Choose right or pay the consequences!

Choosing the right legal structure for your business is the most important question that a new business owner must answer. This is an area where many costly mistakes are made by business owners and some overzealous tax preparers, who are not well versed in this area. As far as the tax landscape goes, a business may as well be in another universe when it comes to taxes. But taxes are not the only factor to consider when choosing a structure for your business. Over the next few lessons, we will delve into this topic to give you the information needed to make the right decision.

Education:

There are four primary entity choices that you can use to operate your business.

1. Sole Proprietorship
2. Corporation (C Corp or S Corp)
3. Limited Liability Company (LLC)
4. Partnership

Within the LLC and Partnership are some additional options, but that is beyond the scope of this lesson. For now, we will focus on these four entity choices. In today’s lesson, we will begin with entity choice #1 – Sole Proprietor.

Sole Proprietorship

A sole proprietorship is the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.

Forming a Sole Proprietorship

You do not have to take any formal action to form a sole proprietorship. As long as you are the only owner, this status automatically comes from your business activities. In fact, you may already own one without knowing it. If you are a freelance writer, for example, you are a sole proprietor.

If you choose to operate under a name different than your own, you will most likely have to file a ficticious name (also known as an assumed name, trade name, or DBA name, short for “doing business as”). You must choose an original name; it cannot already be claimed by another business.

Sole Proprietor Taxes

Because you and your business are one and the same, the business itself is not taxed separately-the sole proprietorship income is your income. You report income and/or losses and expenses with a Schedule C and the standard Form 1040. The “bottom-line amount” from Schedule C transfers to your personal tax return. It’s your responsibility to withhold and pay all income taxes, including self-employment and estimated taxes.

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 cannot 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.

In the next lesson, we will discuss entity choice #2 – Corporation.

Resources: 

• IRS.gov (Small Business and Self Employed) – Find resources and information about legal business structures.

Important terms from this lesson:

Action Step:   Watch and learn.