Just like any other business structure, starting a sole proprietorship is a venture that includes quite a few steps. If you’re thinking about embarking on this journey but you’re not sure how to start a sole proprietorship, this article will help you get acquainted with all the optional and mandatory steps required to form this particular business structure.
We’ll first explain what a sole proprietorship is and go over the different types of sole proprietorships. We follow this section up with a brief overview of the most important advantages and disadvantages of forming a sole proprietorship. Henceforth, we’ll go over every step in starting a sole proprietorship, from choosing a business name to opening a separate business bank account. We also included an FAQ section at the end of our article where we answer some important questions regarding sole proprietorships.
With that out of the way, it’s time to explain what a sole proprietorship is.
What Is a Sole Proprietorship?
A sole proprietorship, also known as a sole trader or proprietorship, is one of the simplest and easiest business structures to form. Essentially, it’s a type of incorporated business owned by just one individual. The owner of a sole proprietorship pays personal income taxes on all the profits the business makes and they are personally liable in case of a lawsuit, claim, or debt.
One of the many reasons why sole proprietorships are so popular is because they’re incredibly easy to set up, so they’re the starting point of many business owners. Once the business grows, many owners change their business into an LLC or a corporation.
Types of Sole Proprietorships
There are three main types of sole proprietorships: freelancers or independent contractors, business owners, and franchisees.
Freelancers are independent contractors who work on different types of projects based on their skills and knowledge. This allows for a lot of flexibility in terms of how many hours they work per week, what kind of projects they take on, and how long they stay with a specific client.
Business owners, just like the name suggests, are sole proprietors who own a business. Much like freelancers, they have a lot of freedom and flexibility in terms of choosing how their business operates.
Franchisees are franchisee owners who sell different kinds of goods or offer a specific kind of service.
Benefits of Starting a Sole Proprietorship
Now that you’re familiar with the basic workings of a sole proprietorship, it’s time to explore some of its potential benefits.
Easy Tax Policies
The popularity of sole proprietorship can be attributed to many aspects, and their easy taxation policies are an important part of why so many business owners are attracted to this type of business structure.
Sole proprietors don’t have to file extensive taxes as is the case with many other, more complex structures – they only need to file individual tax returns based on the profit that the sole proprietorship makes. More specifically, sole proprietors need to complete the IRS Form 1040.
In addition to the inclusion of individual income taxes, many sole proprietorships are eligible for a 20% tax deduction thanks to the Tax Cuts and Jobs Act that came into force in 2017.
Easy to Form and Set Up
Another crucial benefit of starting a sole proprietorship is that they’re much less expensive to set up. The formation process includes fewer steps than some other types of business structures, making them the starting point for many inexperienced entrepreneurs. The formation and ongoing fees are quite lower compared to LLCs and corporations, especially if the sole proprietor decides that they don’t want to hire any legal help in the process.
Very Little Paperwork
The paperwork required when forming a sole proprietorship is minimal compared to other business structures. Once you have completed your applications and you have all your licenses and permits, there are few ongoing paperwork requirements, which is great news for most business owners.
You Get to Keep all the Profits
Unless you decide to hire employees for your business, you get to keep all the profits your business makes. Another benefit related to this is that you won’t have to worry about keeping someone on payroll or paying salaries on a regular basis, or creating multiple business bank accounts.
Drawbacks of Starting a Sole Proprietorship
It’s also important to consider some of the drawbacks associated with sole proprietorships.
No Limited Liability
One of the advantages LLCs and corporations have over sole proprietorships is that the members are granted limited liability in case there something unexpected happens to the business, such as a lawsuit. With sole proprietorships, the owner is solely responsible and fully liable for all the debts and claims, and their personal assets would be up for grabs. This occurs because, in the eyes of the state, the sole proprietorship isn’t separated from its owner as a legal entity.
Many entrepreneurs transitions from sole proprietorships to LLCs or similar structures just for this aspect.
You Are Responsible for All the Finances
The opposite side to keeping all the profits that your sole proprietorship makes is that you’ll be held responsible for all the financial losses. When times get rough, you won’t have someone to rely on for both financial and emotional support.
In addition to this, it can be hard for a sole proprietor to acquire all the finances they need for their business to grow. Oftentimes, the growth of a sole proprietorship is stunted just because the owner doesn’t have the finances required to move to the next step.
You Are Responsible for All the Decisions
Another disadvantage of sole proprietorships worth considering is that you’re the only one responsible for making all the decisions related to your business. Having a partner to consult during difficult times can be of immense help to some entrepreneurs, which is why this business structure is a major turn off for some people. Not to mention, your partner’s contributions extent to sharing skills, knowledge, and expertise, and this lack of symbiosis can be quite detrimental to some businesses.
Starting a Sole Proprietorship
Now that we went over some of the most important benefits and drawbacks associated with sole proprietorships, it’s time to go through all the steps required to form one.
