Sole Proprietorship (West's Encyclopedia of American Law)
A form of business in which one person owns all the assets of the business, in contrast to a partnership or a corporation.
A person who does business for himself is engaged in the operation of a sole proprietorship. Anyone who does business without formally creating a business organization is a sole proprietor. Many small businesses operate as sole proprietorships. Professionals, consultants, and other service businesses that require minimum amounts of capital often operate this way.
A sole proprietorship is not a separate legal entity, like a partnership or a corporation. No legal formalities are necessary to create a sole proprietorship, other than appropriate licensing to conduct business and registration of a business name if it differs from that of the sole proprietor. Because a sole proprietorship is not a separate legal entity, it is not itself a taxable entity. The sole proprietor must report income and expenses from the business on Schedule C of her or his personal federal income tax return.
A major concern for persons organizing a business enterprise is limiting the extent to which their personal assets, unrelated to the business itself, are subject to claims of business creditors. A sole proprietorship gives the least protection because the personal liability of the sole proprietor is generally unlimited. Both the business assets and the...
(The entire section is 416 words.)
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Sole Proprietorship (Encyclopedia of Business and Finance)
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.
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.
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.
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
Health care and social assistance
Professional, scientific, and technical services
Real estate and rental and leasing
Religious, grant making, civic, professional, and similar organizations
Transportation and warehousing
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
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).
Bustner, Irving. (1993). Start and Run Your Own Profitable Service Business. Englewood Cliffs, NJ: Prentice-Hall.
Davidson, Robert L., III. (1991). The Small Business Partnership Kit. New York: Wiley.
Diamond, Michael, and Williams, Julie. (1996). How to Incorporate, A Handbook for Entrepreneurs and Professionals, 3d ed. New York: Wiley.
The Small Business Administration. www.sbaonline.sba.gov.
Sole Proprietorship (Encyclopedia of Small Business)
The sole proprietorship is both the simplest and most common type of business operating in the United States today. Most businesses that are owned and operated by one person take this form; in fact, small business owners who have sole ownership of their enterprises are automatically categorized under this business type if they do not take steps to legally establish themselves as another type of business.
ADVANTAGES OF SOLE PROPRIETORSHIP
Many aspects of sole proprietorship are attractive to entrepreneurs. Primary reasons why small business owners choose to operate in this fashion include:
- Sole proprietors enjoy a great deal of independence and autonomy. As Janet Attard remarked in The Home Office and Small Business Answer Book, the sole proprietor makes all the decisions: "You alone can decide what to sell and how to sell it, when to expand the business and when to pull back, when to look for financing, when to buy new equipment, when and how long to work, and when to take the day offithout having to justify your decision to anyone." In some instances, sole proprietorships can benefit enormously as a result of this streamlined management structure. An entrepreneur who keeps abreast of business trends, community events, and other factors that can impact on a company's fortunes may, in some cases, be able to adjust to changing business realities far more quickly than a partnership or corporation, where multiple owners and/or managers need to reach agreement on appropriate responses to changes in their business environment.
- Figuring taxes is fairly straightforward. Unlike other business types, sole proprietorships do not have to file separate income tax returns. In addition, FICA (Federal Insurance Contributions Act) taxes for such businesses are less than they are for partnerships or other legal operating forms.
- Accounting is a relatively simple affair, although small business experts encourage the owners of even the most modest business ventures to establish separate bank accounts and record keeping practices for their enterprise.
- Business operations, too, are generally simpler in a sole proprietorship. Other forms of business often have to contend with more cumbersome or time-consuming regulatory requirements in conducting or reporting on their operations.
- Start-up costs are often modest. This is due in part to the fact that entrepreneurs who intend to establish sole proprietorships do not need to secure the services of an attorney to prepare documents required by state or federal agencies, since none are needed.
- Business losses can be used to offset other income on personal tax returns. Conversely, business profits do not have to be shared with any other owners.
- Sole proprietors are not forbidden from securing and building a work force. Indeed, many businesses that qualify as sole proprietorships (delicatessens, landscaping firms, canoe liveries, flower shops, etc.) have employees.
DISADVANTAGES OF SOLE PROPRIETORSHIP
But while business owners who choose sole proprietorship understandably enjoy their autonomy and their freedom from the paperwork that can be considerable in other, more complicated, business types, they still need to consider the following drawbacks in the areas of liability and business financing.
