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Ever thought about starting your own business? Whatever you want to do—whether it’s start up your own online store or sell your time and expertise as a consultant—working for yourself as a sole proprietor is more straightforward than you might think.
In this guide, we’ll help you answer some basic questions like “what are sole proprietorships?”, “does a sole proprietor need a business license?”, and “can a sole proprietor have employees?” We’ll also give you a rundown of some of the pros and cons of working under this type of business structure so you can make the best move for you.
What Does Sole Proprietorship Mean?
Before we dive into the advantages and disadvantages of a sole proprietorship, you’re probably wondering “what are sole proprietorships anyway?” It’s actually the simplest business model that you can have.
What Is a Sole Proprietor?
The definition of a sole proprietor is someone who is the exclusive owner of an unincorporated business, meaning that they own the company by themselves with no partner or other individuals. You’re automatically considered a sole prop if you don’t register as any other kind of business structure.
It’s the easiest type of business to establish because you don’t actually need to do anything at all (although there are some extras that you can opt into, but we’ll get to that later). There’s very little government regulation when it comes to sole proprietorship, which means that anyone can start operating a business under their own name…well…today, if they wanted to!
It also means that you can stop operating at any time without needing to inform anyone—you simply stop doing business. That’s why being a sole proprietor is a great option for new small business owners or freelancers who are just getting started.
Is a Sole Proprietorship a Company?
Under the legal definition of sole proprietorship, no, it is not technically a company. There’s no legal distinction between the business and the owner, which has its own pros and cons. But just because there’s no formal structure in place doesn’t mean you get to keep every penny you make for yourself tax-free.
Any income that you make with your business will be added to your personal taxes each year, meaning that you’ll still be contributing to Social Security and Medicare taxes like you would with a traditional job. But instead of someone withholding that for you, you’ll be responsible for covering that amount each year.
Advantages of Sole Proprietorship
You Don’t Have to Register as a Business
There are plenty of sole proprietorship benefits, but the first is that you don’t have to legally register as a business. That means no paperwork, no hassle, and you can start operating under your own name straight away.
This is one of the reasons that many freelancers operate under this structure. Most don’t have plans to expand their team beyond themselves and so they choose to work under their personal name rather than a company or business name (although you can also do this as a sole proprietor, but there’s a couple of forms you’ll need to fill out to register a fictitious or trade name).
Your Taxes Are Simplified
For tax purposes, a sole proprietor files all of their income tax through their personal annual filing on form 1040 U.S. Individual Income Tax Return or what’s known as a Schedule C. This is where you report any earnings that you made outside of any employed jobs that you might have (if you’re in a traditional job where you work for someone else, taxes are already withheld as part of your wages or salary).
When you file your annual taxes, all of your business income will be attached to your personal taxes, rather than filed separately as a business entity. This makes the whole process smoother and simpler for both you and the IRS. This is what’s known as a “pass through entity”, as the taxes are passing through the business to the owner directly, which is one of the best sole proprietorship advantages.
You Have Complete Control of the Business
As the business is only able to be owned and operated by a single person, one of the biggest benefits of sole proprietorship is that you have total freedom when it comes to how your business is being run and the type of work you do.
Under some structures, particularly when a partner is involved, you’re required to create an Operating Agreement that lays out the rules and regulations that your business will work under. Information in the agreement could be about ownership percentages, what happens when there’s a disagreement, and how the business will allocate profits and losses. With a sole proprietorship, you’re the only employee so none of that work is needed.
Sole Proprietorship Disadvantages
You’re Liable for Any Damages
One of the major disadvantages of a sole proprietorship is that your business assets and liabilities are not separated from your personal ones. While we’d always recommend keeping your business income and expenses separate no matter what structure you’re using, it means that you’ll be responsible for any debts the business accrues. Or, if you’re ever sued, your personal assets like your house or car could become collateral.
While it’s the easiest business structure to work under when it comes to filing paperwork (or lack thereof) it’s really important that you take the time to think about this carefully. Can you afford to protect yourself and your hard-earned assets if something were to happen with the business?
It May Be More Difficult to Get a Business Loan
If you ever need additional funding for your business, operating outside of a formal structure can make it tricky to find loan approvals. Banks will often require documentation about your business structure before even considering you for a loan, so without this, it’s unlikely that your application will be approved.
While the lack of filing requirements may be enticing at first, the limitations of what you can do as a business owner are one of the significant disadvantages of sole proprietorship.
