A sole proprietorship is a business structure owned by one person. In this entity, there’s no legal distinction between the owner and the business, which means the owner is entitled to all of the profits. The main downside is that the owner is personally financially responsible for legal liabilities and debts the business incurs.
We recommend that all sole proprietorships eventually transition into being a legal business entity, such as a limited liability company (LLC). Maintaining a sole proprietorship business structure won’t protect your personal assets if someone files a lawsuit against the business. Rocket Lawyer is an online legal service that helps business owners register their business as a legal entity. Use Rocket Lawyer today to get your business registration submitted in less than 10 minutes.
How a Sole Proprietorship Works
To be classified as a sole proprietorship, a business has to earn more than $600 in revenue during a tax year. When earnings exceed $600, you’re required to file the income on an annual Schedule C tax return, which is an additional form you’ll attach to your tax return. Once you file a Schedule C, the IRS considers the business a sole proprietorship. Unlike an LLC, you won’t have to pay a fee to register the business with the state.
A sole proprietorship is the most common type of business structure because technically, any person―even if they don’t consider themselves a business owner―who earns more than $600 is regarded as a sole proprietor, even freelancers and independent contractors. If a person makes more than $600 driving Uber, they are considered a sole proprietor. If someone mows lawns on the weekend and earns more than $600, they are considered a sole proprietor. Typically, part-time, very small, or low liability businesses tend to be sole proprietorships.
A business transitions from a sole proprietor to a legal business entity when the owner registers the business with the state. An LLC registration can cost from $40 to $500 annually, which is why many small businesses remain sole proprietorships. It can be a considerable expense for a business, especially for a company that only earns $1,200 a year.
We recommend that you register your company as a legal entity, such as an LLC, to remove the personal liability if a lawsuit is filed against the business. This is the main reason business owners spend the money to register with the state. They don’t want their personal assets at risk in a lawsuit or if creditors are given a judgment for unpaid debts. Additionally, registering as a legal entity makes the business appear more legitimate to vendors and customers.
Who a Sole Proprietorship Is Right For
Overall, a sole proprietorship may be right for a very small business, part-time, or a low-liability business. Many people don’t know they’re considered a sole proprietorship. The sole proprietorship business structure becomes official when you file a Schedule C on a tax return. It’s challenging to list who specifically a sole proprietorship is right for because although some industries are less accident-prone, there are many stories of sole proprietors who have been held liable for damages resulting from their business operations.
On average, a sole proprietorship business structure is better for the following businesses:
- Bookkeeping: The recording of a business’s revenue and expenses is a low-risk business.
- Photography: Taking photos for someone is certainly a low-risk business. However, if you’re taking photos of an important event like a wedding, there is some liability there.
- Selling handmade items: Selling items such as jewelry and wood signs are low risk. Selling a product that could cause a customer harm is a higher-risk business. For instance, a soap that causes an allergic reaction in a child.
- Freelancing work: Many graphic designers, writers, and marketers do work on the side for clients in addition to their full-time job. These are typically low-risk for legal action against a business.
Most side businesses are low-risk and don’t need to assume any new debt. However, any business that can cause harm to the customer or another business needs to be registered as a legal entity. Debt isn’t an issue for most new businesses because banks won’t lend to startups. However, if the business becomes successful and you’re considering taking out a loan, it’s a best practice to register the business as a legal entity first to avoid personal liability.
Sole Proprietorship Taxes & Costs
Unlike a legal business entity (LLC, S-corporation, or C-corporation), there is no cost to create a sole proprietorship. However, sole proprietorships still have to pay self-employment taxes, which equates to a 15.3% profit. Self-employment taxes include Social Security and Medicare, which everyone who works in the United States has to pay.
For example, if you earned $8,000 under your sole proprietorship and had $2,000 in expenses, you can retain $6,000 in profit. You’d owe $918 ($6,000 x 15.3%) in self-employment taxes. In addition to federal and state taxes on the remainder of the profit, which varies depending on the amount of total income you have.
