With the surge of side hustles in recent years, many people are looking for ways to professionalize themselves further. Instead of establishing LLCs or corporations, many are settling on sole proprietorships.
Here, we’ll look at how to start a sole proprietorship, the advantages and disadvantages of sole proprietorships, and taxes under a sole proprietorship.
Note: If you are a sole proprietor who needs help with invoices, contracts, proposals, and taxes, try Bonsai. Our all-in-one freelancer software can help you take the headache away from running your freelance business. Try a 14-day free trial today.
A sole proprietorship – also known as a sole trader or individual entrepreneurship – is an unincorporated business that has only one owner who pays personal income tax on any profit that the business generates.
If you decide to embark on a freelance job or a solo side gig, you’re automatically a sole proprietor. But if you start a business with other people, your business can’t qualify as a sole proprietorship – it’ll automatically be a partnership instead.
Sole proprietorships are the easiest types of businesses to start or close down, largely because of a lack of government regulation. For this reason, they’re popular among independent contractors, consultants, or sole owners of businesses.
Here are some of the perks you may enjoy when you establish a sole-proprietorship:
Most business structures require you to file forms with your state before you can start doing business. With a sole proprietorship, however, you typically don’t have to register with your state. You’ll be able to scale up your startup quickly without having to deal with lots of government paperwork.
Note, though, that you may have to get a business permit or license, depending on the industry you’re in or your state requirements.
When fighting to get your business off the ground, your budget can be tight. One benefit that a sole proprietorship offers you is the ability to save on registration fees.
As we’ve discussed above, some states and local governments require other business structures to pay registration fees before they can commence business. In other cases, such business entities may even have to pay annual fees to maintain their registration.
Luckily, a sole proprietorship doesn't have such legal requirements. Starting one not only allows you to save on registration fees but also the time and hassle of the registration process.
A sole proprietorship has the easiest business structure. You’re the sole owner, so you’re the one making the decisions, taking responsibility, and taking control of every aspect of the business.
This structure suits many small business owners as there’s no risk of conflict between shareholders and different owners. In simple terms, if you’re a sole proprietor, you aren’t at risk of losing control.
As a sole proprietor, your startup costs are minimal. Assuming you have a small operation, you won’t need to hire multiple staff members or set up your workstation at an expensive building. You can even run your business at home or in a garage. Not to mention you can start with just a laptop and a reliable internet contention if you’re setting up an online business.
As a sole proprietor, you follow fewer regulatory requirements compared to other business entities. Both private and public companies, for instance, have to file financial documents with the state where they incorporate.
Sole proprietorships come with many perks – but there are risks associated, too. They include:
The government recognizes a sole proprietor as the same legal entity as their business. The benefit? You’re entitled to all your business revenue. You can take home any profits the business generates and use them for personal projects.
The downside? You’re personally liable for paying taxes, managing payroll, and paying insurance for your employees. You’re also responsible for honoring debts. Your personal assets are at risk because there’s no legal separation between you and your sole proprietorship.
Let’s say, for instance, someone sues your business for malpractice. If you’re found guilty, all your assets – such as your home, personal cars, and physical possessions – can be seized to cover any losses.
This is different to most business structures where a business is considered legally separate from its owners. There’s no risk to an owner's personal assets if they fail to repay a business loan, if their business gets sued, or if one of their employees is injured.
Being the sole decision-maker can be a double-edged sword. While it offers you the freedom and complete control to do whatever you feel is best for your business, it also places a huge burden on you because you’re solely responsible for your sole proprietorship’s success and failure.
Also when your operations grow, you might be forced to wear many hats – you’re CEO, lead accountant, and head of marketing all-in-one.
That said, here are the steps you may need to follow to set up a sole proprietorship in 2022:
Your business name has a huge effect on how potential customers perceive your business. You want to seem professional and choose a business name that best reflects your brand identity – one that also aligns with the types of services you offer.
A good rule of thumb is to choose a business name that’s short and punchy. A name that your customers will be able to pronounce effortlessly, no matter their linguistic background. Business names that are easy to pronounce and spell are often more memorable to people. People are also more likely to spread the word about business if its name sounds punchy and rolls off the tongue easily.