"In a sole proprietorship," warned Jocelyn West Brittin in Selecting the Legal Structure for Your Business, "the business and the owner are one and the same. There is no separate legal entity and thus no separate legal 'person.' This means that as a sole proprietor you will have unlimited personal responsibility for your business's liabilities. For example, if your business cannot pay for its supplies, the suppliers can sue you individually. The business creditors can go against both the business's assets, including your bank account, car or house The reverse is also true; i.e., your personal creditors can make claims against your business's assets." She does note that some states offer sole proprietors protection of their personal assets from business risks through legal designations that involve the owner's spouse and/or children, but such arrangements are complex and should not be entered into without first consulting with an attorney. Business owners can also elect to purchase liability insurance for protection from lawsuits and other threats. In addition to general liability insurance, producers or sellers of goods may also want to consider securing product liability insurance. The cost of such insurance varies considerably depending on the type of business under consideration.
Raising capital for a sole proprietorship can be quite difficult as well (though many businesses that operate as sole proprietorships are of modest size and thus are not impacted by this reality). Many lenders are reluctant to provide financing to owners of sole proprietorshipsn large part because of fears about their ability to recover the funds should the owner die or become disablednd even those who make such loans require borrowers to provide personal guaranties on the loan. Sole proprietors who consent to such arrangements are in effect pledging their personal assets as collateral on the loan. Small business advisors counsel clients who are considering these stipulations to proceed cautiously. If a potential lender is taking extra measures to protect itself from default, it may be an indication that the prospective borrower's business plan is viewedegitimately, perhapss flawed or risky. In addition, even well-conceived businesses sometimes fail as a result of circumstances beyond the owner's control. An entrepreneur might, for example, establish a store that is enormously successful for its first few years of operation, only to see it suffer a dramatic downturn in performance with the arrival in town of a much larger competitor that provides its customers with a wider variety of services and goods. Banks and other lending institutions are aware that such scenarios occur, and they plan accordingly.
CONTINUITY AND TRANSFERABILITY Unlike other businesses that can be passed down from generation to generation or continue to exist long after the passage of its original board of directors, sole proprietorships have a limited life. As Brittin wrote, "a sole proprietorship can exist as long as its owner is alive and desires to continue the business. When the owner dies, the sole proprietorship no longer exists. The assets and liabilities of the business become part of the owner's estate."
A sole proprietor is free to sell all or a portion of his or her business to a buyer, but any transaction that transfers ownership or turns the business into one with two or more owners puts an end to the sole proprietorship that had been in existence.
STARTING A SOLE PROPRIETORSHIP
Sole proprietorships often operate under the name of the owner of the business, but this is not a requirement. If the owner decides to select a fictitious name, however, he or she may be required to file a certificate explaining the arrangement in the region in which he or she is operating the business in question (this requirement also gives the sole proprietor legal protection, for it serves to protect them from other persons who might otherwise use the name for their own business enterprises). In addition, many states forbid business establishments from using words like "incorporated," "Co.," or "Inc." unless they actually qualify as corporations. Some cities and counties also require sole proprietorships to secure a business license before launching their business. Owners who subsequently change their business location or add new locations to their operation are often required to obtain new business licenses for those sites as well.
Many sole proprietorships also will need to obtain federal and state payroll ID numbers. These numbers are required for any businesses that will have employees or will do business with establishments that have employees. Finally, owners of sole proprietorships will, like all other business owners, have to obtain the appropriate operating licenses and certificates, if any, for the area in which they will be conducting business. Business licenses and zoning permits are among the types of licenses that are sometimes required. Once these few minor licensing issues have been addressed, the sole proprietor is free to conduct business.
Once a sole proprietorship has been established and proven viable, many business owners eventually choose to incorporate. Incorporation is both more expensive and more time-consuming than sole proprietorship, but it also affords the business owner considerably more legal protection from lawsuits and other liabilities than does sole proprietorship, and it also makes it easier to secure financing for business expansion.
Attard, Janet. The Home Office and Small Business Answer Book. Holt, 1993.
Brittin, Jocelyn West. Selecting the Legal Structure for Your Business. Small Business Administration, n.a.
The Entrepreneur Magazine Small Business Advisor. Wiley, 1995.
Fraser, Jill Andresky. "Perfect Form." Inc. December 1997.
Hawkins, Carole. "Beyond the Sole Proprietorship." Home Office Computing. March 2001.
How to Set Up Your Own Small Business. American Institute of Small Business, 1990.
Schneeman, Angela. The Law of Corporations, Partnerships, and Sole Proprietorships. West Legal Studies, 1996.
Sitarz, Daniel. Sole Proprietorship: Small Business Start-Up Kit. Nova, 2000.
SEE ALSO: Incorporation; Partnership