When it comes to simple business structures, sole proprietorships are among the most basic entities that you can set up. When an individual goes into business for themselves, most of the time they will begin their venture as a sole proprietor. The question is, should you structure your company as a sole proprietorship. What are the downsides? How about the advantages? In this article, we look closer at the definition of a sole proprietor as well as the downsides and benefits of this type of structure.
Understanding what a sole proprietor is
Most often a sole proprietorship is owned by a single person. In some cases, a married couple can also own a sole proprietorship. A sole proprietor is therefore a business owner who has not incorporated their company. To this end, the sole proprietor is liable for anything related to the business; meaning, if the company gets sued, if debt accrues, the owner of the company (or sole proprietor) is the one responsible for all such liabilities. Their assets are consequently at risk if there is not enough money in the business to cover the debts.
In terms of taxes for a sole proprietor, the business and personal tax returns are the same. So when you go to file your taxes, you will not pay business taxes per se, rather, any business income will be listed as personal income for a sole proprietor. You will therefore base your income tax on your tax bracket, and this is determined by the amount of income earned. If you are a sole proprietor, you will need to file a Form 1040 Schedule C come tax time. Additionally, sole proprietors have to keep in mind that throughout the year, every quarter, they are responsible for paying estimated taxes to the IRS. Also, sole proprietors will need to pay self-employment tax as they do not get a paycheck from a company—when getting a paycheck Social Security and Medicare are generally taken out automatically. Self-employment tax will be 15.3% of your net income.
The Difference Between Sole Proprietorships and LLCs
One of the primary differences between a sole proprietor and the owner of an LLC is that with an LLC there can be more than just a single owner. This is what is called a multi-member LLC. Also, with an LLC you are protected from the debts and other such liabilities that are incurred by the company. The owner or owners in other words cannot be sued and their assets are not at risk in any sort of legal action. While this is a positive attribute of an LLC, keep in mind that there are more legwork and more cost involved with setting up an LLC versus becoming a sole proprietor.
Forming a Sole Proprietorship
For the most part, anyone who is in business for themselves and makes money from that business is considered a sole proprietor. You can of course go to your local clerk’s office or another relevant state/local governing body to file the necessary paperwork to restructure your business as an LLC or S-Corp, but until you do that, you are considered a sole proprietor.
There are a few requirements that may be necessary for establishing your entity as a sole proprietorship. Among these requirements, as noted, you have to be turning a profit. If for instance, the IRS looks at your endeavor and considers it a hobby then you are not a sole proprietor. Let’s say you donate a certain service/product, this would not be considered a viable company.
Depending on the nature of your business, you may also be required to obtain certain permits and/or licenses. You will need to check both locally and at the state level (in some cases you may also need a federal license/permit). But you want to be sure to get the necessary permits as not getting them could result in fines and penalties for your sole proprietorship.
Many sole proprietors, will do business under their name. You can however operate under an alternate name, but you would have to file for a DBA (doing business as). This is generally handled by the local clerk’s office associated with the county in which you are located.
Another thing you will want to do as a sole proprietor in terms of getting your business up and running is to open a bank account that is separate from your bank account. While a separate account may not be required for your company, it is always a good idea to maintain separate ledgers as far as personal versus business finances. Mingling expenses can get you in trouble down the road. If you have a DBA, you can open your account using this name to make the line between your finances even clearer.
The benefits and drawbacks of a sole proprietorship
As with any type of business structure, there are pluses and minuses to a sole proprietorship. Understanding what these are before establishing your business entity is important. Among the pros of being a sole proprietor are the following:
- You are the sole owner. As noted, a sole proprietorship is an entity owned by a single individual. The plus side here is that you are not sharing control of the company, and as such, you make all the decisions and run things as you see fit.
- Establishing a sole proprietorship is a very easy and cheap process. Versus setting up a corporation, for example, the cost of a sole proprietorship is minimal. And if you are running the business under your name there is no paperwork to file.
- Come tax time, things are much simpler than if you were established as a C Corp for example. All you are doing is declaring business income on your tax returns and consequently filing Form 1040 Schedule C.
There are of course several drawbacks to being a sole proprietor that you should be aware of.
- The biggest drawback of this type of business structure is the fact that you are liable for the company’s debts and any legal action that is taken against the business. So keep in mind, that your assets could potentially be at risk if the company does get into trouble.
- The lifespan of the business is uncertain when it comes to sole proprietorships. That is to say, the company is the owner. Therefore, it is directly tied to how long the owner wishes to engage with the business or, if something happens to the owner and they can no longer helm the company, it is likely to dissolve.
- Raising money as a sole proprietor can also be much more difficult than if you were a corporation. This can occur for a few reasons. Investors tend to view sole proprietorships as less professional. And because of the nature of the structure, they are likely to see your entity as riskier.