In this article we explore the sole proprietorship and its characteristics as a business entity. Many people do not think of or recognize the sole proprietorship as a form of business entity. This is primarily because the boundary between the individual entrepreneur and business entity is often blurred. This chapter should supply you with sufficient information to understand where the boundary exists in a given business.
How are sole proprietorships created?
To create a sole proprietorship the individual entrepreneur simply has to carry on some activity with the intention of seeking a profit. It is really that simple. It arises when a single individual carries on an activity for a profit (or loss). No formal filing or documentation is required.
• Example: Suppose that Jake is walking down the street and see a man in his lawn raking leaves. The man asks Jake if he would like to earn some money by raking up the rest of the leaves. The man says that he will pay Jake $30. In this situation, Jake is undertaking an activity with the intent of making a profit. Jake is not an employee of anyone else; rather, he is undertaking the work as a service provider. This means that he is a default sole proprietor.
• Note: By definition, a sole proprietorship involves one person. The business entity cannot contain more than one owner.
The definition of a sole proprietorship has two primary components: 1) an activity, and 2) intent to earn a profit. This definition is very broad and covers a broad range of activities. For example, the activity could be as little as making a phone call to put resources in order. This could make a person’s actions or activity into an unintended business entity. The important thing to remember is that the entrepreneur does not have to intend to start a business and the type or manner of activity that she undertakes is irrelevant.
The second requirement is that one intend to earn a profit. This definition can be somewhat misleading, as not every sole proprietorship makes a profit. This requirement is interpreted to mean any sort of activity that intends to generate revenue. Most businesses lose money early in their lives. Undertaking an activity with the intent of ultimately generating a profit is sufficient to satisfy this requirement.
• Example: Tom starts a business and seeks revenue from outside investors. He expresses his intent to reinvest every penny of profit toward growth. Tom knows that he will likely suffer a loss every year early on in an attempt to grow the business’s volume and revenue. He believes that at some later point in time he will be able to cut expenses and produce a profit or sell the business at a high valuation based upon its revenue. Even though Tom realizes that he will not earn a profit in the immediate future, he is still a sole proprietor. The same is true for charitable undertakings that produce revenue.
• Note: Numerous other requirements may exist for the sole proprietor. For example, she will likely have to obtain a business license from the local government before undertaking business. She will have to do a fictitious name filing if she operates under a name other than her own name. Further, she will need to set up an employer identification number (EIN) if she plans to have employees for her business.
Who has ownership and control over a sole proprietorship?
The sole proprietor exercises complete control and is the sole owner of the business. As the name implies, a sole proprietorship can only have one owner. Adding another member to the sole proprietorship changes the entity form.
• Note: A sole proprietorship can have employees who work in the business. The key to this relationship is that the employees cannot earn ownership interest in the business activity. This will preclude any profit sharing arrangements between the owner and employee. The owner should be careful when compensating an employee based upon the amount of revenue produced. Such compensation should be carefully structured as a bonus system on a base salary.
What is the continuity of a sole proprietorship?
If the entrepreneur stops carrying on the business activity, the sole proprietorship ceases to exist. Ownership in the sole proprietorship cannot be transferred because the business activity is unique to the individual. The name, property, activity can be transferred, but the actual organizational identity is unique to the individual carrying on the business. The business entity will exist as long as the sole proprietor wishes to continue doing business.
• Example: Tom, a sole proprietor, decides to pass his business down to his son, Jerry. Tom can pass to Jerry the name of the business, the equipment, any intellectual property, etc.; but, he cannot pass the actual business. Jerry will take the assets and start his own sole proprietorship. This is important as any contractual relationships that exist cannot be transferred. Jerry will have to re-establish those relationships when he takes over and begins his sole proprietorship.
• Note: Business activities are often passed from owner to owner. This is done by transferring the actual assets of the business. For tax purposes this re-establishes a basis in the assets and begins the business activity anew. All business relationships will generally have to be re-established (such as the establishment of bank accounts, the supplier relationship, etc.).
What is the personal liability of the sole proprietor?
The sole proprietor lacks the personal liability protection provided by several other business entity types. The main disadvantage of carrying on business as a sole proprietorship is that the owner is personally liable for any contract obligations or torts committed as part of the business activity. An individual is generally liable in tort for her own actions; however, she is also personally liable for the torts of any employees committed in the course of business operations. This fact exposes the sole proprietor to a great deal of risk.
• Example: Jack starts a business providing cleaning services to local businesses. His business is successful and he immediately hires several workers. One day a worker accidentally hits a customer in the eye with a broom when he is sweeping the store. Recall from Chapter 3 that an employee is an agent of the business. The customer is injured and sues Jack’s business. Jack will be personally liable for any judgment against the business. This means that his personal assets (e.g., home, car, bank account) will be at risk in a lawsuit.
• Note: A sole proprietor’s potential personal liability for the torts of the business’s employees begs the question, who are employees of the business? Recall, this question concerns the amount of control the business owner exercises over the individual. If the business owner exercises strong controls over the individual, then she is likely an employee. If the individual more closely resembles a separate business hired by the business owner for a specific task, then she is likely an independent contractor rather than an employee.
How is the sole proprietorship taxed?
In general, tax reporting for the sole proprietorship is relatively simple when compared to other business entity types. Individuals report their personal income tax liability on Form 1040 (or some variation thereof). The sole proprietor does not have to prepare or file a separate tax return for the business entity. The Form 1040 allows the individual to report any income from business operations on their personal income tax return on Schedule C.
• Example: Melanie has a 9-5 job at a large company. She will receive a W-2 at the end of the year indicating her wages received. She is also a sole proprietor in that she earns money providing professional services to clients. This line of work is not related to her 9-5 job. She will report the W-2 wages on line 1 of the IRS Form 1040. She will report the income and expenses from her business activity on Schedule C of her 1040.
