What Are Sole Proprietorships? - dummies

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

A sole proprietorship is basically the business arm of an individual who decides not to do business as a separate legal entity (as a corporation, partnership, or LLC). It’s the default when you don’t establish a legal entity.

Describing a sole proprietorship

A sole proprietorship isn’t a separate entity; it’s like the front porch of a house — attached to the house but a separate and distinct area. You may be a sole proprietor of a business without knowing it! An individual may do house repair work on a part-time basis or be a full-time barber who operates on his own. Both are sole proprietorships.

Anytime you regularly provide services for a fee, sell things at a flea market, or engage in any business activity whose primary purpose is to make profit, you’re a sole proprietor.

If you carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C “Profit or Loss From Business” with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business.

Understanding liability and financial reporting

As the sole owner (proprietor), you have unlimited liability, meaning that if your business can’t pay all its liabilities, the creditors to whom your business owes money can come after your personal assets.

Many part-time entrepreneurs may not know this or may put it out of their minds, but this is a big risk to take. Some part-time business consultants operate their consulting businesses as sole proprietorships. If they’re sued for giving bad advice, all their personal assets are at risk — though they may be able to buy malpractice insurance to cover these losses.

Obviously, a sole proprietorship has no other owners to prepare financial statements for, but sole proprietors should still prepare these statements to know how their businesses are doing. Banks usually require financial statements from sole proprietors who apply for loans.

One other piece of advice for sole proprietors: Although you don’t have to separate invested capital from retained earnings as corporations do, you should still keep these two separate accounts for owners’ equity — not only for the purpose of tracking the business but also for the benefit of any future buyers of the business.