Ebay, Kinkos, JCPenney, Walmart, and Marriott Hotels are a few examples of successful organizations that started under the same simple business structure: a sole proprietorship. This type of business is the most common in the U.S. For example, the Tax Foundation cites there are 23 million business owners with sole proprietorships today. Sole proprietorships are so prevalent because they require very few qualifications. In fact, you might be a sole proprietor without even knowing it.
Nevertheless, if you’re someone with a fast-growing company, it might be time to move your startup to a different business structure. Since sole proprietors and their companies are considered legally indistinguishable, there are also disadvantages for entrepreneurs operating their businesses in this manner.
Find out the definition of a sole proprietorship, how to become one, information regarding tax returns, the pros and cons, and other business structures you might want to move to once your company starts scaling.
What is a Sole Proprietorship?
Sole Proprietorship Definition
A sole proprietorship is a basic business structure considered legally inseparable from the person who establishes, owns, and operates the company. There is no distinction between the business and its owner. The two are so intricately tied together that many people do business under their own name. Additionally, unlike an incorporated company, a sole proprietor’s business’s debt is also personal debt. The same goes for profits and gains, which are paid directly to the business owner.
How to Become a Sole Proprietor of a Business
Unlike establishing a business as a corporation, filing with the federal government is not a necessary requirement when starting a sole proprietorship. The company organically comes into being through a person’s business activity. For instance, those who are freelancers, contract workers, and 1099 employees are sole proprietors.
Yet, there are a few rules when it comes to the paperwork for this type of business owner. First, if the business is not using your legal name, you will need to file a fictitious name or assumed name. For example, if your name is John Smith, but you’re doing business as (DBA) John’s Auto Repair, you’ll need to register the name with your state. Make sure this name is not the same as any other in your local area. Still, a sole proprietorship is not a legal entity itself. This means when it comes to business transactions such as contracts and payments, use the business owner’s legal name.
Secondly, always check to see if the state or local government requires any specific licenses, registrations, or permits before starting a business. Every state has different requirements and fees. To do this, visit your county clerk’s office. Additionally, a person can do this online through LegalZoom, too.
Search for your state’s and city’s requirements using these tools:
- U. S. Small Business Administration’s state license requirements
- City Applications local license requirements
Understanding Sole Proprietorships and Taxes
One of the best perks of being a sole proprietor is the straightforward process of filing tax returns. Taxes owed by the business are the same as personal income taxes. Due to this, make sure you save around 25 to 30 percent of any profits made toward paying your annual income taxes. For example, if you receive a $3,500 check as a contract worker once every two weeks, put back $1,050 for taxes in a savings account.
Three IRS Forms Sole Proprietors Need
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.
A Form 1040 reports individual income and deductions for a person’s annual income tax return.
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.
Owning one of these types of sole proprietorships may offer some tax benefits. As mentioned before, a sole proprietorship is not a legal entity. For this reason, someone with this type of business does not need to report, file, or pay separate business taxes. Additionally, entrepreneurs using this structure will likely pay less personal tax than those using other types of legal entities like a C corp. Sole proprietorships, limited liability companies (LLCs), S corps, and partnerships are similar in that profits and losses “pass-through” owners. In essence, this means entrepreneurs get taxed on profits only once because the business’s income flows directly through them.
Pros and Cons of Sole Proprietorship
As referenced above, there are a variety of types of sole proprietorships an entrepreneur can select when deciding how they’ll operate their company. Check the information below to figure out whether or not a sole proprietorship will work best for you.
Advantages of a Sole Proprietorship
- There are no upfront costs to start a sole proprietorship if you’re doing business under your legal name (necessary licenses and permits excluded).
- The business and the owner are one and the same. There is no need to separate property and profits between that of the owner and that of the business.
- There is minimal administration and documentation required in comparison to C corps, S corps, and nonprofits.
- Unlike a corporation or partnership, a sole proprietorship gives the person who establishes the company full control over business decisions.
- Owners can expect to pay a lower amount in taxes than other legal business structures.
- Tax reporting is much easier and straightforward than for owning a corporation, partnership, or nonprofit.
Disadvantages of a Sole Proprietorship
- The business and owner are legally considered inseparable. Any damages or unpaid debts can result in the loss of personal assets, properties, and funds.
- Owning a sole proprietorship is a huge risk. There is no legal liability protection. For instance, if the business is in debt for $150,000, the owner is held personally responsible for it. A business structure like an LLC offers far more legal protection since the law distinguishes an owner from their company.
- Because of unlimited personal liabilities, work-related accidents could leave a company owner financially depleted.
- Owners take on responsibility for paying legal judgments in the event of a lawsuit.
- Sole proprietorships are not an investor-friendly form of business. Typically, investors want a significant amount of equity in a company. A person cannot offer a stake in the company because there can only be a single owner.
- Since sole proprietorships are not a legal business entity like a corporation, partnership, or nonprofit, they are usually viewed as being more amateur and less legitimate. Establishing strong relationships with large-scale companies or institutions is more difficult.
Moving Toward a Legal Business Structure
While many entrepreneurs start their journey as sole proprietors, those with growing companies usually choose to have more legal protection with a more secure type of business structure. Typically, the natural progression is to create an LLC.
Starting an LLC requires:
- Choosing which type of LLC best suits your company.
- Getting an articles of organization form.
- Finding an available name.
- Selecting a registered agent, filing, and paying any fees.
- Creating an operational agreement.
- Receiving your state’s approval to operate.
- Obtaining an EIN (like a Social Security number for business) to start a business bank account.
- Getting required local, state, and federal licenses.