If you own your business, the simplest form of ownership is a sole proprietorship, even if you have employees. All you have to do to start a sole proprietorship is to obtain the licenses or permits required of any business by state and local laws. Then you must report business income and expenses to the Internal Revenue Service by completing Schedule C and attaching it to your form 1040. The business income will be taxed at the rate established for your filing status (depending on whether you are a single person, head of household, married filing jointly, or married filing a separate return). Usually you will have to file estimated tax returns and make quarterly payments to the IRS. In a few states you may also have to pay an unincorporated business tax, which is usually figured as a percentage of business income.
When you operate your business as a sole proprietorship, you assume personal liability, or responsibility, for all of the activities of the business. For instance, if you borrow money for your business and cannot repay it, the lender will be able to obtain a judgment against you personally for the unpaid amount -- that is, he may be able to attach your personal bank account or put a lien on your house. Similarly, if the goods or services you sell harm someone or damage his property, you may end up forfeiting your personal assets to compensate him.
To avoid this kind of liability, you may choose to form a corporation or a limited-liability company, which is permitted by law in several states. Keep in mind, however, that these business entities require more complex accounting and reporting procedures than a sole proprietorship.
Source: Reader's Digest's Legal Problem Solver: A Quick-and-Easy Action Guide to the Law, 1994, updated 1998