Dreaming of breaking out of the nine-to-five routine? Thinking it would be nice to be your own boss for a change? You're not alone.
Overview: What is a sole proprietorship?
A sole proprietorship is a business owned and operated by one person. Some states allow for joint ownership by a spouse, but for the most part, "sole" means one owner.
Unlike an LLC or corporation, a sole proprietorship does not have to be registered with the state.
If you begin doing business on your own, whether you're working on the side as a freelancer, building a consulting firm, or opening a food truck, you're a sole proprietor by default until you bring in a partner or file business formation paperwork with the state.
As a sole proprietorship, your business is inseparable from you for tax and legal purposes. This simplifies business document management immensely.
Profits from your business "pass through" to your personal income and are reported on Schedule C of your personal income tax return. This makes a sole proprietorship a simple business to start and run.
On the downside, because there's no separate legal entity, if the business is sued or owes money, you're personally accountable. Creditors can come for your home, cars, savings, and other personal assets to satisfy debts.
Sole proprietorship vs. LLC: What's the difference?
A limited liability company (LLC) is a legal business entity formed through your state. It consists of one or more owners called members. Because of its flexible ownership structure, a sole proprietor can form an LLC and continue to work as a solopreneur.
Or you can split ownership and management of the company with one or more members in any proportions you see fit. For example, two members could split ownership evenly, or one member could retain 60% of the business and bring in two others at 20% each.
Unlike a sole proprietorship, an LLC is a separate legal entity with its own assets and liabilities. This shields the members' personal assets from responsibility for the business's debts.
How to start a sole proprietorship
While you don't have to form a business entity to begin working as a sole proprietor, there are other steps you'll need to take to start your business. Ideally, you should complete all of these steps before you begin providing goods or services.
Step 1: Assess your risks
To launch a sole proprietorship is to open up your personal finances to a world of liability. That's not bad on its own, but it can go very badly for you if you haven't given any thought to the risks. Before you get too far down the road, consider these questions:
- Can you imagine a scenario in which your business could cost someone money or do harm?
- Is there anything about your work that might prompt someone to sue you?
In some businesses, the risks are clear. If you provide daycare, for example, and a child is injured in your care, it's not hard to imagine being hit with major medical bills or a lawsuit.
If you're a wedding planner, and you book a wedding on the wrong date, your clients could lose money. Not to be a pessimist, but when it comes to risk, you need to think of worst-case scenarios.
If your business could cause harm that you couldn't repair easily and quickly, consider buying insurance to transfer the risk or filing LLC documents to form an entity that shields you from those liabilities.
Step 2: Get an Employer Identification Number (EIN)
Despite its name, an EIN is not just for employers. It is a universal identifier, much like a Social Security number, for your business. If you don't have one, you'll have to use your Social Security number on tax forms and other official documents, exposing your personal information unnecessarily.
Step 3: Name your adventure
As a sole proprietor, you can generally use your personal name and a literal description of the service you provide as your business name without filing any paperwork.
For example, if your name is Alex Baxter and you provide car detailing, you can call your business Alex Baxter Car Detailing without registering a business name.
If you want to name your business something else, you must apply for a "doing business as" or fictitious name. To do this, you'll need to:
- Research name restrictions: Most states restrict use of certain words in business names. For example, words such as "trust" and "fidelity" may not be used in many states without written permission from regulatory authorities because of their associations with banking and insurance.
- Search name availability: Names must also be distinguishable from those of other businesses on record in your state. In most states, you can run a name availability search through the secretary of state's website to see if your desired name is available.
- Register your name: Once you've settled on a viable name, you can usually submit a fictitious name registration online along with a small fee.
Step 4: Pay estimated taxes
If you're just scaling up your business, you won't have a history of sole proprietorship taxes and income to go on. Just do your best to project your gross income for the year minus business expenses to arrive at an estimate of net annual income. Divide it by four, and pay income tax and self-employment taxes quarterly based on that figure.
As the year progresses, you can adjust each quarterly payment up or down based on your actual income and expenses. You want to get close, but it doesn't have to be perfect. The IRS will fine you if you underpay substantially, but otherwise, it'll all be reconciled with your final tax return.
Step 5: Register for taxes
In addition to federal income taxes, you will need to register your business for applicable state, county, and local taxes. If you hire employees, you'll have to register for payroll taxes.
If you sell taxable goods or services, you must also register with your state revenue department to collect and remit sales and use taxes. If you have an online store with significant sales in multiple states, you may need to register for sales tax in each of those states.
If you buy goods for resale, you should also apply for a reseller's certificate. You can present this when buying goods for resale so you don't have to pay sales tax on them. Consider a simple document management system to keep your records straight, especially if you need to apply for any of the licenses and permits below.
Step 6: Obtain licenses and permits
You may also need to apply for licenses and permits at the state, county, and municipal levels to operate your business. This involves filling out an application, paying a fee, and submitting it to the appropriate authorities.
Types of permits to look for include:
- Premises permits: You may need a home occupancy certificate, sign permits, or other facilities permits to operate your business. These are often required at the local level.
- Occupational licenses: Every state licenses its own set of professions, from nail salons to funeral homes. Before you begin offering goods or services, make sure you know the licenses required for your profession.
- Regulated activities: You may need permits for regulated activities such as food service and games of chance.
Benefits and disadvantages of forming a sole proprietorship
Which business structure is best for your business depends on many factors, including the kind of work you do, your vision for the business, your assets, and your risk tolerance. Here are the main sole proprietor advantages and disadvantages.
Advantages of a sole proprietorship
- Pass-through taxation: For most businesses, being able to pass profits through to personal income results in lower overall taxes.
- Simplicity: Sole proprietorships are by far the simplest business type to create and operate. You can start as small as you like and grow at your own pace without a huge commitment.
- Low costs: The simplicity of a sole proprietorship means you'll spend less on legal fees and tax services.
Disadvantages of a sole proprietorship
- Liability: The biggest drawback of a sole proprietorship is the fact that liability reaches through to your personal assets.
- Limits on ownership: If you want to bring in a partner, you'll need to switch to a different business structure.
Resources for solopreneurs
Being a sole proprietor doesn't mean you have to go it alone.
The fact is, states and the federal government want your business to succeed. Take advantage of their help and put their resources to work for your business.
From small things, big things can grow
The great thing about sole proprietorship is that you don't have to go all in all at once. You can start a side gig, test your theories, pivot, and even start over if need be — all with very little hassle or commitment. That makes it an ideal structure for growing the seed of an idea into the business of your dreams.