Chances are, you’re already running a sole proprietorship. Now, educate yourself on the cons and pros, the tax implications, and the legal liabilities to determine if you want to remain a sole proprietorship.
The sole proprietorship is the simplest business form under which one can operate a business. The sole proprietorship is not a legal entity. It simply refers to a person who owns the business and is personally responsible for its debts. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name, such as Nancy’s Nail Salon. The fictitious name is simply a trade name– it does not create a legal entity separate from the sole proprietor owner.
The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business’s debts. If a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner. The owner will have to pay the business debts with his or her own money if such suits are successful.
The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. The sole proprietor owner will typically have customers write checks in the owner’s name, even if the business uses a fictitious name. Sole proprietor owners can, and often do, commingle personal and business property and funds, something that llcs, corporations and partnerships can not do. Sole proprietorships often have their bank accounts in the name of the owner. Sole proprietors need not observe formalities such as voting and meetings associated with the more complex business forms. Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.
Sole proprietorship taxation is quite simple because a sole proprietorship is indistinguishable from its owner. The income earned by a sole proprietorship is income earned by its owner. A sole proprietor reports the sole proprietorship income and/or losses and expenses by filling out and filing a Schedule C, along with the standard Form 1040. Your losses and profits are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the “bottom-line amount” from Schedule C is transferred to your personal tax return. Because business losses you suffer may offset income earned from other sources, this aspect is attractive.
As a sole proprietor, you must also file a Schedule SE with Form 1040. You use Schedule SE to calculate how much self-employment tax you owe. You need not pay unemployment tax on yourself, although you must pay unemployment tax on any employees of the business. Of course, you won’t enjoy unemployment benefits should the business suffer.
Suing and Being Sued
Sole proprietors are personally liable for all debts of a sole proprietorship business. Because the potential liability can be alarming, let’s examine this more closely. Assume that a sole proprietor borrows money to operate but the business loses its major customer, goes out of business, and is unable to repay the loan. The sole proprietor is liable for the amount of the loan, which can potentially consume all her personal assets.
Imagine an even worse scenario: the sole proprietor (or even one her employees) is involved in a business-related accident in which someone is injured or killed. The resulting negligence case can be brought against the sole proprietor owner and against her personal assets, such as her bank account, her retirement accounts, and even her home.
Consider the preceding paragraphs carefully before selecting a sole proprietorship as your business form. Accidents do happen, and businesses go out of business all the time. Any sole proprietorship that suffers such an unfortunate circumstance is likely to quickly become a nightmare for its owner.
He can bring a lawsuit in his own name if a sole proprietor is wronged by another party. Conversely, if a corporation or LLC is wronged by another party, the entity must bring its claim under the name of the company.
Advantages of a Sole Proprietorship
– Owners can establish a sole proprietorship instantly, easily and inexpensively.
– Sole proprietorships carry little, if any, ongoing formalities.
– A sole proprietor need not pay unemployment tax on himself or herself (although he or she must pay unemployment tax on employees).
– Owners may freely mix business or personal assets.
Disadvantages of a Sole Proprietorship
– Owners are subject to unlimited personal liability for the debts, losses and liabilities of the business.
– Owners can not raise capital by selling an interest in the business.
– Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.
Forming a Sole Proprietorship
You may already be operating a sole proprietorship. One of the great features of a sole proprietorship is the simplicity of formation. Little more than buying and selling services or goods is needed. No formal filing or event is required to form a sole proprietorship; it is a status that arises automatically from one’s business activity.
A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Because a sole proprietorship is indistinguishable from its owner, sole proprietorship taxation is quite simple. Sole proprietors are personally liable for all debts of a sole proprietorship business.
Don’t assume only big companies need the services of an accountant.
Accountants accountants in springwood help you keep an eye on major costs as early as the startup stage, a time when you’re probably preoccupied with counting every paper clip and postage stamp. Accountants help you look at the big picture.
In fact, perhaps no other business relationship has such potential to pay off. Nowadays, accountants are more than just bean counters. A good accountant can be your company’s financial partner for life– with intimate knowledge of everything from how you’re going to finance your next forklift to how you’re going to finance your daughter’s college education.