Create a Business Strategy
Before you start with the official formation process of your business, it’s crucial that you have a clear business strategy and clear evaluations about the budget you have to work with. Create a detailed strategy about how you want your business to operate and if you’re considering hiring employees, define their roles and consider how they might contribute to your business.
Choose a Business Name
Once you have a clear business idea in mind, it’s time to consider a name for your business. You can choose to use your own name, or, if you’d like to have a more creative approach, you can create a trade name that’s related to your product. There are multiple benefits to choosing a trade name versus using your legal name; for instance, it will protect your anonymity and privacy. Whatever you decide, ensure that your business name represents your product extremely well and that you’ll be happy with your choice in the long run. Moreover, double check that your name isn’t already taken on the market by another business.
If you decide to use a trade name, you will have to register your DBA (doing business as) name. Those who choose to use their full legal name don’t have to go through this process. The requirements for registering a DBA name vary from state to state, so double-check with your Secretary of State to ensure that you’re not missing any important documents.
Purchase a Domain Name
In this day and age, most businesses need a website to advertise and sell their products and services, so another step in starting a sole proprietorship is purchasing a website domain name.
Your domain name doesn’t have to be the same as your business name, but it’s very helpful if it is or at least if it’s closely connected to it. It’s important to note that domain names can be reserved, so you can still follow through with your purchase even if you’re not ready to purchase the website. Reserving the name ensures that no other business grabs hold of it before you do.
Obtaining an EIN is Optional
Obtaining an EIN is imperative for some business structures. However, when it comes to sole proprietorships, it’s a completely optional step, unless you have employees, in which case it’s mandatory. If you decide to get an EIN, you can do so on the IRS website. The application is online and relatively simple, so consider following through with it if you think it’ll be a useful step for tax purposes.
Obtain Business Licenses and Permits
Some types of businesses require certain licenses and permits to operate legally. For instance, if your business is in sectors such as food and drinks, transportation, firearms, and agriculture, chances are your state will require you to get a license prior to starting your sole proprietorship. It’s crucial to obtain all the licenses and permits that your business requires before you get it up and running to avoid any legal trouble or paying any additional fees.
Open a Business Bank Account
If you are a sole proprietor, it’s not obligatory to open a separate business account. However, if you want to keep your business life separate from your private life, it’s a must. This allows you to keep track of your business expenses and it allows for the better management of any business credits you might have. If, in the future, you want to take a personal loan for your business, having a separate bank account is important.
In addition, it’s one of the easiest ways to protect your business funds and it makes filing taxes a lot more organized and easier.
Getting insured is especially important for sole proprietorships. After all, you don’t have liability protection, so all your assets will be at stake if you suffer a financial loss, or if you get sued or get a claim. Getting insurance protects you from any additional financial and legal risks, so you can be at peace knowing you’re not putting yourself or your business in danger.
There are several different types of insurance, and you should choose the one that’s related to your business.
Getting insured is one of the most expensive steps in forming a sole proprietorship; however, it’s also one of the most important ones due to the lack of limited liability that comes with this type of business structure.
Can I Change My Business from a Sole Proprietorship to an LLC?
Many entrepreneurs decide that a sole proprietorship isn’t the right business structure for them after growing their business, and transform it into an LLC or another more complex business structure. This requires completing a few steps, like getting a new EIN if you already have one, a new business bank account, and a new license if you’re growing your business. There are also some extra steps, such as filing articles of organization and executing an LLC operating agreement.
Is a Sole Trader the Same as Self-Employed?
While they are similar concepts, there is a slight difference between being a sole trader and being self-employed. Being a sole trader implies that you’ve chosen a certain business structure, while being self-employed indicates that you don’t have an employer whom you work for and that you’re your own boss.
Is a Sole Proprietorship Easy to Start?
Even though becoming a sole proprietor requires completing a few different steps, creating a sole proprietorship is a much easier process than creating a more complex business structure, like an LLC. This is because a sole proprietorship isn’t required to be incorporated, which is a step that can be quite time-consuming when you’re starting a new business.
What Is an Example of a Sole Proprietorship?
An example of a sole proprietorship would be artists, writers, shop owners, and consultants.
How Does a Sole Proprietor Pay Taxes?
Sole proprietorships qualify for pass-through taxation, which essentially means that they don’t have to pay taxes on a corporate level, but all the reports go to their personal tax returns.
We hope anyone who was curious about how to start a sole proprietorship found this article useful and informative.
There are many benefits to starting a sole proprietorship, such as being easy to set up and requiring very little paperwork. Starting a sole proprietorship includes both optional and mandatory steps. For instance, you have to complete the IRS Form 1040 for taxation purposes, but starting a separate business bank account is entirely optional. If, at any point, you want to transform your sole proprietorship into an LLC, you can do so by completing a couple of steps.