What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business, owned by one person. From a legal standpoint, the owner and the business are considered one and the same. The implication of this is that both your business and personal assets are at risk should you be sued.
In contrast, a corporation and its owners (stockholders) are separate legal entities. Stockholders enjoy limited liability, which means, their personal assets are insulated from the legal claims of the corporation's business creditors.
Limited liability companies (LLCs) also enjoy the same limited liability protection as shareholders of a corporation without having to actually incorporate.
Sole Proprietorships Are Easy to Start
Unlike a corporation, limited liability company, or partnership, where there is some formality involved in setting up these business structures, a sole proprietorship doesn't involve any formality. Hang out your shingle, hand out your business cards, and viola, you're in business!
When you open a business bank account the bank will generally need a business license or sales tax license to set up your account.
There are no IRS licensing requirements for sole proprietorships. However, for state and local purposes, you may need a business license. If you sell merchandise at retail you'll need a state/local sales tax permit.
If you use a fictitious business name, for example, Jack Plummer doing business as (dba) Sludge Plumbing Service, you'll need to register it.
Check with your state, county, and local tax agencies.
Tax Identification Numbers
If any one of the following apply, a federal employer identification number is required:
- The sole proprietor has one or more employees
- Has a qualified retirement plan
- Files returns for excise taxes, alcohol, tobacco, or fire arms taxes
If none of the above apply, you can use your social security number for tax reporting.
TIP: With the rise of identity theft, consider applying for a federal employer identification number even if you're not required to get one. Here's why: Should you hire an independent contractor and have to issue Form 1099-MISC, you'll enter your federal employer identification number on this form instead of your social security number.
If you have employees, you'll also need a State Withholding Number, for income tax withholding, and a State Account Number, for state unemployment tax reporting.
Certain states have no personal income tax (e.g., Nevada, Texas, Florida). Check with your state to see what tax identification numbers they may require.
Taking Money Out of Your Business
Withdrawals of cash or property out of your sole proprietorship for your own personal use are called draws. A draw represents a reduction of business capital; it is not a deductible business expense. You should set up a drawing account in your books to keep track of your withdrawals.
Draws used for business purposes:
If you take cash out of your business and use it for business-related items, get receipts. You'll need them to support your deductions and to record the amount of the expenses in your books.
Tax Status of a Sole Proprietor
As the owner of a sole proprietorship you're not considered an employee of your own business. This means you don't receive a paycheck or W-2 Form or have taxes withheld from your self-employment income.
Since no taxes are withheld from your self-employment income, you'll need to make quarterly estimated tax payments (Form 1040-ES) to cover both federal income taxes and self-employment taxes.
For Freelancers and independent Contractors
- Organize your financial data into one central accounting system on the cloud
- Software kept up to date.
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- Pay your quarterly estimated taxes online.
- Export Schedule C to TurboTax at year-end for faster filing.
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Have an accounting or bookkeeping question? Email it to me.
- Return to the Tax Basics for Startups Table of Contents to find related links.