Figuring out what legal form your business should take is one of the things I'm most frequently asked about. But I have to admit, it's probably the least sexy part of starting your biz. I mean...taxes are involved. Need I say more? I know your eyes just glazed over. But it also happens to be one of the most important decisions you have to make. It's going to impact how you're taxed, how much liability you will have for your business' debts and how the IRS will treat you. We're going to start this journey with the cheapest and easiest legal form: Sole Proprietorships.
The sole proprietorship is a one-person business and it's definitely the most simple business form. In fact, the vast majority of self-employed people are sole proprietors because if you don't have a partner or you don't decide to incorporate, you immediately become a sole-proprietor! Congrats, you're a legit business!
Now don't get confused, you don't have to be the only person in the company. Sole-proprietors can hire employees and some are large companies with many employees.
Ok, now bear with me. We're going to talk taxes for a moment. But don't worry, I'll try to keep this simple! What you need to know about being a sole proprietor is that you and your business are one and the same as far as taxes go. You don't have to pay or file your taxes separate, instead you report the income or losses from the business on your personal tax return. If there's a profit, you add it on to whatever other income you have and that total is what gets taxed.
So essentially the IRS only cares about your total income regardless of its source. However, you will still have to report the profitability of your business. This is done by filing an IRS Schedule C "Profit or Loss from you Business" form.
This might seem trivial but one thing you must understand is that you are not an "employee" of the business, you are considered the business owner. This means the business doesn't pay payroll taxes or withhold income tax. So sole-proprietors need to pay self-employment taxes (Social Security and Medicare taxes) on their net self-employment income. You will pay these taxes four times a year in the form of "estimated taxes".
Ok, the tax portion is over! Let's talk liability.
So far being a sole proprietor sounds pretty simple and easy, right? So why doesn't everyone stay in that form? The answer: liability. Since you and your business are one and the same, you will personally be liable for your business debts and your business is liable for your personal debts. This is best illustrated with an example:
Mackenzie is opening a photography studio and purchases $7,000 worth of photography equipment but fails to pay. The equipment company sues for payment and wins a $7,000 judgment. Because she's a sole-proprietor, Mackenzie is personally liable for that judgment. This means the equipment company can not only go after her business bank accounts to collect the $7,000, they can also recover from her personal accounts as well as even her home and car.
This extends into business related lawsuits also. This can mean liability for: Premises (injuries occurring at the office, warehouse, etc.), Product (injuries caused by a product you manufacture or sell), Infringement (if you're accused of infringing on a copyright, etc.), and more.
A quick note if you are freelance or self-employed and working for others: the IRS treats "employees" and "independent contractors" differently and it's up to you and your hiring firm to decide what form you will take. However, the IRS weighs many factors in determining what your status is (what you declare is just one of those factors) because independent contractors usually cost less than employees and they want to prevent employees being treated as ICs when they're not.
This is important because if the IRS reclassifies you as an employee you will be responsible for heavy fines and back taxes. So it's important to be very clear on your status if you want to be treated as an IC. When you are classified as a sole-proprietor you can look a lot like an employee, especially if you're depositing your payments into your personal bank account. So if you do a lot of freelance work it might be to your advantage to choose a different business form to help establish you as an IC. In addition, some hiring firms might not choose to hire you if you're a sole-proprietor for this reason, so take this into consideration if you are a self-employed freelancer.
So to sum it up:
So that's it! That's the rundown on the advantages and disadvantages of being a sole-proprietor. In future posts we will discuss insurance that can help if you choose this business form as well as a look into the other business forms and their characteristics.