Sole Proprietorship

A sole proprietorship is a business carried on by one individual that has not been organised as any other kind of entity. The IRS defines the person rather than the structure: "A sole proprietor is someone who owns an unincorporated business by themselves." Both words are IRS usage, with sole proprietorship naming the business and sole proprietor naming the owner. The defining feature is an absence. No separate legal person is created, so the business has no existence apart from its owner: it holds nothing, owes nothing and is sued for nothing in its own name. That single fact accounts for almost everything else about the form, including why it costs nothing to start, why its profits appear on an individual tax return, and why the owner's personal assets stand behind its debts.

Nothing is filed to create one, and that is the point. A sole proprietorship comes into existence when someone starts carrying on a business without forming anything else. There is no state filing, no charter and no application. What may still be required is unrelated to entity status: a local business licence, an occupational or professional licence, a sales tax registration, and a trade-name filing if the business operates under a name other than the owner's own. That last one is worth being clear about, because it is routinely misread. Registering a "doing business as" or assumed name is a state or county recording requirement whose particulars vary; it puts the public on notice of who is behind the name, and it creates no entity, confers no liability protection and changes nothing on the tax return.

Unlimited personal liability is a consequence of the structure rather than a rule added to it. Because there is no separate person, every contract the business signs is the owner's contract and every claim arising from the business runs against the owner. Business debts are personal debts, and personal assets outside the business are reachable to satisfy them, subject to whatever exemptions state law provides. The exposure runs in the other direction too: a personal judgment against the owner can reach the business's assets, because there is no line between the two sets. Liability insurance is the usual first response for a business of any form, and forming an entity is generally about the business's own obligations rather than about insulating a person from liability for their own conduct. The details of both are state law.

What gets filed, once the business is running. The IRS's own table for a sole proprietor is short. Income tax goes on Form 1040 with Schedule C for the profit or loss of the business. Self-employment tax goes on Schedule SE. Estimated tax goes on Form 1040-ES, because nobody is withholding. If the business has employees, the employment tax returns and the wage statements that go with them apply in the ordinary way, along with the federal unemployment tax return. And payments to nonemployees are reported on information returns like any other business's.

The employer identification number question, which comes up early and has a narrow answer. The IRS's own summary lists three triggers: you need one if you have employees, if you will owe employment or excise taxes or taxes on alcohol, tobacco and firearms, or if you withhold taxes on non-wage income paid to a nonresident alien. That summary is not the whole list, and the omission matters for exactly the reader most likely to be reading this. The instructions to Form SS-4 direct a Schedule C or Schedule F filer to obtain one who has a qualified retirement plan, or must file excise, employment, alcohol, tobacco or firearms returns, or is a payer of gambling winnings; Publication 334 puts the same point as paying wages or filing pension or excise tax returns. So setting up a one-participant retirement plan is itself a trigger, which is easy to miss because the plan is usually presented as a benefit of working for yourself rather than as a filing obligation. A sole proprietor with none of these uses their own Social Security number. The IRS then adds that if you do not need one for federal tax purposes you can still request one for banking or state tax purposes, which is why many sole proprietors obtain one anyway rather than putting a Social Security number on a Form W-9 for every client.

The comparison people actually come for, in one line: a single-member LLC changes the liability answer and not the income tax answer. The IRS treats a single-member LLC as a disregarded entity, saying that "the LLC's activities should be reflected on its owner's federal tax return," and states directly that "an individual owner of a single-member LLC that operates a trade or business is subject to the tax on net earnings from self employment in the same manner as a sole proprietorship." So the profit is reported the same way, at the same rates, with the same self-employment tax as before. What the LLC does is interpose a separate legal person between the business and the owner for liability purposes. It is a state-law change with a state-law cost, and the choice is properly about liability rather than about finding a lower rate.

The refinement that catches people, and it is a real trap. Disregarded status is specific to income tax. The IRS states that "a single-member LLC that is classified as a disregarded entity for income tax purposes is treated as a separate entity for purposes of employment tax and certain excise taxes," and that for wages paid after the start of 2009 the LLC is required to use its own name and employer identification number for reporting and paying employment taxes. A single-member LLC with employees is therefore a non-entity for income tax and a separate entity for payroll at the same time, which is the sort of split that produces filings under the wrong number.

One IRS sentence to read carefully. The IRS's sole proprietorships page says that if you are the sole member of a domestic LLC "and elect to treat the LLC as a corporation, you are not a sole proprietor." That states the exception rather than the default. Absent such an election the disregarded treatment above is what applies, so the sentence should not be read as saying that the owner of a single-member LLC is never taxed as a sole proprietor.

The sequence for a sole proprietor is short because so little of it is structural. Start the business. Register the trade name if it differs from your own and your state or county requires it, and obtain whatever licences the activity needs. Obtain an employer identification number if one of the IRS's triggers applies, or if you would rather not use your Social Security number with clients and banks. Keep the business's records separately even though the law does not treat it as separate, because Schedule C requires the figures and every deduction has to be substantiated. Then file Schedule C with the annual return, Schedule SE for self-employment tax, and estimated payments through the year.

A hypothetical example of what the absence of a separate entity means in dollars. Yusuf runs a mobile repair business as a sole proprietor. The business bank account holds $9,000 and his tools and the equity in his van come to $16,000, so its assets are $25,000. A customer obtains a $70,000 judgment arising from the work. There is no separate legal person for the judgment to be entered against, so it is a judgment against Yusuf. Business assets satisfy $25,000 of it and the remaining $45,000 is collectible from him personally, subject to whatever exemptions his state's law provides. Forming an entity afterward does not change who was liable at the time, which is the practical reason the structure question is worth settling before the exposure exists rather than after.

Advantages of the form

• Costs nothing to start and requires no formation filing, so the business exists the moment the work does.
• No separate tax return for the business. The profit or loss goes on Schedule C with the owner's own return.
• No entity-level formalities to maintain, meaning no charter, no annual report in most states and no separate governance.
• A business loss can offset the owner's other income directly, subject to the ordinary loss limitation rules, because there is only one taxpayer.
• Winding it down is as informal as starting it.

Disadvantages and limits

• Unlimited personal liability. Business obligations are the owner's obligations, and personal assets stand behind them.
• There is nothing to sell as an entity. A buyer acquires assets and contracts individually rather than acquiring the business.
• No continuity. The business has no existence independent of the owner, which makes succession an asset-by-asset exercise.
• Raising outside capital is awkward, because there are no ownership interests to issue.
• Some counterparties will not contract with an individual, and a few licence and bonding regimes assume an entity.