Business Entities: Sole Proprietorship (SP)

A sole proprietorship (SP) is a type of business entity unlike all other business entities in that it is not considered separate from its owner (the sole proprietor). Rather, the SP is regarded as an extension of the sole proprietor. Both combine to form one entity. The sole proprietor reports all profits and losses on his or her personal tax return, and the sole proprietor is generally liable for the obligations of the business and the acts of its employees. In return, however, the sole proprietor enjoys an entity that is simple and inexpensive to create and operate and in whose management no one can participate without the sole proprietor’s consent.

When Can It be Used?

An SP can only be used when you will be the only owner. An SP can have only one owner, though responsibility for management can be delegated to employees. So, if you intend to have others share in ownership, you must consider a different entity (a partnership, perhaps).

Strengths

Business can be freely sold: As a proprietor, you can sell your business without restriction. The business is sold by selling the assets used in the SP.

You get to keep all the profits and deduct all losses: Because you will be the sole owner, you will receive all profits or deduct all losses. As the sole proprietor, however, you will generally not be able to deduct any losses of the business if the business’s gross income does not exceed deductions for three or more out of five consecutive years. The IRS will then consider your activity a mere hobby, not a for-profit business. This is called the Hobby Loss rule(s).

You save taxes if you hire your spouse and children: As a proprietor, you can hire your spouse without having to pay FUTA taxes (federal unemployment) on his or her salary. In addition, if you hire your children, you don’t have to pay FUTA taxes if they are 21 years or younger, and you do not have to pay FICA taxes (Social Security and Medicare) if they are 18 years or younger. You cannot reap these savings if you are incorporated.

Profits taxed only once: Because an SP is not a separate entity, it is not assessed an entity-level tax. The profits are taxed to the proprietor only. Therefore, an SP is not subject to the double tax commonly associated with a C corporation.

Note: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

Management is centralized: You would not have to be concerned about sharing management in an SP because you run the show. However, you can, if you wish, delegate management responsibilities to your employees.

Relatively simple and inexpensive to create and maintain: An SP is the most simple and inexpensive entity to create and maintain. There is no need to file documents with the state or create operating agreements or rules for self-governance, as there is with a corporation. An SP may be required, however, to obtain business permits from the municipality or to register under a municipality’s assumed name statute.

Tradeoffs

Proprietor is personally liable for the obligations of the SP: Because the SP is not a separate entity, the proprietor is generally responsible for SP obligations and the acts of its employees. Therefore, the proprietor has no liability protection. Personal assets and business assets are not considered separately, and it is possible that personal assets could be lost as a result of business activities. Be sure to purchase liability insurance to minimize your risk of losing your personal assets to creditors. Remember, however, that insurance may not cover all possible losses.

Life of SP is limited to the life of the proprietor: The SP will end whenever you cease to be associated with it. The withdrawal, death, bankruptcy, retirement, insanity, or resignation of a proprietor dissolves (ends) the SP. Hence, there is no continuity of life. A proprietor can, however, give the business to another person through his or her will, thereby retaining some continuity for the business.

Setting Up a Sole Proprietorship

Acquire business permits: Your state or municipality will likely require you to obtain business permits. Contact the office of the clerk at your city or town hall to ascertain what you may need.

Register the name of your SP with your state or municipality: Your state or municipality will likely have an assumed name statute, which will require that you register the name of your SP. Inquire at the office of the clerk.

*Checklist is not exhaustive.

Tax Considerations

Profits taxed only once: Because an SP is not a separate entity, it is not assessed an entity-level tax. The profits are taxed once as income to the proprietor. Therefore, an SP is not subject to the double tax commonly associated with a C corporation.

Profits and losses reported by proprietor: As a proprietor, you report all SP income or losses on your personal tax return.

Termination of the business is not taxable event: Though the termination of an SP is not a taxable event, the proprietor will be taxed to the extent each asset sells for more than his or her “basis” (i.e., the cost of that asset when purchased or improved, less any depreciation).

Example: Ken opens a donut shop. Two years later, Ken sells the now-thriving shop for $50,000, double Ken’s basis in all of the shop’s assets. Ken will be taxed on the profits: $50,000 – $25,000 (basis) = $25,000.

However, if you depreciated assets while in business, you may be subject to “depreciation recapture.” When the tax basis of an asset exceeds its sale price, the difference must be reported as income.

Proprietor subject to self-employment tax: Because you are self-employed, you will be assessed a self-employment tax.

You save taxes if you hire your spouse and children: As a proprietor, you can hire your spouse without having to pay FUTA taxes (federal unemployment) on his or her salary. In addition, if you hire your children, you do not have to pay FUTA taxes if they are 21 years or younger, and you do not have to pay FICA taxes (Social Security and Medicare) if they are 18 years or younger. You cannot reap these savings if you are incorporated.

If you have questions, contact the experts at Henssler Financial: