Sole Proprietorship Basics

A sole proprietorship is a business that is owned by one person (and sometimes his or her spouse) and that isn’t registered with the state as a corporation or a limited liability company (LLC).
Sole proprietorships are so easy to set up and maintain that you may already own one without knowing it. For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor.
However, even though a sole proprietorship is the simplest of business structures, you shouldn’t fall asleep at the wheel. You may have to comply with local registration, license or permit laws to make your business legitimate. And you should look sharp when it comes to tending your business, because you are personally responsible for paying both income taxes and business debts.
Personal liability for business debts
A sole proprietor can be held personally liable for any business-related obligation. This means that if your business doesn’t pay a supplier, defaults on a debt or loses a lawsuit, the creditor can legally come after your house or other possessions.
Examples
Example 1: Lester is the owner of a small manufacturing business. When business prospects look good, he orders $50,000 worth of supplies and uses them in creating merchandise. Unfortunately, there’s a sudden drop in demand for his products, and Lester can’t sell the items he’s produced. When the company that sold Lester the supplies demands payment, he can’t pay the bill. As sole proprietor, Lester is personally liable for this business obligation. This means that the creditor can sue him and go after not only Lester’s business assets, but his other property as well. This can include his house, his car and his personal bank account.

Example 2: Shirley is the owner of a flower shop. One day Roger, one of Shirley’s employees, is delivering flowers using a truck owned by business. Roger strikes and seriously injures a pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the accident. The lawsuit names Shirley as a co-defendant. After a trial, the jury returns a large verdict against Roger — and Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This means the pedestrian can go after all of Shirley’s assets, business and personal.
By contrast, the law provides owners of corporations and limited liability companies (LLCs) with what’s called “limited personal liability” for business obligations. This means that, unlike sole proprietors and general partners, owners of corporations and LLCs can normally keep their house, investments and other personal property even if their business fails. If you will be engaged in a risky business, you may want to consider forming a corporation or an LLC. You can learn more about limiting your personal liability for business obligations by reading Nolo’s articles on corporations and LLCs.
Paying taxes on business income
In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. The fact that a sole proprietorship and its owner are one and the same means that a sole proprietor simply reports all business income or losses on his individual income tax return - IRS Form 1040 with Schedule C attached.
As a sole proprietor, you’ll have to take responsibility for withholding and paying all income taxes, which an employer would normally do for you. This means paying a “self-employment” tax, which consists of contributions to Social Security and Medicare, and making payments of estimated taxes throughout the year. For more information, see How sole proprietors are taxed.
Registering your sole proprietorship

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Unlike an LLC or a corporation, you generally don’t have to file any special forms or pay any fees to start working as a sole proprietor. All you have to do is declare your business to be a sole proprietorship when you complete the general registration requirements that apply to all new businesses.
Most cities and many counties require businesses — even tiny home-based sole proprietorships — to register with them and pay at least a minimum tax. In return, your business will receive a business license or tax registration certificate. You may also have to obtain an employer identification number from the IRS, a seller’s permit from your state and a zoning permit from your local planning board.
And if you do business under a name different from your own, such as Custom Coding, you usually must

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register that name — known as a fictitious business name — with your county. In practice, lots of businesses are small enough to get away with ignoring these requirements. But if you are caught, you may be subject to back taxes and other penalties.

Creating a Business Partnership Agreement

If you and your partners don’t spell out your rights and responsibilities in a written partnership agreement, you’ll be ill-equipped to settle conflicts when they arise, and minor misunderstandings may erupt into full-blown disputes. In addition, without a written agreement saying otherwise, your state’s law will control many aspects of your business.

How a partnership agreement helps your business
A partnership agreement allows you to structure your relationship with your partners in a way that suits your business. You and your partners can establish the shares of profits (or losses) each partner will take, the responsibilities of each partner, what will happen to the business if a partner leaves and other important guidelines.

Uniform partnership act
Each state (with the exception of Louisiana) has its own laws governing partnerships, contained in what’s usually called “The Uniform Partnership Act” or “The Revised Uniform Partnership Act” — or, sometimes, the “UPA” or the “Revised UPA.” These statutes establish the basic legal rules that apply to partnerships and will control many aspects of your partnership’s life unless you set out different rules in a written partnership agreement.

Don’t be tempted to leave the terms of your partnership up to these state laws. Because they were designed as one-size-fits-all fallback rules, they may not be helpful in your particular situation. It’s much better to put your agreement into a document that specifically sets out the points you and your partners have agreed on.

