Sole Proprietor Myths You Need to See: Learn the Truth

The use of the “Sole Proprietor” entity when starting a business has been increasing over the past few years mainly due to perceived ease of use and lower start-up costs associated with its use.

Although it is true that there are fewer required forms for sole proprietorships compared with corporations or LLCs, many do not realize that this type of business structure does not offer the same level of protection as other entities and has some additional filing requirements.

Let’s look at what a sole proprietorship is and some of the common myths that surround this business entity.

What is a Sole Proprietor?

In California, a sole proprietorship is defined as “an unincorporated business owned by one individual.”

In other words, a sole proprietor is in business for him/herself and does not plan to incorporate the business, or in the case of a partnership, each partner has full responsibility for all debts of the partnership.

Pros and cons of Sole Proprietorships

Like all business structures, there are pros and cons to consider.

Benefits:

  1. Ease of establishment
  2. Minimal filing requirements (for federal tax purposes)
  3. Ability to use your personal Social Security Number instead of having to apply for a Federal Tax Identification Number
  4. Limited legal liability
  5. Unlimited life span
  6. No double taxation on income (income is taxed only once as opposed to corporations or LLCs that face double taxation due to this business structure).

Disadvantages:

  1. Personal assets are not shielded from creditors of the business
  2. Unlimited life span, which means if the business is not profitable, you can’t dissolve it
  3. Loss of privacy – sole proprietorships are required to disclose the owner’s name and address on all forms filed with the various government agencies (for example, for fictitious business name filings)
  4. Unlimited personal liability.

What does unlimited personal liability mean?

This means that if your customers or clients suffer damages resulting from an accident or injury at your place of business or another type of negligence claim, they can come after your personal assets (home, car, bank accounts) up to the number of your claims against them.

This can be a major problem, particularly if you only have one employee since their workman’s comp insurance will not cover employees that are family members.

You should also be aware that a sole proprietorship can be a turn-off to a bank when applying for a business loan since the bank would not have collateral in the form of your home or other assets.

Finally, if you want to bring on employees at some point, you will have to apply for an assumed name which is another expense and filing requirement associated with running this type of business.

Why should I choose a different entity?

In addition to being responsible for your own debts and liabilities as noted above, here are some additional reasons why incorporating your business may make sense:

  • Ability to attract investors due to protection from creditors;
  • Incorporation offers benefits such as allowing losses from one year to carry forward into future years to offset future profits;
  • The ability to raise capital through the sale of shares or ownership interest in your business.

When should I form my business as a Sole Proprietor?

Sole proprietorships are generally used by those who want to run a low-risk, low-cost entity that offers flexibility and ease of use.

However, if you are an experienced business owner or plan on running a large company that plans to do business all over the world, you may be better off forming another type of legal entity such as an LLC or Corporation since personal assets are protected from creditor claims brought against the business.

A law firm may be able to assist you with filing an assumed name or incorporating your business. However, the information contained in this article is not intended to be legal advice and should not be relied upon as such.

6 Sole Proprietor Myths You Need to See

1. Every business is a sole proprietorship

You may consider yourself a “sole proprietor” simply because you are the only owner of your business. However, this does not meet state law requirements for reporting purposes.

The term sole proprietorship applies to an independent business where there is one owner and no legal distinction between the owner and the business entity itself.

It does not matter if there are also employees or if you have other investors.

An unincorporated company that has more than one member or partner is still considered a partnership for tax filing purposes by both federal and most state governments, including California (with some exceptions).

2. A sole proprietorship can be taxed as an S-Corp!

A common misconception is that if you file your return as a sole proprietorship, you can convert to an S-Corp for purposes without having to prepare any additional forms.

The idea behind this myth is likely due to the fact there are fewer required forms when filing as a sole proprietor.

A single-member LLC that elects to be taxed as an S-Corp must file Form 2553 with the IRS and get approved prior to making their election.

