By Jade Yeban, J.D. | Legally reviewed by Aviana Cooper, Esq. | Last reviewed October 16, 2023
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For many business owners, starting a sole proprietorship is a popular choice. While it's simple and straightforward, like all business structures it has its pros and cons. If you're a sole proprietor, you'll deal with tax returns, sales tax, and more. So, let's dive into the world of sole proprietorship.
A sole proprietorship is a type of business where there's no distinction between the business entity and the owner. Sole proprietorships are the simplest of all legal structures, but they also lack many of the legal and financial protections of other business forms. Sole proprietors experience the key advantage of being their own boss but concurrently shoulder the burden of being responsible for the business's success and failure.
Business owners who are sole proprietors report business income on their individual income tax returns. This means they pay taxes on their personal income. Unlike a C corporation or limited liability company (LLC), a sole proprietorship doesn't have separate taxes or legal structures.
For many small business owners, the allure of a sole proprietorship lies in its simplicity. It offers an uncomplicated setup, often requiring minimal paperwork and legal formalities. When it comes to filing taxes, the process is relatively straightforward. Business income and expenses are reported directly on the owners' personal tax form.
A significant advantage is the ability to claim tax deductions for business expenses. However, a notable challenge is the self-employment tax, which covers costs such as social security. Additionally, while the structure provides ease, it also exposes the owner to personal liability for all business activities. This is a major concern to many.
Starting this type of business is easy. Often, no special paperwork is needed. However, business owners should always check their local rules. Some cities might require you to get a business license. Also, remember to name your business. It can be your name or something unique.
If you are electing to run a business by yourself, you'll need to learn how to choose a business name. Many sole proprietors choose a company name other than their legal name. If you do, you'll need to file a "doing business as" (DBA) with the county where the principal place of business is located. For example, if your name is John Smith and you choose to name your business "Bob Jones Trucking Company," be sure to file the proper forms.
Understanding taxes is crucial for those operating a sole proprietorship. One of the main features of sole proprietorship taxes is that the federal tax applies directly to the owners' personal tax returns. This means that the business income and expenses are reported on an individual's federal tax return.
Additionally, there may be other taxes to consider. Excise taxes are sometimes applicable depending on the nature of the business. If a sole proprietor has employees, payroll taxes become relevant. Proper tax withholding procedures must be in place.
A sole proprietor is responsible for several tax payments. Come tax year, sole proprietors file taxes using various forms. Most use Form 1040, Schedule C, and Schedule SE. Business income, expenses, and self-employment taxes are all reported here. But, it's vital to keep track of all business expenses for tax purposes. This includes payments toward social security and Medicare taxes.
It's essential to file the correct IRS form to report these. For most sole proprietors, this means using Schedule SE to calculate and report their self-employment tax.
Being in business for yourself means you are required to list your business's profit or loss information on Schedule C. You will submit this to the IRS and file Form 1040. There are several deductions you will be allowed to take, but be sure to seek guidance from a tax attorney or other qualified professional if you have questions.
Another tax concern is the Federal Unemployment Tax Act (FUTA). Sole proprietors may need to pay this federal unemployment tax if they have employees. The specifics of FUTA can be intricate. Understanding when and how to make these payments is crucial for tax preparation.
If you and your partner run the business, you're both considered joint owners of the business. The IRS may consider this to be a partnership, even if that's not the couple's intention. As a partnership, the couple will be required to file a partnership return and issue a tax document known as a Schedule K-1 to themselves, as opposed to reporting on a Schedule C. For many family businesses, it will be wise to seek the guidance of a tax professional to further understand their potential liability and obligations.
One of the major disadvantages of running a sole proprietorship is the personal tax liability you will incur. In other words, there is no legal separation between business and personal liability. If the business owes money, creditors can go after the business owner's personal assets. Unlike an LLC, a sole proprietorship does not offer liability protection.
For instance, if you took out a loan to help buy office supplies or a new computer, your creditors can sue you personally if you default on your obligations. Keep in mind many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.
For some, a sole proprietorship works. But as your business grows, you might consider change. You may want to convert your business to a C corporation, nonprofit corporation, or even a single-member LLC. Each has its own tax rate, tax credit, and benefits like health insurance deductions. A sole proprietorship is a great start, but always review your business structure and your net profit to make sure you're meeting all tax requirements. When in doubt, consult a legal professional.
Hiring the best business attorney for your sole proprietorship needs is an important process. Small businesses, such as sole proprietorships, often need help with negotiating contracts with customers or suppliers, assisting with real estate needs such as a lease or a building purchase, taxes, zoning, and licenses, protecting intellectual property, or settling litigation. The right business attorney can save your organization money and time in dealing with complex legal matters.
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