Choosing a business structure is one of the most important decisions you'll make when launching your company. If you're a solo entrepreneur, the simplest business structure you can choose is a sole proprietorship. What is a sole proprietorship? How do you set one up? This guide will explain how to get started as a sole proprietor.
Sole proprietorship: Definition
A sole proprietorship is an unincorporated business owned and operated by a single person. If you're the sole owner of your business, your company is not a separate legal entity. This setup means that you're entitled to 100% of the profits, but you're also liable for 100% of your company's debts.
If you're a solo business owner, you're automatically classified as a sole proprietorship unless you intentionally set up a different business entity. When a sole proprietor opens their business, the name of their company will be the same as their own name. However, sole proprietorships can also operate under a separate business name.
Advantages of a sole proprietorship
If you're a small business owner, there are several reasons why you might consider becoming a sole proprietor.
It's easy to set up
Remember, your business is classified as a sole proprietorship by default. This arrangement means that you won't be liable for formation fees or filing deadlines. It makes sole proprietorships the easiest way to start your own business and helps you save money by avoiding these additional fees.
Taxes are simplified
Sole proprietorships are sometimes known as "pass-through entities," meaning that the business does not pay income taxes.
Instead, the profits pass through to the owner, and they will report these earnings on their personal income tax return. That means you won't have to obtain an Employer Identification Number (EIN) from the IRS.
You don't need a business bank account
Usually, business owners maintain a business bank account to keep their personal assets separate from their business assets. But sole proprietors are 100% liable for everything, so there's no need to maintain multiple bank accounts.
It legitimizes your side hustle
Sole proprietorships are a great way to get your business off the ground. You can start small and expand your business over time. Down the road, you can easily convert your company into one of the other business structures, such as a partnership or even a corporation.
Disadvantages of a sole proprietorship
Before you get too excited, there are a few drawbacks to sole proprietorships that you should carefully consider. These include:
Your personal assets are at risk
You'll be held personally liable for any business losses as a sole proprietor. If your business fails, you'll be personally responsible for covering your business debts and obligations. This responsibility might include loans, leases, credit accounts, and lawsuits. If you have employees, you'll also be liable for their actions.
While liability insurance is always an option, the fact is that sole proprietors face considerable risk compared to other business structures.
It's hard to get funding
Many sole proprietors will require funding to expand their business. But banks and lending institutions typically prefer to offer business loans to established companies with a longer track record. And since all of the company's debts are your personal responsibility, your lender may question your ability to cover your obligations should things go south.
Sole proprietors must pay self-employment taxes when they file their personal tax returns. This tax is in addition to paying income tax. For 2022, the self-employment tax rate is 15.3% and includes 12.4% for Social Security and 2.9% for Medicare taxes. Other business structures provide some tax options that can help you save money.
When to choose a sole proprietorship over an LLC
Overall, the sole proprietorship model is a great way to start your business. Sole proprietorships are ideal for small businesses that:
- Are relatively small and low-profit
- Have a small customer base
- Offer little financial risk
Sole proprietorships are ideal for businesses that begin as a hobby and are just beginning to take off.
Understandably, the personal liability issues are enough to make any entrepreneur cautious. One way to shield yourself from these risks is to start a limited liability company (LLC).
Sole proprietors face unlimited liability when it comes to their business debts. But a limited liability company protects against any of the liabilities incurred during the regular operation of your business.
You can form a single-member LLC, though you can also include multiple owners. That makes this business structure a bit more flexible, offering the benefits of a sole proprietorship with the security of a corporation. But that comes with some added responsibilities. For instance, some states will require LLCs to file an LLC operating agreement.
How to form a sole proprietorship
A sole proprietorship is the most straightforward business structure to set up and doesn't have many requirements. Technically, step 1 is all that's really required to become a sole proprietor, but the additional steps can help you make the most of your new business.
1. Start making money
Believe it or not, the minute you start generating revenue, you're considered a sole proprietor. Once you demonstrate that your business is producing a profit, the Internal Revenue Service (IRS) will classify your business as a sole proprietorship.
2. Get the right licenses and permits
Depending on your industry and location, you may need additional licenses and permits. If you're not sure if this applies to you, check with the Business License and Permits section of the Small Business Administration website.
