By far, sole proprietorships are the most popular form of business ownership. Starting your entrepreneurial journey as a sole proprietorship is also the easiest route for a startup business owner to take as the paperwork and compliance requirements are minimal. However, there are risks inherent in this type of legal structure, too.
Here’s what you need to know about sole proprietorships.
What is a Sole Proprietorship?
By default, states consider a single-owner business (or a married couple who co-own a business) to be a sole proprietorship unless the owner or owners register the business as another legal structure such as a Limited Liability Company (LLC), Partnership, or Corporation. Also, unlike other legal entities, sole proprietors are not employees of their companies. They do not receive a W-2 or file separate business taxes, nor are they required to register the business with the state. Sole proprietorships do not have any formal document requirements unless the type of business requires the owners to obtain specific licenses and permits.
Many freelancers, consultants, and other creative service providers work as sole proprietors. But, really, the sole proprietorship structure is available to entrepreneurs in almost any industry, from retail to landscaping to cleaning. It’s more common for small business owners to start as sole proprietors and then incorporate as their businesses grow and they need to hire employees. Another reason for sole proprietors to incorporate is if they want to attract investors.
How Do I Know If I Am a Sole Proprietor?
Essentially, the Internal Revenue Service (IRS) deems anyone who starts a business by themselves or a married couple who start one together to be sole proprietors if they don’t incorporate that business.
If your business is an LLC, even if you are the sole member of that LLC, you are not considered a sole proprietor since LLCs must register with the state government and are required to file paperwork, pay fees, and pay business taxes. For more about LLCs, check our page on how to form an LLC.
What Is the Difference Between Being Self-employed and a Sole Proprietor?
Proclaiming oneself “self-employed” can mean several things. In general, you are considered self-employed if you carry on a trade or a business as a sole proprietor, an independent contractor, a member of a partnership, or are otherwise in business for yourself, even part-time.
A sole proprietor is a business without a legal entity, and all the business activities, including any profits, debts, and actions, belong to the sole proprietor. This means there is no legal separation between the business and owner, and all liabilities belong to the sole proprietor, as well. If your business is sued, for whatever reason, this lack of legal separation puts your personal assets at risk.
On the other hand, owners of corporations are considered employees of that company—specifically, you would be an owner/employee. Similarly, the owner of an LLC is a member/employee. For these legal structures, you must apply for a Federal Tax ID (or Employer Identification Number). You are also responsible for registering the business’s name with the state, submitting organizational documents called Articles of Incorporation or Articles of Organization, have regular board meetings, pay fees, and stay within the state’s requirements for being in Good Standing. There’s more information about incorporating your business on our website, and CorpNet can handle all the appropriate business filings for you.
Partnerships are similar to sole proprietorships. Again, there is no legal separation between the partners and the business, putting the partners’ personal assets at risk. Partners are typically equally responsible for all financial profits and losses and are not considered employees.
Independent contractors (or freelancers) are self-employed and contract for work with other independent contractors or businesses. They are not employees and instead receive IRS Form 1099 from each of their clients, which shows all the money they earned during the calendar year from those clients.
Does a Sole Proprietor Need a Business Name?
The minute you start conducting business with the intent to make a profit (as opposed to pursuing a hobby), the state considers your business a sole proprietorship unless you incorporate it. By default, the legal name of your sole proprietorship is your first and last name. If you don’t want to use your name as a business name, then you must file the business name you want to use with the state. This filing is called “Doing Business As (DBA),” a “fictitious name,” or a “trade name.” Depending on the business’s location, filing a DBA begins with the Secretary of State’s office or the county clerk.
Filing a DBA with the state offers the public complete transparency into who the business’s actual owners behind the fictitious name are and provides consumers some protection against unscrupulous or fraudulent companies. For sole proprietors, a DBA allows them to create and use a more marketable business name than their own name and establish a separate professional business identity—without the expense and complexity of incorporating.
