Business Numbers · Chapter 1 · Choosing a Business Entity

Sole Proprietorships

The default structure of the one-owner business — where you and the business are legally the same person, for better and for worse.

bookSHelf · Business Numbers · §1.1 · a self-paced section

Sole Proprietorships · bookSHelf Business Numbers§1.1

Outline — by the end of this section you will be able to

Learning objectives

Describe what a sole proprietorship is and how one is formed Def 1.1.1
Explain the unlimited personal liability a sole proprietor carries Def 1.1.2
Explain how a sole proprietor's income is taxed — SE tax and estimated payments Def 1.1.3–1.1.4

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.1 — What the structure is

One owner, one legal person

Definition 1.1.1 — Sole Proprietorship

A sole proprietorship is an unincorporated business owned entirely by one individual, in which the owner and the business are treated as the same legal person — no separate entity stands between the owner and the business's income, debts, and legal obligations.

You and the business share one wallet. It isn't a new "person" the law creates — the money it makes and the debts it owes all land in the same place: yours. That one fact drives every advantage and every danger below.

A sole proprietorship: the owner and the business are one legal person.

Figure 1.1.1: The owner and the business are one legal person.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.1 — Check your understanding

Try It Now 1.1.1

Try It Now 1.1.1 — Delta Glow Candles

You start selling handmade candles at weekend markets under the name "Delta Glow Candles," working evenings and Saturdays while keeping your day job. You file no paperwork with the state. (a) Are you a sole proprietor? (b) Does part-time work change the answer? (c) The name isn't your legal name — what one filing usually applies?

(a) Yes — you became a sole proprietor the moment you began carrying on the business by yourself; there is nothing to "file to exist." (b) No — self-employment doesn't require full-time work, as long as there's a genuine profit motive. (c) A Fictitious Business Name Statement (DBA), filed with the county, because you operate under a name other than your own.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.2 — The defining risk

No wall between business and personal money

Definition 1.1.2 — Unlimited Personal Liability

Unlimited personal liability means the owner is personally responsible for all of the business's debts and legal obligations, with no ceiling tied to the amount invested — creditors and successful plaintiffs may reach the owner's personal assets (savings, home, car).

This is the opposite of a corporation or LLC, where an owner's loss is generally limited to the amount invested. It is the single most common reason small-business owners eventually incorporate.

Unlimited personal liability: business debts can reach the owner's personal assets, with no ceiling.

Figure 1.1.2: Business debts can reach personal assets, with no ceiling.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.2 — Worked example

Why the liability wall matters

Example 1.1.1 — A $150,000 catering claim

Maria runs a small catering business as a sole proprietor. A client claims food from an event made guests ill and sues for $150,000 — more than the business is worth. Whose assets are exposed, and how would an LLC or corporation have changed the answer?

Who is sued. Because Maria and her business are legally the same person, the lawsuit is against Maria herself — no entity stands between her and the claim.

Where a judgment lands. Past her business assets and insurance, the remainder can be collected from her personal property. The $150,000 exposure is not capped at what she invested.

The alternative. A properly maintained LLC or corporation would generally have shielded her personal assets, capping her loss at her investment.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.2 — Check your understanding

Try It Now 1.1.2

Try It Now 1.1.2 — Rosa's unpaid supplier

Rosa runs a sole proprietorship. Her business owes a supplier $40,000 it cannot pay, and the business's own assets are worth only $10,000. (a) Can the supplier collect the remaining $30,000 from Rosa, and from where? (b) How would the answer change for a properly maintained LLC with no personal guarantee?

(a) Yes. The supplier applies the $10,000 of business assets, then pursues Rosa's personal assets for the remaining $30,000 — there is no ceiling tied to what she invested. (b) In a properly maintained LLC her loss is limited to what she invested; absent a personal guarantee, the supplier could not reach her personal assets for the $30,000.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.3 — How the income is taxed

One layer of tax

Definition 1.1.3 — Pass-Through Taxation

Under pass-through taxation, the business pays no separate income tax; its net income or loss "passes through" to the owner's personal return, where it is taxed once, at ordinary individual rates. This single layer contrasts with the double taxation of a C corporation.

