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Many people think they have to take some sort of legal action such as obtaining an operating license from a state or the federal government to become a sole proprietor, but that’s not true. You could be keeping track of clients’ financial records, doing their tax returns, writing content for their websites or mowing their lawns and be a sole proprietor. If someone pays you, as an individual, to do a job, you are a sole proprietor. If you have full time job, but do some freelance work on your own when you have time, you are doing so as a sole proprietor – unless you have created some entity like a corporation or LLC.
So what is a sole proprietor? By definition, a sole proprietor is someone who owns and runs an unincorporated business by himself or herself. As the Small Business Administration explains, sole proprietors are business owners and businesses ― and there is no distinction between the two.
Being a sole proprietor, though, does not mean you have no legal responsibilities. Nor does it mean that you should depend on your sole proprietorship for your full-time income.
You probably know the most important advantages of a sole proprietorship ― you make all the decisions and keep all the profits. Consequently, costs to start doing business are minimal and the business isn’t taxed separately, which cuts down on accounting and tax return preparation costs.
However, you should also be prepared for the disadvantages, the biggest of which is being personally liable for damages you cause in the course of doing business. Some customers and banks may shy away from you because you are not an incorporated company, which can appear unprofessional. Also, investors are unlikely to invest in sole proprietorships, because there are no shares of stock or other fractional ownership units they can purchase.
If your profession requires licensure, you still need to have the proper license to operate your sole proprietorship. For example, if you cut hair or are an attorney, you are required to have a current license from the state of Arizona. If you aren’t sure whether you need a license, your attorney or the Small Business Administration can help guide you to the proper licensing agencies.
Sole proprietors usually can deduct the cost of their health insurance, as well as the health insurance costs of their spouse and dependents. They can also deduct the costs of other business expenses from their tax returns, including home office expenses if they work at home as well as the cost of work-related entertainment, equipment, meals and travel.
You should keep records that prove business-related expenses, such as meals and travel, because the IRS tends to look closely at tax returns from individuals who claim to be sole proprietors, says Intuit.
If you are going to continue solo operations for a long time, your attorney and accountant will probably advise you to consider forming an LLC. The LLC limits your personal liability, as the name suggests, if the company is sued or defaults on a loan. Setting up an LLC is easy, and most of it can be done online; an experienced attorney can also expedite the process.