Business owners need to consider a number of things before deciding the best legal structure for their business and selecting a specific form of ownership. There are several business structures or entities that you can choose from. The most common business structures are partnerships, limited partnerships, sole proprietorship, independent contractors, C corporations, S corporations, and LLCs.
A sole proprietorship is an unincorporated business that is owned by a single person or a one-person company. Hence, there is no legal distinction between you and your business. The sole proprietor is also the business. A sole proprietorship is the most common form of ownership because it is the most accessible type of business to set up. It is low to no cost, and it doesn't require a lot of paperwork.
Another nice aspect of sole proprietorships is that they don't have any ongoing maintenance implications or responsibilities to worry about. However, one of the flaws of being a sole proprietor is that you have no protection. You are held personally liable for any debts and obligations your business should incur. This means your personal bank accounts and your home residence can be used to repay these debts.
To start a sole proprietorship, you will need a DBA (Doing Business As). This lets you legally use a trade name. The cost of a DBA ranges between $10 and $100 depending on where your business is located. You may also have to register with the state for a business permit or license.
When it comes to tax responsibilities, if your business owes more than $1,000 at year's end, the IRS requires you to make estimated quarterly tax payments in addition to your annual business income tax return. You will pay interest and penalties if you fail to do so.
Every business structure has positive and negative aspects. That's why you should weigh the advantages and disadvantages of a sole proprietorship before you decide to become a sole proprietor.
So, what are the advantages of a sole proprietorship? Depending on what you consider an advantage, there can be many.
In order to establish a sole proprietorship, you simply have to begin operating your business. There is no paperwork involved, no filing fees, and no formal process to form.
Individual tax rates are much less than the corporate rate, and with a sole proprietorship, you and your business are considered one entity. Sole proprietors may end up paying less in taxes because they are claiming their self-employment income or any gross income from their business at their personal rate.
Unlike other entity structures where you may have governance requirements, such as having a board of directors or shareholders to worry about, as a sole proprietor, you are in charge and can decide what to produce, how to market, who to hire, etc. You have full rein. Everything you make is yours, and there is no board to meet, no shareholders to consult. You make every business decision.
As a sole proprietor, you don't have to file separately for your business nor pay corporate taxes in addition to personal income tax. Instead, you file your taxes one time. When you claim profit from a sole proprietorship, all profits that you earn go to your tax return. You would then add a Schedule C addendum to your individual 1040 to subtract any business expense, claim profits, and then pay taxes on that difference. Then you will be left with your net profit.
Also, if you are a sole proprietor with no employees, you don't have to pay payroll tax.
If things aren't going well and you are not making enough profit to continue your work, you can easily remove yourself from the company without filing paperwork.
Here are eight disadvantages of sole proprietorship and how you can overcome them.
In the eyes of the law and the IRS, you and the business are one entity. This is a disadvantage when it comes to liability. If your business incurs a particular debt and cannot fulfill the means to repay that debt, you are personally responsible for debts and obligations. Your personal assets can be used as collateral, meaning assets like your home, property, and vehicle can be repossessed.
Some businesses are riskier than others. Depending on the level of risk, a sole proprietorship may or may not be the right option for you. On the bright side, you can always secure limited liability insurance to protect yourself.
If the owner of the business passes away for whatever reason, the company ceases to exist because the business is an extension of the owner, and there is only one owner.
To avoid this from happening, prepare some formal documents outlining what happens to the entity after the death of the owner. If you fail to do so, the business ceases to exist at that particular point.
Unlike a partnership, you don’t have the opportunity to pull your and your partners' assets together, such as financial resources, human capital, and skill sets. You can't do any of that with a sole proprietorship because you are relying solely on your skills and financial resources. If you aren't equipped in those areas, that can lead to potential issues.
As a sole proprietor, you need to look into another business structure such as a partnership, a corporation, or a Limited Liability Company (LLC) to go into business with another person.
It is hard to raise financial capital. It can be hard to get business loans from banks if you are a self-employed worker. Because a sole proprietorship is not a formally established company, you can't sell stocks.
But, on the bright side, you can get an online payday loan for self-employed when you need more capital for your business. You may also be qualified for an EIDL Loan or a PPP loan. Fill out the PPP loan application and check if you can use the PPP loan proceeds to pay payroll costs. You may also want to check if you are eligible for loan forgiveness, owner compensation replacement, or help from the CARES Act.
It may be complicated for a sole proprietor to hire a qualified employee because they can't offer a competitive wage or as many benefits as more prominent companies.