Set Up a Fictitious Name
We recommend that sole proprietorships set up a fictitious name with the state if the public business name is different than the business owner’s last name and, in many cases, it is. A fictitious name, also called a doing-business-as (DBA), refers to the public name of a business. If your last name is Mathews, and you want your business recognized as Mathews Bookkeeping Services, filing a DBA is a good idea. By default, when you fill out a Schedule C, your sole proprietorship’s name is automatically your last name.
To use a fictitious name, you’ll need to register your business’s name with the state. This is beneficial because if someone needs to contact you, they can research your business on a state registry. Typically, fictitious names cost around $50 per year to register with the state.
To ensure you’re not caught off-guard by the costs associated with establishing a sole proprietorship, we recommend you write a business plan. At the very least, you should have a working list of financial projections to which you can compare when paying the actual expenses. If you need help putting together your business plan, consider using LivePlan. You can use its templates to create your own personal plan, track day-to-day business performance, and even curate a set of professional business documents to present to investors. Sign up for a free trial today.
Advantages & Disadvantages of the Sole Proprietorship
To learn what a sole proprietorship is and determine if it’s right for your business, it’s best to know the good and bad attributes. For one, it allows you to have complete control over the business, but it doesn’t come with the unlimited liability that protects your personal finances from being impacted in the event of a lawsuit or judgment against the business.
Advantages of a Sole Proprietorship
Here are the benefits of having a sole proprietorship:
- You keep all profits: As the sole owner of the business, you decide what to do with the profits. There is no other entity or person with which to share the profits.
- You have complete control: You don’t need approval from other shareholders or board members when making decisions for the business. Additionally, if you’d like to sell the business, you are free to do so.
- Easier to file taxes: Because you and the business are the same, you don’t need to file a separate business tax return.
Disadvantages of a Sole Proprietorship
Here are the disadvantages of having a sole proprietorship:
- No liability protection: You are directly responsible for paying any debts the business owes. Additionally, if an employee acts unlawfully on behalf of the company, you personally can be held liable and be sued.
- Funding limitations: Unlike a corporation, you cannot sell shares or stock in your business. As the individual owner, you are the primary source of your business’s funding.
- No business continuity: If something were to happen to the business owner, such as an illness or death, the business would be sold or liquidated, and its assets passed on to the owner’s estate.
Many of the disadvantages above apply to a full-time business with employees. A sole proprietorship may be a good idea when you’re just starting out. However, as you hire employees and take on risk, it’s best to establish your business as a legal entity. For example, if you started a marketing company as a side business, and it eventually grew to the point that you need to hire employees, it would be a wise decision to transition from the sole proprietorship classification.
How to Set Up a Sole Proprietorship
From the IRS’s perspective, earning income legally sets your business up a sole proprietorship. Although you aren’t required to set up a DBA, we recommend you do, so your business appears professional to potential customers researching your business on the state’s business registry. Visit your state’s official business registration page and submit your DBA paperwork for around $50.
Additionally, you can use an online legal service to assist with the DBA (also called fictitious name). Rocket Lawyer is a website that will submit your fictitious name on your behalf for $99 plus state fees.
Alternatives to the Sole Proprietorship
There are several alternatives to the sole proprietorship business structure, including the LLC, S Corp, and C Corp. The LLC is the most common small business legal entity with more than 80% of all registrations. An S Corp has certain tax advantages over an LLC. C Corps are a costly option due to double taxation and includes a 21% corporate tax.
Here are alternatives to a sole proprietorship business entity.
LLC
The LLC is the most common alternative to the sole proprietorship business entity. It protects a business owner’s assets if a lawsuit or bankruptcy were to occur against the business. Most states can create. It may take up to 30 days for the state to process the registration. The fee to register an LLC varies state-to-state from $40 to $500 per year.
S Corp
Similar to an LLC, the S Corp provides personal liability protection. Another benefit of an S Corp is that you can pass profits directly to the owners’ personal tax returns and avoid the double taxation of a C Corp. A downside of the S Corp is that you have to document and the annual meeting minutes, which requires more paperwork than the LLC. Typically, an S Corp is more expensive than the LLC with state registrations costing between $100 and $500 per year.
