Thinking about starting a business and want to know what is a sole proprietor? You have landed at the right place. This article discusses everything related to a sole proprietorship and offers a detailed explanation of the structure. Read till the end to be fully informed.
When we think of a businessman, we have this very grand, fancy idea in our minds which revolves around well-furnished offices, international tours, a multi-story building, and a whole army of employees- the list is not exhaustive, though! We have been conditioned to think that way because this was the only style and form that businesses had for a long time.
Things have changed drastically with the advent of technology, especially communication technology. The market shift to small businesses had started taking shape even before the pandemic Covid 19, but this trend has picked up speed after it. As people lost jobs and were confined to homes, personal small businesses became the increasingly famous choice for money-making.
Starting a business of your own can be a daunting task, especially if you follow the traditional business structure. A massive pile of paper, challenging legal formalities, licenses, permits, and registration will be waiting for you. Not to forget the hefty taxes. You will have a lot on your plate, and it might exhaust you as a first-timer.
How about we told you about a trick to evade all of these nagging troubles of a business? Yes! You can start a business without all the paperwork, the official red-tape, licenses and permits, and even the overwhelming amount of taxes if you start as a sole proprietor. This status comes with some magnanimous, fantastic, and incredible benefits. It is the best thing that can happen to a small business owner.
If you want to start a small business of your own and you aren’t sure which structure to choose, you might want to read this article. It explains each and every detail of a sole proprietorship and compares it with other business structures like LLCs and contractors so you can confidently choose a structure for your business.
Who is a sole proprietor?
A sole proprietor is someone who owns a business by himself or herself solely and without anyone’s cooperation. However, if you choose to treat this setup as a corporation like an LLC, you will no longer be a sole proprietor.
As a sole proprietor, there is no distinction between you and the business itself. You are the only benefactor; all profits go to you. As a sole proprietor, you have to bear all debts, investments, losses, and business liabilities as well.
What is a sole proprietorship?
Simply speaking, a sole proprietorship is a business that has just one owner; it’s an unincorporated business, in other words. The business owner is the only person who pays personal income tax on profits earned from the business. There are no shareholders, no benefactors as per law, so no one else is liable for the losses or debts against the business.
It is usually considered the easiest type of business because it features a complete lack of governmental regulations. Sole business owners or anyone who can financially handle establishing a business will prefer a sole proprietorship because it’s simple and easy.
As a sole proprietor, you can start a business under your own name; there is absolutely no need to register a separate name for the business, which can be a hassle. You are not required to take any formal or legal action while forming a sole proprietorship. There is no legal obligation on your part at all; the business or earning activities are the startup on their own.
A sole proprietorship is so smooth and straightforward that you might as well have one without even noticing. For example, suppose you are a freelancer and earning money via your remote work. In that case, you are already a sole proprietor, whether you realize it or not. No badge, no registration, no separate income Tax number, or any such formality is required for your sole proprietorship.
Some licenses and permits cannot be ignored while starting a business. The exact nature of permits and licenses will depend on the industry you choose for the venture. You can start the sole proprietor business venture with your name.
However, if you decide to use a separate name for your business, you will need a fictitious name for it. Fictitious business names, aka trade name, an assumed name, or a DBA (doing business as) name must be original; they should not be in anyone else’s use already, or you could face a copyright case.
Understanding a sole proprietorship
To understand the true nature of a sole proprietorship, you shouldn’t think of it as a separate legal entity. It does not work like a corporation, an LLP( limited liability partnership), or an LLC (limited liability company); the owner has no relaxation from the business liabilities like losses, investments, and debts.
It seems a little intimidating and even slightly discouraging when we say the debts and liabilities are solely the proprietor’s responsibility, but it is leveled by the fact that the profits also flow to the owner’s account without anyone else’s interruption. The proprietor is the only one who receives the benefits and earnings.
