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What is a sole proprietorship and how do I register?

Overview

Are you planning to start up a business but are confused about what type of business it should be? Do the words “Sole Proprietorship” and “Limited Liability Company (LLC)” run together in your head and leave you confused? 

You aren’t the only one. Many prospective business owners struggled with these terms initially, and now they have the hang of it. You will, too, starting from a sole proprietorship. 

This article discusses sole proprietorship in detail, from its definition to steps on how you can set one up. When you’re done reading this article, you should know everything there is to know about a sole proprietorship and even some about an LLC!

We break down what the sole proprietorship is, the advantages and disadvantages of structuring your business as one, how to register one, taxes and more.

What is a sole proprietor business?

Simply defined, a sole proprietorship is an individual who goes in business with the intention to make a profit.  A sole proprietor has complete ownership of the business and is free to make any decision he or she wishes concerning the business.

What is the difference between a sole proprietorship and being self-employed?

The terms are often used interchangeably, but anybody generating income from self-employment is a sole proprietor.  This also includes independent contractors and freelancers.   The term sole proprietorship is used for the business entity.

What are the advantages of a sole proprietorship

Aside from the fact that a sole proprietorship is the oldest form of business and allows you to be your boss, many advantages come with choosing a sole proprietorship. 

Here are some of the more notable ones. 

Less Paperwork 

At first glance, less paperwork may seem to be a pretty funny advantage. Still, when you consider the amount of paperwork required for tax season and the business’s initial setting up, you’ll realize that less paperwork is a serious advantage. 

From legal to state registration, setting up a limited liability or partnership business model requires a lot of paperwork. On the other hand, a sole proprietorship requires far less paperwork in the initial stages. The sole proprietor might be required to register his business with the local government or acquire a license to practice depending on the business type. Beyond this, there’s very little paperwork needed to set up a sole proprietorship. 

Sole proprietorships also don’t have to file much paperwork during tax season because they share a legal entity with the sole proprietor who can pay taxes using their Social Security Number (SSN). 

Little to no Bureaucracy in Decision Making 

A significant advantage of a sole proprietorship is the lack of bureaucracy and the quickness of making and executing decisions. The sole proprietor is in control of the business decisions and their implementation. His decisions don’t have to be approved by a board of directors or shareholders, so the sole proprietor has the right to decide and implement on his timetable. 

Easy to Set Up 

There’s a reason why sole proprietorships are the most common type of business out there. It’s because they are easy to set up. Anyone with a service to sell, clients willing and ready to purchase, and the intention to have a business can set up a sole proprietorship. 

Since a single individual owns the sole proprietorship, there is no need for any formal legal papers detailing a part-owner and how profits intend to be shared as one would have in a partnership. Another reason why setting up a sole proprietorship is easy is because sole proprietorships don’t have to be registered in federal and state offices. 

All the sole proprietor needs to be functional is a license (if his industry requires one), and he is good to go. 

Control and Confidentiality 

Unlike other business models that have a legal entity, the law cannot compel a sole proprietor to publish its financial documents and accounts to the public. There is more confidentiality in business operations in a sole proprietorship. 

Having total control of your business and being your boss is another advantage of owning a sole proprietorship. You don’t have to answer anyone. You can make decisions alone without having to run them by someone else. It also doesn’t hurt that the sole proprietor is the sole beneficiary of any profits or financial incentive.  

What are the disadvantages of the sole proprietorship?

No business is without its flaws, and a sole proprietorship has its fair share. 

Business Lifespan 

In every way that matters, a sole proprietorship and the sole proprietor are one entity. While this makes for an easier business to set up, it also affects the company’s lifespan. When the sole proprietor dies, the business is only a few months away from meeting the same end as its owner. Consider a chiropractor who sets up his shingle and provides services in a neighborhood. The private practice will shut down when he dies because the business was tied to its owner. 

Limited Expertise 

The sole proprietor has to be a jack of all trades in every sole proprietorship. He is the executive for the business, the account officer, the marketer, etc. These multiple roles could result from necessity (inability to pay for qualified staff) or choice. Either way, the business would suffer somehow because as good as the sole proprietor is at multiple roles, he isn’t an expert in those roles and may be unable to make informed decisions out of ignorance. 

