The term sole proprietorship refers to a business owned and operated by one person, which is not registered as a corporation or a limited liability company. In a sole proprietorship, there is no legal distinction between the individual and the business owner. While the owner is entitled to all profits from the business, he is also responsible for the business’ debts, liabilities, and losses. To explore this concept, consider the following sole proprietorship definition.
Definition of Sole Proprietorship
- A business owned by one person who has complete responsibility for its operation, and exclusive right to its proceeds.
17th century English
What is a Sole Proprietorship
A sole proprietorship is a business that is owned and operated by a single individual. When it comes to financial responsibility, the business does not have a separate existence from the owner, who may be held personally liable for business expenses.
Sole proprietorships may operate under the owner’s name, or under a fictitious name, though the laws governing the use of fictitious names vary by state. Even when a fictitious name is used, it does not create an entity separate from the business’ owner. Sole proprietorships are popular because of the simplicity of getting started.
Example of a Sole Proprietorship
Jane owns a beauty supply store in the town where she resides. Business has picked up for Jane so she decides to order several months’ worth of supplies in advance, at a cost of about $12,000, which is to be paid in monthly installments.
A couple of months after Jane purchased the large order of inventory, the mill in her town closed down, laying off more than 200 employees. Suddenly the town is experiencing an economic recession, and Jane can’t sell her products quickly enough to make her payments.
In this example of a sole proprietorship of the business, Jane is personally liable for the debt. This means that the supply company, and any other creditors, can file a civil lawsuit against Jane and go after her business assets, as well as her personal property, including her home.
Characteristics of a Sole Proprietorship
When an individual creates a sole proprietorship, he owns and controls all aspects of the business. Even if the owner hires employees, he still personally has full legal responsibility, which is one characteristic of a sole proprietorship that sets it apart from other business types. Other characteristics of a sole proprietorship include:
- Ease of startup – no charter is required, no registration with the secretary of state, and no EIN required. A sole proprietorship can be started in minutes, often with minimal cost.
- Liability – The owner of a sole proprietorship bears personal responsibility for the business, being financially responsible for the business’ expenses and debts, and receiving all of its profits. It may be difficult to obtain financing, as credit for such a business is based on the sole proprietor’s personal credit score.
- Continuity – A sole proprietorship lasts as long as the owner wishes. Upon death, the sole proprietorship ceases to exist.
- Transferability – A sole proprietor can freely transfer his business by selling his assets.
- Taxes – A sole proprietor is not required to have an EIN, or to file separate business taxes. Most sole proprietorships are required to report their business activities on IRS Schedule C: Profit or Loss from Business.
How to Start a Sole Proprietorship
An individual considering starting a business may wonder how to start a sole proprietorship. Unlike limited liability companies or corporations, a sole proprietorship does not have to be registered with the state. In fact, starting a sole proprietorship is so easy, many people have such a business without even realizing it. For instance, a freelance graphic artist working from home technically owns a sole proprietorship.
There are certainly steps anyone can take to get their business gets off on the right foot. Proper preparation helps avoid problems, minimize taxes and other expenses, and increase profits. Recommended steps to start a sole proprietorship include:
Write a Business Plan
The first major step to get organized is to create a business plan. This serves as an outline of the steps that need to be taken to start and grow the business, and keeps the new business owner focused on the business.
Choose a Name
The name of any business is one of the most important decisions a new owner can make. The business name should describe the purpose of the business, while being attention-grabbing and memorable. The owner may use his name as the business’ name, such as “Bob’s Computer Repair,” or the business name can be completely fictitious, such as “A+ Computer Repair.”
After choosing a name, it is important to make sure the name is not already being used. This can be done by conducting an internet search. Additionally, most businesses must be registered with the city or county in which they operate. Before issuing a business license, the clerk will conduct a search for the business name requested. Freelancers and others using their name as their business name are not required to register their business name, but they may still be required to obtain a business license.