A general accounting practice covers four basic areas of expertise:
- Business advisory services
- Accounting and record-keeping
- Tax advice
These four disciplines often overlap. If your accountant is helping you prepare the financial statements you need for a loan, and he or she gives you some insights into how certain estimates could be recalculated to get a more favorable review, the accountant is crossing the line from auditing into business advisory services.
The best way to find a good accountant is to get a referral from your attorney, your banker or a business colleague in the same industry. Don’t underestimate the importance of a CPA (certified public accountant). This title is only awarded to people who have passed a rigorous two-day, nationally standardized test.
The first step in setting the stage for a successful search is to take an inventory of what you will need. Given the level of fees you are prepared to pay, you must decide where your responsibility stops and where the accountant’s begins.
You’re ready to interview your referrals once you have compiled your documentation and given some thought to your expectations. Five candidates is a good number to start with. For each candidate, plan on two meetings before making your decision. One of these meetings should be at your site; one should be at theirs. Both parties need to know the environment the other works in.
Related: 10 Questions to Ask Before Hiring a Small-Business Attorney.
During the ensuing interviews, your principal goal is to find out about three things:.
Most accounting firms offer tax and auditing services. What about bookkeeping? Management consulting? Estate planning? Will the accountant help you design and implement financial information systems? Other services a CPA may offer include analyzing transactions for loans and financing; preparing, auditing, reviewing and compiling financial statements; managing investments; and representing you before tax authorities.
Smaller accounting firms are generally a better bet for entrepreneurs, they may not offer all these services. Make sure the firm has what you need. In addition to services, make sure the firm has experience with small business and with your industry.
Is the accountant’s style compatible with yours? Be sure the people you are meeting with are the same ones who will be handling your business. At many accounting firms, some partners handle sales and new business, then pass the actual account work on to others.
When evaluating competency and compatibility, ask candidates how they would handle situations relevant to you. For example: How would you handle an IRS office audit seeking verification of automobile expenses? Listen to the answers, and decide if that’s how you would like your affairs to be handled. Realize, too, that having an accountant who takes a different approach can be a good thing. Be sure that the accountant won’t pressure you into doing things you aren’t comfortable with. It’s your money, and you need to be able to sleep at night.
Ask about fees upfront. Most accounting firms charge by the hour; fees can range from $100 to $275 per hour. There are some accountants who work on a monthly retainer. Figure out what services you are likely to need and which option will be more cost-effective for you. Get a range of quotes from different accountants.
Try to get an estimate of the total annual charges based on the services you have discussed. Don’t base your decision solely on cost, however; an accountant who charges more by the hour is likely to be more thus able and experienced to work faster than a novice who charges less. At the end of the interview, ask for references– particularly from clients in the same industry as you.
After you have made your choice, spell out the terms of the agreement in an “engagement letter” that details the returns and statements to be prepared and the fees to be charged. This ensures you and your accountant have the same expectations and helps prevent misunderstandings and hard feelings.
Make the most of the accounting relationship by doing your part. Don’t hand your accountant a shoebox full of receipts. The better you maintain your records, the less time your accountant has to spend– and the lower your fees will be.
It’s a good idea to meet with your accountant every month. Review financial statements and go over any problems so you know where your money is going. This is where your accountant should go beyond number-crunching to suggest alternative ways of cutting costs and act as a sounding board for any ideas or questions you have.
A good accountant can help your business in ways you never dreamed possible. Spending the time to find the right accountant– and taking advantage of the advice he or she has to offer– is one of the best things you can do to help your business soar.
A good accountant can be your company’s financial partner for life– with intimate knowledge of everything from how you’re going to finance your next forklift to how you’re going to finance your daughter’s college education.
The best way to find a good accountant is to get a referral from your attorney, your banker or a business colleague in the same industry. Will the accountant help you design and implement financial information systems? Realize, too, that having an accountant who takes a different approach can be a good thing. Don’t base your decision solely on cost, however; an accountant who charges more by the hour is likely to be more experienced and thus able to work faster than a novice who charges less.
The IRS’s Definition of Self-Employment
According to the IRS, you’re self-employed if you carry on a trade or business as a sole proprietor, an independent contractor, a member of a partnership or if you’re otherwise in business for yourself. You can be a full-time employee and still have self-employment income from a side job. To determine whether a particular income is self-employment income (rather than employee wages, for example), look at the source of your income and the extent of your involvement in the activity. If you’re self-employed, understand the self-employment tax and be aware of the tax planning opportunities.