What to include in your partnership agreement
Here’s a list of the major areas that most partnership agreements cover. You and your partners-to-be should consider these issues before you put the terms in writing:

• Name of the partnership. One of the first things you must do is agree on a name for your partnership. You can use your own last names, such as Smith & Wesson, or you can adopt and register a fictitious business name, such as Westside Home Repairs. If you choose a fictitious name, you must make sure that the name isn’t already in use.
• Contributions to the partnership. It’s critical that you and your partners work out and record who’s going to contribute cash, property or services to the business before it opens — and what ownership percentage each partner will have. Disagreements over contributions have doomed many promising businesses.
• Allocation of profits, losses and draws. Will profits and losses be allocated in proportion to a partner’s percentage interest in the business? And will each partner be entitled to a regular draw (a withdrawal of allocated profits from the business) or will all profits be distributed at the end of each year? You and your partners may have different ideas about how the money should be divided up and distributed, and each of you will have different financial needs, so this is an area to which you should pay particular attention.
• Partners’ authority. Without an agreement to the contrary, any partner can bind the partnership without the consent of the other partners. If you want one or all of the partners to obtain the others’ consent before binding the partnership, you must make this clear in your partnership agreement.
• Partnership decision-making. Although there’s no magic formula or language for divvying up decisions among partners, you’ll head off a lot of trouble if you try to work it out beforehand. You may, for example, want to require a unanimous vote of all the partners for every business decision. Or if that leaves you feeling fettered, you can require a unanimous vote for major decisions and allow individual partners to make minor decisions on their own. In that case, your partnership agreement will have to describe what constitutes a major or minor decision. You should carefully think through issues like these when setting up the decision-making process for your business.
• Management duties. You might not want to make ironclad rules about every management detail, but you’d be wise to work out some guidelines in advance. For example, who will keep the books? Who will deal with customers? Supervise employees? Negotiate with suppliers? Think through the management needs of your partnership and be sure you’ve got everything covered.
• Admitting new partners. Eventually, you may want to expand the business and bring in new partners. Agreeing on a procedure for admitting new partners will make your lives a lot easier when this issue comes up.
• Withdrawal or death of a partner. At least as important as the rules for admitting new partners to the business are the rules for handling the departure of an owner. You should set up a reasonable buyout scheme in your partnership agreement. To learn more about this issue, read Plan for changes in partnership ownership with buy-sell provisions.
• Resolving disputes. If you and your partners become deadlocked on an issue, do you want to go straight to court? It might benefit everyone involved if your partnership agreement provides for alternative dispute resolution, such as mediation or arbitration.

As you can see, there are many issues to consider before you and your partners open for business — and you shouldn’t wait for a conflict to arise before hammering out some sound rules and procedures. A good self-help book, such as The Partnership Book, by attorneys Denis Clifford and Ralph Warner (Nolo), can help you think through the details and put them in writing.

Creating an LLC Operating Agreement

An LLC operating agreement allows you to structure your financial and working relationships with your co-owners in a way that suits your business. In your operating agreement, you and your co-owners establish each owner’s percentage of ownership in the LLC, his or her share of profits (or losses) and his or her rights and responsibilities, as well as what will happen to the business if one of you leaves.

Why an operating agreement is necessary
While many states do not legally require your LLC to have an operating agreement, it’s foolish to run an LLC without one, even if you’re the sole owner of your company. An operating agreement helps your LLC by guarding your limited liability status, heading off financial and management misunderstandings, and making sure your business is governed by your own rules — not the default rules of your state.

Protecting your limited liability status
The main reason to make an operating agreement is as simple as it is important: It helps to ensure that courts will respect your limited personal liability. This is particularly key in a one-person LLC, where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Just the fact that you have a formal written operating agreement will lend credibility to your LLC’s separate existence.

Defining financial and management structure
Co-owned LLCs need to document their profit-sharing and decision-making protocols as well as the procedures for handling the departure and addition of members. Without a thorough operating agreement, not only will you and your co-owners be ill-equipped to settle misunderstandings over finances and management, but you will also be subject to the rules of your state law (see below).

Overriding state default rules
Each state has laws that set out basic operating rules for LLCs, some of which will govern your business unless your operating agreement says otherwise (these are called “default rules”). Many states, for example, have a default rule that requires owners to divide up LLC profits and losses equally, regardless of each member’s investment in the business. Unless you and your co-owners invest equal amounts in the LLC, it’s doubtful you’ll want profits allocated this way. To avoid this, your operating agreement must spell out how you and your co-owners want to split profits and losses.

In this same way, many state laws regarding LLCs will not be favorable to your business. Don’t be tempted to rely on them to structure your LLC; instead, decide on the best rules for your situation and put them in a written operating agreement.

