Key Takeaways
- In a sole proprietorship, all financial and legal responsibilities of the business fall on the owner.
- The owner of the sole proprietorship will pay an income tax and a 15.3% self-employment tax.
- Sole proprietors are responsible for filing taxes quarterly and annually.
- The sole proprietorship business structure is best for businesses with low start-up costs and low legal and financial risk.
What Is a Sole Proprietorship?
A sole proprietorship is a basic business structure with no distinction between the business and its owner. Unlike a corporation or LLC, a sole proprietorship’s legal and financial obligations fall on the business owner. The same goes for profits and gains, which are paid directly to the business owner.
Sole proprietors save time and money when establishing the business because there are generally no initial fees or paperwork to establish yourself as a sole proprietor. However, the business owner is subject to a personal income tax and a 15.3% self-employment tax.
The sole proprietorship business structure is best for businesses with low start-up costs and low legal and financial risk. Here are a few careers that are well-suited for a sole proprietorship business structure:
- Accountants and financial consultants
- Writers and editors
- Independent fitness trainers
- Landscape designers
- Graphic designers
- Web developers
How Sole Proprietorships Differ From Other Business Entities
As a business owner, you have multiple options for how you want to structure your business entity. Each structure has different legal protections, tax strategies, and leadership structures. Here’s what you need to know about the most common types of business entities:
Partnership
The only difference between a partnership and a sole proprietorship is that a partnership has more than one owner. Just like in a sole proprietorship, there is no distinction between the business and the owners in a partnership. This means business and personal income are one and the same, and that income is subject to a self-employment tax.
Limited Liability Company (LLC)
LLC business owners are considered separate from the business when it comes to liabilities like debts or lawsuits, which protects the owner’s personal assets. These businesses can have one or more owners. Like a sole proprietorship or partnership, LLC owners pay self-employment taxes on the income they earn, but the business itself is not taxed on business income.
LLC owners pay themselves through an owner’s draw. An owner’s draw is when an LLC owner takes money from the business for personal use. The business owner can choose how much and how often to take an owner’s draw. This flexibility can be used to reduce the business’s tax liabilities.
Corporations
Unlike sole proprietors and LLC owners, corporation owners are not considered self-employed. Instead, they are employed by the corporation and, therefore, must receive a reasonable salary. That salary is then taxed as personal income.
Like LLC business owners, owners of corporations are considered entirely separate entities from their businesses, meaning their personal assets are protected if the company experiences legal or financial trouble.
| Owner Assumes Personal Financial and Legal Responsibility | Subject to 15.3% Self-Employment Tax | Costs to Form the Business | Method of Payment for the Business Owner | |
| Sole Proprietorship | Yes | Yes | None | Business and personal income are one and the same |
| Partnership | Yes | Yes | None | Business and personal income are one and the same |
| LLC | No | Yes | Low | Owner’s draw |
| Corporation | No | No | High | Salary |
Pros and Cons of Sole Proprietorships
As with any type of business structure, the sole proprietorship is not the right structure for everyone. This business structure has advantages and disadvantages. Here’s what to consider when deciding if this is the right structure for your business:
Pros
- Zero costs to establish
- Lower tax obligations
- Business and personal tax are one and the same
Cons
- Increased personal legal and financial risk
- Increased audit risk
- 15.3% self-employment tax
- Can be difficult to raise funds for the business
6 Steps to Creating a Sole Proprietorship
Sole proprietorships are the default business structure, which means if you have not registered yourself as an LLC or corporation, but you are conducting business, the IRS considers you a sole proprietor. So while you can create a sole proprietorship with minimal effort, to protect yourself and your new business, it’s a good idea to follow these simple steps.
1. Choose a Name for Your Business
Sole proprietorships are required to operate under the business owner’s name unless the owner has established a DBA, which stands for “doing business as.” If you wish to use a brand name rather than your personal name, you’ll need to file a DBA application through your state or county and pay the fee, which ranges from $5 to $150.
2. Check Which Permits or Licenses Your Local Government Requires
Contact your local small business development center to learn which permits or licenses you need to be sure your business is operating legally. Some cities require a business license to operate any business, regardless of size or industry.
Additionally, certain industries require permits or certifications to ensure you’re qualified to provide high-quality services. For example, any type of business involving food handling, like a catering business or bakery, requires permits that certify the safety and cleanliness of your products. The financial industry also requires licensing for offering services like financial planning or accounting. No matter your industry, it’s a good idea to double-check the requirements before you begin operating.
3. Get an EIN If You Plan to Hire Employees
As a sole proprietor, you’re able to operate your business under your social security number, but if you hire any employees, you’ll need an EIN (employer identification number). If you think there’s a chance you’ll hire employees in the future, it’s best to get this step taken care of in advance. You can apply for an EIN through the IRS here.
4. Set Up a Business Bank Account
While there is no legal requirement to use a business bank account rather than your personal bank account, keeping your finances separate will make it easier to track your income and expenses, pay taxes, and prove your legitimacy in the case of an audit from the IRS.
Many sole proprietors are inexperienced in tracking their finances, which puts the IRS on high alert. This means you are more likely to be audited as a sole proprietor, so it’s critical you keep a clean record of your finances.
5. Open a Savings Account
You’ll need a savings account as a sole proprietor to ensure you’re not spending money you will need for taxes. Open a savings account and set money aside each time you get a check. For example, if you receive a $3,500 check from one of your clients, put 30% or $1,050 in savings until tax season. This should be enough to cover both federal and state taxes.
6. Get an Insurance Policy
Because a sole proprietorship does not protect your personal assets, it’s a good idea to take out a business insurance policy. An insurance policy can cover some or all of your expenses if your business gets into legal or financial trouble.
Sole Proprietorship FAQ
Is being a sole proprietor and self-employed the same thing?
The terms sole proprietor and self-employed are similar but not interchangeable. Being self-employed means someone is not employed by another person or company but instead earns a living through their own business or freelance work.
Being a sole proprietor and self-employed are similar in that the individual is running their own business. However, being self-employed can also include other types of business structures like a partnership, a limited liability company, or a corporation that they own.
Do sole proprietors make a salary?
No, sole proprietors do not make a salary. Instead, clients will typically pay you by the project or by the hour. The amount you earn in a year will depend on how much work you choose to take on, how much you choose to charge, your experience level, and the type of services you offer.
Employment website ZipRecruiter reports, “As of Jan 11, 2023, the average annual pay for a freelance accountant in the United States is $57,981 a year. A 2022 report found the average self-employed consultants earn an average hourly rate of $119, self-employed IT professionals earn an average of $95 per hour, and self-employed workers in the graphics, media, and content industries earn an average of $65 per hour.
Can you hire a team as a sole proprietor?
Yes, sole proprietors are business owners and are, therefore, able to hire employees. However, many complications come from expanding your team, so it is typically recommended that you restructure your business to an LLC or corporation if you’ve grown large enough to hire employees.
Here are a few things to consider when hiring employees as a sole proprietor:
- Some states require you to carry worker’s compensation insurance, so be sure to read up on your state’s laws.
- You must have an EIN (employer identification number) to hire employees. Because sole proprietorships often operate under the owner’s social security number, many sole proprietors will have to obtain an EIN before hiring anyone.
- Additional employees can increase your legal and financial risks. As a sole proprietor, you will be personally liable for any legal and financial trouble that arises.
How do I handle taxes as a sole proprietor?
As a sole proprietor, taxes owed by your business are the same as personal income taxes. Because of this, it’s important to save around 25–30% of your profits for state and federal taxes.
Keep in mind that sole proprietors are responsible for filing taxes annually and quarterly. There are three forms that will help you keep track of your tax obligations.
- Schedule C: This form helps business owners calculate their income tax by reporting profits and losses. Here, a person can deduct expenses like travel and meals, utilities, and office expenses. Overall, itemizing deductions can greatly affect how much an individual owes in federal taxes. This form should be filed annually.
- Form 1040: Form 1040 reports individual income and deductions for a person’s annual income tax return. This form should be filed annually.
- Schedule SE: This form determines your self-employment tax. Attach it to your Form 1040 and use it to find out how much annual tax you owe. This form should be filed quarterly.
How to Transition From a Sole Proprietorship to an LLC
As your business begins accumulating greater expenses, earning more income, and taking on greater risks, you should consider forming an LLC. While a sole proprietorship offers a simple way to test out a business venture, once you’re on your way, you should structure your business under an entity that offers greater legal and financial protection.
Anyone setting up an LLC should follow these steps:
- Choose which type of LLC best suits your company.
- Get an articles of organization form.
- Find an available name.
- Select a registered agent, file, and pay any fees.
- Create an operational agreement.
- Receive your state’s approval to operate.
- Obtain an EIN (which is like a social security number for a business) to start a business bank account.
- Get any required local, state, and federal licenses.
To read more tips for business leaders, check out these articles:
Economies of Scope: What Are They and How Do They Maximize Profit
How to Calculate and Understand Your Company’s Debt-to-Equity Ratio