Setting up a business in the United States can be quite complex, depending on the business structure you decide on. Choosing a business structure and going through the mandatory steps to form your business entity is one of the first steps to doing business in the United States.
Agreeably, state laws govern the formation and structure of business entities in the US, but the same legal structures are available throughout the country. And just like we all know, the most common legal structures are sole proprietorships, partnerships, corporations, and limited liability companies. Each type of legal structure has its own benefits and drawbacks, which will also generally depend on your specific business.
However, note that choosing a business structure is a strategic decision that should be made with thorough consideration of the advantages and disadvantages. Some people might choose to consult their attorney who can make company specific recommendations. But have it in mind that you can change your business structure in the future. Whether it is possible and how complex it will be depends on your state laws.
What is a Sole Proprietorship?
According to Investopedia, a sole proprietorship also referred to as a sole trader or a proprietorship, is an unincorporated business that has just one owner who pays personal income tax on profits earned from the business. This is the easiest type of business to form or dissolve, due to a lack of government regulation.
In the United States, these types of businesses are very popular among sole owners of businesses, individual self – contractors, and consultants. 73 percent of U.S. businesses are owned and operated by sole proprietors or sole traders. Many entrepreneurs prefer sole proprietorships due to the ownership they have over business decisions and revenue and how easy and cost – effective they are to set up.
The primary benefits of sole proprietorship are the pass – through tax advantage, the ease of creation, and the low fees of creation and maintenance. While the primary disadvantages of a sole proprietorship are the unlimited liability that goes beyond the business to the owner, and the difficulty in getting capital funding, specifically through established channels, such as issuing equity and obtaining bank loans or lines of credit.
Entrepreneurs usually begin as an entity with unlimited liability, but as the business grows, they tend to often transition to a limited liability entity, such as an LLC or LLP, or a corporation—e.g. S Corp, C Corp, or Benefit Corp.
Different Types of Sole Proprietorship in the United States
Note that although legal and tax requirements have no differences among them, there are a few different subcategories of business that informally fall under the umbrella of a sole proprietorship business.
1. Self – employed and Freelancers
First and foremost, note that these individuals may come from any type of background or pursue any kind of work and the vast majority of these are one – person operations. They may include consultants, writers or graphic artists who fall under the freelance tab and likely work from home without a ton of capital tied up in the business. In many cases, freelancers handle their trades on the side and may have full – time day jobs.
Howbeit, comparing freelance versus self – employed folks, it may be quite confusing but the latter group could be seen as depending entirely on revenue from sole proprietorships as their primary source of income, and the hustle is a full – time affair. Also note that this might include a small retail business that employs family members or perhaps a non – related part – time worker.
2. Franchises
A franchise may also take on the form of a sole proprietorship. In a franchise, the sole proprietor, also referred to as a franchisee, pays a fee to a franchisor in exchange for the right to leverage the company brand. Note that this franchisee is mandated to follow a tried and trusted business model that controls such areas as operations, marketing, pricing and the ability to expand.
The franchisee is also expected to always pay the franchisor royalties, which are more or less a percentage of the franchise unit is gross sales. In the United States, a franchise can be an ideal option for the sole proprietor who has little business experience, as the franchisor provides a successful business model as well as marketing and operational support.
3. Independent Contractors and Subcontractors
An independent contractor is also a self – employed sole proprietor, but his role more closely fits that of an employee. Notably, an independent contractor is hired by an employer to perform a specific task but has no taxes withheld from his pay and typically receives no benefits such as health insurance. And just unlike an employee, the independent contractor enjoys the freedom to accept or decline assignments.
By contrast, when an independent contractor is hired by a general contractor (GC) overseeing operations on a multifaceted commercial project, for example, independent contractors can also double as subcontractors, receiving payments from the GC that are reported on an IRS 1099 Form.