What to include in your operating agreement
There’s a host of issues you must cover in your operating agreement, some of which will depend on your business’s particular situation and needs. Most operating agreements include the following:

• the members’ percentage interests in the LLC
• the members’ rights and responsibilities
• the members’ voting power
• how profits and losses will be allocated
• how the LLC will be managed
• rules for holding meetings and taking votes, and
• “buy-sell” provisions, which establish a framework for what happens when a member wants to sell his interest, dies or becomes disabled.

While these items may seem fairly straightforward, each is rife with details. Make sure you fill out the particulars in the following key areas.

Percentages of ownership
The owners of an LLC ordinarily make financial contributions of cash, property or services to the business to get it started. In return, each LLC member gets a percentage of ownership in the assets of the LLC. Each member is usually given an ownership percentage that’s in proportion to his contribution of capital, but LLCs are free to divide up ownership in any way they wish. These contributions and percentage interests are an important part of your operating agreement.

Distributive shares
In addition to receiving an ownership interest in exchange for his investment of capital, each LLC owner also receives a share of its profits and losses, called a “distributive share.” Most often, an operating agreement will provide that each owner’s distributive share corresponds to his percentage of ownership in the LLC. For example, because Tony owns only 35% of his LLC, he receives just 35% of its profits and losses. Najate, on the other hand, is entitled to 65% of the LLC’s profits and losses since she owns 65% of the business. (If your LLC wants to assign distributive shares that aren’t in proportion to the owners’ percentage interests in the LLC, you’ll have to follow rules for “special allocations.”)

Distributions of profits and losses
In addition to defining each owner’s distributive share, your operating agreement should answer these questions:

• How much — if any — of the allocated profits of the LLC (the members’ distributive shares) must be distributed to LLC members each year?
• Can members expect their LLC to pay them at least enough to cover the income taxes they’ll owe on each year’s allocation of LLC profits?
• When will distributions of profits be made?
• Or are the owners entitled to draw periodically from the profits of the business?

Because you and your co-owners may have different financial needs and marginal tax rates (tax brackets), the allocation of profits and losses is an area to which you should pay particular attention.

Voting rights
While most LLC management decisions are made informally, sometimes a decision is so important or controversial that a formal vote is necessary. There are two ways to split voting power among LLC members: either each member’s voting power corresponds to her percentage interest in the business or each member gets one vote — called “per capita” voting. Most LLCs mete out votes in proportion to the members’ ownership interests. Whichever method you choose, make sure your operating agreement specifies how much voting power each member has as well as whether a majority of the votes or a unanimous decision will be required to resolve an issue.

Ownership transitions
Many new business owners neglect to think about what will happen if one owner retires, dies or decides to sell his interest in the company. These concerns may not be on your mind now, but such situations crop up frequently for small business owners, and it pays to be prepared. Operating agreements should include a buyout scheme — rules for what will happen when one member leaves the LLC for any reason. For more information, see Plan for changes in LLC ownership with buy-sell provisions.

How to create an operating agreement
Obviously, you’ll need help beyond this article to make your own operating agreement. There are many sources for blank or sample LLC operating agreements, but you must be sure that your operating agreement is drafted to suit the needs of your business and the laws of your state.

Law libraries are a good source of state LLC law as well as technical material on preparing an operating agreement, but since the material is written for lawyers, you may find it more confusing than helpful.

You can pay a business lawyer for assistance, and in fact we recommend this for LLCs with more than five owners, or for those that opt to have a special manager or management group run the LLC. Lawyers typically have several types of standard agreements on hand that can be customized for your LLC.

If expense is an issue, software that helps you create your own LLC may be your best alternative. For example, LLC Maker (from Nolo.com) will use your input to customize an operating agreement that suits the needs of you and your co-owners and meets the requirements of your state’s laws.

Legal Entities, Licenses and Permits

How you form your business, and its legal structure, is one of the most important decisions you will make in the process of launching your venture.

The business entity

The pros and cons of different business formations are worth understanding. They vary by state—consequently this is not a good area for guesswork, and not a good place to save money, so please go through this with a local attorney you can trust. The following is for background information.

Although the details vary, it starts with the choice between sole proprietorship, partnership, corporation, or the more trendy Limited Liability Company, LLC. Within the corporation classification you have additional choices, between the standard corporation or the small business S corporation.

The simplest form is the sole proprietorship

The simplest form is the sole proprietorship. Simply put, your business is a sole proprietorship if you don’t create a separate legal entity for it. This is true whether you operate it in your own name, or under a trade name. If it isn’t your own name, then you register a company name as a “Fictitious Business Name,” also called a DBA (”Doing Business As”). Depending on your state, you can usually obtain this through the county government, and the cost is no more than a small registration fee plus a required newspaper ad, for a total of less than $100 in most states.

