What is a Sole Proprietorship?

A sole proprietorship is one of the most basic business types. It is also the most inexpensive and simple way to start a business. All that is needed to establish a sole proprietorship is for the single business owner to obtain necessary licenses and permits. After that, you can start doing business without any additional steps required. Owners of sole proprietorships are considered to be self-employed.

Sole Proprietorship: Tax Identification Number

In the early stages of running a sole proprietorship, most business owners usually use their own social security number as the tax identification number for the business. This is a quick and simple way to get your business up and running without having to do any additional paperwork. However, you can also get an Employer Identification Number (EIN) from the Internal Revenue Service. This number functions like a social security number for your business but is an identification number issued by the IRS specifically for your business. The advantage of an EIN is that it will limit the number of documents with your social security number on it, which can help you to keep your personal identification number safe and prevent it from being misused. Sole proprietors must get an EIN if they wish to hire employees, and if you want to open a business bank account.

Sole Proprietorship: Taxation

Regarding profits, a sole proprietorship is considered a “pass-through” business. That means that the profit from your business, or the money that remains after you pay all your expenses, is included on your Schedule C of your 1040 and will “pass through” to your personal tax return as your income. Business owners who file an IRS 1040 with a Schedule C or receive a K-1 for self-employment income are taxed at the self-employment rate of 15.3% and their personal income tax rate. Pass-through entities will only experience this one layer of taxation with profits treated the same as your income. What this means is that when a business is a pass-through entity, the business profits are taxed as the owner’s personal income at their personal rate. The profits for businesses that are not considered pass-through entities are taxed twice: First on the business level on corporate tax returns, and again once remaining profits are distributed to shareholders as a dividend.

It's important to remember that as a sole proprietor you are the business, and the business is you. This means that in terms of taxes and liability, there is no separation between the sole proprietorship and the business owner. For example, if you have business debt, your personal assets are not protected and can be legally seized if you were to default on a loan. On the positive side, a sole proprietorship is inexpensive to start and maintain each year, and you have full control over all business decisions.


What is a Coporation?

Most basically, a corporation is a business that has been incorporated resulting in a separate “corpus,” or body. Where a sole proprietorship is not separate from the business owner in terms of taxes, liability, and debt, a corporation is a legal entity that is separated from yourself as the owner. There are undoubtedly benefits to this legal separation between business and business owner, though this comes with some additional effort (such as annual filings and a separate tax return) that is needed in setting up the corporation and maintaining it. In terms of liability, your personal property and money are usually protected from outstanding debts of the corporation. In terms of taxes, some corporate forms, like those for the S corporation or nonprofit corporations can provide some tax advantages, which will be discussed in the following section.

There are five corporation types that you will most likely consider:

• Nonprofit corporations
• C Corporations.
• S Corporations.
• Partnerships.
• Limited Liability Companies (LLCs).

Nonprofit corporations are “charities,” public-serving companies that are not owned by an individual. Instead, they have a board of directors, who are typically not employees, that lead the organization. Nonprofits can be difficult to manage day-by-day since the director of the corporation will need approval from the board of directors to make key decisions. Additionally, since the organization is not supposed to be operating for the generation of profit, there are several rules about how money must be spent. On the positive side, nonprofits are typically exempt from most federal, state, and local taxes and may be eligible for some government and foundation grants

The remaining corporation types are for-profits, meaning that they are “owned” by people or other corporations and are intended to provide profit for those owners.

Most of the large companies you see and hear about are C corporations. The C corporation is owned by shareholders. This structure is easier for large enterprises since it allows ownership to be transferred through shares. They are also the most complex in terms of their legal requirements and the most expensive to run in terms of administrative fees and taxes. They also suffer from “double taxation,” that is the profit from the company is taxed at a corporate rate and then the owners need to pay additional income taxes on it. For most child care businesses, the additional efforts of a C corporation in terms of paperwork and taxes will likely outweigh the benefits.

In reaction to the complexities of owning a C corporation, the federal government created a small-business version, called an S corporation. The S corporation is a separate legal entity from you personally (like a C corporation) but is limited in the number of owners. Like a sole proprietorship, the S corporation is a “pass-through” entity, which means that any profit you take out of an S corporation flows into your personal taxes, so it is usually a less complex structure to manage throughout the year and at tax time. The structure also means that the corporation itself is not receiving profits (they flow to your personal taxes); therefore, you typically are not subject to corporate taxation in addition to income taxes.

As an S corporation you can also pay yourself a reasonable salary as a w-2 employee (which does get taxed as wages) but then any profit above this salary is only subject to income tax.

A partnership is a business where two or more individuals share ownership. Each person contributes equally in terms of the investments of the business but also shares the profits and losses of the organization in the same way. Because of the nature of the partnership involving shared governance, typically there are very explicit processes to address how to resolve disputes, share profits, and change ownership. Partnerships are usually inexpensive to set up, but they also have shared liability and governance.

We saved the most typical company classification for last – the limited liability company, or LLC. LLCs usually offer small business owners the greatest ease at start-up, flexibility, and ownership. LLCs can be owned by one or more individuals and are governed first and foremost by your state. This means that they are a state-level corporation, not a federal one. For your federal taxes, you need to let the IRS know how you want to be taxed. That means when you start the LLC, and again each year, you can “choose” which type of corporation you want to be treated as for tax purposes. This means that when you begin your business, you can start being taxed the same way as a sole proprietorship when your business is small. As you begin to grow, you can elect to be treated as an S corporation or C corporation. In addition to having some flexibility around taxation, LLCs typically also cost less to start up and maintain with the state.