How a Sole Proprietorship is Different from Other Business Structures

Starting a new business is always exciting, no matter what the industry. A quick Google search of best steps for entrepreneurs will always include selecting the best type of business entity, but for many this is a no-brainer: They’re going to own and operate their business on their own, and therefore their business will be a sole proprietorship.

If that describes you, you’re certainly not alone. While there are an estimated 7.4 million businesses set up as partnerships or S corporations and another 1.7 million that are incorporated, sole proprietorships represent the lion’s share of American businesses. The Tax Foundation estimates that the United States boasts approximately 23 million sole proprietorships today. But despite this enormous representation, many people have no idea what running a sole proprietorship entails or what its benefits and risks are as compared to the other types of entities. We will run through some of the most important issues and elements that distinguish this particular type of business operation.

The Basics of Sole Proprietorship

Before contrasting the various aspects of sole proprietorship to those of corporations, limited liability corporations, and partnerships, it is important to understand the most elemental and consistent principle of this type of business: A sole proprietorship is not distinguishable from its owner. There is no need for it to be registered under a separate name, as its profits and losses, debts and legal liabilities flow through to its owner.

Though sole proprietors are by definition self-employed — they are their own boss — that does not mean that all self-employed individuals are necessarily sole proprietors. A member of a limited liability company or a partner in a partnership may be self-employed but would not qualify as a sole proprietor. As for shareholders in a corporation, they are neither self-employed nor sole proprietors.

Distinguishing Sole Proprietorships from Other Types of Business Entities  

• Ease of opening – When you want to start a sole proprietorship, there are no forms to fill out or file and no permissions to be sought. It is the easiest type of business to open, as it requires little more than having a bank account and – if appropriate and required by your locality – filing a fictitious name statement.
  
  
• Simple taxation – Just as there’s no need to file paperwork to open a sole proprietorship, the entity requires no special tax forms. The business’ profits are viewed as personal income and are reported using Schedule C along with the owner’s personal tax return at their calculated personal rate. Though this can be true for a single-member LLC, if a business is operated as a multi-member LLC then its taxes will need to be divided between the various partners, each of whom will report its income and pay its taxes as pass-through, personal income. As an entity, a corporation will pay its taxes at the corporate rate while its shareholders will pay personal income tax on any distributions that they receive and any dividends that they are paid.
  
  
• Number of owners – Where a partnership will always have more than one partner and most corporations have more than one shareholder, a sole proprietorship has only one owner. It is the simplest type of business entity, as it issues no stock and requires no division of member shares (as is the case with a multi-member LLC) or assignment of percentages (as is the case with a partnership). In some cases, a limited liability company may have just one owner.
  
  There is one other type of business that should be noted, and that is a Qualified Joint Venture, or QJV. Many couples who operate a business together elect to file their taxes as this type of entity, as it allows each of them to report their share of the net business income on a Schedule C in the same way that sole proprietors do. In order to qualify as a QJV there are certain criteria that must be met, and many of its requirements preclude LLCs from taking advantage of this process.

• Complete control – One of the top reasons for choosing to run your own business as a sole proprietorship is the total control it provides. With no other owner, partners or shareholders to voice an opinion, every decision about how the business is run is entirely under your control. By contrast, shareholders in a corporation must leave decisions to the board of directors, and even if they hold a significant enough number of shares to have a controlling interest the shareholder has only limited control. Similarly, being a partner or a member of a multi-member LLC means that you are restricted to the amount of control that is spelled out in the original partnership agreement or LLC operation agreement.
  
  
• Legal liability – One of the most critical differences between a sole proprietor and other types of entities has to do with legal liability. Should a customer suffer a loss as a result of negligence or fraud on the part of a business, it is able to pursue legal action against the business. Since a sole proprietor is legally indistinguishable from the business that they run, the same is true of the assets that can be sought in legal action. By contrast, legal action filed against an owner of a limited liability corporation or other corporate entity is limited to the individual’s investment within the business.
  
  
• Business continuity – One of the earliest issues that a partnership, LLC, or corporation needs to address is business continuity and what steps are to be taken to keep the business running in the event that something happens to one or more of the principals. In a sole proprietorship the owner is the business, so when something happens to the owner, the business is essentially considered to have come to an end.

The best structure for your business will depend on many factors and is a decision that should not be made lightly. It is always a good idea to sit down with a business attorney and a tax professional to make certain that you have all the pertinent data you need.

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All Articles by Martinez & Shanken, PLLC