The main disadvantage of the sole proprietorship is the lack of a separate entity, which means you have personal responsibility for it. If the business fails then its creditors can go after your personal assets.

Tax treatment is quite simple, your profit and loss goes straight through to your personal taxes. Your business income is normally on Schedule C of your tax return. This can be good or bad for your tax situation, depending on where you stand with other income.

Partnerships

Partnerships are harder to describe because they change so much. They are governed by state laws, but a Uniform Partnership Act has become the law in most states. That act, however, mostly sets the specific partnership agreement as the real legal core of the partnership, so the legal details can vary widely. Usually the income or loss from partnerships pass through to the partners, without any partnership tax. The agreements can define different levels of risk, which is why you’ll read about some partnerships that have general partners and limited partners, with different levels of risk for each. The agreement should also define what happens if a partner withdraws, buy and sell arrangements for partners, and liquidation arrangements if that becomes necessary.

If you think a partnership might work for your business, make sure you do this right. Find an attorney with experience in partnerships, and check for references of present and past clients. This is a complicated area and a mistake in the agreement will cause a lot of problems.

Corporations

Corporations are either the standard C corporation or the small business S corporation. The C corporation is the classic legal entity of the vast majority of successful companies in the United States. Most lawyers would agree that the C corporation is the structure that provides the best shielding from personal liability for owners, and provides the best non-tax benefits to owners. This is a separate legal entity, different from its owners, which pays its own taxes. Most lawyers would also probably agree that for a company that has ambitions of raising major investment capital and eventually going public, the C corporation is the standard form of legal entity.

The S corporation is used for family companies and smaller ownership groups. The clearest distinction from C is that the S corporation’s profits or losses go straight through to the S corporation’s owners, without being taxed separately first. In practical terms, this means that the owners of the corporation can take their profits home without first paying the corporation’s separate tax on profits, so those profits are taxed once for the S owner, and twice for the C owner. In practical terms the C corporation doesn’t send its profits home to its owners as much as the S corporation does, because it usually has different goals and objectives. It often wants to grow and go public, or it already is public. In most states an S corporation is owned by a limited number (25 is a common maximum) of private owners, and corporations can’t hold stock in S corporations, just individuals.

Corporations can switch from C to S and back again, but not often. The IRS has strict rules for when and how those switches are made. You’ll almost always want to have your CPA, and in some cases your attorney, guide you through the legal requirements for switching.

LLC (Limited Liability Company)

Be careful with this one, because the LLC form is different for different states, with advantages in some states that aren’t relevant in others. An LLC is usually a lot like an S corporation, a combination of some limitation on legal liability and some favorable tax treatment for profits and transfer of assets. This is a newer form of legal entity.

Why would you establish an LLC instead of a corporation? That’s a tough legal question, not one we can answer here. Since the advisability and advantages varying from state to state, here again, this is a question to take to a good local attorney with small business experience.

See an attorney

Make sure you know which legal steps you must take to be in business. I’m not an attorney, and I don’t give legal advice. I do strongly recommend working with an attorney to go through the details of your company’s legal establishment, licenses, and other items covered here. By including this information in this book, I don’t mean to imply you should do it yourself.

The trade-offs involved in incorporation vs. partnership vs. other forms of business are significant. Small problems developed at the early stages of a new business can become horrendous problems later on. The cost of simple legal advice in this regard is almost always worth it. Starting a company should not involve a major legal bill except in special cases. Don’t skimp on legal costs.

Licenses and permits are usually local issues

It’s hard to generalize on licenses and permits, because some of these depend on where you are, and some depend on what you do. When in doubt, you should check with local sources. If you don’t want to go straight to the local government and ask your questions directly, then ask at a Chamber of Commerce, or Small Business Development Center (SBDC).

For example, many cities have zoning laws that define where you can put retail stores, office space, and industries. Few of these affect the small home-based business, but it’s not unusual to have zoning laws prohibit signs on lawns or houses.

Some types of businesses require local or state licenses. This depends on where you are, but businesses including daycare, hair care, food service, and of course bars and nighclubs often require special licenses.

Resale licenses and sales taxes

In states that have sales tax, state authorities manage a system that sets reseller businesses into a special category, so they don’t have to pay sales taxes on items they buy for resale. The required paperwork and the state offices that manage it are different in many states, so you’ll have to ask state offices for your state as you establish your business.

Taxpayer ID and employer numbers

Employer ID numbers (EIN) are assigned by the IRS and state tax authorities. If you don’t have employees and you haven’t established a corporation, then your Social Security number is your federal taxpayer ID. If you’ve established a corporation or you have employees, then you must have a federal EIN, which is assigned by the federal IRS. In most states, the state assigns a separate state number.