Sole proprietorships are so easy to set up and maintain that you might already have one without knowing it. For instance, if you're 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're 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 might have to comply with local registration, business license, or permit laws to make your business legitimate. And you're personally responsible for paying both income taxes and business debts.
A sole proprietor can be held personally liable for any business-related obligation. So, 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.
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'll be engaged in a risky business, you might 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.
In the eyes of the law, a sole proprietorship isn't legally separate from the person who owns it. Instead, it's considered a pass-through entity for tax purposes. 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 that person's 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. So, 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, including information on the 20% tax deduction for pass-through business entities, see How Sole Proprietors Are Taxed.
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 small, 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 might also have to get an employer identification number (EIN) 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're caught, you might 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).