What is a Sole Proprietorship?

Thinking about flying solo in business? You’re in good company. Of the 28 million small businesses in the United States, 73.2% are sole proprietorships. A sole proprietorship is the simplest type of business structure and definitely has its advantages. You get to make all the decisions, and you don’t have to split your profits with anyone else (well, except Uncle Sam and a few others.) When your business is a smashing success, you can pat yourself on the back – you did it!

On the other hand, you don’t have a partner to share the workload or the decision making. You won’t have the financial resources that a partner can bring to the table. And if your business doesn’t fare so well, you know who to blame.

Before you make your final decision about your business structure, here’s more about sole proprietorships.

Regulations and Registrations

You don’t have to complete complicated paperwork or pay hefty legal fees before becoming a sole proprietor. However, you may need to register with your state and local government and apply for other licenses, depending on the type of business. When you decide to hire your first employee, you will need to apply for a federal employer identification number (EIN) before running payroll.

Taxes

In layman’s terms, the government considers a sole proprietorship and the company owner to be one and the same for tax purposes. You will pay a tax on your company’s profits as part of your personal income taxes. At tax time, you will file the 1040 Individual Tax Return and report your income and expenses on Schedule C, Profit or Loss from Business.

Estimated Income Tax and Self-Employment Tax

The government would rather not wait until April 15th to receive any tax that you owe. You will need to estimate your first year’s income and pay quarterly estimated taxes based on that amount.

Also, if your net earnings are $400 or more, you will also pay self-employment tax – the employer and employee shares of Social Security and Medicare taxes combined – as part of your quarterly tax payment.

You can use the worksheets in Form 1040-ES to figure your estimated tax payment, including self-employment tax. You will include Schedule SE (Self-Employment Tax) along with your income tax return.

Be careful when arriving at your quarterly estimate. You don’t want to estimate too low and pay a penalty later, or aim too high and have to dip into your cash reserves to afford the tax payments. For that reason, it’s a good idea to consult an accountant to make sure your estimate is reasonable.

Paying Yourself

As a sole proprietor, you will pay yourself by taking an owner’s draw – basically, writing a check to yourself from your business account. You can set up a periodic draw schedule and take draws to supplement your income quarterly or annually, based on your business performance. Make sure to record any draws from the business in your accounting records.

Legalities of Sole Proprietorships

One of the drawbacks of being a sole proprietor is the potential legal liability for you.

Unlike a corporation, with a sole proprietorship, there is no legal separation between you and the business. That means your business and personal assets (house, car, etc.) may be up for grabs in case of a lawsuit or bankruptcy.

You may be thinking, who would sue me?

Someone slips and falls on your sidewalk outside your store…your employee gets into a car accident while making a delivery…a client isn’t happy with your work…it happens!

With a sole proprietorship, you personally can be held liable for the debts of the business, so it makes sense to discuss all the “what-if” scenarios of your business with your attorney.

Other Considerations of Sole Proprietorships

Business Insurance

Before officially launching your business, check in with your insurance agent. Your personal insurance policies may not cut it. If you harm someone’s property in the course of doing business, your personal insurer may deny coverage.

You may be able to purchase a rider on your homeowners’ policy to protect a home-based business. But you might need additional business insurance, including a general liability policy, commercial auto policy, etc. There are many different kinds of business insurance, so find an insurance agent that you trust to steer you in the right direction.

Workers’ Compensation

In most states, business owners are required to have workers’ compensation coverage for their employees, but each state has its own rules. For example, in Alabama, only businesses with four or more employees must have coverage, while in Colorado, all employees must be covered with a few exemptions.

Depending on your state and type of business, you may need to purchase coverage for yourself, even if you don’t have any employees. For example, in Florida, construction business owners who are sole proprietors, partners, members of LLCs, and corporation officers must cover themselves with workers’ compensation. California requires roofers, in particular, to carry workers’ compensation insurance, even if they have no employees on the payroll.

In many states, employers can purchase workers’ compensation through an insurance company, but a few states have monopolistic state funds, including Ohio, through which you purchase your workers’ compensation insurance. Since each state has its own rules, you should check with your state business gateway to find out how workers’ compensation applies to your business.

Separation of Funds

Even with a sole proprietorship, it’s just not a good idea to mix your personal and business funds. Here’s why:

• The IRS requires that your business recordkeeping clearly shows your gross income, deductions, and credits (although they do not dictate what kind of recordkeeping you must have.)


• You need to keep track of how your business is doing, which will be more difficult if your business funds are in your personal account. You can easily lose track of potential deductions and get behind on paying your personal and business bills.


• It’s not a professional way to run a business. Keeping your funds separate will help establish that you are serious about being successful.

As soon as possible, set up a business checking account and start paying for business expenses with money from your business, making sure to record all transactions in your accounting software or spreadsheet.

A sole proprietorship can be a great way to launch your new business. By planning ahead and consulting with advisors, you will be in a better position for a successful business venture!

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What is a Sole Proprietorship?