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Formalizing Your Sole Proprietorship

Blog entry by Gillian Katsumi
January 28, 2020
If you are thinking of starting or already have your own small business, you may be asking yourself, "what business structure is best for me?" and "how can I formalize my business?" The Sole Proprietorship is the most common business type because it is so simple to form—in fact, you may already be a Sole Proprietor without realizing it. Many people are under the impression that the only way to formalize their business is to incorporate; however, as this posting will explain, you can formally establish your business while maintaining the simplicity of the Sole Proprietorship business type. 
What is a Sole Proprietorship? 
A Sole Proprietorship is a one-owner business in which there is no distinction between the business and its owner; it is simply an extension of its owner; it is simply an extension of its owner and not considered a separate entity. If you own a Sole Proprietorship, you are entitled to all your business’ profits and likewise responsible for all its losses, debts, and liabilities. If your business has more than one owner, then it cannot be a Sole Proprietorship. 
Am I Already a Sole Proprietor? 
If you have a business but have not registered as another business type with the state of North Carolina, then you are probably a Sole Proprietor. In North Carolina, a Sole Proprietorship is formed when a single person starts a for-profit business—you do not have to fill out any paperwork for your Sole Proprietorship to be established. You may want to keep your business a Sole Proprietorship for your or the business’ life, or you may decide to change the entity type later on. This posting will review some of the advantages and disadvantages of Sole Proprietorships to help you better understand your options. 
Pros of Sole Proprietorship 
1. Easy and inexpensive formation.
As previously mentioned, Sole Proprietorships are very easy to form. There are no forms to complete, unless you want to do business under a trade name that is different from your legal name. For example, if Jane Smith runs a shoe retail business under the name Smith’s Super Shoes, she should file with her local government that she is doing business as this fictitious name. This prevents other people from using the same name in your area. Costs are minimal; contact your city or county register’s office for more information on specific fees and local licenses and permits you may need.
2. Complete control over your business.
As a Sole Proprietor, you have complete control over every business decision you make. You do not have to consult any other parties (e.g. partners, shareholders, directors) when making decisions or changes. 
3. Simple tax preparation.
A Sole Proprietorship is not considered to be a separate entity from its owner, so it is not taxed separately from your personal income. This makes filing income taxes significantly easier for the Sole Proprietor. You simply need to add the business’ income/loss to your other income using Schedule C on Form 1040 of your personal tax return. 
4. Avoid double taxation.
A major advantage of being a Sole Proprietorship is that your business will avoid any corporate double taxation. A Sole Proprietor only pays taxes on the business’ profit, and this tax rate is determined by the owner’s personal tax rate, not a corporate tax rate. Sole Proprietorships are only taxed once whereas C-corps are taxed on profits made from corporate net income and again on any dividend income distributed to the owners. You can find more information on Sole Proprietorship taxes here
Cons of Sole Proprietorship 
1. Personal liability for all business-related obligations.
As a Sole Proprietor, your business is not legally separate from you. Consequently, you are personally responsible for all business losses, debts, and liabilities. For example, if your business defaults on a loan, creditors can pursue your personal assets. Additionally, if a customer is harmed by your product or service, you are personally liable if a lawsuit is filed against your business; if they win, they may have access to all your assets. This is the biggest drawback of being a Sole Proprietorship and why many business owners choose to incorporate or become LLCs. Those business entities offer personal liability protection, which means that if your business fails, you will likely face no personal debts. However, you can have insurance for your business and many creditors may still want you to sign personal guarantees, linking you personally to your business. 
2. Difficult to raise money.
Sole Proprietors are not permitted to sell stock or other interests in their business which limits opportunities for investment. Banks may also be more hesitant to lend personal guarantees to a Sole Proprietorship due to a higher perceived risk of repayment in the event your business fails. These factors can make it challenging for Sole Proprietorships to raise money. 
Should I Form an LLC or a Sole Proprietorship? 
While a Sole Proprietorship provides you with no liability protection, a Limited Liability Company (LLC) will protect you from claims made against the business. When you form an LLC, the business becomes its own legal entity which can protect the business owner from the wrongdoings or negligence of employees. If an LLC is found liable for the actions of an employee, creditors can take the money or property of the LLC and/or the individual responsible, but the LLC owner is generally not personally responsible. However, as the name suggests, the protection provided by an LLC is limited—LLC owners are still personally liable for any negligence, wrongdoing, or malpractice they personally commit. 
A single-member LLC is taxed the same as a Sole Proprietorship, unless the owner elects to be treated as a corporation. This means you can still avoid double taxation as an LLC and your business’ activities will be reflected on your personal tax return, just like a Sole Proprietorship. Keep in mind that the extra protection an LLC provides you with is not free. Owners must file an Articles of Organization with the state they register in (the filing fee is $125 in NC), pay yearly fees to the state (the annual fee is $200 in NC) and follow specific rules to ensure the business is kept separate from personal assets. Tax preparation also becomes more complicated as owners are required to also file a Schedule K-1 tax form. 
