Frequently Asked Questions About Sole Proprietorships
If you have ever been in the higher echelons of business management, then you know there are different ways that a large corporation can be structured as a legal and tax entity. Some are public and others are private, but none of them are sole proprietorship status.
Likewise, if you are considering starting up your own small business, there are a variety of forms it can take shape as, such as an LLC, S corp, or a C corp. However, have you considered getting started as a sole proprietorship? Do you know exactly what one is? What are the risks and benefits? To learn the answers to frequently asked questions about sole proprietorships, keep reading.
What Exactly Is A Sole Proprietorship?
The shortest possible definition of a sole proprietorship is as follows: It is a business that is not a distinct or separate legal entity from whoever the owner is, meaning that all possible income or losses are taxed by the government through the individual owner’s personal annual income tax return.
A sole proprietorship then is the most simple form under which any business can operate. Since it does not exist as a distinct legal entity, it just means that whoever owns the business is individually responsible for the debts and tax obligations of that business. Even a sole proprietorship with a name is not its own legal entity. Fixing up automobiles under the guise of Carl’s Car Repairs just means that it’s a trade name.
What Are Examples Of A Sole Proprietorship?
A great number of home-based businesses or other self-employment scenarios are ones where sole proprietorship is used as the business structure. These work across many industries, but knowing some examples of common ones can help you decide if it is an appropriate format for your business.
Bookkeeping businesses are ones that serve the financial recording needs of another business, as bookkeepers are often hired from outside of the business. Financial planners are somewhat similar, except they are more of an advisory role and focus on individuals or families and households.
Professionals that focus on providing services to households and homes are often sole proprietorships. These include private tutors, landscapers, house-cleaners, home health care specialists, and even computer repair people working for themselves.
Sole proprietorships certainly predate the Internet, but the Web has created opportunities that result in it. Virtual assistants and freelance writers are two such occupations or work-at-home opportunities.
So, Is A Sole Proprietorship Actually A Private Company?
Companies that are considered ‘private’ are usually ones that are established as a distinct legal entity but do not have publicly traded stocks or other equities available to anyone willing to buy. Sole proprietorships are private in the sense that all records, income, and expenses are the sole purview of the owner and are not a matter of public record, as public companies do have to disclose a wide variety of forms and pieces of information each year.
However, a sole proprietor does not exactly have a ‘private financial life’ outside of his or her business, as financial and legal liabilities are solely theirs to burden.
What Are The Pros And Cons Of Operating As A Sole Proprietorship?
Sole proprietorships are popular choices for start ups of small businesses because of the sheer simplicity. All a sole proprietor has to do is register their name and secure applicable local licensing.
That simplicity extends to contracts and checks even. Customers can write their payments out to the owner’s name instead of the business, as the owner can use his or her own bank account, and the owner can sign business contracts in his or her own name.
Sole proprietors can even, when necessary, mix up money and property between personal ownership and business use. This is forbidden for corporations, LLCs, and partnerships to do. Another benefit of running such a business format is that there is no need for the owner to pay unemployment tax on them-self, although it still applies to employees hired.
So, anyone looking to get a business off the ground with ease and simplicity can do so with a sole proprietorship. There are, however, drawbacks and disadvantages.
The biggest drawback and disincentive is that owners are personally liable, to an unlimited degree, for any debts or losses the business suffers. Also, if the business is found legally liable for anything, that judgement and responsibility fall firmly onto the shoulders of the owner.
If someone chooses to sue your business and you are a sole proprietorship, they can sue you by name, possibly impacting your spouse and family in the process. On the other hand, businesses that are actual legal entities carry with them a layer or protection between their owners and their liabilities.
The more common and likely scenario is if a business goes under. If loans and borrowing were done for the sake of the business, repaying those obligations becomes the personal responsibility of the owner, and if he or she fails to do it, they can face losing personal possessions and money they have saved up.
Furthermore, if an owner wants to expand the business by raising capital, selling any portion of the business or interest in it is not possible, unless of course the business is restructured into an actual legal entity.
Sole proprietorships also have little value to heirs or survivors of the death of an owner, as these kinds of businesses rarely continue operating after the owner’s demise. Even a mental or physical incapacitation can stop a sole proprietorship from continuing to operate or function, and there is little to no retaining value to pass on to others.
How Are Sole Proprietorships Different From LLCs Or Partnerships?
