Everything you need to know about Sole Proprietorship

Tax Tips
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Fincent Team

Sole proprietorships, or sole props, are the simplest and most common types of business in the world, especially in the United States. Business owners and aspiring entrepreneurs prefer to start as sole props as they are the easiest to form and dissolve.

By default, your business will be a sole prop entity. However, you must do your homework to determine whether this is the right fit for you and your company.

If you are a sole prop owner or new to the business market, read this article to find out all about sole proprietorships, how it benefits you, what shortcomings it might have, and how to set it up for your business.

What Is Sole Proprietorship?

A sole proprietorship is exactly what it means: a business with only one owner. In this type of business, the individual owner pays personal income tax on the profits they make from the business.

As a sole proprietor, you are responsible for all matters related to the business, such as liabilities, debts, lawsuits, and more. This also includes personal appearances in the court, being answerable to the Internal Revenue Service (IRS), and so on.

Everything to know about k1 form is to report each partner's share of the partnership's earnings, losses, deductions, and credits. It serves a similar purpose for tax reporting as one of the various Forms 1099

Taxes for Sole Proprietors

Taxes for sole proprietors work like individual taxes, even if they have registered a separate business name. The business income is treated as personal income, and tax is deducted from the profits.

This is beneficial because the tax rates are equal to personal cases and can thus be lower than corporate rates. All business tax forms are filed with IRS Form 1040 Schedule C.

If the tax amount exceeds $1,000, the owner must pay estimated taxes quarterly or as applicable.

Sole proprietors are also treated as self-employed individuals. Hence, they are subject to self-employment taxes, which include social security and healthcare. The self-employment tax is charged at 15.3% of the net income.

Consider the following before you start your business as a sole proprietorship:

  • If your business involves working as a consultant, designer, freelancer, and such similar services, you fall under the independent contractor category as well. This means your clients should issue you Form 1099 whenever your yearly income exceeds $600.
  • You can run your business as a limited liability company (LLC) instead of a sole proprietorship. But in that case, you share ownership with another person and should file for business taxes separately. You also become subject to other fees related to business operations.
  • If your business is expected to have two owners, you can turn it into a partnership. If we compare sole proprietorship vs. partnership, they are similar with regards to tax, depending on each partner's stake in the business

How to Form a Sole Proprietorship

Setting up a sole proprietorship business is surprisingly easy. As soon as you offer a product or service and charge financial compensation for it, it can be considered a business. And unless you file for different paperwork, your business is a sole prop.

However, you should know some terms and conditions that qualify your business as a sole prop:

1. Making a Profit

Any hobby or one-off service cannot be considered a sole proprietorship. For the IRS to recognize your company legitimately, you need to profit from the business.

Let's assume that you sell lemonade to people by the park and ask for donations rather than charging a fixed price. Chances are you'd make barely enough to cover the costs of the business.

In this case, the IRS would consider your lemonade counter to be more of a social service rather than a business. To be qualified as a sole prop, you need to make significant profits and consistently carry on the business activity.

2. Applying for Permits and Licenses

A business needs certain permits and licenses to operate legally, depending on the state and industry. Explore the Small Business Association’s Business License and Permits to check which permits are required by your business.

For a sole proprietorship, all the permits come with the owner’s name and personal information on them. To get your business name featured, you must file a “doing business as” form. Plus, you need an employer identification number to hire employees.

3. Opening a Business Account

Although not a government mandate, using a business account for company-related transactions can make your life much easier while filing taxes.

You can also get a business credit card, business tax track your expenses separately, and ensure clean bookkeeping with a separate account. This is also highly useful if you run multiple businesses.

Common Sole Proprietorship Businesses

Ideally, you can run any business as a sole proprietorship, but certain types of businesses are better suited to this structure. They need a lower initial investment and don't need investors or loan liability protection.

Some common sole prop businesses include:

  • Home Health Care: This may include healthcare contractors that serve people at their homes, including physiotherapists, masseurs, healthcare technicians, and so on.
  • Home and Lawn Decorators: Businesses in this field may include landscaping workers, seasonal home maintenance workers, interior designers, and similar services.
  • Cleaners: Cleaning businesses often work as sole props, as they are generally independent contractors who clean houses, office buildings, outdoor areas, etc.
  • Creative Store Owners: Small store owners and those who run creative businesses often prefer to work under sole proprietorships. These are generally the ones who make the products that they sell, like craft items, handmade jewelry, paintings, etc.
  • Caterers: Caterers often start as home-based businesses working for informal events until they become popular enough to be called professionally for functions.
  • Freelancers: Any kind of freelancing for profit can be considered a sole prop if it is maintained by a single owner. This only works if the freelancer sends invoices to the clients in return for their services.
  • Consultants: Consultants of any kind, be it financial advisors or life coaches, can be sole props, especially if consulting is their side hustle. Under this model, you can work as a consultant for individual clients as well as organizations.

Advantages of Sole Proprietorship

Owning a sole proprietorship certainly gives you an upper hand in more ways than one. Let's look at a few key benefits:

1. Complete Ownership

Since you are the only owner of the business, you can control it as you please. All its income would come to you, just as all its debts would. But since you will be in charge of all business decisions, you can steer the ship away from troubled waters as and when needed.

2. Easy on the Pocket

A sole prop requires less investment as it operates under your own name. You can escape tons of tax liabilities, permit fees, and such. Of all the business structures, this is the easiest and quickest to form.

3. Easy Tax Filings

You can file all business taxes as an individual. The only form needed for this kind of business is the 1040 Schedule C. It is simple to fill out, file, and keep track of if you open a separate account for business-related expenses.

4. Less Documentation

A sole prop requires the least amount of paperwork to maintain. You only need to keep a simple record of business operations and profits.

5. No Corporate Gimmicks

All other corporations - be it C corps, S corps, or partnerships - have tons of regulations to follow, paperwork to maintain, and red tape to overcome. In contrast, a sole prop is free of these issues and can operate with a lot less stress and formalities.

Disadvantages of Sole Proprietorship

Now that you understand the advantages, let us list a few drawbacks of sole proprietorships:

1. Massive Liability

There are two sides to being the sole owner of a business. With all its profits, all the debts come to you as well.

You will be personally responsible for all laws your business might violate and any money it may owe. You can also be personally sued for any customer issues or malpractices, even if any employee is responsible.

2. Lack of Security

Your business cannot be deemed as secure in the long run. As the sole proprietor, you may be plagued by certain personal and professional issues that may impact your business. You can also find it difficult to transfer ownership to someone else if you want to opt out.

3. Limited Experience

If you are a new businessperson, your lack of knowledge or experience about the field can harm your venture. Having an advisory board or consultants can save you from such risks or events.

4. Financial Woes

If you need a loan or a big investment to keep your company afloat, it might be challenging for you to secure a loan from banks. Generally, banks and financial organizations prefer to invest in corporations rather than sole proprietorships to ensure better security for their money.

Also understand the working principle of LLC taxes which give business owners significantly greater federal income tax flexibility than a sole proprietorship, partnership and other popular forms of business organization.

Conclusion

Sole proprietorships are perfect for small business owners who prefer to work independently and without any additional liabilities. If run properly, such a business can make huge profits and turn out to be generational and future-proof.

But becoming a sole proprietor doesn't mean you have to manage your bookkeeping all by yourself. Fincent makes tracking business expenses easier so you can focus on growing your business. Find out how our services are designed with creative small businesses in mind.

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