An Overview of the Sole Proprietorship Entity Structure

It’s common for first-time business owners to be unsure of the appropriate entity structure for their fledgling enterprise. At first, entrepreneurs don’t necessarily have to let this hold them back. 

If a business begins to trade before its owner gets a chance to incorporate it as a standalone legal entity, it’s considered a sole proprietorship. Many small businesses remain as sole proprietorships for years. As unincorporated entities, these structures offer business owners a large degree of flexibility, but as we’ll explore, there are also some significant drawbacks to bear in mind. 

Sole proprietorships are best suited to small, one-person businesses. They’re popular among freelancers, consultants, and solo contractors. As the business starts to grow, many business owners transition their sole proprietorship to another type of entity, such as an LLC, S Corp, or C Corp.  

In this overview, we outline exactly what a sole proprietorship is. Then, we will explore the tax and non-tax considerations that business owners should assess to determine whether a sole proprietorship is a good match for their business goals. 

This article is part of our series on entity selection. View our other articles here:

• The Importance of Entity Choice
• An Overview of the Sole Proprietorship Entity Structure
• An Overview of C Corporations: Tax and Non-Tax Considerations
• S Corporations: Key Tax and Non-Tax Considerations for Entrepreneurs
• Partnerships: What Entrepreneurs and Business Owners Need to Know
• Factors to Consider When Choosing Entity Structure – Smith and Howard

What is a Sole Proprietorship?

Sole proprietorships are unregistered, unincorporated businesses that are wholly owned by a single individual. For legal and tax purposes, the owner and the business are considered one and the same. 

The owner of a sole proprietorship receives 100% of the profits of the business and is responsible for paying personal income taxes on this income. Equally, however, the business owner assumes all liability for the business’s debts and expenses, since the business is not considered a separate legal entity. 

Entrepreneurs don’t have to do anything to set up a sole proprietorship: it’s considered the default for any business owned by one person unless action is taken to incorporate a different type of entity. There are no registration forms to be filed or administrative requirements: as soon as your business starts trading, it’s considered a sole proprietorship. 

Sole proprietorships are typically used by small, one-person businesses. Classic examples of sole proprietor businesses may include solo photographers, housekeepers, personal trainers, and so on. As the business expands, entrepreneurs often switch from a sole proprietorship to a more formal entity structure.  

Key Tax Considerations for Sole Proprietorships

For tax purposes, a sole proprietorship is considered as one with its owner. Income from a sole proprietorship is reported on Schedule C, Profit or Loss from a Business, which is submitted to the IRS annually alongside the individual’s Form 1040. 

The business owner is responsible for paying taxes on the profits generated by the business. These profits are calculated by subtracting the business’s expenses from its revenue. Expenses that can be deducted include operating expenses, advertising expenses, certain start-up costs, and more. Sole proprietorship owners can also take advantage of some tax deductions, such as the home office deduction. 

Business owners should always work with a tax professional to determine the amount of taxes they owe. While the owner and the business are considered one entity for tax purposes, there are several considerations that must be taken into account when planning for the tax liability related to your business income.

Pass-Through Deduction

Many sole proprietors qualify for the pass-through tax deduction called the Qualified Business Income (QBI) deduction, which allows business owners to deduct up to 20% of their net business income. 

The level of deduction a business owner can take depends on several factors such as their income threshold and whether the business is classified as a Specified Service Trade or Business (SSTB).  If your business is an SSTB you may be phased out of the deduction based on taxable income limitations, whereas other types of businesses could still qualify even with much higher taxable income from the business.

Paying Estimated Taxes

When individuals work a W-2 job, their employer withholds taxes from their paycheck and remits payment to tax authorities. Sole proprietors are responsible for estimating their tax liability based on their projected business income. 

Throughout the year, sole proprietors must make estimated tax payments to the IRS every quarter. Estimated state income tax payments may also be required. When the sole proprietor submits their tax return, they may have to pay additional taxes or receive a refund, depending on how accurate their projections were. Failure to pay taxes throughout the year may cause penalties and interest to be assessed by the IRS and states.

Self-Employment Taxes

In addition to income taxes, sole proprietors must also make their contributions to Social Security and Medicare. These are known as self-employment taxes and can be considered equivalent to the payroll taxes paid jointly by an employer and employee. 

These taxes amount to 15.3% of a sole proprietor’s income: 12.4% for Social Security and 2.9% for Medicare. In 2023, the first $160,200 of an individual’s income is subject to Social Security – after that, no further taxes are due. Medicare taxes have no income ceiling. Additional Medicare taxes may be owed for income above certain threshold amounts. 

These taxes are reported on Schedule SE, which individuals submit alongside Form 1040 and Schedule C. Sole proprietors pay the full amount but may deduct half of their self-employment taxes from their Adjusted Gross Income (AGI). 

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For entrepreneurs just starting out, a sole proprietorship often makes sense from a tax perspective. However, as the business grows, adopting a different type of entity structure, such as an S Corporation, can unlock tax savings. 

Key Non-Tax Considerations for Sole Proprietorship

Sole proprietorships offer business owners an attractive option when first starting a business. With no set-up costs and a simple structure, opting for a sole proprietorship allows entrepreneurs to focus on running their business.

However, sole proprietorships have a major drawback: personal liability. Unlike other entity structures, a sole proprietorship business is not considered a separate legal entity from the individual that owns it. In short, this means the business owner is personally responsible for all of the business’s debts and liabilities. 

Sole proprietorships offer no liability protection, making them a risky choice for businesses that could be exposed to litigation. In the event of a lawsuit, or the business running up debts it is unable to pay off, the business owner’s personal assets – their home, car, and investment accounts – can be pursued by creditors. Equally, creditors can pursue the assets of your business to settle personal debts. 

This lack of liability protection is the greatest disadvantage of the sole proprietorship model, but it’s not the only drawback. Raising business financing, whether from investors or lenders, can be challenging with this entity structure. 

Smith + Howard: Experienced Tax Advisors

Selecting the most appropriate entity structure is one of the most important decisions entrepreneurs make in the early stages of their business journey. While many small businesses begin with a sole proprietorship, as they scale, they often pivot to a different entity structure that is better suited to their needs. 

At Smith + Howard, we’re proud to serve entrepreneurs at every stage of their journey: from ambitious founders starting a new business to experienced executives managing well-established firms. By partnering with our experienced professionals, business owners can work to identify the entity structure that best supports their business goals while ensuring an optimal tax strategy. 
To learn more about how Smith + Howard can support your business, contact an advisor today.