13.5 Sole Proprietorships

Sole proprietorships are the simplest business structure, formed when an individual starts selling goods or services. They offer complete control and direct profits but come with unlimited personal liability. This structure is popular for its ease of formation and pass-through taxation.

Tax implications include self-employment taxes and quarterly estimated payments. While sole proprietors can deduct business expenses, they face challenges in raising capital and ensuring business continuity. Proper management and insurance are crucial for protection against risks.

Sole Proprietorships

Formation of sole proprietorships

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• Easiest and most common business structure to start requires no formal registration or paperwork in most cases
• Formed automatically when an individual begins selling goods or services (freelance web design, tutoring)
• Business is not legally separate from the owner who has complete control over all decisions and receives profits directly
• May operate under the owner's name or a fictitious "doing business as" name (Joe's Landscaping)
• Often requires obtaining a business license from local authorities to operate legally

Tax implications for sole proprietors

• Pass-through taxation means business profits are only taxed once at the owner's personal income tax rate, avoiding double taxation experienced by some other structures (C corporations)
• Sole proprietors must pay self-employment tax which includes Social Security (12.4% up to an annual limit) and Medicare taxes (2.9% with no limit) for a total rate of 15.3% as of 2021
• Generally required to make quarterly estimated tax payments to cover expected income and self-employment tax liabilities
• Can deduct ordinary and necessary business expenses (office supplies, advertising costs, vehicle mileage) from income
• Report business income and expenses on Schedule C of their personal income tax return

Personal liability in sole proprietorships

• Unlimited personal liability due to no legal separation between the owner and business
• Owner is personally responsible for all business debts and obligations, meaning creditors can pursue personal assets (primary residence, personal savings) to satisfy debts
• Increased risk exposure as the owner is liable for employee actions within the scope of their employment (delivery driver causes an accident)
• Difficulty raising capital since investors may be hesitant due to personal liability risks, resulting in limited options compared to other structures (partnerships, corporations)
• Challenges with business continuity if the owner becomes incapacitated or passes away, unless a succession plan is outlined in legal documents (will, power of attorney)

Business Management and Protection

• Sole proprietors are responsible for managing all business assets, including inventory, equipment, and cash
• Establishing business credit separate from personal credit can help with future financing opportunities
• Obtaining appropriate business insurance is crucial to protect against potential risks and liabilities
• Careful tracking of business expenses is essential for accurate tax reporting and financial management