What is a sole proprietorship?

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In a Nutshell

A sole proprietorship is one type of business structure that’s the default for many freelancers, consultants and other individual business owners. As a sole proprietor, you and your business are considered one “entity,” which means you’re responsible for all the profits — as well as the liabilities — of your business on your own. Sole proprietorships are the simplest type of businesses to set up, but they do come with some risks as well.
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A sole proprietorship is an easy way to start a business where you are the sole owner.

Whether you’re making money on the side or starting a business on your own, any time you are working to make a profit, you are engaging in business activity in the eyes of the IRS. How you classify that business with the IRS matters: The business structure you choose will affect your taxes and legal liability for any debts or other issues your business runs into.

There are several different types of business structures, but if you’re on your own, you may consider being a sole proprietor. A sole proprietorship is a type of business where there is one sole owner of an unincorporated business who acts and operates as the business. Think of freelancers, artists, contract workers and other small-business owners. In fact, as a freelance writer I am a sole proprietor and have been for four years.

It’s the easiest way to begin a business, but you should still be aware of what you’re taking on. If you’re thinking of pursuing a sole proprietorship, keep reading to learn more.

Who should consider a sole proprietorship?

If you’re just starting a business — and there are no other owners or partners — a sole proprietorship could be your best bet initially.

A sole proprietorship can be a good fit for independent workers who offer a service or sell a product. There is no barrier to entry and no application to fill out, making it a good option for a new, one-person business.

But be aware that as a sole proprietor, you are personally liable for any of your business debts and losses. That means that if you can’t pay a business debt, your personal assets could be on the hook.

How does a sole proprietorship work?

Anyone who is building out their side gig or running a business on their own can be considered a sole proprietor, even without filing any paperwork. You may not even think of yourself as a business owner if you offer tutoring on the side — but when you’re making money, the government will likely consider it a business activity, whatever it is.

Technically, sole proprietors can hire employees, but by their very name sole proprietorships are typically solo ventures.

As a sole proprietor, you are responsible for saving for your own taxes and making any estimated tax payments that may be required. Your tax return is filed with your personal taxes, because in the eyes of the IRS, you are the business.

While being a sole proprietor comes with a lot of perks, there are some important things you should know. Namely, since there is no distinction between you and the business, you are personally liable for any financial losses, debt and damages in case of a lawsuit.

How to become a sole proprietor

If you’ve decided sole proprietorship is the right business structure for you, you might wonder how to make it official. The good news: You don’t have to do much.

As a freelance writer and full-time business owner, I didn’t have to file any paperwork with the IRS to get started. I did, however, have to register with certain business and tax authorities in my county. Be sure to research any licenses or permits you may need that are specific to your industry or are required by the federal government or your city or state.

As a sole proprietor, you can typically use your own Social Security number because there is no legal separation between you and your business. But if you’d like a bit of separation from your personal info or you’re looking to build your business credit, you can apply for an employer identification number.

An EIN is similar to a Social Security number but used in business for tax reporting. As a sole proprietor, if you have an EIN, you probably won‘t have to give out your Social Security number as much — and that may help lessen the risk of identity theft. And if you intend to hire an employee, you will need to get an EIN anyway.

Managing finances as a sole proprietor

As a sole proprietor, it’s best practice to create a business bank account (I use Spark® Business Savings with Capital One) so you can separate your business income and expenses from your personal income and expenses.

I didn’t do this my first year in business, so during tax time it was a mess to go through my account and separate expenses, like a personal coffee shop visit with a friend compared with a coffee shop visit with a business associate. Separating your finances can make it easier to track.

If you want to get a business credit card, it’s likely that your personal assets will be on the line. That means if your business suffers, your personal finances could suffer too. Your personal finances can affect your business finances — and vice versa — as there is no separation.

Bottom line

A sole proprietorship can be an easy entrance into the world of business. Just be mindful of the risks and personal liability you’re taking on. As you grow your business, you may consider a different business classification, but you may be able to get started today as a sole proprietor.

About the author: Melanie Lockert is a freelance writer and editor currently living in Portland, Oregon. She is passionate about education, financial literacy and empowering people to take control of their finances. Her work has been f… Read more.