Starting a new business is an exciting and challenging task that requires careful planning and a clear understanding of the legal requirements. If you’re in Alabama and dreaming of launching your own business, one of your first steps should be to form a business entity.
There are several types of business entities to choose from, and the sole proprietorship is a popular one, as it offers the lowest cost to start and simplicity to get off the ground of any of them. To say the sole proprietorship is a popular entity in Alabama is an understatement because, according to the IRS, there are 313,692 sole proprietorships out of the 417,092 small businesses in the state.
In this article, I’ll explain what a sole proprietorship is and who it’s for, along with a guide on how to get started.
Related: How to start a business in Alabama
What is a Sole Proprietorship?
Let’s start by understanding what a sole proprietorship is. It is the most simple and least expensive form of a business structure, which is owned and run by one individual. The small business owner, or the “sole proprietor,” is personally responsible for the business’s profits and debts. There are no partners, no board of directors, no shareholders – just you.
Sole Proprietorship Advantages
A sole proprietorship has several advantages, making it an appealing choice for many business owners.
Simplicity and ease of formation: Starting a sole proprietorship is straightforward and requires less paperwork than other business structures. You don’t have to file formation documents with the state, though you may need to register the business name, which can make the initial setup much quicker and easier.
Cost-effectiveness: The costs to start and maintain a sole proprietorship are lower than other business structures as there are no formation or ongoing costs like annual report fees that are necessary for corporations and LLCs.
Control: As a sole proprietor, you have complete control over your business. You make all the decisions, which allows you to steer your business in the direction you desire.
Tax simplicity: Sole proprietorships do not pay separate business taxes. The business’s income is your income, and it’s reported on your individual tax return, making tax time a bit simpler. This structure allows for pass-through taxation, meaning that the business’s profits and losses “pass through” to the owner’s personal tax return.
Sole Proprietorship Disadvantages
While a sole proprietorship offers several advantages, there are also potential downsides to consider. Here are a few:
Unlimited personal liability: In a sole proprietorship, there’s no legal distinction between you as an individual and your business. This means you have unlimited personal liability for the debts and obligations of your business. If your business can’t pay its debts or gets sued, your personal assets (like your house or car) could be at risk.
Difficulty raising capital: Sole proprietorships might face challenges when trying to raise money. The ability to raise funds for a sole proprietorship is strictly debt, while other entities, such as the corporation and LLC, can raise investment funds.
Less business continuity: A sole proprietorship is tied directly to the owner. If the owner decides to stop the business, becomes incapacitated, or passes away, the business effectively ends. This can be a big negative for businesses that have certain contracts or sell to the government.
Potentially higher taxes: Depending on the income level of the sole proprietorship, you may pay more taxes than you would as a corporation. This is because sole proprietors pay self-employment taxes on all profits, which cover Medicare and Social Security contributions, whereas the LLC can distribute some profits that aren’t subject to payroll taxes (which is effectively the same amount).
Lack of corporate benefits: Unlike corporations or LLCs, sole proprietorships can’t offer certain types of benefits and take advantage of certain tax deductions related to healthcare, retirement, etc., which could impact your ability to attract and retain employees if your business expands.
If protecting your personal assets is a key concern, it might be worth considering forming a Limited Liability Company (LLC) instead. An Alabama LLC provides a layer of protection between your personal assets and your business’s debts and liabilities.
You can actually start out as a sole proprietorship and later move to an LLC as your business grows and changes. There are a few accounting hoops to jump through, but at this stage you should be working with an accountant who can properly take care of this.
How to Start an Alabama Sole Proprietorship
Step 1: Come Up with a Business Name
Consider, for instance, John Smith, a seasoned barbecue pitmaster based in Birmingham, Alabama. John is in the process of setting up his own home-based barbecue catering service. Rather than conducting business under his full name – John Smith – he chooses to operate under the trade name “Smoky Delights.” In this case, John will need to register a Trade Name, commonly called a DBA name or Doing Business As name.
In my experience guiding new business owners, adopting a creative trade name instead of using your personal name can be a game-changer for branding and marketing. It lends a professional touch that can make your business seem larger and more established right out of the gate. I’ve seen this help many sole proprietors gain credibility and trust.
Nonetheless, it’s critical to acknowledge that registering a Trade Name in Alabama is not required for a sole proprietorship. By default, a Sole Proprietorship’s name is the owner’s legal name, so if John prefers to manage his business under his own name, that’s entirely permissible. He can simply conduct business as “John Smith,” without the requirement to register a DBA name. The decision to use a personal or assumed name hinges on your individual preferences and the manner in which you wish your business to be recognized by your clients.
Step 2: Verify the Name is Available
Before registering your chosen trade name, I recommend using the Alabama Secretary of State’s online database to verify the name isn’t already taken. During my time advising clients on business formation, I’ve seen folks go through the hassle of filing paperwork only to learn the name was unavailable and have to start over. Don’t let that happen to you!
Step 3: File the Trade Name Registration Form
After confirming the name you want is available to use, you will want to either mail or submit the Application to Register or Renew Trademark, Service Mark, or Trade Name form in-person or file it online with the Lands & Trademarks Department of Alabama Secretary of State.
