Before you decide to do business as a sole proprietor, it’s important to understand how sole proprietorships work, the advantages and disadvantages of becoming a sole proprietor, and the legal and tax implications involved. Below, we’ve answered common questions about sole proprietorships to help no matter your business needs.
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A sole proprietorship is a common term for when an individual does business without forming a separate legal entity, and so creates no legal separation between the business and its owner. This means the business’s profits, losses, debts, and potential legal entanglements all rest squarely on the sole proprietor’s shoulders.
Most U.S. businesses are owned by sole proprietors because there is no formal documentation required to get started, as there is when you start a corporation or form an LLC. There are also no state filing fees or ongoing state compliance fees involved.
In fact, if you’re currently selling goods or services on your own without creating a formal business entity—or if you’re otherwise conducting business outside of an employer-employee setting—you’re likely operating as a sole proprietor whether you know it or not.
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Nothing is easier than “starting” a sole proprietorship because you don’t have to submit formation documents to the state to get started, and you don’t have to pay any state filing fees. You just start doing business.
That said, though you do not need to file sole proprietorship-specific formation paperwork with the state, some states may require alternative documentation. For example, Idaho requires all businesses to report their name and entity type with the state prior to conducting business, and other state and local governments may have requirements of their own.
Here are some key details to keep in mind when you decide to operate as a sole proprietor:
By default, your sole proprietorship’s name is your name (because you are the business), but you can also operate under a fictitious or DBA (Doing Business As) name. If you go this route, you’ll likely need to register the name with your state and/or local jurisdiction.
When naming your business,check your state’s business naming rules to ensure you haven’t included any words you shouldn’t. For example, most states prohibit including the word “incorporation” in a business name unless the business is actually incorporated.
Many states require businesses—including sole proprietors—to obtain business licensees. For example, Alaska requires all businesses operating in the state to obtain a license.
Note that even if your state doesn’t require a business license, your city or county may. Make sure to check local laws and regulations before selling goods or offering services.
When you’re a sole proprietor, your business’s income is taxed as personal income. Your business does not pay taxes separately from you because there is no legal distinction between you and your business. All business-related tax forms are included with the personal return.
To file taxes as a sole proprietor without employees, you need to file Form 1040 with Schedule C. You may also need to include Schedule SE.
As a sole proprietor, you will likely have to pay estimated tax quarterly. (Remember that your taxes aren’t automatically deducted from a paycheck like they are when you work for an employer.) To calculate these estimated taxes, you’ll use Form 1040-ES and the worksheet within, in conjunction with your tax return from the year prior.
This is not an exhaustive list of potential sole proprietor tax forms. There may be more tax paperwork to file as a sole proprietor, especially if you have employees.
The qualified business income tax deduction allows for up to a 20% tax deduction on qualified taxable business income for certain business owners. Sole proprietors are among those who potentially qualify for the deduction.
To qualify for the full deduction, numerous components must be met. For example, total taxable income must not exceed certain amounts, which change annually. For the 2021 tax year, the limit is $164,900 for single filers and $329,800 for joint filers.
The QBI deduction was enacted through the Tax Cuts and Jobs Act of 2017. It is set to expire in 2025 unless expanded.
No. Sole proprietors do not have to file compliance reports with their state, unlike LLCs and corporations, which are often required to do so.
Yes. There are a few common loan options available to sole proprietors. SBA loans exist specifically for small businesses, including sole proprietorships; they’re issued by private lenders and backed by the federal government. Bank loans are another option, though they can be harder for sole proprietors to get, depending on whether business credit has been established and how good the sole proprietor’s personal credit score is. Another route is to get a business line of credit—where loans are given in lump sums, lines of credit have a limit that can be pulled from as needed.
No. When you’re a sole proprietor, the IRS sees no difference between you and your business, and so whatever money your business earns (minus expenses) is part of your income.
Not necessarily. In most cases, a sole proprietor can use their social security number in place of an employee identification number (EIN). However, you may need an EIN to open a business bank account, and you will need an EIN if you decide to hire employees. Additionally, some states may require EINs on business license applications.
Yes. Sole proprietors can hire employees. If you add employees to your business, you’ll need to get an EIN. You’ll also have to pay employment taxes.
The differences between sole proprietors and independent contractors have to do with taxes and how money is made. Note that an individual can be both an independent contractor and a sole proprietor. Independent contractors are hired by clients to perform a specific service. Sole proprietors might be hired by clients, but they may also make money by selling goods. This distinction has tax implications. Clients who pay independent contractors $600 or more are required to send them Form 1099-NEC. If a sole proprietor is not hired by clients and makes money solely by selling goods, they will not receive this form.