The simplest structure under which to operate a small business is as a sole proprietor. Once you have procured any required local business license, you have nothing further to do to operate as a sole proprietorship.
But there are notable risks to operating in this fashion. The most notable one is that you have absolutely no liability protection. If someone takes legal action against your company, a judgment against you can expose your personal assets to confiscation.
Author: Mike Armour
Even though this tutorial examines legal and tax issues faced by small business owners, it should not be construed as legal, accounting, or tax advice. Always seek competent professional counsel in addressing issues and questions raised in this tutorial.
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Your Startup — What Legal Structure Is Best?
Part 1 of a Four-Part Tutorial
The simplest way to structure your business is to function as a sole proprietor. In effect, you and the business are one and the same. Laws in your area may or may not require you to register the business with your local or county government. But this normally consists merely of filing a brief form and perhaps paying a modest fee. Once you have taken these steps, you are free to start doing business.
Even filing for a Federal Employer Identification Number (EIN) may be optional. Unless your business has employees or must file excise, firearms, tobacco, or alcohol returns, you are not required to have an EIN. You file your taxes using your personal social security number.
Even though you are acting as a sole proprietor, you can appear to the public as though you are a company. You do this by registering an assumed name for your business. This allows you to issue invoices, accept payments, advertise, enter contracts, and pay taxes under this assumed name, not your personal name. Most jurisdictions allow you to register multiple assumed names. (Elsewhere on this site we have provided a fuller explanation of assumed names and how to obtain them.)
Using an assumed name is often referred to as "having a dba," which stands for "doing business as." In the eye of vendors, clients, customers, and the community you are no longer doing business as John Doe, but as XYZ Company.
Assumed names are typically registered at the county and/or state level. From one state to the next, there will be differing rules as to the terms which may be part of your dba.
One rather universal rule is that your assumed name cannot include words like "Incorporated" or "Corporation" or abbreviations like "Inc" or "Corp." These terms imply that your business is legally recognized as a corporation, which it is not. But apart from a few limitations along these lines, you are free to name your sole proprietorship whatever you wish so long as no one else locally is using that name.
Paying Federal Taxes as a Sole Proprietor
When you operate as a sole proprietorship, you pay business income taxes as part of your personal income tax. For Federal filings, this means that you attach a Schedule C to your Form 1040. You will also have to pay self-employment tax for both Social Security and Medicare by attaching IRS Form SE to your 1040.
As a sole proprietor, you pay your business' income tax as part of your personal income tax.
But what happens if a sole proprietor's spouse is materially involved in running the business? Is the business still technically a sole proprietorship (from a tax standpoint), so that it reports its income on Schedule C? Historically the IRS has said "no." It treated the couple as partners in a joint business venture.
Consequently, to conform with annual reporting requirements for a partnership, the business had to issue a K-1 to both the husband and wife, stating their respective share of the profits or losses. To report this income, the two parties individually filed a Schedule E with their Form 1040. The business also filed a partnership information report with the IRS.
Of course, these filing requirements violate one of the primary reasons for having a sole proprietorship in the first place, namely, minimizing the amount of government-related paperwork. Today the rules have slightly changed for husbands and wives who jointly run an unincorporated business. An IRS ruling in 2002 and Congressional legislation passed in 2007 have created a structure that allows many couples to opt out of the partnership filing. Instead, they can each be treated as a sole proprietor and use Schedule C to report income from the business.
However, since Schedule C's are filed in the name of a single tax-payer, each party should file a separate Schedule C, showing his or her portion of the income and expenses for the business. For more details governing eligibility for this option and how to exercise it, see the tutorial on joint ventures between spouses elsewhere on this web site.
Pros and Cons of a Sole Proprietorship
The advantages of a sole proprietorship are the following.
- You can start it or terminate it immediately at no cost or very minimal cost.
- Since you are not answerable to most reporting regulations that govern corporations and partnerships, record-keeping requirements are minimal. Fundamentally you simply need to maintain sufficient financial records to complete Schedule C annually and to defend your income and expenses in the event of an audit.
- You have absolute control of your business, since you do not have to answer to partners or to a board of directors.
In effect, you and your business are one and the same. And therein lies a wholesale problem. Because you and your business are one and the same, any legal action against your business is in fact a legal action against you personally. In legal parlance, you have no limited liability.
If some disgruntled party takes you to court, your personal bank accounts and most of your family assets are not protected from a court settlement that goes against you or a lien that is created against your business.
Now, you may be saying to yourself, "I’m not worried about being sued. I’m starting a business that has little risk of causing harm to anyone or doing damage to someone’s property." But your business can be drawn into a lawsuit in dozens of ways that have nothing directly to do with your products or services.
- What if you have an automobile accident while running errands for your business?
- What if you get behind on your bills and a creditor sues you in small claims court?
- What if you fire a worker, who then takes you to court for a wrongful termination?
- What if an independent contractor, while working for you, takes actions that trigger some legal action? In such a case you may be named as a co-defendant, or even the primary defendant.
Should something like this occur, you can’t protect your personal assets by quickly going out and incorporating your business. Liability will be determined by the structure of your business at the time of the incident around which the legal action centers.
So a word to the prudent — don’t risk everything you own to chance by operating any business as a sole proprietor. Is it legal to do so? Yes! Is it wise to do so? Absolutely not. Build limited liability for yourself as quickly as possible.
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