The simplest form of business entity is the sole proprietorship. If you choose this legal structure, then legally speaking, you and the business are the same. You can continue operating as a sole proprietor as long as you're the only owner of the business.

Establishing a sole proprietorship is cheap and relatively uncomplicated. If you're going to conduct your business under a trade name such as Smith Furniture Store rather than John Smith, you'll have to file an assumed name or fictitious name certificate at a local or state public office. This is so that people who deal with your business will know who the real owner is. In addition, you may have to obtain a business license to do business under state laws or local ordinances.

States differ on the amount of licensing required. In California, for example, almost all businesses need a business license, which is available to anyone for a small fee. In other states, business licenses are the exception rather than the rule. But most states require a sales tax license or permit for all retail businesses. Dealing with these routine licensing requirements generally involves little time or expense. However, many specialized businesses -- such as an asbestos removal service or a restaurant that serves liquor -- require additional licenses, which may be harder to qualify for.

From an income tax standpoint, a sole proprietorship and its owner are treated as a single entity. Business income and business losses are reported on your own federal tax return (Form 1040, Schedule C). If you have a business loss, you may be able to use it to offset income that you receive from other sources.

Personal Liability
A potential disadvantage of doing business as a sole proprietor is that you have unlimited personal liability.

Example 1: Lester is the sole proprietor of a small manufacturing business. When business prospects look good, he orders $50,000 worth of supplies and uses them up. Unfortunately, there's a sudden drop in demand for his products, and Lester can't sell the items he's produced. When the company that sold Lester the supplies demands payment, he can't pay the bill.

As sole proprietor, Lester is personally liable for this business obligation. This means that the creditor can sue him and go after not only Lester's business assets, but his other property as well. This can include his house, his car, and his personal bank account.

Example 2: Shirley is the sole proprietor of a flower shop. One day Roger, one of Shirley's employees, is delivering flowers using a truck owned by the business. Roger hits and seriously injures a pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the accident. The lawsuit names Shirley as a codefendant. After a trial, the jury returns a verdict against Roger -- and Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This means the pedestrian can go after all of Shirley's assets, business and personal.

One of the major reasons to incorporate a business is that, in theory at least, incorporation allows you to avoid most personal liability. Limited personal liability is also a characteristic of a limited liability company.

Income Taxes
As a sole proprietor, you and your business are one entity for income tax purposes. The income of your business is taxed to you in the year that the business receives it, whether or not you remove the money from the business. By contrast, a corporation is a separate entity for income tax purposes. As a shareholder in a corporation, you don't pay tax on money earned by the corporation until you receive payments as compensation for services or as dividends. The corporation pays its own taxes.

Special S Corporation Rules
There's a different rule for corporations that have elected S corporation status under federal tax regulations. Basically, an S corporation is taxed like a sole proprietorship or partnership: The owners report their share of corporate profits on their own tax returns, whether or not the money has been distributed to them.

Compared to a sole proprietorship, a corporation can offer some tax advantages if you're able to leave some income in the business as " retained earnings." For example, suppose you wanted to build up a reserve to buy new equipment, or your small label manufacturing company accumulated valuable inventory as it expanded. In either case, you might want to leave $50,000 of corporate profits or assets in the business at the end of a year. If you operated as a sole proprietor, those " retained" profits would be taxed at your marginal tax rate. But if you incorporated, the rate would almost surely be lower.

Note: You can share ownership of your business with your spouse and still maintain its status as a sole proprietorship. If you choose to do this, in the eyes of the IRS you'll be co-sole proprietors. You can either split the profits from your business if you and your spouse file separate returns, or you can put them on your joint Schedule C if you file a joint return. Only a spouse can be a co-sole proprietor. If any other family member shares ownership with you, the business must be organized as a partnership, corporation, or limited liability company. More on husband/wife sole proprietorships.

Fringe Benefits
If you operate your business as a sole proprietorship, tax-sheltered retirement programs are available. A Keogh plan, for example, allows a sole proprietor to salt away a substantial amount of income free of current taxes. You can't really do any better by setting up a corporation.

A corporation does have an advantage when it comes to medical expenses for the owner and his or her spouse and dependents. As a sole proprietor, you can deduct only 40% of your family's health insurance premiums on Form 1040. You can deduct the remaining 60% as an itemized deduction on Schedule A, but only to the extent that the 60% of the premiums, plus other uncovered medical expenses, exceed 7.5% of your adjusted gross income for the year. If you form a corporation, however, and hire yourself as an employee, the corporation can pay for 100% of your family's health insurance premiums and uncovered medical expenses and then take these amounts as a business deduction.

Hiring Your Spouse Can Have Tax Benefits
If you choose to do business as a sole proprietor, there's a way you can deduct more of your family's medical expenses. First, hire your spouse at a reasonable wage. Then, set up a written health benefit plan covering your employees and their families. A sample form is shown below. Your business can then deduct 100% of the medical expenses it pays.

But balance whether such a plan can save you enough money to justify the effort. There may be some expense for setting up the plan and handling the associated paperwork. And remember that your business will be obligated for payroll taxes on your spouse's earnings. But this isn't all bad since your spouse will become eligible for Social Security benefits in his or her own right, which can be of some value -- especially if he or she hasn't already worked enough quarters to qualify.

If you're audited, the IRS will look closely to make sure that your spouse is really an employee and performing needed services for the business.

Recommended Reading
To learn about how a person qualifies for Social Security benefits, see Social Security, Medicare, and Pensions, by Joseph L. Matthews (Nolo).

Sample Reimbursement Plan
Sam Jones, a sole proprietor doing business as Jones Consulting Services (the Company), establishes this Health and Accident Plan for the benefit of the Company's employees.
  1. Coverage. Beginning January 1, 20XX, the Company will reimburse each employee for expenses incurred by the employee for the medical care of the employee and the employee's spouse and dependents, and for premiums for medical, dental, and disability insurance. The medical care covered by this plan is defined in Section 213(d) of the Internal Revenue Code. Dependents are as described in Section 152.
  2. Direct payment. The Company may, in its discretion, pay any or all of the expenses directly instead of reimbursing the employee.
  3. Expense documents. Before reimbursing an employee or paying an expense directly, the Company may require the employee to submit bills and insurance premium notices.
  4. Other insurance. The Company will reimburse an employee or pay bills directly only if the reimbursement is not provided for under any other health and accident or wage continuation plan.
  5. Ending or changing the plan. Although the Company intends to maintain this plan indefinitely, the Company may end or change the plan at any time. This will not, however, affect an employee's right to claim reimbursement for expenses that arose before the plan was ended or changed.

Dated: December __, 20XX

Sam Jones, doing business as Jones Consulting Services

Routine Business Expenses
Day-to-day business expenses can be deducted in the same way for a sole proprietorship and a corporation. Whether it's car expenses, meals, travel, or entertainment, the same rules apply to both types of business entity.

You'll need to keep accurate books for your business that are clearly separate from your records of personal expenditures. The IRS has strict rules for tax-deductible business expenses, and you need to be able to document those expenses if challenged. One good approach is to keep separate checkbooks for your business and personal expenses -- and pay for all of your business expenses out of the business checking account. But whatever your system, please pay attention to this basic advice: It's simple to keep track of business income and expenses if you keep them separate from the start -- and murder if you don't.

Copyright © 2000 Nolo.com Inc.

Published on: May 12, 2000