A new business can be an exciting and overwhelming time. You have a terrific idea that you’ve researched. You’ve come up with your business plan. Now, you need to decide on the legal structure of your business. There are several options that come with different risks and benefits. Selecting the right one for your business is an important step.
This guide will walk you through the benefits and drawbacks of choosing a sole proprietorship. It will take you through the steps to setting one up and explain how the right partner can make the process easier.
If you plan to start a business with no additional partners or employees, you could form a sole proprietorship. Sole proprietorships are owned and run by one business owner. With this designation, you and your business are the same, and there is no legal protection between the two. As the sole proprietor, you would receive all the profits and be responsible for all the debts and liabilities.
What are the benefits of a sole proprietorship?
The benefits of forming a sole proprietorship include:
- Simple to set up
- Inexpensive to begin
- Control over your business
- Deductions and tax rates
Simple to Set Up
Sole proprietorships are easy to set up. In fact, as a single owner, your business is automatically considered a sole proprietorship and, in most states, you don’t have to do anything more than potentially filing your “doing business as” (DBA) name and ensuring you have the proper licenses and permits for your business.
Inexpensive to Begin
Because it is so simple to set up a business this way, there are very few costs associated with the establishment. For example, your legal costs would be centered around licensing and permitting and not registering your business with the state or obtaining a registered agent.
Control Over Your Business
As the only owner of the business, every decision is yours. You can run your business the way you want with no compromise or outside influences. Additionally, all the profits and benefits will be yours.
Deductions and Tax Rates
Because there is no legal separation between you and your business, the business is not taxed separately from the owner. Instead, you will report all your business income and deduct business losses on your personal tax return. The tax rates for this business structure are also usually the lowest.
What are the disadvantages of a sole proprietorship?
There are some disadvantages to forming a sole proprietorship, including:
- Personal liability
- Complete responsibility
- Raising capital
While having no distinction between you and your business has its advantages, personal liability is one of the disadvantages. You are held completely responsible for any business debts and any actions made by you. This can put your personal assets at risk.
Running a business alone can be lonely. While having complete control is nice, you also will carry all of the responsibility for success or failure, creating a lot of pressure.
Suppose you need to raise startup capital for your business, rather than self-funding, prepare for a difficult road. Investors will want something in return, and your business will not have stock or partnership shares to sell. Banks hesitate to provide business loans to sole proprietorships because it is difficult for them to secure repayment if the business venture fails.
How do I start a sole proprietorship?
Starting a sole proprietorship is simple, although the specific steps you take may vary depending on where you live. In most states, you need to follow these three steps to become a legal entity:
Steps to start a sole proprietorship
- Name your sole proprietorship
- File for an EIN if necessary and review tax requirements
- Obtain any necessary business licenses and insurance
1. Name Your Sole Proprietorship
With a sole proprietorship, you can name your business using your name, and you can also include a description of the work you do. For example, if your name is Joe Smith and you will open a landscaping business, you can name the company “Joe Smith Landscaping” without registering your business name. If you would prefer to call your business “Trees and Shrubs,” you would need to apply for a DBA name.
To apply for your DBA, start by researching name restrictions and availability. Restrictions in most states include avoiding false associations with other businesses or institutions, not using words that describe activities illegal in that state, and avoiding words associated with regulated industries like banking.
To determine name availability, you need to conduct a search of business names. Searches can be conducted through your state’s Secretary of State website. Most include a searchable database. Try searching for as little of your chosen name as possible, as this will give you more results.
Once you’ve selected a name, you can register your DBA name. Usually, this can be done online through your local county. Fees will vary between states. Before you take this step, though, it’s good to determine your business’s domain name. Most companies have at least some online presence, and you don’t want to register a name and then discover it isn’t available as a website.
While you are naming your business, you may wonder if you need to trademark your business name. While not required, trademarking your name does provide additional protections that a DBA does not. For example, someone else could register your name, causing confusion for your customers and forcing you to rebrand potentially.
If you decide to pursue a trademark, you will need to:
- Select what you are trademarking and search the United States Patent and Trademark Office (USPTO) to see if it is available.
- Complete and submit your online application.
- Continue the process by working with the attorney they assign to you.
- Receive approval or denial.
- If your trademark is approved, it will be for a defined period. You will need to maintain the registration.
The fees for registering a trademark vary depending on how you file and how many trademarks you need. You can find more information on the filing fees on the USPTO website.
