Sole Proprietorship: What It Is, Pros & Cons, Examples, Differences From an LLC
What is Sole Proprietorship?
A single-owner, unincorporated business is known as a sole proprietorship. As soon as you launch a solo side hustle, freelance job, or new business, you become a sole entrepreneur. But if you're launching a company with others, you can't be a sole proprietorship-you'll be in a general partnership by default.
Sole proprietorships, despite the name, are allowed to hire employees so long as they have an EIN (Employer Identification Number). A sole proprietorship's profits are taxed as the owner's income. It is the base of the most straightforward business models.
Because it is not a separate legal entity from the owner, a sole proprietorship differs from an LLC or a corporation. However, many sole owners ultimately decide to incorporate their firms as LLCs when ready to grow.
When you establish a sole proprietorship, there is no paperwork or fees to be paid. However, in line with the regulations of your state, you might need to register a Doing Business as (DBA) name or Fictitious Business Name (FBN) if you don't want to use your name as your company's name. If a licence is not required, you can start providing your services straight immediately.
The Operation of a Sole Proprietorship
There is no preliminary documentation necessary for sole proprietorships. The designation is automated and becomes effective the moment you begin conducting business.
For instance, you would become a sole owner if you started accepting freelancing jobs. Additionally, your company and you are treated the same in the case of the sole proprietorship. Due to its simplicity, a sole proprietorship is the most popular type of business form in the US.
In addition to continuing to run their side enterprises as sole proprietorships for as long as they desire, sole owners also have the option of changing their small businesses into LLCs or corporations. You might not see the need to submit LLC papers and pay fees to maintain it if it's merely a side business that you do in addition to your day job. For independent contractors like web designers, small Etsy sellers, or personal trainers, adhering to short-term contracts and filing taxes as a sole proprietor may be sufficient.
Benefits and Drawbacks of a Sole Proprietorship
A sole proprietorship is a simple way to launch a new firm because no formation costs are involved. There is no filing procedure; you can begin right away.
You can swiftly legalize your side business because it's simple and affordable. If you enjoy manufacturing candles, inquire if any nearby shops are interested in carrying goods made by regional craftsmen. You can open a bank account and distribute marketing materials. Once you start earning money and establishing yourself as an expert in your chosen field, converting your sole proprietorship into an LLC or a corporation is also simple.
In a single proprietorship, keeping track of expenses is crucial so you may claim them as company expenses on your tax return. Some expenses related to your home may be tax deductible if you run your business from there. Some people find keeping everything in one location simpler than opening new business bank accounts. Having a separate checking account for company expenses and income is unnecessary, but it may make it easier for you to keep track of everything. Losses incurred by your firm may be deductible from your income.
The main disadvantage to be on the lookout for is liability. You are individually liable as a sole proprietor for all your business's debts and commitments, including any loans, leases, credit accounts, and legal actions. If you have workers, you might also be responsible for what they do. Although liability insurance can be helpful, an LLC or corporation may be a better choice if you are worried about the risk to your assets in the event that your business fails or is issued.
Another disadvantage is paying self-employment taxes, especially if you are making a sizable profit. Corporations and LLCs provide additional tax options that could result in self-employment tax savings for you.
Apart from this, there can be many unwanted expenses in the case of a sole proprietorship. For instance, suppose Amelia establishes a reading room and tea store. Customers can choose from a wide variety of teas and other beverages, and they frequently assemble in the inviting sitting areas to chat, use the internet, and unwind. John, a worker at Amelia's Tea Shop, once noticed a puddle close to one of the couches but was unable to mop it up because of being preoccupied.
Suzy, a customer, stumbles in the puddle and hits her head on a chair arm. The Tea Shoppe will probably cover Suzy's medical expenses, but if she decides to sue the company for negligence, she can also sue Amelia personally or try to collect her judgment from Amelia's assets.
Assess Your Suitability for a Sole Proprietorship
A sole proprietorship is the best option to test the entrepreneurial waters. There are no significant up-front expenses, and you are solely accountable to yourself for the business's ongoing operations.
On the other hand, you might be better off establishing your firm as an LLC or corporation if you already have a very solid business plan, are employing staff, or are worried about liability.
In the end, a sole proprietorship is ideal for you if you have a concept and want to launch it immediately.
Changing from a Sole Proprietorship to an LLC
An LLC is typically formed when a solo entrepreneur wants to incorporate the business. The owner must first confirm that the company name is available in order for this to work. Articles of incorporation must be submitted to the state office describing where the business will be located if in case the desired name is accessible.
The business owner must draught an LLC operating agreement that details the organizational structure after filing the paperwork. The new business must then get an EIN (Employer Identification Number) from the IRS (or other institution based on the respective nation), which is like an SSN (Social Security Number) but is specific to businesses.
Understanding by the Example
The majority of small firms begin as sole proprietorships and change into other legal forms as they develop over time.
For instance, suppose Kate Schade started Kate's Real Food as a one-person business. The business started as a small local seller in Jackson Hole, Wyoming, and now also produces and distributes energy bars. Furthermore, consider that the respective sole proprietorship can be found today in over 4,000 merchants and has a production plant in Bedford, Pennsylvania.
In this way, Kate's Real Food has expanded since its 2005 debut to supply accounts all over the nation. In response, Schade may transform the company from a sole proprietorship to a corporation, which can be a logical move for a developing company.
How does a sole proprietorship get started?
A sole proprietorship typically just requires that you launch your firm. The decision of a company name is also helpful. You might need to submit an application for a permit or license with your city, county, or state, depending on your industry and local laws. You will require an employee identification number (EIN) from the Internal Revenue Service in order to hire staff. You must apply for a sales tax license with your state if you plan to sell taxable goods.
How should a Sole Proprietor pay tax?
When filing taxes as a single proprietor, you must complete Schedule C, which details your company's profits and losses, as well as the normal tax Form 1040 for individual taxes. If you have employees, you will need to complete additional forms, and the amount of taxes you owe will depend on the combined income reported on Form 1040 and Schedule C.
The Concept behind Taxes
Your Schedule C form on your income tax return is where you, as a lone owner, detail your business's earnings and outlays. Profits from your company are subject to self-employment taxes and federal, state, and local income taxes.
When you work as an employee, your employer contributes 50% toward your Social Security and Medicare taxes and deducts the remaining 50% from your income. In the case of a sole proprietorship, you are liable for all of your Social Security and Medicare taxes as a sole proprietor. To avoid fees, penalties, and a sizable tax bill in April of the following year, sole proprietors should pay estimated taxes on their self-employment income quarterly.
The Bottom Line
A simple business idea or structure for an individual to use to start something of their own is the key to the introduction of a sole proprietorship. For the most part, it is not necessary to register with a state agency or receive an EIN from the IRS to become a sole proprietorship.
The advantages of simplicity come with some disadvantages, such as the transfer of all liabilities from the business to the individual and the difficulty in obtaining capital. Those dangers shouldn't initially cause too many problems. But as the company expands, switching to a different legal framework might make sense.