How it's reported: a sole proprietor files Schedule C as part of the personal Form 1040. A start-up loss can often offset the owner's other income.

Pass-through taxation: profit passes through the business, untaxed there, and is taxed once at the owner.

Figure 1.1.3: Profit passes through untaxed, then is taxed once at the owner.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.3 — The tax an employer would have withheld

Self-employment tax

Definition 1.1.4 — Self-Employment (SE) Tax

Self-employment tax is the Social Security and Medicare tax a self-employed person pays on the business's net earnings, computed on Schedule SE — it replaces the payroll taxes an employer would otherwise withhold. The owner may deduct one-half of it on Form 1040.

Estimated quarterly payments. With no employer withholding, a sole proprietor generally makes quarterly Form 1040-ES payments covering both income tax and SE tax — required once you expect to owe about $1,000 or more.

Self-employment tax: the self-employed pay both the employer and worker payroll halves on Schedule SE.

Figure 1.1.4: The self-employed pay both payroll halves on Schedule SE.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.3 — Worked example

One layer of tax, plus SE tax

Example 1.1.2 — Mai's $60,000 net profit

Mai runs a graphic-design sole proprietorship and, after expenses, reports $60,000 of net profit on Schedule C. What taxes does Mai owe, and how should she have paid them during the year?

Income tax (one layer). The $60,000 flows onto Mai's Form 1040 and is taxed at her individual rate. The business writes no separate check for income tax — that's the pass-through form.

Self-employment tax. Because no employer withheld Social Security and Medicare, Mai also owes SE tax on the net earnings — illustratively about $15.3\%$ :

0.153 \times \$60{,}000 \approx \$9{,}180

Estimated payments. With nothing withheld, Mai should have sent quarterly Form 1040-ES payments covering both taxes, rather than one large bill — and a possible penalty — at filing.

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1.3 — Check your understanding

Try It Now 1.1.3

Try It Now 1.1.3 — Andre's $30,000 profit

Andre expects about $30,000 of net profit this year and has no taxes withheld by any employer. (a) Which form reports the profit, and on which return does it land? (b) What additional tax applies simply because there's no employer — and what schedule computes it? (c) What should Andre do during the year to avoid a penalty?

(a) Schedule C, filed as part of his Form 1040, taxed at individual rates. (b) Self-employment (SE) tax, computed on Schedule SE, because no employer withheld Social Security and Medicare. (c) Make quarterly estimated payments with Form 1040-ES covering both income and SE tax — required once he expects to owe about $1,000 or more.

Sole Proprietorships · bookSHelf Business Numbers§1.1

The headline result

One layer of income tax — plus ~15.3% SE tax

Profit is taxed once, at the owner's individual rate — but every dollar of net earnings also bears Social Security and Medicare through self-employment tax.

Schedule C carries the profit onto Form 1040; Schedule SE computes the SE tax that replaces employer withholding.

† Illustrative combined rate: 12.4% Social Security (up to the wage base) + 2.9% Medicare. One-half of SE tax is deductible on Form 1040, and quarterly 1040-ES payments cover both taxes.

1.1

Sole Proprietorships · bookSHelf Business Numbers§1.1

§1.1 — Conclusions

What to carry forward

The one idea

One owner, no separate entity: you and the business are the same legal person. That makes it the simplest and cheapest structure to form, with one layer of tax — profit passes through to your Form 1040.

The trade-off

The same identity brings unlimited personal liability and the full weight of self-employment tax on all profit. Insurance limits the size of a loss; choosing an LLC or corporation limits whose assets are exposed.

Next: §1.2 Partnerships — what changes when a second owner joins. Back to start.