As you know by now, a single owner calling the shots and carrying the financial and legal responsibility for a business is a sole proprietor. A different structure known as a partnership is when two (or more) persons decide to share the responsibilities. Perhaps the most well-known business structures are the many kinds of corporations, which are distinct identities from their owners. Corporations may have many shareholders as owners.
Many times, the business format is decided by how many people are involved when the business activity starts up. Many private individuals start up business and have no idea that they are technically sole proprietors. Partnerships are started automatically when it is more than one person involved. Neither case really requires documentation to get going.
On the other hand, corporations must file articles of incorporation or a certificate of formation in order to be a legal entity within a state’s boundaries or economy. Fees are levied for this filing, and they vary from state to state. Not only must a corporation file for all this in the state it starts in, but it must do so in every state it intends to do business in.
Partnerships and sole proprietorships do not have to worry about any of this, and can do business freely in any state at any time.
As stated previously, sole proprietors are solely responsible for all debts and possible liabilities that happen while their business is operating, potentially resulting in the loss of their personal assets, investments and savings, and even their vehicles and homes.
Owners of corporations however have limited liability protection against this. They do not lose their homes if the company goes bankrupt, and their financial responsibility is limited to how extensive their investment within the business is.
Sole professorships and partnerships are sometimes called ‘pass-through entities’ since profits and/or losses are directly reported on individual tax returns. On the other hand, corporations are practically subjected to double taxation, since the legal entity that is the business pays taxes, and then the shareholders pay taxes on their corporate income.
Corporations must also set up an internal structure that pass-through entities do not. All corporations must pick a minimum of one person to serve on the board of directors, which is the group responsible for delegating available resources and conducting activities that boost profits for shareholders.
Individual officers are the people responsible for daily management of the company and implementing the board’s decision. Pass-through entities are far more informal, and sole owners have full control over all facets of their businesses. One thing that partnerships and corporations have in common is the need for voting on critical or essential issues.
Corporations have formalities that must be tended to that pass-through entities do not have to usually deal with. These include a mandatory annual meeting, stringent financial records, and a ledger tracking how the board makes particular choices. Annual reports and financial statements are also often necessary, with details varying by state.
How Do You Set A Sole Proprietorship Up?
According to the IRS, there were over 22 million sole proprietorships operating within the United States as of 2008, and the number has likely exploded since then, as individuals started making money on their own through the Great Recession and stagnant aftermath. One of the benefits of this business structure is the simplicity of starting it up, but that can be a drawback too, as local registration requirements might get ignored, as well particular business licenses, and appropriate payments on income.
To get answers on local rules and regulations so you can be in compliance with them as well as learn of any opportunities you can take advantage of, it is prudent to identify and contact your local SBDC. Small Business Development Centers are government-sponsored agencies and entities designed to walk entrepreneurs through the steps of setting up a compliant sole proprietorship.
Small and new businesses account for more than half of all job growth, so there is tremendous government and political interest in helping out anyone looking to get a business up and running. Even if you intend to work alone, you’ll hopefully grow the point of needing employees.
Choosing a name is also a good idea so that your business as a brand. While it won’t be a legal entity unless you grow and/or restructure, you should claim a domain name online, register your name, and trademark it too. Trademark protection is available through the U.S. Patent and Trademark Office. Those who are laboring in lines of work such as business consulting and freelance writing might not need a business name however.
How Does A Sole Proprietorship File And Pay Taxes?
Tax preparation is rather simple in a sole proprietorship since the owner does personal and business taxes all in one return. Business income is reported as personal income, and losses or expenses are filed using a Schedule C in conjunction with the standard 1040 form and paperwork.
The Schedule C is done first to record applicable profits and/or losses. The Schedule C has a ‘bottom line amount’ that is added to the 1040 personal tax return. This actually proves alluring to some taxpayers because their business losses can actually counteract income from other areas of their lives, meaning they reduce their tax liability overall and have to pay less.
Sole proprietors must also file Schedule SE forms with their 1040. Those calculate the amount of self-employment tax owed. Unemployment tax is not mandatory for an owner, but it is for employees, although you don’t get to partake of unemployment benefits if the business goes under.
You should now not only know what a sole proprietorship is and is not, but also be well-versed in the advantages and disadvantages, as well as what makes it distinct from other forms of business structures. Should you choose to use this form of business entity for yourself, you know what you are getting into and how to handle taxes and other matters.
Of course keep in mind that even if you start a business as a sole proprietor, you can still restructure your business into a different form later, should you find it more beneficial to later convert into a partnership, LLC, or other form. With luck, all this information will help you pursue profits and your dreams!