That said, by default, your business name is your own name when you start a sole proprietorship. But you can decide to run your business under a different name, referred to as a ‘doing business as (DBA) or assumed name.
Not every state or county requires you to register a DBA. However, it can come in handy as it makes it easier to open a designated business bank account and an employer identification number (EIN). It can also allow you to establish brand credibility and improve your branding. And if you ever choose to end your sole proprietorship and establish an LLC, you can use your DBA to ensure brand continuity.
Note that DBA requirements vary with each state. Check your state’s offices or websites to get more information about registering your DBA. You can also check the United States Patent and Trademark Office (USTPO) to see if the business name you’ve chosen is available.
There are several ways of registering your business name. Each way serves a different purpose, and some of them may be a legal requirement, depending on the structure of your business and where you're located. They include:
An Employer Identification Number – also known as a Taxpayer Identification Number – is a unique number that the Internal Revenue Service (IRS) assigns to you for tax reporting. Think of it as kind of like a Social Security Number, except that it is for businesses.
In fact, your Social Security Number can serve as your Tax ID in most cases as the IRS doesn’t require sole proprietors to have an EIN. You can use your SSN and report your income on a Schedule C tax form for sole-proprietors (which we will talk about later).
However, using only your SSN can limit you in some ways. As a sole proprietor, you need to have an EIN to:
Many sole proprietors choose to use an EIN because it helps reduce the risk of identity theft. Also, many banks require you to have an EIN to open a designated business bank account.
Getting an EIN is an easy and free process. The fastest way to do so is by applying directly at the IRS website, where the IRS offers an EIN assistant tool that you can use. If you’re uncomfortable sending your private information through the internet, then you can download Form SS-4 and send it by postal mail.
If your sole proprietorship is a one-man show, you can run your operations comfortably out of your personal bank account. But the drawbacks of this approach far outweigh its benefits.
For instance, your bookkeeping can be a mess. Because you’ve mixed all your personal and business transactions, you’ll have to sift through lots of invoices and receipts to update your books. Also, tax time can be a nightmare, and you likely won’t take full advantage of your tax deductions due to poor expense tracking.
Consider opening a business bank account to:
That said, there are typically 3 types of business bank accounts
If you’re just setting up your business then this may be all you need. It will allow you to do all the basics – from making payments to managing your cash flow.
As your business starts to scale and your income increases, you might consider putting away some money in a business savings account to protect your sole-proprietorship's future.
If you expect to receive credit card payments from your customers, then consider opening a business merchant account. Such an account processes every payment you receive and deposits them into your designated business bank account. You can open a merchant account with companies such as Stripe, PayPal, and Square accounts. Most of these payment processing apps can integrate easily with your business bank account.
That said, not all banks require the same documents for you to apply for a business account. Generally, though, you can’t go wrong when you arm yourself with these documents:
You can apply for a business bank account either in person or online, but some banks may require you to do so in person. If you have plans to expand your business operations or you think you’ll need a line of credit or loan, then making an in-person application may be the better option. Applying in-person allows you to build a relationship with the bank representative serving you, and over time, your representative can help you achieve your financial goals.
Applying online, however, offers more convenience, and you can do so at any time.
Although starting a sole proprietorship doesn’t have complicated requirements, you may need to apply for licenses at the state and municipal levels to make your business legitimate. This may involve you filing an application, paying a registration fee, and submitting your application to the appropriate authorities.
The industry you operate in also determines whether you’re required to get a business permit or not. For instance, if you sell or prepare food, then you need to obtain a permit from the health department. Also, if you operate a home-based business, then you may need to obtain a land and zoning permit.
Ensure you check your state’s or county’s requirements for your type of business so that you can remain compliant with all laws and regulations.
Running a business, even a brick-and-mortar one, without a web presence doesn’t cut it anymore. For a long time, customers have been turning to the internet to make their purchasing decisions – they can easily research a product, determine a business’ location, and find out its operating hours with a quick search.
