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- March 12, 2024
Which Business Type to Choose? – Part I: Sole Proprietorship
If you are starting a new business, you must make some critical decisions. One of those decisions is choosing the proper business structure. While there are multiple options, it’s always better to pick the structure that suits your business model, size of business, and more.
For example, if you are an entrepreneur venturing solo, a Sole Proprietorship is generally the preferred structure. The reason is that it’s less complicated, offers more flexibility, and compliances less. In this blog, we will take a deep dive into the entire sole proprietorship structure.
Let’s begin.
What is a Sole Proprietorship?
A Sole Proprietorship is the most basic and prevalent business structure, where one individual owns and operates the business. The owner and the business are not treated as separate legal entities. This signifies that the owner gains all the profits generated and bears complete personal liability for all business debts and losses. Since the business and owner are one, they report business income and expenses on their personal income tax return.
Benefits of a Sole Proprietorship:
1. Simplicity: Establishing a sole proprietorship is easy and requires minimal paperwork. In most instances, you must only acquire the necessary licenses and permits to begin operations. There are no specific filing fees associated with forming a sole proprietorship.
2. Flexibility: Sole proprietors have complete control over all business decisions, allowing them to adapt and adjust quickly when needed. This autonomy empowers them to capitalize on new opportunities and make strategic changes efficiently.
3. Tax Advantages: Business income and expenses directly flow to the owner’s tax return, simplifying tax filings. Also, sole proprietors may qualify for beneficial tax deductions, such as home office expenses, business travel, and vehicle usage for business purposes (subject to IRS limitations).
4. Low Cost: Sole proprietorships have minimal formation and maintenance costs compared to other structures. Aside from obtaining permits and licenses, no recurring fees are associated with maintaining this structure.
What are the Challenges with Sole Proprietorship?
1. Unlimited Liability: This is the most significant drawback of a sole proprietorship. Since the business and owner are inseparable, the owner’s personal assets (including home, car, and savings) are not shielded from creditors if the business incurs debts or liabilities. This implies that if the business experiences financial difficulties and cannot pay its debts, creditors can seize the owner’s personal assets to satisfy the outstanding debts.
2. Difficulty Raising Capital: Attracting investors can be challenging for sole proprietorships as they cannot issue stock like corporations. This limits their ability to raise large amounts of capital needed for expansion or major investments. Additionally, banks may be more cautious when lending to sole proprietors due to the perceived higher risk associated with this structure, often requiring stricter loan terms or higher interest rates.
3. Limited Growth Potential: Sole proprietorships are often limited by the owner’s skills, resources, and ability to secure funding. The business growth primarily depends on the owner’s capacity to manage operations, attract new clients or customers, and secure the necessary resources.
How to Establish a Sole Proprietorship?
No formal registration process is required at the federal level to establish a sole proprietorship. However, depending on your business type and location, you might need to obtain specific permits or licenses. Checking with your local county clerk’s office is crucial to understand the specific requirements in your area.
If you operate under a name different from your own, you may need to register a “Doing Business As” (DBA) name. This informs the public and government about your business’s official name. This might be necessary, for instance, if you want to use a brand name distinct from your own legal name.
While not mandatory for sole proprietors without employees, an EIN (Employee Identification Number) may be needed if you plan on hiring employees, dealing with excise tax activities, or filing pension plan tax returns. Acquiring an EIN is free and can be done online or through IRS Form SS-4.
How do you upgrade to another Business Structure from Sole Proprietorship?
As businesses evolve and grow, the limitations of a sole proprietorship might become more apparent. Some owners transition to a Limited Liability Company (LLC) to gain legal separation between personal and business assets while maintaining operational flexibility. This legal distinction protects the owner’s personal assets from potential business liabilities.
How Taxes are Levied on Sole Proprietorship?
In addition to regular income tax, sole proprietors are subject to self-employment taxes encompassing Social Security and Medicare contributions.
These taxes are calculated on the net business earnings after deducting allowable business expenses.
Business income and expenses are reported on your personal income tax return using Schedule C (Form 1040 or 1040-SR), which details your business profits and losses. The net result from Schedule C is then transferred to your Form 1040.
Since taxes aren’t withheld from business earnings, you may be required to make quarterly estimated tax payments throughout the year if you expect to owe $1,000 or more when you file your return. This is crucial to avoid penalties and interest charges. You can use Form 1040-ES to calculate and pay estimated taxes.
Moreover, sole proprietors can establish self-employed retirement plans like SEP-IRAs or Solo 401(k)s. The best part? Contributions to these plans may be tax-deductible, which allows you to save for retirement while reducing your taxable income.
What are the limits and thresholds related to Sole Proprietorship?
As mentioned earlier, certain limits and thresholds are associated with owning and operating a sole proprietorship. Here are some key points to consider:
Filing Requirements: While there’s no formal registration process, obtaining permits and licenses might be mandatory depending on your business type and location.
Tax Filing: You must file a personal income tax return (Form 1040 or 1040-SR) and use Schedule C to report your business income and expenses.
Self-Employment Tax Threshold: As of 2024, the Social Security tax applies to the first $168,600 of combined wages, tips, and net earnings from self-employment. The Medicare tax applies to all net earnings from self-employment, with an additional Medicare tax of 0.09% for combined income exceeding $200,000.
Employee Threshold: If you plan on hiring employees, you must obtain an EIN, register for state unemployment insurance, and withhold income taxes and Social Security/Medicare taxes from employee paychecks.
Business Name Registration: While not always mandatory, registering a DBA name helps establish brand identity and informs customers about your business.
Recordkeeping: Maintaining accurate and detailed records of your business income and expenses is crucial for tax purposes and monitoring your business performance.
Zoning Regulations: Ensure your business location complies with local zoning regulations for your business type.
Wrapping up
A Sole Proprietorship offers a simple and affordable way to start a business, particularly for individuals venturing solo who value flexibility and control. However, the unlimited liability and limited growth potential are crucial factors. Carefully weighing the advantages and disadvantages against your specific business goals and risk tolerance is essential when choosing a business structure. As your business evolves, you might need to consider transitioning to a different structure that aligns better with your long-term objectives.
Disclaimer: This blog post is intended for informational purposes only and should not be construed as professional tax or legal advice. We strongly recommend to consult with a qualified tax advisor or attorney for guidance specific to your situation. You can always reach out to our experts at CROWNGLOBE for further clarification
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