Sole proprietors can change the status of their small businesses or side hustles to LLCs or corporations, but they also might not do that so often, keeping their side hustle as a sole proprietorship for a long time.
You may never want to change your small business to an LLC and incur fees on yourself; it can go on being your side hustle and bring in money without any legal and financial obligations. Filing taxes as a sole proprietor will suit freelancers like web designers, personal trainers, and even small crafters selling on Etsy.
Advantages and disadvantages of a sole proprietorship
The main benefits that are part and parcel of a sole proprietorship have already been discussed, like the tax advantage (there are no extra taxes), the simple creation procedure, and a nominal fee of maintenance and creation.
What’s refreshing about a sole proprietor business is that you get to skip the silly paperwork. Sometimes, the legal paperwork is so overwhelming that you feel like giving up on the whole idea itself. Reduced paperwork comes from the fact that there is no registration required. You don’t have to register your business with the state of residence.
Some states may ask for the acquisition of some licenses and permits, but not in all cases. With fewer formalities in this type of business, you can have the business running faster.
The tax process marks another great difference. It is so simple that you would not want to let go of your small business at any time. With a sole proprietorship, you are not under the obligation to obtain an EIN (employer identification number). The IRS allows you to go ahead without this number. It’s entirely up to your discretion; if you want to have this number, you can. Otherwise, you can keep doing the business without it. Alternatively, you might as well use your own SSN to pay your taxes.
If you are a small business owner just starting with limited resources, a sole proprietorship may be the only solution available to you. It is so because of the negligible overhead charges part and parcel of sole proprietorship. Since you are not required to register your business with the state, your registration and registration renewal bills are next to nothing.
A separate business checking account is unnecessary with a sole proprietorship, which most other business structures must have. Your personal checking account will suffice in this case.
If you aspire to be a businessman in the United States and you are low on investment, a sole proprietorship may be the only answer to your worries.
Sole proprietorship comes with some alluring benefits, but that should not blind you to the disadvantages. As impressive as it is to know that one receives all benefits and profits from the business and no other parties are involved, one must understand that there is a corresponding duty to this lavishness, i.e., you will be solely responsible for all liabilities.
You will have to source all of the capital funding on your own; there is no one else to help you in this regard. It gets especially tricky when you have to revert to the traditional finance channels like banks loans and equity bonds.
It is also worth noting that you will have no asset protection for your business because the state offers protection to only the registered, legal entities. As the sole proprietorship is not registered, you should remember that you have no governmental backing for your business. When a company is registered with the state, it is protected in multiple scenarios. In case of liabilities, a sole proprietorship will not have support or coverage from the government.
For example, An LLC enjoys state protection against creditors who try to seize personal assets; as a sole proprietor, you have no such protection.
The real challenge of sole proprietorship comes from having to bring all the funds for the startup by yourself. There are no shareholders in this game, so you do not have the option of splitting the startup investment into pieces. Now, you may be thinking, why not ask banks and creditors?
The answer is that you will have to assure banks that you are trustworthy enough that they should invest in you. Banks usually go easy on companies with multiple stakeholders and a proven track record, whereas things can be shaky for a new and solo business. You will have much less capital than businesses with many stakeholders, which will go against you in front of the banks. Banks read such endeavors as risky and shy away from putting their money in them.
It is not just about banks; any kind of investors will want to invest in setups that are big, lavish, refined, and backed by the authority of a few well-established people. The upfront money and its problems often force small startups to transition into LLCs and LLPs.
- Less paperwork.
- No need for an employer identification number (EIN) from the IRS.
- Quick and easy setup.
- Low registration and renewal fees.
- Taxes are leveled against the owners and not the business.
- Easier banking.
- Unlimited liability for losses and debts
- Complications while raising capital
LLC vs. sole proprietorship
1- Formation differences
As discussed above, starting a sole proprietorship may not require anything legal or formal for its formation. You can be a sole proprietor even without knowing it; it’s that simple! In a nutshell, if you are selling goods and services and have no partner in this business, you are a sole proprietor. It’s marked by a complete lack of paperwork and documentation.
Things are a little formal when it comes to an LLC. AN LLC needs permits and even DBA when starting with a separate name. It also requires “articles of organization” documents, which the state issues; the acquisition of this document costs anything between $50-$200. The state of residence will determine the exact fee.
2- Operational differences
A sole proprietorship is a one-man show; there is just one person at the helm, and all decisions come from him (of course, there are other employees, but the decision-making power is not shared). Sole proprietorships may devise higher employees, finance managers, and auditors just like any other business, but the hierarchy of power does not change. The owner is still just one person, and his ownership is not shared with anyone.
There are no documents stipulating the power of autonomy or operational procedures/power divisions because this setup does not need any such thing.
There is a marked difference when we move to an LLC. The operational setup is quite complicated as there are shareholders in the structure. No single person can call himself the owner of the company, and for this reason, the decision-making powers are distributed among the stakeholders.
The operating document thoroughly explains the power distribution policies and standard operating procedures. Most LLCs have a formal operating document that stipulates standard operating procedures, hierarchy, and voting rights.
All critical company matters are decided according to the ownership stakes of the members. For example, if you have a 33% ownership stake, you have 1/3 voting power on important matters. Profits of the business are also distributed according to the ownership stakes.
3- Taxation differences
Since LLCs have several stakeholders, the operating agreement clarifies the proportion to ownership which helps in smooth decision making, voting rights, and profit shares of all members. LLCs and sole proprietorship enjoy pass-through tax advantages, but LLCs with multiple members have to file for business tax returns instead of personal tax returns, as in the case of sole proprietors.
LLCs can choose their tax status while sole proprietorships cannot. LLCs can decide if they will be taxes and C-corporations or S-corporations. The two statuses have their own tax responsibilities and specifications.
Apart from income taxes, some tax responsibilities are the same for all corporations, for example, payroll taxes if you have employees. No matter which business structure you have, some taxes remain in place. If you are selling taxable items, you will have to pay local taxes. As a self-employed business owner, you will have to pay self-employment taxes to the IRS.
You may have to pay additional business taxes subject to your state laws if you are an LLC.
LLC or sole proprietorship: which should you choose?
Many business owners, especially freelancers, personal trainers, and consultants, start as sole proprietors because of this setup’s ease. Minimal paperwork, fewer taxes, next-to-nothing overheads, and minimal legal formalities are some of the most attractive features of a sole proprietorship. In short, it’s an easy ride down the road, and who wouldn’t want it that way!
The rubber hits the road as the business grows. Why do most initial sole proprietors choose to transition into an LLC as the business grows? Because an LLC comes with governmental protection in case of bankruptcy. A sole proprietorship has no legal protection for its assets because it’s not a registered legal entity.
You could end up personally bankrupt if things go downhill in your business because you and your business are not considered two different entities. With LLC status, Your personality is differentiated from that of the business. You are not personally liable for losses and debts of the company. So you have more personal asset protection with an LLC status.
In addition to the facts mentioned above, LLCs offer tax flexibility. Most LLCs and sole proprietors choose to be taxed as pass-through structures, but LLCs can choose their status under the law. Choosing your tax status comes with considerable monetary benefits. All 50 states recognize and promote the LLC structure to give impetus to small business growth.
Choosing the best business structure depends on many factors; it is not about one thing or the other. Quite a bit of your decision will depend on your financial situation, availability of funds, and the extent of your business. Hiring a professional business lawyer can help you make this critical decision.
In most cases and due to the combination of liability protection and tax flexibility, an LLC is better for small businesses.
How do you start a sole proprietorship?
Starting a sole proprietorship is as simple as writing a few articles online. You have a sole proprietorship whenever you are earning from a business and are not required by law to register with the state. This is the basic stance. Starting a sole proprietorship is a straightforward business. Just start a business under your name, and you are a sole proprietor already.
