A sole proprietorship is by far the most popular business structure in the United States. More than 70% of U.S. companies can be classified this way, according to the Small Business Administration. They include restaurants, online Etsy shops and even freelance consultants.
One reason this business type is so common is because it’s practically the default for entrepreneurs. If you’re putting time and effort toward an activity for profit, you have a business. And if you haven’t set up a specific structure, such as an LLC or corporation, and you’re not in partnership with someone else, then you have a sole proprietorship. In short, the definition of a sole proprietorship is an unincorporated business owned by one person who pays personal income taxes on its profits.
Running your company as a sole proprietor has many advantages, but there are some drawbacks as well.
Advantages of sole proprietorships
This business type is great for you if you don’t have the resources to do a lot of paperwork. With a sole proprietorship, you don’t have to spend time writing bylaws, issuing stock or making complicated financial decisions, so you can spend more time focusing on your company. When it comes to taxes, income and expenses are simply reported on your personal return, using the form Schedule C.
A sole proprietorship is defined as a pass-through entity because there is no separate tax on business profits. Instead, earnings are “passed through” to you to file on your personal taxes. Other business structures can serve as pass-through entities, but they’re usually more complex to set up and maintain.
Another benefit of sole proprietorships is that you can deduct company expenses on your personal return, even if those expenses are higher than business income.
“Your business might have losses in the first few years until it gets established. You’d generally want to put those losses on an individual return so you could offset them against other income,” says Mark Luscombe, principal analyst at Wolters Kluwer tax and accounting company in Riverwoods, Illinois.
Another benefit: When customers and clients pay you, income taxes don’t have to be withheld. You get more money upfront, which can help with business cash flow. However, you do have to pay estimated quarterly income taxes to the IRS or risk penalties.
Disadvantages of sole proprietorships
If you could easily face lawsuits in your line of work, think twice about a sole proprietorship. Since your business assets are not separate from your personal assets, liability risk is a major drawback. If a disgruntled person sues your company, all of your property could be exposed, including your home and car.
Say an employee of yours causes a traffic accident while working and hurts someone. The injured party could potentially sue you for damages. If you or an employee sends out a tweet that defames someone, you may be sued for libel.
Other business structures, such as LLCs or corporations, keep your business assets separate from your personal concerns. But you could still face lawsuits regardless of business type.
In addition to liability risk, another drawback of sole proprietorships is that they tend to face tighter scrutiny at tax time.
“For many sole proprietorships where only one person is involved, there’s no one else double-checking what they’re doing in terms of claiming expenses,” Luscombe says.
This could lead to fraud.
“If you look at the audit statistics, the IRS has one of their highest rates for sole proprietorships,” he says.
More than 2% of sole proprietor business returns reporting income between $25,000 and $100,000 were audited in 2014, according to the IRS. That’s compared with an audit rate of only 0.4% for all S corporations and 0.4% for partnerships.
Another downside to sole proprietorships is that when profits increase, you have to pay higher Social Security and Medicare taxes. The current rate for these payments is 15.3% of annual income that exceeds $400.
NerdWallet verdict
Being a sole proprietor is a good idea if you have adequate insurance and you estimate that the cost of paying your self-employment taxes will be less than the cost of creating a more complex business structure (in both time and money). Examples of good sole proprietor entrepreneurs are web designers, IT consultants and hairstylists.
As your company grows, and if you consider hiring employees, the Nerds suggest you look at other business structures for tax and liability advantages. If you’re running, say, an auto shop, a clothing store or a gym with employees, you should consider filing as a corporation or an LLC.
How to get started
- You might have already begun. If you’re in business for yourself, you haven’t formed any other type of entity and you don’t have a partner, then you’re already a sole proprietorship.
- Get a business license and permits. Contact your city or county clerk for more information on local requirements, and the office of your secretary of state for other licensing rules.
- Apply for a free Employer Identification Number from the IRS. Many clients will require a tax number on invoices. It’s not a good idea to share your Social Security information on these documents, because of the risk of identity theft. Use an EIN instead.
- File for a fictitious business name (also called “Doing Business As” or DBA) with your local municipality if you don’t have an LLC. When you have a DBA, clients can write checks to the name of your company instead of to you, and that makes a better impression. You’d probably get more business as “John Smith Landscaping” than you would as plain old “John Smith”. You’ll have to search local records to make sure your desired name isn’t being used by someone else, and you should also make sure you don’t infringe on another company’s trademark. (You can search for active trademarks at the United States Patent and Trademark Office.)
- Open a business checking account to go alongside your personal account. Even though you will report business and personal income and expenses together, you should keep the money separate, so in the event of an audit you can prove your deductions are for business purposes.
- If you’re married and go into business with your spouse, determine how both of you will file taxes. The IRS would ordinarily view your company as a partnership, and filing requirements would be different. Spouses living in one of the nine community property states can treat their business as a sole proprietorship, and those in the other states can file as a qualified joint venture, which is similar. Each individual would then report his or her share of business income and expense on a separate Schedule C.
For more information about how to start a small business, visit NerdWallet’s Small Business Guide.
Margarette Burnette is a staff writer covering personal finance for NerdWallet. Follow her on Twitter @margarette and on Google+.
Photos via iStock.
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