A sole proprietorship is a business entity owned and managed by one individual. The owner is called a sole proprietor. He or she does not pay separate income tax on the company. Instead, the owner reports all profits and losses on their individual tax return. The owner is not legally separate from the business, so is personally liable for all debts of the business.
What is a Sole Proprietorship?
The sole proprietorship is the simplest and most common form of business structure. Many businesses begin as sole proprietorships and graduate to more complex business forms as they develop.
A sole proprietorship simply refers to a person who owns the business and carries on the business as the sole owner. It is not a legal entity and there is no legal separation between the business and the owner. This is the distinguishing characteristic between it and an incorporated business or a partnership, which are both legal entities, separate from their owners.
As there is no legal separation, the owner will sign contracts in his or her own name and hold bank accounts in his or her own name.
Formation and Dissolution of a Sole Proprietorship
A sole proprietorship is easy to form. In some jurisdictions, it does not require any formal filing of documents or events. It is a status that arises automatically from the owner's business activity of buying and selling goods or services. In other jurisdictions, a sole proprietorship is created by registering the business name with the appropriate authority.
Equally, a sole proprietorship is easy to dissolve - it just involves the cancellation of the registered business with the appropriate authority, after:
- the owner concludes any ongoing contracts;
- sells the business stock;
- collects debts and pays his or her creditors; and
- notifies interested parties such as banks.
Taxation of a Sole Proprietorship
Taxation of a sole proprietorship is simple because the income earned by a sole proprietorship is the income earned by its owner. And because there is no corporate tax, profits from the business flow directly to the owner’s personal tax return.
There are some advantages to this tax liability. Firstly, the authorities tax the business profits at the sole proprietor's marginal tax rate. This is often lower than the corporate tax rate.Secondly, other income of the proprietor can offset business losses.
On the other hand, tax liabilities for sole proprietorships are not as flexible as they are for incorporated companies. This is because the owner must report all business income as regular income in the year in which it is earned. Incorporated companies have greater flexibility in how and when to pay the owners.
Liability of a Sole Proprietorship
Sole proprietors are personally liablefor all debts of the business. This means that if the business fails and incurs debts, the owner's assets (including his or her home and any other asset registered in his or her name) could be seized to discharge the debts and liabilities of the business.
In this crucial respect, a sole proprietorship is different from an incorporated business, limited company or partnership.For these latter entities, there is a legal separation between the business and its owners. This separation protects the personal assets of the owners from seizure to meet debt obligations or liabilities.
Advantages of Sole Proprietorship
The advantages of a sole proprietorship are:
- Owners can establish a sole proprietorship instantly, easily and inexpensively.
- Sole proprietorships carry little, if any, ongoing formalities.
- Owners may freely mix business and personal assets.
- With no imposed legal structure, owners get to organisethe business as they see fit.
- Expensesrelated to the cost of doing business are fully deductible from income tax. Likewise, travel, automobile and advertising expenses. A portion of an owner's home expenses are also tax deductible if the owner is operating a home-based business.
- Business losses can be deducted against other forms of income or carried forward or backward. So, sole proprietorships that lose money in the early years can deduct losses against personal income.
- Owners need not hold shareholder's meetings or take votes on management issues, unlike corporations.
The disadvantages of a sole proprietorship are:
- As already stated, owners are subject to unlimited personal liability for the debts, losses and liabilities of the business. This exposes the owner's personal assets to risk. Having sufficient business insuranceis, then, extremely important.
- Owners have greater difficulty raising capital. Unlike other business structures, they cannot raise equity financing from angel investors or venture capital. Nor can they raise equity by selling interests or shares in the business.
- Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.
- Sole proprietorships can be difficult to sell because the business is completely tied to the owner. Since there is no distinction between the assets of the owner and the assets of the business, obtaining a proper valuation of the business can be difficult. Customer loyalty resides with the original owner of the business and may not readily transfer to a new owner.
- Some businesses, government agencies, consulting groups, etc. will not deal with unincorporated businesses. This is because they view a sole proprietorship as not having the same level of legitimacy and professionalismas an incorporated business. Also, hiring a sole proprietor increases the risk of the tax authorities treating the person as an employee rather than an independent contractor.
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Disclaimer: This overview is for informational purposes only and cannot be counted as legal advice.