For anybody starting a business, the choice of entity is a crucial initial decision. A sole proprietorship is perhaps the most straightforward and least complex business entity, and it’s important to understand what a sole proprietorship is and why it may or may not be an appropriate choice for your new venture.
What is a Sole Proprietorship?
- A sole proprietorship is a business that's owned and managed by one owner.
- If two or more people own a business together, it will be treated automatically as a partnership.
- A significant exception to this rule is if the spouse of a sole proprietor is involved in the business. The spouse does not have to be treated as an owner or employee of the business and a partnership is not created for tax purposes.
What “start-up” paperwork is required for a sole proprietorship?
- A sole proprietorship should obtain a federal taxpayer ID number for the business, separate from the owner’s social security number. This will allow the business to open bank accounts as an independent entity and to comply with any local or state registration requirements.
- If it has employees, a sole proprietorship may have to register as an employer for federal and state unemployment programs.
- A sole proprietorship might need to register with state or local authorities for certain purposes. For example, although the requirements vary from state to state. In Virginia, the business might have to register for the so-called BPOL tax, which is a gross receipts tax that every business (with few exceptions) pays in Virginia.
- If the business is operating under a “fictitious” name (I.e., a name other than the owner’s), the business owner must register that name with the local jurisdiction. If there is a special name or logo that needs protection for federal and state law purposes, a trademark attorney should be consulted to obtain a trademark.
How is a sole proprietorship treated for tax purposes?
- Sole proprietorships are usually treated as pass-through entities for tax purposes.
- All business income and expenses flow through the entity and are reported on Schedule C of the owner’s tax return (usually on Form 1040). T
- Losses that are generated from the business activities, which may be significant in the early years, may be used to offset not only the revenue from the business but other earned income as well. If the business’s initial losses continue for an extended period, however, be aware that the IRS may treat the business as a “hobby,” disallowing the excess losses and not permitting their offset against other income.
- Any net income that is generated from the business is subject to self-employment tax as a sole proprietor. Remember that the business owner pays self-employment not only for the business owner, but also as an employer, essentially doubling the amount due.
- If there is net income from the business, the sole proprietor will have to pay estimated taxes using vouchers that are filed with the Internal Revenue Service on Form 1040-ES (as well as in your state of residence). These estimated taxes basically take the place of withholding taxes that would be deducted from your pay as an employee.
What is the major disadvantage of a sole proprietorship?
- The owner is personally liable for business-related obligations and debts incurred while operating the business. For example, if the business fails to pay a supplier and the supplier obtains a judgment against the owner and against the business, the owner will have to pay out of personal assets.
- There is no monetary limit to the personal liability that an owner could incur for business liabilities.
- Obtaining commercial and umbrella insurance coverages can mitigate this risk to a certain extent but cannot eliminate it altogether. It's always recommended to get plenty of insurance, but even with insurance, it may not be enough.
- Many policies may have exclusions that aren't covered (commercial insurance typically doesn't cover slip-and-fall business liability that might occur on business property).
- What should a business owner do? The best choice is to incorporate, choosing between a limited liability company or a traditional corporation, both of which will afford limited liability protection.
What would we recommend?
In advising our clients, we usually recommend that they not use a sole proprietorship. Despite its ease of creation and use, a sole proprietorship does not afford the personal liability protection that most business owners would prefer. If possible, we suggest incorporating your business, either as a limited liability company or a corporation.