Even when a small business starts as a sole proprietorship with only a solitary business owner who handles everything, growth and expansion are often the ultimate objectives. To achieve those goals, a sole proprietor will likely need some help along the way — which may involve hiring workers.
Since a sole proprietorship is not an officially registered business entity nor recognized as its own tax entity, you may be wondering if a sole proprietor can have employees. The answer is yes! Let’s explore this further and answer some common requestions that relate to this topic.
1. What is a sole proprietor exactly?
A sole proprietorship is a business not formally registered as an entity with the state. It is owned by a sole proprietor (either an individual business owner or a married couple). In a sole proprietorship, the business owner and the business are considered the same legal and tax-paying entity. The sole proprietor is personally responsible for all of the business’s legal and financial liabilities.
For tax purposes, a sole proprietorship’s business income, expenses, profits, and losses flow through to the individual business owner’s tax returns (using Schedule C of IRS Form 1040).
2. Can a sole proprietor employ himself (or herself)?
A sole proprietor is NOT an employee of the company and may not be on the company payroll. Rather than earn a salary or wages from the business, the sole proprietor takes “owner’s draws” (typically by writing business checks to themselves) to withdraw money from the business’s profits for personal use.
No taxes are withheld from owner’s draws, so the sole proprietor must make quarterly estimated tax payments to the government based on the business’s approximate taxable earnings each quarter. Those quarterly tax payments include income tax and self-employment taxes (Social Security and Medicare).
3. Can a sole proprietor employ their spouse?
Sometimes, sole proprietorships are owned by a married couple rather than an individual. If a spouse works in the business as a partner, the individual takes owner’s draws and is not compensated through a traditional payroll process.
However, if the sole proprietor hires their spouse as an employee, the spouse must be set up on payroll and pay income tax and FICA (Social Security and Medicare) taxes on their wages. However, their wages are not subject to FUTA (federal unemployment tax).
4. Can a sole proprietor hire their children as employees?
If a sole proprietor hires children (even their own), they must do so in compliance with child labor laws.
How taxes are handled for child workers depends on their age. Generally, the federal government applies the following rules:
- Children under the age of 18 are exempt from FICA taxes (Social Security and Medicare).
- Employers do not have to pay FUTA on wages of children under the age of 21.
- Children of any age must pay income tax on their wages. Employers must withhold that tax from the child’s pay.
State and local tax laws vary, so business owners should check with their state and local governments to determine if they exempt children from their income taxes.
5. What does a sole proprietor need to hire employees?
For payroll and other employment tax purposes, sole proprietors need the following tax accounts and documentation:
- EIN (Employer Identification Number) – A sole proprietor must obtain an EIN (a 9-digit ID number) from the IRS before hiring employees. The federal government uses that ID number for tracking the employer’s tax remittances from employee withholdings, payment of the employer’s share of FICA taxes (Social Security and Medicare), and payment of FUTA tax (Federal unemployment tax).
- Payroll Tax Registration with the State and Local Governments – Employers typically have to establish payroll tax accounts in the states and local jurisdictions where they have employees. The process and requirements vary, so business owners should research the rules that apply to them and ask an accountant for insight if needed. Similar to how the IRS uses an EIN, state and local payroll tax IDs are used for tax reporting and tracking purposes related to employee withholdings and payments to the state unemployment insurance program.
- Workers’ Compensation Insurance Policy – Most states require employers to carry workers’ comp insurance to cover medical, rehabilitation, and lost wages costs for workers who have suffered work-related injuries or illnesses.
- Form W-4 – Employers must get a completed Form W-4 (Individual Withholding Certificate) from each employee, so they know how much income tax to withhold from the individual’s wages each pay period.
- State Tax Withholding Form – Some states may require employers to have their employees complete an official state form to determine how much state income tax to withhold. Other states go by the withholdings on the W-4.
- Form I-9 – They must also ask for a completed Form I-9 (Employment Eligibility Authorization) to certify the individual is legally authorized to work in the United States.
A sole proprietor may also need other information and documentation from new hires. The requirements can vary depending on the business and the state where the employee performs their work.
Below are several examples of documentation needed for new hires:
- Signed offer letter
- Bank account information (if the employee’s pay will be issued through direct deposit)
- Forms to authorize enrollment in benefits (such as retirement savings plans and health care plans)
- Signed acknowledgment of receipt of workplace policy documents or employee handbook
6. How does a sole proprietorship pay employees?
A sole proprietor must choose their payroll schedule — the frequency of paying employees. Most small businesses pay employees weekly or biweekly (every two weeks) with a physical paycheck or direct deposit.
Some states allow businesses to pay employees via other means, such as prepaid payroll cards. The sole proprietor loads funds to the employee’s card account, and the employee can then use their card as they would a debit card to make purchases, withdraw cash, pay bills, etc.
When issuing pay to workers, employers must deduct the required tax withholdings, set those monies aside, and remit them to the tax agencies (e.g., U.S. Treasury Department and state and local tax agencies).
If the sole proprietorship offers benefits such as medical insurance, health savings accounts, or 401K plan, employee contributions to those programs must also be withheld from employees’ pay and remitted to the appropriate provider or financial institution.
Also, there may be mandatory deductions that employers must withhold from an employee’s pay, such as court-ordered wage garnishments for child support or back taxes.
7. What are the steps for calculating an employee’s take-home pay?
Here’s an overview of the payroll calculation and payment process:
- Calculate gross pay – Multiply the total hours worked by the hourly pay rate.
