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Sole Proprietorships Explained

14. What are the major characteristics of a “sole proprietorship”?

The sole proprietorship is not a true form of business entity. This is because there is no boundary between the individual entrepreneur and business entity. The entrepreneur and the business activity are one in the same. The sole proprietorship, however, is the basis for comparing other entities. The primary characteristics of the sole proprietorship are as follows:

•    Creation & Maintenance – To create a sole proprietorship the individual entrepreneur simply has to carry on some activity with the intention of seeking a profit. It is really that simple. It arises when a single individual carries on an activity for a profit (or loss). No formal filing or documentation is required. The definition of a sole proprietorship has two primary components: 1) an activity, and 2) intent to earn a profit. This definition is very broad and covers a broad range of activities. This could make a person’s actions or activity into an unintended business entity. The important thing to remember is that the entrepreneur does not have to intend to start a business and the type or manner of activity that she undertakes is irrelevant.

⁃    Note: The definition of a sole proprietorship can be somewhat misleading, as not every sole proprietorship makes a profit. This requirement is interpreted to mean any sort of activity that intends to generate revenue. There are no maintenance requirements for the sole proprietorship, as it is not true a business entity.

⁃    Example: I am walking down the street and see a house that has lots of leaves in the yard. I need some extra money, so I knock on the door of the home and offer the owner to rake her leaves for $25. The owner agrees. I am a sole proprietor and have created a sole proprietorship through my efforts.

•    Continuity – If the entrepreneur stops carrying on the business activity, the sole proprietorship ceases to exist. The business entity will exist as long as the sole proprietor wishes to continue doing business. Ownership in the sole proprietorship cannot be transferred because the business activity is unique to the individual. This includes selling the business or passing it to one’s heirs.

⁃    Note: The name, property, activity can be transferred, but the actual organizational identity is unique to the individual carrying on the business. The business activity carried on as a sole proprietorship is often passed from owner to owner. This is done by transferring the actual assets of the business.

⁃    Example: I start carrying on business as a sole proprietor. When I am ready to retire, I cannot pass my business to my heirs because the business is inseparable from me. There is no form of stock or ownership interest to transfer. I can, however, sell my naming rights, real estate, and business assets.

•    Ownership – By definition, a sole proprietorship has one owner.

⁃    Note: A sole proprietorship cannot contain more than one owner or it becomes, by default, a general partnership.

•    Control – The sole proprietor exercises complete control over the business entity. A sole proprietorship can have employees who work in the business. The key to this relationship is that the employees cannot hold or earn ownership interest in the business activity. This will preclude any profit sharing arrangements between the owner and employee.

⁃    Note: The owner should be careful when compensating an employee based upon the amount of revenue produced. Such compensation should be carefully structured as a bonus system on a base salary.

⁃    Example: I create a consulting business as a sole proprietorship. I employ several people to work for me. I stop working in the business and charge one of my employees with managing the firm. In this scenario, I still have complete control over the business as sole proprietor. The authority I vest in a manager is based upon the complete control I have over the business.

•    Personal Liability – The sole proprietor is liable for any obligations or torts arising pursuant to the business activity. An individual (employee or business owner) is generally liable in tort for her own actions; however, a sole proprietor is also personally liable for the torts of any employees committed in the course of business operations. This is a form of vicarious liability.

⁃    Note: The personal risk to the business owner is perhaps the greatest disadvantage of carrying on business as a sole proprietor.

⁃    Example: I start a coffee shop and I run it as a sole proprietor. I hire several employees. One day an employee is not paying attention and spills hot coffee on a customer. She sues the employee, the business, and me personally. The employee will likely be liable for her negligent act. Further, the business will be vicariously liable for the acts of the employee. Because the sole proprietorship does not protect the owners for liability for business obligations, I will be personally liable for any judgment rendered against the business. This means that the judgment can be satisfied (paid) from my personal assets (bank account, home, car, etc.).

•    Taxation – Profits or losses from the sole proprietorship pass through to the business owner. The sole proprietor reports her taxable income on her personal income tax returns (Form 1040 or some variation thereof). The Form 1040 allows the individual to report any income from business operations on her personal income tax return on Schedule C. The sole proprietor does not have to prepare or file a separate tax return for the business entity.

⁃    Note: A sole proprietorship does not withhold income taxes or payroll taxes for its owners. Sole proprietors must withhold and make estimated payments to the IRS and state taxing authority to cover the tax liability attributable to business profits. Further, the sole proprietor must make estimated payments to cover self-employment taxes. The sole proprietor also has to withhold any special business taxes imposed by the state or locality. The withheld taxes must be transferred to the appropriate government agency on the appropriate schedule.

⁃    Example: I carry on business as a sole proprietor. Any business profits flow to me. At the end of the year, I will report the profits on Schedule C of my IRS Form 1040. The sole proprietorship does not file an income tax return. It does not withhold income or payroll taxes for me as owner. I must calculate the profits from the business each month or quarter and pay an estimated amount of taxes to cover my income tax and self-employment tax obligations.

•    Discussion: Can you identify a business activity where operating as a sole proprietor is not a bad idea? Hint: Think of a combination of the following characteristics: service vs product, employees vs no employees, business premises vs none, business assets vs none, low personal tax rate vs high personal tax rate.

•    Practice Question: In a short paragraph, can you describe the primary attributes of a sole proprietorship?

 

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