Sole proprietorships are so easy to set up and maintain that you may already own one without knowing it. For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn't on an employer's regular payroll, you are automatically a sole proprietor.
However, even though a sole proprietorship is the simplest of business structures, you shouldn't fall asleep at the wheel. You may have to comply with local registration, business license, or permit laws to make your business legitimate. And you should look sharp when it comes to tending your business, because you are personally responsible for paying both income taxes and business debts.
Personal Liability for Business Debts
A sole proprietor can be held personally liable for any business-related obligation. This means that if your business doesn't pay a supplier, defaults on a debt, or loses a lawsuit, the creditor can legally come after your house or other possessions.
Example 1: Lester is the owner of a small manufacturing business. When business prospects look good, he orders $50,000 worth of supplies and uses them in creating merchandise. Unfortunately, there's a sudden drop in demand for his products, and Lester can't sell the items he has produced. When the company that sold Lester the supplies demands payment, he can't pay the bill. As sole proprietor, Lester is personally liable for this business obligation. This means that the creditor can sue him and go after not only Lester's business assets, but his personal property as well. This can include his house, his car, and his personal bank account.
Example 2: Shirley is the owner of a flower shop. One day Roger, one of Shirley's employees, is delivering flowers using a truck owned by the business. Roger strikes and seriously injures a pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the accident. The lawsuit names Shirley as a co-defendant. After a trial, the jury returns a large verdict against Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This means the pedestrian can go after all of Shirley's assets, business and personal.
By contrast, the law provides owners of corporations and limited liability companies (LLCs) with what's called "limited personal liability" for business obligations. This means that, unlike sole proprietors and general partners, owners of corporations and LLCs can normally keep their house, investments, and other personal property even if their business fails. If you will be engaged in a risky business, you may want to consider forming a corporation or an LLC. You can learn more about limiting your personal liability for business obligations by reading Nolo's articles on corporations and LLCs.
Paying Taxes on Business Income
In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. The fact that a sole proprietorship and its owner are one and the same means that a sole proprietor simply reports all business income or losses on his or her individual income tax return -- IRS Form 1040, with Schedule C attached.
As a sole proprietor, you'll have to take responsibility for withholding and paying all income taxes -- something an employer would normally do for you. This means you'll have to pay a "self-employment" tax, which consists of contributions to Social Security and Medicare, and pay estimated taxes throughout the year. For more information, see How Sole Proprietors Are Taxed.
Registering Your Sole Proprietorship
Unlike an LLC or a corporation, you generally don't have to file any special forms or pay any fees to start working as a sole proprietor. All you have to do is state that your business is a sole proprietorship when you complete the general registration requirements that apply to all new businesses.
Most cities and many counties do require businesses -- even tiny home-based sole proprietorships -- to register with them and pay at least a minimum tax. In return, your business will receive a business license or tax registration certificate. You may also have to obtain an employer identification number from the IRS (if you have employees), a seller's license from your state, and a zoning permit from your local planning board.
If you do business under a name different from your own (such as "Custom Coding" instead of "Jim Smith Graphics"), you usually must register that name -- known as a fictitious, or assumed, business name -- with your county. For more information on filing and publishing a fictitious business name statement, see Registering Your Business Name.
In practice, lots of businesses are small enough to get away with ignoring these requirements. But if you are caught, you may be subject to back taxes and other penalties.
For more help in deciding on the best legal structure for your business, see LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo).