Legal Structure
A sole proprietorship is the simplest form of business there is. You simply go out and start working. You are not required to enter into any agreements or file any documents with the government to create a sole proprietorship. However, you may in some jurisdictions be required to register your business name (if you conduct your business under an assumed name such as 'Joe's Painting Company'.)
This is the format that most small businesses operate under as it is the most basic and informal form of conducting a business. It can have as many employees as necessary, but it can only have one owner.
Accounting
The sole proprietorship does not have a separate financial structure. Although the business needs to keep its own set of bookkeeping, all financial assets and liabilities are considered to belong to the individual owning the business. For instance, the sole proprietorship may borrow money to finance the business, but the business owner will be totally responsible for its repayment. The interest expense may be deducted against the business profits to the extent that the money is used for business purposes.
Not only should you keep separate sets of books for business and personal, but you should also set up separate banking accounts (checking, savings, loans) for the business. This creates a better audit trail to prove the deductions you take are for business expenses. It is important to properly document your deductions not only to reduce the owner's personal taxes, but also the business's payroll taxes (Social Security, Medicare) which are over 15% of your net profit.
What really shocks most new sole proprietors is the fact that between payroll taxes and regular income taxes - your tax liability will exceed 25 of your net profit. This is why it is so important to keep good books to make sure your net profit is correct. We will go into this in more detail on the next page.
Considerations
The owner of a sole proprietorship is completely liable for anything their business does. In some countries, this can come in the form of a lawsuit against the business which could strip you of everything you own. There are a couple of things you can do to help protect yourself. The first is to purchase an umbrella liability insurance policy. A million dollar policy is usually sold on an annual basis and they are reasonably priced.
In most states, you may form a single-member limited liability company (LLC) which may be taxed as either a corporation or a sole proprietorship, whichever the owner decides. LLCs are by default taxed as sole proprietorships unless you elect to be taxed as a corporation. Thus you get the benefits of limited liability, with the advantages of passthrough taxation and easier filing requirements. (There will be more on this format later in this course.)