When you want to establish a business, you need to do so legally, and the first step involves choosing the type of business that you will form. You have several options, including limited liability company (LLC), corporation, and partnership. But the most common form of one-owner business is the sole proprietorship.
Should you consider operating as a sole proprietorship, rather than as an LLC or a corporation? We break it all down for you below to help you determine what path is best for your business.
Please keep in mind that, although we’ve made every effort to ensure the information below is up-to-date and accurate, it doesn’t constitute legal advice, nor should it be considered a substitute for legal advice. Consult with your attorney if you have any questions about how to form your business.
What Is a Sole Proprietorship?
A sole proprietorship is a business in which the owner (referred to as the sole proprietor) personally owns the company, including all of the assets. In other words, there’s no separate legal entity like there would be with an LLC or a corporation. Just like owning your car or your house, you’ll own the business as well.
What if you co-own your business with one or more individuals? Well, then you can’t be a sole proprietor. As the name implies, sole proprietorships are one-owner businesses. If you want co-owners and partners, you can opt to form a multi-member LLC, a partnership, or a corporation.
It’s important to note that sole proprietors are also commonly called “self-employed.” However, when you operate as a sole proprietor, you aren’t actually an employee of your business. Rather, you’re the owner. On top of that, you aren’t an employee of your customers or your clients either. Instead, you’re classified as an independent contractor, who is an individual that performs services for clients and customers without being considered an employee. All sole proprietors are independent contractors.
What Are the Perks That Come with Being a Sole Proprietor?
There are a few reasons why operating your business as a sole proprietor is a great idea:
- The sole proprietorship is, by far, the most affordable and the easiest legal option for organizing and running a one-owner business. You don’t have to form a separate legal entity like you would with an LLC or a corporation, and there’s no need to file any articles of organization with the Secretary of State. You don’t even need to draft an operating agreement. You simply start doing business!
You’ll very likely need a business license from your city or county even if you function as a sole proprietor. But that’s about all of the paperwork that you’ll need to worry about in order to get your business up and running. And if you wish to use a name other than your personal name to identify your business, you can do that easily by filing a fictitious name statement with your county (that’s relatively inexpensive, too).
- Once you start running your sole proprietorship, you’ll find that it’s as simple as it gets. You don’t have to worry about LLC or corporate meetings or other formalities, and you don’t need to make any periodic filings with the Secretary of State. Plus, you aren’t required to pay any special state taxes either!
- Finally, as a sole proprietor, you own the business personally. This means that you also make all of the decisions, so you don’t need to consult with anyone because you’re in complete control. Everything that your business owns, you personally own. All of the money that your business earns is your personal money. And, even though it’s wise to have a separate bank account for your business, that isn’t legally required either.
What Are Some of the Drawbacks of Being a Sole Proprietor?
When it comes to sole proprietorships, the big drawback is liability.
- Because the proprietor and the business are one and the same, a sole proprietor is personally liable for all debts and liabilities taken on by the business. This can be scary because a business creditor (a person or company to whom you owe money for items you use in business) can go after all of your assets, including your personal assets, to get what you owe them. This may include, as a few examples, your personal bank accounts, car, and house.
Similarly, a personal creditor (a person or company to whom you owe money for personal items) can go after your business assets, such as your business bank accounts and your business equipment.
- As a sole proprietor, you’ll be personally liable for business-related lawsuits, too. For example, if someone slips and falls in your (or your client’s) office, you can be personally sued for damages. This is why it’s wise to get insurance that will protect you against these types of lawsuits.
Note: You can avoid this level of liability by forming an LLC or a corporation, which will limit your personal liability for business debts and lawsuits.
What Should You Know About Taxes When You’re a Sole Proprietor?
Taxes are simple when you’re a sole proprietor because you and your business are one and the same for tax purposes.
- You don’t need to pay taxes or file tax returns separately for your sole proprietorship. Instead, you must report the income that you earn, or the losses that you incur, on your personal tax return (IRS Form 1040).
- When you earn a profit, you add the money to any other income that you have, such as interest income or your spouse’s income if you’re married and file jointly. In doing so, you’ll get to the total income that will be taxed at your personal tax rate.
- If you incur a loss, you can use it to offset income from other sources. To show whether you have a profit or loss from your sole proprietorship, file IRS Schedule C, Profit or Loss from Business, with your tax return. On the form, list all of your business income and your deductible expenses. Easy! Just remember that, if you have more than one sole proprietor business, you must file a separate Schedule C for each.
