Home > Encyclopedia of Business and Finance > Sole Proprietorship

A sole proprietorship is the simplest form of business ownership. Not surprisingly, the vast majority of small businesses begin their existence as sole proprietorships. A sole proprietorship has but one owner. That sole owner may engage in any form of legal business activity any time and anywhere. Other than the various local and state business licenses that every business must purchase regardless of type of ownership, no legal formalities are required to start or operate the business. The owner is responsible for securing and investing the funds for the business. These funds may come from the owner's existing or borrowed financial resources.

The Internal Revenue Service (IRS) permits one exception to the "one sole owner" rule. If the spouse of a married sole proprietor works for the firm but is not classified as either a partner or an independent contractor, the business may still considered to be a sole proprietorship and forgo having to submit a partnership income tax return. Also, the sole proprietorship can avoid self-employment taxes.

If the owner's true name is used, such as "John Smith Auto Repair," there is ordinarily no problem in selecting a name for the sole proprietorship. But care must be taken if a fictitious name is contemplated. The owner must register the name with the county to see whether the name duplicates that of another business. Even if it does not, the owner must submit a "doing business as (dba)" form to the county, or, in a few states, to the secretary of state.

ADVANTAGES

An owner of a sole proprietorship gets to keep all profits derived from the operation but must also bear all losses. The owner may even share any portion of the profits and losses with another person or persons.

The owner has the authority to make all the decisions relating to the business. Since there are no co-owners, there is no need to hold policy-meeting sessions or form any group similar to a board of directors. The owner, of course, must bear the responsibilities that accrue from the decisions made.

The owner may hire employees or work with independent consultants and still retain the sole proprietorship form of ownership. Even if these employees or independent consultants are requested to offer their opinions relating to the firm's business decisions, the opinions are considered to be only recommendations. The owner cannot abdicate any responsibility for the outcomes fostered by these recommendations.

DISADVANTAGES

Unlimited liability is the major disadvantage borne by the sole proprietorship. The owner is financially responsible for satisfying all business debts and/or losses suffered by the firm, even to the point of sacrificing his or her personal or other business interests to pay off any liabilities. For example, assume a lawsuit inflicts a debt of $190,000 on a sole proprietorship that is able to contribute only $85,000 toward settlement of the liability. Further assume that the proprietor owns a home, equipment, and other business investments totaling $365,000.

The following shows the picture of the owner's liability:

Total liability of the proprietorship $190,000

Capability of the proprietorship in settling the liability $85,000

Extent to which the owner's personal assets (totaling $365,000) must be used to settle the debt $105,000

Owners of sole proprietorships have severe potential liabilities from customers, competitors, lenders, employees, and even government. The cost of liability insurance or of defending against a lawsuit is beyond the financial capability of many business firms. For this reason, most individuals holding somewhat extensive personal assets do not ordinarily use the sole proprietorship form of ownership. Instead, an alternative form of ownership is often used, such as corporation or special forms of partnership, that eliminates the unlimited liability.

TERMINATION OF THE BUSINESS

A sole proprietorship legally terminates immediately upon the death of the owner. Even if a spouse, relative, or friend of the deceased owner assumes ownership and keeps the business operating under the same name, legally a new business enterprise has been formed. It is recommended that owners at least make a will, and preferably a revocable trust, to name the beneficiary of the owner's interest in the business.

A sole proprietorship also terminates if the ownership interest is sold to another person or group of persons, if the business is abandoned by the owner, or if the owner becomes personally bankrupt.

These potential risks of sudden termination place sole proprietorships at a serious disadvantage in attracting top-flight employees who may not to wish to tie their future to a business that may suddenly become inoperative.

INCOME TAXES

When filing an income tax return, no legal distinction exists between a person as a sole proprietor and an individual person. The sole proprietor's personal income tax return (Form 1040) must include calculation of the proprietorship's income tax as well as any income or loss that the owner incurs from any additional entity, such as an employee, investor, or the like.

If, for example, a taxpayer realizes net earnings of $65,000 from a sole proprietorship and $28,000 from investments, the IRS considers the total net income to be $93,000. But, on the other hand, if a sole proprietor suffers a net loss of $42,000 from the business and a $71,000 net income from investments, the IRS would consider the total income to be $29,000.

