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Sole Proprietorships
by Mark Minassian, CPA

A sole proprietorship is the simplest form of business to operate and it is a great vehicle for getting your feet wet running your own business. However, the liability exposure and self-employment taxes make sole proprietorships unattractive for many business owners. If you plan on growing your business, a sole proprietorship should be a stepping stone on your way to forming a corporation or LLC.


Formation   •   Operations   •   Taxes   •   Liability Protection   •   Ending

Formation

Forming a sole proprietorship does not require any paperwork to be filed with your state or the federal government. Once you declare yourself open for business, you are up and running. You may need to obtain a business license from your town or county clerk’s office, but that is usually an easy process and requires a nominal fee. If you are going to collect sales tax or if you have employees, you will need to register with your state's Department of Revenue and obtain the proper certificates.

As a sole proprietor, you do not to register for an employer identification number unless you have employees. However, even if you do not have employees, it is still a good idea to get one because otherwise you will have to use your social security number on your accounts and on any legal paperwork.

Operations

Sole proprietorships are easier to operate than other types of entities because there is only one owner and no corporate bylaws or partnership agreements that need to be adhered to. All of the managerial decisions are made by the owner and he or she does not have to answer to anyone else.

You are not required to have a separate name for your business. For example, if you are a freelance consultant, you may very well not have a separate name for your business. However, most sole proprietors operate their business under a separate name. This is known as a “D/B/A”—short for Doing Business As. For example, your name may be Joe Smith and your business may be D/B/A Joe’s Painting Company. If you operate as a D/B/A, be sure to check that the name of your business is not already being used or that it does not violate any trademarks or patents.

Sole proprietors are not required to have separate bank accounts for their businesses, but it is good idea to do so. Many times sole proprietors end up commingling their business and personal funds and have a very difficult time determining their profit or loss come tax time. Keeping your business and personal finances separate is smart business. You can open a bank account and get a credit card in your business’ name. Even if you are not operating a D/B/A, you should still open a separate bank account for your business and get a separate credit card for business use only.

Taxes

Sole proprietors report their business' income and expenses on their personal tax return. A separate form called Schedule C - Profit or Loss from Business is used to report the income and expenses of the business. The form is attached to the owner's Form 1040. Any profit is taxed to the owner and any losses are deductible by the owner and may offset any other income the owner or his or her spouse may have.

Sole proprietors must pay a self-employment tax on any net profit of $400 or more. The self-employment tax is equal to 15.3 of the business' net profit. The self-employment tax must be paid in addition to any regular income tax that you may owe on your (and your spouse's) combined taxable income. One-half of the total self-employment tax is allowed as a deduction on your Form 1040.

TIP: A good rule of thumb to follow is to keep 1/3 of your business’ gross income aside to cover the regular and self-employment tax liabilities due on your business' net profit.

Sole proprietors are required to make estimated tax payments throughout the year to both the IRS and the state (if your state has an income tax). These estimated payments are due on April 15th (for income earned between January 1 and March 31), June 15th (for income earned between April 1 and June 30), September 15th (for income earned between July 1 and August 31) and January 15th of the following year (for income earned between September 1 and December 31). If you do not make estimated payments, you will have to pay your tax due when you file your tax return. In addition, failure to make estimated payments may result in you being charged an underpayment penalty (approximately 6 to 8 annual rate) on the tax due.

The self-employment tax catches many sole proprietors by surprise. It takes discipline to make estimated payments, but it is well worth the effort. Otherwise you may get stuck with a huge tax bill when you file your tax return and may not have the money available to pay it.

Liability Protection

The liability exposure is one of the biggest drawbacks of operating as a sole proprietor. The owner is personally liable for all of the business’ debts and taxes. In addition, if someone were to sue your business, all of your personal assets would be at risk because there is no separation between the owner’s assets and the business' assets.

If you are operating in a high-risk industry where there is a high potential for lawsuits (such as the restaurant or construction industries), you should seriously consider incorporating or forming an LLC to protect yourself from a liability standpoint. But regardless of what form of business you operate, you should obtain solid liability insurance to protect yourself.

Ending a Sole Proprietorship

Sole proprietorships are the easiest form of business to end—you simply stop conducting your business. There is no formal dissolution process and no legal forms to file with your state. However, if you collect sales tax or have employees, you should notify your state's Department of Revenue that you will no longer be operating your business.

If a sole proprietor dies, the business ends. Sole proprietorships do not get passed on to surviving heirs. The sole proprietor’s assets may get passed on, and the surviving heirs may continue running the business, but they are under no obligation to do so.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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