If you’re making money from a side gig or doing freelance work, you’re probably a sole proprietor without even knowing it.
A sole proprietorship is an unincorporated business formed by a single individual and is not recognized as a legal entity separate from its owner; it designates the person who operates a business and is responsible for its debts.
It is the most common private business structure, comprising 69.8% and numbering 21.5 million, in 2014. On the other hand, S corporations made up 13.6%, partnerships 8.4%, and C corporations 8.1%, per the Tax Foundation.
A sole proprietorship can operate under the name of its owner or a fictitious name (also called a DBA (short for “doing business as”), trade name, or assumed name). Have a business name that is different from that of its owner, however, does not make it an independent legal entity.
Less legal red tape and costs than other business structures are a couple advantages of sole proprietorships. In most states, you don’t have to register as a sole proprietor, and simply doing business designates you as such (unlike limited liability companies [LLCs] and corporations).
On the flip side, as a sole proprietor you’re responsible for your company’s liabilities, and your assets could be seized to satisfy a debt or legal claim against you. If this is a concern, consider becoming an LLC or corporation.
Sole proprietors’ income and losses are “passed through” to their personal income tax returns; your business income and losses would be recorded on Schedule C, Profit or Loss from Business, or a simplified version, C-E7, Net Profit from Business, filed with Form 1040, U.S. Individual Income Tax Return. Information from Schedule C (or its alternatives) are then used on Schedule SE, Self-Employment Tax, to calculate self-employment tax owed, which schedule is also filed with Form 1040.
In a regular job, your employer would pay half of your Medicare and Social Security taxes (termed payroll taxes in that context), but since sole proprietors are considered self-employed, you’d be required to pay the full amount when self-employed (termed self-employment tax in this context), though you can deduct half. In 2017 the Social Security tax rate is 12.4% up to the annual income limit of $127,200 (beyond which no tax applies), and the Medicare tax rate is 2.9% (with no limit).
You’d be required to pay taxes on all profits, regardless of whether how much you actually spend. As with other business structures, however, you’re entitled to deductions for business-related expenses such as operating costs, advertising costs, meals, and travel.
Further, you would have to make estimated tax payments if you expect to owe at least $1,000 in federal taxes for the year after deducting your withholding and credits. Your withholding would be the lesser of either 90% of the tax shown on your tax return for the current year or 100% of your tax liability for the previous year, except if your adjusted gross income exceeded $150,000 in the previous year, you’d instead have to pay 110% of your previous year’s tax bill. You’d have the option of making a single estimated tax payment or quarterly payments.
Sole proprietorships run into some difficulty when it comes to trying to obtain financing due to financial institutions’ perceived lack of credibility in the event of business failure. This translates to greater dependence on personal financing sources for business costs, such as savings and home equity loans. Because they can’t create stock, raising money through investors is also a challenge.
A sole proprietorship can hire employees, and the business owner’s spouse can be considered an employee without a formal declaration as such.
Additionally, individual owners of single-member limited liability companies (LLCs) that operate a trade or business are considered sole proprietors for tax purposes; in the same manner, they are subject to taxation of net earnings from self-employment.
For more information, refer to IRS Publication 334, Tax Guide for Small Business.