Tax Consequences of Self-Employment
If you have self-employment income, you must pay self-employment tax. If you file a Schedule C as a sole proprietor, independent contractor or statutory non-employee, the income listed on your Schedule C is self-employment income and must be included on Schedule SE, which is filed with your Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed. Self-employment tax is used by the federal government to fund Social Security and Medicare benefits.
The self-employment tax rate on net earnings is 15.3 percent (with 12.4 percent of this rate going to Social Security and 2.9 percent allotted to Medicare). All net earnings from self-employment in excess of $400 are subject to the Medicare portion of the self-employment tax. The Social Security portion of the self-employment tax applies only to net earnings from self-employment in excess of $400, up to and including $102,000 in 2008 ($97,500 in 2007). (The maximum is reduced if you have income from sources other than self-employment that has been subject to Social Security tax.).
Employees generally have income tax, Social Security tax and Medicare tax withheld from their paychecks. If you’re self-employed, it’s likely that no one is withholding federal and state taxes from your paychecks, so make estimated tax payments to cover your federal income and self-employment tax liability. This will help you avoid liability for penalties, interest and substantial tax bills at the end of the year.
As a self-employed individual, you have a number of income tax planning opportunities. Here are some you may wish to consider:.
- Shifting and Timing Income.
Shifting income to family members can be an important tax planning technique. Your ability to shift income to a family member who is in a lower marginal tax bracket can be a significant advantage if you run your own business. Your relative may benefit from the increased income and you may benefit by the decreased tax liability. It’s also possible that the overall amount of federal income taxes paid by the two of you would be lower. Be aware that the IRS could question an unreasonable amount of compensation paid to a family member, considering the services actually provided by the family member.
As a self-employed taxpayer, you also have greater control and flexibility on timing the receipt of your income. This means that you have more control when you pay tax on the income.
- Planning Retirement.
Establishing a retirement plan is another tax planning advantage for the self-employed. If you’re self-employed and have no employees, a qualified retirement plan (such as a Keogh) may allow you to place pre-tax dollars into a retirement account to grow tax deferred until withdrawal. If you have employees, your business may have to provide coverage for them as well. The type of retirement plan that your business should establish depends on your specific circumstances.
- Reviewing Employee Benefit Plans.
Aside from retirement plans, there are other employee benefit plans– such as cafeteria plans and medical benefit plans. You may wish to have your business establish one or more such plans. Employee benefit plans play an important role in attracting and retaining employees. Sole proprietors may also derive certain limited benefits under these plans.
- Considering Business Expenses and Other Deductions.
Make sure your business is taking advantage of all of the deductions it’s entitled to, including deductions for certain startup costs. You may be able to deduct a portion of the expenses for a business trip even when the trip is combined with vacation. Other key deductions that you should consider include the use of a home office, automobiles and business assets.
One major area of concern for many self-employed individuals is the high cost of health insurance. Some of your health-care related expenses may be tax deductible. You may be eligible for the self-employed health insurance deduction, which would enable you to deduct the cost of health insurance that you provide for yourself, your spouse and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., “above-the-line”) when computing your adjusted gross income, so it’s available whether you itemize or not.
Contributions you make to a health savings account (HSA) are also deductible “above-the-line.” An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside tax-free funds for health-care expenses.
Sometimes it’s unclear whether you’re engaged in a trade, business or merely deriving occasional income from a hobby. Income generated from a trade or business activity is taxable, losses from such an activity are generally fully deductible. For this reason, taxpayers sometimes try to classify a hobby as a trade or business. Consequently, the IRS closely scrutinizes purported trade or business activities that regularly show losses. If your business consistently shows a loss, be aware of the IRS’s rules for classifying activities as hobbies.
If you’re self-employed, understand the self-employment tax and be aware of the tax planning opportunities.
You must pay self-employment tax if you have self-employment income. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed. Employees generally have income tax, Social Security tax and Medicare tax withheld from their paychecks. If you’re self-employed, it’s likely that no one is withholding federal and state taxes from your paychecks, so make estimated tax payments to cover your federal income and self-employment tax liability.