It is recommended that you come up with a separate name for your business and apply for the necessary permits and licenses. If the business plan is such that you will need to hire employees, you will need a separate certificate. The IRS will issue an EIN (Employee Identification Number), making your employees’ status legal and secure.
Also, if your business includes selling taxable products, You will be taxed differently, and it’s necessary for you to register with the state as such.
Is sole proprietor the same as self-employed?
Yes, a sole proprietor and a self-employed person have no distinction. A sole proprietor and a self-employed person do not work for anyone else; their setups serve themselves. So they are the same.
Can you be self-employed and have employees?
As discussed earlier, most small businesses take off as a sole proprietorship because it’s easy, and there is no juggling between legal formalities. You start a nascent setup and get to work. However, pressure mounts, workload increases as the business grows, and legal asset protections become necessary. However, the sole proprietor is a single owner, although spouses can share the ownership.
Being self-employed doesn’t mean you have to run your business all by yourself. You can definitely and without restriction hire employees as a sole proprietor. In fact, you can employ as many as you want without changing your status as a sole proprietor.
However, employing people for work comes with many responsibilities regarding the employees and your business. Here are some of the things you will require doing:
- Complying with state and local business license and permit rules
- Registering for an Employer Identification Number (EIN) from the Internal Revenue Service (you may also need an EIN to open a bank account or credit card)
- Verifying employment eligibility to work in the U.S.
- Applying and acquiring the name and Social Security Number of each employee
- Collecting income tax withholding information
- Meeting small business insurance requirements like buying workers’ compensation insurance.
While hiring your employees, You will have to meet all legal requirements at the local, state, and federal levels. You must also realize that overhead costs will increase as you hire employees, not to mention the money spent paying the employees.
Bookkeeping records tracking will also require professional services, which will add to the costs. Other than this, the sole proprietor is not disturbed with hiring employees.
How do you file taxes as a sole proprietor?
You will need to fill out the standard tax Form 1040 used for sole proprietor and individual taxes and then Schedule C for reporting the profits and loss of your business. Since, as a sole proprietor, you are no different from your business, you get to file for business in an individual capacity. The amount of taxes you will need to pay will be based on the combined income of both Form 1040 and Schedule C.
Independent contractors Vs. sole proprietors
Owing to many similarities between a sole proprietor and an independent contractor are usually thought to be the same. There are, however, some essential distinctions that set the two apart. The main difference lies in the kind of things that the two do and not how they do them. You will notice that a sole proprietor usually makes things, sells products (non-taxable in the first phase of their businesses), teaches classes (online or live), and sells products or services.
In contrast, a contractor usually works for others, but not as a typical, dependent employee. The nature of the contract usually affords quite a few liberties to the contractor. Being an independent contractor, you are under no obligation to start a distinct and separate business structure. You do not have any legal business liabilities and responsibilities either.
Independently joining a business line and providing services (consulting, web design, or construction) for someone else independently without being a formal/traditional employee will make you a contractor. However, you are your own master, and just like a sole proprietor, you are a self-employed person.
So, can independent contractors hire employees like sole proprietors? Yes! As a self-employed person, you are the boss and the sole owner of your business, and guess what! Owners can hire employees!
However, just like a sole proprietor, your responsibilities and bills will increase tremendously as you proceed to hire people under your name.
Starting a business as a sole proprietor entails many benefits, and that’s why most small businesses and personal initiates kickstart this way. The sole proprietorship status offers freedom from hefty taxes, paperwork, and time-consuming legal formalities. You get to reap and use all of your profits in this setup because you are the sole owner, and no one else is a shareholder. You have the ultimate freedom of choice, advancement, and growth too.
It’s great to have a business of your own, especially when you can start so easily. The sole proprietorship also offers quite a lot of flexibility in many aspects. However, you will also have to understand its limitations, which is especially important if you look forward to growing your business in scale and scope.