The Complete Guide to Starting a Sole Proprietorship
TLDR: A sole proprietorship is one of the simplest ways to start a business and often forms automatically when you begin operating on your own. It is easy to manage and has fewer formal requirements, but there is no legal separation between you and the business, which means your personal assets may be exposed to business liabilities. As your business grows or takes on more risk, forming an LLC can provide stronger liability protection and a more formal business structure.
Starting a sole proprietorship is one of the simplest ways to begin doing business. In many cases, there is no formal entity to create. In fact, if you start operating an unincorporated business by yourself, you may already be considered a sole proprietor.
That simplicity makes sole proprietorships attractive to freelancers, consultants, contractors, online sellers, and other new business owners. However, the structure also comes with an important tradeoff: there is generally no legal separation between you and your business.
Before starting a sole proprietorship, it helps to understand how they work, what steps you’ll need to take, and when forming an LLC may be a better choice.
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What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business owned by one individual. Unlike an LLC or corporation, it generally does not require you to file formation documents. Furthermore, the owner and business are not separate legal entities. This means the owner receives the business profits, but may also be personally responsible for its debts and obligations.
For a small side business with limited risk, general simplicity is a strong selling point. As the business grows, however, we’ve found that most owners consider forming an LLC to establish a separate legal entity and gain liability protection.
Sole Proprietorship vs. LLC
The biggest difference between a sole proprietorship and an LLC is legal separation. With a sole proprietorship, business liabilities can potentially become the owner's personal liabilities. An LLC creates a legal distinction between the company and its owner, which can help protect personal assets during litigation.
On the administrative side, a sole proprietorship usually has fewer formation requirements and lower initial costs. Meanwhile, an LLC requires a state filing and other ongoing state compliance obligations.
Taxes alone do not necessarily distinguish the two. A single-member LLC is generally treated as a disregarded entity for federal income tax purposes by default, meaning its business activity may still be reported similarly to a sole proprietorship.
Steps for Starting a Sole Proprietorship
Although you may not need to formally create a sole proprietorship, you’ll still have a few registration and operational requirements.
- Choose your business name. If you operate under a name other than your personal legal name, you may need to register a DBA. Requirements may vary by state.
- Check licenses and permits. Your city, county, state, and industry may require very specific business licenses or permits.
- Consider opening a business bank account. Although sole proprietors are generally not required to maintain a separate bank account, doing so can help distinguish business transactions from personal expenses. This simplifies your bookkeeping and helps maintain clear financial records.
Understanding Sole Proprietor Taxes
A sole proprietorship is generally subject to pass-through taxation. This means that owners generally report their business income as part of their personal tax return rather than filing a separate federal income tax return for the business. They are also generally responsible for paying self-employment taxes if their net earnings from self-employment are $400 or more (subject to applicable IRS rules and exceptions).
Obviously, tax requirements can vary based on income and location, so keeping accurate financial records is an important part of running a sole proprietorship.
When Should You Form an LLC Instead?
A sole proprietorship may appeal to entrepreneurs testing a low-risk business idea or earning occasional independent income because of its simplicity. An LLC may become more attractive when the business starts signing significant contracts, hiring workers, leasing property, accumulating valuable assets, or taking on greater financial or legal risk.
Nevertheless, some entrepreneurs choose to form an LLC from the beginning rather than transition later. If you are ready to establish a separate business entity, Harvard Business Services, Inc. can help you form a Delaware LLC and provide ongoing Delaware Registered Agent services to help keep your company in compliance.
FAQs
Do I need to register a sole proprietorship?
You generally do not form a sole proprietorship through a state filing. However, you may still need business licenses, permits, or a DBA depending on your location and business activities.
Is an LLC better than a sole proprietorship?
An LLC generally offers stronger personal liability protection because it creates a separate legal entity. A sole proprietorship is simpler, but the owner and business are not legally separate.
Can I change from a sole proprietorship to an LLC later?
Yes. Many entrepreneurs begin as sole proprietors and later form an LLC as the business grows. The transition may require forming the LLC, updating licenses and contracts, opening new financial accounts, and handling applicable tax registrations.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.