Are you looking to leave the corporate world and start your own business? One of the first things to consider is how to structure your new company. Today we will look at the most basic type of business entity: the sole proprietorship.
A sole proprietorship is the easiest type of business to form. In fact, unless you plan on hiring an employee right away then a federal identification number (FEIN, or EIN) from the IRS is not necessary. Just make sure to open a separate bank account so that all business transactions will be separate from personal transactions. If you plan on using credit cards to pay for expenses then designate one or two that will only be used for business purposes going forward to ease the burden when it comes time to put together your financials.
The main advantage of a sole proprietorship is the tax reporting requirements. Instead of filing Form 1065 or Form 1120-S, which are complex and 5+ pages in length, a sole proprietorship can file their taxes on Schedule C. Schedule C is a two-page form where that lists business income and business expenses for the year. No Balance Sheet is required.
The main disadvantage of a sole proprietorship is the self-employment tax. Not only will your business profit be subject to income tax, it will be subject to an additional 15% self-employment tax. For example, a business that earns $100,000 will pay roughly $15,000 in self-employment tax and income tax at their individual tax rate. Forming an S-Corporation can eliminate at least 50% of the self-employment tax.
Sole proprietors must make estimated tax payments at the end of each quarter to the IRS and applicable states to cover at least 90% of their current year tax liability or 100% of their prior year tax liability to avoid penalties and interest on their tax return.