3. Register your business name
By default, your business will be registered under your name. Naturally, most business owners would prefer to operate under a specific business name. This name is what's known as a "fictitious business name" or "doing business as" (DBA) name.
To register your name, you'll have to contact the registrar's office of your local county clerk, who can explain the local requirements for registering a business name.
4. Open a business bank account (optional)
Even though there's no legal separation between you and your business, it might help you stay organized if you open up a business bank account. This way, you can keep your company's income separate from your personal assets and have a completely separate account for managing your business transactions.
Additionally, many banks offer some essential services aimed at small businesses. This perk means that even if you can't get a massive small business loan, you might still be able to take advantage of a business line of credit or other small benefits.
5. Get an Employer Identification Number (EIN) (optional)
Do you plan to hire employees? You'll need to obtain an Employer Identification Number (EIN) from the IRS. However, this is only required if you plan to employ staff. If not, this won't be necessary, as you'll pay taxes on your business income when you pay your personal taxes.
6. Plan for the future
Finally, it's always wise to think about what your business will look like in the future. When you're first getting started, a sole proprietorship makes sense. It gives you complete control over every aspect of your business and doesn't require a lot of hassle or costs to set up.
But as your business grows, so does your personal liability. For this reason, you may consider a different business structure, one that provides protection from debts and losses that your business may incur.
How to file taxes as a sole proprietor
Sole proprietors will have to pay two different types of sole proprietorship taxes: income tax and self-employment taxes. Here's how to pay each:
A sole proprietorship is also referred to as a pass-through entity. This designation means that all of your business income is passed on to you, the business owner. As the only owner, it's even easier since you'll be the sole recipient of your revenue.
You'll fill out the standard IRS Form 1040 for individual taxes every year. You'll also file Schedule C, which records your business profits and losses. The IRS will combine the income reported on both of these documents to calculate the amount of tax you'll pay.
This combination may be crucial for those who have a "day job" and their sole proprietorship. You'll pay your regular income taxes on your primary source of income, in addition to the income generated by your small business.
When you work for a larger company, your employer will cover 50% of the cost of Social Security and Medicare taxes. But when you work for yourself, you'll have to pay these taxes on your own. These are commonly called "self-employment taxes." The current tax rate is 15.3%.
You'll use Schedule SE when you pay taxes each year. This form will help you determine the amount of taxes you'll owe. When filing taxes the following year, you'll be allowed to deduct 50% of your self-employment tax as a business expense.
Is a sole proprietorship right for me?
Ultimately, you'll have to choose the business entity that fits you and your business. If there's only one owner, a sole proprietorship can make things simpler and give you total control over all of your business decisions.
But if you're concerned about your liability issues or intend to have a business partner, you have other options. An LLC can provide you greater protection against liability, and limited partnerships can allow others to invest in your company without taking on a governing role.
The right tools make it easier
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Frequently asked questions
Running a sole proprietorship isn't easy. Here are some of the most common questions about running this type of business:
If you operate a sole proprietorship, you're considered self-employed. This designation means that you'll be subject to the self-employment tax, which covers your portion of your Social Security and Medicare taxes.
Most LLC owners are also considered self-employed unless they specifically elect to be taxed as corporations.
Yes. A sole proprietorship can hire workers, though to do so, you'll have to obtain an Employer Identification Number (EIN) through the IRS website.
Don't forget that you'll be held personally responsible for your employees' actions in a sole proprietorship. Additionally, you'll be required to carry business insurance to cover workers' compensation, unemployment, and disability insurance.
Independent contractors will often have their own EIN since they're also considered self-employed. You'll need this EIN for tax purposes, though, for individual contractors, a Social Security number (SSN) will be sufficient.
Can a business owner make tax deductions when operating a sole proprietorship?
All of the revenue from your sole proprietorship is passed on to you, the business owner, but that also includes the expenses. You can deduct legitimate business expenses from your taxes when you file your taxes.
Common examples might include:
- Office supplies
- 50% of last year's self-employment taxes
- Business travel
- Business meals
- Home office costs
- Business insurance
These expenses are why it's great to have a separate bank account to keep track of your business income and expenses, making it easier to make deductions and file taxes each year. As always, don't forget to keep track of your receipts so that you can validate these expenses.