What is Sole Proprietorship? Advantages and Disadvantages

What is a sole proprietorship?

A sole proprietorship also known as a one-man business is a business that does not legally have a separate existence from its owner. Income and losses are on the individual tax return. It is an unincorporated business that has a single owner who pays personal income tax on profits he earned from the business.

This form of business is very easy to establish due to a lack of government regulation, this makes it common with small business owners, individual self-contractors, and consultants. Many sole proprietors do business with their names because creating a separate business name becomes unnecessary

A lot of sole proprietorships end up changing into a limited liability company (LLC) in line with the company’s expansion. The business owner of a sole proprietorship cannot exempt himself from the liabilities that the entity incurs.

The business entity is different from limited liability companies (LLC), corporations, or limited liability partnerships. There is no separate legal entity created.

For example, the debts of the business are the debts of the owner. The profits of the business are however the profits of the owner because all profits flow directly to the business owner.

Entrepreneurs begin a business as an entity that has unlimited liability, but as the business grows, they usually transit to a limited liability entity. Such entities include limited liability companies, limited liability partnerships, or corporations.

Who is a sole proprietorship?

The term Sole Proprietorsimply refers to a person who owns a business and is personally liable for its debts.

This popular form of business is popular because of its simplicity, ease of setup, and nominal cost. A sole proprietor only needs to register his name and secure local licenses, then he is good to go. A noticeable disadvantage of sole proprietorship however is the fact that its owner remains liable for all the debts of the business. If the entity runs into financial trouble, creditors are bound to charge the business owners to court. If these lawsuits are successful, the owner will be compelled to pay the business debts with his own money.

Business owner under sole proprietorship typically signs contracts with his own name. This is because the owner does not have a separate identity under the law. He will have his customers write cheques in the owner’s name even when the business uses a fictitious name.

Sole proprietors can, and they usually blend their personal and business property, and funds. This is something that limited liability companies and corporations cannot do. Sole proprietorships usually have their bank accounts in the owner’s name. They do not need to carry out formalities like elections and meetings that are usually associated with more complex business entities.

A sole proprietorship business can sue, and be sued using the name of the business owner. Because the business is not a separate entity from its owner, its taxation is quite simple. The income the business earns is the income the business owner earns.

Every sole proprietor must also file a Schedule SE with Form 1040. He uses Schedule SE to calculate the amount of self-employment tax he owes. Also, he does not need to pay unemployment tax on himself, though it is mandatory to pay unemployment tax on every employee of the business. The sole proprietor will not enjoy unemployment benefits if the business suffers.

Characteristics of a sole proprietorship (Features)

Single ownership

An individual wholly owns a sole proprietorship, he provides the total capital from his own wealth or borrowed funds. In other words, he runs the business exclusively all by himself. He invests his own capital and has full control over the entire business. He bears all the risks or losses and enjoys all the profits.

One-man control

The sole proprietor makes all the decisions that pertain to the business all alone, he must not consult anybody before making his decisions. Both ownership and management are vested in one person. There are cases whereby the owner will employ some persons to assist him, but the ultimate control belongs to him.

He manages the entire business by himself, he as well prepares plans and executes them under his own control and supervision. The owner has the authority to manage and control his entity.

No legal entity

A sole proprietorship has does not have a legal identity separate from that of its owner. The law does not make any difference between the owner and his business. Both business and its owner exist together. The business dies or dissolves if the owner dies or becomes insolvent. Both the business and the proprietor are one and the same.

Unlimited liability

Sole trade business is faced with unlimited liability, the proprietor is liable for every debt in the business. In cases whereby the assets are not sufficient to meet his debts, the sole proprietor can attach his personal property. In other words, his private properties are liable for the business obligations. He bears all the losses that arise from the business.

No profit-sharing

The sole proprietor alone is entitled to every profit and loss of the business. He bears the entire risk and there is no one to share the profits or losses.

Small size

Usually, it is a small-scale operation that the owner carries out in his business. He can arrange limited funds and managerial ability and has a limited area of operations.

No legal formalities

The sole proprietor does not require any legal formality to start, manage, and dissolve the business. In other words, he does not need to meet any legal requirements. He may engage in any business unless there is a requirement for a license under law.

For example, if he wants to open a cloth shop or a grocery store, he will do it without obtaining any license but if he wants to open a restaurant, he will need to obtain a license first.

Secrecy

Types of a sole proprietorship

Self-Employed Business Owner

This is someone that conducts trade or business with the aim of making a profit. They may conduct business as a part-time venture or on a full-time basis. Usually, there is no contractual relationship between a self-employed sole proprietor and his clients/customers.

Examples include an individual who runs a small retail shop with few or no employees, or home services such as a painter or a roofer. In the internet age, an individual who buys and sells merchandise online is also a self-employed sole proprietor

Independent Contractor

Though an independent contractor is also a self-employed sole proprietor, his role looks more closely like that of an employee. An employer hires him to perform a specific task but they do not withhold taxes from his pay. He does not receive benefits like unemployment or insurance benefits.

The independent contractor has the right to accept or decline assignments, unlike an employee. A distinct feature an individual contractor has from an employee is the amount of control an employer has with regard to the work process.

For example, a writer working as an independent contractor receives his payment for the final work without taking into account the efforts involved in creating it.

Franchise

Under this, we can also refer to the sole proprietor as a franchisee. The franchisee pays a fee to the franchisor in exchange for the right to use the brand of the company. The franchisee has the obligation to follow a predetermined business model that controls areas such as operations, marketing, pricing, and the ability to expand. It is also mandatory for the franchisee to pay the franchisor royalties. These royalties are a percentage of the franchise unit’s gross sales.