While many recommend that business owners should always form an LLC, there are several reasons why remaining a Sole Proprietorship may be the best option for you:
1. You are not exposed to much liability.
If your business does not expose you to much liability, then you may not need the extra protection that other business entities provide. Being a Sole Proprietor does not mean you cannot be protected—you can easily obtain insurance, such as general liability insurance, to protect your personal assets from claims made against your business. Forming an LLC also does not necessarily mean you will be exposed to less liability, as many creditors want owners to sign personal guarantees. A personal guarantee is an individual's legal promise to repay credit issued to a business for which they serve as an executive or partner. Providing a personal guarantee means that if the business becomes unable to repay a debt then the individual is personally responsible. 
2. Your business makes less than $40,000 per year.
There are several tax benefits owners can receive from filing as an LLC rather than a Sole Proprietorship. Certain tax benefits are either not available to Sole Proprietorships or might be scrutinized more by the IRS when filing as a Sole Proprietorship. It can also be easier to deduct specific expenses as an LLC, especially LLCs that are taxed as S-corps. However, many of these tax benefits are not received by an unless your business is making around $40,000 - $50,000 each year. 
In summary, many of the benefits small business owners believe they will gain by forming an LLC or Corporation are illusive because these same benefits can be achieved as a Sole Proprietorship. If you are someone who prefers simplicity, then the Sole Proprietorship might be best fit for you. Even if you choose to remain a Sole Proprietorship, there are numerous measures you can take to formalize your business which are listed below. 
How to Establish Your Sole Proprietorship in North Carolina 
After weighing the pros and cons of various business types, you have decided to form a Sole Proprietorship. Here are 5 easy steps you should follow to formally establish your Sole Proprietorship in North Carolina: 
1. Register your business name.
In North Carolina, a Sole Proprietorship automatically assumes the legal name of its owner. However, you may elect to register an assumed name which will allow your business to use a name other than your personal legal name. Keep in mind, North Carolina law requires that this name be distinguishable from other businesses currently on record in the county where your business operates. You can check name availability with your County Register of Deeds Office. 
2. Complete a Certificate of Assumed Name.
If you elect to register your business with an assumed name, you must complete a certificate of assumed name with the County Register of Deeds Office where your Sole Proprietorship operates. As the Sole Proprietor, you must provide your name, address and social security number as well as report how long your business has existed and how long the assumed name has been used. There is a fee to file the certificate of assumed name, which may vary between counties. You can find more information on filing an assumed name in Durham County here
3. Acquire an Employer Identification Number (EIN).
If you do not have any employees, you are not required to obtain an EIN; instead, your business can operate under your Social Security Number. However, once you hire staff or set up a retirement plan, you will need to acquire a federal Employer Identification Number (EIN). Regardless, it is still a good idea to have an EIN as a security measure—the less people you give out your social security number to the better. It is completely free to obtain an EIN. Simply call the IRS at 1-800-829-4933 or apply online on the IRS’s website here. You will need to provide your name, social security number, home address, the name and address of the business and a description of your business activities. 
4. Register your business with the North Carolina Department of Revenue.
On the North Carolina Department of Revenue’s website, you must complete an online business registration form. This will allow you to register for sales and use taxes, machinery and equipment tax, and income tax withholding. You will need to provide the same information you provided to the IRS to obtain your EIN. You can fill out the form directly here
5. Obtain any necessary licenses and permits.
The licenses and permits your Sole Proprietorship will need to legally operate will depend on the nature of your business activities. Your business may not require any licenses, or it may need many if it is significantly regulated. For example, if your business sells any tangible goods to the public, you must have a seller’s permit. There are various specialized licenses and permits you may need depending on your business: zoning and land use permits may be necessary for home-based business operations; a permit from your fire department may be required if your business uses any flammable materials or if your premises will be open to the public; and you probably need a county health department permit if you plan to sell food. 
Other Ways to Formalize Your Sole Proprietorship 
Once you have completed the five steps above and successfully established your Sole Proprietorship, there are a few other important things to consider doing to further formalize your business: 
1. Open a bank account for your business.
It is important that you keep your business and personal finances separate—this will make preparing financial statements and tax returns significantly easier. An easy way to do this is to open a bank account for your business. You will most likely need to provide the bank with your SSN or EIN and a copy of your business name filing. You should also consider having a business credit card that will only be used for business expenses. 
2. Obtain insurance.
As a Sole Proprietor, the best way to protect yourself is to obtain insurance to cover any unexpected costs. Purchasing general liability insurance is a smart idea in the event your business fails. General liability insurance, also known as business liability insurance, protects you and your business from “general” claims involving bodily injury and property damage. General liability insurance can help cover medical expenses and attorney fees resulting from claims that may arise from your business operations. Sole Proprietors should also consider purchasing property and liability coverage, auto insurance (if you drive your personal vehicle for business), health coverage (if you are not insured by a former employer or under a partner’s policy), or disability coverage (if something happens where you are no longer able to work). 
3. Report and pay taxes.
It is extremely important to accurately report your business’ profits and losses and that you pay your taxes. To ensure that you are reporting the correct taxable income for your business, you should hire a professional bookkeeper or accountant before filing your tax returns. Depending on the nature of your business activities, the state may require that you report items such as sales tax and use tax. You can find more information about business-specific taxes here
Consult with a Legal Professional 
We recommend that all business owners consult with a tax advisor and legal professional before deciding on a business form. The experienced attorneys at Taibi Law Group are well-equipped to help you weigh all your options before starting your Sole Proprietorship.