How To Form A Sole Proprietorship?

What is a Sole Proprietorship?

A sole proprietorship, also known as a sole trader or proprietorship, is an unincorporated business owned by just one person who pays personal income tax on the profits earned from the business.

Due to a lack of government regulation, sole proprietorships are the easiest type of business structure to start or dissolve. Therefore, these types of businesses are very popular among sole proprietors, independent contractors, and consultants. Since they don’t have to create a separate business name, sole proprietors usually do business under their own names.

How to Start a Sole Proprietorship

If you’re thinking about opening your own business, forming a sole proprietorship is likely your easiest option.

As a sole proprietor, you own and control the business; there is no legal separation between you and the business, and you receive all the profits while being responsible for all its debts and liabilities. As soon as you start your business activities, you become a sole proprietor by default. However, you need to follow a few steps to make it all legal.

1. Pick Your Name

You need to register a “Doing Business As” (DBA) name if you wish to use a business name that isn’t your own. Obtaining a DBA is often required by states before you can obtain permits and licenses, and banks will require you to do so before they will issue business checks.

2. Obtain Your Permits and Licenses

Licenses and permits may be required at the federal, state, and local levels, depending on the regulations in each state. You can obtain all your licenses and permits with help from resources like Wise Business Plans Licences.

3. Establish Separate Finances

For business expenses, you will want to open a separate business bank account and business credit card. By doing so, it will be much easier for you to keep track of your expenses and income, which will simplify your taxes at the end of the year.

The failure to separate business and personal expenses can also put you at risk for an audit during tax season.

4. Report Your Taxes Correctly

In the absence of employees, you and your business are legally one entity, so you can report your income on Form 1040, Schedule C, or Schedule C-EZ, which uses your Social Security number.

However, if you hire staff or want to set up a retirement plan, you will need to obtain a federal employer identification number (EIN) and use it to file your taxes.

Understanding a Sole Proprietorship

The sole proprietorship is different from a corporation, a limited liability company, or a limited liability partnership in that no separate legal entity is created. The business owner of a sole proprietorship is therefore not exempt from liability incurred by the entity.

As an example, the debt of the sole proprietorship is also the debt of the owner. The profits of the sole proprietorship, on the other hand, are also the profits of the owner, because all profits flow directly to the business owner.

Advantages of a Sole Proprietorship

However, despite its simplicity, sole proprietorships offer several advantages, including:

1. An easy and inexpensive process

Forming a sole proprietorship is generally a simple and inexpensive process. Certainly, the process varies depending on the country, state, or province where you live. In all cases, however, very little paperwork is required, as well as very little or no fees.

2. Few government regulations

There are a few regulatory requirements for sole proprietorships. In contrast to corporations, the entities do not have to comply with various government requirements, such as reporting financial information to the public.

3. Tax advantages

The owner of a sole proprietorship is only taxed once, unlike the shareholders of corporations. A sole proprietor pays only personal income tax on the profits earned by the business. There is no tax on the entity itself.

4. Straightforward banking

The next significant benefit of a sole proprietorship is simplified banking. A sole proprietorship is the only type of business entity that does not require a business checking account. As a sole proprietor, you can accept business payments directly from your personal bank account.

Disadvantages of a Sole Proprietorship

There are several disadvantages to operating as a sole proprietorship, including:

1. Unlimited liability of the owner

The owner of a sole proprietorship has unlimited personal liability for all the debts incurred by the company since there is no separate legal entity to protect it. A company’s owner may have to use his or her own assets to repay outstanding debts or other financial obligations if the entity is unable to meet its obligations.

2. Limitations on capital raising

Compared to partnerships and corporations, sole proprietorships have fewer options for raising capital. They cannot, for instance, sell their equity shares to acquire new capital. As well, lenders look at the owner’s credit history when determining whether to grant loans.

3. It’s harder to sell your business

Due to the nature of a sole proprietorship being attached to an individual, it is impossible to sell your business or hand it down to someone else. In other words, your business ends upon your death or if you decide you no longer want to run it.

4. Harder to get financing and business credit

Another disadvantage of a sole proprietorship is the difficulty of obtaining loans or financing. Essentially, this is because most banks desire to work with established companies, not just because they have a larger revenue base, but also because they tend to have a longer credit history.

How Do You File Taxes as a Sole Proprietor?

If you are a sole proprietor, you are required to file the standard individual tax form 1040 along with Schedule C, which reports your business’ profits and losses. Your tax liability will depend on your combined income from both Form 1040 and Schedule C.

How Do You Convert a Sole Proprietorship to an LLC?

It is necessary to file articles of organization with your state secretary when converting a sole proprietorship to an LLC. The IRS will also require you to obtain an employee identification number (EIN) from the IRS. You will also have to update your “doing business as” (DBA) to keep your business name.