and liabilities incurred.
A sole proprietorship is generally considered an informal business organization. That is, it does not require any formal documentation or state filings to legally create it. It is a single individual conducting business in his or her individual capacity.
To create a sole proprietorship, the individual simply obtains the necessary business licenses, tax numbers if necessary, and perhaps registers a name, at which point he or she is free to conduct the business, making all the decisions for the company and receiving all of the profit. Employees may be hired and business assets purchased and disposed of. There are no required annual reports or meetings. If the business is sold, it is treated as a sale of the assets of the business, not as the transfer of the business itself. Therefore, gain or loss on sale is determined on an asset-by-asset basis.
As a sole proprietor, the business owner is personally liable for all of the debts, obligations, and liabilities of the company. All assets of the company are the individual’s assets since a separate entity does not exist. No separate tax return is filed. The individual completes a schedule C to account for the income and expenses of the company and claims all income or loss on his or her individual tax return. The sole proprietor also files a schedule SE for self employment taxes. Quarterly estimated tax returns must be filed to avoid tax penalties.
Given such a lack of formalities, the sole proprietorship is often the entity of choice for small startup businesses. However, depending on the type of business, this strength can quickly become a weakness. Since no separate entity exists, there is nothing to shield the proprietor from the liabilities of the company. For someone in the business of buying, selling, or leasing real estate in his or her own name, this poses a major risk. Over recent years, liability for contaminated property has raised grave concerns for those in the chain of title on real estate. The liability for cleanup is not limited to those who caused the contamination but extends generally to all owners in the chain of title.
Leasing property is another area where where limited liability should be sought. Case law is replete with plaintiffs suing landlords for liability based on the conditions of the property and personal injuries that arose out of that condition.
In short, whenever a business poses substantial liability risks, a proprietorship should be avoided.
From a tax planning perspective, the sole proprietorship provides little opportunity for tax relief. Business expenses can be offset against business income; however, all income over expense is considered self-employment income and therefore subject to the self-employment tax. As any small business owner will tell you, it is the self-employment tax that represents the greatest tax problem. Some deductions, such as health insurance, are also limited for a sole proprietor, though this is changing. Other types of business organizations have greater flexibility in tax planning in most cases.
In summary, sole proprietorships are ideal for small startup companies headed by a single owner with activities that raise few liability risks and few tax-avoidance needs. Individuals “testing the water” can do so without the startup costs associated with other business organizations, and yet move to a more sophisticated organization as the business shows promise. That said, in most cases a formalized business structure can save significantly on both tax liability and avoid liability as well.
Still not sure if a sole proprietorship is the best fit for you? Reach out to us directly at the information listed below.
Jeff B. Skoubye