C Corp
A C Corp is a business owned by shareholders. The company is held liable financially and legally, not the shareholders. C Corps typically give shares to help raise money for the business. A downside to registering as a C Corp is that it’s subject to double taxation, which means income is taxed at the corporate rate of 21% and then taxed at a dividend rate of about 15%. The cost to register a C Corp is similar to that of an S Corp and is between $100 to $500 a year.
Frequently Asked Questions (FAQs) for a Sole Proprietorship
This section includes the most commonly asked questions about a sole proprietorship. If you don’t see your question, head over to our forum, and post your question there. We have a whole team of industry experts who answer questions from small business owners every day.
What is an example of a sole proprietorship?
From the perspective of the IRS, any business that earns more than $600 in revenue must report it on the business owner’s Schedule C tax returns. Once it’s reported as Schedule C, the business is considered a sole proprietorship. The business stops being a sole proprietorship when it is registered as a legal business entity, such as an LLC.
Examples of common sole proprietorships are small side businesses, such as selling handmade goods, handyman services, and babysitting. Additionally, anyone who is considered a 1099 independent contractor is a sole proprietorship, such as Uber and Lyft drivers.
Why is it better to have a sole proprietorship?
It is better to have a sole proprietorship to save money on the yearly business registration fee. The cost to register a business as an LLC ranges anywhere from $40 in Kentucky to $500 in Massachusetts. If a side business in Massachusetts only earned $1,000, do they want to spend $500 to register the business? Most likely, they do not.
Do you need a business license if you are a sole proprietor?
Yes, you may need a business license. It mostly depends on the type of business you’re operating. It’s best to check with your state and county’s official business websites to see if you do need a particular business license.
For example, if you work from home, your county may require a work-from-home business license. This license was mostly created for businesses who see clients in a home or have employees visiting or working in the home. If you don’t register for the work-from-home license and get caught, you will be charged a fee.
What’s the difference between individual and sole proprietorship?
The difference between an individual and sole proprietorship is that the sole proprietorship will earn over $600 in revenue during a tax year. An individual will earn less than $600. The sole proprietorship is the definition given to a business not registered as a legal business entity.
How do I set up a sole proprietorship business?
No set up is necessary to be a sole proprietorship business. Earn more than $600 in revenue and report it on your Schedule C tax return, and the IRS will recognize the business as a sole proprietorship. If you’re running a business with a name that is not your last name, it’s recommended to register a fictitious name (DBA) with the sole proprietorship.
Do I need a DBA if I am a sole proprietorship?
Yes, if you’re operating a business, we recommend you purchase a DBA. To register a DBA, visit your state’s official business registration website and follow the steps. Additionally, no matter what state you’re operating in, you can go to a legal services website like Rocket Lawyer to register your DBA.
Do I need a business bank account for a sole proprietorship?
No, you don’t need a business bank account for a sole proprietorship. However, we recommend you open one to keep your personal and business finances separate. A business bank account will help keep track of all expenses in your business. When it comes time to file your Schedule C tax form, it’s important not to miss any expenses because you will pay more in taxes.
Additionally, if you do choose to register as an LLC in the middle of the tax year, it’s important to have a business checking account in the event of a tax audit. An audit goes more smoothly when income and expenses are in one checking account and not mixed with personal finances.
How much does it cost to register a sole proprietorship?
A sole proprietorship doesn’t cost anything because it doesn’t have to be registered. The term sole proprietorship is more of an IRS term for collecting taxes than an official business structure. If you’re operating a business as a sole proprietorship, then you may want to register a fictitious name with the state. This makes it easier for a person or business to get in contact with you.
Bottom Line
A sole proprietorship is a common business entity for very small businesses. Typically, it is used by those who have businesses with little risk of legal liability. Many people choose to keep their business a sole proprietorship to save on yearly registration fees. As soon as the business takes on additional risks, such as hiring an employee, it’s recommended to register the business as a legal entity, such as an LLC.
When a business owner is ready to register as an LLC, they can complete it on their state’s official business registration website. Some business owners find government websites to be difficult to navigate. Rocket Lawyer is an online legal service that specializes in helping small business owners with legal matters, such as registering their business as an LLC. Register your business with Rocket Lawyer today for as little as $99 plus state fees.
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