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How to Set Up a Sole Proprietorship

By far, it may be easiest to set up a sole proprietorship as the business structure for your company.

In its simplest form, a sole proprietorship is just a one-person business that does not have to be registered with the state, unlike a limited liability company (LLC) or a corporation.

If you are running your own one-man business, then you may already be operating as a sole proprietorship without even knowing it. Indeed, there are some situations when people automatically set up a sole proprietorship, even without paperwork. Some examples include freelance photographers, a person who builds cabinets on a contract basis, and even salespeople that work solely on commission.

Just because you may have already set up a sole proprietorship, however, does not mean that there's nothing else you need to do. Some states have laws mandating that sole proprietorships register and get a business license. In addition, you should also make sure that you have all the required permits that allow you to perform your duties.

In addition, you should not try to use your business as a tax shelter or some other loophole, as any profits that your business sees will translate to you as income for your personal tax return. By extension, if your business owes any debts, you owe those debts, and creditors can come after your personal assets if your business can't afford to pay.

No Limited Liability

Unlike a corporation or LLC, owners of sole proprietorships do not enjoy the comforts and security provided by limited liability. Because of this, if there is a judgment or debt owed by your company, the creditor or judgment seeker can come after you and your personal assets just as easily as they can go after the assets of your company. In other words, if you make a blunder on the job as a sole proprietor, it could cost you your bank accounts and/or your home.

To clearly see this point, it is helpful to look at some examples.

Suppose that Manny owns and operates a machine shop in his home garage. With the construction of a custom car shop in Manny's hometown, he has recently run into many more orders than he has ever had before. Because of this, he decides to order a new lathe to make custom exhaust pipes for the cars that the car shop builds. He finances the $100,000 piece of equipment through the seller and makes regular payments for two months before the custom car shop closes its doors. As a sole proprietor, Manny is personally liable for the business debts of his company. After the company repossesses the lathe, they still demand $20,000 for the reduction in value because the lathe was used. The lathe company can seek this money from Manny's personal assets, such as his car, bank accounts or even his home.

Now suppose that Manny has one employee in his shop that not only helps him make the exhaust pipes, but also delivered them to the, now closed, custom car shop. One day while driving over two new exhaust pipes in the company truck, Manny's employee hits another car, causing damage to the car and injuries to the other car's driver. The driver sues the employee and Manny's company, and the court rules that a $200,000 settlement is in order. Manny's insurance will only cover $150,000 of the claim, leaving Manny personally liable for $50,000, which could be taken from any of his personal assets (with a few exceptions).

As noted above, sole proprietorships do not provide owners with any form of limited liability. If Manny had organized his company as an LLC or a corporation, he could have enjoyed limited personal liability. Both the creditor and the injured driver would only be able to seek money from the assets of the company, not from Manny himself. This is why it makes sense to form you business as an LLC or corporation if you foresee that your business will be engaged in a dangerous activity, or if you have personal assets that you want to protect from potential liability.

Taxes and Sole Proprietorships

Unlike a corporation, which is its own tax entity, a sole proprietorship does not pay taxes as a business. Instead, because the business and the owner of the business are one and the same, the taxes "pass through" the business to the owner. This means that all business profits and losses are reported on the owner's tax return.

If you do set up a sole proprietorship, you will have to be responsible for paying your taxes by yourself. This means that not only should you self-withhold taxes for the IRS and the state that you live in, but you also must pay taxes for social security and Medicare. You will need to engage in a "self-employment tax." You should visit the Internal Revenue Service at http://www.irs.gov to find out more about this tax.

Sole Proprietorship Registration

As an owner of a sole proprietorship, you will probably not have to go through the same process of registering as an LLC or a corporation. When you start your new business, you will simply declare that you are running a sole proprietorship instead of filing paperwork with the state creating a corporation.

Almost every city and county in the nation requires that any business, even a sole proprietorship, register and pay at least a small tax, however. In return for this tax and registration, your business will receive a business license and tax registration certificate. In addition to these documents, you should also go about getting a federal employer identification number from the Internal Revenue Service (so you can withhold taxes from your employees), a license to sell from your state, and a zoning permit from your local land planning board if it is required.

Also, if you plan on doing business under a name other than your own legal name, you will probably be required to register that name as a "fictitious business name" with your local county or state government.

Next Steps
Contact a qualified business organizations attorney to help you
choose the best formation for your business.
(e.g., Chicago, IL or 60611)

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