• Note: Like any business, the sole proprietor will report all revenue generated by the business and all expenses of operations. She must also keep track of specific issues, such as depreciation schedules on business equipment. Despite the simplicity of tax reporting for sole proprietorship income, there are several other tax considerations for the sole proprietor.
What are the sole proprietor’s other tax reporting obligations?
Understanding the tax reporting obligations of the sole proprietor requires an understanding of the general tax withholding and reporting system. Most notably among these obligations are the requirement to withhold and report sales and use taxes and self-employment taxes.
• Note: A sole proprietorship, like other business entities, has to withhold taxes for its owner and employees. Further, it has to withhold any special business taxes imposed by the state or locality. The withheld taxes must be transferred to the appropriate government agency on the appropriate schedule.
How does sales and use tax withholding work?
Businesses that sell any sort of good are subject to sales and use tax. Sales tax is the amount that the merchant must charge to customers who purchase the good. Sales tax is generally a fixed percentage of the value of the good. Other taxes that accompany sales tax may also apply for specialty occupations, such as merchants selling luxury goods, hotels, and restaurants. The merchant must collect the tax from the customer and not simply pay the taxes from the proceeds of the sale. The taxes withheld must be deposited with the state’s department of revenue on a regular basis.
• Example: Jason sells custom furniture that he manufactures in his wood shop. The chairs retail for $300 each. The state sales tax on goods of this kind is 7%. When a customer purchases a chair, Jason must charge the customer $321 ($300 + $21) at the time of purchase.
• Note: The taxing state is the location where the good was sold. It does not matter the location where the seller is located. Many states allow that, if the customer is located out of state and Jason ships the item to him, then Jason does not have to collect sales tax.
Use tax is a separate tax that applies to the purchase of goods. Specifically, use taxes are assessed against goods purchased for resale. Use tax is assessed when goods are purchased in another state at a lower sales tax rate. The merchant must pay the tax rate difference to the state where the good is sold.
• Example: You purchase a widget from state A. The applicable sales tax is 5%. You then resell that widget in state B. The applicable sales tax in state B is 6%. You will owe use tax to state B in the amount of 1% of the value of the widget.
• Note: The reason that the seller must pay the tax rate difference to the state where the good is sold is because that is the state to which income tax is owed. Even if the good was intended for sale in one state, if it may be sold in another. Therefore, the use tax will become due in the state in which the good is sold.
What are the employee and self-employment tax withholding rules?
Sales and use tax is not the sole proprietor’s only tax withholding obligation. She also is charged with withholding income taxes from an employee’s wages. The employee must fill out form W-4 to provide necessary withholding information, which is then used to determine the amount of income to withhold. The withheld wages serve to satisfy the employee’s federal and state income tax obligations. The employer will also withhold Federal Unemployment Tax (FUTA), State Unemployment tax (SUTA), Social Security and Medicare taxes (known as Federal Insurance Contributions Act or FICA taxes) from the employee’s wages. The employer also has the obligations to match the employee’s FICA taxes with business funds. She deposits all of the taxes withheld at regular intervals with the IRS or state taxing authority.
• Example: William has a lawn care business. In the last year he has expanded to hire four employees. William will have to withhold estimated income taxes from the employees’ paychecks and deposit them with the IRS and state department of revenue. William must also withhold FICA taxes from each employee’s paycheck. William will match these amounts and then deposit them with the IRS.
• Note: The Social Security portion of the FICA taxes is capped at a certain amount for the individual. The Medicare portion of the taxes has no cap and is assessed against the total wages of the employee.
The sole proprietor is subject to a unique situation with regard to tax withholding. The sole proprietor is, in effect, her own employee. She must pay income taxes and self-employment taxes on any income earned from the sole proprietorship. Self-employment taxes are made up of a combination of the employer and employee’s Social Security and Medicare tax obligations. She will deposit this amount regularly with the taxing authorities. She must also deposit funds to cover any expected income tax obligations. Failure to deposit sufficient funds to cover the sole proprietor’s income tax obligations may result in a penalty.
• Example: Tori is a cosmetologist, specializing in hair coloring. She has her own hair practice that she runs out of her home. As a sole proprietor, she will have to make estimated tax payments to the IRS and state department of revenue to cover her income tax liability. Further, she will have to withhold self-employment taxes and deposit those taxes with the IRS.
• Note: The fact that a sole proprietor pays twice the amount of Social Security and Medicare taxes as an employee leads owners and investors in businesses to seek alternative business entities to shield themselves from most or all of the self-employment tax obligation.
Registering your Sole Proprietorship with the State
You do not have to file any documents or register with the state in order to form the sole proprietorship. This is in contrast to an LLC or Corporation, which requires specific filings with the Secretary of State’s office. It is important to remember that business entities are controlled and regulated by each individual state. The requirements for forming an entity will vary from state to state. The rules governing and surrounding the sole proprietorship are relatively uniform across all states.
Business Name Registration Requirements
Now that you have formed your sole proprietorship, there may be state laws in place that require you to take additional steps in order to continue setting up your business. Often a state will require that you register you business name with the state. This is often the case if you use a name for your business that is anything other than your personal name. In some states you have to register the name locally, such as through the local courthouse. Registering your business name is often referred to as a “fictitious business filing” or “doing business as” filing.
Business License Requirements
Another requirement is that you will likely be required to register locally and apply for a business license. Local governments have the authority to regulate business activity that takes place within their territory. The business license serves as a manner of regulating the business activity and a manner of collecting additional revenue from the business operations. For example, a business license may have a flat fee associated with the application and a variable annual fee based on business revenue. Access our article “Business Licenses Overview” for the numerous requirements that accompany receiving a business license.