When deciding to start a business, there is a seemingly endless series of decisions to make. One of the first and most important will be what form of business structure to choose. The United States defines a number of structures with varying levels of complexity and tax implications, but the most common is a sole proprietorship.
Sole proprietorships are the most basic business structure, requiring very little paperwork and formalities. In fact, you may be running a sole proprietorship and not even realize it.
However, there are also considerations that may mean sole proprietorships aren’t right for your business, so it is important to understand exactly how these businesses work.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business structure that is both owned and run by a single person. The business and the owner are treated as the same entity when it comes to all government requirements, including taxes and liabilities.
This means that if the business is sued or owes money to a creditor, the individual who owns it is fully responsible for those business debts and obligations with no additional protection.
In addition to the personal liability of a business, the owner of a sole proprietorship also takes on the tax responsibility associated with their business. Any profits, losses, expenses, and other taxable items that come from the business are filed as a part of the owner’s personal tax returns.
While this can simplify the process, it also means some protections afforded to other companies will not be present. Personal assets can be seized to cover the business’s debts.
Sole props vs. other structures
There are four primary types of business structures in the United States that a business can choose from when starting out. Each has similarities and differences to a sole proprietorship and may be a good fit for different scenarios.
Limited Liability Company
Aside from sole proprietorships, limited liability corporations or LLCs are the most commonly chosen business structure. LLCs offer some benefits of a corporation as well as partnerships, allowing for a flexible small business structure.
When an LLC is formed, it is a business entity separate from the owner or owners and considered its own entity under state law. LLC owners can determine their own management structure, operational procedures, and tax treatment depending upon their needs. One primary difference between LLCs and sole proprietorships is the liability itself- as the name implies, an LLC offers some level of protection against business debts and legal obligations for the owner. Taxes are also filed for the business itself, as either pass-through taxation or corporate tax status.
Because of the additional protections, LLCs require slightly more paperwork and compliance procedures to form. However, the process is simple and can be used for businesses of all sizes.
Partnerships
By definition, a sole proprietorship has a single owner who is legally inextricable from the business itself. Partnerships operate similarly to sole proprietorships but will have two or more small business owners instead of a single owner. While the formation of these structures is simple, introducing multiple people into the decision-making process for a business can have other complications and benefits.
The law does not require a partnership agreement to be put in place before forming a business, but it can be beneficial. Not only does it delineate responsibilities and rights, but it can help distribute the legal and tax liability associated with a partnership, which is the same as in a sole proprietorship.
Corporations
A corporation is a separate legal entity that is established under state law in order to conduct business that offers both the most protection and comes with the most requirements. While this can include not for profits, business corporations are the most relevant in this context.
When a corporation is formed, a new legal person is created, making the business an entity entirely separate from the owners. This means that regardless of what happens to the individuals and shareholders, the corporation will persist. The formation process for these entities is complex and requires multiple people to be named beyond the owners, including directors and officers. These people must meet annually and share reports with the government.
Taxation is also much more complex, as there is an entirely separate corporate tax structure. Multiple types of corporations, like an S Corp and a C Corp, exist to delineate the exact method of taxation, but they will never be applied to the individual owners’ taxes.
Who is a sole prop good for?
Determining a business structure will involve a few elements of consideration, including ownership and protection.
A sole proprietorship requires there is a single owner, not a group of people, running the business. This structure will not work for any groups of people, who should look into a partnership instead. But if you are an individual looking to open a business on your own, a sole proprietorship can be the right choice.
Some states do allow spouses to be co-owners of a sole proprietorship as long as they pay taxes jointly, but this can vary. You can also choose to pay estimated taxes quarterly.
Many people choose a sole proprietorship because of the level of effort involved. Most states do not require any formal filing for a sole proprietorship.
If you are operating a business, whether it is a formal storefront, an online store, or working as an independent contractor or freelancer, you are technically operating a sole proprietorship. This means there is no long time frame for approval and little cost involved. If you are looking to start a simple business quickly, sole proprietorships can be a good choice.
The biggest consideration in whether a sole proprietorship is right for you is the level of protection you need.
Certain types of businesses may open you up to higher levels of liability that make something like an LLC make sense, while others may not be as concerned and can use a sole proprietorship.
You can also work with a tax attorney to determine if the tax implications of a sole proprietorship on your individual taxes is the right choice for you.