In many jurisdictions, the use of a fictitious business name, also referred to as a “DBA,” or “doing business as,” requires additional steps, such as publishing the opening of the new business, including the business name, for a certain period of time. The requirements may be obtained by contacting the county or city clerk responsible for issuing business licenses.
Example of Sole Proprietorship Naming
Marcos wishes to start his own landscaping business. After obtaining the equipment he will need, he decides to name his business “A-1 Landscaping,” which will help ensure the business is listed at the top of the Yellow Pages listings.
When Marcos goes to the county clerk to request a business license, he is told that the name he has chosen is already taken. Marcos must choose another business name, and once he confirms the new name, “Fast & Serious Landscaping,” is not in use, he must list his new DBA in the local classified ads for three days.
If, in this example of sole proprietorship naming, Marcos had named his business “Marcos’ Lawn Care,” he would not have to register the business name, or pay to have it listed in the classified section of the local paper. Marcos would, however, have to obtain a business license.
Separate Personal and Business Finances
If a sole proprietorship runs into financial problems, the business’ creditors can try to recoup their money by attaching the owner’s personal bank accounts or other assets, including his home. Although, in this situation, there is no distinction between the business and owner, it is import for the business owner to maintain good recordkeeping practices. This begins by maintain separate personal and business finances.
Creating a degree of separation requires:
- Creating a business bank account for depositing business income, and paying business expenses
- Obtaining a business credit card to be used only for business expenses
- Use computer software or actual accounting books to record any and all business transactions
Keeping business records and finances separate from personal activities is essential when tax time rolls around. While sole proprietors are not required to file a separate business tax return, they are required to report their business activities on a separate schedule to their personal tax return.
Sole proprietors can use their personal Social Security numbers to identify their businesses, if they have no employees. Those with employees, or who simply prefer to create an additional layer of separation, obtain an Employer Identification Number (“EIN”), sometimes referred to as a Tax Identification Number (“TIN”) to track business dealings.
EINs are easily obtained on the Internal Revenue Service website. In most cases, the application takes only minutes to complete, and the EIN is assigned at the end of the session, so the business owner can get started using it right away.
People who are self-employed do not have the advantage of having taxes withheld from their paychecks to cover their tax obligations at the end of the year. Many sole proprietors pay self-employment taxes each quarter, as estimated tax payments. The amount is based on how much money the business is expected to make for that tax year, and the payments basically set aside money to avoid having to pay a large amount to the IRS at tax time.
Any excess self-employment taxes can be rolled over to the following year, or refunded. The IRS offers a great deal of helpful information for self-employed individuals online at their Self-Employed Individuals Tax Center.
Pros to Setting Up a Sole Proprietorship
There are many pros to setting up a sole proprietorship, the greatest of which is that it is the easiest and least expensive business type to set up. A sole proprietorship is not actually a legal business entity. The term simply describes a person who owns a business, and is personally responsible for its operation, as well as its debts. There are no legal costs, as it is not necessary to complete all of the forms required by the Secretary of State for other business entities, such as corporations.
A sole proprietor is in complete control of his business operations, without having to consult with another person to make decisions for, or to make changes to, the business. Finally, tax rates for sole proprietorships are often lower than those for other business types.
Cons to Setting Up a Sole Proprietorship
There are certainly cons to setting up a sole proprietorship, the first of which is that the owner is personally liable for all of the business’ debts and obligations. While it is easy to understand that the owner’s personal bank accounts may be responsible for paying business debts in the event the business fails, there is another very important consideration: liability for negligence or accidents.
Amelia opens a tea shop and reading room. Customers find a broad selection of teas and other beverages, and often gather in the comfortable sitting groups to chat, surf the web, and relax. One day, John, an employee at Amelia’s Tea Shoppe, notices a puddle near one of the settees, but becomes distracted before he can clean it up.
Customer Suzy slips in the puddle and falls, striking her head on the arm of a chair. The Tea Shoppe will likely be responsible for paying Suzy’s medical bills, but if Suzy sues the business for negligence, she can also sue Amelia personally, or seek to collect her judgment from Amelia’s personal assets.