Unlimited Personal Liability 

We talked about unlimited liability as a core characteristic of sole proprietorships. It also doubles up as a significant disadvantage. The downside to having the same entity as your business is that your company’s assets and debts cannot be separated from you. In the event of debt, the sole proprietor would have to part with his assets to pay what the business owes. This is known as unlimited personal liability. 

Difficulty in Raising Capital 

Raising capital for a sole proprietorship is difficult. If the sole proprietor doesn’t have enough money saved up to fund his business idea, he may be unable to set up his business. Aside from savings, a sole proprietor’s only means of raising capital is borrowing either from friends or the bank. These two sources are wary of lending money to a sole proprietor for starting a small business because the business has no legal identity, and paying back the loan is uncertain. 

Related: What are the 7 disadvantages of a sole proprietorship?

How to register as a sole proprietor

Of the four primary business entities (sole proprietorship, partnership, corporation, LLC) the sole proprietorship is the easiest one to form.  Read more about the differences between the four business entities.

The sole proprietorship isn’t a formal legal entity, so there is nothing to apply for or register.

It’s important to note that by default, a single-owner business is automatically considered a sole proprietorship by the IRS.

There may also be additional steps needed depending on the state.  The most common is the business name registration.  If a sole proprietorship is doing business under a name other than the owner’s full first and last name, they will need to register for a DBA (Doing Business As) or Assumed Name or similar type of registration in most states.  For more information and to see the states that require a name registration for a sole proprietorship, visit https://startingyourbusiness.com, select your state and see Step 3. An individual can have several DBAs, however, they all have to be operated under one SSN/EIN.

Related: Does a sole proprietor need a business license?

Does a sole proprietor need an EIN?

The EIN or Employer Identification Number is a unique identifying number with the Internal Revenue Service (IRS) for a business.  A sole proprietor is not required to have an EIN unless they have employees.  A sole proprietorship without employees will simply use the owner’s social security number (SSN).

Some sole proprietors will get an EIN even if they are not required to as some of their clients will require the business to supply an identifying number which will be used to issue a 1099 at the end of the year.  They could choose to use their SSN, but don’t want to share it for privacy reasons.

Applying for an EIN for a sole proprietorship with the IRS takes about 5 minutes and there is no cost.

How does the owner of a sole proprietorship pay themselves?

As a sole proprietor, provided money is in the business checking account, you can take money out or “pay” yourself whenever you want.  You simply write a check to yourself and at this time you don’t have to pay tax on the money received.  This isn’t technically a salary or wages, but instead a draw.  A draw is an amount of money you take (or, draw) out of the business.

The profits of the business will eventually be taxed, regardless of how much money is drawn from the business.  If money is left in the business’s bank account and not “paid” to the owner, that money will still be taxed.

What taxes does a sole proprietorship pay?

Being self-employed generally requires the filing of an annual return and paying a self-employment tax (SE tax) in addition to a personal income tax.  While there are taxes that need to be paid, it’s important to realize that a sole proprietorship does not pay taxes at the business level.   Instead, business income or losses are reported on the owner’s personal income tax return.  The IRS refers to this as pass-through taxation, because the profits of the business pass through the business to the individual.

All expenses incurred in the operations of a business are able to be deducted, same as any of the other business entities.  When claiming deductible expenses, be sure to keep records of the receipts in case you need to prove the expense if audited.  Read more about business deductions…

Income Taxes

For tax purposes, the sole proprietorship is the owner of a business and the business income or losses are not separated from their personal tax return. At the end of the calendar year, a sole proprietor files a business tax return on IRS Schedule C or C-EZ, in addition to state income taxes.  To complete this return, the income, cost of goods and operating expenses are calculated, which results in the net income of the sole proprietorship.

The net income is the amount of taxable business income and is added to Line 12 the owner’s individual income tax return (IRS 1040) at the federal level and will vary on the state.    The owner of the sole proprietorship pays income tax on all income listed on the personal tax return, including income from business activities, at the applicable individual tax rate for that year.  If the business shows a loss, this loss can be used to reduce the taxable income of the owner.

Self-employment taxes

Sole proprietors must also pay self-employment taxes which are made up of contributions to Social Security and Medicare.  Self-employment taxes are similar to payroll taxes for employees, but only for self-employed individuals.

One difference between the two is while employees make their contributions through deductions from their paychecks, sole proprietors make estimated payments based on the profit of the business.