You Won’t Benefit From Certain Business Deductions
When we’re thinking about sole proprietorship advantages and disadvantages, many of them come down to taxes. As one of the big advantages is being able to connect your personal and business taxes to make the process simpler, there also comes the flip side: You’re not able to claim certain expenses when you’re not legally registered as a business.
Like other businesses, you are able to deduct everyday expenses like operating costs, product or advertising materials, and travel expenses. But, depending on how much profit you make, you may be eligible to work with a lower tax rate as a regular corporation (or C Corp), where your business will be considered as a separate entity from the owners.
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What Are EINs?
An Employer Identification Number, or EIN, is a little like a Social Security Number (SSN) but for your business. Before becoming a business owner, you would have used your SSN to file your taxes each year with the IRS.
As you start doing work with clients, they may provide you with a 1099 if you’ve done more than $600 of work for them in a tax year. This is the self employed version of a W2, which reports your income earned. Clients will often request information from you on a W9 form in order for them to complete your annual 1099. When they do, one of the fields on this form is either your SSN or EIN.
So you’re probably wondering, “do sole proprietors need an EIN?” They don’t, but that doesn’t mean you can’t get one. It’s free to apply for one on the IRS website and there’s a selection option specifically for sole proprietors when you’re filling out the application. While you don’t legally need one, it can be useful to have so that you can keep your SSN private and confidential.
What to Know About Hiring Employees
Even though your business is not legally registered anywhere, that doesn’t stop you from hiring employees. There’s no limit on how many people can work for you, and you’re responsible for withholding and paying any payroll taxes that you’re legally obligated to pay.
Once you become a business owner with employees, the situation does get more complicated. Each employee will need to file a W4 so that you know how much tax to hold back from their paychecks. You’ll need to decide if they’re on an hourly wage or annual salary. You’ll also need to think about benefits and tax liability at the local, state, and federal levels.
What to Know About Business Licenses
Like any other business, you may need a business license for sole proprietorship if your city or state requires one. It’s really important that you look into this before you start working as the fines can be lofty if you’re caught operating without one when you should have had a license.
You should also check for any licenses that are specific to the type of work you do. If you’re preparing or serving food, you’ll need visible licenses that show you’ve passed food safety inspections. Or, if you’re running a daycare, you’ll need various health and safety certifications.
Characteristics of a Sole Proprietorship
A sole proprietorship can look very different from person to person, depending on what kind of business they’re running and the industry they work in. As the IRS explains, someone is a sole proprietor if:
- They own an unincorporated business
- They own that business by themselves
Sole proprietors can be anything from web developers, freelance writers, virtual assistants, and accountants, to wedding planners, landscape gardeners, bakers, housekeepers, nannies, and photographers.
Sole Proprietorship Example
As an example of sole proprietorship, let’s think about this situation. Katie is finishing her senior year of college but still isn’t quite sure what she wants to do after graduation. She’s an English major, so she knows that she’d like to do something in writing or media, but with so many big corporations laying off their full-time journalists, she’s concerned about pursuing this type of job.
To make some money while she finishes her studies, Katie starts writing website content and blog posts for the landscaping business owned by one of her parents’ friends. She doesn’t have a registered business name and they pay her monthly in cash.
But Katie knows that she still has to pay taxes on this income, so keeps detailed records in her online bookkeeping system of how much she’s paid each month. When it comes to tax time, Katie reports this income on a Schedule C, alongside the money she’s earned at her on-campus part-time job. She has no plans to expand her business but may continue to freelance on the side once she’s found a job after graduation.
How to Form a Sole Proprietorship
It’s time to figure out how to start a sole proprietorship of your own. And as we’ve learned, it’s really quite simple.
Starting a New Business as a Sole Proprietorship
The first aspect you’ll want to consider is whether a sole proprietorship is the right business structure for you. We’ve been through some of the pros and cons, so now it’s in your hands. It may be helpful to speak with an accountant or an attorney before making any final decisions.
Then it’s time to decide on a name. If you plan to operate under your own legal name, there’s nothing else you’ll need to do before you start working. But if you want to work under a company name, you should register a “Doing Business As” (DBA) with your state authority. Check the US Patent and Trademark Office site first to be sure that you’re not stealing another company’s name by mistake.
Once you’ve registered for any business licenses or permits that you might need, it’s time to get to work. You can build a website and plan how you’re going to market your business. You can start working on inventory or services, and do all the fun parts of running a business that you’ve been waiting for!
Launch the Business of Your Dreams (With Less Paperwork)
Whether or not you decide that sole proprietorship is the right path for you, you can rest assured that you’re now more informed about this type of business entity and can make a choice for your business.
As with anything else in business, what matters most is finding what suits you best.
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