An overwhelming percentage of small businesses are sole proprietorships. This is the case for a number of reasons, but primarily due to the ease of formation and the cost effective manner in which such an entity can be run. To be sure, the IRS reports that over 25.5 million businesses paid taxes as sole proprietors, by filing Schedule C of Form 1040.
Setting up a sole proprietorship might be cheap and simple, but there are certain caveats that need to be mentioned. As there is no legal separation between your new business and you, as the owner, you alone are personally responsible for the failures and debts your business incurs. Also, raising money for your startup might be extremely challenging, as most investors are hesitant to jump in because you cannot sell stock in business, and the banks rarely lend money to sole proprietorships, regarding them as high liability risk. The rest of this article is devoted to helping you understand more about the entity type and some of the risks associated with it.
What is a Sole Proprietorship?
The sole proprietorship is the oldest and simplest form of business ownership. A sole proprietorship (or “sole prop”) is a form of business in which an individual starts a business under his or her own name. It’s a one-person business; if there is more than one owner, your business can’t be a sole proprietorship. In a sole proprietorship, you are the business; that is, the business is not a separate entity from you.
The Internal Revenue Service (IRS) calls a sole proprietor someone who owns an “unincorporated business by himself or herself).” That means the business isn’t a corporation (or S corporation) or a single-member limited liability company (LLC).
How Does a Sole Proprietorship Get Formed?
Pretty quickly and easily, that’s how! A sole proprietorship is unique because it’s the only business that doesn’t have to register with a state. All other business types – partnerships, limited liability companies, and corporations – must file a short form with each state in which they do business.
Starting a sole prop business is fairly simple. To start a sole proprietorship, all you need to do is:
- Create a business name and decide on a location for your business
- File for a business license with your city or county, and get permission from your locality if you want to operate your business from home.
- Set up a business checking account so you don’t mix up business and personal spending.
In addition, your sole proprietorship may need to register with federal or state entities (these registrations are the same for all types of businesses):
- if you plan to sell taxable products or services, you’ll need to register with your state’s taxing authority.
- if you plan to hire employees, you’ll need to get an Employer Tax ID Number (EIN) from the IRS. (Your bank may also require this tax number.)
Advantages of Sole Proprietor Form
The advantages of forming a sole proprietorship include:
Easy Startup. You don’t need to prepare any legal agreements because you are not in business with someone else, and you don’t have to set up an elaborate business structure: no board of directors, no meetings, no minutes, no complicated accounting for shares in the business. You just start running your business.
Control. As the sole owner of the business, you have complete control over all the operations, and you get to make all the decisions. You don’t need to have a board of directors, shareholders, or other owners to answer to.3
Tax Preparation and Filing. Sole proprietorship income taxes are easy to file, using Schedule C and adding the income/loss from the business to your other income on your personal tax return.
Disadvantages of the Sole Proprietorship
The primary disadvantage of a sole proprietorship is that your personal finances and those of your business are one and the same. You as the owner are personally liable for any debts or obligations of the business. Lawsuits or creditors may be able to access your personal accounts, assets, or property if your business can’t pay its bills.
Some sole proprietors, however, might become too overwhelmed and burdened by being personally responsible for every aspect of running the company; or they might want to expand the scope of their business and look for outside investors. In that case, they might eventually decide to incorporate their small business to protect their personal assets, reduce personal liability, and grow their operation.
You cannot file bankruptcy for your business without filing personal bankruptcy. Filing bankruptcy your sole proprietorship means involving your personal assets. A bankruptcy case involving a sole proprietorship includes both the business and personal assets of the owners and debtors.
For many business people, the issues of personal liability and involvement of personal assets outweigh the advantages of sole proprietorship structure. If this is the case with you, consider forming a limited liability company (LLC) or corporation.
Getting Business Insurance Protection
You can’t protect your personal assets if your business is in trouble financially, but you can get some protection from liability lawsuits if you get property and liability insurance. You will probably have to get this insurance specifically for your business, but it can help protect you if your business is involved in a liability lawsuit.
If you drive your car for business, you might want to get business auto insurance to cover you while on business trips. Most personal auto policies won’t cover business driving.
Taxes and Sole Proprietorships
A sole proprietor pays federal and state income taxes on all of the net income of the business (income minus expenses), even if you don’t have cash in hand to pay these taxes.
Any business income is included with your personal income on your personal tax return. The tax rate you pay may on the business income is hard to determine, since it’s all combined. The corporate tax rate is a flat is likely to increase under the incoming Biden administration, so your tax rate may be higher or lower, depending on your personal tax rate. Keep a close eye on that over the coming months.
Don’t forget self-employment tax. Sole proprietors have to pay self-employment tax on the profits of their business, for Social Security and Medicare. Since this tax isn’t withheld from your business income, you’ll probably need to make quarterly estimated tax payments for this tax and your business income tax.
The IRS publishes a Tax Guide for Small Business, which you might find helpful in dealing with federal taxes.
Check with Tax and Legal Professionals
Even if you have a very small one-person business, you should check with your tax and legal advisors before settling on a business form. There may be other things you need to consider before you start a sole proprietorship business.