The sole proprietorship: Everything a business founder should know

Many employees dream of becoming their own boss. What they might not realize is that it’s easy to get started. All you need is a promising business idea, good preparation, and confidence in your own abilities. You can become a sole trader without any large seed capital from influential business partners. But what prerequisites need to be met, what formalities must be observed, what is the business day like, and what risks should you be aware of in advance?

What is a sole proprietorship? Definition and background

With a sole proprietorship, anyone who wants to become self-employed in the USA can easily set up their own business. As the name suggests, the prerequisite is that it is founded and managed by an individual. However, you can hire as many employees as you like from the start, or with increasing business success.

The sole proprietorship is an independent legal form, which stands on equal footing with corporations that are also managed by a single person. However, to create a corporation, the law often prescribes a minimum capital amount necessary. This isn't the case for sole proprietorships, making it much easier for young entrepreneurs to move into self-employment. This is one of the most important reasons why the sole proprietorship is the most widely used business structure in the USA.

Definition: sole proprietorship

A sole proprietorship is founded by an individual, who can employ others. As an independent legal form, it stands on equal footing with single-person corporations. No seed capital is required for the foundation, but the sole trader is liable with their private and company’s assets.

For more information on setting up a sole proprietorship, for more information, see our guide on starting your business as a sole proprietor.

What differentiates a sole proprietorship?

What distinguishes the sole proprietorship from other business forms? It is on a level with corporations and partnerships, and, like these, is also bound by certain requirements - from rules on tax treatment to business registration. Once you understand the rights and obligations of a sole proprietor, you can decide whether or not it is the right choice for your business idea. If you have any doubts, you should seek the help of professional consultants.

Company name – the future flagship of your business

First things first, the company must be given a name. Small businesses and freelancers often use their own names as their business names, attaching an addendum that clearly describes the industry or specific service provided. If you prefer to choose a different name other than your own, you will be required to register your company name with your local Secretary of State. If the name is already taken, you will have to select a different one. We recommend selecting an industry-typical name, which makes it obvious to potential customers and business partners what goods and services you’re offering.

Management and external representation

The management usually connotes the owner or founder of the company, but it is important to remember that the term “managing director” should not be used, since this is an official title in the hierarchy of a corporation. This could result in an official warning. Referring to yourself as the “owner” means you are on the safe side.

The owner has the possibility to transfer the conduct of business by commercial powers to another person, or to share management responsibilities. This makes sense if the company continues to grow and becomes difficult to manage by a single person.

Seed capital

There is no required start-up capital for setting up a sole proprietorship. However, it is not possible to start a business without some kind of financial reserve, because depending on the company, machines, tools or basic office equipment will need to be purchased. It may also take some time for the company to generate profits. During this time, running costs (insurance, chamber contributions, etc.) must be covered.

Liability

Liability is the one major weakness of the sole proprietorship structure. The owner is fully liable with both their company and private assets. This includes real estate, vehicles, and valuables like jewelry, works of art, and so on. All this can be pledged up to the value limit set out in the law if the company becomes insolvent.

It is therefore important to be aware of all business risks before setting up the business. If there is a high entrepreneurial risk, a structure like a limited company may be more suitable. If you still opt for a sole proprietorship, it is important to protect yourself from insolvency by taking out additional insurance.

Accounting

Each individual contractor is obliged to provide the tax office with an overview of the income and expenditure at the end of the financial year, which serves as the basis for the future tax treatment of the company. For small businesses and freelancers, simple record-keeping is sufficient. This is included in your annual tax return. In contrast, larger companies are required to keep double-entry accounting records.

Taxation

After registering your business with the Internal Revenue Service (IRS), you will be required to pay taxes on your individual earnings through a regular tax return, rather than paying taxes directly on the business. This is known as “flow-through” taxation. In your tax return, you will be required to pay self-employment tax and income tax.

Resolution

A sole proprietorship can be dissolved as quickly as it can be set up. For this purpose, business assets have to be transferred to private assets, i.e. transferred from the company to the private account. The IRS and state tax authorities need to be informed of the business’s termination. If you are registered with your local Secretary of State, you must ensure that your entry in their register is removed.

The most important facts about sole proprietors at a glance

  • Foundation: Only possible by an individual
  • Company name: Name of the founder, plus possible addition
  • Seed capital: Not required by law
  • Liability: Unlimited (with both business and private assets)
  • Registrations: IRS, state tax authorities, Secretary of State
  • Accounting requirements: single-entry bookkeeping is sufficient
  • Tax obligations: Income and self-employment filed through an individual tax return
  • Dissolution: Business assets are converted into private assets and the tax office is informed

Individual companies – Advantages and disadvantages at a glance

The biggest advantage of setting up a sole proprietorship is certainly that no seed capital is required. In addition, there are relatively small bureaucratic hurdles. Sole proprietorships only have to register with their state and federal tax authorities, and register their name with the Secretary of State should they choose a name other than their own for the business. This means that the cost of setting up a sole proprietorship is very manageable.

However, all these advantages come with a major disadvantage: unlimited liability. This means that the owner is liable with all their assets, including private ones. For this reason, a founder should carefully consider whether their business idea involves increased entrepreneurial risk. If that is the case, opting for a company with limited liability may be preferable.

Advantages Disadvantages
Simple, cost-effective start-up Unlimited liability with business and private assets
No seed capital required Admission of additional owners is not possible
Notarized articles of association or partnership are not required  
No corporation tax; sole proprietorships are “flow-through“ entities  

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