If you have no employees and you’re the only owner of your business, your business can be formed as a sole proprietorship instead of a limited liability company (LLC) or other organizational structure. The advantages of doing so are numerous, but so are the disadvantages. To help you decide, here’s what you need to know about sole proprietorships, the simplest type of business organization you can choose.
What's a sole proprietorship?
A sole proprietorship is one of the most common business structures in the U.S. It’s also the easiest to form and operate. Unlike corporations or LLCs, you don’t need to register your sole proprietorship with the state because it’s not a separate legal entity. Plus, as the sole proprietor, you have full control over the direction of your business.
Types of sole proprietorships
Three types of business entities can function as sole proprietors:
- Independent contractors. An independent contractor is an individual who performs work for several companies. This structure essentially makes you a one-person business. You’re an independent contractor if your clients don’t classify you as an employee and your paychecks include no deductions. Learn more via the SmartBiz Loans ® guide to employees versus independent contractors.
- Business owners. If you own your company by yourself and have no employees, you’re a sole proprietor. Sole owners who have employees also qualify as sole proprietors. However, as your number of employees increases, you may find another type of business, such as an S or C corporation, to be more beneficial.
- Franchise. If you own a franchise location by yourself, then to tax authorities, you’re a sole proprietor. Yes, you pay franchise fees for unique rights to a well-established brand’s logo and name, but you don’t own that logo and name. You just own your one location branded accordingly, so you’re a sole proprietor.
Advantages of a sole proprietorship business
Among the reasons business owners like yourself might benefit from a sole proprietorship structure are:
- Ease, control, and flexibility. You don’t need to file any forms to designate your company as a sole proprietorship business. You also lack co-owners, shareholders, and a corporate board, so you have full control and flexibility over how you operate your business.
- Privacy. Since sole proprietorship businesses don’t have shareholders or a corporate board, you’ll have no financial or operational reporting requirements. You also don’t need to file separate business tax returns – your business and personal tax returns are one and the same. On both these fronts, you preserve your privacy, as you’ll have no corporate documents or business tax returns for the public to access.
- Simple tax preparation and filing. Sole proprietorship businesses are pass-through entities. That means that, as a sole proprietor, all of your small business’s profits or losses are also your personal profits and losses. You won’t need to file corporate tax forms or calculate two sets of taxes – one takes care of the other.
- Lack of registration and fees. You don’t need to register your business or pay any fees to start a sole proprietorship. If you were to form an LLC, on the other hand, you’d need to create articles of organization and pay hundreds to thousands of dollars. As a sole proprietor, you save both time and money establishing your business.
- Potentially lower tax rates. Your sole proprietor business tax rate is equal to your personal tax rate. However, the Small Business Administration (SBA) has found that the average effective tax rate for sole proprietorships is 13.3 percent. Other types of businesses pay, on average, effective tax rates between 17.5 and 26.9 percent.
- Balance sheets not required by the IRS. Unincorporated businesses such as sole proprietorships aren’t required to file balance sheets with the IRS. C corporations, on the other hand, must include balance sheets with their annual tax returns. Sole proprietorships thus aren’t required to maintain balance sheets in the first place, though balance sheets are highly recommended for all businesses.
- Full control over revenue. Sole proprietors don’t need to set aside business revenue for shareholders. Plus, if you have no employees, you can keep all your money for yourself. Few other business structures offer this extent of revenue control.
Disadvantages of a sole proprietorship business
Some drawbacks of operating as a sole proprietorship include:
- Mixing business and personal liability and taxation. Your personal assets and business finances are one and the same as a sole proprietor. This means that any losses will affect not only the business, but your own accounts as well. You also represent the business when it comes to legal situations and is responsible for all of its debts.
- Business bankruptcy means personal bankruptcy. Since sole proprietorship businesses are indistinct from their owners for financial purposes, business bankruptcy means personal bankruptcy. If you instead owned a separate business such as a C corporation, you could file for business bankruptcy without being personally liable.
- Personal assets are at risk. The above example shows that your personal assets are always at risk when you operate as a sole proprietor. They’re also at risk if your business faces a lawsuit. Since you and your business are equivalent for legal and taxation affairs, you’ll be personally responsible for all outcomes of lawsuits against your business.
- Difficulty raising capital. Since you can’t protect your personal assets as a sole proprietor, you may find that investors are unwilling to risk funding you. Investors may also see your business as less stable and less credible if you’re the only person at the helm. Corporations typically face fewer obstacles obtaining funding given their inherent business-personal divide and perceived credibility.
- Perceived lack of professionalism. The above funding examples hint at the perceived lack of professionalism that sole proprietors may sometimes face. This perception may extend to all things business. For example, a potential client choosing whether to hire a third-party sole proprietorship or corporation may choose the corporation because its large staff may appear more legitimate.
- Self-employment tax rates can be high. Despite the earlier explanation that sole proprietorships have the lowest effective tax rates, this fact may not always hold true. For starters, sole proprietors pay self-employment tax rates of 15.3 percent, and these taxes don’t apply to corporation owners. Additionally, the federal corporate tax rate is 21 percent, which could be lower than your personal income tax rate.
Taxes a sole proprietor owes
You’ll also have to file a Schedule SE with your Form 1040, which is used to calculate how much self-employment tax you owe.
How Does a Sole Proprietorship Get Started?
Ready to launch your business as a sole proprietorship? All you really need is a few essentials:
- Business name. It’s one thing to come up with what you think is a great business name. It’s another to determine whether someone else has already trademarked that name. To find out, you’ll need to search the US Patent and Trademark Office trademark database.
- Business checking account. Even though your business and personal finances are equivalent for tax purposes, you should still separate your business and personal finances. Opening a business checking account is the simplest way to do so. This way, you can have your sole proprietorship income deposited in your business account and keep a certain portion there for tax payments and business expenses. You can then move the rest to your personal account.
- Business plan. A business plan guides all your operations and can potentially help you obtain funding. It’s an important document to create before launching any type of business, not just a sole proprietorship. Use the SmartBiz Loans ® guide to business plans to start creating your plan.
Some legal requirements include:
- Local business license. To operate a business in your municipality, you must obtain proper licensure from your local business authority. To find the right authority, visit your city hall or contact your city government via its website.
- Sales tax permits. If you sell anything on which sales taxes can be levied, you need a sales tax permit to go into business. This permit is required even for sole proprietorships despite sole proprietors having no non-personal tax burdens. Learn whether you need a sales tax license and how to get one via the SmartBiz Loans ® sales tax guide.
- Relevant licenses and permits, depending on your industry and location. Your services or products and location may subject you to additional licensure requirements. Find some potential licenses you might need and tips on how to obtain them via the SmartBiz Loans ® business license guide.
- Federal Employer Identification Number (EIN) . If your sole proprietorship has employees, you’ll need an EIN to operate. You can apply for an EIN for free via the IRS, and that’s important. Unfortunately, it’s not unheard of for scammers to target small businesses owners with fake paid EIN application services. In reality, you’ll never have to pay to apply for an EIN.
Once you have these tasks checked off your to-do list, you’ve started a business!
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WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.