You can also apply to register a trademark at the state level. While federal registration of a trademark often comes with broader protections, which can help if you plan on doing business out of state, trademark registration is often easier and quicker at the state level.
2. File for an EIN If Necessary and Review Tax Requirements
For many sole proprietorships, obtaining an Employer Identification Number (EIN) from the IRS is unnecessary. You are only required to get one if you hire employees or plan to open a retirement account.
However, securing an EIN is a step you should consider regardless of the requirement. If you plan on opening a business bank account, for instance, most banks prefer an EIN. Your EIN works as an identifier, much like a Social Security number.
If you do not have an EIN, you must use your Social Security number, which opens you up to potential fraud. Obtaining your EIN is also relatively simple. You can fill out the form through the IRS. This is a free service, and you’ll be able to use your EIN immediately.
3. Obtain Any Necessary Business Licenses and Insurance
Ensuring your business obtains the proper licenses and insurance is a critical step in setting up your company. As a sole proprietorship with no liability protection, you have to make sure you are doing business the right way and have insurance if the worst happens.
The licenses required varies largely on your business type, but some common types of business licenses include:
- General business license
- Food or alcohol
- Vending machines
- Insurance or real estate agents
- Personal services
Because you will be a sole proprietor, you will want to make sure you have some business insurance to protect yourself. Your state may also require specific types of insurance. Even if you do not have employees and are not required to pay for things like workers’ compensation insurance, there may be insurance requirements for specific industries.
Unfortunately, there is no one place to check and find the full list of what you might need. There are not only federal and state licenses and permits to check on but also local licenses and permits.
Once you have obtained everything, you need to keep track of which ones expire and when. Hiring a service to do this work for you can take a lot of worry off your plate.
What taxes are associated with a sole proprietorship?
While sole proprietors report income on their personal taxes instead of as a separate business entity, taxes can still be a big headache. Again, at the state and local levels, what you will be required to pay may vary. Generally, though, you will be responsible for:
- Federal income tax
- State income tax (where applicable)
- Self-employment tax
- Sales tax (where applicable)
Sole proprietors will also pay quarterly estimated taxes rather than just paying once a year. The estimated taxes include your income and self-employment tax. Estimated tax payments are owed if you expect to owe at least ,000 in taxes at the federal level and are due in January, April, June, and September.
Sole proprietors should also closely track their business deductions. These will help offset your income and result in lowering your tax obligation. A few common deductions include home office space, some retirement plans, health savings accounts (HSAs), marketing, loan interest, bank fees, legal fees, and the internet.
There are ways to make the tax headache easier and let you focus more on the business. Employing a tax professional can help you with the guidance, preparation, and filing of your taxes.
More Sole Proprietorship FAQs
- When does a sole proprietorship make sense for me?
Setting up your business as a sole proprietorship makes the most sense for individuals starting a business by themselves with no plans to hire employees or bring on additional partners. It also makes sense for individuals starting a business they plan to self-fund. It is difficult to raise startup capital through investors or bank loans with a sole proprietorship.
- What’s the difference between a sole proprietor and an independent contractor?
The key difference between a sole proprietor and an independent contractor is how they receive income. Otherwise, both are self-employed business owners, file income taxes using Schedule C, and pay self-employment taxes on their business income.
- Where should I form a sole proprietorship?
It is usually best to form your sole proprietorship in the state where your business is located. There are ordinarily no great advantages to forming your sole proprietorship in any other state.
- Do I need a lawyer to form a sole proprietorship?
No. You form your sole proprietorship yourself; there’s no paperwork to file with your state to create the business. For other aspects of running and growing your business, ZenBusiness has many services to help you.
- Can I change my EIN from a sole proprietorship to LLC?
You can change your designation from a sole proprietorship to LLC. However, when you make that change, you will need to contact the IRS and receive a new EIN.
- Who assumes the risk in a sole proprietorship?
While a sole proprietorship has many advantages, one of the disadvantages is the risk. Because you and your business are not considered separate entities, you will assume the complete risk.
- How do I close a sole proprietorship?
As a sole proprietor, you maintain control over business decisions. If you decide to close, you can make that decision on your own and without paperwork. If you do close, you need to research what you can cancel, like trade names, DBA names, licenses, and registrations.
- Can a sole proprietor be tax-exempt?
Unfortunately, no. Tax exemption is reserved for nonprofit organizations to help them raise more money. Sole proprietorships cannot be tax-exempt because there is no distinction between you and your business.