Elements of a Sole Proprietorship

By John Cromwell

Sole proprietorships are arguably the simplest and most basic of businesses. Anytime an individual begins working on a business of her own, she has started a sole proprietorship. A sole proprietorship is not legally distinct from its owner. This means the sole proprietorship is an extension of its owner, so she can freely mix her personal assets with the business assets. A sole proprietorship can only last as long as the sole proprietor lives, and the business cannot be sold to another person. This relationship between the business and its owner creates several key differences between sole proprietorships and other types of business organizations -- such as corporations or partnerships.

Registration

A sole proprietor does not need to register with a state to organize as a business. However, she may still need to apply for licenses if she wants to participate in certain industries. Examples of businesses that may require licenses include child care and real estate, among others. And since a sole proprietorship is not legally distinct from its owner, its legal name is the name of its owner. If the business wants to use a different name, the owner may need to file a “doing business as” application with the state in which the business is based. Licensing and registration laws vary by state.

Liability

Due to the relationship between a sole proprietor and her business, the owner is personally liable for all business liabilities and obligations. This includes any damages or obligations that may result from lawsuits that arise out of the business’s negligence or those that pertain to selling any of the products or services in the business. A sole proprietor may take several steps to protect her personal assets from the business’s liabilities. She may attempt to get her customers to sign a release, which will release her from most legal liability. Although how much liability that can be absolved by a release varies by state, a liability release generally cannot protect against claims based on reckless conduct by the business or violations of statutes by the sole proprietorship. She may also buy an insurance policy that will cover potential legal liabilities.

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Taxation

All of the proceeds from a sole proprietorship are included on the owner’s personal tax return. This means that any losses a sole proprietor sustains in her business can be used to offset all of her taxable incomes, including interest and gains from the sale of nonbusiness property. However, significant business income may cause a sole proprietor’s tax rate to increase by placing the individual in a higher tax bracket. Also, unlike other businesses, a sole proprietorship cannot take tax deductions on health and life insurance premiums it pays. Finally, a sole proprietor will be required to pay self-employment taxes on the income the business earns.

Relationship With Third Parties

A sole proprietor is prohibited from having partners, which prevents a sole proprietor from selling a part of her business to raise capital. However, this prohibition does not prevent a sole proprietor from hiring employees. The sole proprietor will be required to pay all necessary employment taxes in relation to her employees’ work.

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Deduction Categories for a Sole Proprietor

References

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