Confused about what is required to start and run a sole proprietorship? We break down the sole proprietorship advantages and disadvantages, registration, filings, 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
The primary advantages of a sole proprietorship over other business entities is that the entity can be immediately set-up in most cases, very inexpensive to start and the owner has complete control of business decisions.
What are the disadvantages of the sole proprietorship?
While the sole proprietorship is fast, easy and inexpensive to start, the major downside is that the assets of the business and the owner are the same. If the business is sued, the business owner could risk losing their personal assets.
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.
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…
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.
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.