Below are five good examples of companies and professions where people sometimes operate as a sole proprietorship:
● An Amazon Business
● Etsy Shop
● Massage therapist
● Local grocery store
● IT consultant
An independent contractor is a self-employed individual who provides goods or services to others under terms outlined in a contract. Like sole proprietors, they are business owners and not employees. Before starting the project, both parties agree on the deliverables and due date included in a contract. The service provider, who is the small business owner, sets their own rates. They also decide when and where to work and can dictate their own schedules. Most companies hire independent contractors if the work is temporary or project-based. Independent contractors can work for multiple clients and on various projects. When tax season comes, they can deduct any expenses related to the purchase and maintenance of their equipment and workspace.
If you’re wondering, “What is the difference between a sole proprietor and an independent contractor?” the answer is that sole proprietorship refers to how an individual pays taxes, and independent contractor refers to how one earns an income. There is no difference between sole proprietorship vs self-employed. If you are a sole proprietor, then you are by default self-employed as well.
Independent contractors are subject to self-employment tax and are responsible for filling their own taxes. They will receive a 1099 or W9 if they earn more than $600 in a year. When filing taxes, the independent contractor and the person they are working for must report to the IRS.
A W 9 provides personal identification of the independent contractor like their name, address, tax identification number, and tax classification. The IRS form acts as an agreement that the independent contractor is responsible for their business income tax.
The business that paid the independent contractor for their services will use the W9 to file 1099 at the contractor's end. The 1099 form is a summary of the total amount they paid the contractor for the tax year.
If you are an independent contractor, you will receive a copy of 1099 to report on your business income taxes.
The businesses that you are working for will also report to the IRS. The IRS will run the 1099s against your tax return to make sure you are claiming all the business income and paying all the appropriate taxes.
Consider the advantages and the disadvantages of working as an independent contractor to decide whether it is the right business type for you or not.
Below are the four main advantages of operating as an independent contractor.
Working as an independent contractor gives you the freedom to set your schedule, rates, rules, and more. You can work full-time or part-time, wherever and whenever you want.
Independent workers set their rates, which gives them the potential to earn more money than a regular employee. They also set their own working schedule and hours.
Independent contractors can deduct business costs from their taxes. Business costs include anything they need to perform their jobs, such as office supplies, internet bills, phone bills, computer repair, part of the mortgage, or rent for the home office space. Keep your receipts to help you file your taxes.
If you are a creator or inventor, you have copyright ownership over your intellectual property and any royalties that arise from it.
Here are the six main disadvantages of working as an independent contractor.
Independent contractors get paid when there is a demand for their service, and sometimes business can be slow. When demand is not high, contractors may not get work.
Independent contractors may have to work longer hours than regular employees to finish a project. They may also be working on weekends and late into the night.
Independent contractors don't have their taxes taken out of their earnings. Instead, they have to cover the expenses of Social Security and Medicaid themselves. Also, contractors are taxed quarterly, not yearly, and the amount due is estimated based on what they have earned.
Independent contractors may be taken advantage of since they are somewhat at the mercy of the client. Some may pay you late or at their convenience. Others may not pay you at all. You don’t have protection under some labor laws, meaning clients may be able to hire or fire you on a whim and can discriminate against protected classes.
If you are a sole proprietor, you are entirely liable for your business (with the exception of limited liability corporations). Should an employee of yours suffer a work-related accident, you could be sued. If you have employees, consider getting workers' compensation insurance.
Unlike an employee, an independent contractor is not entitled to employer-provided benefits such as sick leaves, health insurance, paid vacation, retirement plans, unemployment benefits, etc.
Although this may not be a significant disadvantage, you need to register your business and get a license to operate as an independent contractor. You must also get an employer identification number if you have employees, corporations, or partnerships. If you are a sole proprietor, you can use your Social Security number instead.
Like sole proprietors, independent contractors are liable for the debts of their businesses and may risk losing their assets if the company fails. You may be able to avoid this by not getting caught up in a debt cycle.
Below are five good examples of professions where it is possible to operate as an independent contractor:
● Auto mechanic
Now that you know the difference between a sole proprietor and an independent contractor, you can determine what is right for you.
Even if you start small, it may be possible to turn your sole proprietorship into a corporation one day. Being a sole proprietor is the first thing you do before becoming a Limited Liability Company (LLC), an S corporation, or an L corporation. You can form other corporate structures later on.
Before you get started, it is best to consult a lawyer who specializes in business entity formation and liability protection. It is also good to seek advice from a tax expert if you have questions or need further guidance. You can take advantage of online personal finance classes to help your business grow.