Advantages of a sole proprietorship
Full ownership
Many people prefer a sole proprietorship because it offers them total control of their business. There are no other owners, legal partners, or shareholders who need to approve decisions, big or small. This freedom is one reason many people start their own business, and the ability to adjust as you experience owning a business can be a huge advantage.
Simple formation
A sole proprietorship can require little to no formation processes, eliminating long wait times and large fees that other structures may require. In fact, many people are operating a sole proprietorship without realizing it. The simple, inexpensive start means that you can legitimize a business quickly without a huge investment.
Ability to grow and change business
Just because you form a business as a sole proprietorship does not mean that you can only ever use that structure. It is common for businesses to start as a sole proprietorship in order to understand the business and find success, then be converted to an LLC or corporation down the line.
Disadvantages of a sole proprietorship
Lack of protection
The major downside of a sole proprietorship is that it does not offer a distinction between the owner and the business. This means that any financial obligations, legal issues, or tax problems will fall to you as the owner.
Less options to sell the business
If your business becomes profitable and successful enough that you could consider selling it, a sole proprietorship can make that difficult. The transaction would leave you subject to capital gains tax, and the buyer would need to assume liability for your business debts.
Difficulty securing funding
There are a huge variety of business loans, grants, and lines of credit for new business owners available, but they are often not given to sole proprietorships. LLCs and corporations are eligible for more funding, and it can be difficult to raise capital without the credibility of a more formal business structure.
Starting a sole prop
1. Naming your business
Because the sole proprietorship is legally the same entity as its owner, the name of the business is the same as your own name.
This can be a good option for certain types of businesses, but most people will choose to use a different name for their business. Using a name other than your own requires filing through your state for something that can be known as doing business as, a fictitious name, trade name, or assumed name.
The process of using a trade name can vary by state but typically involves an application through the state to ensure you are not using a business name that is taken within the state. You may need to pay a small fee or inform local governments as well.
2. Formation with the state
The majority of states do not require any formal application to start a sole proprietorship, though you can confirm with your individual state department. In some cases, the state does not have a formal requirement but a city or county may require you to file.
3. Obtaining Licenses & Permits
Each state has different requirements when it comes to business licenses. Some require a general business license, while others do not.
However, if you will be selling or leasing goods or offering taxable services, you will likely need to obtain a seller’s permit or sales tax permit. This permit allows you to collect sales tax on behalf of the state if you are in a state that has a sales tax. A small fee can be associated with this permit.
Certain industries and professions will require licensure through the state, local government, or even the federal government. Each state should have a website that lays out who does and does not require licensure, and it is important to make sure you are in compliance with these laws to be able to continue your work.
In addition to state laws, local governments often have their own regulations. You may live in a state that does not require a general license but operate in a town that does have that requirement. It’s crucial to always check with all local governments to ensure you have not only licenses and permits, but relevant zoning clearances.
4. Obtaining an EIN
Because a sole proprietorship is taxed as a part of the owner’s personal income taxes, they do not need to obtain an Employer Identification Number. EINs are issued by the IRS for tax purposes and do not apply in this scenario.
However, if you plan to have any employees, an EIN will be required in order to report wages and properly withhold federal income taxes. Your state may have a similar identification method that will also be required in this case.
How do sole props pay business taxes?
When the owner of a sole proprietorship files their personal income taxes each year, they will include all profit and loss related to the business. This will be reported on a Schedule C form, which calculates the business income, including income and expenses, cost of goods sold, and costs for home-based businesses. The net income is then included with all other income and loss reported for the purpose of income taxes.
Along with an income tax return, the owner of a sole proprietorship will need to pay self-employment taxes like Social Security and Medicare. Property taxes and employment taxes may also be applicable.
FAQs
While a sole proprietorship can have only one owner, they are able to have as many employees as necessary. Hiring an employee will require the business to obtain an EIN and file all appropriate state and federal taxes, as well as following appropriate withholding procedures. Some states may also require workers’ compensation insurance when hiring employees.
Most states do not require a business owner to file for formation of a sole proprietorship, so there is no fee associated. Some states may assess a small, one-time fee. Other costs, like filing a trade name or obtaining a seller’s permit, may also be necessary but will vary by state.
The owner of a sole proprietorship is considered self-employed, as they work for themselves and not another entity. This means they will need to pay associated self-employment taxes and be responsible for their own status.