- You’re entitled to the same deductions as any other business. Those deductions include mileage, home or outside office expenses, and business equipment. Plus, you’re also eligible to claim the new pass-through deduction that took effect in 2018. This means you might be able to deduct as much as 20% of your net sole proprietorship profits from your income taxes. Sweet!
- Bear in mind that sole proprietors aren’t employees because they’re business owners. Therefore, a sole proprietorship doesn’t pay payroll taxes on a sole proprietor’s income, nor does it withhold income tax. However, as a sole proprietor, you do have to pay self-employment taxes (Social Security and Medicare taxes) on your net self-employment income. These taxes must be paid four times a year, along with income taxes, in the form of estimated taxes.
- Because you’re working as an independent contractor with clients and customers, the firms that hire you also don’t withhold taxes from your compensation. However, any firm that pays you $600 or more within a year must file Form 1099-MISC to report the payment to the IRS.
What Types of Businesses Work Well as Sole Proprietorships?
The great news is that the sole proprietorship form can work well for any one-owner business that doesn’t have employees, including part-time and side businesses. Also, millions of self-employed individuals work full-time as sole proprietors in every field.
However, if you have employees or partners, it might be a good idea to form a separate business entity, such as an LLC or a corporation. This strategy will limit your personal liability for your employees’ actions. But you can always start your business as a sole proprietorship and then convert it to another form, such as LLC or corporation, later on if you choose to hire employees as you grow your business.
Note: if you really wish to avoid any personal liability for business debts and lawsuits as much as possible, forming an LLC or corporation might be right for you. Just bear in mind that even LLCs and corporations are far from foolproof when it comes to personal liability.
How Do You Become a Sole Proprietor?
Because the sole proprietorship is the default business form for one-owner businesses, if you start this type of business and you don’t form an LLC or corporation, you automatically become a sole proprietor. Doesn’t get much easier than that, right?
There are a few details, though, that you need to take care of before, or at least soon after, your business starts operating:
Federal Tax ID (EIN)
As long as you don’t have any employees, you can use your personal Social Security number as your IRS and state tax ID number. But you might prefer getting a separate Employer Identification Number (EIN) from the IRS to help keep your Social Security number private and safe from identity thieves. Don’t worry, this is easy to do, and you can read our Freelancer’s Guide to Federal Tax ID (EIN) for more information on this important topic.
There isn’t any IRS or legal requirement stating that you have to set up a separate bank account or use separate credit cards when you run your business as a sole proprietor. Nevertheless, it’s a really good idea to take these steps, as doing so will help you accurately keep track of deductible expenses. Plus, this will also be really helpful if you’re ever audited. Opening a business bank account (or establishing a second personal bank account for your business) are wise choices, and you can learn more in our article Freelancer’s Guide to Bank Accounts.
It’s likely that you’ll need to get a business license from the city or county where your office is located. This involves filling out a simple application and paying a license fee, so it’s easy too. For more details on this topic, check out our article Freelancer’s Guide to Business Licenses in California.
Because you’re personally liable for all business-related lawsuits when you’re a sole proprietor, you can obtain business liability insurance to help protect yourself. The type of insurance and the level of coverage that you’ll need will depend on the work that you do. You can consult with an insurance broker if you aren’t sure of what direction to take in this area.
Sure, you can use your personal name to identify your sole proprietorship, and if that’s the route you choose to take, you won’t need to make any government filings or pay any fees to use your name.
However, you might prefer using a different name for your business, and that’s totally fine. You can do so by filing a fictitious name statement or assumed name certificate, also known as a DBA “doing business as”, with the California county in which your principal place of business is located (where your office is located or where you own most of your income if you don’t have an office). However, you can’t use a name that’s similar to a fictitious name already on file in your county, so be sure to search county records first. Check with your county, too, for specific requirements for filing a fictitious business name statement, or use an online service like Hyke to get the job done for you.
Note: If you wish to use an assumed business name, your sole proprietorship bank account should be created in that name, and the bank will ask to see a copy of the statement before it will open an account in your assumed name, so be sure to file your fictitious name statement prior to opening your bank account.
Think a Sole Proprietorship Is the Right Way to Go?
If you’re ready to start a sole proprietorship to do what you love and reap all of the benefits that come with this form of business, join us today. We can help take the stress and mystery out of the process of establishing your business, including helping you with setting up a bank account, registering a business name, and getting your EIN and the appropriate business licenses. Once your sole proprietorship is up and running, you’ll be well on your way towards becoming a successful business pro!
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.