Step 4: Get an EIN
This step is optional if you don’t plan to hire employees. The EIN or Employer Identification Number is a unique nine-digit number assigned by the Internal Revenue Service (IRS).
The EIN is needed for Alabama businesses that are either registered as a general partnership, corporation, or multi-member Limited Liability Company or; a sole proprietorship or single-member LLC that has employees.
The EIN is optional for sole proprietorships and single-member LLCs without employees. Those business entities will use the owner’s social security number (SSN) or Individual Taxpayer Identification Number (ITIN). While it’s not required, using an EIN instead of the owner’s SSN can help protect the owner from identity theft.
Related: How to register for an EIN
Step 5: Research Business License Requirements
After registering the business name, you will want to research any required business licenses. Business licenses are required regardless of the business entity and will vary depending on what the business does and its location.
A few common types of business licenses in Alabama include:
Business Privilege License: In Alabama, all individuals operating a business are required to get a Business Privilege License. This licensing process is overseen by the Department of Revenue, but the actual issuance of the license is handled locally by either the county Probate Judge or License Commissioner. Please note that your business may need multiple Business Privilege Licenses, contingent on the nature of your products or services. It is also common for most businesses to need a Business Privilege License for every county where they conduct business.
City business licenses: Many cities require businesses to be licensed in order to operate legally. For instance, the City of Birmingham requires an annual business license for certain businesses, including those that sell alcoholic beverages, dance or pool table licenses, street vendors, and more.
Health department permits: If you’re opening a business that involves food service (like our fictional John Smith and his catering service), you may need a health department permit from your local health department.
Alabama sales tax license: Most businesses operating in the state will need to obtain an Alabama Sales Tax License. This registration from the Alabama Department of Revenue is needed for any business in the state of Alabama that will collect sales taxes, lodging taxes, or will have employees.
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Alabama Sole Proprietorship FAQs
Does a sole proprietor need a business license in Alabama?
While Alabama does not require a general business license, all businesses will be required to get a Business Privilege License. In addition, certain industries and professions may need specific licenses or permits.
How much does it cost to start a sole proprietorship in Alabama?
There is no cost to start a sole proprietorship in Alabama; however, there will be a cost to register a Trade Name and obtain business licenses.
The cost to register a Trade Name in Alabama is $30 and needs to be renewed every 5 years.
What is the difference between a sole proprietorship and an LLC in Alabama?
Both Sole Proprietorships and Limited Liability Companies (LLCs) are the two most popular business structures, but they have key differences that are important to consider.
Liability protection: The most significant difference is personal liability. In a sole proprietorship, there’s no legal distinction between the owner and the business. This means that the business owner is personally responsible for all debts and liabilities of the business. If the business faces a lawsuit or goes into debt, the owner’s personal assets (like their house, car, and personal bank accounts) could be at risk.
On the other hand, an LLC is a separate legal entity. This means the owners, known as members, are not personally responsible for the company’s liabilities and debts (unless the debts are personally guaranteed, which is commonly required when obtaining a business loan). If the company faces a lawsuit or goes bankrupt, in most cases, only the assets of the LLC can be used to pay off the debts.
Taxes: In a sole proprietorship, the business itself does not pay income tax. Instead, all profits and losses are passed through to the owner’s personal income tax. The owner pays self-employment and personal income taxes on the business profits on their personal tax return.
An LLC, however, can choose how it wants to be taxed: as a disregarded entity (like a sole proprietorship or a partnership, where profits and losses are passed through to the member’s personal income tax) or as a corporation where there may be tax savings as some of the business profits may not be subject to self-employment taxes.
Complexity and cost: Setting up a sole proprietorship is very simple and less expensive than forming an LLC. A Limited Liability Company requires filing articles of organization with the Illinois Secretary of State and paying a state filing fee. Also, LLCs in Illinois must file an annual report and a fee.
Credibility: This benefit will vary by industry, but some people believe an LLC can give your business more credibility because it shows you’ve made a formal commitment to your business.
Related: How to form an LLC in Alabama
Which is better, an LLC or a sole proprietorship?
Whether an LLC or a sole proprietorship is better for you depends on your specific situation and needs. A sole proprietorship is simple and inexpensive to start but doesn’t provide any separation between your personal and business assets. This means that if the business is sued or owes money, the owner’s personal assets may be at risk.
A sole proprietorship can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business entity. Some examples of businesses that commonly operate as sole proprietorships include freelancers, consultants, artists, and writers.
On the other hand, an LLC requires upfront paperwork and costs but could provide your business with long-term benefits that make the investment worth it. An LLC exists separately from its owners, known as members, and members are not personally responsible for business liabilities and most debts. Another bonus for the LLC is that for more profitable businesses, LLCs can save money on taxes.
Neither an LLC nor a sole proprietorship is inherently “better.” Instead, each is suitable for different circumstances and comes with its own benefits and considerations. It’s all about assessing your specific situation and determining what best suits your needs. Always remember, when in doubt, consult with an attorney or accountant to understand all the implications of your choice.