Another difference is that employees pay half of the Social Security and Medicare contribution and the employer pays the other half.  As a sole proprietor, the business owner is essentially both the business and employee, which means they pay both halves.

The self-employment tax rate for 2018 is 15.3% of the first $106,800 of income and 2.9% of everything over $106,800. Half of the self-employment taxes are tax deductible.

Self-employment taxes are reported on IRS Schedule SE (Self-Employment Tax).  This filing is submitted annually with the owner’s income tax filing and (IRS 1040) and Schedule C or C-EZ.

How to pay taxes

Since taxes don’t come out of the business owner’s “pay” like they would for an employee, the sole proprietor will pay an estimated amount quarterly.  As a general rule, if a self-employed person expects to incur over $1,000 in taxes for the year, they will need to pay quarterly.  While the business owner could wait to pay their taxes in the last quarter, there is the potential for an underpayment penalty from their state and IRS from underpaying the taxes.

There are a few ways to avoid an estimated tax underpayment penalty by either;

(1) Owing less than $1,000 in taxes for the current year or

(2) Pay estimated tax payments that total at least 90% of the total tax liability for the current year or 100% the total tax liability for the prior year, whichever amount is lower.

As a new business filing for the first year, since there was no tax liability from the previous year, a sole proprietor may be able to wait until the end of the year to pay these taxes.

Whichever route you go, it’s important to continually set aside a portion of the profits from the business to pay taxes, rather than try to scramble to come up with the funds as the penalties and fines can be substantial for underpayment.

To calculate how much to pay in estimated taxes use IRS Form 1040-ES.  This form helps in calculating the amount due and the quarterly payment vouchers.  To mail in the voucher, use the IRS processing center for your state and send it in along with the payment.    https://www.irs.gov/pub/irs-pdf/f1040es.pdf

When Are Payments Due?

Taxes for self-employed individuals is based on the calendar tax year.  As discussed earlier a new, first-year business can pay federal taxes at the end of the first year and then may have to pay taxes quarterly (though you can pay quarterly in the first year if you would like).  Quarterly payments are due based on the 15th the month after a calendar quarter.  For instance, the first quarter is January, February and March.  Those taxes would be due on April 15th.  The remaining quarters are due June 15, September 15 and January 15.

Does a sole proprietor need workers’ compensation?

A sole proprietor with no employees is typically exempt from being required to purchase workers’ compensation insurance for themselves.  Some states have some extra stipulations where the owner has to purchase insurance, especially in high-risk industries, but most can opt-out.

Workers’ compensation insurance may be worth considering as if the owner is injured at work and the income from the business is their only source of income, this insurance would replace the money they lost from the injury.

Also note that even though an owner may not be required to purchase workers’ comp insurance, clients may require them to purchase this insurance before they can take the job.  This is legal for the client to do and helps to protect their business.

See more information about workers’ compensation

Can a sole proprietor hire employees?

There is some confusion about this and yes a sole proprietor or self-employed individual can hire employees and there is no limit on the number of employees that can be hired.  Just as with any other entity, the owner is responsible to withhold state and federal withholdings pay payroll taxes and purchase workers’ compensation insurance.

Setting up a new business as a sole proprietorship is a good choice for many businesses.  It’s important to remember that the business entity can be changed whenever it is appropriate.  If the business outgrows the sole proprietorship, the business can change to a corporation or LLC relatively easily.  For other businesses, it’s better to spend a little extra and form a corporation or LLC to have liability protection.  Read more about the pros and cons on each of the business entities.

Should I form a Sole Proprietorship or an LLC?

It depends on what type of business you want to set up. If you’re starting up a small business, a sole proprietorship is the best option. You can always convert your sole proprietorship to an LLC by refiling your business name and procuring an EIN from the IRS.

On the other hand, an LLC is a much bigger operation than a sole proprietorship and can’t be treated. The size and motive of your new business would determine what type of business you should open.

Related: Sole Proprietorship vs LLC

What is the difference between a sole proprietor, self-employment, or independent contractor?

These terms are often interchanged but can have slightly different definitions as one refers to the business structure and the others a designation.

At its core, a sole proprietor or independent contractor is a self-employed individual, but a self-employed individual or independent contractor is not necessarily a sole proprietor.

Related: What is the difference between a sole proprietor, self-employment, and independent contractor?

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