How to Start a Sole Proprietorship

What is a sole proprietorship?

A sole proprietorship is a business legal structure; it’s the Internal Revenue Service’s automatic classification for individuals starting a business. A sole proprietorship means you and your business have a shared identity; the business isn’t a separate legal entity. As the owner, you take on all legal responsibility if your business gets sued or faces financial troubles. This is the biggest risk of a sole proprietorship.

Examples of sole proprietorships

Here are some examples of professionals who may form sole proprietorships to offer their services to clients and customers:

• Chefs
• Accountants
• Writers
• Personal trainers
• Landscapers
• Editors

Other types of business entities to consider

Apart from a sole proprietorship, several other types of business entities may better fit your company. These entities offer limited liability, which means your business’s assets are considered separate from your personal assets, thereby protecting your personal assets in the event of fines or lawsuits.

• Limited liability company. Unlike a sole proprietorship, a limited liability company (LLC) business structure protects your personal assets from company legal trouble. You won’t be held personally responsible if your business is sued. An LLC is also known as a “pass-through entity” because business income isn’t subject to corporate income tax. With LLC taxes, profits are taxed as personal income only when paid out to the owner or owners. In other words, company income “passes through” to owners and is subject to personal income tax rates.
• Partnership. A partnership is when two or more people share business ownership and create a partnership agreement. “If you have friends that want to pool in their money, you can opt to form a partnership,” advised Jeremy Harrison, founder of Hustle Life. “It gets a little bit complicated because you need to agree with all the partners to come up with the stipulations and agreement.”
• Corporations. Corporations are considered separate entities from their owners. There are five kinds of corporations: C corporations, S corporations, B corporations, closed corporations and nonprofit corporations. Each corporation type has different requirements regarding governance structure and taxation.

Steps to starting a sole proprietorship

A sole proprietorship is straightforward to get up and running. Because you don’t have to register your business with the state, there are few formal steps. However, specific steps may be advisable, including the following:

1. Change your business name when creating a sole proprietorship.

If you want your business to be legally called something other than your name, you must establish a DBA, which stands for “doing business as.” In a sole proprietorship, the sole owner is legally required to use their personal name as their domain name unless they follow the name-change process.

To change your sole proprietorship’s name to a brand name, you must register a DBA name by filing an application with your state. You’ll often file through the secretary of state’s office, though the specific agency can vary from state to state. Depending on the state, a DBA application can cost between $5 and $150.

2. Obtain an employer identification number for your sole proprietorship.

As a sole proprietor, you will also need a federal employer identification number (EIN). The IRS uses this number to identify your company when you pay taxes. Some banks even require an EIN to open a business bank account.

3. Open a business bank account.

Opening a business bank account separate from your personal account helps keep your business finances organized and less entwined with your private funds, which also helps when applying for a business loan.

“This is a requirement to separate business money from your personal money,” explained finance consultant Julia Brookes. “This will also give you a clearer view of your profit and increase your credibility in the bank in case you need to apply for a loan.”

However, if you operate as a sole proprietor, your business’s assets are not legally considered separate from your personal assets, as would be the case for an LLC. There is no limited liability associated with a sole proprietorship.

4. Secure the proper sole proprietorship paperwork for your state.

Depending on your industry, you may need specific business licenses, permits or zoning clearance to operate legally. Check your state’s requirements for building permits or regulations for businesses to make sure you’re in compliance with all applicable laws and regulations.

What are the benefits of a sole proprietorship?

Many businesses start as sole proprietorships, and for a good reason: Sole proprietorships are simple and inexpensive to create and run.