A franchise tends to be a good favorable choice for the sole proprietor who already has business experience. The franchisor makes provisions for a successful business model as well as marketing and operational support.

Examples of a sole proprietorship

Usually, most small businesses start as sole proprietorships but end up graduating into different legal entities. As time goes on, the company grows.

For example, in 2005, Kate Schade started her entity, Kate’s Real Food, as a sole proprietor. The company created and sold energy bars. It began as a local vendor in Schade’s hometown of Victor, Idaho. The sole proprietorship sold its energy bars at local farmer’s markets, it expanded to sell online and to a few accounts in Jackson, Idaho. Since 2005, Kate’s Real Food has grown to supply accounts across the country. She graduated her business from a sole proprietorship to a corporation to take on investments and expand, which is a natural step for a growing business.

Other examples include salon owners, small shop owners, a mini waste recycling business, a water factory, and catering services.

Advantages of a sole proprietorship

Quicker Tax Preparation

It is generally easier for sole proprietors to file their taxes than for corporations to do the same. Simply file an individual income tax return (IRS Form 1040), including one’s business profits and losses incurred. We consider one’s individual and business income are considered the same and because of that, self-employed tax implications will apply.

Lower Start-up Costs and Easy Formation

Limited capital makes it impossible for many to set up large businesses and corporations. The costs of setting up and operating a corporation usually involve higher set-up fees and special forms. For a one-man business, it does not require a large amount of capital.

The sole proprietorship is the only form of business that is easy to form and simple to run or maintain. No requirement for legal formalities such as registration, etc. Sometimes he may obtain a license where required under government rules such as the opening of restaurants.

Ease of Money Handling

It is easier to handle money in this business than in other legal structures. A payroll setup is not a requirement here. A proprietor can decide to set up a separate bank account to keep his business funds separate and avoid conjoining personal and business activities.

Easy to Raise Finance

A sole proprietor is able to create goodwill for his business which helps him to establish his creditworthiness in the market. The fact that his liability is unlimited, the creditors can have a claim on his private property as well. The creditors feel more secure in giving out credit facilities to the sole proprietors.

Minimum Government Regulation

A sole proprietorship business has the least government rules and regulations guiding it. Such businesses do not have to fulfill licensing requirements within their state. They only need to pay attention to local regulations. The paperwork required in large corporations is much more than that of the sole proprietorship. They can operate easily and they do not pay corporate taxes, they only pay income and sales tax.

In essence, the government regulates the activities of sole traders at a minimal rate. There is hardly any other government law interference in his affairs. Also, the formation and dissolution are not subject to any form of government laws or regulations.

Sale and Inheritance

The sole proprietor can own the business for as long as he wants. He can cash in and sell the business when he decides to get out, he can even pass the business down to his successor which is a common practice.

Perfect Control

Because the sole proprietor himself is the master of the business, he maintains perfect control. He takes the decisions and also faces the consequences. Also, because the employees are very few, he maintains personal contact and creates teamwork with them. The favorable rule of capitalism is that “where the risk lies, control must lie”. There is usually no wastage because of his perfect control.

Flexibility in Operations

The sole owner of a business is in a position to effect any change he considers as necessary. There is a high level of flexibility in the policy-making of this type of organization.

Direct Motivation

The proprietor personally takes interest in the business because the profits belong to him. He is enthusiastic about running the business efficiently and economically because the success of a business is his own success as well as failure. The direct relationship that exists between his efforts and rewards acts as a great motivation for working hard and making a successful enterprise.

Maintenance of Secrecy

Secrecy/privacy is very important for the success of a small business. A sole trader is in a position to keep all his affairs to himself and maintain perfect secrecy in every matter that concerns the business.

Prompt Decision

The proprietor is to discover issues in the business and take decisions. He takes prompt decisions which contribute to promoting efficiency. As the owner of the business, he takes a prompt decision and takes advantage of the opportunity that shows up. Because no one challenges his decisions, he does not hesitate to take decisions.

Catering for Individual Tastes

As a sole proprietor, he is in the right position to have close contact with his customers and can meet up to the tastes of the customers. This gives him the ability to build goodwill which naturally causes the business to flourish. The individual owner flourishes in every enterprise where the personal element is important.

Social Advantages

A sole proprietor is rendering service to society and at the same time maintaining an independent way of living.

Below are some of the social advantages;

a) Independent Way of Life

This form of organization provides a way of life for those who take pride in or derive pleasure from ownership and control of what they have full control over. They obviously have an independent spirit and would not care to work under others. Such persons are in a position to utilize their capacity to the full extent and enjoy the freedom to act. Because he is both the master and manager, it gives him the highest possible satisfaction.

b) Generation of Social Values

It fetches the owner a high degree of self-determination, the enjoyment of purposeful work, the warmth of social contact, a well-integrated family, and respectable life. This develops the qualities of self-dependence, responsibilities, and initiative which are of great social importance and value.

c) Diffusion of Business Ownership

Under the sole proprietorship, a very large number of people must own and manage a large number of small business units. It allows the spreading of business ownership as against concentration of power in few hands offered by a joint-stock company.

Disadvantages of a sole proprietorship

In conclusion, the sole proprietorship registration is not as complex as that of the LLC and corporations. The first step is to pack a name for your business. Secondly, make sure that no legal entity has taken the name of your business. Register your business with your name, home address, email, and the description of the business. When the registration is complete, you will formally be a business owner. Finally, you may be required to renew your business name and contracts so often.

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