Sole Proprietorship
A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
A sole proprietorship is a simple type of business structure that is owned and operated by the same person. It does not involve many of the complex filing requirements associated with other types of business structures such as corporations. Sole proprietorships allow persons to report business income and expenses on their individual tax returns.
Sole proprietorships are attractive to small investors because they are relatively easy to start up. Also, the owner is entitled to all the profit that the sole proprietorship collects. On the other hand, sole proprietorships can be risky because there is no separation between the owner and the business.
In other words, the owner remains personally liable for any losses or debts that the sole proprietorship incurs. They can also be held legally responsible for violations committed by the business or its employees. A sole proprietorship can best be summed up by the phrase, "You are the business.
In addition to the relative simplicity compared to large corporations, opening a sole proprietorship is a low-cost method of entering into the business world. From consultants and free lancers to independent contractors, nearly anyone can create a sole proprietorship.
As the name suggests, "sole proprietorship" refers to a business that is owned by a single owner and should not be confused with a corporation. There are no corporate taxes involved and the sole proprietor pays income tax on the profits generated. The person who organized the business pays personal income taxes on the profits made. This makes the accounting procedure relatively simple for the sole proprietor, who also enjoys complete autonomy in terms of making business decisions.
Setting up a sole proprietorship is easy. One of the main steps is to obtain a local business license (a sales tax permit may also be required). For certain businesses, such as restaurants or legal practices, you may need additional local or state licenses. Legal regulations and licenses aside, there are other major factors to consider when setting up a sole proprietorship. You will have to create a business plan, develop marketing and advertising campaigns, set up a budget, and find ways to fund your business.
Advantages and Disadvantages of a sole proprietorship
Many business owners choose to operate as a sole proprietorship to alleviate the difficult tax procedures that go along with other forms of operation. As a sole proprietor, you would simply have to file an individual income tax return (IRS Form 1040) including your business losses and profits. There are no restrictions on the number of people you can hire, and from the tax and legal perspective there is no distinction between you and your business. You can therefore hire as many people as you want and also recruit independent contractors if need be. Being in complete control of their business, sole proprietors make all the business decisions keeping law in mind.
Some of the Advantages of a Sole Proprietorship
There are many reasons why a person would choose to start their business up using a sole proprietorship structure. Some of the main advantages of sole proprietorships include:
Ease of formation: Starting a sole proprietorship is much less complicated than starting a formal corporation, and also much cheaper. Some states allow sole proprietorship to be formed without the double taxation standards applicable to most corporations. The proprietorship can be named after the owner, or a fictitious name can be used to enhance the business’ marketing.
Tax benefits: The owner of a sole proprietorship is not required to file a separate business tax report. Instead, they will list business information and figures within their individual tax return. This can save additional costs on accounting and tax filing. The business will be taxed at the rates applied to personal income, not corporate tax rates.
Employment: Sole proprietorship can hire employees. This can lead to many of the benefits associated with job creation, such as tax breaks. Also, spouses of the business owner can be employed without having to be formally declared as an employee. Married couples can also start a sole proprietorship, though liability can only assumed by one individual.
Decision making: Control over all business decisions remains in the hands of the owner. The owner can also fully transfer the sole proprietorship at any time as they deem necessary.
Disadvantages of Sole Proprietorships
Forming a sole proprietorship does involve some risks, mainly to the owner of the business, as legally speaking they are not treated separately from the business. Some disadvantages of sole proprietorships are:
Liability: The business owner will be held directly responsible for any losses, debts, or violations coming from the business. For example if the business must pay any debts, these will be satisfied from the owner’s own personal funds. The owner could be sued for any unlawful acts committed by the employees. This is drastically different from corporations, wherein the members enjoy limited liability (i.e., they cannot be held liable for losses or violations).
Taxes: While there are many tax benefits to sole proprietorship, a main drawback is that the owner must pay self-employment taxes. Also, some tax benefits may not be deductible, such as health insurance premiums for employees.
Lack of “continuity”: The business does not continue if the owner becomes deceased or incapacitated, since they are treated as one and the same. Upon the owner’s death, the business is liquidated and becomes part of the owner’s personal estate, to be distributed to beneficiaries. This can result in heavy tax consequences on beneficiaries due to inheritance taxes and estate taxes.
Difficulty in raising capital: Since the initial funds are usually provided by the owner, it can be difficult to generate capital. Sole proprietorship do not issue stocks or other money-generating investments like corporations do.
So, while sole proprietorship do not necessarily create more liabilities, they do expose the business owner to a risk of being sued. Lawsuits can be filed against the business owner for legal violations, as well as to collect any outstanding debts.
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Accounting for a sole proprietorship
The accounting for a sole proprietorship does not require a separate set of accounting records, since the owner is considered to be inseparable from the business. Nonetheless, one should maintain records for business activities, in order to judge whether these operations are generating a profit.
A sole proprietorship tends to generate smaller amounts of revenue and incur lower levels of expenses than more complex types of organizations. Consequently, it can make sense to start off with the most minimal accounting record keeping that is based on the cash flows into and out of a bank account. This means maintaining separate cash receipts and cash disbursements journals, and little else. This is considered a single entry accounting system, since it cannot be used to produce a balance sheet, only an income statement.
A single entry system is most suited to a cash basis accounting system, where revenues are recorded as cash is received, and expenses are recorded as payments are made. There is no attempt to track assets or liabilities, so there is no formal tracking of fixed assets, inventory, and so forth in separate journals.
The tax reporting for a sole proprietorship flows through the owner's personal tax return, with a separate form used to itemize the major classes of revenues and expenses incurred by the business. There is no separate tax return for the business, since there is no separate business entity.
The main limitation of this accounting system is that there are insufficient accounting records to be translated into an auditable set of financial statements. If the owner of a sole proprietorship wants to obtain funding for his or her business, the lender will likely require audited financial statements, which will require the following sequence of actions to upgrade the accounting records:
Form a business entity
- Switch to the accrual basis of accounting, using a double entry bookkeeping system
- Have the resulting financial statements audited by a CPA
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ReplyDeleteA sole proprietorship is a business that can be owned and controlled by an individual, a company or a limited liability partnership. There are no partners in the business.
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