• Sole proprietorships have few administration hassles. Sole proprietorships are easy to start and have few administration headaches. “There is no cost to organize, and you don’t have to renew your business entity yearly with the state,” noted Matt Jensen, a certified public accountant at Cook Martin Poulson. 
• Sole proprietorships have fewer business formalities. Sole proprietorships don’t require articles of incorporation or organization. You’re not mandated to assemble and regularly meet with a board of directors, nor must you appoint a registered agent. Additionally, there are no requirements for annual owner meetings or state filings.
• Sole proprietorship taxes are straightforward. Sole proprietorship taxes are much simpler than corporate taxes. Since you’re self-employed, you’ll pay freelance taxes, which often resembles paying your typical personal income taxes while taking advantage of more tax deductions.
• Sole proprietorships offer control. As a sole proprietor, all business decision-making and financial control falls entirely to you. You’ll have the freedom of freelancing with all the benefits of saying you work for a great company — your own.

What are the disadvantages of a sole proprietorship?

Sole proprietorships have many benefits, but they also present some disadvantages. 

• Sole proprietorships place enormous responsibility on business owners. Although a sole proprietorship is one of the simpler business entities, it puts a lot of responsibility on business owners. It offers zero legal protection of your personal assets, and there can be only one owner. “If a business owner was sued, the owners could literally lose their personal car and personal home because of a business liability,” Jensen warned.
• Sole proprietorships present security risks. Sole proprietorships may also pose security risks. “Another con is that when a business identification number is needed, the owner has to give out their Social Security number, greatly increasing the chance of identity fraud,” Jensen explained.
• Sole proprietors aren’t eligible for some tax breaks. Sole proprietors are not eligible for specific business tax breaks and some of the best business loans. They could, however, be eligible for certain tax deductions intended for self-employed individuals.

What are the tax implications of a sole proprietorship?

When filing your taxes as a sole proprietorship, you report your business’s income and losses on your personal tax returns. You’re also required to submit a Schedule C, Profit or Loss from the Business, as part of your IRS 1040 filing. This form is used to document your business’s income and expenses.

“A sole proprietorship doesn’t have to file a separate [business] tax return,” Jensen explained. “A business schedule is attached to the owner’s personal tax return.”

Income earned by sole proprietorships is treated like personal income, which is why it’s reported on your personal tax return.

You may instead be able to submit Schedule C-EZ, which documents your net profit from the business. Because the sole proprietor is considered both the employer and the employee, they are responsible for paying both the employer and employee portions of Social Security and Medicare taxes through Form SE, Self-Employment Tax. However, the employer portion of the tax can be claimed as a tax deduction when filing your tax return.

Sole proprietorship FAQs

Can you hire employees if you’re a sole proprietor?

A sole proprietor can hire employees. However, you must carefully avoid violating local or state regulations. Further, you must first obtain an employer identification number (EIN). The EIN is needed for tax purposes; the sole proprietor can’t use their Social Security number in place of a legal EIN.

What is the difference between a sole proprietor and a self-employed individual?

“Sole proprietor” and “self-employed” mean essentially the same thing. A sole proprietor is the only — the sole — person who runs their business. A sole proprietor is not the same as an independent contractor. An independent contractor typically works for another organization or multiple organizations. They’re often creative professionals like graphic artists or writers.

An independent contractor will not have taxes withheld from any payments. Sole proprietors are responsible for paying taxes associated with their businesses.

What are the insurance implications of forming a sole proprietorship?

Sole proprietors are not shielded from debts or liabilities incurred by the business. Due to personal liability, sole proprietors usually must secure some type of insurance to stay protected in the case of lawsuits. They should secure either a small business insurance policy or general liability policy.

Does a sole proprietor receive a salary?

No, a sole proprietor does not receive a salary. Therefore, you can’t pay yourself a salary and receive a tax deduction for the salary. Your pay depends on the fees you collect for the products or services you provide your customers.

Flying solo in the business world

Many business owners behind large corporations were previously sole proprietors. Between launching their operations and incorporating their companies, these business owners worked solely for themselves. This means they were sole proprietors for the earliest years of their business’s existence. If they can grow from flying solo to leading their fields, you can too — and establishing your sole proprietorship is a great place to start.

Max Freedman contributed to this article. Source interviews were conducted for a previous version of this article.