Sole proprietors use Schedule C of IRS Form 1040 to file their income tax return for the proprietorship section of their income. The details of Schedule C can get very involved; many sole proprietors require professional advice for this phase of their income tax report.

Where applicable, sole proprietors file Form 4562 to report depreciation and amortization, and Form 8829 to report business use of the owner's residence.

TYPES OF BUSINESS

Proprietorships engage in a wide variety of businesses. Using the major categories of the new North American Industry Classification System (NAICS), the types of business activity that small businesses (including sole proprietorships) are likely to be involved an as follows:

Accommodation, food services, and drinking places

Administrative and support and waste management remediation services

Agriculture, forestry, hunting, and fishing

Arts, entertainment, and recreation

Construction

Educational services

Health care and social assistance

Information

Manufacturing

Mining

Professional, scientific, and technical services

Real estate and rental and leasing

Religious, grant making, civic, professional, and similar organizations

Retail trade

Transportation and warehousing

Utilities

Wholesale trade

REQUISITES FOR SUCCESS

Success does not come easily for small business enterprises. To achieve success, authorities have recommended a number of characteristics and activities.

Successful sole proprietors should be strong physically and emotionally. It is very important that they be in good health. Attitudes of business owners are critical; they should possess a positive outlook and enthusiasm. They should be receptive to advice. They need to work very hard, particularly during the first several years.

Sole proprietors should possess considerable business experience, especially in the product or service lines offered by their business. Having an appropriate and sufficient education is very valuable. Other capabilities could be added, such as getting along with different kinds of people, having the ability to plan and organize, knowing how to arrive at and carry out decisions, and being a self-starter.

It is often recommended that sole proprietors select a type of business in which they have both skills and interest. The geographic location should be investigated thoroughly regarding its growth potential. And it may be important for a sole proprietor to consider having a partner.

In setting up a business, a new sole proprietor should do the following:

• Learn as much as possible about the product or service being offered for sale
• Make sure there is enough capital available to meet necessary equipment and building needs as well as to pay for the first year's operating expenses
• Determine the amount to be invested and find the sources of any necessary loans
• Secure the assistance of an accountant, attorney, insurance agent, and banker
• Become familiar with licenses required, zoning laws, and other regulations
• Determine the most desirable types of employees; take steps to locate them and interest them in applying; and learn how to handle all withholdings
• Learn the fundamentals of advertising and, if appropriate, store layout
• Make sure that the appropriate forms of accounting and record keeping are established, and see that balance sheets and income statements are prepared
• Learn all aspects of marketing, including the principles of determining market share

In addition, the new sole proprietor should write a thorough business plan. The Small Business Administration provides the following outline for the elements of a business plan:

• I. Cover sheet
• II. Statement of purpose
• III. Table of contents
• A. The Business
• 1. Description of business
• 2. Marketing
• 3. Competition
• 4. Operating procedures
• 5. Personnel
• 6. Business insurance
• 7. Financial data
• B. Financial data
• 1. Loan applications
• 2. Capital equipment and supply list
• 3. Balance sheet
• 4. Break-even analysis
• 5. Pro-forma income projections (profit and loss statements)
• Three-year summary
• Detail by month, first year
• Detail by quarters, second and third years
• Assumptions upon which projections were based
• 6. Pro-forma cash flow
• C. Supporting documents
• Tax returns of principals for last three years
• Personal financial statement
• Copy of franchise contract and all supporting documents if appropriate
• D. Copy of proposed lease or purchase agreement for building space
• Copy of licenses and other legal documents
• Copy of resumes of all principals
• Copies of letters of intent from suppliers, and so forth

SEEKING ADVICE

Sole proprietors find it very helpful to consult with other sole proprietors who successfully operate a business. Many also seek the advice of the Small Business Administration (SBA), an independent government agency.

Organized by Congress in 1953, the SBA now has offices in nearly every major city in the United States. Its toll-free telephone number is 1-800-8-ASK-SBA. Among many other services, SBA sponsors the Service Corps of Retired Executives (SCORE), Business Information Centers (BICS), and Small Business Development Centers (SBDC).