What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business that one person owns and manages. As the business and the owner are not legally separate, it is the simplest form of business structure. It is also known as individual entrepreneurship, sole trader, or simply proprietorship.
The business owner, also known as a proprietor or a trader, conducts business using their legal name. They may also choose to do business using another name by registering a trade name with their local authority.
This type of business is the easiest and cheapest form to start. For this reason, it is common among small businesses, freelancers, and other self-employed individuals.
A sole proprietorship begins and ends when the business owner decides, or upon their death.
A sole proprietorship may transform into another, more complex business structure if the business grows substantially.
- Sole proprietorships are the simplest form of business structure and are easy and cheap to start due to few government rules.
- Proprietors enjoy full control and profits from the business but incur unlimited legal liability personally.
- Sole proprietorships are limited by the amount of capital available, the ability to get outside assistance, and a potential shortfall of needed skills to be successful.
Advantages of Sole Proprietorships
1. The easiest and cheapest way to start a business
Though the process varies depending on the jurisdiction, establishing a sole proprietorship is generally an easy and inexpensive process, unlike forming a partnership or a corporation.
Compared to other business forms, there is very little paperwork a proprietor needs to file with their local authorities. As a result, proprietors do not have to wait long before they have permission to carry on a business.
The start-up fees are also low, in line with many government policies that encourage entrepreneurs to take risks and grow the economy by minimizing the friction of starting new businesses.
2. Few government rules and laws
There are very few government rules and regulations that are specific to proprietors. Sole proprietors must keep proper records, file, and pay taxes on the business income and other personal income sources.
Record keeping and tax filing obligations are generally no more complicated than maintaining records for individual tax filings. Due to the time and the effort, proprietors may wish to pay for specialized software and advisors to streamline the time spent on administration.
Government rules for larger enterprises and public companies, such as financial disclosure, require far more administration and do not apply to sole proprietorships.
3. Full management control
Proprietors control all aspects of their business, including production, sales, finance, personnel, etc. This degree of freedom is attractive to many entrepreneurs, as the venture’s success also means personal success.
To be successful, proprietors must be “good enough” at the various aspects of their business they have control over.
While some proprietors have employees and delegate some of their authority, they are ultimately accountable for all the decisions and acts of their business.
4. Flow-through of business profit
There is no legal separation between the owner and the business, so the owner gets 100% of the profits. Although all profits go to the owner, taxes are paid once, and proprietors pay taxes individually.
Proprietors must pay individual taxes on the income periodically, for example, as part of the annual individual tax filing. Tax payments may be more frequent, for example, quarterly, depending on local tax rules.
Making regular payments can help a proprietor keep their tax burden from becoming overwhelming and incurring tax penalties. Tax advisors can help proprietors estimate taxes so they can set aside enough of the profits to make mandatory government payments.
Disadvantages of Sole Proprietorships
1. Unlimited legal liability
There is no legal separation between the owner and the business. Similar to how all profits flow to the owner, all debts and obligations rest with the proprietor.
If the business cannot satisfy its obligations, creditors may pursue the proprietor’s personal assets in order to be repaid.
This accountability is clearly outlined within legal documents signed with lenders, sometimes called a promissory note. A proprietor does not need to provide a personal guarantee to their sole proprietorship, as the two are the same legal entity in the eyes of the law.
2. Limit to available capital
Owners put their own resources to bear when going into business for themselves. There are limits to their financial resources and the amount of credit they get when they seek out lending relationships.
Proprietors cannot sell shares, or interest, in their business to raise money.
Putting ideas into reality is risky and can be costly. Keeping a business going can be capital intensive. Some expenses must be incurred before revenue is generated. Any sales on credit, and any cash paid towards expenses, must be financed by working capital. Equipment and other long-use resources required for the business must be rented or financed.
If business requirements exceed the resources and financing available to proprietors, they will need to closely manage their working capital and potentially curtail the acquisition of fixed assets.
A fulsome business plan helps proprietors determine the capital necessary to start up, sustain, and grow the business.
3. Backup and succession
If the owner cannot or does not want to operate the business, it stops. An owner may have a family member or trusted employee who can briefly work in place of the owner in the case of illness or any temporary and unforeseen reason.
Business interruption insurance may cover expenses for longer-term issues, but these policies cannot complete the work that a proprietor has already taken on.
Without a separate legal identity, sole proprietorships cannot readily pass any intangible assets from one owner to another. Aside from equipment and fixed assets, the value of the business is inherently tied to the proprietor.
To make any sale attractive, a proprietor must find someone with comparable skills willing to purchase the goodwill the owner has built up. If they cannot find a buyer, the proprietor may pass the business on to a family member or a trusted employee if one exists.
4. Skills and experience
The proprietor must make “good enough” decisions in all business areas. If an owner does not have enough knowledge or skills, their decisions may be flawed. There is a finite amount of time to do things correctly or learn to do everything adequately.
It can be difficult for individuals to manage all aspects of their business properly. The owner can hire employees, outside help, or get professional advice on parts of the business process.
The owner’s ability to use their own time to earn greater profits to offset the cost of hiring help is a crucial consideration.
Employees, contractors, and other services may be too costly for such sole proprietorships. The owner’s time must be productive enough to pay for the cost of hiring others.