When you are just getting started as a business owner, you should consider forming a sole proprietorship. You are able to easily and quickly set it up, naming yourself as the sole owner of the business. Yon are the business. The business is you. All profits (and losses) pass through to your personal return.
Advantages
• It is easy to set up. The IRS is notified of your sole proprietorship when you file your tax return on April 15 of the year following the tax year in question. All you have to do to become a sole proprietor is to say you are in business. This means that you are engaging in business activities in pursuit of profit.
• Any losses pass through to the owner’s personal income tax return, where they can be used to offset other taxable income.
• Owner is compensated using distribution of profit. This means the owner can pay him- or herself merely by writing a check whenever personal money is need (provided the business have the available cash). This eliminates the need to write oneself a payroll check, withhold taxes, pay employment taxes, or file a separate W-2.
• Bottom-line profit is considering "earned income." qualifying the owner for special "fringe benefit" treatment. Since the bottom-line profit is considering earned income to the sole proprietor, he or she can enjoy any fringe benefit that is based on earned income. A prime example of this is your eligibility for a retirement plan.
• As a sole proprietor, you can deduct 100 percent of health insurance premiums you pay for yourself and your family, up to the extent of your net profit.
• There are benefits to how to put money into and take money out of your business. You and the business are the same entity. Your business dollars are considered to be your personal dollars; therefore, there is no formal way to put dollars into your sole proprietorship except to deposit your personal dollars into the business checking account. This is also true if you obtain a business loan, since a loan to a sole proprietor is considered to be a personal loan that will be used for the business. You, as the owner, take dollars out of the business by paying yourself a distribution of profit.
Disadvantages
• Multiple ownership is not an option. Only one owner is allowed; if you plan to have more than one owner, you must select an alternative form of organization.
• Profits represent taxable income to the owner, whether or not they are distributed to that owner. Tax information is summarized on a Schedule C, Profit or Loss from Business. The bottom line of Schedule C is considered the profit (or loss) of the sole proprietorship and is included in the owner's individual tax return, Form 1040. This is called a pass-through of profit or loss, and therefore sole proprietors are personally liable for tax due on any profit; conversely, they can use a loss to offset other taxable income. As the owner, you are personally liable for tax due on this bottom-line profit. no matter how much you take out in the form of distribution of profit.
• Sole proprietorships are subject to scrutiny under the IRS's so-called hobby rule. If your sole proprietorship shows a profit on your Schedule C, the IRS will tentatively presume" that you are "in business" and intending to make a profit. If you show a profit for three of five years, the IRS will apply its "presumptive guideline" that you are in fact in business and attempting to make a profit, not merely engaging in a hobby (which would allow you to deduct expenses only up to the extent of any income). If you fail to show a profit for three of five years, the IRS will not automatically disallow your "in business" status, nor will it automatically reject the deductions you took for your business expenses. If required by the IRS. The burden is on you to prove that you are "in business" and intending to make a profit!
• Your profit is subject to self-employment tax. The bottom-line profit is considered earned income and is subject to self-employment tax equal to 12.4 percent of profit shown, up to $90,000 for Social Security, plus 2.9 percent of all profit for Medicare.
• You are subject to unlimited personal liability. As a sole proprietor, you are personally liable for any debts, judgments, or other successful legal claims against your business.
• There is no continuity after death. When the owner dies, the sole proprietorship ceases to exist.
Although the sole proprietorship form of business organization is often the best form to begin with, several intrinsic characteristics of a sole proprietorship make it less than desirable and in some instances very inappropriate, for your business.
The sole proprietorship form of organization allows only one (sole) owner; if there is more than one owner, this form is not an option. In addition, all profits of the sole proprietorship are considered earned income and therefore are subject to an additional tax of 15.3 percent (for Social Security and Medicare). Furthermore, the owner of a sole proprietorship is personally liable for the financial obligations of the business. This means that all the owner's personal assets are at risk for business debts and court judgments.