Keep in mind, when filing for a DBA, each state has its own set of rules regarding what you can and can’t use in a business name. Sole proprietorships are not incorporated, so you can’t use any business entity identifier, such as “Incorporated,” “Corporation,” or “Inc.” Typically, you cannot imply the business is a governmental unit, such as “Village,” “City,” or “Borough.” You also can’t use anything that is the same or similar to another registered business name in the state.
How Do I Become a Sole Proprietor?
As we stated above, as soon as the company owner begins to conduct business with the intention of making a profit, the sole proprietorship is legally established. However, depending on the type of business you own, there may be other actions you need to take to be compliant, including:
- Registering a DBA with the state if you use a name that’s different than the owner’s name
- Obtaining a business license from your city or county (permission to do business in your location).
- Obtaining other permits and certifications for the business. If a federal agency regulates your business, you most likely need a federal license or permit. Also, specialty service businesses such as salons or accountants need special certifications.
- Does the business require zoning permits? Does it need to be approved by any city, county, or state department, such as the health department?
- If your business sells taxable products or services, you will need to obtain a sales tax license from the state tax authority office. If you’re selling products or services in more than one state, you will need a license from each state. If you plan to sell taxable products on a wholesale basis to retailers, you will need a reseller license (resale certificate), which gives a business permission to sell taxable products without collecting sales tax.
In addition, a sole proprietor’s responsibilities include reporting and paying income and self-employment taxes, withholding and paying payroll taxes (if the sole proprietor hires employees), and renewing any required licenses and permits. If you want to protect a trade name, logo, or any other design associated with your business, you will need to file a trademark application with the U.S. Patent and Trademark Office (USPTO).
Do I Need a Tax ID for a Sole Proprietorship?
According to the IRS, a sole proprietor who does not have employees and doesn’t file excise or pension plan tax returns does not need a Tax ID number or EIN but can get one, if desired. Usually, the sole proprietor’s social security number is used as the Tax ID number for business and personal purposes. However, in some cases, a bank will not allow a business owner to open a business bank account without having a Federal Tax ID number. If the sole proprietor wants to hire an employee, an EIN is needed.
Also, if you have an existing EIN as a sole proprietor and subsequently decide to become an LLC or corporation owner, you will need to get a separate EIN for that business so you can file employment taxes.
How Do I File Taxes as a Sole Proprietor?
Because the sole proprietor has no legal separation from the business, they file their business income on a Schedule C (IRS Form 1040) “Profit or Loss From Business.” The deadline is the same as the personal income tax deadline: April 15, 2021.
Also, in most cases, a sole proprietor is expected to pay quarterly estimated tax payments. The IRS directive is a business owner should pay estimated taxes using IRS Form 1040-ES, Estimated Tax for Individuals, if they expect to pay $1,000 or more during one tax year. Payments for estimated taxes are due on four different quarterly dates throughout the year:
- 1st Quarter: April 15
- 2nd Quarter: June 15
- 3rd Quarter: September 15
- 4th Quarter: January 15 of the next year
Sole proprietors are also responsible for paying self-employment taxes (Schedule S.E.: Form 1040 or 1040-SR), Social Security and Medicare taxes, and withholding income tax. For sole proprietors with employees, the business owner must also file Form 941, Employer’s Quarterly Federal Tax Return quarterly.
Instead of hiring employees, most sole proprietors outsource projects and tasks to independent contractors. The sole proprietor is then responsible for distributing 1099-MISC forms for the contractors’ miscellaneous income and reporting the payments to the IRS.
Is a Sole Proprietorship Right for Me?
Operating a business as a sole proprietorship works for many startups, especially those testing the waters of business ownership who want to find out if opening a business is the right move for them. It can also be a viable option if you:
- Do not plan on reinvesting any money back into the business.
- Do not want to deal with the compliance formalities of incorporating.
- Do not intend to hire employees. While sole proprietors can hire employees, it is not recommended.
- Will sell products and services that have minimal legal risks associated with them.
When the above scenarios apply, or if you want to legally protect your personal assets from possible lawsuits, a more formal and liability-safe business structure is a better idea. Make sure you consult with an attorney and accountant to consider every legal and tax possibility. When you’re ready, let CorpNet help you get started on the right path to business ownership.