Starting a business as a sole proprietorship seems natural for most first time entrepreneurs. The structure is based on a single owner. Legally, it is an extension of that person. While they are referred to as ‘sole’ proprietorships, it includes married couples (and sometimes dependents). Taxes are paid on a joint return with a filing of Schedule C (profit or loss from a business) and Schedule SE (self-employment taxes). The major advantages are simplicity (easy to start) and the tax rate is based on your personal tax bracket. The major disadvantages come from increased liability risk and difficulties in expanding.
Starting a Home Business
Getting started as a sole proprietor can be as easy as setting up a website. Depending on local rules, you may not need any licensing at all. Some localities do require a business license. Others have zoning rules that allow some types of business and not others to be home based. Generally, if you are dealing with the public in person, your business will have to meet higher standards.
Licensing also depends on the type of business you are doing. If you have employees, the situation immediately gets more complicated. Payroll and benefits (as well as overall accounting) become issues. This usually limits the size of ‘Mom & Pop’ operations to a few (if any) employees and a small footprint.
Sole Proprietorship Taxes
The required records are tax-based. Net profit (or loss) is straightforward. The business income is part of your overall household income. The main difference is that as a sole proprietor, you are required to pay the entire amount of social security and Medicaid contribution. Most single owner businesses file quarterly estimated taxes.
In many tax brackets, running a sole proprietorship is an advantage. Business related expenses are deductable and can offset other income. Two important deductions are for a home office and automobile mileage. You are even allowed to claim a loss for your business and offset the taxes you would otherwise pay on a second income. The IRS does, however, expect you to make money sooner or later. It is unwise to tempt an audit by losing money consistently.
Sole Proprietorship Liability
As the owner, you will keep all the assets and liabilities under your own name. While the business can have another name, this type of structure doesn't separate you legally from business obligations. A DBA (Doing Business As) is a filing with the local treasurer's office that registers your business name. If you are sued though, it will be a direct attack against your personal assets. Your non-business belongings (house, property, and savings) are all at risk.
This is one of the major downsides to a sole proprietorship. We live in a society that is quick to place blame and attempt recovery through the courts. One way to deal with this and maintain sole ownership is to buy liability insurance. Many home insurance policies offer a tie-in for liability under an umbrella policy – check with your insurance agent. Bonding is also available in many industries.
There are ways to shield your assets through a trust and in retirement portfolios. Unfortunately, many sole proprietors ‘go naked’ and hope for the best.
Credit and Financing for Sole Proprietorships
Loans are an important issue for most businesses. They allow for expansion and smooth out cash flow bumps. As a sole proprietor, any loans you receive will be based on your personal credit history and assets. Banks will also look at your risk profile.
In effect, any loan you receive will be a personal loan. For this reason, it is common for sole proprietors to leverage their home (with a second mortgage) or any business property. The current credit environment has made these types of loans difficult to obtain in many areas of the country.
Because a single owner business is an extension of you, if you go bankrupt, it is a personal bankruptcy. All of your assets are at risk. More than anything else, this is a good reason to carefully consider the protections offered by incorporating.