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.
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What is a sole proprietorship?
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.
Advantages of a sole proprietorship
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.
Fewer business fees
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.
Low start-up costs
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.
Minimal government regulations
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.
Disadvantages of a sole proprietorship
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:
Choose a business name
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:
Trademark – Protects your business at the federal level
Domain – Protects the website address of your business
Entity – Protects your business at the state level
Obtain an Employer Identification Number (EIN)
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:
file for bankruptcy
register for a retirement plan
buy an existing business that you run as a sole proprietorship
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.
Open a business bank account
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:
Easily project cash flow
Establish a clear audit trail
Come up with accurate financial statements
Legitimize your business
Avoid overspending on your business
Keep organized accounting records
Reconcile bank statements
Avoid missing out on valuable business growth opportunities
That said, there are typically 3 types of business bank accounts
Business checking account
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.
Business savings account
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.
Business merchant account
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:
Valid personal identification
Doing-business-as (DBA) certificate
Social Security Number (SSN)
Employer Identification Number (EIN)
Business license, depending on your industry
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.
Obtain business licenses and permits
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.
Buy a domain
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:
It shows your potential customers what your business is about
It allows you to gain online visibility
It lets you engage with your customers without much hassle
It allows you to look more professional and lends business credibility
It lets you sell your products online, without the need for a brick-and-mortar store
It makes your contact information easily available for potential clients
It allows customers to connect with your brand values and identity
It’s a great branding tool
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.
Get business insurance coverage
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:
General liability insurance
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.
Professional liability insurance
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.
Commercial property insurance
This covers any losses caused by damages to your workplace in the form of disasters, fires, and vandalism.
Business interruption insurance
This covers any losses you incur when you’re unable to run your sole-proprietorship because of a disaster.
Commercial auto insurance
If you regularly use your vehicle for business, then you may need this coverage.
Cyber liability insurance
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:
Policy coverage – What exactly is covered or isn’t covered by the insurance policy?
Limits of liability – How much of the loss you incur will your insurance provider cover?
Price – Does the cover have a deductible? What is the total cost of the policy cover?
What you need to know about taxes for sole proprietorships
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).