A sole proprietorship is a business that is directly owned by a single individual. It is not incorporated, so that the sole owner is entitled to the entire net worth of the business, and is personally liable for its debts. The individual and the business are considered to be the same entity for tax purposes.
The advantages of a sole proprietorship are:
- Simple to organize. The initial organization of the business is quite simple. At most, the owner might reserve a business name with the secretary of state. It is also quite easy to upgrade to other forms of organization.
- Simple tax filings. The owner does not have to file a separate income tax return for the business. Instead, the results of the business are listed on a separate schedule of the individual income tax return (Form 1040).
- No double taxation. There is no double taxation, as can be the case in a corporation, where earnings are taxed at the corporate level and then distributed to owners via dividends, where they are taxed again. Instead, earnings flow straight to the owner.
- Complete control. There is only one owner, who has absolute control over the direction of the business and how its resources are allocated.
The disadvantages of a sole proprietorship are as follows:
- Unlimited liability. The chief disadvantage is that the owner is entirely liable for any losses incurred by the business, with no limitation. For example, the owner may invest $1,000 in a real estate venture, which then incurs net obligations of $100,000. The owner is personally liable for the entire $100,000. An adequate amount of liability insurance and risk management practices can mitigate this concern.
- Self-employment taxes. The owner is liable for a 15.3% self-employment tax (social security and Medicare) on all earnings generated by the business that are not exempt from these taxes. There is a cap on the social security portion of this tax. There is no cap on the Medicare rate – instead, the rate increases by 0.9% at certain threshold levels.
- No outside equity. The only provider of equity to the business is the sole owner. Funding usually comes from personal savings and debt for which the owner is liable. For a large increase in capital, the owner would likely need to use a different organizational structure that would admit multiple owners.
The unlimited liability aspect of the sole proprietorship and the inability to bring in additional investors tends to limit its use to smaller organizations that require reduced levels of funding.