SOLE PROPRIETORSHIP

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. However, 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.

ADVANTAGES

An owner of a sole proprietorship gets to keep all profits derived from the operation. 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.

DISADVANTAGES

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 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 topflight employees who may not to wish to tie their future to a business that may suddenly become inoperative.

INCOME TAXES

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. However, 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, so 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 in are:

Accommodation, food services, and drinking places

Administrative and support and waste management remediation services

Agriculture, forestry, hunting, and fishing

Arts, entertainment, and recreation

Construction

Educational services

Health care and social assistance

Information

Manufacturing

Mining

Professional, scientific, and technical services

Real estate and rental and leasing

Religious, grant making, civic, professional, and similar organizations

Retail trade

Transportation and warehousing

Utilities

Wholesale trade

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:

• 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 an outline for the elements of a business plan (see Figure 1).

SEEKING ADVICE

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 has offices in nearly every major city in the United States. Its toll-free telephone number is 1-800-UASK-SBA. Among many other services, SBA sponsors the Service Corps of Retired Executives (SCORE), Business Information Centers (BICS), and Small Business Development Centers (SBDC).

bibliography

Bustner, Irving (1993). Start and Run Your Own Profitable Service Business. Englewood Cliffs, NJ: Prentice-Hall.

Davidson, Robert L. III (1993). The Small Business Partnership Kit. New York: Wiley.

Diamond, Michael, and Williams, Julie (2001). How to Incorporate: A Handbook for Entrepreneurs and Professionals (4th ed.). New York: Wiley.

United States Small Business Administration. Retrieved October 29, 2005, from www.sbaonline.sba.gov.

G. W. Maxwell

Sole Proprietorship

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. The essential feature of a sole proprietorship is that the law makes no distinction between the person, the sole proprietor, and the business. Virtually all of the legal and tax consequences associated with sole proprietorships flow from this basic fact.

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. The sole proprietor makes all the decisions. As a sole proprietor, you alone can decide what to sell and how to sell it, when to expand 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 off. 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

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 proprietorships—in large part because of fears about their ability to recover the funds should the owner die or become disabled—and 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 viewed—legitimately, perhaps—as 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.

see also Partnership; Incorporation; Organizational Structure

BIBLIOGRAPHY

Anderson, Brian L. "Benefit Issues Regarding Partnerships, S Corporations, and Sole Proprietorships." Jouranl of Pension Benefits. Spring 2004.

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, and Other Business Organizations. Thomson Delmar Learning, 2002.

Sitarz, Daniel. Sole Proprietorship: Small Business Start-Up Kit. Nova, 2000.

U.S. Small Business Administration. Brittin, Jocelyn West. Selecting the Legal Structure for Your Business. n.d.

                                Hillstrom, Northern Lights

                                 updated by Magee, ECDI

SOLE PROPRIETORSHIP

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 personal assets of the sole proprietor are subject to claims of the sole proprietorship's creditors. In addition, existing liabilities of the sole proprietor will not be extinguished upon the dissolution or sale of the sole proprietorship.

Unlike the managers of a corporation or a partnership, a sole proprietor has total flexibility in managing and controlling the business. The organizational expenses and level of formality in a sole proprietorship are minimal as compared with those of other business organizations. However, because a sole proprietorship is not a separate legal entity, it terminates when the sole proprietor becomes disabled, retires, or dies. As a result, a sole proprietorship lacks business continuity and does not have a perpetual existence as does a corporation.

For working capital, a sole proprietorship is generally limited to the individual funds of the sole proprietor, along with any loans from outsiders willing to provide extra capital. During her lifetime, a sole proprietor can sell or give away any asset because the business is not legally separate from the sole proprietor. At the death of the sole proprietor, the business is usually dissolved. The proprietor's estate, however, can sell the assets or continue the business.

cross-references

S Corporation.

SOLE PROPRIETORSHIP

A sole proprietorship is a form of business organization owned and operated by one person. A proprietorship requires no formal legal process except appropriate licensing, if necessary, to begin providing goods or services for profit. The proprietor owns all assets and liabilities of the business. Although sole proprietorships are not limited in the number of workers employed, they generally are small in size. Sole proprietorships are a common form of organization with professionals, consultants, farmers, service businesses, small retail firms, and small local restaurants. The owner keeps records of revenues and costs that he must report on Schedule C of the personal federal income tax return.

Organizing a businesses as a sole proprietorship offers several advantages. In addition to their ease of formation, proprietorships afford the owner total flexibility and freedom in decision-making, management, and control since consultation with others is not required. The owner may retain all business profits as income, a strong incentive for doing well.

Economic disadvantages include the ability to raise capital. Most sole proprietors have limited personal financial resources, rarely sufficient for long term expansion. Specialization is also problematic. The proprietor may have an excellent talent or skill to start the business, but later must provide marketing and financial expertise that he may not possess. Sole proprietorships have limited life. If the owner dies or wants to quit, legally the business itself ceases to exist. Lastly, the largest risk in a sole proprietorship is unlimited liability. The owner is personally responsible for all the liabilities or debts of the business. If the business does poorly, both the firm's assets and the owner's personal assets may be taken to satisfy creditors.

Through the 1980s and 1990s, the percentage of total firms in the United States organized under sole proprietorships and their total sales remained relatively constant. In 1993approximately 75 percent of all firms were sole proprietorships, representing almost 16 million businesses. However, they accounted for less than six percent of total sales, or about $757 billion.