Sole proprietorships are so easy to establish that you may already own one without realizing it -- all the more reason for getting set up properly so that you can make more money, minimize taxes, and avoid potential problems.
A sole proprietorship is a one-person business that, unlike corporations and limited liability companies (LLCs), doesn't even have to be registered with the state in order to exist. There were more than 22.6 million sole proprietorships in the U.S. in 2008, according to the Internal Revenue Service (IRS). And even though this type of business is easy to set up, it's also easy to ignore local registration requirements, business licenses, and paying taxes on your income.
"It's by far the most common type of business, the easiest to set up, and the one that most businesses end up starting as," says Jerry Osteryoung, director of outreach at the Jim Moran Institute at Florida State University's College of Business. "You can always migrate up to an LLC or a corporation, but when first starting a business you need to make sure it's easy to start."
The following guide explains how to set up a sole proprietorship, its financial structure, and the potential drawbacks of starting one.
Dig Deeper: Sole Proprietorships Defined
Setting Up a Sole Proprietorship
Once you have an idea for a sole proprietorship, whether it means selling a product or providing a service, make the decision to run your activity like a business. "Be prepared to devote time, use business methods, and get set up properly so you can make more money, minimize taxes, and avoid potential problems," says Barbara Weltman, a tax and business attorney and author of such books as J.K. Lasser's Small Business Taxes (Wiley 2010).
Become a business. To be a sole proprietorship, you do not have to take any formal or legal steps at the federal, state, or local level, Weltman says. "As long as you are the only owner, you automatically become a sole proprietorship by conducting business," she adds.
Depending upon the city or municipality where you set up shop, you may need to register your business or obtain business and/or occupancy licenses. Osteryoung suggests contacting the nearest government-sponsored Small Business Development Center (SBDC). The Small Business Administration maintains an SBDC locator. They can usually provide you with step-by-step instructions on how to set up a sole proprietorship in compliance with all local laws and regulations.
One key component to starting a business is writing a business plan. The plan serves as a roadmap so you know the order in which to implement actions necessary to start and grow the business, Weltman says. It's also useful in making you focus on various aspects of the business, such as obtaining start-up capital and deciding whether or not you will be selling through the Web.
Choose a name. A name can describe in one or a few words what the business is all about. Think carefully in choosing a name when you start up a sole proprietorship and then protect it.
"You have to make sure the name isn't being used by anyone else," Osteryoung says.
Dig Deeper: Choosing a Form for Your Business
The Financial Structure of a Sole Proprietorship
When you start a sole proprietorship, you must separate your personal finances from your business. This helps you prepare financial statements (so you know whether you're making or losing money) and prepare tax returns. Weltman suggests establishing the following to set up business finances:
"Keep business finances and records separate from your personal activities to show the IRS that you are conducting the activity with the intent to make a profit, so that losses, which often occur during start-up years, will be deductible," Weltman adds.
"If you start co-mingling personal and business finances it can get messy in terms of taxes and family," Osteryoung adds.
Be prepared for paying taxes. As a sole proprietor you must file an annual return with the IRS to report your business income and expenses; use Schedule C (or, if eligible, a simplified Schedule C-EZ), which is part of Form 1040. If you do not have employees, then the business can operate under your Social Security number, Weltman says. However, once you hire staff or set up a retirement plan, you'll need a federal employer identification number (EIN), which you can obtain online at no cost from the IRS.
"If the business is profitable, you will owe self-employment taxes," Weltman says. "These taxes cover the employer and employee share of Social Security and Medicare taxes."
Because you are self-employed, you do not have withholding from a paycheck to cover your tax obligations. Instead, you pay income and self-employment taxes through quarterly estimated tax payments (you should set aside money on a regular basis to cover these payments). "When you file your return for the year, you will then pay any shortage or receive a refund if you've overestimated your quarterly payments," Weltman says.
Check with your locality to learn about sales tax collections. You may be required to collect sales taxes on the goods and services you sell and to turn over your collections to the state, as well as to report on collections on sales tax returns.
Dig Deeper: How to Structure a Partnership
Potential Drawbacks to a Sole Proprietorship
One of the biggest arguments against setting up a business as a sole proprietorship is that, as a sole proprietor, you can be held personally liable for any and all business-related obligations. So if your business defaults on a loan, fails to pay suppliers, or loses a suit in court, creditors can legally go after your personal possessions -- even the roof over your head.
That's why many businesses choose to incorporate or establish LLCs -- those forms offer you personal liability protection for those same business-related obligations. If your corporation or LLC fails, you -- as an owner -- can still likely keep your house and other personal property.
Obtain insurance. If you choose to stay as a sole proprietor, the best way to protect yourself is to obtain adequate insurance coverage for the unexpected. Weltman advises sole proprietors to consider the following:
"If you plan to invest considerable time and money in starting a business, consider reviewing your plans with experts," Weltman says. "Discuss the decisions you've made with an attorney, accountant, insurance agent, Web designer, and other professionals for additional guidance."
Internal Revenue Service
What new business owners need to know about a sole proprietorship in terms of federal taxes.
Female Sole Proprietors
The most popular business structure for female entrepreneurs.
Sole Proprietorship Basics
The sole proprietorship is the simplest legal structure for owning your own business, according to Nolo, the legal publisher.
Get your business plan reviewed for free by counselors to America's small businesses.