- Withhold pre-tax deductions – Certain deductions are taken from workers’ pay before taxes are applied. Examples include contributions to traditional 401K plans and healthcare plan contributions.
- Withhold taxes – Employers must withhold Statutory deductions such as federal, state, and local income taxes and FICA taxes from the adjusted gross income after deducting pre-tax withholdings.
- Withhold post-tax deductions – If wage garnishments are required or the employee is contributing to any voluntary taxable benefits (e.g., Roth 401K, long-term disability insurance), those amounts are deducted after taxes are withheld.
- Pay workers – After working through the above steps, the end result is the employee’s net pay.
8. Can sole proprietors handle payroll on their own?
While business owners may calculate employees’ gross pay, withholdings, and net income on their own if they wish, the process can be time-consuming and confusing.
Payroll software (e.g., Gusto, ADP, Paychex, etc.) can help simplify and automate the process. Or it may be beneficial to contract a payroll services provider, bookkeeper, or accountant to manage payroll. Failure to calculate payroll correctly, issue payments to agencies on time, or maintain accurate payroll records can result in costly penalties.
9. Can a sole proprietor have 1099 employees?
Technically, there’s no such thing as a “1099 employee.” What people mean when using that term is “independent contractor.” Independent contractors are individuals contracted to do work for a business, but they are not on the company’s payroll. Instead, they send invoices to the business and usually get paid by check, payment app (such as PayPal), or electronic funds transfer.
At the end of the tax year, a business must send the independent contractor a Form 1099-NEC (Non-Employee Compensation) if it paid the independent contractor more than $600 in the year. No income taxes or other payroll deductions are withheld from payments to independent contractors. Also, employers do not have to pay unemployment tax or workers compensation insurance for independent contractors.
It’s critical to classify workers as employees or independent contractors correctly. The IRS has “common law” rules for when someone must be treated as an employee for tax purposes based on the degree of control and independence they have over their work and various other factors. When it’s unclear whether the individual meets the criteria for independent contractor or employee, either the business owner or the worker can file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. Then, the IRS will review the situation and officially determine the individual’s status.
States’ guidelines for classifying workers may be stricter than the federal government’s rules.
10. What employment laws should a small businesses be aware of?
Laws exist at the federal and state levels to protect the safety and rights of employees. Some apply to all employers, while others are tailored to specific industries and types of businesses.
The U.S. Department of Labor summarizes its major laws on its website. Sole proprietors who plan to hire employees should also verify what state employment-related regulations apply to them. An attorney or human resources specialist can help business owners understand their responsibilities.
11. Do sole proprietors need an employee handbook?
No laws require private employers to have an employee handbook per se. However, some federal, state, and local laws require that businesses have specific written workplace policies to demonstrate compliance with employment laws. Sole proprietors should find out which federal, state, and local laws apply to them and then determine the written policies required. Policies may be stand-alone documents or part of an employee handbook containing all of a business’s policies, rules, and expectations.
Here are some examples of what employee handbooks include:
- Equal employment opportunity (antidiscrimination) policy
- Workplace anti-harassment (including sexual harassment) policy
- Employee leave policies (vacation, sick leave, other paid time off)
- Pay policies
- Benefits eligibility policies
- Holidays and other annual office closures
- Communications policies
- Family and medical leave policy (if 50 or more employees)
- Safety and security policies
- Employee code of content
- Employee review process and assessments for raises and promotions
- Disciplinary process
- Complaint filing process
- Termination policy
12. What payroll records must you keep?
Keeping accurate and complete payroll records is vital. The amount of time business owners must retain records can vary depending on the government agency and applicable employment regulations. Some human resource experts suggest keeping employee records for a minimum of seven years to cover all record-keeping requirements.
Here are several examples of essential payroll records:
- Employee name, address, phone number, email address
- Employee pay authorization and direct deposit information (if applicable)
- Employee date of birth
- Employee occupation
- Employee Social Security Number
- Emergency contact information
- Benefit plan enrollment documentation
- Pay dates
- Hours worked (time sheets)
- Exemption status (exempt or non-exempt)
- Pay rate (i.e., hourly wage or salary)
- Overtime pay
- Attendance and time off records
- Leave balances (e.g., paid sick leave, vacation, other paid time off)
- Payroll withholdings and deductions
- Work-related expense reports and reimbursements
- Form W-2 (Wage and Tax statements) for federal income tax withholdings
- State and local tax withholding certificates (if required)
- Form W-4 (Employee’s Withholding Certificate)
- Form I-9 (Employment Eligibility Verification)
13. How many employees can a sole proprietor have?
There is no limit to the number of employees allowed in a sole proprietorship. That said, it is important to note that adding employees may potentially increase the business owner’s legal risks. The sole proprietorship business structure offers no legal separation between the business owner and the company. Therefore, the sole proprietor’s personal assets are not protected if an employee sues the business. This isn’t meant to dissuade solo business owners from hiring, but it does give some food for thought. Perhaps another business structure may be more advantageous to minimize risks as a company grows.
14. Should a sole proprietor change business structures?
Many sole proprietorships choose the Limited Liability Company (LLC) structure because it provides personal liability protection and tax flexibility while maintaining simplicity. Forming an LLC is relatively straightforward and results in separating the business owner (known as a “member”) from the legal and financial debts of the business.
The ideal entity type can depend on many factors, and every entrepreneur’s circumstances are different in some way. That’s why sole proprietors should consider their options carefully and seek the advice of trustworthy legal and tax professionals when deciding.
CorpNet Can Help
Hiring employees and need to get your ducks in a row? CorpNet can help you register for your state unemployment insurance and state income tax accounts.