Starting a Sole Proprietorship FAQ

Starting a new business can be both exciting and confusing. With various types of business structures available, small business owners have a lot of questions. In this FAQ guide, we'll delve deep into one popular business type for startups and entrepreneurs: the sole proprietorship.

Starting a sole proprietorship is the easiest and cheapest way to begin a business. Other business structures include partnershipscorporationslimited liability companies (LLCs), and nonprofit corporations. Sole proprietorships may transition to different business structures as their needs change.

It is important to understand the benefits and drawbacks of starting a sole proprietorship before you start one. Below are answers to some of the most frequently asked questions about sole proprietorships.

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What is a sole proprietorship?

A sole proprietorship is a type of business where the business owner is the only person responsible for the business activity. This means that the business and the owner are the same legal entity. It's the simplest form of business type. A sole proprietorship does not have to register with the state, unlike a limited liability company (LLC) or corporation.

Entrepreneurs may have a business idea and start their own business without creating a separate entity. In this scenario, they typically begin as sole proprietors.

Starting a sole proprietorship requires no paperwork. All you do to create a sole proprietorship is simply go into business. You still have to get required business licenses and permits, like with any other form of business.

The business name can be the owner's legal name or a trade name often referred to as a “doing business as" (DBA) name. You don't need to register the business unless you're using a trade name different than your own name.

How does a sole proprietorship differ from other company forms?

A sole proprietorship differs from other forms of business in several ways. Compared to other business entities, a sole proprietorship is relatively straightforward. Unlike an LLC or a corporation, there isn't a separation between the business owner and the business itself. This has pros and cons.

The chief ways a sole proprietorship is different include:

  • Sole proprietorships are the least complex and cheapest form of doing business.
  • Sole proprietorships need no formal paperwork to set up. They don't have to register with the state.
  • Sole proprietorships do not shield individuals from liability for their business debts.
  • Sole proprietorships are treated as simple income for tax purposes. You do not need to have separate taxes prepared.

On the positive side, it's easier to set up and there's less paperwork. On the downside, the owner has personal liability for business debts. Entrepreneurs often choose this business type when they have a small business idea or a startup and want to test the waters. They can do so without too much initial paperwork.

How are sole proprietorships treated for tax purposes?

For tax reasons, the sole proprietorship is unique. Sole proprietorships are not treated separately by the Internal Revenue Service (IRS). This means you treat any profit from your sole proprietorship as your personal income. You report it on your individual tax return on Schedule C. You pay taxes on this income in the year you receive it on your personal tax return.

The business is not a separate legal entity. As such, it doesn't file its own tax return. However, the business owner must pay self-employment tax, which covers Social Security and Medicare, if applicable. The IRS website has useful tools and guidelines for sole proprietors on how to file taxes. In addition, some local governments require sales taxes or other business tax payments. This usually depends on the nature of the business.

How do I manage finances as a sole proprietor?

It's essential to keep personal and business finances separate. Most business owners open a business bank account to manage business income and expenses. This not only helps with organization but also simplifies things during tax season. 

If your business has employees or if you're an independent contractor, you might also need an employer identification number (EIN). This number is a tax ID from the IRS. If you are a sole proprietor, you can use your social security number as your taxpayer identification number.

Am I personally liable for my business under a sole proprietorship?

Yes. Personal liability is one of the main concerns for sole proprietors. Unlike other forms of incorporation, you are personally liable for any of your sole proprietorship's debts or legal judgments against your business. Since the business owner and the business are the same legal entity, any debts or liabilities the business incurs are the responsibility of the owner. This means if someone sues your business, your personal assets, such as your home or car, could be at risk.

Many entrepreneurs transition to an LLC or another business entity later on. They can do this to reduce this personal liability as their business grows. For the reason of personal liability alone, you should be extremely cautious about setting up a sole proprietorship.

Do I need an attorney to help me start a sole proprietorship?

Not necessarily, but every business is unique. There may be circumstances where a partnership, LLC, or some other kind of business structure is a better fit. You also may want to get more insight into the specific liabilities your sole proprietorship may face. See FindLaw's Sole Proprietorships section for more articles and resources.

An attorney can be helpful, especially if you have questions about your business name, business plan, or potential personal liability risks. Starting a sole proprietorship is generally straightforward. The Small Business Administration (SBA) and the secretary of state's office in your state can provide guidance on any necessary registrations or licenses.

Learn more by contacting a business organization lawyer licensed to practice in your state.

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