How to Form a Sole Proprietorship in 7 Steps
One of the primary benefits of a sole proprietorship is that it is very simple to get up and running. Since you won’t have to register your business with the state, there aren’t many formal steps. Nonetheless, there are few things you may want to apply for, depending on certain changes you might like to make to your business. Here are some steps you may want to consider:
1. Start with your business name
In the United States, if you want your business to legally be called a name other than your own, you will have to form what is known as a DBA. In a sole proprietorship, the sole owner is legally expected to use their personal name as their domain name unless they follow the process to change the name. However, to change the name of the sole proprietorship to a brand name, you will have to file a doing – business – as application, which gives you the option of using a different name.
You are expected to file the doing – business – as (DBA) application with the state, often through the secretary of state’s office, though the specific agency can vary from state to state. A DBA application can cost between $5 and $100 depending on the state.
Howbeit, while choosing a name, you also have to make sure it doesn’t already belong to someone else. And you wouldn’t want to pick a name that is too similar to someone else’s. To check whether the name you want is available, visit the U.S. Patent and Trademark Office site or search your state’s DBA registry.
2. Obtain an employee identification number (EIN)
If you are going to be operating your sole proprietorship alone, you don’t really need an employee EIN and can operate and file taxes under your social security number. However, as soon as you hire an employee or set up a retirement plan, you must file for a federal employer identification number (EIN). It is free and can be obtained online.
3. Secure the proper paperwork needed in your state
Have it in mind that even sole proprietorships need a business license to operate, in most cities. Note that the fines of operating a business in the United States without a license can be enormous. You might also need your business license to open a bank account. Also note that the penalty associated with not have the correct licenses or permits can be crippling to a young business. The licenses you need may include:
- A health department permit for preparing for serving food
- A federal license for transporting animals
- A health and safety training for opening a day – care
- A certification exam to become a financial advisor
- A zoning permit to operate your business from home
- Registration with the state tax authority if you have employees or collect sales tax
4. Open a business bank account
It is very crucial to keep personal and business expenses separate when running a sole proprietorship. Note that opening and operating a business bank account ensures a certain level of protection for your business funds, allows customers to pay with a credit card and make checks payable to your business, and allows your business to have a good credit history.
It is your duty to prove to the IRS you are running your business to make a profit. This ensures the losses you experience during the first few years will remain tax deductible. It is also imperative to build good credit history before actually starting your business.
Although credit cards can help you out in your company’s early days when cash flow is low, the interest adds up quickly and can easily become overwhelming. A personal loan is often a better option, and good credit history is necessary for securing a loan of this type.
5. Acquire adequate insurance
Note that one of the biggest risks to starting a sole proprietorship is the liability it creates for the owner, so having adequate insurance is imperative. Also consider property and liability coverage, auto insurance, health coverage, and disability coverage, at the very least. Although it can get expensive, but it ensures you and your personal assets are protected from lawsuits and professional setbacks, should they arise.
6. Pay your taxes
As a sole proprietor, you are expected to pay income tax on all income your business nets. You will have to fill your sole proprietorship incomes taxes by using Schedule C on your Form 1040 and adding the income or losses your business incurred to the other income you record.
Also note that you can use any business losses to offset other sources of income, like a salary from your day job or a spouse. However, be careful not to step into “hobby business” territory with the IRS. Note that you are expected to prove your business is not a hobby in order to lower your taxes.
When your business becomes profitable, it might be time to file for corporate status or become an S Corporation. Also don’t forget that since you are self – employed, your pay checks don’t have proper withholdings taken out at the time you are paid. Instead, you can expect to pay quarterly estimated tax payments, and cover the difference or receive a refund for any shortage or overage come tax season.
Conclusion
Starting a business is one of the biggest choices you’ll ever make. However, start by building a strong foundation to ensure lasting success. A sole proprietorship is just one business option in the United States. It is particularly advantageous to small businesses. You should carefully consider what business structure is most appropriate for your business.