Sole Proprietorships: What You Need to Know
Starting a business can be a complex process, but there is a legal business structure that lacks many of the complications of a corporation, cooperative, partnership or limited liability company. This type of organization, a sole proprietorship, is an automatic status that occurs when a person starts doing business. For example, a freelance photographer or writer is a sole proprietor. Even though it is simpler, a sole proprietorship is still a structure, so it is important to catch all the details to avoid trouble with state and local governments, the Internal Revenue Service or clients. It is also essential to recognize the unique risks of this option.
Although there is relatively limited paperwork, there are still often registrations that must be completed to do business as a sole proprietorship. Some state or local governments require a sole proprietorship that has a name other than the owner’s legal name to be registered as a “fictitious business name.” The type of product or service that is offered affects what licenses and permits a person may need, and location also frequently has a bearing on what criteria must be met to establish the business. Counties and municipalities typically require registration to receive a business license, regardless of structure. A sole proprietor will probably also need to get a tax registration certificate and pay local taxes. Businesses that sell products or services will need a license from the state. A professional such as an accountant or therapist will need whatever licenses or certifications the field requires. It may be necessary to have health and fire inspections of the building before opening the doors to customers as well.
Employer Identification Number
The IRS issues employer identification numbers to companies for tax account identification. A sole proprietor should not assume that an EIN is unnecessary simply because there is no plan to hire employees. First of all, those who will have a pension plan or file excise tax returns are required to have an EIN. However, even when the IRS does not require it, owners may still want to consider getting one rather than using their Social Security numbers, which is the only other option. Independent contractors typically have to provide the SSN or EIN to clients who use their services. Some people may feel uncomfortable with the increased potential for identity theft that comes with sharing their SSN so often, and getting an EIN can mitigate that risk. Independent contractors may make themselves more attractive to potential clients by having an EIN because companies that wrongly use that classification for their employees can be penalized harshly by the IRS. The EIN provides instant identification of the independent contractor and reduces the chances that there will be unwanted IRS attention.
A sole proprietorship is simultaneously a person and a business, so the profits and losses of the company are reported on the personal tax returns, and the business itself does not pay taxes. In addition to the Form 1040, a person would file a Schedule C to report the business income, expenses and/or losses. Medicare and social security taxes, self-employment tax and any applicable state taxes must be paid by sole proprietors, and because there is no employer to withhold them, they must do this themselves. The IRS also requires sole proprietors to pay an estimated tax on their business income as well as other taxable income such as rental income, alimony, interest and dividends. This tax can be paid on April 15, or it can be divided into quarterly payments. The calculation of expected income may be garnered from the previous year’s tax forms. But, for those with a significant cash flow fluctuation, an updated profit and loss statement can provide real-time numbers to prevent over or under payment. A person who does not foresee owing the IRS $1,000 or more for the year will probably not need to make estimated tax payments.
Corporations and LLCs form a shield between the owner and the business. When profits or losses affect the sole proprietor’s company, they will directly reflect on personal finances as well. So, if the company is liable for damages in an accident, the owner is liable, and an asset such as a home could be lost if there is a creditor demanding payment for a business account. A person who wants to start a business involving high-risk activities may not be best served by the sole proprietorship. However, for many entrepreneurs, the control and simplicity of this business structure is well worth the risk of liability.
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