With the rise of side hustles and finding ways to earn passive income, many people want to know how to professionalize themselves further. Instead of starting a small business as an LLC or corporation, many are opting for a sole proprietorship.
Aside from legitimizing a side hustle, sole proprietorships can help you ease into business ownership—while retaining the ability to scale if and when you’re ready.
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What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with one owner. As soon as you embark on a solo side gig, freelance job, or a new business venture, you’re automatically a sole proprietor. However, if you’re starting a business with other people, you can’t be a sole proprietorship–you’ll automatically be a general partnership instead.
A sole proprietorship’s profits are taxed as the owner’s personal income, and—despite its name—sole proprietorships may hire employees so long as they have an Employee Identification Number (EIN). They’re the easiest types of businesses to set up. As such, they’re also the most common.
A sole proprietorship is not like an LLC (limited liability company) or a corporation in that it is not a separate legal entity from the owner. However, many sole proprietors end up turning their businesses into LLCs later on when they’re ready to scale up.
There are no forms to file or fees to pay when you start a sole proprietorship. However, if you don’t plan to use your own name as your business name, you will need to register a Doing Business As (DBA) name or Fictitious Business Name (FBN) depending on your state.
If the services you provide don’t require licensing, you can get started immediately.
How Does a Sole Proprietorship Work?
Sole proprietorships don’t require any upfront paperwork. The designation is automatic and kicks in as soon as you start doing business.
If you start taking on freelance contracts, for example, you are now working as a sole proprietor. And you and your business are the same. Because of the simple nature of sole proprietorships, they’re the most common form of business in the U.S.
Sole proprietors may choose to convert their small businesses to LLCs or corporations, but they also might keep their side hustle as a sole proprietorship for as long as they work on it.
If it’s just a side hustle outside of your regular employment, you may not see a need to file LLC paperwork and pay fees to keep it up. Sticking with small contracts and filing taxes as a sole proprietor may be enough for freelancers like web designers, small crafters on Etsy, or personal trainers.
Taxes
As a sole proprietor, you’ll report your business income and expenses on the Schedule C form of your personal income tax return. You’ll pay federal and state income tax on your business profits, and you’ll also pay self-employment taxes.
Here’s what that means. When you’re an employee, your employer pays half of your Social Security and Medicare taxes and withholds the other half from your pay. As a sole proprietor, you’re responsible for paying the full amount of your Social Security and Medicare taxes (otherwise known as self-employment taxes) Sole proprietors should pay estimated taxes on their self-employment income quarterly to avoid fees, penalties, and a massive tax bill in April of the next year.
Pros and Cons of a Sole Proprietorship
Pros
Since you don’t have to pay any formation fees, a sole proprietorship is an incredibly easy way to start a new business. There is no filing process—you can start immediately.
Since it’s easy and inexpensive to set up, you can quickly legitimize your side hustle. If you have a candle-making hobby, you can ask around local stores to see if they’re interested in selling items from local artisans. You can distribute marketing materials and open a bank account. It’s easy to transition your sole proprietorship into an LLC or a corporation once you start making money and proving yourself in your chosen field.
Keeping track of expenses is important in a sole proprietorship so you can list them as business expenses on your tax return. If you operate your business out of your home, there are some home costs that may be tax-deductible. Some people find it easier to avoid starting new bank accounts for their business and keep everything in one place. You are not required to open a separate account, but having a separate checking account for business expenses and income could help you keep track of everything more easily. You may be able to deduct business losses from your personal income.
Cons
Liability is the biggest con to keep yourself aware of. As a sole proprietor, you are personally responsible for all your business debts and obligations, including loans, leases, credit accounts and lawsuits. If you have employees, you may also be liable for their actions. Liability insurance can help to some extent, but if you are concerned about the risk to your personal assets if your business fails or is sued, an LLC or corporation may be a better choice.
Self-employment taxes are another drawback, particularly if you are making a substantial profit. LLCs and corporations offer additional tax options that may help you save money on self-employment taxes.
Determine if a Sole Proprietorship Right for You
A sole proprietorship is ideal if you want to dip your toes into the waters of entrepreneurship. There are no major upfront costs, and you’re only responsible to yourself for the continued operation of the business.
On the other hand, if you already have a very strong business plan, are hiring employees, or are concerned about liability, you might be better off starting your business as an LLC or corporation.
Ultimately, a sole proprietorship is best for you when you have an idea and want to start immediately.
Frequently Asked Questions (FAQs)
What's the difference between an LLC and a sole proprietership?
A limited liability company is a business structure that shields members from personal responsibility of the LLC’s debts and liabilities, whereas owners of sole proprietorships are fully responsible for the company’s debts and liabilities.
What is an example of a sole proprietorship?
An independent artist who sells their work to clients is an example of a sole proprietor. Many freelancers, artists, actors, writers and makers tend to function as sole proprietors.
Can I pay myself a salary as a sole proprietor?
In theory, yes. But it won’t make a difference in how you’re taxed. As a sole proprietor, all of your business’s income is considered your personal income. So even if you had a separate business bank account that you drew a salary from, all of the money your business made—not just the salary you’re choosing to withdraw—would be taxed as your personal income.
What taxes do sole proprietors pay?
Sole proprietors should file taxes quarterly to avoid being assessed fees and penalties by the IRS. Since no taxes are taken out of your income, quarterly tax payments also mean you won’t owe a lot of money at the end of the year. Sole proprietors need to report their business income and expenses by filing the Schedule C form along with the 1040. Business profits and losses listed in Schedule C are transferred to your personal tax return. The Schedule SE form must also be filed, which calculates how many taxes you owe in self-employment taxes. Be sure to follow the IRS guidelines when filing.