Of course, you could still depend on word-of-mouth from local customers to win more business. But if you’re determined to grow your sole-proprietorship over time, a business website can help in several ways. They include:
Like your business name, you want your website name to be memorable. Avoid overly-complicated domains that don’t relate to anything you’re doing. You want customers to search for the services you’re providing and for your business website to appear as the number one search result.
You can use ICANN-accredited databases to see if the domain you’ve chosen is taken. If it isn’t available, you can come up with a variation that’s still similar to the name you’ve chosen for your business.
Sometimes you may not have the funds to build your website immediately. If this is the case, then you can reserve your website name so that other business owners can’t.
For many businesses, ensuring you’re covered with the right insurance plan can be just as crucial as having a good business plan. And this is especially true for sole proprietors.
Sole proprietors face the same risks as the owners of other business entities such as:
The difference, however, is that these risks can easily cripple sole proprietors financially when they occur. Remember that sole proprietors are personally responsible for the losses and legal liabilities of their businesses. For this reason, they can easily lose all their personal assets if any of these risks happen.
Simple mistakes on the job or accidental injuries can put not just your sole-proprietorship at risk, but also your home, savings, and personal possessions.
For instance, imagine you’re a freelance writer. You craft a blog post for one of your clients. In the process of writing your post, you forget to mention your source and cite quotes. If the original website – where the article is going – decides to hit your client with a lawsuit, you could be expected to shell out a lot of bucks.
To protect your sole-proprietorship – and prevent such instances from happening – you’ll need to arm yourself with the right business insurance coverage. Here are some of the most common types of business insurance that your sole proprietorship may need:
This policy covers claims against your business for property damage, personal injury, or third-party bodily injury. If you regularly work at your home, you can consider adding an endorsement to the homeowners insurance you have rather than purchasing a separate policy.
This covers claims of work negligence, mistakes, inaccuracies, or similar allegations. If your customers pay a fee for your services, you might also consider getting Errors and Omissions insurance.
This covers any losses caused by damages to your workplace in the form of disasters, fires, and vandalism.
This covers any losses you incur when you’re unable to run your sole-proprietorship because of a disaster.
If you regularly use your vehicle for business, then you may need this coverage.
This covers any data breaches or software hacks. For instance, if hackers break into your servers and get access to your customer's private financial information, then this policy will help cover the costs of notifying them, investigating the attack, among other things.
A good rule of thumb is to get multiple quotes from different insurance providers before you make your decision. When comparing insurance coverage providers, look into things such as:
In the eyes of the IRS, sole-proprietorships are “pass-through” entities. A pass-through entity is a business type where any income the business generates is considered personal income of the owner. Tax liability is also the owner’s responsibility, as it “passes through” to the business owner’s personal tax return.
As a sole-proprietor, you report your business’ income and expenses on your personal income returns, rather than on a different business tax return like how the owner of a corporation would. You’re required to complete Schedule C for your business taxes, and then file the Schedule C form with your personal income tax form, Form 1040.
The IRS also requires you to pay self-employed taxes – Social Security and Medicare – on any income your sole-proprietorship generates. If your business suffers a loss, then you won’t need to pay any self-employment tax, but you won’t receive Social Security and Medicare credits.
Also, self-employment taxes aren’t withheld from your earnings because you’re not an employee. You’ll instead have to pay these taxes throughout the year through estimated quarterly taxes. These estimated payments are due four times a year – typically on April 15, June 15, September 15, and January 15 of the following year).
A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.
Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.
Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.
The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.
Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.
For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:
Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.
Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.
If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.
That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.
There are some types of contracts which must be in writing.
The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:
Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.
Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.
Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?
Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!
If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.
Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.
Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.
So, ultimately, the question is: written or verbal agreements?
Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.
Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.
Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.
There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.
A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.
Bonsai's product suite for freelancers allows users to make contracts from scratch, or using professional templates, and sign them using an online signature maker.
With Bonsai, you can streamline and automate all of the boring back-office tasks that come with being a freelancer. From creating proposals that clients can't say no to, to sealing the deal with a professional contract - Bonsai will revolutionize the way you do business as a freelancer.
Why not secure your business today and sign up for a free trial?