Another disadvantage of a sole proprietorship is the challenge of raising money to fund the business startup. Because the business cannot sell stock, and obtaining credit would depend on Amelia’s personal credit score, obtaining much-needed capital may be difficult.
Challenge to Liability of Sole Proprietorship
In 1998, an employee of ABC Towing in Alaska, poured gasoline on the ground. The state’s laws regarding pollution are very strict, but organizations are generally held to a stricter standard than individuals. The state of Alaska filed criminal charges against both ABC Towing, which was a sole proprietorship owned by Rodney Lewis, and the employee who poured the gasoline on the ground.
The law holds “organizations” responsible for the acts of its principals or employees. Otherwise, an individual can only be held responsible for the acts of another if he asked the other party to engage in the illegal act, or he participated with the other party in the act. The prosecution made no claim that Lewis had instructed the employee to discharge the gas illegally, or that he had helped cover it up. It instead argued that ABC Towing, and therefore its owner, is responsible for the acts of its employees.
It is true that the Alaskan criminal statute regarding criminal liability of organizations provides that an organization is legally accountable for an act considered a criminal offense, which is committed by an employee or other agent, if that act is within the agent’s scope of employment, and it was done on behalf of the organization.
The organization would be liable for the employee’s conduct was later approved, requested, or adopted by the organization. While the statute goes on to define the term “agent,” there is no specific definition of the term “organization.”
The charges levied against ABC Towing and its owner were based on the prosecution’s claim that the employee had been acting within the scope of his regular employment, and that he took the action on behalf of the company, whether he was asked to do it or not.
At trial, all of the parties agreed that the employee had violated Alaska’s anti-pollution statute, and that he had done it while acting within the scope of his job, but that Lewis had not instructed him to do it. A primary question, then, became whether ABC Towing could be considered an “organization” under Alaska state law.
ABC Towing and its owner, however, argued that it didn’t meet the legal definition of “organization,” and therefore Lewis should not be held liable for his employee’s illegal act. The defense pointed out that Alaska Statute Section 11.81.900 (b)(41) defines the term “organization” as:
“… a legal entity, including a corporation, company, association, firm, partnership, joint stock company, foundation, institution, government, society, union, club, church, or any other group of persons organized for any purpose.”
The attorney went on to argue that ABC Towing was not an organization, because it fell under the sole proprietorship category, as it was solely owned by Rodney Lewis. The judge agreed with the defense, and declared:
“[A] sole proprietorship is not a legal entity. [It] has no legal significance apart from its sole proprietor. It cannot incur debts, conduct business, sue or be sued, or incur or pay taxes apart from its sole proprietor. Legally, it makes no difference whether the business is named ABC Towing or Rodney E. Lewis. The accountability of ABC Towing is therefore no different from that of an individual․ This court finds that ABC Towing, a sole proprietorship, is not an organization within the meaning of AS 11.81.900(b)(39) and is therefore not legally accountable [for acts of its agents under] AS 11.16.130.”
The complaint was dismissed and the state appealed. Upon appeal, the state argued that a sole proprietorship becomes an organization when it hires employees to assist in the business. The appellate court disagreed with the defendant and affirmed the lower court’s ruling.
Related Legal Terms and Issues
- Appellate Court – A court having jurisdiction to review decisions of a trial-level or other lower court.
- Assets – Property or finances owned by an individual or entity, and regarded as having value.
- Civil Lawsuit – A lawsuit brought about in court when one person claims to have suffered a loss due to the actions of another person.
- Criminal Charge – A formal accusation by a prosecuting authority that an individual has committed a crime.
- Legal Entity – An individual, company, association, trust, or other organization that is legally recognized in the eyes of the law. A legal entity is able to enter into contracts, take on obligations, pay debts, be sued, and be held responsible for its actions.
- Liable – Responsible by law; to be held legally answerable for an act or omission.
- Plaintiff – A person who brings a legal action against another person or entity, such as in a civil lawsuit, or criminal proceedings.