Freelancers. Independent contractors. Solopreneurs. Self-employed workers. What do they all have in common? They are all sole proprietors—business owners who operate an unincorporated company. According to the IRS, more than 27 million businesses paid taxes as sole proprietors by filing Schedule C of Form 1040 for 2018.
Just how do entrepreneurs become sole proprietors? And what are the advantages and disadvantages of choosing this legal structure over a limited liability corporation (LLC) or a corporation?
Becoming a sole proprietor is one of the most uncomplicated business structures to form legally. By following just a few steps, an entrepreneur can launch a sole proprietorship and begin serving clients.
- A sole proprietorship is the least-complicated business structure for an entrepreneur to launch.
- Sole proprietors do not have to legally register their business with the federal government. However, there are state and local guidelines for establishing one.
- Sole proprietors are responsible for filing quarterly estimated taxes and a Schedule C of Form 1040.
- As a sole proprietor, you will be held personally responsible for the business’s debt, financial losses, and liabilities.
- It is difficult to partner with investors as sole proprietors, as there is no ability to own stock in the company.
What Is a Sole Proprietorship?
A sole proprietorship is a business structure that is easy to establish for people looking to launch a business. As a sole proprietor, you are establishing an unincorporated business that you alone run. And unlike with an LLC or a corporation, there is no distinction between the business and its owner. As such, you can collect all the income generated from your business. But be aware you also are liable for any business debt, liabilities, or losses.
Types of Sole Proprietorships
A self-employed business owner is an example of a sole proprietor. They can work either full-time or part-time. Many self-employed business owners work from their homes to complete jobs for clients. For example, a freelance graphic designer who works with several small businesses could be considered a self-employed business owner.
An independent contractor also can be a sole proprietor. Unlike a self-employed business owner, an independent contractor’s relationship with a client might appear more like that of an employee. An employer typically hires an independent contractor to complete specific tasks.
For instance, an editor contracted to review and revise the content on a company’s website on an ongoing basis would be considered an independent contractor. However, no taxes are withheld from an independent contractor’s pay. In addition, an independent contractor is not eligible for employment benefits such as health insurance or retirement savings plans.
How To Start a Sole Proprietorship
Launching a sole proprietorship is easy. If you are the sole owner, you are automatically considered a sole proprietor, based on the activity of your business. However, if you need specific licenses and permits to run your business, you will need to apply for those credentials based on your industry or local regulations.
As a sole proprietor, you do not have to legally register your business with the federal government. However, there are state and local guidelines for establishing a sole proprietorship.
Here are some steps to follow when launching a sole proprietorship:
- Identify your business name. If you chose to run your business under a name other than your own, you would have to file a “doing business as” (DBA) form with state or local agencies.
- Decide on the location of your business. While many sole proprietors run their businesses out of their homes, others use office or coworking spaces.
- File the necessary business licensing forms with your local agency.
- If you are selling taxable products or services, you will need to register with your state’s tax authority.
- Apply for an Employer Tax ID Number (EIN). An EIN is necessary if you plan to hire employees. In addition, some financial institutions require an EIN for business bank accounts.
- Establish a business checking account.
It’s recommended that you separate your business and personal income by establishing separate bank accounts.
Sole Proprietorship Startup Costs
There are many costs associated with starting any business. As a sole proprietor, you will have to consider how you will market your business, the equipment you will need to run it, and the professional support you will require as your business grows. Here are some typical startup costs associated with launching a sole proprietorship:
- Federal and state fees: Depending on your locale, you will need specific licenses to run your business.
- Taxes: Once you begin generating income in your business, you will need to start paying taxes. Entrepreneurs typically pay estimated taxes quarterly.
- Professional services: Every small business owner needs the support of professionals to protect their business and keep it running smoothly. Having an attorney and accountant, for instance, will help you establish contracts and manage your finances effectively.
- Equipment and supplies: Do you need a new computer or printer to run your business effectively? Special equipment to meet the needs of your customers? Also, general office supplies such as paper and pens should not be forgotten.
- Marketing: You’ll need to develop an online presence as well as hard-copy marketing materials. Costs such as market research, website hosting, business cards, and presentation banners are essential to promoting your business.
- Transportation: Are you traveling to meet your clients? Transportation is an expense you cannot ignore. You will need to make sure you have reliable transportation to meet the demands of your customers.
- Professional memberships and networking opportunities: To grow your business, you will need to network and consistently build your skills.
Advantages and Disadvantages of Starting a Sole Proprietorship
Inexpensive to launch
Simple tax preparation
You are in control
Financing is a challenge
Limited help in running your business
Inexpensive to launch: Sole proprietorships are the least-expensive legal business structure to launch. You only need to pay state or local filing fees to establish a sole proprietorship officially.
Simple tax preparation: It’s easy to report your taxes because your business income is also your income. Your business won’t be taxed separately; you will be able to complete a Schedule C of Form 1040 to file.
You are in control: You can make all the decisions in your business as a sole proprietor. For example, you determine your operating procedures, how you want to manage your business, and the clients you want to serve.
Personal liability: You are responsible for all the business’s liabilities, debts, or losses. As a sole proprietor, there is no legal distinction between you and your business.
Financing is a challenge: Financing can be difficult to find because there is no legal separation in a sole proprietorship. Here’s why: Investors always want the opportunity to own stock in a company. However, because a sole proprietorship is only you, there are no shares to be sold or invested. In addition, lending institutions consider sole proprietorships to lack creditworthiness. If the business is not successful, what collateral will be available if your business cannot repay the debt?
Limited help in running your business: While it might be enticing to be the head of your own business, it can also be burdensome. As a sole proprietor, you are responsible for every decision that is made in your business. Therefore, you have to be ready for the successes and failures of going it alone.
How Sole Proprietorships Will Affect Your Taxes
As a sole proprietor, your business income is considered your income. However, you are responsible for paying taxes on any income you generate in your business.
The most significant difference between income from a sole proprietorship and wages from a job is that you will include your business’s income and expenses on Schedule C of Form 1040 annually. However, you will deduct your expenses on your Schedule C—the money you spend to generate a profit. Expenses can include your startup costs, business equipment, operating costs like storage, marketing, advertising, travel, business-related meals, and supplies. This form will be submitted when you file your taxes, along with Form 1040.
In addition, you will be responsible for paying self-employment tax, the equivalent of Social Security and Medicare. Therefore, you will have to make quarterly estimated tax payments to cover these costs as well as tax applied to your business income.
If you do not file, or underpay, your quarterly estimated taxes, you can be hit by monetary penalties from the IRS.
Frequently Asked Questions (FAQs)
How much does it cost to start a sole proprietorship?
Fees to legally establish a sole proprietorship vary by state and locality. In addition, there are other costs to consider, including taxes, professional services, equipment, office space, and marketing expenses.
Can I start a sole proprietorship then switch to LLC?
Yes, it is possible to begin your business as a sole proprietorship, then change to an LLC. As your business expands, switching your business to an LLC will protect your personal and business liabilities.
How old do I have to be to start a sole proprietorship?
Children under the age of 18 can run or participate in a sole proprietorship and its operation. However, they cannot be legally responsible for a company until they turn 18.