A sole proprietorship is an individual (or married couple) who owns a business which is not otherwise incorporated or organized as a separate legal entity (i.e., there is no partnership, limited liability company, corporation, etc.). Putting it differently, sole proprietorships are businesses where an individual conducts business and holds title to property in his or her name and is directly and personally liable for the obligations of the business. There is no corporate entity or other legal device employed to hold the business assets or ameliorate the liability of the owner for any debts or obligations of the business.
Despite the personal liability that comes with the sole proprietorship, this form can be preferable where the owner contemplates no complex financing and no co-owner relationships with other parties. In fact, there are 15 to 20 million sole proprietorships in the United States. This comprises over 80% of the businesses in the United States!
Maintenance costs are very low for the sole proprietorship. Apart from any “doing business as” filings necessary if the sole proprietorship is using a name different from that of its owner, no documentation is needed to organize a sole proprietorship and no special record-keeping or corporate formality is necessary. You would not even need an attorney to form this type of business entity. By hanging out a sign, you have opened up a sole proprietorship.
Unlike other forms of business entities, there are no specific statutes governing the creation and existence of sole proprietorships. Instead, basic rules of contract law, tort law, and property law will apply. In addition to these basic concepts, all regulatory restrictions applied to businesses generally will apply to the sole proprietorship (e.g., environmental laws, civil rights laws, etc.).
The existence of the sole proprietorship ends upon the death of the owner and the property of the business will be disposed of according to the terms of the owner’s will. All assets of the sole proprietorship are owned by the owner as personal property.
On the whole, if you are planning to have a business of any sophistication, you probably want to avoid this entity.
The tax code treats the sole proprietorship and the owner as one and the same: income earned by the business is seen as income of the owner and must be reported on the owner’s IRS Form 1040. Expenses of the business are also claimed by the owner as deductions against income on the owner’s year-end tax return.
Another important point to remember about sole proprietorships is that sole proprietorships are taxed on all net income; there is no way for your small business to retain earnings without you being taxed on that money. So if you expect or want to use income from the business to grow (i.e., you are going to reinvest the profits back into the business), you may want to consider creating a C-corporation. (A C-corporation is not taxed on retained earnings.) For instance if your sole proprietorship had income of $50,000 one year and you wanted to invest that money in new computer equipment, you will pay income tax on that $50,000. If, however, your business was a C-Corporation, that $50,000 would still be taxed but at the rate for corporations, not individuals. This would mean more money with which to buy computer equipment. (There are downsides to C-corporations too, such as double taxation.)
Reporting Income from Your Sole Proprietorship The only forms you need to file to report your income from your sole proprietorship are:
- Schedule C which is attached to your annual 1040 form. (It comes with instructions .) Schedule C must be filed whenever your sole proprietorship income exceeds $400 but you should file it even if you do not make $400 in a year. You will be able to get business deductions for losses only if you file your Schedule C. Filing also starts the statute of limitations clock on the IRS’s ability to audit you on that year’s business operations.
- If you have a pretty small business, you may be able to file Schedule C-EZ instead of Schedule C. To be eligible to file Schedule C-EZ, you must meet the following conditions.
(a) gross receipts of less than $25,000
(b) claimed business expenses of less than $2,500
(c) no inventory
(d) no employees
(e) cash accounting methods are used
(f) no depreciation of assets claimed, and
(g) no overall loss being claimed.Most people just opt for filing the regular Schedule C since it is almost identical.
- Estimated Tax Payments. If (1) you are going to owe more than $1000 in income taxes AND (2) at the end of the year your tax bill will be less than either 100% of your tax bill for the previous year or 90% of the tax you will owe, then you must make quarterly estimated tax payments. You must make these payments using Form 1040-ES. This form and your payments must be made on April 15, June 15, September 15, and January 15. (These estimated tax payments will include the money you owe for payroll taxes such as Medicare and Social Security. See below!) Please note that most states are also addicted to prepayment of taxes, so you will probably have to send the state some estimated tax payments as well.When you estimate the quarterly tax payment, what you should do is figure out how much you will probably owe in income taxes at the end of the year. Then plan on sending in one quarter of that amount with each tax payment. Using the previous year’s income tax bill is a very good way to estimate the current year’s tax payments. As long as you pay about 90% of your tax bill over the course of the four quarterly installments, you will not incur the 9% penalty for failure to comply. But if your adjusted gross income exceeds $150,000, you will need to pay no less than 105% of the previous year’s tax to avoid the penalty. (And if your adjusted gross is this high, you probably should have an accountant who is helping you manage your tax affairs.)
- Employee Taxes. If you have employees, then you definitely need to read our sections concerning employees and the tax laws.
Crib Notes–Sole Proprietorship
- Selling the Business: Selling a sole proprietorship is more difficult than selling a corporation or LLC.
- Existence: The business and you are one, if you die, the business assets are treated as part of your estate.
- Liability: YOU have liability for all business debts and legal troubles!
- Taxes: All business income is taxed as your personal income.