Sole Proprietorships do not need the approval of the IRS because they are already “pass-through” entities, meaning all income or losses of the business flow through directly to its owner(s) and are reported on his/her individual return.

During the initial formation of a business, it is recommended that new business owners investigate forming either a corporation, LLC, or LLP to ensure that they have the maximum level of protection and ease of business succession.

3. If I use my bank account, it’s a sole proprietorship

The use of a personal checking account does not automatically make your business a sole proprietorship.

It is important for small business owners to understand how their entity will be classified by state and federal agencies so that they can properly report all income received from the company as well as any losses incurred throughout operations.

Although businesses operating under a sole proprietorship can technically operate off of “cash only,” this may not be the most prudent financial decision in regards to mitigating potential risks associated with being an unincorporated entity.

In California, you should obtain at least a “DBA” ( Doing Business As ) name to separate your business from your personal assets.

4. A sole proprietorship must have a license or permit for their trade

It is not required that a sole proprietorship obtain any special licenses, permits, or certifications to conduct business in most localities, with the exception of collecting sales taxation.

Local governments may require new businesses to register with them so that they are aware of who is conducting transactions within their jurisdiction and can track taxable revenue generated by these entities.

Most licensing boards also require that you make an application and pay fees before obtaining licensure for your specific trade.

A few examples of state-federal licenses that sole proprietors may be subject to include:

  • hazardous materials handling
  • food service sanitation
  • firearms possession.

5. A sole proprietorship pays only income taxes on their earnings

The IRS rules for taxation of sole proprietorships are relatively straightforward: all business income is reported as personal income on your federal return, even if it has been retained in the business account exclusively.

In an LLC with no co-members, this is usually not a problem as the business is taxed as a pass-through entity without double taxation. However, if your LLC needs to retain some earnings to fund future capital expenditures, then you must still pay self-employment taxation on any retained income over $400.

This will be required so that you report self-employment (SE)income on your individual federal return. In an LLC taxed as a corporation, the business itself is subject to taxation, and shareholders pay them on any dividends distributed from the business unless those dividends were paid out of already taxed corporate income.

6. I should file my taxes as a sole proprietorship because it’s easier

While filing a sole proprietorship can be relatively less cumbersome than other types of entities, that does not necessarily make it the best option for tax purposes.

Sole Proprietorships can have significant advantages over incorporating if you plan to operate under a “trade” name only and do not anticipate large revenue streams or changes in ownership throughout operations.

If these factors are important for your specific industry, then you may want to consider forming an LLC or corporation to protect your personal assets, limit the liability of partners/shareholders, and remain in compliance with ever-changing tax codes.

Tips for filing as a sole proprietorship:

  • If you are receiving any type of income, including non-salary income, then you must report your taxes by April 15th or face penalties.
  • You are responsible for all payroll tax filings payments even if you do not have any employees.
  • The IRS recommends that you obtain an Employer Identification Number (EIN). This can be obtained online through various private companies for around $100.

You only need an EIN if your business is required to file W2 forms at the end of the year since it appears on each form.

Your accounting records must include information about your assets, liabilities, and net worth. This information will be required when filing a personal tax return.

Should I form my sole proprietorship as a dba or an LLC?

A d/b/a stands for doing business as. In most states, you can use a d/b/a name if it is different from your full legal name and more specific to the type of products or services being offered.

This permits you to operate under a trade name that may be more marketable than your personal name without having to go through the process of registering a formal “fictitious” business name with local government agencies.

When operating as a sole proprietorState, like forming an LLC, can provide protection but is time-consuming and costly.

Conclusion

There are many myths surrounding the formation and taxation of sole proprietorships.

While these businesses can be an attractive option for some new entrepreneurs, it is important to consider all possible consequences before filing with your state.

By understanding how different entities are classified by agencies such as the IRS and your local governments, you will be able to make more informed decisions about which business structure best fits your specific industry and will help to minimize any risks associated with running a new company.

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